Document of The World Bank FOR OFFICIAL USE ONLY Report No. 62869-BR INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PROGRAM DOCUMENT ON A PROPOSED EXPANDING OPPORTUNITIES, ENHANCING EQUITY IN THE STATE OF PERNAMBUCO DEVELOPMENT POLICY LOAN IN THE AMOUNT OF US$500 MILLION TO THE STATE OF PERNAMBUCO WITH THE GUARANTEE OF THE FEDERATIVE REPUBLIC OF BRAZIL February 16, 2012 Poverty Reduction and Economic Management Department Brazil Country Management Unit Latin America and the Caribbean Region This document is being made publicly available prior to Board consideration. This does not imply a presumed outcome. This document may be updated following Board consideration and the updated document will be made publicly available in accordance with the Bank’s policy on access to information. BRAZIL - GOVERNMENT FISCAL YEAR January 1-December 31 CURRENCY EQUIVALENTS (Exchange Rate Effective as of November 18, 2011) Currency Unit Real (R$) US$1.00 R$1.77 WEIGHTS AND MEASURES Metric System ABBREVIATION AND ACRONYMS AGEFEPE Development Agency of the State of Pernambuco APAC Agency for Water and Climate BACEN Brazil Central Bank CAF Andean Development Corporation CAS Country Assistance Strategy COMPESA Pernambuco State Water Supply and Sanitation Company CPS Country Partnership Strategy DPL Development Policy Loan EIU Economist Intelligence Unit FDI Foreign Direct Investment FPE State Participation Fund FUNAFIN Retirement and Pension Financial Fund of State of Pernambuco FUNDEB Fund for the Development of Basic Education and Valuing of Education Professionals FUNDEF Fund for the Development of Fundamental Education and Valuing of Education Professionals FY Fiscal Year GDP Gross Domestic Product GFS Government Finance Statistics GOP Gross Operating Balance HDI Human Development Index HFA Hyogo Framework for Action HOI Human Oportunity Index IBC Central Bank - Indicator of Economic Activity IBGE Brazilian Institute of Geography and Statistics IBRD International Bank for Reconstruction and Development ICMS Tax on Goods and Services IDA International Development Association IDB Inter-American Development Bank IFC International Finance Corporation IGP Prices General Index IMF International Monetary Fund IOF Tax on Foreign Transactions IPCA National Index of Consumer Price i IPVA Property Tax on Motor Vehicles LOA Annual Budget Law LDO Budget Law Guidelines LRF Law of Fiscal Responsibility MAR Metropolitan Area of Recife MSME Micro, Small, and Medium Enterprise NCD Net Consolidated Debt NCR Net Consolidated Revenue NGO Non-Governmental Organization PAF Fiscal Adjustment Program PBM Planning, Budgeting and Management PE Management Institute of Pernambuco PEFA Public Expenditure Financial Accountability Assessment PFM Public Financial Management PNAD National Household Survey PPA Multi-year National Plan PRONAF Programa Nacional de Fortalecimiento da Agricultura Familiar PSIA Poverty and Social Impact Analysis RLC Net Revenue SAD Management Secretariat SAEPE Educational Evaluation System of Pernambuco SECGE Special Secretariat of the General Controller of the State SEF-2 Sistema de Escrituracao Fiscal e Contábil 2 SEFAZ Department of Finance SENAC National Commercial Training Service SENAI National Service for Industrial Apprenticeship SEPLAG Secretary of Planning and Management SME Small and Medium Enterprise SUS Unified Health System SWAp Sector Wide Approach TCE Court of Auditors of the State of Pernambuco WEO World Economic Outlook WRM Water Resource Management Vice President: Hasan Tuluy Country Director: Makhtar Diop Sector Manager: Louise Cord Sector Leader: Pablo Fajnzylber Task Team Leader: Luis F. López-Calva Co-Task Team Leaders: Indu John-Abraham and Marcos Thadeu Abicalil ii BRAZIL EXPANDING OPPORTUNITIES, ENHANCING EQUITY IN THE STATE OF PERNAMBUCO DPL TABLE OF CONTENTS I. INTRODUCTION ........................................................................................................................................ 1 II. COUNTRY CONTEXT ............................................................................................................................... 3 A. RECENT ECONOMIC DEVELOPMENTS IN BRAZIL ......................................................................... 3 B. RECENT SOCIOECONOMIC AND FISCAL DEVELOPMENTS IN PERNAMBUCO ........................ 9 III. THE GOVERNMENT’S PROGRAM AND PARTICIPATORY PROCESSES ................................. 19 A. THE GOVERNMENT PROGRAM ........................................................................................................ 19 IV. BANK SUPPORT TO THE GOVERNMENT’S PROGRAM ............................................................... 21 A. LINK TO COUNTRY PARTNERSHIP STRATEGY (CPS) FOR FY12-15 .......................................... 21 B. COLLABORATION WITH THE IMF AND OTHER DONORS ........................................................... 22 C. RELATIONSHIP TO OTHER BANK OPERATIONS ........................................................................... 23 D. CHOICE OF INSTRUMENT AND RELATIONSHIP TO OTHER BANK OPERATIONS.................. 25 E. LESSONS LEARNED ............................................................................................................................ 26 F. ANALYTICAL UNDERPINNINGS ...................................................................................................... 28 V. THE PROPOSED OPERATION: EXPANDING OPPORTUNITIES, ENHANCING EQUITY IN THE STATE OF PERNAMBUCO .................................................................................................................... 30 A. OPERATION DESCRIPTION ................................................................................................................ 30 B. POLICY AREAS ..................................................................................................................................... 31 VI. OPERATION IMPLEMENTATION....................................................................................................... 52 A. POVERTY AND SOCIAL IMPACTS .................................................................................................... 52 B. ENVIRONMENTAL ASPECTS ............................................................................................................. 52 C. IMPLEMENTATION, MONITORING AND EVALUATION .............................................................. 55 D. FIDUCIARY ASPECTS ......................................................................................................................... 55 E. DISBURSEMENT AND AUDITING ..................................................................................................... 58 F. RISKS AND RISK MITIGATION .......................................................................................................... 59 VII. ANNEXES .............................................................................................................................................. 60 ANNEX 1: LETTER OF DEVELOPMENT POLICY ...................................................................................... 60 ANNEX 2: OPERATION POLICY MATRIX.................................................................................................. 67 ANNEX 3: MACRO ECONOMIC OUTLOOK AND DEBT SUSTAINABILITY IN THE STATE OF PERNAMBUCO ............................................................................................................................................... 73 ANNEX 4: POVERTY AND SOCIAL IMPACT ASSESSMENT (PSIA) ..................................................... 93 ANNEX 5: GENDER AND POVERTY IN PERNAMBUCO....................................................................... 109 ANNEX 6: FUND RELATIONS NOTE ........................................................................................................ 122 ANNEX 7: STATEMENT OF LOANS AND CREDITS .............................................................................. 125 ANNEX 8: COUNTRY AT A GLANCE ....................................................................................................... 127 iii List of Tables: Table 1: Brazil - Key Macroeconomic Indicators and Projections, 2005-2015 ......................... 4 Table 2: Fiscal Indicators ......................................................................................................... 12 Table 3: Access to Sanitation Services (%) Pernambuco, 1999-2009. .................................... 18 Table 4: Summary of Proposed Policy Actions for Expanding Opportunities, Enhancing Equity in the State of Pernambuco DPL................................................................................... 32 Table 5: Progress in Pernambuco Education over Time (2000-2010) ..................................... 36 List of Figures: Figure 1: Growth, Poverty and Inequality ................................................................................ 10 Figure 2: Unemployment Rate (%)—12-months Average ....................................................... 11 Figure 3: Real GDP Growth (%) .............................................................................................. 11 Figure 4: Tax Revenue and ICMS collection Performance—Pernambuco.............................. 12 Figure 5: Evolution of Debt and Debt Service during 2004-2010 ........................................... 13 Figure 6: Difference in the Share of the Population Living in Poor Household between Pernambuco and Brazil, 1995-2009 ......................................................................................... 14 Figure 7: HDI at Municipality Level ........................................................................................ 14 Figure 8: Human Opportunity Index (HOI) for Pernambuco ................................................... 15 Figure 9: Estimated Number of Years Required to Achieve Universal Access (HOI = 100%) .................................................................................................................................................. 15 Figure 10: Age-Grade Distortion and Dropout Rates for Pernambuco Relative to Brazil, 2010 .................................................................................................................................................. 17 Figure 11: Pernambuco State Schools’ Education Performance Relative to all States in Brazil, 2009 (Pernambuco Highlighted) .............................................................................................. 18 Figure 12: Participation Rates in All for Pernambuco Regional Seminars .............................. 20 Figure 11: Brazil FY12-15 CPS Strategic Objective and Result Areas ................................... 22 Figure 12: Complementarity of DPL and Investment loans ..................................................... 26 List of Boxes: Box 1: Brazilian Fiscal Federalism and the Control of Sub-National Fiscal Performance ........ 8 Box 2: Pernambuco’s Management Model .............................................................................. 20 Box 3: Bank Historical Support to Pernambuco ...................................................................... 24 Box 4: Good Practice Principles for Conditionality ................................................................. 31 Box 5: Bank Engagement in Education in Pernambuco and Implications For Extended School Hours ........................................................................................................................................ 38 The Expanding Opportunities, Enhancing Equity Development Policy Loan was prepared by an IBRD team consisting of Luis Felipe López-Calva (Task Team Leader, LCSPP), Marcos Thadeu Abicalil (co-Task Team Leader, LCSUW), Indu John-Abraham (co-Task Team Leader, LCSPP), Erik Alda (LCSPP), David Evans (LCSHE), Pilar Gonzalez (LEGCF), Mariano Lafuente (LCSPS), Miriam Muller (LCSPP), Ane Castro de Orsi (LCSPP), and Aude-Sophie Rodella (LCSPP). The team received very valuable contributions and inputs from Francisco Carneiro (OPCCE), Gabriel Facchini (LCSPP), Sol Garson (LCSPP), Jorge Jatobá (LCSPP), Edith Kikoni (LCSPE), Gunars Platais (LCSEN), Megan Zella Rounseville (LCSPP), Seynabou Sakho (LCSPE) and Rogerio Santarrosa (LCSPP). This operation was undertaken under the general guidance of Makhtar Diop (Country Director, LCC5C), Rodrigo Chaves (Sector Director, LCSPR), Louise Cord (Sector Manager, LCSPP), Pablo Fajnzylber (Sector Leader, LCSPR). Peer reviewers were Harry S. Patrinos (Lead Education Economist, HDNED), Fernando Blanco (Senior Economist, AFTP4), Andrew L. Dabalen (AFTP3). iv LOAN AND PROGRAM SUMMARY BRAZIL EXPANDING OPPORTUNITIES, ENHANCING EQUITY IN THE STATE OF PERNAMBUCO DPL The State of Pernambuco, Brazil, with a Guarantee of the Federative Borrower Republic of Brazil. Secretaria de Estado de Planejamento e Gestão de Pernambuco Implementing Agency (SEPLAG) US$500 million with a sovereign guarantee from the Federative Financing Data Republic of Brazil Operation Type One tranche of US$500 million Main Policy Areas Economic Development, Education, Water and Disaster Risk Management, and Public Sector Management The key outcome indicators are as follows  Additional 32,881 secondary school students enrolled in schools providing 40 hours of instruction per week  Additional 12,261 secondary school students enrolled in schools providing 32 hours of instruction per week  Additional 28,970 secondary school students enrolled in integral and semi-integral schools outside of the MAR  212 water rights for groundwater and 188 water rights for surface water issued by APAC  Four additional reservoir management committees for water basins created in the interior of the state (Terra Nova, Brigida, Garças e Key Outcome Pontal) Indicators  Cadastre of water users established for the water basins of Ipanema, Pajeú and Moxotó  Population in additional 37 municipalities covered by the monitoring alert system of APAC  Additional 4,124 secondary school students enrolled in professional education schools, including 1,935 outside the Metropolitan Area of Recife  Additional 2,000 public employees trained on gender issues related to their public responsibilities  Twelve regional coordinators of the Women’s Affairs Secretariat hired, to work in each of the 12 regions within the State  Financing and training provided to 16 new productive projects in specific value chains in the interior of the State through the State Development Agency  ICMS Revenues increased by 3.3 percentage points of State’s v GDP by reducing tax evasion, without increasing tax burden  Real growth of ICMS revenues at 24.3% above projected inflation 2010-2012  Seventy-five percent of approved budget executed for Strategic Priorities  Number of budgetary revisions approved during the year of execution reduced by 10 percent  Three Social Management Reports produced and published online per year (covering periods of four months each) Program Development Objective is to strengthen public policies that expand economic opportunities and enhance equity of access to quality services for the people of Pernambuco. Program Development The proposed operation is fully aligned with all four of the strategic Objective(s) and priorities identified under the FY12-15 World Bank Group Country Contribution to CAS Partnership Strategy (CPS) for Brazil. The operation specifically focuses on promoting a more equitable, sustainable and competitive Pernambuco by supporting the State’s agenda of interiorização, integrating the hinterland more closely into the development of the State. More specifically, the program supports the establishment of a policy and regulatory framework in the State to comprehensively address issues of social inequity and gender inclusion, with emphasis on the non-metropolitan areas. The operation faces a series of risks, including: (i) institutional risks due to low capacity in targeted areas under the operation; (ii) social risks related to potential distributional impacts on segments of the population; and (iii) economic and fiscal risks related to prudent management of the State of Pernambuco’s fiscal position in an uncertain global environment. In order to mitigate against these risks, the Bank and the Borrower have conducted a thorough analysis of the Risks and Risk poverty and social impacts, as well as the strength of the fiscal Mitigation position of the State under different scenarios. The results show that the distributional impacts of the policies supported by the operation are unambiguously positive. The fiscal position of the State is strong and shows that there is room to manage potential shocks that are not under the control of the State. With regards to institutional risks, the Bank has initiated a dialogue with the Borrower on its plan for capacity building. Operation ID P106753 vi INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PROGRAM DOCUMENT FOR A PROPOSED EXPANDING OPPORTUNITIES, ENHANCING EQUITY IN THE STATE OF PERNAMBUCO DEVELOPMENT POLICY LOAN I. INTRODUCTION 1. The proposed operation is envisaged as a one tranche Development Policy Loan (DPL) to the State of Pernambuco in the amount of US$500 million. The operation consolidates the Bank’s long-term engagement with the State of Pernambuco, particularly in the areas of education, water resource management, public sector management and poverty reduction. The operation will support the State’s strategy to reduce inequality, particularly in the context of the Government’s agenda of interiorização. The latter is a strategy for balanced regional development throughout the State that aims to expand economic opportunities and reduce inequities in access to public services, quality education, and jobs. 2. The State of Pernambuco is the second largest economy in northeast Brazil. It is also one of the poorest, most poorly educated and most vulnerable states to natural and social hazards. Pernambuco accounted in 2009 for 2.4 percent of the national gross domestic product (GDP), while its population—9 million inhabitants— represented 4.6 percent of total national population. Like other northeastern states, it has long lagged behind the rest of Brazil, with a GDP per capita, also in 2009, of R$8,901.9—about half of the national average. Pernambuco’s GDP growth performance was also below the rate for Brazil and the northeast during the last decades of the twentieth century (World Bank, 2002). Social outcomes are also below the national average in Pernambuco. In 2009, the share of the population below the poverty line was twice that of Brazil and well above the Northeastern average. On most measures of quality, schools lag behind those in the rest of the country. Life expectancy in Pernambuco is below the Brazilian average (68 years in the State versus 69.3 years nationwide) (IBGE). The incidence of contagious diseases such as tuberculosis and dengue fever is significant and poor sanitation conditions prevail.1 The state is also very exposed to natural disasters. Occupation of the semi-arid region and urbanization in the coastal area has made the State vulnerable to both droughts and flooding. 3. Pernambuco remains a very unequal State with highly concentrated economic opportunities and strong spatial disparities. Divisions exist along several dimensions, including geography, ethnicity, gender, and sector of economic activity. Household per capita income in the interior of the State was half that of the Metropolitan Area of Recife (MAR) in 2009; more than 70 percent of the State’s GDP is produced in the coastal area and poverty rates are systematically higher in non-metropolitan areas. Moreover, ethnic and racial origins, as well as gender overlap with geographic factors to aggravate inequities: poverty incidence among the non-white population in the interior of the State is four times higher that of the white population in the MAR. Economic opportunities for women are more limited than those for men throughout the State, and lower quality employment and labor force participation are more prevalent in the interior. The average income gap between male and female employees is about 20 percent after controlling for hours worked and individual characteristics of the 1 See: www.datasus.gov.br 1 workers. Natural risk factors are also framed along geographic lines and coincide with areas of high poverty, further aggravating opportunities for balanced poverty reduction. 4. The geographic dimension of inequality is particularly salient, and economic progress has not been shared equally within the State. Access to social services and their quality are geographically imbalanced. Divergence in education enrollment rates between metropolitan and non-metropolitan areas remain significant at the secondary school level, with 33 percent enrollment of 15-17 year olds in the interior, as compared with nearly 50 percent of their counterparts in the MAR in 2009. The same pattern holds with the State’s scarce water resources. Eighty-nine percent of households in the MAR had access to water, compared to only 66 percent of the households in the interior in 2009. Access to water has a strong bearing on health outcomes, such as child and maternal mortality. These inequities have made it difficult to enhance social cohesion and productivity, and the State has selected them as a priority to be tackled by ongoing reforms. 5. The State faces two main challenges: to consolidate its current growth rate; and, to turn the recent higher growth into lower poverty and inequality outcomes. Following more than two decades of low and declining growth, in 2003, Permanbuco started an accelerated growth period, with growth rates on par with the national average. This economic rebound was further supported by the development of the Suape Port in 2007, which helped shift the drivers of growth from agriculture to industry. The port has attracted a massive influx of public and private investments to MAR. 6. In order to tackle socioeconomic challenges, the State has to boost investment. After stagnating since the eighties, investment levels have doubled since 2004 (as percentage of net consolidated revenue) and are expected to continue growing for the next ten years. This expansion will only be sustainable if the improvement in the State’s revenue generating capacity is accompanied by an increase in borrowing, taking advantage of the current low debt ratio. Due to growing fiscal revenues and consistent fiscal adjustment, net consolidated debt fell steeply from over 104 percent of net consolidated revenue in 2004 to 39 percent by 2010, well within the 200 percent limit imposed by the Law of Fiscal Responsibility. 7. The proposed DPL is a multi-sectoral operation integrating growth and equity- oriented policy reforms that are directly linked to the strategic objectives outlined by the Pernambuco Government in its Strategy Map. The three main areas of the Strategy Map are: i) Improving the quality of life of the citizens of Pernambuco, by improving access to quality services and protecting the citizens and their property from crime and climate- related hazards. ii) Changing the pattern of growth (the so-called New Economy) by strengthening linkages between the most dynamic sectors and the rest of the State’s economy. iii) Establishing conditions for better government, by increasing the capacity and efficiency of public administration to generate concrete results for the citizens of Pernambuco. 8. This DPL aims to support policies that will enable the conditions for a sustainable growth path and a more equitable economy and society. The equity dimensions of the operation relate to three specific dimensions: (i) a more even distribution of 2 economic activity throughout the State; (ii) more opportunities for disadvantaged socioeconomic groups, mainly through regional targeting of interventions; and (iii) an emphasis on horizontal equity, particularly in relation to gender. 9. The proposed operation seeks to further the Government’s reform agenda to increase opportunities for development, while addressing issues of equity among traditionally excluded groups. The reforms supported by the DPL deepen recent progress in Pernambuco by focusing on key sectors, such as water, education, public sector reform, and economic development, while ensuring that the benefits of the reforms reach vulnerable populations in the interior as well as women. The Program is fully aligned with the priorities of the World Bank Group’s Country Partnership Strategy 2012-2015 (Report # 63731-BR) (CPS) to promote a more equitable, sustainable and competitive Pernambuco, including the integration of a strong gender focus. The program also facilitates the Bank’s strategic engagement in key areas of the State’s development plan. II. COUNTRY CONTEXT A. RECENT ECONOMIC DEVELOPMENTS IN BRAZIL 10. Brazil’s relative resilience to the global financial crisis reflected good macroeconomic management and a solid financial system. Following the global crisis in September 2008, Brazil suffered a sudden reduction in external and domestic credit, and significant currency depreciation. Rapidly falling external demand and a sharp decline in investment led to a 4.2 percent contraction in gross domestic product (GDP) in the fourth quarter of 2008 followed by a 2 percent decline in the first quarter of 2009. The recession, however, lasted only those two quarters. Prompt response by the authorities avoided a credit crunch, and mitigated the impact of the global financial crisis on the Brazilian economy, which recovered rapidly. Fiscal policy was appropriately countercyclical in 2009 and remained expansionary in 2010, driven by strong rigidities in current expenditures, the political cycle, and difficulties in quickly reversing the countercyclical measures enacted in the previous year. After contracting by 0.6 percent in 2009, the economy grew at a 7.5 percent annual rate in 2010. 11. At least until mid 2011, large portfolio inflows exerted a strong upward pressure on the real and were accompanied by growing private sector indebtedness. The currency, which had already appreciated by 11.9 percent in 2010, traded at a high of R$1.59 per US dollar at the end of August 2011, a 44 percent appreciation since the start of 2009. The Central Bank rapidly accumulated international reserves, reaching US$350 billion in November 2011 (up from US$238.5 billion in December 2009). This was accompanied, however, by an increase of about 50 percent in Brazil's external debt, from US$198 billion in 2009 to US$301.5 billion in end-November 2011, of which 15 percent had a maturity of up to 360 days. Broadly defined gross external debt, however, including intercompany loans and nonresident holdings of domestic fixed income instruments, has also increased significantly, from US$373.4 billion to US$537.3 billion between 2009 and November 2011. Private sector gross external indebtedness, in particular, rose 65 percent over this period, reaching US$344.5 billion. The biggest increase occurred among banks, whose gross external debt reached $140.7 billion, a 121 percent increase with respect to December 2009. 3 12. To address risks of overheating, in 2010 the Central Bank adopted a contractionary monetary policy stance, complemented with a tighter fiscal policy in 2011. Consumer price inflation (IPCA), as measured by the Brazilian Institute of Geography and Statistics (IBGE), closed 2010 at 5.91 percent. To control inflation, the Central Bank increased the policy rate by 375 basis points, starting in April 2010, to 12.5 percent in June 2011. Furthermore, in February, 2011, the Government announced cuts in budgeted expenditures of R$50 billion, which, coupled with strong revenue performance enabled it to generate a primary surplus of 3.1 percent of GDP in 2011, compared to 2.4 percent in 2010 (see Table 1 for Key Macroeconomic Indicators). Table 1: Brazil - Key Macroeconomic Indicators and Projections, 2005-2015 Est. Projection Indicator 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 National Accounts (annual real percent change, unless noted) Real GDP Growth (%) 3.2 4.0 6.1 5.2 -0.6 7.5 2.9 3.0 4.0 5.0 4.2 (in percent of GDP, unless noted) Gross domestic investment 15.9 16.4 17.4 19.1 16.9 18.4 19.6 20.5 21.2 21.4 21.4 Public sector 2.5 2.5 2.6 2.9 3.0 3.2 3.2 3.2 3.2 3.3 3.3 Private sector 13.5 13.9 14.8 16.2 13.9 15.2 16.4 17.3 18.0 18.1 18.1 External Sector (in US$ billions, unless noted) Current account 14.0 13.6 1.6 -28.2 -24.3 -47.5 -52.6 -65.5 -69.2 -94.7 -104.3 Trade balance 44.7 46.5 40.0 24.8 25.3 20.3 29.8 19.8 15.0 -5.7 -6.3 Exports (fob) 118.3 137.8 160.6 197.9 153.0 201.9 256.0 258.9 272.0 296.9 330.0 Imports (fob) 73.6 91.4 120.6 173.1 127.7 181.6 226.2 239.1 257.0 302.6 336.3 Nonfactor services, net -8.3 -9.6 -13.2 -16.7 -19.2 -31.1 -31.9 -37.8 -40.9 -44.5 -47.5 Income and current transfers, net -22.4 -23.2 -25.3 -36.3 -30.3 -36.7 -50.5 -47.4 -43.3 -44.5 -50.5 Direct investment, net 12.5 -9.4 27.5 24.6 36.0 37.0 63.2 58.9 63.1 67.3 71.7 Portfolio investment, net 4.6 4.3 37.9 3.5 50.5 57.8 39.4 25.9 26.4 28.8 31.2 Gross international reserves 53.3 85.2 179.5 192.9 237.4 287.5 352.0 359.8 369.7 379.8 399.0 Current account (% of GDP) 1.6 1.2 0.1 -1.7 -1.5 -2.3 -2.3 -2.6 -2.5 -3.2 -3.3 Non Financial Public Sector (in percent of GDP, unless noted) Total Revenues and Grants 35.8 35.9 35.7 36.6 36.1 36.2 37.8 37.4 37.9 38.1 38.2 Total Expenditure 39.2 39.4 38.3 38.0 39.3 37.8 40.3 40.5 40.9 40.5 40.5 Current Expenditure 37.0 37.4 36.3 35.5 36.8 35.2 37.1 37.4 37.6 37.2 37.2 of which: Interest payments 7.3 6.8 6.0 5.4 5.3 5.3 5.7 5.9 5.9 5.5 5.4 Capital Expenditure 2.1 2.1 2.0 2.5 2.5 2.6 3.2 3.2 3.2 3.3 3.3 Primary Balance 3.9 3.3 3.4 4.1 2.1 2.4 3.1 2.8 3.0 3.1 3.1 Overall Balance -3.4 -3.5 -2.6 -1.3 -3.2 -2.9 -2.5 -3.1 -2.9 -2.4 -2.3 Gross Public Sector Debt 69.2 68.1 66.5 70.7 67.9 66.8 63.2 60.9 58.7 55.6 53.3 Domestic Debt 59.9 60.3 61.4 65.2 63.8 63.4 60.4 58.2 55.9 52.9 50.7 External Debt 9.3 7.8 5.1 5.5 4.1 3.4 2.8 2.8 2.8 2.7 2.6 Prices and Economic Activity (annual percent change, unless noted) GDP Deflator 7.2 6.1 5.9 8.3 5.7 7.3 7.3 6.0 5.2 5.3 4.8 Consumer Price Index (eop) 5.7 3.1 4.5 5.9 4.3 5.9 6.5 5.4 5.0 4.8 4.7 Producer Prices ( eop) -1.0 4.3 9.4 9.8 -4.1 13.9 4.1 4.4 4.9 4.8 4.7 Memorandum items: Nominal GDP (LCU) 2,147 2,369 2,661 3,032 3,185 3,675 4,058 4,430 4,847 5,359 5,852 Source: IM F, BCB, IBGE, EIU, WB Calculation 13. While inflation continued accelerating during most of 2011, starting in August 2011, the Central Bank eased its policy stance in response to the worsening global economic outlook. During most of 2011, labor market conditions have tightened, with record levels of job creation and historically low unemployment (5.2 percent in November 2011). 4 Inflation reached 6.5 percent in 2011, in line with the upper limit of the inflation target. However, since August 31, 2011, in response to a perceived deterioration in the outlook for global growth and the expectation that it will have a disinflationary impact in Brazil, the Central Bank has reduced its policy rate by 200 basis points to 10.5 percent. Moreover, in November, 2011, the Central Bank significantly reduced capital requirements for consumer loans, in some cases by 50 percent. On the fiscal policy front, however, the Government intends to maintain its current contractionary policy stance. In particular, it has announced a commitment to primary surplus targets of 3.1 percent of GDP in both 2012 and 2013. 14. Economic activity decelerated significantly during the second half of 2011 reflecting both domestic and external factors. On one hand, the deceleration was driven by the tighter monetary and fiscal policy stances adopted by the Government during the first half of the year. On the other hand, the fiscal crisis in the Euro zone has led to a worsening of the global economic outlook coupled to a reduction in business and consumer confidence. In this context, GDP exhibited zero growth during the third quarter of 2011, a sharp deceleration with respect to the 0.8 percent growth observed, on average, during the previous four quarters. On the supply side, the largest deceleration was observed in industry and services, which contracted by respectively 0.9 and 0.3 percent in the third quarter, compared to average quarterly growth of respectively 0.5 and 0.9 percent over the previous year. Among these, the industrial sector was arguably already being hardly hit by global economic developments, as reflected in the appreciation of the real and the deceleration of external demand for Brazilian manufactured products. On the demand side, the deceleration observed during the third quarter was driven by the contraction of domestic demand, especially government consumption (-0.7 percent), followed by gross capital formation and household consumption (respectively -0.2 and -0.1 percent). 15. More recent data suggest that economic activity continued to be weak in the fourth quarter, albeit with some signs of moderate recovery starting in November. While in October industrial production and broadly defined retail sales (including vehicles and construction material) contracted by respectively 0.6 and 0.4 percent month-on-month (strictly defined retail sales were flat in that month), they expanded by respectively 0.3 and 1.5 percent in November (1.3 percent for narrow retail sales), and by 0.9 and 1.6 percent in December (0.3 percent for narrow retail sales). Similarly, the Central Bank’s IBC-Br index, a proxy for monthly GDP, exhibited a -0.32 percent contraction in October but expanded by 1.15 percent in November. 16. The banking system appears well prepared to absorb a possible worsening of the credit portfolio. Early stage delinquency indicators (loans that are between 15 and 90 days overdue) have been rising gradually over the last year, mainly in the consumer segment (6.9 percent in October 2011 up from 5.3 percent in December 2010). Even though this development portends higher non-performing loan (NPL) ratios in the upcoming months, potentially aggravated by the ongoing economic deceleration, banks appear well prepared to withstand such negative developments. The system-wide solvency ratio currently stands at around 17 percent, as supervisors have been phasing in tightened capital requirements in anticipation of Basel III while banks have obtained robust profits which they have been able to capitalize. Similarly, while housing loans have grown very strongly (47 percent in the year to October 2011, accounting for 44 percent of growth in bank loans to individuals), there is a low risk of an ―asset bubble‖ developing in Brazil’s real estate markets. Indeed, those loans still represent only 10 percent of total private sector credit and their delinquency rates have 5 fallen significantly thanks to the improvement of the mortgage foreclosure system (e.g. loans overdue for more than 90 days were 5.9 percent in July 2011, down from 23.9 percent in 2006). 17. The current account has remained stable during 2011 while FDI has exhibited solid growth even as the global economic outlook has deteriorated. The current account deficit totaled $48.1 billion in the twelve months to October 2011. FDI, however, totaled $75.1 billion over the same period, compared to $36 billion in the year to October 2010. Going forward, the current account deficit is expected to increase slightly in 2012, driven by lower growth in export prices and a reduction in the trade surplus. While FDI may experience a moderate reduction in 2012, due to the unfavorable external scenario and a deceleration in domestic demand, it is expected to remain strong over the medium term and help finance the majority of the current account deficit. 18. The prospect for growth in foreign portfolio investments is less positive. Driven mainly by high real domestic interest rates at a time of exceptionally low interest rates internationally, these inflows have put strong upward pressure on the real and prompted the authorities to increase taxes on financial transactions (IOF) of foreign fixed income investments from 2 to 6 percent in October 2010. This measure, together with recent increases in global risk aversion associated with the fiscal crisis in Europe, has already caused a slowdown in portfolio flows. Going forward, these inflows could be negatively affected by the increased international turmoil. Moreover, while real interest differentials are likely to remain large, the recent Central Bank decisions to reduce the policy rate will diminish the stimulus for carry-trade operations. On the positive side, portfolio inflows should benefit from the recent GoB suspension of IOF taxation on foreign variable income investments 19. Going forward, a further build-up of reserves is possible in 2012. Persistently higher domestic interest rates are expected to prompt the private sector to continue increasing its external indebtedness. In this context, the Central Bank has stepped up its monitoring of prudential and macro-prudential risks associated with potential currency mismatches by financial and non-financial companies, by increasing reporting requirements on foreign borrowing by non-financial corporations. It has also taken measures to mitigate those risks by tightening regulations on banks’ net open positions and, at least until very recently, by also tightening capital requirements to curtail credit growth. Current Macroeconomic Outlook 20. While GDP growth can be expected to be close to 3 percent in 2011 and 2012, the medium-term macroeconomic outlook points to an annual GDP growth rate of between 4 and 4.5 percent. In the short term, the forecast is for lower growth compared to previous periods, as the Brazilian economy suffers the consequences of the deterioration in the global economic outlook. In the medium term, growth is likely to be driven by strong domestic aggregate demand. Investment growth, in particular, will be spurred by the development of new offshore oil fields and preparations for upcoming mega events. 21. In the short term, the external sector is one of the main sources of Brazil’s vulnerability to a global slowdown through possible impacts on trade volumes, commodity prices and exchange rate movements. A worsening of the global economy caused by a full-blown euro zone debt crisis and/or a US recession, may translate into lower 6 external demand for Brazil’s exports, while a Chinese hard landing would hit Brazil’s terms of trade, and demand for exports, given the significant demand from China. As the current- account deficit widens, the Real could weaken slightly in nominal terms against the US dollar, as was observed during the third quarter of 2011. Nonetheless, Brazil’s vulnerability to external events will remain low due to its high reserves and favorable debt composition. 22. Secondly, the banking sector is vulnerable to continued global slowdown given the exposure of some small and medium sized banks to liquidity risk. Small and medium sized banks, currently holding 8 percent and 12 percent of the Banking system’s assets still largely rely on more volatile sources of funding. However, system-wide assessment of banks indicates that Brazil’s banking system currently has solid liquidity levels and capital cushions. 23. Further worsening of the global economic environment also poses risk to the fulfillment of fiscal targets. The achievement of primary surplus targets may be affected by the deceleration of economic activity, as federal revenues could decline and social protection expenditures are likely to increase. Moreover, despite the Government’s current commitment to using mainly monetary policy levers to counter the ongoing economic deceleration, recent policy measures suggests that it remains open to adopting complementary fiscal and quasi fiscal stimuli if economic activity were to decelerate more sharply. 24. In the medium term, Brazil also faces structural challenges that limit its long- term growth potential. A short list of challenges includes developing a private market for long-term financing and improving the business environment (in particular, reducing the costs associated with complying with tax obligations and obtaining business permits and licenses). Other important issues are the need to increase public and private investment, so as to address growing infrastructure bottlenecks and achieve faster productivity growth, and that of improving the effectiveness and cost-effectiveness of public expenditures. 25. Despite the above external risks and domestic policy challenges, the Government’s overall macroeconomic framework is deemed sustainable in the medium term and adequate for the purposes of a DPL. Brazil’s fiscal framework (see Box 1 for more details on Brazilian Fiscal Federalism) provided the government with the flexibility to successfully respond to the global financial crisis with an array of fiscal, monetary, and external measures to stimulate domestic demand. Gross public sector debt is expected to decline in the future, from 63.2 percent of GDP projected for 2011 to around 58.7 percent of GDP in 2013, despite difficulties in maintaining fiscal balance in the face of large investment needs and pressures from current expenditure growth. Moreover, flexible exchange rates and relatively large foreign reserves should help Brazil address the consequences of a potential external crisis, including a possible abrupt shift in market perceptions and an associated turn- around in capital flows. 7 Box 1: Brazilian Fiscal Federalism and the Control of Sub-National Fiscal Performance The fiscal stance of Brazilian states has always been an important element in macroeconomic management in Brazil. Until the late 1990s, the expansionary fiscal policies by the states and the lack of effective controls over their indebtedness resulted in frequent sub-national debt crises. On three different occasions (1989, 1993 and 1997) the federal Government had to take on and reschedule the debts of the states. The largest operation occurred in 1997, under Law 9496, when the federal Government restructured R$200 billion (12 percent of national GDP) of the debts owed by the states. In the 1997 refinancing operation, the debts were refinanced for 30 years. This refinanced debt, so called intra-limite debt, carries a real interest rate of 6 percent with the nominal value of the debt rising by inflation. The debt service was capped at 13 percent of states’ net current revenues. Any debt service above the 13 percent cap is recapitalized and added to the intra-limite debt stock. At the end of the contracts (in 2028), if there are residual debt balances, the state must pay off the remainder within 10 years. The 1997 bailout was conditioned upon the state’s compliance with medium-term fiscal adjustment and structural reform programs. In exchange for the rescue package, the debt renegotiation contracts mandate the implementation of three-year rolling Programs of Fiscal Adjustment (PAFs) to be agreed upon by the National Treasury Secretariat and the 25 states that had their debt rescued by the National Treasury Secretariat during the period of the contract. The PAFs set annual targets on indebtedness, primary balances, personnel spending, tax revenue and public investment, in order to guarantee a gradual decline in indebtedness. In addition, the PAFs include structural reforms such as privatization or other public sector modernization initiatives. The controls on sub-national fiscal performance were further strengthened by the approval of the Fiscal Responsibility Law (Lei de Responsabilidade Fiscal—LRF) in 2000. The LRF institutionalized fiscal discipline at all levels of government, incorporating hard budget constraints into a single unifying framework. It explicitly prohibits debt refinancing operations between different levels of government, thereby addressing the moral hazard problem in intergovernmental fiscal relations caused by sequential bailouts. Complementary Senate resolutions also prohibit borrowing if: (i) the net consolidated debt exceeds twice net current revenue (RLC—Receita Liquida Corrente) (ii) new credit operations exceed 16 percent of RLC; and (iii) debt service exceeds 11.5 percent of RLC. Borrowing is also prohibited if it violates the debt reduction schedules set by the debt renegotiation contracts under the Law 9496. Finally, emission of sub-national governments bonds is generally prohibited through 2016; however, states whose net debt is less than net current revenue can issue bonds after 2011, although even here the Federal Government retains the option to review the decision to issue bonds. This system of controls has resulted in repeated state and municipal surpluses—an adjustment that has continued through four federal administrations. In addition, this system has also favored the adoption of appropriate expenditure programs by sub-national governments. Besides the controls on indebtedness, LRF requirements improved transparency and strengthened budgetary practices. Transparency: budget outturns and compliance with the LRF—including a statement of corrective measures if the relevant provisions are breached—are reported on a regular basis. Municipalities and states are also required to report the fiscal outturns of the previous year to the Ministry of Finance. The legislative branch of each level of government, aided by their respective Court of Accounts, monitors observance with the fiscal targets and ceilings. Budget Institutions: the LRF introduces more stringent requirements on fiscal targets in the preparation of the Budget Guidelines Law (Lei de Diretrizes Orcamentárias—LDO), strengthening its role in budget preparation and fiscal management in general. The LRF also calls for a detailed assessment of the government’s contingent liabilities and strengthens the link between the Annual Budget Law (Lei de Orçamento Annual—LOA) and the LDO. A complementary Fiscal Crime Law is applied to all levels of the public administration, with the possibility of detention for those public officials not complying with the LRF. 8 B. RECENT SOCIOECONOMIC AND FISCAL DEVELOPMENTS IN PERNAMBUCO Historical background and political context 26. Pernambuco is located in the middle of Brazil´s northeast alongside the South Atlantic Ocean and is closer to US and European markets than the most developed regions of the country. It has borders with five other states of the region. This geographic position makes the State a key distributor of goods and services to a growing regional market. Most of the State is located in the natural disaster-prone semi-arid zone and displays sharp inequalities in economic and social development. Given its history, Pernambuco has transformed radically from its agriculture-based past to become an economy mainly driven by services and commerce and, more recently, by industrial sector growth. Agriculture today represents less than 10 percent of its GDP while more than 60 percent of the Pernambuco economy is in the service sector. 27. Politically, the reelection of Governor Eduardo Campos in 2010 with a wide margin has enabled his administration to carry out important reforms in the economic, social and political arena. The reform agenda has been accompanied by a strengthening of a new model for planning and accountability for the public sector in Pernambuco. Macroeconomic Environment 28. The State of Pernambuco is the second largest economy in the northeast of Brazil. Pernambuco accounted for about 2.3 percent of the national gross domestic product (GDP) ranking as the tenth economy of the country in 2008. Pernambuco’s population of 9 million inhabitants represents 4.6 percent of total national population. Pernambuco, like other northeastern states, has long lagged the rest of Brazil in terms of socio economic development with a GDP per capita about half the national average at R$8,065 in 2008. 29. The State has entered a new growth period in the last eight years. After a period of stagnation, the year 2003 marked an inflexion point for State growth and the beginning of an accelerated growth period that puts the State on par with national average growth rates. Estimates for 2010 indicate that Pernambuco’s real growth was 9.3 percent, against the 7.5 percent Brazilian GDP growth (Figure 1 shows 5-year average growth rates). This is a result of the dynamics linked to the Suape Port Complex, and the State’s increased capacity to invest in physical and social infrastructure due to fiscal strengthening and growth itself. The Government plans to continue and even accelerate its pace of investment in the medium term in partnership with the private sector and the federal Government. 9 Figure 1: Growth, Poverty and Inequality GDP Growth Rate GDP per capita 9000 5-year average growth rate 12.0% 8000 10.0% 7000 8.0% 6000 6.0% 5000 4.0% 2.0% 4000 0.0% 3000 -2.0% 2000 Brazil Northeast Pernambuco Brazil Northeast Pernambuco Gini coefficient Poverty Headcount (%) 0.66 80 0.64 70 0.62 60 0.60 50 0.58 40 0.56 0.54 30 0.52 20 0.50 10 0.48 0 Brazil Northeast Pernambuco Brazil Northeast Pernambuco Source: IBGE/Ipeadata Note: The poverty line is defined as the double of the extreme poverty line, which is defined as the cost of a basic food basket that supplies the minimum individual caloric intake. The poverty line varies between regions, states, urban, rural and metropolitan areas. Poverty lines account for these differences. 30. Recent growth fostered the creation of formal jobs that enabled Pernambuco to sharply reduce its unemployment rate. The unemployment rate in the metropolitan area of Recife, which accounts for 42 percent of the State population, fell from an annual average of 14.6 percent in 2006 to 8.7 percent in 2010, and maintained a downward trend in 2011 (Figure 2). The unemployment rate in the MAR shifted from 10.9 percent in August 2009 to 6.7 percent in the same month of 2011. Partly due to this, in addition to the role played by federal poverty reduction programs, the percentage of the population living below the extreme poverty line has decreased from 33 percent in 2003 to 17 percent in 2009.2 2 The extreme poverty line is defined as the costs of basic food basket that supply the minimum individual caloric intake. The extreme poverty line varies between regions, states, urban, rural and metropolitan areas. Poverty lines account for these differences. 10 Figure 2: Unemployment Rate (%)—12-months Average 18 16 14 12 10 8 6 4 BRAZIL PERNAMBUCO BAHIA Source: IBGE 31. Pernambuco faces the dual challenge of consolidating its recent growth pattern and turning its capacity to turn higher growth rates into lower poverty and inequality. In 2009, the share of the population below the poverty line was twice that of Brazil and above the northeastern average (Figure 3). The levels of per capita GDP, poverty, and inequality in Pernambuco reflect the large gaps between the northeast and the rest of Brazil. However, within the northeast, Pernambuco is well positioned to catch up faster to the rest of Brazil in terms of economic and social development. Figure 3: Real GDP Growth (%) 10.0 9.3 7.5 8.0 6.8 5.1 5.4 6 5.4 5.2 6.0 4.2 4.1 3.9 4.0 2.7 3.1 2.0 1.1 0.0 -0.6 -2.0 2003 -0.6 2004 2005 2006 2007 2008 2009* 2010* Pernambuco Brazil Source: IBGE, CONDEPE/FIDEM Recent Evolution of Fiscal and Debt Indicators for the State of Pernambuco 32. Pernambuco’s fiscal policy framework has been prudent. Over the past decade all fiscal indicators improved, mainly due to an improvement of the efficiency of the State’s fiscal administration, the stability of net personnel expenses, and the significant decline of net consolidated debt.3 All indicators are currently well within the prudential limits set in the Fiscal Responsibility Law (LRF). The State is in solid compliance with the prudential limits 3 The improvement in fiscal administration efficiency was due mainly to the introduction to tax payer substitution systems and the adoption of the electronic fiscal note. 11 set out in the LRF since 2004. This situation has allowed the State to drastically reduce net consolidated debt (NCD), build up fiscal balance and increase slowly investment. 33. On the revenue side, total revenues grew at an average of 10.8 percent in real terms during 2004-2010, one of the highest rates among Brazilian states. This revenue growth was due to the good performance of all main revenue categories: tax revenues, transfers, social contributions and other revenues. The ICMS to the State Participation Fund (FPE) ratio was 240 percent in 2010, the highest among the northeastern states, after a break in the trend in 2008 (Table 2, Figure 4) Table 2: Fiscal Indicators Tax/Transfers ICMS/FPE ICMS/GDP NORTHEAST (2010) (2010) (2008) Alagoas 63.9% 98.9% 8.2% Bah ia 136.9% 228.2% 7.9% Ceará 119.4% 165.1% 7.7% Maranhão 70.6% 81.0% 6.1% Paraíba 91.9% 109.0% 7.5% Pernambuco 129.6% 240.3% 8.7% Piauí 68.8% 88.8% 6.3% Rio Grande do Norte 98.4% 134.4% 8.9% Sergipe 70.0% 87.8% 6.9% Source: National Treasury Secretariat, IBGE, WB Calculation Figure 4: Tax Revenue and ICMS collection Performance—Pernambuco 2.60 2.40 2.20 2.00 1.80 1.60 1.40 1.20 1.00 2004 2005 2006 2007 2008 2009 2010 Tax Revenue/Transfers ICMS/FPE Source: SEFAZ, WB Calculations 34. On the debt front, Pernambuco’s situation is also solvent. Due to the aforementioned growing fiscal revenues and consistent fiscal adjustment, the net consolidated debt-to-revenue ratio fell steeply from over 104 percent of net consolidated debt (NCR) (See Figure 5) in 2004 to 39 percent by 2010, well within the LRF limit of 200 percent. During 12 2004-2008, Pernambuco made large amounts of amortization. Debt service has been decreasing since 2004 driven by lower interest payments and increasing NCR (Figure 5) Figure 5: Evolution of Debt and Debt Service during 2004-2010 120% 15 15% 0.80 Net Consolidated Debt Debt Service R$ 2010 Billions R$ 2010 Billions 100% 0.60 80% 10 10% 60% 0.40 40% 5 5% 20% 0.20 0% 0 2004 2005 2006 2007 2008 2009 2010 0% 0.00 Net Consolidated Debt (NCD) - right 2004 2005 2006 2007 2008 2009 2010 Net Current Revenue (NCR) - right NCD / NCR (left) Interest Payments (right) Amortization (right) Source: SEFAZ, WB Calculations Note: Values deflated by IPCA Medium-Term Fiscal and Debt Sustainability 35. The fiscal perspective shows that the objective of supporting an ambitious regional development agenda can be accompanied by borrowing. The projected fiscal and debt paths for the State of Pernambuco are sustainable in the medium term. The baseline scenario projections indicate a sustainable path, with positive primary fiscal balances. Pernambuco’s fiscal balances (the primary fiscal balance, the overall balance, and the gross operating balance) are all expected to record surpluses for the projected period, allowing for fiscal space for State investments, while net consolidated debt is projected to fall from 39 percent of net current revenue in 2010 to 20.1 percent by 2020. Social Development: Inequality, Race, Gender, and Spatial Distribution 36. Inequality in Pernambuco is higher than in the rest of Brazil but lower than other states of the northeast region. Inequality in Pernambuco overlays with characteristics such as geographic location, gender, race and socioeconomic groupings. These inequalities are tackled comprehensively as part of the proposed operation, by focusing on the expansion of opportunities throughout the State and enhancing equity among regions and socioeconomic groups. 37. There is a dual dynamic of poverty reduction in Pernambuco. While poverty decreased in both metropolitan and non-metropolitan areas of the State, the gap between the interior of the State and the rest of the Brazilian non-metropolitan areas widened, and the gap between the MAR and other metropolitan areas narrowed.4 (Figure 6). In 2009, over 60 percent of the population in the interior of the State had an average income of less than half the minimum wage, while the proportion for the MAR was 4 PNAD includes only ten Brazilian metropolitan areas: Belém, Fortaleza, Recife, Salvador, Belo Horizonte, Rio de Janeiro, São Paulo, Curitiba, Porto Alegre and Brasília. 13 below 40 percent. These poverty levels highlight the unequal conditions in the interior of the State. Figure 6: Difference in the Share of the Population Living in Poor Household between Pernambuco and Brazil, 1995-2009 percentage points Non Metropolitan Metropolitan area Pernambuco - of Recife - Other Other non- Metropolitan areas Metropolitan areas of Brazil of Brazil 1995 28.6 23.4 2009 18.3 28.6 Source : Brazilian Household Survey (PNAD—IBGE) (Note: Average family income below ½ of the minimum wage of Sep/2009 (R$465)) 38. Poverty in Pernambuco is correlated with people’s circumstances in terms of location, race, and gender, especially in the interior of the State. The gap in average income between white and non-white residents increased between 1995 and 2009. Coverage of secondary education is worse in the interior of the State than in the MAR, and non-whites are at even more disadvantage. While almost 70 percent of whites between 18-24 years old living in Recife were able to complete 11 years of schooling (secondary education) in 2009, less than 30 percent of non-white living in the interior of the State did so. 39. Disparities in social indicators are also linked to geography, gender, ethnicity and sector of economic activity. Gaps across different groups in their rates of access to social services are visible measurements of inequality. The Human Development Index (HDI)— constructed using averages in income, school attendance, literacy and life expectancy—shows large variations across the territory (Figure 7). Figure 7: HDI at Municipality Level Source: United Nations Development Program. 14 40. Pernambuco has one of the lowest Human Opportunity Indexes (HOI) in Brazil, particularly underperforming in terms of access to water.5 The HOI measures both the level of basic opportunities and how equitably those opportunities are distributed; it indicates how personal circumstances for which an individual cannot be held accountable, like birthplace, gender, or socioeconomic background, affect a child’s probability of accessing basic services. An HOI of 100 indicates a society that provides universal and equal access to a given service. Pernambuco’s HOI for access to water is indicative of continued inequality in access and coverage shortages (Figure 8). Without changes in current trends, it would take Pernambuco more than a century to achieve equitable and universal water coverage (Figure 9). Figure 8: Human Opportunity Index (HOI) for Pernambuco Eight grade completed at 15 years… Fourth grade completed at age 11… School enrollment for children ages… 2010 (est.) School enrollment for children ages… 2008 Access to Electricity 1998 Access to Sanitation Access to Water 0 20 40 60 80 100 120 Source: Estimates produced based on Pesquisa Nacional por amostra de Domicilios (PNAD), 1998 and 2008. Figure 9: Estimated Number of Years Required to Achieve Universal Access (HOI = 100%) Eight grade completed at 15 years… 43 Fourth grade completed at age 11… 32 School enrollment for children ages… 4 School enrollment for children ages… 4 Access to Electricity 0 Access to Sanitation 48 Access to Water 107 0 20 40 60 80 100 120 Source: World Bank (2010) Human Opportunity for Children in Brazil: An Assessment with the Human Opportunity Index 5 A detailed discussion of the HOI and its use is in World Bank (2010). 15 Labor markets: Significant Decline in Unemployment but Unequal Regional Distribution of Employment 41. A faster pace of job creation will be a key determinant of Pernambuco’s development as well as of its capacity to reduce inequality. Job creation was been slower than the Brazilian average both in the MAR and the interior of the State during the past 15 years. More strikingly, during the 2005-2009 period the MAR saw the creation of over 100,000 new jobs (an 8 percent increase), while the countryside lost almost 200,000 (an 8 percent decrease). The proportion of non-registered workers in both areas declined between 1995 and 2009; however, the proportion of non-registered workers in the interior (still above 70 percent in 2009) reflects the greater challenge of informality in job markets in the interior. 42. A tight labor market was the outcome of a period of faster growth. Open unemployment in the MAR fell from 10.4 percent in 2006 to 6.9 percent in 2010 (measured in December of each year). Unemployment rates for women also declined but were, on average, 53 percent higher than for men. During the period 2006-2010 the average unemployment rate was 7.0 percent for men and 10.4 percent for women. Both rates of unemployment were higher than the national average (5.5 percent and 8.6 percent, respectively). Due to an educational and skills deficit in the labor force, there is a component of structural unemployment in the metropolitan labor market. Informality declined from 64.6 percent in 2004 to 59.5 percent in 2010, leaving fewer people outside the social protection net. 43. A fast growing economy has resulted in a strong rate of formal job creation. Workers with a labor contract expanded at the annual rate of 7.0 percent during the period 2005-2010, rates above those presented by Brazil as a whole (5.8 percent) and the northeast (6.6 percent). This growth was led by job creation in civil construction (23.7 percent per year), commerce (8.4 percent), services (8.0 percent) and manufacturing (6.3 percent). The outstanding rate of job creation in civil construction reflects robust investment in infrastructure, productive activities, and housing. Most of the formal employment, nevertheless, has been generated in the services and public administration sectors that jointly represented 55.8 percent of overall employment in 2010. 44. A tight labor market is reflected in the growth of labor earnings. In the MAR, the percentage variation in real labor earnings over the period 2006-2010 was 12.2 percent while the average figure for all metropolitan areas reached 8.4 percent. Although average labor earnings in the MAR are the lowest among the six metropolitan regions in which data is collected, they nevertheless present the fastest growth. 45. The regional distribution of employment is unequal, reflecting the spatial concentration of economic activity in the MAR. Sixty-six percent of formal employment in 2010 was located in the MAR, which accounts for 42 percent of Pernambuco’s population and 65 percent of the State’s GDP. Thus, a distinctive feature of Pernambuco is a heavy concentration of population, employment and output in the MAR. Further, there are sharp differences among regions in terms of GDP per capita, among other indicators that point to the level of economic and social development in the State. 16 Education Presents Important Challenges Despite Recent Improvements 46. Education conditions have improved in Pernambuco, especially at the primary level, but challenges remain at the upper secondary level, most notably in the interior of the State. The share of 7 to 14 year-olds attending primary school increased significantly, from 76 percent in 1995 to 95 percent in 2009 and is now comparable to the national average (98 percent for Brazil), with disparities between the MAR and the interior of the State virtually negligible for this particular indicator. However, student enrollment at the upper secondary level for the 15 to 17 age group remains low despite recent growth: coverage increased from a low 10 percent in 1995 to 33 percent in 2009 in the interior; and from 20 percent to just under 50 percent in the MAR. 47. Pernambuco schools lag behind the rest of the country on most measures of quality. Drop-out rates are 44 percent higher in primary school and 8 percent higher in upper secondary school for Pernambuco than in the rest of Brazil.6 Likewise, age-grade distortion— the proportion of children at least two years too old for their grade—is much higher in Pernambuco than in the rest of Brazil at every level of education (Figure 10). State scores on the Index of Basic Educational Development—which combines test scores and student progression data—are in the bottom third of all states at each level of education (Figure 11). Illiteracy among young adults (15 to 24 years of age) declined significantly, particularly in the interior of the State.7 However, the share of 18 to 24 year-olds capable of completing secondary education is still below 50 percent. Figure 10: Age-Grade Distortion and Dropout Rates for Pernambuco Relative to Brazil, 2010 Source: Data are compiled by Todos Pela Educação, an education advisory group. 6 In Brazil, basic education is divided into the early years of Ensino Fundamental (Grades 1-5), the later years of Ensino Fundamental (Grades 6-9) and Ensino Medio (Years 1-3). These correspond to primary, lower secondary, and upper secondary school. 7 Illiteracy in the interior of the northeastern region is quite high, particularly among older age groups. 17 Figure 11: Pernambuco State Schools’ Education Performance Relative to all States in Brazil, 2009 (Pernambuco Highlighted) 5th Grade (Primary) 9th Grade (Lower Secondary) 3rd Year (Upper Secondary) Note: Performance is measured on Brazil’s standard Index of Basic Education Development (IDEB), which is measured on a one to ten scale and combines student test score performance with student advancement. Data are from the National Institute for Education Research (INEP). Table 3: Access to Sanitation Services (%) Pernambuco, 1999-2009. Utilities All areas Urban areas 1999 2005 2009 1999 2005 2009 Recife’s Metropolitan Area Water - public network 86.8 89.4 89.4 89.7 90.8 89.9 Sewage - public network 33.0 37.8 38.9 34.5 38.7 39.6 Garbage collection 74.3 81.9 84.1 77.0 82.8 84.9 Interior of the state Water - public network 58.4 61.9 66.4 87.1 88.5 92.5 Sewage - public network 21.6 32.6 38.2 33.9 52.9 57.8 Garbage collection 45.1 55.2 59.1 68.5 84.9 88.5 Source: Brazilian Household Survey (PNAD—IBGE) Water: a Key Sector in Reducing Poverty and Improving Equity in Pernambuco 48. Pernambuco still faces challenges in providing efficient access to basic public utilities. While some services are nearly universal, others, such as coverage for sewage collection, remain very low in both the MAR and the interior of the State (Table 3). Sewage service levels for urban areas in the interior are surprisingly better than those in the MAR: sewage collection was higher in the interior urban areas (57.8 percent) than in the MAR in 2009 (39.6 percent). The same was true for water distribution and water collection, although differences were less pronounced. In spite of high levels of coverage of the public water supply network, the service is unreliable and intermittent. Low sanitation coverage impacts not only the un-served population, presenting risks to public health, but also, indirectly, the population served, as raw wastewater contributes to the pollution of water resources. Some of the State’s most important water sources, located in the Capibaribe river basin and providing 18 water to about 2.6 million people, face increased pollution due to untreated domestic sewage. Water scarcity, unreliable water supply, and insufficient sanitation services have a negative impact on economic performance and social development in the State. III. THE GOVERNMENT’S PROGRAM AND PARTICIPATORY PROCESSES A. THE GOVERNMENT PROGRAM 49. The centerpiece of the current Government’s program has been the All for Pernambuco—Results-focused, Democratic and Regionalized Management strategy. In the face of stark inequalities between interior and costal Pernambuco, black and white populations, and women and men, the positive economic developments in the State have not fully overcome the deficits that have kept social indicators in Pernambuco significantly below national averages. Since assuming office in 2007, the Campos administration has centered its priorities on promoting balanced development in Pernambuco. In particular, the Government’s strategy seeks the integration of regions and populations isolated from the positive transformations taking place in other areas of Pernambuco, notably the MAR. At the same, the Government also seeks a reduction of inequality within the MAR. 50. In the process of developing the All for Pernambuco program, the Government has undertaken an extensive strategy to build more participatory planning and monitoring mechanisms that would allow for more direct engagement of citizens, institutionalizing spaces for dialogue and consultation with key stakeholders. The administration shaped its agenda through public seminars conducted throughout all 12 development regions of the State. As such, the strategy has been largely developed from the ground up, consolidating the commitment of key actors. 51. With these inputs, the Government has operationalized the All for Pernambuco strategy through a new Management Model, structured around results-based management (Box 2). The Government’s actions have been structured around strategic objectives that guide the planning and monitoring for results. This Strategy Map has then served to align the actions of different agencies around a common vision. The agreement of all secretariats to the Strategy Map has enabled the Government to focus its actions into two priority areas—―Most Vulnerable Population Layers‖ and ―Interiorization of Development,‖—which address disparities between the different population segments and regions of the State. The Management Model has been led mainly by the Governor, with support by SEPLAG. 52. In 2010, the incumbent Governor was re-elected by an overwhelming majority8, which was interpreted as a strong show of support for the Government Strategy. Building upon its initial iteration during the first Campos administration, the All for Pernambuco program was fine-tuned to consolidate the administrative structure and government team. By the end of 2010, the Management Institute of Pernambuco (Instituto de Gestão - PE) was created to promote the continuous production of and training in new knowledge to strengthen public management. 8 The governor of Pernambuco was re-elected with 82 percent of the vote. 19 Box 2: Pernambuco’s Management Model Law 141/2009 established Pernambuco’s Management Model – a systemic organization of the functions related to the state’s formal planning instruments (the Multiannual Planning or PPA, the Annual Budget Guidelines, and the Annual Budget Law) and management tools adopted by the state’s public administration. A participatory process defines the strategic priorities for a four-year period, which are formalized in the PPA document. These priorities feed into the budget formulation of individual institutions on an annual basis through the Annual Budget Guidelines. Budget formulation following centrally planned priorities is then reflected in budget allocations in the Annual Budget Law. During budget execution, the state monitors expenditures related to strategic priorities in real time to ensure expenditures are executed towards these objectives. Finally, the state’s performances to meet the targets by strategic priority are monitored on a quarterly basis through the Social Management Report, closing the Management Model cycle and feeding into discussions for revising the PPA. The law established a Core Management Group, reporting directly to the Governor’s Office, for the coordination of the Management Model. 53. Similar to the process that began in 2007, the 2011–2014 Government development plan has been developed through a participatory process. The consultation process was carried out through the second round of regional seminars from February to May 2011, aimed at fostering thematic discussion between the population and the secretaries of the main strategic areas, including Health, Education, Economic Development, Social Development, Infrastructure, and Security. As part of the process, questionnaires were distributed to gather suggestions from the population, with a high response rate among participants. 54. A comparison between the population’s participation rates in 2007 and 2010 demonstrated an increase in participation of 154 percent, reflected in all regions, as shown in Figure 12. Figure 12: Participation Rates in All for Pernambuco Regional Seminars Participation in "Todos Por Pernambucos" Seminars 2007 2011 1706 1468 1419 1157 892 1087 1217 1019 812 915 702 855 750 577 500 380 350 350 300 400 400 350 350 500 Source: SEPLAG Documento Base, 2011 20 55. The Government’s Development Plan has identified three strategic areas of intervention for the current period, namely:  Improving the quality of life of Pernambucanos to ensure goods and quality services to all residents.  Generating opportunities for productive inclusion and income distribution, expanding and improving the standards of productivity and competitiveness of Pernambuco’s economy.  Enhancing the capacity of the State public administration to generate positive outcomes for society, with particular emphasis on Fiscal Responsibility and the Management Model. 56. Interiorização (regional development strategy in the interior of the State) is a key element of the link between growth and equity. By spreading the benefits of growth throughout the State, the Government aims to address correlated dimensions of inequality, such as gender, resulting in more inclusive development dynamics. IV. BANK SUPPORT TO THE GOVERNMENT’S PROGRAM A. LINK TO COUNTRY PARTNERSHIP STRATEGY (CPS) FOR FY12-15 57. Brazil’s priorities for its partnership with the World Bank Group are focused on second-generation development problems that require innovative solutions, in terms of improving national policy frameworks and finding new ways to implement programs with sub-national governments and at the firm level. The proposed operation is fully aligned with the principles of flexibility, selectivity, innovation, and leveraging chosen by the Bank to deploy its resources in Brazil. Flexibility: Adjusting areas of engagement and instruments to better respond to the country’s evolving needs. Selectivity: Focusing on areas where Brazil faces second-generation development challenges and can benefit most from the Bank’s knowledge and experience. Innovation: Supporting innovative investments and policy reforms that can be replicated locally and internationally, and offering innovative services and instruments (e.g. result-based and multi-sector loans, partial credit risk and other guarantees). Leveraging: Increasing the use of leveraged resources from government, the private sector, and other development partners, to maximize development impacts 58. The World Bank Group’s Country Partnership Strategy 2012-2015 (Report # 63731-BR), discussed by the Executive Directors on November 1, 2011, will help address these challenges, and help achieve the overarching goal of higher rates of inclusive and sustainable growth by focusing on four strategic objectives (See Figure 13): (i) increase the efficiency of public and private investments; (ii) improve the quality and expand the provision of public services for low income households; (iii) promote regional economic development through improved policies, strategic infrastructure investments, and support for the private sector in frontier areas; and (iv) further improve sustainable natural resource management and enhance climatic resilience while contributing to local economic development and helping to meet rising global food demand. Brazil is looking to the Bank as a partner in the dissemination of country knowledge and development experiences to other countries. 21 59. The proposed multi-sectoral operation directly responds to these four objectives and as such reflects the alignment of government priorities with the strategies for World Bank engagement. Given the low levels of income and capacity in the northeast, the CPS has highlighted the importance of engagement in the region. More specifically, the CPS envisions a notable participation of the Bank in Pernambuco, with a particular emphasis in supporting policy reforms to promote regional and social inclusion. Figure 13: Brazil FY12-15 CPS Strategic Objective and Result Areas B. COLLABORATION WITH THE IMF AND OTHER DONORS 60. As the International Monetary Fund (IMF) does not work directly with sub- national governments, there has been no direct collaboration with the IMF on the proposed DPL. This DPL does, however, comply with the guidelines for coordinating with the IMF on development policy lending set forth in the Joint Management Action Plan (JMAP) as relevant to national DPL collaboration.9 61. The Inter-American Development Bank (IDB) is actively implementing four investment loans within the State of Pernambuco: the development of the National Tourism Program (PRODETUR) for the State of Pernambuco (US$75 million); the Modernization and Transparency of Fiscal Management in the State of Pernambuco (PROFISCO-Pernambuco) (US$15 million); Innovation and Dissemination Local Cluster Competitiveness (US$10 million); and the northeast Brazil Small Business Fund (US$1.5 million). These four operations are complementary to the reform program supported by the 9 Guidance on Coordinating with the IMF on Development Policy Lending (2010) and Enhancing Collaboration: Joint Management Action Plan (Follow-Up to the Report of the External Review Committee on World Bank- IMF Collaboration) (2007) 22 proposed DPL, demonstrating the commitment of resources to the implementation of the policy reforms. 62. The Andean Development Corporation (CAF) is a regional development bank that has ongoing programs in Brazil. Their recent lending in Brazil has focused heavily on supporting productive sectors, international trade, and infrastructure lending to both the public and private sectors. In 2010, CAF approved a lending portfolio of US$1.226 million. Their current lending portfolio does not include investments directly with the State of Pernambuco.10 C. RELATIONSHIP TO OTHER BANK OPERATIONS 63. The proposed DPL complements on-going and previous Bank development policy and investment operations in water and sanitation, education, economic growth, and public sector governance. Currently, in the State of Pernambuco the Bank is engaged in two active investment loans in the areas of water resource management, education, and public sector management The proposed DPL includes policies directly linked to the institutional frameworks to accompany these investment operations. 64. Development Policy Loans complement investment loans by supporting policy reforms that enhance the institutional context and enable higher investments to reinforce their desired impact. Regulatory frameworks, government efficiency and accountability, educational reforms, and policies to support the strengthening of backward and forward linkages of private investment within the State, are important to guarantee the sustainability and consistency of specific investments. 65. The Pernambuco Sustainable Water Project is a World Bank investment loan that seeks to improve sustainable water supply and sanitation services for the population residing in the Capibaribe river basin. It complements and contributes to the implementation of the Government of Pernambuco’s water sector program through improvement of water sector management and institutions, and support for expansion and increased efficiency in the provision of water supply and sanitation services. The Adapting Water Resources Planning and Operation to Climate Changes in northeast Brazil Analytical and Advisory Activity also directly addresses water provision in the region (not only in Pernambuco). The proposed DPL advocates a strengthening of the institutional framework to improve the management of water resources, and is thus closely linked to these ongoing water projects. The proposed DPL further advances these current initiatives through its focus on disaster risk management, particularly through policies to improve the hydro- meteorological monitoring and early warning systems. 66. The Pernambuco Education Results and Accountability SWAp (Sector Wide Approach) is the second active Bank project being implemented directly in Pernambuco. Its development objectives are to: (a) improve the quality, efficiency and equity of public education in Pernambuco; and (b) introduce management reforms that will lead to greater efficiency in the use of public resources by the Government of the State of Pernambuco in the education sector. The proposed DPL complements this Bank investment by supporting policies to improve the quality of education, particularly in the interior of the country. 10 CAF Informe Anual (2010). Available at: http://www.caf.com/view/index.asp?ms=19&pageMs=61502 23 Box 3: Historical Bank Support to Pernambuco The Bank has been engaged in a partnership with the State of Pernambuco since 1979. The proposed DPL represents a complement to the recent and on-going Bank engagement in the State of Pernambuco. It reflects a concerted strategy by the Bank to support key areas for development in the State, namely quality of education, water sustainability and management, and economic and social integration of the rural sector. Project Lending Status and Approval/ closing IBRD instrument data Pernambuco Educ Results and Account. SIL Active 154 (PERA) 14-Apr-2009/ 31-Dec-2013 Pernambuco Sustainable Water SIL Active 190 14-Jan-2010/ 30-Nov- 2015 Leveling the Playing Field for Quilombola Technical Active - Communities in Northeastern Brazil Assistance Loan 19-Feb-2009 / N-A SIL Pipeline 100 Pernambuco Rural Economic Inclusion 30-DEC-2011/ Rural Poverty Alleviation - Pernambuco SIL Closed 39 12-Dec-1996/ 31-Dec-2001 Northeast Rural Development Project SIL Closed 92 12-Jun-1986/ 30-Jun-96 Pernambuco Rural Development Project Sector Closed 40 investment and 14-Jun-1979 / 31-Dec-1986 maintenance loan Additional Financing for the Rural Poverty SIL Closed 30 Reduction Project - Pernambuco 19-Oct-2006 / NA Pernambuco Integrated Development: SIL Closed 31.4 Education Quality Improvement Project 14-Oct-2004/ 30-Jun-2010 Growth and Poverty Reduction in Pernambuco: ESW Closed - Developing a Sustainable Policy Framework 22-Jan-2001/NA Recife Urban Upgrading program SIL Closed 46 24-Apr-2003/ 02-Mar-2011 Pernambuco PPA Integration ESW Closed - 24-Oct-2003/ NA Rural Poverty Reduction Project – Pernambuco SIL Closed 30.1 26-Jun-2001/ 31-Jan-2010 24 D. CHOICE OF INSTRUMENT AND RELATIONSHIP TO OTHER BANK OPERATIONS 67. Development Policy Lending versus Investment Lending. The DPL supports a multi-sectoral approach directly linked to the strategic objectives outlined by the Pernambuco Government in their Strategy Map. Given the State’s commitment to and ownership of its development strategy, and its track record of reform, a DPL is an appropriate vehicle through which to further advance the State’s developmental goals. The State’s reform program is robust and embodies cross-cutting themes: (i) improving the quality of life of the citizens of Pernambuco, by improving access to quality services and protecting the citizens and their property from crime and climate-related hazards; (ii) changing the pattern of growth (the so- called New Economy) by strengthening the linkages between the most dynamic sectors and the rest of the State’s economy; and, iii) establishing the conditions for better government, increasing the capacity and efficiency of public administration to generate concrete results for the citizens of Pernambuco. The Government’s program and priorities provide a solid ground for confidence that the operation will contribute to poverty reduction. 68. Development policy lending, as mentioned above, complements investment lending by supporting policy reforms that enhance the institutional context and enable higher investments to reinforce their impact (see Figure 14). Thus far, IBRD support to the State of Pernambuco has been primarily in the form of investment loans in rural poverty reduction, water, and education.11 In the rural poverty sector, the Bank has been engaged in a partnership with the State Government since 1979. The latest project (Pernambuco Rural Economic Inclusion) is scheduled for Board approval in March 2012. In the education sector, the Bank has been engaged in two projects, the first one (Pernambuco Integrated Development: Education Quality Improvement) closed in June 2010 while the latest, a SWAp (Pernambuco Education Results and Accountability) is currently active, closing in December 2013. It aims to: (i) improve the quality, efficiency and equity of public education in Pernambuco; and (ii) introduce management reforms to increase efficiency in the use of the State’s public resources in the education sector. In the water sector, the Bank is supporting the Pernambuco Sustainable Water Project, which is currently active and closing in November 2015. As such, a development policy lending would be complementary to previous and ongoing IBRD support by strengthening the institutional and policy environment to make investment lending more effective. 11 Save for the Pernambuco Rural Development Project (P006432) implemented from 1979-1986 and funded through a US$40 million IBRD loan. 25 Figure 14: Complementarity of DPL and Investment loans12 69. One-tranche DPL versus two-tranche DPL. A single-tranche DPL was preferred for two reasons. First, the long partnership between the Bank and the State of Pernambuco (Box 3) demonstrated a track record of successful development cooperation in the State. Second, the relatively higher capacity of the Government of Pernambuco compared to other states of the northeast and its strong commitment to increasing the capacity and efficiency of public administration confirm the advisability of a single-tranche loan. 70. The State operation is linked with two ongoing investment loans in education and water. In particular, the Bank has had a long partnership with the State Government in the areas of rural development, water management, urban upgrading, and education. Those projects are relevant to the design of the proposed DPL. First, they are supporting the Government in the same areas; as such complementarity and continuity were key to the design of the new operation. The engagement of experienced teams encouraged better information flow, coordination with the Government, and operation design. E. LESSONS LEARNED 71. The proposed operation seeks also to support the advances being made in the areas of economic development, public sector management and gender to facilitate 12 In January 2012, the Bank approved a third complementary instrument, the Program-for-Results (P4R). P4R would be the instrument of choice when the objective is to support the performance of a government program using the government’s own systems, when the results require expenditures, and when the risks to achieving the program’s objectives relate to the capacity of the systems to achieve better results, including with respect to fiduciary and environmental and social issues. 26 deeper development change for all Pernambucanos. The World Bank currently is engaged in two investment operations in Pernambuco in the sectors of education and water resource management. The proposed operation complements the on-going engagements in the State of Pernambuco and seeks to further these lines of work, while promoting new areas for engagement. 72. The Bank is well placed to support the State of Pernambuco in its efforts towards more equity, efficiency and governance. As a sub-national DPL, the operation is similar in nature to other Bank operations with Brazilian state governments. The relevant projects are Alagôas (Fiscal and Public Sector Reform, 2009), Rio Grande do Sul (Fiscal Sustainability for Growth, 2008), Minas Gerais (Partnership for Development, 2006). Rio Municipality (Fiscal Consolidation for Efficiency and Growth, 2010), Rio State (Fiscal Efficiency, Competitiveness, and Human Development, 2010 and Urban 2011). These experiences with sub-national governments have provided strong foundations for this operation in two ways. First, the preparation and supervision of the five operations gave the Bank substantial experience as to the nature of sub-national fiscal and public-sector management. The Rio State: Fiscal Consolidation, Human Development and Competitiveness DPL and the Rio Municipality Fiscal Consolidation for Efficiency and Growth DPL have allowed the Bank to support the alignment of health and education policies at different levels of government, namely state and municipalities. Second, as part of project preparation and supervision, the Bank has been fostering increased dialogue on technical issues among civil servants of these sub-national governments on debt management, project monitoring, and public investment management. 73. The operation has been prepared with careful consideration of key lessons in Bank experience in the development of DPLs: a. The policy actions should reflect the Borrower’s reform agenda. The operation nearly mirrors the Strategy Map recently approved by the Governor of Pernambuco. As such, the policies proposed are in line with and advance the Government’s program of policy reform. b. Participation promotes accountability. The current administration of Pernambuco has engaged in an extensive consultation process with citizens throughout the State to define the Government agenda. In doing so, it has facilitated widespread commitment and encouraged accountability within the Government for its policy actions. c. The operation should highlight areas for continued dialogue with the client. The proposed loan builds upon priority areas of engagement between the World Bank and the Borrower, as defined by the CPS as well as the current operational portfolio. In addition, it opens the door for future areas of engagement in key development sectors for the State, such as gender, public sector management, and economic development. d. Monitoring and evaluation—specificity and “monitorability� of indicators. The policy matrix employs outcome indicators that are realistic, quantifiable (with targets to be determined by baselines), and opportune in terms of the availability of information within the timeline defined by the program. In doing so, the matrix is able to look not only to actions, but also to their intended results. 27 e. Coordination with the federal Government. The experience of other DPLs demonstrates the importance of acting in a coordinated fashion with respect to different levels of the administration. F. ANALYTICAL UNDERPINNINGS 74. The proposed Expanding Opportunity, Enhancing Equity in Pernambuco Development Policy Lending builds on the analytical underpinnings established in the literature on the links between equity and development (World Bank, 2006; Bourguignon, et al., 2007), and the empirical findings in Molinas-Vega, et al. (2010). This research shows that the disparity of initial conditions for individuals, which tend to be linked to socioeconomic background and other group-specific circumstances, are a key determinant of future income. The absence of interventions to ―level the playing field‖, or equalize the initial conditions for all, can reinforce intergenerational poverty traps and perpetuate inequality. 75. Economic growth is a precondition for sustained expansion of opportunities. More equitable access to basic goods and services, such as health and education, in turn improves overall productivity and fosters further growth. Active policies, as well as the political conditions for their sustainability, are required to trigger such virtuous circles between equity, growth and reductions in inequality (Bourguignon, et al. 1997; Levy and Walton, 2008). 76. Existing research shows that following the recent expansion of the economy in Pernambuco, bottlenecks must be removed to make the growth pattern sustainable in the long run and to strengthen its regional and sectoral linkages. Growth has not resulted in proportionally more balanced distribution of opportunities in the state. Molinas-Vega, et al. (2010) estimate indicators of access to services for different groups, corrected for differences by socioeconomic circumstances, and find that Pernambuco is among the most unequal states, in an already unequal country. The Human Opportunity Index (HOI), which measures both the level of essential services and how equitably those services are distributed, shows an improvement between 2005 and 2008 for services such as water and sanitation, and schooling, but at a slow pace. Moreover, when the indicator is used to measure the advance in school performance, using national tests in mathematics and language, the results are poorer, and in some cases there is a decrease in average performance for the state. The indicators to monitor the proposed DPL include targets for the HOI for specific services, as an index of advancement in equity in access to quality services. 77. Improving equity in the access to socioeconomic opportunities will help the State to take advantage of otherwise hidden margins of productivity. In turn, increased equity results in a higher potential growth pattern in the long run. Moreover, enhancing equity improves conditions for social cohesion and may have an impact on other social outcomes, such as reductions in crime and violence, thereby improving the investment climate and further feeding back into growth (Fajnzylber et al., 2002). Thus, two components of a comprehensive strategy for long-run sustained economic development are intrinsic to the framework of the proposed DPL: namely the expansion of opportunities and the enhancement of equity. 28 78. Existing experience in Water Resource Management (WRM) indicates the importance of monitoring downstream impacts. To date, WRM programs have focused on upstream micro-level activities and institutions. Adequate WRM requires a more comprehensive and participatory process of planning, robust institutional arrangements, and a broader range of planning tools, incorporating land use and water resources together with other aspects of spatial planning. At the same time, WRM programs need to develop adequate tools and mechanisms to reconcile cross-sectoral water demands, focus on longer-term objectives, and implement an integrated approach at the basin and urban levels. Persistence, patience, and flexible adaptation to local circumstances are needed to implement such integrated approaches. Institutional stability is key for long-term policy development and implementation. Institutional, environmental, and service improvement objectives associated with integrated WRM should be treated as long-term program goals. 79. The use of economic instruments in WRM requires a measured and realistic approach. To date, advances in the use of economic instruments in WRM have been limited in Brazil. The few successful initiatives in implementing bulk water charges followed a gradual and pragmatic approach where charges were set at values negotiated with key water users (particularly water supply and sanitation). Efforts to develop water rights systems need to be selective and consistent with the institutional capacity to enforce such rights. Once demonstrable results become available in more critical basins, water authorities may build support for scaling up and for institutional strengthening. 80. The design of the proposed operation is backed by extensive analytical work in the field of disaster risk reduction conducted by the Global Facility for Disaster Reduction and Recovery, the World Bank, the IDB, and specialized United Nations agencies. This work has provided the basis for the dialogue with the Government of Pernambuco during the design of this DPL. The ability to manage disaster risk (rather than treating a disaster as an exogenous shock to development that cannot be proactively addressed) has been documented in a wide array of studies and is the underpinning of the Hyogo Framework for Action (HFA). Pernambuco has acknowledged that managing disaster risk is good practice for sustainable development. In addition to the HFA, this operation is built on the findings from a number of key documents and publications: i. Natural Disaster Hotspots, A Global Risk Analysis (World Bank 2005). This is a comprehensive analysis of countries’ risk exposure to hydro-meteorological and geotectonic hazards. The study found that Brazil is among the countries that are most at risk of droughts, floods, and landslide hazards, based on land area, percentage of total population, and GDP exposed. ii. The Global Assessment Report on Disaster Risk Reduction (United Nations 2011). This assessment is a comprehensive review and analysis of natural hazards threatening humankind. It also critically examines Disaster Risk Management instruments where significant barriers still exist, such as land use planning, building codes and ecosystem management, and where new approaches need to be adopted. The study concluded that disaster risk is increasing faster in low- and lower-middle-income countries with rapidly growing economies, and that countries with small and vulnerable economies are less resilient. While Brazil is considered an upper-middle-income country, in the recent past its economy has been affected by external shocks, including those caused by natural hazards. 29 iii. Natural Hazards, UnNatural Disasters: The Economics of Effective Prevention (World Bank and United Nations 2011). This report focuses on the economics of reducing the vulnerability to natural disasters, and presents examples from around the world that demonstrate that government investments in ex-ante measures, instead of solely in emergency response and recovery actions, can be more cost-effective. V. THE PROPOSED OPERATION: EXPANDING OPPORTUNITIES, ENHANCING EQUITY IN THE STATE OF PERNAMBUCO A. OPERATION DESCRIPTION 81. The program development objective of the proposed operation is to strengthen public policies that expand economic opportunities and enhance equity of access to quality services for the people of Pernambuco. Consistent with the State’s development plan, the areas of support can be summarized in the matrix below (Table 4). In particular, the proposed DPL supports the State’s strategy aimed at: (i) improving the quality of life of the people of Pernambuco; (ii) establishing the conditions for a new, more inclusive economic growth pattern; and, (iii) developing a culture of efficient government for results. These policy areas are described in detail in the next section with the complete policy matrix presented in Annex 2. The Program has been defined in close collaboration with the State Government, based on a shared assessment of the importance and relevance of the policies to the development objectives, the feasibility of their implementation, and the comparative advantage of the Bank to the policy reforms. 82. The definition of the prior actions has been guided by the recommendations provide through the ―Good Practice Note for Development Policy Lending‖ (World Bank, 2011). In particular, the preparation and dialogue around the proposed operation has followed the principles outlined in the Box 4 below. 30 Box 4: Good Practice Principles for Conditionality Principle 1: Reinforce Ownership  Operation follows in line with the strategic priorities defined under the Government’s 2011-2015 Strategy Map  The Strategy Map is the result of an extensive participatory process of dialogue with citizens, government (secretariats in particular), and other key actors  There appears to be broad-based support for the Government’s reform agenda as evidenced by the re- election of the incumbent with an overwhelming majority Principle 2: Agree up front with the Government and other financial partners on a coordinated accountability framework  Identification of very specific and measurable indicators  Operation complements projects of other donors, particularly the IDB Principle 3: Customize the accountability framework and modalities of Bank support to country circumstances  First operation planned as a DPL to respond to immediate priority fiscal issues, with the intention to provide follow-on support through investment loans and other modalities of Bank assistance  Operation addresses both the access and targeting issues expressed in the Government’s agenda of interiorização  Monitoring framework facilitated by existing monitoring mechanisms of the government Principle 4: Choose only actions critical for achieving results as conditions for disbursement  Focus on critical areas of the Government’s agenda that have a direct impact on development and wellbeing of its citizens  Focus on strategic areas of existing or potential World Bank engagement where the Bank has a comparative advantage Principle 5: Conduct transparent progress reviews conducive to predictable and performance-based financial support  Policy actions will be closely monitored through the regular monthly meetings on the progress of strategic priorities, chaired by the Governor  Monthly meetings will be focused specifically on the progress towards the expected results of strategic priorities B. POLICY AREAS 83. The proposed operation will support critical reforms towards more inclusive development and growth under three broad policy areas: (i) improving the quality of life for Pernambucanos by contributing to improvements in the quality of education, particularly at the secondary level, increased water security and reliability of water supply, and improvements in disaster and risk management; (ii) expanding economic and social opportunities for Pernambucanos through the development of human capital for the local job market, greater gender equity, and support for the integration of micro, small and medium- size enterprises and rural producers into local supply chains; and (iii) increasing public administration capacity for generating results by improving tax administration, planning and budgeting, and the institutionalization of the State’s Management Model. 31 The policy matrix can be summarized as follows: Table 4: Summary of Proposed Policy Actions for Expanding Opportunities, Enhancing Equity in the State of Pernambuco DPL POLICY POLICY ACTIONS RESULTS INDICATORS OBJECTIVES Policy Area 1: Improving the Quality of Life for Pernambucanos 1.1 Provide Quality Policy Action 1  Secondary school students Education The Borrower has created conditions enrolled in schools providing conducive to improving the quality of 40 hours of instruction per education, including an increase in the hours week: of instruction, as evidenced by: Baseline 2010: 22,593 students Indicator 2012: Additional (a) Gubernatorial Decree No. 36.120 of 32,881 students January 21, 2011, authorizing full- day instruction (40 hours per week) Secondary school students in six (6) additional secondary enrolled in schools providing schools, for an aggregate total of 65 32 hours of instruction per secondary schools; and week: (b) Gubernatorial Decree No. 36.119 of Baseline 2010: 31,310 students January 21, 2011, authorizing Indicator 2012: Additional expanded hours of instruction (32 12,261 students hours per week) in fourteen (14) additional secondary schools, for an Secondary school students aggregate total of 108 secondary enrolled in integral and semi- schools. integral schools outside of the MAR: Baseline 2010: 33,373 students Indicator 2012: Additional 28,970 students 1.2 Improve Policy Action 2  Issuing of water rights for both Water Security and The Borrower has strengthened its groundwater and surface water Increase Reliability of management of water resources through the by APAC: Water Supply appointment of permanent technical personnel Groundwater: for APAC in accordance with competitive Baseline 2010: 188 procedures, as evidenced by Gubernatorial Indicator 2011: 212 Act No. 4570 of May 10, 2011 and Joint Resolution (Portaria Conjunta) SAD/APAC Surface Water: No. 117 of December 14, 2010, all in Baseline 2010: 168 accordance with the APAC Law and the Indicator 2011: 188 APAC Resolutions. Creation of reservoir management committee for water basins in the interior of the State Baseline 2011; 8 committees formed (Moxotó, Ipanema e Pajeú) Indicator 2012: Additional 4 committees formed (Terra Nova, Brigida, Garças e Pontal) Establishment of water users 32 Table 4: Summary of Proposed Policy Actions for Expanding Opportunities, Enhancing Equity in the State of Pernambuco DPL POLICY POLICY ACTIONS RESULTS INDICATORS OBJECTIVES cadastre for the water basins of Ipanema, Pajeú and Moxotó Baseline 2011: 0 Indicator 2012: cadastre concluded 1.3 Improve Disaster Policy Action 3 State protocol formalizing and Risk Management The Borrower has improved the management procedures and responsibilities of disaster risks through the issuance of for the flood risk early warning APAC’s Board Resolution No. 001-2011 system established: dated August 22, 2011, defining activities Baseline 2010: 0 related to forecast and early warning of Indicator 2012: 1 disasters linked to hydro-meteorological events in the Borrower’s territory, and Population covered by the identifying such activities jointly as activities monitoring alert system of of a situation room, as said activities have APAC: been integrated into the Hydrological Critical Baseline 2010: 0 Events Forecast System of the Guarantor’s Indicator 2011: 2,192,764 Federal Government. people (21 municipalities) Indicator 2012: Additional 3,694,178 people (37 municipalities) Communication strategy developed and implemented to disseminate hydro- meteorological information produced by APAC Baseline 2011: 0 Indicator 2012: Plan developed and implemented Policy Area 2: New Economy—Expanding Opportunities for Pernambucanos 2.1 Promote Job Policy Action 4 Secondary school students Creation through the enrolled in professional The Borrower has improved and developed Development of education schools, which offers human capital for the job market with Human Capital courses meeting local job emphasis on professional education through demand and vocation: the transformation of six (6) State schools into Baseline August 2010: 5,224 schools of professional education, as students; evidenced by Gubernatorial Decrees No. Indicator August 2012: 36.355 of March 29, 2011 and No. 36.121 of Additional 4,124 students. January 21, 2011. Secondary school students outside of the MAR in professional education schools, which offer courses meeting local job market demands: Baseline 2010: 1,320 students Indicator 2012: Additional 1,935 students 33 Table 4: Summary of Proposed Policy Actions for Expanding Opportunities, Enhancing Equity in the State of Pernambuco DPL POLICY POLICY ACTIONS RESULTS INDICATORS OBJECTIVES 2.2 Increase Policy Action 5  Increase in the number of Opportunities through The Borrower has strengthened its public employees who have Greater Gender institutional framework aimed at promoting received training on gender Equity gender equality through the creation of a issues permanent Women’s Secretariat (Secretaria Baseline 2011: 600 da Mulher) to replace the former temporary professionals trained special Women’s Secretariat, and the approval Indicator 2012: 2,000 of regulations for said secretariat, as professionals trained evidenced by the Borrower’s Law No. 14.264 of January 6, 2011 and Gubernatorial Decree Creation of regional No. 36.659 of June 14, 2011, respectively. coordinators in the 12 development regions of the State Baseline 2011: 0 Indicator 2012: 12 2.3 Promote Economic Policy Action 6 Number of productive projects Development through of several segments among the The Borrower has taken the following steps to development regions of the State Support to SMEs and establish its Development Agency (Agência supported by AGEFEPE through Rural Producers de Fomento do Estado de Pernambuco, S.A.) financing and/or training (―AGEFEPE‖), aimed at promoting economic Baseline 2011: 3 and social development by supporting micro, small and medium-size enterprises and rural Indicator 2012: 19 producers in local production chains: (a) the authorization by the Guarantor’s Central Bank (Banco Central do Brasil) to commence the operations of AGEFEPE on December 9, 2010; and (b) the enactment of the Borrower’s Law No. 14.282 of March 29, 2011, allocating resources to AGEFEPE. Policy Area 3: Increasing Public Administration Capacity for Generating Results for Pernambucanos 3.1 Improve ICMS The Borrower has taken the following Increase of ICMS Revenues as Tax Revenues without measures to improve tax revenues without % of State’s GDP by reducing Increasing Tax increasing tax burdens on taxpayers: tax evasion, without increasing Burden on Firms and Policy Action 7 tax burden: Citizens, to Expand (a) the establishment of a regulatory Baseline 2009: 9.1% (latest Fiscal Space for framework for the implementation of a new year with official information Investment and fiscal control system (Sistema de Escrituração on GDP) Promote Private Fiscal e Contábil 2) (―SEF-2‖), as evidenced Indicator 2012: 12.4% Sector Development by the Borrower’s Resolution (Portaria) No. 190, dated November 30, 2011, issued by SEFAZ; and Real growth of ICMS revenues: Policy Action 8 (b) the establishment of a Tax Baseline 2010: Substitution System for selected R$8,613,857,888 34 Table 4: Summary of Proposed Policy Actions for Expanding Opportunities, Enhancing Equity in the State of Pernambuco DPL POLICY POLICY ACTIONS RESULTS INDICATORS OBJECTIVES products, as evidenced by Indicator 2012: Gubernatorial Decrees No. 35.655 of R$11,584,122,900 (24.3% October 7, 2010 (linens), No. 35.656 above projected inflation 2010- of October 7, 2010 (bicycles), No. 2012) 35.657 of October 7, 2010 (toys), No. 35.677 of October 13, 2010 (cosmetics, pharmacy products and toiletries), No. 35.678 of October 13, 2010 (construction and home design materials), No. 35.679 of October 13, 2010 (automobile parts), No. 35.680 of October 13, 2010 (electric materials) and No. 35.701 of October 19, 2010 (electronic products and home appliances). 3.2 Improve Efficiency Policy Action 9 Approved budget versus of Allocation and executed budget13 for Strategic The Borrower has improved the efficiency of Execution of PPA and Priorities: budget allocation and execution through the Budget to Make Sure Baseline 2011: 64.1% formulation and execution of the PPA and Public Expenditure (Projection based on period budget, both structured into strategic Reflect Pernambuco’s Jan-Aug, as this is the first year priorities, as evidenced by: Strategic Priorities for which information will be (a) the Borrower’s Law No. 14.234 of available); December 13, 2010; Indicator 2012: 75% (b) the Detalhamentos de Despesas por Elemento (DDEs) published in Number of budgetary revisions www.transparencia.pe.gov.br; and approved during the year of (c) letter dated September 12, 2011 from execution: Secretary of SEPLAG attaching a Baseline 2010: 1,560 report on the budget execution by Indicator 2012: 1,404 (10% strategic priorities for the period reduction) January 1, 2011 through August 31, 2011. 3.3. Improve Capacity Policy Action 10 Social Management Report to Plan and produced and published online The Borrower has consolidated its Implement Public (in accordance with Art. 17 of Management Model and strengthened its Policies through the Lei Complementar No. capacity to generate results through the Institutionalization of 141) establishment of the Management Institute, as Pernambuco’s Baseline 2010: 0 evidenced by Gubernatorial Decree No. Management Model 37.828, dated February 2, 2012. Indicator 2012: 3 Social Management Reports produced and published online per year (covering periods of four months each) 13 Resources from all sources of revenue excluding transfers and credit operations (outside the control of the state) 35 Policy Area 1: Improving the Quality of Life for Pernambucanos Policy Objective 1.1: Provide Quality Education Policy Action 1 The Borrower has created conditions conducive to improving the quality of education, including an increase in the hours of instruction, as evidenced by: (a) Gubernatorial Decree No. 36.120 of January 21, 2011, authorizing full-day instruction (40 hours per week) in six (6) additional secondary schools, for an aggregate total of 65 secondary schools; and (b) Gubernatorial Decree No. 36.119 of January 21, 2011, authorizing expanded hours of instruction (32 hours per week) in fourteen (14) additional secondary schools, for an aggregate total of 108 secondary schools. 84. Description and Challenges: The State of Pernambuco has shown marked education improvements over time, despite lagging behind the rest of Brazil in education coverage and quality. Upper secondary school enrollments are low, dropout rates are high, and test scores consistently place Pernambuco in the bottom third of Brazilian states. Despite these challenges, the State of Pernambuco has made significant progress over the last decade. Coverage for children age 7 to 14 has reached the national average over the last decade, and coverage for children age 15 to 17 has expanded from 70 percent to 78 percent. Even in the face of expanding coverage (which usually means inclusion of children with fewer resources and higher likelihood of dropping out), dropout rates have dropped dramatically (Table 6). In lower secondary school, dropout rates have dropped significantly, although in upper secondary school they have remained roughly constant. Age-grade distortion rates have dropped from 66 percent to 49 percent at the upper secondary level, similarly reflecting improvements across age levels. Student performance has also risen over time, with upper secondary IDEB (Brazilian Index of Educational Development) scores rising from 2.7 to 3.3 between 2005 (the first year of the IDEB) and 2009 (with even greater gains in earlier years of education). Table 5: Progress in Pernambuco Education over Time (2000-2010) 2000 2010 Primary 55.1 23.2 Age-grade distortion rates Lower secondary 61.8 37.3 Upper secondary 66.2 49.1 Primary 10.9 2.6 Drop-out rates Lower secondary 16.0 7.3 Upper secondary 10.8 11.1 85. The Government is taking action to improve the quality of teaching at all levels of education (Box 5). The State of Pernambuco has implemented a range of programs in recent years to improve its student learning outcomes. The State has defined basic standards in order to make sure that—over time—every State school has sufficient infrastructure, equipment, teaching materials, and teachers so as to provide quality education. Further, the State has implemented accelerated learning programs for literate students at each level of education in order to reduce age-grade distortion and keep children engaged in school for as long as 36 possible. In 2008, the State introduced its own annual student assessment program (Sistema de Avaliacão Educacional de Pernambuco, or SAEPE) in order to monitor student performance at more levels of education than the federal student assessment permits. The State has also implemented a reform to improve school management through competitive selection and intensive training of school directors. Finally, the State implemented a reform to provide schools and teachers with bonuses directly related to student performance. This reform is being rigorously evaluated in partnership with the Bank and the evaluation will inform further design adjustments. 86. In this context, a revision of the full-day upper secondary school education curriculum will further the enhancement of the quality of learning for students. Although expansion of full-day coverage under the current curriculum is expected to improve student results, the federal Government recently issued a set of directives to guide full-day schooling, and the State is undergoing a curricular revision to bring its curriculum into line with these directives. In addition, the State is taking advantage of new knowledge, such as that created by a program of systematic classroom observation recently carried out by the State in partnership with the World Bank, in order to identify specific areas to improve the quality of education. These observations form the basis for future interventions, and the goal of the revised curriculum is to improve the quality of teaching in extended day classrooms. 87. The DPL will support as a prior action the increased hours of instruction as part of Pernambuco’s broader efforts to improve the quality of education, particularly outside the MAR, so as to promote equity of education. As mentioned above, Pernambuco has undertaken a broad series of reforms to improve the quality of its educational system, from the revision of its curriculum, to the development of the State’s own assessment system, to performance-based bonuses to teachers. In the same vein, the State has initiated another key reform for quality education through the expansion of school hours. Extensive research has demonstrated the importance of sufficient academic learning time and the effective use of that time for improving student performance (Cotton, 1989; Bellei, 2009) (see Box 5). To date, the expansion has taken place in 173 schools (108 with the 32-hour week and 65 with the 40-hour week), currently reaching 67,000 students. 88. More than three-quarters of the schools to be incorporated are outside the MAR, enhancing the equity dimensions of the policy. The DPL specifically supports the recent gubernatorial decrees authorizing the expansion of six additional schools into the jornada integral, and 14 schools into the jornada semi-integral program, as part of an ongoing expansion across the State. The indicators are intended to demonstrate the expected progress to be made under the policy reform in the coming year, with an emphasis on reaching schools in the interior of the State. The State plans to achieve universal coverage of full-day upper secondary schooling in 2014. 37 Box 5: Bank Engagement in Education in Pernambuco and Implications For Extended School Hours A. Operational and Analytical Complementarities in Education Over the last several years, the World Bank and the State of Pernambuco have capitalized on their complementarities in operational and analytical work. The State Government and the World Bank have collaborated on an evaluation of Pernambuco’s teacher pay-for-performance program, which has demonstrated significant learning gains. This is the first major evaluation of teacher pay-for- performance in Brazil, despite many states implementing such programs. The evaluation has demonstrated both the positive impact of the program overall and that schools with more ambitious targets achieved more progress. The Bank and the State have collaborated on two rounds of detailed classroom observations to identify the difference in practices between teachers in the highest performing schools and the lowest performing schools. These data have proven so useful that the State has opted to invest in a third round using its own resources. B. The Effect of Extended School Hours on Outcomes Expanding the hours of schooling creates potential conditions to improve the quality of learning. In addition, the expansion of the school day in other countries demonstrates positive impacts not only on student performance but also on social outcomes (leading to lower crime and lower adolescent motherhood) (Pires and Urzua, 2010; Krueger and Betherlon, 2011). In Pernambuco, the State has commenced an expansion of the school day at the upper secondary level in order to provide both more time for learning, as well as more time for extra-curricular activities. The expansion lengthens the school day from four hours to eight hours. In some schools, the expansion takes places all five school days (achieving 40 hours of schooling) – jornada integral. In other schools, the expansion takes place on three school days (achieving 32 hours of schooling)—jornada semi-integral. Early evidence from Pernambuco itself suggests that these schools are delivering among the best test score results in the State. In 2010 standardized tests for mathematics and Portuguese, schools with 40 hours per week delivered scores 58 percent higher than regular schools (with only 20 hours of schooling per week), and schools with 32 hours per week delivered scores 27 percent higher than regular schools. Policy Objective 1.2: Improve Water Security and Increase Reliability of Water Supply Policy Action 2 The Borrower has strengthened its management of water resources through the appointment of permanent technical personnel for APAC in accordance with competitive procedures, as evidenced by Gubernatorial Act No. 4570 of May 10, 2011 and Joint Resolution (Portaria Conjunta) SAD/APAC No. 117 of December 14, 2010, all in accordance with the APAC Law and the APAC Resolutions. 89. As shown previously (Figure 9), water provision in Pernambuco performs poorly on composite measures of coverage and equity, such as the Human Opportunity Index. If the trend in terms of coverage is maintained, it would take more a century to achieve equitable universal provision of water in the State. The poor are disproportionately affected by water scarcity, as the cost and access to alternative sources of water demand a relatively higher portion of resources of the poor. As such, any agenda devoted to enhance quality of life and equity in the State must include water-related policies. 38 90. Pernambuco is one of the driest states in Brazil with per capita water availability of 1,320 m3 per year on average, equivalent to only 3.5 percent of the national average per capita availability. The State’s semi-arid Sertão and Agreste sub-regions represent 89 percent of the State’s territory and have only about 20 percent of the available water, with per capita availability ranging from 400 m³ per year to 800 m³/year, respectively. The coastal wetter sub-regions of Mata Pernambucana and the MAR concentrate 57 percent of the population, mainly in the MAR (43 percent of the population and 65 percent of GDP) and about 80 percent of the available water. 91. The low water availability in the semi-arid regions of the State, coupled with the high rate of urbanization and economic activity in the coastal regions place the State’s available water resources under a great deal of stress. In spite of high levels of coverage of urban households connected to the public water supply network, the service is unreliable and intermittent. Of the 172 municipalities that are served by the Pernambuco State Water Supply and Sanitation Company (COMPESA), only 30 receive water 24 hours per day. Rationing is commonplace even in the MAR. Water losses were estimated to be around 56 percent, which is significantly above the 38 percent national average. To reduce rationing and increase water reliability, the State of Pernambuco, with support from the World Bank, is implementing large investment programs to increase water production in the MAR and to manage and control water losses. 92. Strategic confined aquifers are being overexploited at alarming rates in the MAR. The unreliability of the water services supplied by COMPESA in the MAR has had serious impacts on groundwater resources, as large users seek alternatives by self- provisioning from aquifers. The State Secretariat for Water Resources and Energy has introduced zoning criteria to guide the licensing of new wells and the issuance of groundwater rights; however, the unsustainable use of groundwater has persisted due to the limited institutional capacity for enforcement. The increase of water supply and improvement in service delivery generated by the ongoing investment programs are expected to reduce pressure on the aquifers and allow their preservation as a strategic resource. 93. Although the legal framework for water resources management in Pernambuco includes all basic principles of modern water management, implementation of the State water resources management (WRM) policy has been hindered by the lack of adequate information and institutional capacity. Frequent administrative changes at the state level with regards to the management of water resources have contributed to the vulnerability of sector institutions and prevented the formation of an entity at the state level with adequate resources and staff to carry out integrated planning and management of water resources. This situation has changed recently with the establishment, consolidation and strengthening of the State Water and Climate Agency (APAC). APAC serves as a regulatory agency, responsible for water resource planning and management in the State, including the issuance of water rights and bulk water charges as well as the State’s water and climate monitoring network. 94. Given the negative impact water scarcity and unreliable water supply and sanitation services have on the economic performance and social development in the State, the Government of Pernambuco has selected the water resource management as a priority sector and an important element of its State Development Plan. To this effect, the Government of Pernambuco developed a strategy for the sector with the following ambitious objectives: 39 (i) Reach universal access to water supply and sanitation in urban areas by the years 2014 and 2018, respectively. (ii) Improve the State’s water resources development and management policies and practices in order to allow for the expansion of access to safe and reliable water for human consumption and productive use. 95. Improved water resources management policies and practices are crucial to allow access to safe and reliable water for human consumption and productive uses in the State of Pernambuco, contributing to long-term sustainable growth, greater equity, and protection of the most vulnerable populations. The enactment of measures to ensure proper water resources management through appropriate, capable, and stable institutions is key to addressing core development challenges. The establishment of the State of Pernambuco Water and Climate Agency (APAC) represents the commitment of the State Government to addressing the main challenges faced by the water sector. The enactment, staffing, and strengthening of APAC provides the necessary environment to ensure the proper implementation of the government policy and institutional framework in Integrated Water Resources. 96. Government Actions Supported by the Proposed DPL: The DPL will support as a prior action the strengthening of the management of water resources through the institutional strengthening of the State Water and Climate Agency (APAC). The Government of Pernambuco is starting to implement a comprehensive water sector program that improves water management to ensure reliable and safer water for human and productive uses. APAC was created in March 2010 to take charge of water resources planning and management. APAC will enable a consolidation and strengthening of the State’s institutional framework to adequately manage water resources, including adequate organization, planning and management tools. The agency has the mandate to monitor the hydraulic balance in the State, triggering alerts for potential imbalances that could predict floods and droughts. Moreover, the agency is in charge of fostering participatory management activities, such as the establishment of new river basin committees and strengthening of existing ones, as well as the establishment of water supply infrastructure users’ associations and councils. These committees are representative of the communities, including their gender makeup, thereby reflecting the needs and demands of the users. The framework put in place also calls for: the revision, preparation, publication and dissemination of plans on water resources and selected river basins; the preparation of technical studies for the efficient and sustainable use of groundwater, with a special focus on the MAR and its complex groundwater dynamics; improved water use regulation; and modernization and expansion of the hydro-meteorological and water quality monitoring network, with a focus on disaster risk management of the most critical river basins and aquifers. Policy Objective 1.3: Improve Disaster and Risk Management Policy Action 3 The Borrower has improved the management of disaster risks through the issuance of APAC’s Board Resolution No. 001-2011 dated August 22, 2011, defining activities related to forecast and early warning of disasters linked to hydro-meteorological events in the Borrower’s territory, and identifying such activities jointly as activities of a situation room, as said activities have been integrated into the Hydrological Critical Events Forecast System of the Guarantor’s Federal Government. 40 97. Description and Challenges: Occupation of the semi-arid region and urbanization in the coastal area has made the State especially vulnerable to both long droughts and high rainfall events. Poor residents, who often live in rural areas and small towns in the semi-arid region and informal settlements located in flood plains, typically suffer the largest impacts from these events. Damages and losses from droughts and floods are not assessed on a systematic basis, particularly for localized events that affect small communities. The impact of these events is often concentrated in the poorest neighborhoods, where the value of assets is limited, but the impact on affected households is significant. In Pernambuco, floods and landslides are responsible for about 69 percent of registered disasters. The State Conference on Civil Defense, in 2010, involving representatives of about 130 municipalities, warned society of the existing risks and prepared the State to mitigate the negative effects of the extreme rainfall and floods of June 2010. As a result of the extreme event that affected several municipalities in the southern part of the coastal area, the State decided to improve its disaster risk management system, with a focus on monitoring and early warning, response, reconstruction, and improved knowledge about climate related hydrologic events. 98. Preventing and mitigating the effects of water-related disasters can positively impact equity, due to the correlation between disaster exposure and poverty. Both regions that are more exposed to risk, as well as those areas that are more vulnerable within the sub-regions, concentrate the most disadvantaged socioeconomic groups. 99. The establishment of the Crisis Cabinet to coordinate the reconstruction and the installation of local offices in the critical municipalities were key elements of the response to the crisis and preparation for the reconstruction. During the crisis of June 2010, the State launched the Reconstruction Operation, based on legal actions (emergency decrees), allocation of budget, a special fund, and an institutional structure comprising a Management Committee and 12 local offices (with 170 staff from 11 State secretariats) dedicated to response and reconstruction coordination. This operation has also produced an integrated action plan. In the course of responding to the event, the State of Pernambuco extracted lessons for improving its disaster management system, through better coordination, climate and rivers monitoring, and early warning systems. The de facto protocol for response, which is led by civil protection and involves action by several government entities, was formalized through a decree that established clear lines responsibilities. Other actions, including the expansion of flood vulnerability hydrologic modeling and mapping, are still to be developed. 100. During the past year, the State of Pernambuco has taken a proactive approach to mitigating the risks of losses due to disasters from extreme weather events. The civil protection and reconstruction programs launched in 2010 can be considered a best practice example of bringing together technical experts and government officials to mitigate risk. The program has produced an early warning system based on hydro-meteorological network placed in critical river basins, initiated the mapping of vulnerable areas to floods risk, prioritized areas of intervention, and raised the awareness of vulnerable communities to the risks they face. However, because informal settlements have continued to grow, a significant gap remains. Adaptation against flooding, particular in high-risk coastal areas, still needs to be developed. In the same way, adaptation against severe, longer droughts is to be improved, particularly for the semi-arid areas in the west of the State. 41 101. The Government’s Water Program also includes measures to protect citizens and producers, particularly those at high risk, from water-related extreme climate events. The high risk for water-related calamities in Pernambuco may increase as a result of climate change and increased hydrologic variability. Adequate hydro-meteorological monitoring, modeling and mapping, particularly for floods, and the implementation of an effective early warning system are key elements of disaster risk management. These activities are part of the adaptive measures that can reduce economic and social losses, and benefit the most vulnerable population by reducing their exposure to risks. In addition to its regulatory function for water resource management, APAC is also responsible for the monitoring of the hydraulic balance in the State, triggering alerts for potential imbalances that could predict floods and droughts. 102. Government Actions Supported by the Proposed DPL: The DPL will support as a prior action the framework necessary for improved disaster risk management through APAC. APAC will receive technical assistance from the National Water Agency for its monitoring and early warning system. APAC will contribute to reinforcing activities related to forecast and early warning of extreme hydro-meteorological events in the State of Pernambuco. This includes identifying activities such as the establishment of a situation room, integrated into the Hydrological Critical Events Forecast System of the federal Government. Policy Area 2: New Economy—Expanding Opportunities for Pernambucanos Policy Objective 2.1: Promote Job Creation through the Development of Human Capital Policy Action 4: The Borrower has improved and developed human capital for the job market with emphasis on professional education through the transformation of six (6) State schools into schools of professional education, as evidenced by Gubernatorial Decrees No. 36.355 of March 29, 2011 and No. 36.121 of January 21, 2011. 103. Description and Challenges: Technical education is essential to keeping students in secondary school and is an integrated part of the State of Pernambuco Education and Job Creation Strategy. It is also key to leveraging equity in education, by expanding the training options for all students, and facilitating their labor market entry. The one level of education that has shown little improvement in drop-out rates is upper secondary, and both federal and State officials see a great need to offer vocational training opportunities for students reaching that level of schooling to ensure that they perceive the relevance of schooling and enter the job market with marketable skills. At the federal level, the current presidential administration has introduced the Expansion Plan for Technical and Vocational Education, which is building new technical institutes and providing full-day secondary schooling that integrates traditional and vocational education. 104. The State Government of Pernambuco has undertaken a major expansion of vocational education. In 2005, there were just 1,774 students enrolled in six State vocational education institutions. By 2011, vocational enrollments had grown to 12,000 students in 14 institutions. This includes the establishment of integrated vocational and regular education in some schools to help students to both continue traditional study (leaving higher education 42 options available) while learning more immediately marketable technical skills. Market studies have been conducted to determine the training and skill sets needed by the local market, including the private sector. This experience builds on successful experiences and lessons learned in other countries, and emphasize private sector engagement. Technical programs have been developed based on studies, including evidence from Colombia, the Dominican Republic, and Peru, which demonstrate that vocational training programs can have positive returns on wages.14 There is also evidence that vocational options within a secondary school can keep students in school and lead to the improvement of core skills, such as literacy and numeracy.15 A close link to the private sector seems to be key to success. The Pernambuco program builds on this evidence, using studies of private sector demand in planning vocational offerings in each region of the State. 105. The expansion of educational options, as well as extension of school hours, may also have an impact on other social indicators. As the literature (including evidence from Chile) shows, relevant social indicators related to poverty traps and cohesion, such as the incidence of teenage pregnancy and violent crime, are negatively correlated with teenage school attendance (Krueger and Berthelon, 2011). Vocational school options are expected to help keep students in school. Thus, the educational policies described above are expected to have other positive social externalities beyond immediate educational improvements. 106. Government Actions Supported by the Proposed DPL: The DPL will support the transformation of six State schools into schools of professional education. These schools will focus specifically on the development of technical skills based on local market demands in order to increase the likelihood of translating training into local jobs. In the next two years, the State will establish the Pernambuco Network for Secondary School Professional Training and Competency. This network will establish uniform curriculum and quality standards for professional school offerings in the State, municipal, and private sector professional schools. It will include representatives from each sector and from each region of the State to ensure that courses represent local needs. The planned expansion will pay particular attention to more deprived areas in the interior of the State. The establishment of a State network to improve the quality of professional training across not only state schools but also municipal and private districts will improve quality even as the state expands coverage. Policy Objective 2.2: Increase Opportunities through Greater Gender Equality Policy Action 5 The Borrower has strengthened its institutional framework aimed at promoting gender equality through the creation of a permanent Women’s Secretariat (Secretaria da Mulher) to replace the former temporary special Women’s Secretariat, and the approval of regulations for said secretariat, as evidenced by the Borrower’s Law No. 14.264 of January 6, 2011 and Gubernatorial Decree No. 36.659 of June 14, 2011, respectively. 14 See Attanasio et al, ―Subsidizing Vocational Training for Disadvantaged Youth in Colombia: Evidence from a Randomized Trial,‖ American Economic Journal: Applied Economics, 2011; Card et al, ―The Labor Market Impacts of Youth Training in the Dominican Republic,‖ Journal of Labor Economics, 2011; and Chong & Galdo, ―Does the Quality of Training Programs Matter? Evidence from Bidding Processes Data,‖ IZA DP 2202, 2006. 15 See Stern et al, ―Combining Academic & Vocational Courses in an Integrated Program to Reduce High School Dropout Rates: Second Year Results,‖ Education Evaluation and Policy Analysis, 1988. 43 107. Description and Challenges: Gender disparities continue to impede the social and economic opportunities of women in Pernambuco. Despite the decline in overall poverty in the State in recent years, the gap between male and female heads of household continues to loom large at 9.4 percent and 13.1 percent, respectively. Levels of unemployment are also higher for females in Pernambuco, with 17 percent of female heads of household unemployed in 2009. The unemployment rate for female heads of household is 11.6 percent in the northeast, and 9.7 percent in Brazil as a whole. Those women who are employed also receive lower salaries than men, receiving only 82 percent of the income earned by men. 108. Despite efforts to improve endowments for women in Pernambuco, serious problems persist. For example, maternal mortality remains very high with 76.4 deaths per 100,000 live births, based on 2008 data. In northeast Brazil, only Bahia has a higher maternal death rate. Furthermore, although educational attainment is somewhat higher in Pernambuco (6.07 years) for females than for males (5.58 years), that data is substantially lower than for Brazil as a whole for the same period (6.38 and 5.91 years for females and males, respectively). Females’ higher educational attainment, moreover, is not reflected in higher returns to education compared to males. At 39.4 percent, the economically active female population in the MAR is the lowest of the six largest metropolitan regions in Brazil16, which show an average of 48.4 percent. 109. Females still experience heavy constraints in terms of agency both in the private and public spheres. One example of this is teenage pregnancy, which remains a serious problem in Pernambuco. Evidence suggests that pregnancy before the age of 20 has negative implications for mothers and their children’s future opportunities in society.17 In Pernambuco, the pregnancy rate for 15 to 19 years old girls was 74.4 per 1,000 live births, which ranks as the fourth highest in the northeast Brazil and in the middle of the pack for Brazil as a whole. 110. A clear manifestation of the lack of agency is violence. While violent crime is an issue that affects males disproportionately in Brazil and in Pernambuco, levels of violence against females have remained high in recent years. The female homicide rate in Pernambuco of between 6 and 7 per 100,000, remained high throughout the past decade, and is second only to Alagoas in the northeast (6.8 per 100,000) and the fifth highest in all of Brazil. Thirty-four percent of females in Pernambuco reported having experienced physical violence, while 14 percent reported sexual violence at least once in their life (WHO, 2005). 111. While the State had maintained a Special Secretariat for Women since 2007, its role and impact had been limited. The Special Secretariat for Women had the capacity to cover only two major areas of activity: (i) rights-based training of women; and, (ii) job training in non-traditional sectors for women in rural areas of the State through the Chapeu de Palha program.18 16 Salvador, Belo Horizonte, Rio de Janeiro, São Paulo, Porto Alegre. 17 Teenage pregnancy is often correlated with higher poverty rates and lower economic opportunities of the mother, as well as lower educational outcomes of the child. However there is little empirical evidence on whether these correlations represent causal links, or on the direction of any causality. 18 The Chapéu de Palha Program was created in 2007 with the objective of reaching families in the Zona Canavieira (sugarcane producing region) who are unemployed in between harvests, and strengthening rural populations’—and particularly females’—productive, social, and political capacities. Vocational training for females is a special focus of the program and activities are implemented in partnership with SENAI (Serviço Nacional de Aprendizagem Industrial) and SENAC (Serviço Nacional de Aprendizagem Comercial). SecMulher 44 112. Government Actions Supported by the DPL: The DPL will support as a prior action the creation of a Permanent Secretariat for Women to replace the former temporary Special Secretariat for Women. By becoming a permanent secretariat, SecMulher is able to more vigorously advance gender mainstreaming in the public sector, while expanding its areas of focus to other key pressing gender issues in Pernambuco— namely the protection of violence against females, gender education, and women’s and maternal health. While many services currently exist to partially respond to these issues, the ability to reach and address the specific issues and constraints facing women remains limited. SecMulher is now able to promote more actively the institutional framework within the public sector to support gender issues through specialized gender units to respond to issues affecting the opportunities and wellbeing of women. It reflects the commitment of the Government of Pernambuco to the importance and relevance of gender issues to the development of the State. 113. As a permanent secretariat, SecMulher has gained significant weight within the governmental structure, which has greatly facilitated discussions with other Secretariats in order to mainstream gender issues in the public sector. In this regard, it has initiated partnerships with the Secretariat for Education (SecEdu) and the Secretariat for Health (SecSaude) to mainstream gender issues into the daily functioning of the secretariats. In the case of SecEdu, gender units will be established in full-time schools (Escolas de Referencia) where gender sensitization activities will be developed and conducted with students and teachers. Five pilot units are already in place and there are plans to expand this to all Escolas de Referencia as well as 14 vocational training schools, reaching a total of 116 municipalities and more than 70,000 students by the end of SecMulher’s current term. In the case of the SecSaude, the partnership aims to define and implement strategic actions providing comprehensive assistance and services to females in areas such as violence prevention, screenings for cervical, breast, and skin cancer, and training on gender issues to municipal health secretaries and coordinators. 114. Reducing and preventing violence against women is also an important area of focus for SecMulher. It is working closely with the police and the judiciary to help implement 19 regional women police stations by 2015. This is a very innovative initiative since it will facilitate women’s access to police services, especially for those residing in remote areas.19 To strengthen the support to women victims of violence, SecMulher initiated training workshops on gender sensitization for police officers and public servants working in the criminal justice sector. The objective is to train 1,000 people per workshop and to have two workshops per year for a total of six workshops by 2014. has organized a course to train females in non-traditional sectors (mechanics, construction, and electricity) with the objective of changing the prevailing gender-specific obstacles to accessing the labor market in non- traditional sectors. A condition for participation in these courses is the completion of a rights literacy course that addresses basic concepts of citizenship, human rights, and gender equality. The trainings started in 2007 in the Zona Canavieira and were expanded to the São Francisco Valley in 2009, and to the Agreste in 2010. Another expansion of the project was initiated in 2011 to reach women in the coastal areas of Pernambuco. By becoming a full secretariat, there will be a substantial increase in the number of women trained annually: an estimated 4300 females received vocational training in 2011 whereas 1,215 women received training in 2010. Moreover, there is an interest from SecMulher to absorb the full execution of this program as of 2012. 18 An Action Plan for Women Living in Rural Areas already exists. 19 The fact that SecMulher is working closely with the police to open more women’s police stations is significant since several women’s police stations have been closed in another state – Sao Paulo – as part of the restructuring of the police force. 45 115. The SecMulher intends to expand its reach at the local level through the establishment of regional coordinators to facilitate the articulation of policies and programs with a gender perspective. The regional coordinators serve as an innovative strategy to bring the services and advocacy of SecMulher to the local level. The regional coordinators will be established as mobile units in the 12 regions of the State, with each responsible for several municipalities. The regional coordinators will engage with the municipalities to determine the quality and effectiveness of services provided to women, identify and provide gender-based capacity building programs for public service providers, and serve as a conduit to advocate for gender issues at the local level, conveying those needs to SecMulher at the state level. Policy Objective 2.3: Promote Economic Development through Support to SMEs and Rural Producers Policy Action 6: The Borrower has taken the following steps to establish its Development Agency (Agência de Fomento do Estado de Pernambuco, S.A.) (―AGEFEPE‖), aimed at promoting economic and social development by supporting micro, small and medium-size enterprises and rural producers in local production chains: (a) the authorization by the Guarantor’s Central Bank (Banco Central do Brasil) to commence the operations of AGEFEPE on December 9, 2010; and (b) the enactment of the Borrower’s Law No. 14.282 of March 29, 2011, allocating resources to AGEFEPE. 116. Description and Challenges: Economic growth in Pernambuco is highly concentrated geographically, with weak links to local suppliers. Currently, 74 percent of the GDP of the State is produced in the coastal area, in an area that encompasses 17 percent of the territory and 57 percent of the population. The prevalent sector composition favors demand for relatively unskilled labor and shows low productivity growth. The strategy to attract investment to the Suape port complex has been accompanied by a definition of strategic sectors that will be supported and eventually linked to the main growth drivers. Among the large projects that are envisaged are an oil refinery, a shipyard, a plastic resin factory, a pharma-chemical complex, and a car manufacturer (Fiat). Following these prospects, the expectation is to maintain growth above the national average, increasing the state’s share in national GDP and raising per capita GDP toward the national average. 117. The Government strategy for development is founded on three pillars. First, enhancing skill levels and actively linking those to local needs for specific sectors, as described under Policy Action 4. Second, implementing an active policy to attract investment, generate economic activity, and increase long-term tax revenue as a result. Third, establishing a professional agency that links credit for investment in small and medium enterprises in strategic value chains to managerial, technical and market development support, as described below. 118. Government Actions Supported through Proposed DPL: The DPL would support as a prior action the establishment of a State Development Agency aimed at promoting economic and social development by supporting micro, small, and medium-size 46 enterprises (MSMEs) and rural producers in local production chains. The Agência de Fomento Do Estado de Pernambuco (AGEFEPE) received formal approval to operate in early 2011 and has received an initial capital of R$30 million. Its mandate covers a wide range of actions, all related to the provision of support for entrepreneurship. It focuses on both the interiorização and internalização of value chains, promoting stronger links to local firms within the State (particularly in the interior) that can supply large private firms and government, strengthening also access to technology, quality control protocols, commercialization networks, and managerial training. AGEFEPE, in conjunction with the Secretariat for Economic Development, have conducted extensive studies and research to determine growth-generating sectors and well-defined value chains in Pernambuco. 119. After the pilot stage, concluded in December 2011, AGEFEPE will scale up its activities gradually. The agency will have an instrumental role in accessing federal funds devoted to similar objectives. Once AGEFEPE is in full operation, it will be able to have a portfolio ten times higher than its own capital, with minimum risk for the State. The priority production sectors to be supported—after a series of feasibility studies—are: apparel; dairy products; different kinds of supplies for government procurement; tourism and transport (including taxi companies); and farming of high value added goods. The Rural Economic Inclusion Project in Pernambuco, supported by the Bank, also offers potential for synergies with AGEFEPE’s work through the integration of rural producers into local supply chains. 120. Estimates suggest that the State’s development strategy should add between 0.5 and 0.7 percent of annual GDP growth to the State after consolidation (the strategy should be working at full scale by 2016). Given the nature of the priority sectors, the strategy implies an important growth in the demand for technical (medium skill) workers, and thus a reduction of unemployment and poverty in the interior of the State. A specific line of activity is devoted to support gender-related priorities, providing services to women entrepreneurs under competitive conditions and emphasizing support in sectors that generate demand for female labor. Policy Area 3: Increase Public Administration Capacity for Generating Results for Pernambucanos 121. The Bank supports efforts to increase the effectiveness and efficiency of public management in Pernambuco as a means of enhancing equity and expanding the opportunities of Pernambucanos. A more effective tax administration, which reduces evasion, will increase the redistribution capacity of the State through the generation of more resources. Improvements in budget management aim to allocate and execute more resources in the strategic priorities identified through a participatory process. Finally, the establishment of the Management Institute will contribute to the consolidation of Pernambuco’s Public Management Model, which operationalizes the All for Pernambuco strategy by strengthening the link between planning and budgeting, and promotes a participatory, centrally coordinated approach and the monitoring of outputs and outcomes of social policies and programs. 47 Policy Objective 3.1: Improve ICMS Tax Revenues, without Increasing Tax Burden on Firms and Citizens, to Expand Fiscal Space for Investment and Promote Private Sector Development The Borrower has taken the following measures to improve tax revenues without increasing tax burdens on taxpayers: Policy Action 7: (a) the establishment of a regulatory framework for the implementation of a new fiscal control system (Sistema de Escrituração Fiscal e Contábil 2) (―SEF-2‖), as evidenced by the Borrower’s Resolution (Portaria) No. 190, dated November 30, 2011, issued by SEFAZ; and Policy Action 8: (b) the establishment of a Tax Substitution System for selected products, as evidenced by Gubernatorial Decrees No. 35.655 of October 7, 2010 (linens), No. 35.656 of October 7, 2010 (bicycles), No. 35.657 of October 7, 2010 (toys), No. 35.677 of October 13, 2010 (cosmetics, pharmacy products and toiletries), No. 35.678 of October 13, 2010 (construction and home design materials), No. 35.679 of October 13, 2010 (automobile parts), No. 35.680 of October 13, 2010 (electric materials) and No. 35.701 of October 19, 2010 (electronic products and home appliances). 122. Description and Challenges: Pernambuco has shown strong commitment to expand fiscal space for investments over the last five years and has achieved remarkable results. Pernambuco was the top performer among Brazilian states in terms of real revenue growth during the period 2005-2010, increasing by over 57 percent. Even with the financial crisis, Pernambuco’s tax revenues increased by over 12.5 percent in real terms between 2008 and 2010, well above Brazilian states’ average of 5.9 percent. This increase is explained by strong economic growth, but also by institutional improvements in SEFAZ, more effective monitoring, and more capable information systems. 123. Despite this strong increase in revenues, there is considerable space for enhancing efficiency and effectiveness of the tax administration of the ICMS (tax on goods and services)—the main source of revenue controlled by the state. The ICMS represented over 44 percent of total tax revenues in 2010. Modernization and automation of processes would enable a more efficient and effective control of ICMS compliance. Because Pernambuco is a net importer of goods, its main efforts are focused on controlling goods entering the state. Until 2010, this control was done physically upon arrival of the goods. Taxes were calculated manually and on paper records, consuming substantial human resources, and increasing the rates of mistakes and unregistered transactions, especially for those products more difficult to control. Audits were mainly conducted ex-post, and planned only after the arrival of documentation. 124. Government Actions Supported by the Proposed DPL: The DPL will support as prior actions State policies to improve tax revenues without increasing the tax burden on taxpayers. Two major efforts have been undertaken for strengthening controls of the ICMS administration with the objective of increasing the fiscal space available for investments with no additional tax burden on firms and citizens: (i) the implementation of the new fiscal control system, Sistema de Escrituração Fiscal-2 (SEF-2); and (ii) the implementation of a tax 48 substitution system for selected products with the highest risk of evasion, representing close to 30 percent of ICMS tax collection. 125. The implementation of the new fiscal control system SEF-2 will increase the quantity and quality of sales information, substantially reducing fiscal evasion (Policy Action 7). SEF-2, approved by decree in February 2010 and implemented in November 2011 through Portaria No. 190, makes it mandatory for all firms and individuals reporting ICMS to submit detailed information of all sales receipts electronically (previously, less detailed information was provided and could be submitted in paper). The system also classifies the way users provide information. In the past, firms may have undervalued their sales to small and medium enterprises in their reports to the Government. The expansion in sales receipts, combined with the higher level of detail required and the new electronic format, provides the State with a powerful tool to detect and act on incompliance by taxpayers. 126. The establishment of a tax substitution system for selected products will allow the State to perform more strategic and effective physical controls to reduce evasion and promote voluntary tax compliance (Policy Action 8). A new electronic system, mandated and in use since the issuance of eight decrees since November 2010, identifies goods, registers sales electronically, and collects taxes at the point of sale for selected products with high volumes of sales and highest risk of evasion.20 The automatic estimation of taxes at the goods’ departure rather than at their arrival in Pernambuco, and the use of detailed classification systems will ensure an easier process for taxpayers and will give the State more time and resources to devote to strategic physical checks, increasing their effectiveness and compliance with the tax system.21 Policy Objective 3.2: Improve the Efficiency of Budget Allocation and Execution Policy Action 9: The Borrower has improved the efficiency of budget allocation and execution through the formulation and execution of the PPA and budget, both structured into strategic priorities, as evidenced by: (a) the Borrower’s Law No. 14.234 of December 13, 2010; (b) the Detalhamentos de Despesas por Elemento (DDEs) published in www.transparencia.pe.gov.br; and (c) letter dated September 12, 2011 from Secretary of SEPLAG attaching a report on the budget execution by strategic priorities for the period January 1, 2011 through August 31, 2011. 127. Description and Challenges: Pernambuco has made important progress towards linking its planning and budgeting processes. These improvements were made gradually, 20 The decrees and products covered are the following: Gubernatorial Decrees No. 35.655 of October 7, 2010 (linens); No. 35.656 of October 7, 2010 (bicycles); No. 35.657 of October 7, 2010 (toys); No. 35.677 of October 13, 2010 (cosmetics, pharmacy products and toiletries); No. 35.678 of October 13, 2010 (construction and home design material); No. 35.679 of October 13, 2010 (automobile parts); No. 35.680 of October 13, 2010 (electric material); and No. 35.701 of October 19, 2010 (electronic products and home appliances). 21 Pernambuco’s ICMS tax substitution system had already registered a 141 percent nominal increase in tax collection for the period January-June 2011 as compared to the same period in 2010 (Source: SEFAZ) 49 following a careful implementation strategy. The State moved from a fragmented budget planning process that followed standard increases across the board based on inputs, to a new Management Model. Beginning in 2008, along with other states, Pernambuco defined strategic priorities following the Government’s plan and outcomes from participatory regional meetings. The strategic priorities that result from this process inform the preparation of the Plano Pluri-Annual (PPA) and budget formulation of individual institutions on an annual basis. They are defined for the period of the Governor’s mandate and they align the allocation of public expenditures to the State’s policy priorities. 128. By 2010, the planning process had fully incorporated the strategic priorities into the budget formulation phase, but budget execution continued to follow a traditional input-based structure. Budget execution through the financial management system E-Fisco continued to track categories of expenses rather than expenditures related to specific policy priorities. Physical and financial targets were linked manually during execution, placing onerous demands on the administration to collect and analyze the data. While the State had strengthened the controls over modifications to budget allocations during the fiscal year compared to 2008, improved regulation was still needed to ensure strategic execution of public expenditures. The new regulation needed to eliminate the practice of making changes on a daily basis as a result of poor budget formulation, while providing the Government space to address contingencies or changes in assumptions that occur during the fiscal year. 129. Government Actions Supported by the DPL: The DPL will support as a prior action the State’s actions to improve the efficiency of budget allocation and execution. The PPA and budget are now being formulated and executed to reflect Pernambuco’s strategic priorities. The participatory process for the PPA—identifying strategic priorities and linked to budget formulation through the Management Model—has now been further improved through measures that contribute to ensuring resources are effectively spent on the Government’s policy priorities. 130. The formulation and execution of the PPA and budget, structured into strategic priorities, will allow for more effective verification that resources are being spent on the Government’s strategic priorities. The introduction of the category sub-action in the budget codes indicating the strategic priority together with the new programmatic and strategic priority classification of the PPA and the budget allowed the State to allocate and execute budget resources based on the State’s strategic priorities for the first time in 2011. Budget execution per strategic priority can now be monitored in real time, using E-Fisco—the State’s financial management system – ensuring that allocation and execution of public expenditures match the State’s development plan, and providing key information for decision makers during the year. 131. The new regulation of budget modifications during the fiscal year will also contribute to strengthening the link between budget formulation and execution. Governor’s Decree 36.092/2011 and Resolution 2/2011, issued jointly by SEFAZ, SEPLAG, SAD and SECGE in January 2011, regulate potential modifications made to the budget during execution by: (i) introducing a governance system for doing so; and (ii) creating specific periods for ordinary changes and providing flexibility for extraordinary circumstances. This reform will encourage a more careful budget formulation by line ministries and will help to protect budget allocations made towards strategic priorities from potential reductions during the fiscal year. 50 Policy Objective 3.3: Improve Capacity to Plan and Implement Public Policies through the Institutionalization of Pernambuco’s Management Model Prior Action 10: The Borrower has consolidated its Management Model and strengthened its capacity to generate results through the establishment of the Management Institute, as evidenced by Gubernatorial Decree No. 37.828, dated February 2, 2012. 132. Description and Challenges: Pernambuco has improved its capacity to plan and implement public policies by taking initial steps for the institutionalization of the State’s Management Model. Strengthening SEPLAG through the establishment of the Management Institute and the implementation of the Planning, Budgeting and Management (PBM) career represent important milestones towards this goal. 133. The State has taken steps toward the long-term goal of developing its human resources with the objective of strengthening the public administration’s capacity to deliver. The creation of the PBM career in June 2008 represented a key milestone in improving capacity within the center of government, as well as in institutionalizing the State’s new Management Model.22 The creation of positions for administrative management analysts and internal control analysts also supported the stated objective.23 However, as of November 2010, only 15 PBM analysts had been appointed out of the 220 authorized positions. As a means of capacity building, the Government also invested significant resources in staffing and increasing pay for public servants in service-delivery sectors, such as health, education, and security. This was done to attract and retain skilled personnel while staying within the personnel expenditures limit established in the Fiscal Responsibility Law. 134. Government Actions Supported by DPL: The DPL will support as a prior action the consolidation of the State’s Management Model through the establishment of the Management Institute in order to strengthen its capacity to generate results. The lack of a ―whole-of-government‖ view, aligning the Government’s priorities in its development plan with policy-making, program formulation, and program implementation, is a chronic problem in Latin America (World Bank, 2010). The Management Institute, a strategic unit within SEPLAG, will help institutionalize the State’s Management Model through a legal mandate to: (i) monitor the connection between the All for Pernambuco strategy, and the planning instruments (PPA and Budget law), and the Management Model, thereby ensuring a ―whole- of-government‖ view in the planning instruments and avoiding isolated and inconsistent agendas from line ministries and agencies; (ii) developing, structuring, implementing, and updating the social management report, to be produced on an annual basis, including performance indicators on education, health, and the labor market, and providing outcome information on the State’s priority areas defined through regular consultation with all Pernambucanos; (iii) designing and implementing a continuous training program for politicians holding management positions, senior public sector managers, and PBM analysts across the administration to strengthen a ―whole-of-government‖ view; and, (iv) linking the State with external entities for the discussion of public policies in Pernambuco. The establishment of the Management Institute will institutionalize the Management Model by 22 Lei Complementar No. 118/2008 23 Lei Complementar No. 117 and 119/2008 51 assigning the functions mentioned above to a technical institution led by permanent staff, ensuring political neutrality and continuity across different administrations. VI. OPERATION IMPLEMENTATION C. POVERTY AND SOCIAL IMPACTS 135. The proposed operation is expected to have a positive effect on poverty reduction and socioeconomic equity. As explained above, the Government’s development plan for the period 2011-2014 and this DPL aim to ensure a more equal geographic distribution of the benefits of growth. For the purpose of the operation, a thorough analysis of potential impacts of the supported policies on poverty and equity was carried out. The Poverty and Social Impact Assessment (PSIA) concluded unambiguously that the policy package under the proposed DPL will have a progressive incidence and will enhance equity.24 136. Poverty reduction in Pernambuco, as in the rest of Brazil, has occurred alongside persistent socioeconomic disparities. Brazil made notable progress in reducing poverty in the past decade. Data reveals that Brazil’s poverty rate declined significantly from 29.1 percent in 2006 to 22.1 percent in 2009.25 In Pernambuco, poverty reduction was even more striking than in the northeast and Brazil as a whole: poverty in Pernambuco fell from 48.6 percent in 2006 to 38.3 percent in 2009. Such a reduction, however, hides regional and within-state heterogeneity. The policies supported in the proposed operation take these inequities into consideration and target the areas of the State that are lagging behind in socioeconomic terms. Policy Area 1: Improving the Quality of Life of Pernambucanos 137. In the area of education reform and the extension of hours of instruction, priority will be given to schools in relatively backward areas. The expected improvement of the quality of education will lead to higher employability, raising the potential earnings for people in those areas. The extended school hours may also have an effect on reducing youth involvement in violent and criminal activity, in addition to potentially reducing teenage pregnancy, particularly in the poorest municipalities.26 138. The water resources management components, focused on the improvement of water security and reliability of supply, will also have a positive distributional impact. The new framework and the creation of APAC, by increasing water security, will favor poor urban communities and rural areas, which have been traditionally affected by unreliability of water supply. Health-related outcomes, such as reductions in child mortality and morbidity, are positively influenced by more reliable water provision in relatively poor areas, particularly in the urban sector. In the rural sector, there is a time-use related gain for the poor, especially women, who typically spend a non-negligible amount of time transporting and collecting 24 The PSIA is being finalized. All the PSIA-related documentation will be available, including the list of stakeholder meetings that took place. The PSIA is based on survey data, administrative data and in-depth interviews. 25 Using the World Bank 4USD/day moderate poverty line. As a result, percentages may differ from those using Brazil’s official moderate poverty line. Unless otherwise specified, poverty rates are for head of household. 26 The evidence in the literature is based on the Chilean case (Krueger and Berthelon, 2011). 52 water. Alternative suppliers may oppose the reform on the grounds that an increase in the efficiency of the system could reduce their business. Indeed, poorer people tend to buy water from alternative suppliers, at higher prices, whenever the system does not satisfy their demand. 139. The risk and disaster management policies supported by the operation can be expected to have a large pro-equity impact. Qualitative evidence reveals that such policies have the support of rural producers, rural workers, unions, and NGOs. This is mainly due to recent experiences droughts and floods that have imposed economic and social costs on these groups. The policies supported by the DPL are expected to contribute to reducing the economic and human costs associated with population displacement in the semi-arid zone of the State. Disaster risk and losses due to extreme events have been shown to be associated with socioeconomic conditions: in other words, the same level of exposure tends to result in higher relative losses for poorer populations, both with regard to physical assets and non- tangible assets (due to the interruption of schooling and health services). As the PSIA shows, the map of disaster risk exposure overlaps with the poverty map. Thus, reducing the magnitude of the impact of extreme events, through the policies supported by the operation, is likely to have pro-poor implications. Policy Area 2: New Economy—Expanding Opportunities for Pernambucanos 140. The promotion of economic development and job creation, through the policies supported by the DPL, are expected to be positive for all stakeholders. The PSIA analysis concludes that labor unions, entrepreneurs’ associations, families, and NGOs are all likely to support these policies. Stronger links between the supply of and demand for skills and the interiorization of value chains linked to the Suape port will promote more inclusive growth in the State. The newly-created Development Agency (AGEFEPE) aims to boost job-creation and improve the benefits of growth. The structure and financing of the agency does not represent a fiscal burden, and it may become an instrument to obtain more resources from centralized funds to finance local development. 141. The policies supported by this DPL, including the support to the establishment of the SecMulher as a permanent secretariat and the implementation of partnerships with other sectors, will enhance economic, social and cultural opportunities for women in a non-regressive way. Certainly, when analyzing gender-related measures the most common framework is to think in terms of between-group inequalities.27 The PSIA shows that gaps in female labor force participation and entrepreneurship are likely to be reduced through the policies in this operation. Policy Area 3: Increase Public Administration Capacity for Generating Results for Pernambucanos 142. A more effective tax administration will increase the State Government’s resources to implement its All for Pernambuco strategy, while online monitoring of budget execution by strategic priority will ensure the State’s funds are spent on the 27 Decomposable inequality measures (such as the Theil index) can shed light into Between-group versus within- group inequality in population groups. 53 strategy priorities. The strengthening of the tax administration capacities of the State does not imply an increase of tax burden on the poor. The estimated increase in revenues due to improved tax administration would support the Government’s efforts towards poverty reduction and would have a progressive effect. Online monitoring of budget execution by priority will ensure revenues are spent according to existing priorities and will enhance budget execution for these programs, making the pro-poor effects even stronger. Finally, the consolidation of the Management Model, which ensures a central coordination of the planning and budget processes following State priorities and periodically monitors the performance of strategic priorities, will help to keep the focus on results of the All for Pernambuco Strategy. D. ENVIRONMENTAL ASPECTS 143. The policies supported by this operation are likely to have a significant positive impact on the environment, forests and natural resources. The associated programs can also contribute to the protection of the region’s environment. Strengthening evaluation and management will have positive impacts on environmental protection. 144. The principal environmental implications of the proposed DPL stem from the water and disaster risk management components. Under objective 1.2—Improve Water Security and Increase Reliable Water Supply—several substantial positive effects on human welfare are expected outcomes: (a) an expected 400,000 more Pernambucanos with increased reliability and security of urban water; and (b) improved water supply management. Managing water systems more efficiently implies not only looking at infrastructure but also at the source of water and how land-use practices upstream affect the quality, quantity and timing of water delivery. With regard to objective 1.3—Disaster and Risk Management— timing and quantity of water delivery is of significant importance. In addition to the positive impacts on human welfare, the policy supported by this DPL is expected to positively and durably impact environmental management in the State of Pernambuco. 145. Pernambuco faces problems of water scarcity and water leakages, being one of the driest states in Brazil with per capita water availability of 1,320 m³/year on average, equivalent to only 3.5 percent of the national average per capita availability. The State’s semi-arid Sertão and Agreste sub-regions represent 89 percent of the State’s territory and have only about 20 percent of the water available in the State, with per capita water availability ranging from 400 m³ per year to 800 m³ per year, respectively. The coastal wetter sub-regions of Mata Pernambucana and the MAR concentrate 57 percent of the population, mainly in the metropolitan area of Recife (43 percent of the State population and 65 percent of the State GDP) and about 80 percent of the available water. Improved management of scare water resources is critical to ensuring that they are allocated and used in an equitable and sustainable manner, all the more so in the larger context of climate change, which is likely to exacerbate current vulnerabilities to climatic shocks and natural hazards. 146. Although the legal framework for water resources management in Pernambuco includes all basic principles of modern water management, implementation of the State water resources management (WRM) policy has been hindered by the lack of adequate information and institutional capacity. Furthermore, environmental management in Brazil is decentralized across the three tiers of government—federal, state and municipal. Most environmental licensing and enforcement is under the responsibility of the state agencies. The 54 strengthening of the capacity of state-level institutions is critical to achieve sustainable improvement in environmental management. The policies supported by this DPL will contribute to strengthening the State of Pernambuco’s capacity and preparedness to address water and disaster management issues, particularly through the newly created Agência Pernambucana de �guas e Clima (APAC). E. IMPLEMENTATION, MONITORING AND EVALUATION 147. The State Secretariat of Planning and Management (SEPLAG) will be responsible for the overall implementation of the proposed operation. This will be done in close coordination with other relevant line secretariats, namely the Secretary of Education, the Secretary for Water Resources, and the Secretary for Economic Development, as well as several complementing agencies that support the reform programs included in the policy matrix. 148. SEPLAG has instituted an elaborate monitoring and evaluation system for its strategic priorities. The Governor convenes a meeting of the secretaries of all the State secretariats to assess progress on strategic objectives, analyze advances towards reaching outcome and results indicators, and identify obstacles to progress and budgetary implications. As the proposed operation is fully aligned with the State’s strategic map, the progress of the indicators defined under this program will be monitored as part of this process. This will facilitate regular updates of program implementation and allow for necessary adjustments. F. FIDUCIARY ASPECTS Public Financial Management (PFM) 149. The Bank’s knowledge of the public financial management system in Pernambuco is based on a Public Expenditure Financial Accountability (PEFA) assessment that was finalized in 2009 and on subsequent analyses undertaken in the preparation and supervision of Bank lending operations, including the SWAP. 150. A centerpiece of Government’s All for Pernambuco strategy is the commitment to increasing the capacity and efficiency of public administration, including strengthening public financial management. The State Government’s reelection to another term represents recognition that this commitment has been translated into actions aimed at improving service delivery. The strategy recognizes transparency, accountability and the increased efficiency of public expenditures as key elements necessary to ensure equitable economic growth in the State. To achieve these, the Government has undertaken a number of reforms to enhance efficiency, transparency, and accountability in the use of public funds. These reforms have been aimed at strengthening linkages between strategic planning and the budget preparation process, increasing capacity for the accounting and internal audit functions, and upgrading information systems. 151. The Constitution of the Federative Republic of Brazil underpins the management of public finances at all levels of Government throughout the country. More detailed requirements and guidelines relating to PFM procedures to be adopted at all levels of government are contained in a well-developed legal framework. This framework was 55 developed through the introduction of legal and institutional reforms to help strengthen accountability and transparency in the management of public finances in Brazil. A public accountability law (Lei 4.320 of 1964) regulates financial controls, budgeting and reporting at the federal, state and municipal levels. The Law of Fiscal Responsibility (LRF) of 2000 established particular requirements for macroeconomic and fiscal discipline. The federal government is leading an initiative to adopt international public sector accounting standards that will improve financial reporting and accountability at all levels in Brazil. These reforms have been implemented in an environment characterized by increased demand for accountability in the use of public resources. 152. The PFM system consists of strong internal rules and controls. These clearly define the roles of the different institutions involved in the management of public funds and allocate responsibilities between them. The legislature is responsible for approving the budget and for oversight of its execution. SEPLAG is responsible for the preparation of the budget while SEFAZ undertakes budget execution duties. The budget classification system is governed by federal rules that are consistent with international standards. These rules require the publication of comprehensive information in the budget documents. Brazil scores highly on the 2010 Open Budget Index, indicating that significant information is provided to the public in budget documents.28 Accounting rules and regulations are generally respected and there is a high level of transparency with respect to financial information on the State’s transactions. This is due to a number of factors, including the clarity with which relevant laws describe obligations in relation to the preparation of these financial statements, and the diligence with which they are applied. 153. The budget preparation process is orderly, and is guided by well-defined budget preparation procedures and calendar. These establish proper sequencing and allow sufficient time for budget preparation activities. The State has consistently met the deadlines for the preparation of the key budget documents (the Plano Plurianual de Ação (PPA), the Lei de Diretrizes Orçamentárias (LDO) and the Lei Orçamentária Annual (LOA)), and for their submission to the legislature for their consideration and approval. The process is designed in such a way as to promote participation by all key stakeholders and sectoral agencies. The PPA provides a reasonable foundation for a multi-year perspective in fiscal planning, upon which further linkages to the annual budgeting process can be built. It covers a period of four years, the latest being 2008 to 2011. 154. Despite this fairly robust multi-year planning framework, there are remaining inconsistencies between the program objectives, costs and targets listed in the PPA, and those reflected in the work plans of budget agencies, and the execution reports prepared by them. This weakens the linkage between multi-year planning and the annual budgeting process. The definition of program objectives, costs and targets in the PPA is at times inconsistent with that in the LOA. Also, PPAs do not sufficiently reflect the lifecycle costs of investment programs. The Government is committed to improving the medium-term outlook in its planning and budgeting process, through better coordination between planning agencies and the sector and financial units in individual secretariats. 155. Pernambuco’s new E-Fisco financial management information system represents a vast improvement. E-Fisco contains an accounting module that is used to link the 28 See http://www.internationalbudget.org/files/OBI2010-Brazil.pdf. 56 approved budget with accounting and budget execution data. For a number of years, Pernambuco used the Integrated System for State Financial Management (SIAFEM) as its integrated financial management information system. The PEFA review noted weaknesses resulting from the outdated architecture upon which it was based, which limited its usefulness as a management tool. The new system also enables the real time capture of transaction data, making budget execution data instantly available for the preparation of financial reports. These are prepared in conformity with federal laws and regulations. In addition, the system is used to provide citizens of Pernambuco access to budget execution data, thus promoting transparency in the use of public funds. 156. Pernambuco is undertaking a number of reforms to prepare for the implementation of the new accounting requirements, including the adoption of a plan of accounts and training of staff. Brazil has established a timetable for the adoption of international public sector accounting standards in all federal entities by 2013. Upgrading the information system will also facilitate the implementation of the new accounting procedures once introduced. 157. Weaknesses in the internal audit function of the State were noted during the PEFA assessment. Since then, the State established the Secretaria Especial da Controladoria Geral do Estado (SECGE) to undertake internal audits. The head of the SECGE reports directly to the Governor, thus enhancing its independence. The department has sufficient access to other government departments to enable it to undertake its audits, and its recommendations are generally implemented. The Government continues to strengthen the SECGE through the creation of a specific career path designed to increase the professionalism of staff in the department. It has also undertaken a recruitment drive and training program for staff aimed at increasing their knowledge and skills. 158. The responsibility for external audit of the accounts of the Government and its agencies is exercised by the Tribunal de Contas do Estado (TCE) of Pernambuco (TCE). The TCE enjoys operational independence and its staffing is considered sufficient for it to carry out its duties. In addition to compliance and financial audits, the TCE has recently embarked on performance audits in a bid to help enhance efficiency in the use of public funds. The recommendations of the TCE are generally implemented, partly due to an effective system it uses to monitor its previous recommendations. 159. A specific committee, whose recommendations are submitted to the legislature plenary session for approval, carries out legislative scrutiny of the budget. Rules for budget amendments during the budget execution cycle are clear and these establish limits to which the administration adheres. The above assessment indicates that the PFM environment in Pernambuco meets the Bank’s requirements and is adequate to support the proposed operation. In addition, through the preparation of Pernambuco’s development strategy and actions undertaken subsequently to implement related reforms, the Government’s commitment to a strong PFM environment is satisfactory. Foreign Exchange Control Environment 160. The IMF undertook a Safeguards Assessment of the Central Bank of Brazil in October 2002 and updated it in March 2004. It concluded that the Central Bank does not present widespread vulnerabilities that could compromise the safeguarding of Fund 57 resources. The Bank also undertook a review of the financial statements of the Central Bank to assess the extent to which the foreign exchange control environment remained adequate. As part of this review, the Bank examined the financial statements for the years ending December 31, 2006 to 2010. These included Explanatory Notes to the financial statements and a report of the independent audit carried out by an international firm of auditors. The latter contained an unqualified opinion on the financial statements for all years. The Explanatory Notes, an integral part of the financial statements, provide an extensive explanation of the Central Bank’s risk management policies, including those related to financial instruments held to manage the international reserves. 161. In relation to operational risks, the Explanatory Notes state that the Central Bank ―uses internal control systems, which are considered adequate for its activities.‖ The Bank’s conclusion based on the review of the financial statements was that the control environment governing the Central Bank’s operations, within which the loan’s foreign exchange would flow, continued to be adequate. G. DISBURSEMENT AND AUDITING 162. The proposed loan will follow the Bank’s disbursement procedures for development policy lending loans. The funds will be disbursed against satisfactory implementation of the development policy program and will not be tied to any specific purchases. Once the loan is approved by the Board and becomes effective, the Bank will deposit the proceeds of the loan in an account designated by the Borrower and acceptable to the Bank at the Banco do Brasil S.A. This commercial bank is an acceptable financial institution for the Bank as it is: (a) financially sound; (b) authorized to maintain the account in the currency agreed between the Bank and the Borrower; (c) is audited regularly, and has received satisfactory audit reports (reviewed December 31, 2010 Financial Statements audited by KPMG); (d) able to execute a large number of transactions promptly; (e) is able to perform a wide range of banking services satisfactorily; (f) is able to provide a detailed statement of the account; (g) is part of a satisfactory correspondent banking network; and (h) charges reasonable fees for its services. 163. This account at the Banco do Brasil S.A is denominated in local currency and does not form part of the country’s official foreign exchange reserves. The State will ensure that upon the deposit of the loan into said account, an equivalent amount will be credited in the State’s budget management system. The State will provide a confirmation to the Bank that an equivalent amount was accounted for in the State’s budget management system. Such confirmation will be sent to the Bank within 30 days after payment. If the proceeds of the loan are used for ineligible purposes as defined in the Development Loan Agreement, the Bank would require the State to refund the amount. Due to the conclusions related to the adequacy of the State’s public financial management environment, no additional fiduciary arrangements will be put in place for the operation. 58 H. RISKS AND RISK MITIGATION The proposed operation is considered to have moderate to substantial risks. 164. Economic and fiscal risks are related to prudent management of the State of Pernambuco's fiscal position in an uncertain global environment. Even though the State of Pernambuco has a strong fiscal stance, its domestic tax collection from the ICMS tax revenues are vulnerable to macroeconomic fluctuations in Brazil and partner countries, as well as changes in the tax base stemming from fiscal wars and tax evasion. Most of the planned investments in the State will come from European firms (such as Fiat). As such, Pernambuco’s revenues may be vulnerable to developments in Europe, the slowing of U.S. growth, as well as a potential hard landing from China. Risk to the ICMS is mitigated by the significant increase in the state’s tax collection over the last years, and the low level of indebtedness of the State. The former is due to economic growth, efficiency reforms, and the commitment of the State Government to implement more reforms in tax administration, including those supported in this DPL. 165. The State may face fiscal pressure due to the investment requirements for the World Cup. The reforms in public sector management supported by this operation are designed to mitigate these risks by improving efficiency as well as prioritization of expenditures, mainly through the linkage of expenditures to the strategic priorities in the PPA. 166. There may be deficits in institutional capacity, which can affect program implementation. Given the emphasis of the operation in supporting the interior of the State, it is likely that existing capacity issues may weaken the implementation of policy reforms. The investments being made in the interior also include further development of human capital. As such, the activities will be complemented with capacity building in both the public and private sectors. 167. In an environment of fiscal competition among Brazilian states, the federal Government has initiated a discussion with all states on possible institutional changes related to the ICMS. In addition, the outcome related to the rules to distribute the royalties is highly uncertain. ICMS, a value-added tax on the commerce of goods and services, represents the main revenue source for the State. The federal Government is considering possible institutional changes to the ICMS. The rules for the distribution of royalties to the states are also under discussion. As a mitigation measure, the State Government is aware of the risks and has taken appropriate measures, bringing the level of debt to a manageable standard and strengthening its fiscal stance. In terms of royalties, Pernambuco is not dependent on those, and can only benefit from any change. 168. The political economy of reforms in education may imply opposition on the side of teachers to the reforms. The extended hours in schools require either more hours worked by teachers or more teachers working. In both cases, there may be reasons for teachers to oppose the reforms. They have argued, for example, that extended hours require also investment in equipment and materials in order to be effective. As a mitigation measure, there also exists a program for incentives to teachers, and there is permanent dialogue with teachers to ensure that their concerns do not turn into active opposition to reform. 59 VII. ANNEXES ANNEX 1: LETTER OF DEVELOPMENT POLICY 60 61 62 63 64 65 66 ANNEX 2: OPERATION POLICY MATRIX OBJECTIVES STRATEGY POLICY ACTIONS RESULTS INDICATORS EXPECTED OUTCOMES COMPONENT 1 - IMPROVING THE QUALITY OF LIFE FOR PERNAMBUCANOS Expand the number of hours Policy Action 1: The Borrower has Secondary school students enrolled An increased proportion of of secondary schools, with an created conditions conducive to in schools providing 40 hours of students enrolled receiving greater emphasis on schools in the improving the quality of education, instruction per week: academic training through interior of the State, as part of including an increase in the hours of Baseline 2010: 22,593 students expanded school hours. a broader strategy to improve instruction, as evidenced by: Indicator 2012: Additional 32,881 the quality of education students (a) Gubernatorial Decree No. through support for increased 36.120 of January 21, 2011, authorizing full-day instruction (40 performance of students, Secondary school students enrolled teachers and administration. in schools providing 32 hours of hours per week) in six (6) additional 1.1. - PROVIDE secondary schools, for an aggregate instruction per week: QUALITY EDUCATION total of 65 secondary schools; and Baseline 2010: 31,310 students Indicator 2012: Additional 12,261 (b) Gubernatorial Decree No. students 36.119 of January 21, 2011, authorizing expanded hours of Secondary school students enrolled instruction (32 hours per week) in in integral and semi-integral schools fourteen (14) additional secondary outside of the MAR: schools, for an aggregate total of 108 Baseline 2010: 33,373 students secondary schools. Indicator 2012: Additional 28,970 students Strengthen the institutional Policy Action 2: The Borrower has Improved water resource  Issuing of water rights for both and regulatory framework for strengthened its management of water management with the groundwater and surface water by the management of the scarce resources through the appointment of implementation of management APAC: 1.2 – IMPROVE WATER water resources in the State permanent technical personnel for tools. Groundwater: SECURITY AND APAC in accordance with competitive Baseline 2010: 188 INCREASE RELIABILITY procedures, as evidenced by Indicator 2011: 212 OF WATER SUPPLY Gubernatorial Act No. 4570 of May 10, 2011 and Joint Resolution (Portaria Surface Water: Conjunta) SAD/APAC No. 117 of Baseline 2010: 168 December 14, 2010, all in accordance Indicator 2011: 188 with the APAC Law29 and the APAC Resolutions30. 29 ―APAC Law‖ means the Borrower’s Law No. 14.028 of March 26, 2010 creating APAC. 67 OBJECTIVES STRATEGY POLICY ACTIONS RESULTS INDICATORS EXPECTED OUTCOMES Creation of reservoir management committee for water basins in the interior of the State Baseline 2011; 8 committees formed (Moxotó, Ipanema e Pajeú) Indicator 2012: Additional 4 committees formed (Terra Nova, Brigida, Garças e Pontal) Establishment of water users cadastre for the water basins of Ipanema, Pajeú and Moxotó Baseline 2011: 0 Indicator 2012: cadastre concluded Improve the policies and Policy Action 3: The Borrower has State protocol formalizing Disaster risk management model of protocols for response to improved the management of disaster procedures and responsibilities for Pernambuco in operation natural hazards, which will risks through the issuance of APAC’s the flood risk early warning system integrated with municipalities. particularly support poor and Board Resolution No. 001-2011 dated established: vulnerable communities that August 22, 2011, defining activities Baseline 2010: 0 are disproportionately affected related to forecast and early warning of Indicator 2012: 1 by natural hazards. disasters linked to hydro- meteorological events in the Population covered by the Borrower’s territory, and identifying monitoring alert system of APAC: such activities jointly as activities of a Baseline 2010: 0 1.3 IMPROVE situation room, as said activities have Indicator 2011: 2,192,764 people (21 DISASTER AND RISK been integrated into the Hydrological municipalities) MANAGEMENT Critical Events Forecast System of the Indicator 2012: Additional 3,694,178 Guarantor’s Federal Government. people (37 municipalities) Communication strategy developed and implemented to disseminate hydro-meteorological information produced by APAC Baseline 2011: 0 Indicator 2012: Plan developed and implemented 30 ―APAC Resolutions‖ means the Borrower’s Decree No. 34.860 of April 23, 2011, regulating APAC’s structure and procedures. 68 OBJECTIVES STRATEGY POLICY ACTIONS RESULTS INDICATORS EXPECTED OUTCOMES COMPONENT 2 - NEW ECONOMY – EXPANDING OPPORTUNITIES FOR PERNAMBUCANOS Provide vocational training, Policy Action 4: The Borrower has Secondary school students enrolled Improve and develop human principally in the interior of improved and developed human capital in professional education schools, capital to meet local job market the State, focused on local for the job market with emphasis on which offers courses meeting local demand with emphasis on market demands in order to professional education through the job demand and vocation: professional education. promote job creation, while transformation of six (6) State schools allowing students the into schools of professional education, Baseline August 2010: 5,224 2.1. PROMOTE JOB opportunity to pursue further as evidenced by Gubernatorial Decrees students; CREATION THROUGH education if desired. No. 36.355 of March 29, 2011 and No. Indicator August 2012: Additional THE DEVELOPMENT OF 36.121 of January 21, 2011. 4,124 students. HUMAN CAPITAL Secondary school students outside of the MAR in professional education schools, which offer courses meeting local job market demands: Baseline 2010: 1,320 students Indicator 2012: Additional 1,935 students Promote gender Policy Action 5: The Borrower has Increase in the number public Improved policies in support of the mainstreaming in public strengthened its institutional employees who have received social and economic inclusion of administration by elevating framework aimed at promoting gender training on gender issues women. the Women's Secretariat to a equality through the creation of a permanent secretariat level permanent Women’s Secretariat Baseline 2011: 600 professionals with the responsibility of (Secretaria da Mulher) to replace the trained 2.2 INCREASE informing and advocating the former temporary special Women’s Indicator 2012: 2,000 professionals OPPORTUNITIES public sector on issues for Secretariat, and the approval of trained THROUGH GREATER increased gender equity regulations for said secretariat, as GENDER EQUITY evidenced by the Borrower’s Law No. Creation of regional coordinators in 14.264 of January 6, 2011 and the 12 development regions of the Gubernatorial Decree No. 36.659 of State June 14, 2011, respectively. Baseline 2011: 0 Indicator 2012: 12 2.3 PROMOTE Promote economic Policy Action 6: The Borrower has Number of productive projects of An increased number of micro- ECONOMIC development in the State by taken the following steps to establish several segments among the entrepreneurs contributing to local DEVELOPMENT supporting micro, small and its Development Agency (Agência de development regions of the State supply chains in the State of 69 OBJECTIVES STRATEGY POLICY ACTIONS RESULTS INDICATORS EXPECTED OUTCOMES THROUGH SUPPORT TO medium size enterprises Fomento do Estado de Pernambuco, supported by AGEFEPE through Pernambuco SMES AND RURAL through the provision of S.A.) (―AGEFEPE‖)31, aimed at financing and/or training PRODUCERS credit, technical assistance promoting economic and social Baseline 2011: 3 and business development in development by supporting micro, Indicator 2012: 19 order to link to targeted local small and medium-size enterprises and supply chains rural producers in local production chains: (a) the authorization by the Guarantor’s Central Bank (Banco Central do Brasil) to commence the operations of AGEFEPE on December 9, 2010; and (b) the enactment of the Borrower’s Law No. 14.282 of March 29, 2011, allocating resources to AGEFEPE. COMPONENT 3 - INCREASING PUBLIC ADMINISTRATION CAPACITY FOR GENERATING RESULTS FOR PERNAMBUCO’S CITIZENS Increase in revenue in the The Borrower has taken the following Increase of ICMS Revenues as % of Increase in fiscal space through State in order to provide measures to improve tax revenues State’s GDP by reducing tax improvements in the reduction of greater support to policies and without increasing tax burdens on evasion, without increasing tax tax evasion, with no increase of tax 3.1 IMPROVE ICMS programs for equity through taxpayers: burden: burden. TAX REVENUES, mechanisms to facilitate tax Baseline 2009: 9.1% (latest year Policy Action 7: WITHOUT INCREASING collection TAX BURDEN ON FIRMS (a) the establishment of a with official information on GDP) AND CITIZENS, TO regulatory framework for the Indicator 2012: 12.4% EXPAND FISCAL SPACE implementation of a new fiscal control system (Sistema de Escrituração Fiscal FOR INVESTMENT AND Real growth of ICMS revenues: PROMOTE PRIVATE e Contábil 2) (―SEF-2‖)32, as evidenced SECTOR DEVELOPMENT by the Borrower’s Resolution Baseline 2010: R$8,613,857,888 (Portaria) No. 190, dated November Indicator 2012: R$11,584,122,900 30, 2011, issued by SEFAZ; and (24.3% above projected inflation 2010-2012) 31 ―AGEFEPE‖ means Agencia de Fomento do Estado de Pernambuco, S.A., the Borrower’s Development Agency created through Gubernatorial Decree No. 35.156 of June 11, 2010. 32 ―SEF-2‖ means the Borrower’s new fiscal control system created by Gubernatorial Decree No. 34.562. 70 OBJECTIVES STRATEGY POLICY ACTIONS RESULTS INDICATORS EXPECTED OUTCOMES Policy Action 8: (a) the establishment of a Tax Substitution System33 for selected products, as evidenced by Gubernatorial Decrees No. 35.655 of October 7, 2010 (linens), No. 35.656 of October 7, 2010 (bicycles), No. 35.657 of October 7, 2010 (toys), No. 35.677 of October 13, 2010 (cosmetics, pharmacy products and toiletries), No. 35.678 of October 13, 2010 (construction and home design materials), No. 35.679 of October 13, 2010 (automobile parts), No. 35.680 of October 13, 2010 (electric materials) and No. 35.701 of October 19, 2010 (electronic products and home appliances). Ensure compliance with the Policy Action 9: Approved budget versus executed Improved quality of public State's equity-focused reform The Borrower has improved the budget35 for Strategic Priorities: expenditures through an effective 3.2 IMPROVE agenda through budget efficiency of budget allocation and integration of planning and Baseline 2011: 64.1% (Projection EFFICIENCY OF allocation and oversight of execution through the formulation and budgeting (formulation and based on period Jan-Aug, as this is ALLOCATION AND strategic priorities execution of the PPA and budget, both execution). 34 the first year for which information EXECUTION OF PPA structured into strategic priorities, as will be available); AND BUDGET TO MAKE evidenced by: SURE PUBLIC Indicator 2012: 75% EXPENDITURES (a) the Borrower’s Law No. REFLECT 14.234 of December 13, 2010; Number of budgetary revisions PERNAMBUCO’S (b) the Detalhamentos de approved during the year of STRATEGIC PRIORITIES Despesas por Elemento (DDEs) execution: published in Baseline 2010: 1,560 33 ―Tax Substitution System‖ means the Borrower’s system applicable to selected products with high volumes of sales and highest risk of evasion, which identifies goods, registers sales electronically, and collects the tax on goods and services (Imposto sobre Operações relativas à Circulação de Mercadorias e Prestação de Serviços de Transporte Interestadual e Intermunicipal e de Comunicação or ICMS) at the point of origin or initial sale rather than at the point of the final consumer or client. 34 ―PPA‖ means Plano Pluriannual, the Borrower’s multiannual planning instrument, as published in www.transparencia.pe.gov.br. 35 Resources from all sources of revenue excluding transfers and credit operations (outside the control of the state) 71 OBJECTIVES STRATEGY POLICY ACTIONS RESULTS INDICATORS EXPECTED OUTCOMES www.transparencia.pe.gov.br; and Indicator 2012: 1,404 (10% reduction) (c) letter dated September 12, 2011 from Secretary of SEPLAG attaching a report on the budget execution by strategic priorities for the period January 1, 2011 through August 31, 2011. Promote results-based Policy Action 10: The Borrower has Social Management Report produced State’s Management Model is 3.3. IMPROVE management through a consolidated its Management Model36 and published online (in accordance consolidated, improving public CAPACITY TO PLAN AND management institute for and strengthened its capacity to with Art. 17 of the Lei administration’s capacity for IMPLEMENT PUBLIC continuous learning and generate results through the Complementar No. 141) generating results. POLICIES THROUGH training of the public sector. establishment of the Management Baseline 2010: 0 Institute, as evidenced by INSTITUTIONALIZATION Indicator 2012: 3 Social OF PERNAMBUCO’S Gubernatorial Decree No. 37.828, Management Reports produced and dated February 2, 2012. MANAGEMENT MODEL published online per year (covering periods of four months each) 36 ―Management Model‖ means the Borrower’s management model established under Lei Complementar No. 141 of September 3, 2009, which consists of the systemic organization of the functions related to the Borrower’s formal planning instruments (i.e., its PPA (as defined below), its annual budget guidelines and its annual budget law) and management tools adopted by the Borrower’s public administration. 72 ANNEX 3: MACRO ECONOMIC OUTLOOK AND DEBT SUSTAINABILITY IN THE STATE OF PERNAMBUCO Current Macroeconomic Outlook of the State of Pernambuco 1. The State of Pernambuco is the second largest economy in the northeast of Brazil. Pernambuco accounted for about 2.3 percent of the national gross domestic product (GDP) ranking as the tenth economy of the country in 2008. Pernambuco population of 9 million inhabitants represents 4.6 percent of total national population. Pernambuco, like other northeastern states has long lagged the rest of Brazil in terms of socioeconomic development, with a GDP per capita about half the national average at R$8,065 in 2008. 2. Poverty has come down significantly in the past decade. Brazil’s social policies coupled with high economic growth averaging over five percent annually since 2003, and have lifted a great part of the poor into the middle class. The percentage of the population living below extreme poverty line has decreased from 33 percent in 2003 to 17 percent in 2009.37 3. The State is now starting a new growth period that will need to be more inclusive than in the past to reduce poverty and inequality. In the 1970s, the State benefited along with the rest of Brazil from high growth rates, albeit lower than the national average. In the 1980s and the 1990s, GDP average growth dropped but remained close to the national and northeast average; however, poverty and inequality increased substantially, exceeding national and northeastern rates. In the early 2000s, Pernambuco growth declined well below the northeast and the national average. The year 2003 marks an inflexion point for State growth and the beginning of an accelerated growth period which brought the State on a par with national average growth rates. Nevertheless, Pernambuco has yet to turn higher growth rates into lower poverty and inequality statistics. In 2009, the share of the population below the poverty line was twice that of Brazil and well above the northeastern average (Figure A3.1). 37 The extreme poverty line is defined as the cost of a basic food basket that supplies the minimum individual caloric intake. The extreme poverty line varies between regions, states, urban, rural and metropolitan areas. Poverty lines account for these differences. 73 Figure A3.1: Growth, Poverty and Inequality GDP Growth Rate GDP per capita 9000 5-year average growth rate 12.0% 8000 10.0% 7000 8.0% 6000 6.0% 5000 4.0% 2.0% 4000 0.0% 3000 -2.0% 2000 Brazil Northeast Pernambuco Brazil Northeast Pernambuco Gini coefficient Poverty Headcount (%) 0.66 80 0.64 70 0.62 60 0.60 50 0.58 40 0.56 30 0.54 0.52 20 0.50 10 0.48 0 Brazil Northeast Pernambuco Brazil Northeast Pernambuco Source: IBGE/Ipeadata Note: The poverty line is defined as the double of the extreme poverty line, which is defined as the cost of a basic food basket that supplies the minimum individual caloric intake. The poverty line varies between regions, states, urban, rural and metropolitan areas. Poverty lines account for these differences. 4. Recently, Pernambuco’s growth pace has accelerated above the country average. The State’s economy was quite resilient to the global financial crisis, with a 5.2 percent estimated real growth in 2009 well above the 0.6 percent decrease in the national GDP. Estimates for 2010 indicate that Pernambuco’s real growth was 9.3 percent, against the 7.5 percent Brazilian GDP growth (Figure A3.2). This is a result in part of the State’s increased capacity to invest in physical and social infrastructure. The State Government plans to continue and even accelerate its pace of investment in the medium term in partnership with the private sector and the federal government. Of the estimated R$64.8 billion investments that will take place until 2015, R$46.3 billion will come from the State Government (including through partnerships with the federal government), R$10.9 billion from national private sector, and R$7.6 billion from foreign private sector. A large share of the resources will support investment in the industrial sector. 74 Figure A3.2: Real GDP Growth (%) 10.0 9.3 8.0 7.5 6.8 6 6.0 5.1 5.4 5.4 5.2 4.1 4.2 3.9 4.0 3.1 2.7 2.0 1.1 -0.6 -0.6 0.0 2003 2004 2005 2006 2007 2008 2009* 2010* -2.0 Pernambuco Brazil Source: IBGE, CONDEPE/FIDEM 5. The State boasts a diversified economy with a strong presence of the tertiary sector. In 2008, services accounted for 72.8 percent of gross value added of the state, while industry and agriculture represented 21.8 percent and 5.4 percent, respectively (Figure A3.3). These shares have been quite constant over the past decade. Pernambuco has a greater participation of the tertiary sector when compared to the national average, while industry participation is lower than the national average, and agriculture’s contribution are on a par with the national average. A large share of service activities comes from the public sector, especially in the poorest municipalities. Figure A3.3: GDP Composition—Brazil and Pernambuco Pernambuco 100% Brazil 100% 90% 90% 80% 80% 70% 70% 63.0 71.4 72.1 72.8 73.1 72.8 64.8 65.0 65.8 66.6 66.2 60% 73.3 60% 50% 50% 40% 40% 30% 30% 20% 20% 27.8 30.1 29.3 28.8 27.8 27.9 23.0 22.8 22.1 21.6 21.9 21.8 10% 10% 5.5 5.1 5.1 5.2 4.7 5.4 7.4 6.9 5.7 5.5 5.6 5.9 0% 0% 2003 2004 2005 2006 2007 2008 2003 2004 2005 2006 2007 2008 Services Industry Agriculture and farming Services Industry Agriculture and farming Source: IBGE, Condepe/FIDEM 6. The recent economic growth of the State has been driven by the industrial sector. Since 2007, the industrial sector has led the growth of the overall economy. The sector has been more resilient to the financial crisis than the country (see Figures A3.4 and A3.5). In the second 75 quarter of 2011, the sector grew 8.6 percent (y-o-y), on the back of a strong performance in the construction sector, which grew 19.1 percent (y-o-y). The expansion of the industrial sector has much to do with the growth of investment in the sector as well as improved fiscal management and improved public sector management to better align investment with State priorities. Investments from the State Government in real terms increased threefold in three years from 2007 to 2010.38 Figure A3.4: Industrial Production Index 130 125 120 115 110 105 100 95 90 85 80 Sep-07 Sep-08 Sep-09 Sep-10 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Jan-07 Jan-08 Jan-09 Jan-10 Nov-07 Nov-09 Nov-10 Jan-11 May-08 Nov-08 May-07 May-09 May-10 May-11 Brasil Pernambuco Bahia Source: IBGE Figure A3.5: Pernambuco’s Real GDP Growth by Sectors (%) 15.0 12.5 10.1 10.0 9.4 10.0 8.4 8.7 8.3 6.6 6.9 6.7 6.3 5.8 4.4 4.1 4.6 4.6 4.7 5.1 5.0 3.1 3.0 0.4 0.5 -0.5 0.0 2003 2004 2005 2006 2007 2008 2009* 2010* -5.0 -7.6 -10.0 Agriculture and Farming Industry Services *Estimates Source: IBGE, CONDEPE/FIDEM 38 From R$ 559,514 thousands to R$ 1,819,976 thousands; values in 2010 R$ constant prices. IPCA index was used. 76 7. Recent growth fostered the creation of formal jobs which enabled Pernambuco to sharply reduce its unemployment rate. The unemployment rate in the metropolitan area of Recife, which accounts for 42 percent of the State population, fell from an annual average of 14.6 percent in 2006 to 8.7 percent in 2010, and maintained a downward trend in 2011. The unemployment rate is moving towards the national average and declining at a faster rate than that of Bahia. The unemployment rate in the MAR shifted from 10.9 percent in August 2009 to 6.7 percent in the same month of 2011. In Bahia the unemployment rate changed from 11.4 to 8.9 percent in the same period (Figure A3.6). Figure A3.6: Unemployment Rate (%), 12-months Average 18 16 14 12 10 8 6 4 BRAZIL PERNAMBUCO BAHIA Source: IBGE 8. Pernambuco has had a negative trade balance since 1993. During 2004-2010 Pernambuco exports grew at an average annual rate of 13.6 percent while imports increased at a 27.6 percent average annual rate, in part due to currency appreciation (see Figure A3.7). The Government’s strategy aims to strengthen logistic services for the industrial sector that can also benefit surrounding states. The State strategy also views the development in logistics as an important source of growth for the tertiary sector. This is the case for the Suape complex, around the port of the same name. Indeed the State’s recent dynamic activity has been linked to the development of the Suape Port, which has helped to attract a massive influx of public and private investments to the MAR. 77 Figure A3.7: Trade Balance, Pernambuco (US$ millions) 500 0 -500 -1000 -1500 -2000 -2500 Source: CONDEPE/FIDEM Recent Evolution of Fiscal and Debt Indicators for the State of Pernambuco 9. Over the past decade, the State of Pernambuco has achieved fiscal consolidation. Stronger growth as well as the debt renegotiation and the LRF have allowed the State to drastically reduce NCD, build up fiscal balance, and slowly increase investment. On the debt front, application of the steady debt payment of 11.5 percent of NCR until 2007 has significantly cut down NCD from 104 percent of NCR in 2004 to 39 percent of NCR in 2010. On the fiscal side, increased efficiency in collecting tax and economic growth has strengthened tax collection and thus revenues. The State was also able to curb the growth of expenditures. In a context where most current expenditures are mandated by the constitution, the state’s control of the wage bill is commendable. Revenues outgrew expenditures, and have quickly rebounded from the crisis (Figure A3.8). As such, gross operating balances and investment have markedly increased since 2007 and have been resilient to the crisis (A3.8 and A3.9). Figure A3.8: Revenue and Expenditure Total Revenues and Expenditure (GFS Methodology) Annual Growth in Revenues and Expenditure 25 4 16.0% R$ 2010 Billions R$ 2010 Billions 14.0% 20 3 12.0% 15 10.0% 2 8.0% 10 6.0% 1 4.0% 5 2.0% - - 0.0% 2004 2005 2006 2007 2008 2009 2010 2005 2006 2007 2008 2009 2010 I. REVENUE (left) II. EXPENSE (left) III. GROSS OPERATING BALANCE (I - II) - right I. REVENUE II. EXPENSE Source: SEFAZ, WB Calculations Note: Values deflated by IPCA 78 Figure A3.9: Gross Operating Balance, Primary Balance and Investments (as % of NCR) 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% 2004 2005 2006 2007 2008 2009 2010 Gross Operating Balance Primary Balance Investments Source: SEFAZ, WB Calculations Note: Values deflated by IPCA 10. Total revenues grew at an average of 10.8 percent in real terms during 2004-2010, one of the highest rates among Brazilian states. This revenues growth was due to the good performance of all main revenues categories: tax revenues; transfers; social contributions; and other revenues. The good performance of tax revenue also owes much to the increase of intergovernmental transfers and extraordinary revenues. Also, the improved performance owed much to higher collection of social contributions from public employees, almost inexistent in 2003 and now accounting for almost 25 percent of pension payments (Table A3.1 and Figure A3.10). The employers’ contribution to the pension fund—FUNAFIN—reached 27 percent of payroll in February 2010 with employees contributing 13.5 percent of payroll. Table A3.1: Evolution of Revenues during 2004-2010 (R$ 2010 thousands) REVENUES 2004 2005 2006 2007 2008 2009 2010 Total Revenues 10,543,439 11,949,568 13,078,248 13,771,150 15,851,931 17,153,331 19,479,953 Tax revenue 5,524,250 6,190,581 6,768,615 7,210,436 7,866,307 8,231,031 9,528,773 ICMS 4,833,423 5,392,170 5,900,989 6,279,418 6,754,520 7,106,850 8,287,879 IPVA 228,728 253,883 285,702 319,635 351,352 395,160 408,424 Other 462,099 544,528 581,924 611,382 760,434 729,020 832,469 Social contributions 1,677,605 1,825,472 2,142,342 2,147,790 2,290,773 2,107,807 2,476,062 Capital and current transfers 3,723,480 4,427,924 4,637,768 5,160,053 6,344,033 6,484,564 7,349,792 Other current revenues 502,710 510,780 617,123 573,542 973,602 2,119,882 2,100,338 Deductions: FUNDEF/FUNDEB (884,606) (1,005,188) (1,087,600) (1,320,671) (1,622,783) (1,789,953) (1,975,011) Memo Items: - - - Deductions: 3,490,096 4,000,249 4,048,455 4,059,211 4,793,119 5,901,011 7,044,234 Net Current Revenue (NCR) 7,053,344 7,949,319 9,029,792 9,711,939 11,058,812 11,252,320 12,435,719 Source: SEFAZ, WB Calculations Note: Values deflated by IPCA 79 Figure A3.10: Composition of Revenue, 2004-2010 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2004 2005 2006 2007 2008 2009 2010 Other current revenues Capital and current transfers Social contributions Tax revenue Source: SEFAZ, WB Calculation 11. On the tax revenue side, the evolution of ICMS is strong and positive, driven by economic growth and improved efficiency. ICMS increased quickly since 2004, due mainly to tax management measures, particularly tax payer substitution systems and the adoption of the electronic fiscal note. Recent robust economic growth is helping as well. The ratio of ICMS to GDP increased from 8.2 percent in 2002 to 8.7 percent in 2008, one of the most significant performances in the northeast (Table A3.2). Table A3.2: Fiscal Indicators NORTHEAST Tax/Transfers (2010) ICMS/FPE (2010) ICMS/GDP (2008) Alagoas 63.9% 98.9% 8.2% Bahia 136.9% 228.2% 7.9% Ceará 119.4% 165.1% 7.7% Maranhão 70.6% 81.0% 6.1% Paraíba 91.9% 109.0% 7.5% Pernambuco 129.6% 240.3% 8.7% Piauí 68.8% 88.8% 6.3% Rio Grande do Norte 98.4% 134.4% 8.9% Sergipe 70.0% 87.8% 6.9% Source: National Treasury Secretariat, IBGE, WB Calculation 80 Figure A3.11: Tax Revenue and ICMS Collection Performance, Pernambuco 2.60 2.40 2.20 2.00 1.80 1.60 1.40 1.20 1.00 2004 2005 2006 2007 2008 2009 2010 Tax Revenue/Transfers ICMS/FPE Source: SEFAZ, WB Calculations 12. Transfer revenues have increased in terms of net current revenue since 2006. FPE, the main component of the federal transfers, decreased over the last years and stood at 27.1 percent of NCR as of 2010. In contrast, revenues from Convenios and the Fund for the Development of Basic Education and Valuing of Education Professionals (FUNDEB) have increased (Table A3.3). Regarding the Convenios (Co-financing agreement with the federal government), Pernambuco has received higher health transfers (SUS—Sistema Único de Saúde) as a result of the new attribution to the states of full management of health services in their territories (Gestão Plena). Under this condition, the states received from the Ministry of Health not only resources to fund the state health net, but also resources to pay for services provided by units registered in the SUS—private companies, philanthropic organizations and the smaller municipalities. In 2009, SUS provided a substantial amount of resources to the states and municipalities, due mainly to a revision of the per capita values that partially regulate the amounts transferred. Also, the increase in transfers from FUNDEB (an instrument of intergovernmental financial cooperation for improving education) benefited from the legal change. The sources of the initial Fund for the Development of Fundamental Education and Valuing of Educational Professionals (FUNDEF) were transformed in 2007 into FUNDEB and expanded to cover not only basic education, but also early childhood care centers (under the responsibility of municipalities) and high schools (under the responsibility of states). 81 Table A3.3: Transfer Composition, 2004-2010 (Percentage of NCR 2004 2005 2006 2007 2008 2009 2010 Transfers Revenues 52.8% 55.7% 51.4% 53.1% 57.4% 57.6% 59.1% Current Transfers 49.8% 53.4% 49.8% 51.9% 54.5% 54.3% 52.0% FPE 31.2% 32.8% 31.0% 31.9% 32.4% 29.4% 27.1% IPI 1.0% 1.2% 1.1% 1.0% 0.9% 0.5% 0.7% Convenios 2.1% 1.9% 1.7% 1.1% 1.5% 1.5% 3.1% Lei Kandir 0.0% 0.0% 0.0% 0.3% 0.2% 0.2% 0.2% Transfers Revenues from FUNDEB 6.7% 6.4% 5.9% 7.7% 9.8% 12.0% 10.7% Other Current Transfers 8.7% 11.2% 10.1% 9.8% 9.8% 10.7% 10.4% Capital Transfers 3.0% 2.3% 1.6% 1.2% 2.8% 3.4% 7.1% Transfers Expenses 20.0% 19.9% 19.1% 19.8% 20.0% 20.8% 21.3% Federal 0.1% 0.1% 0.1% 0.2% 0.4% 0.2% 0.1% Municipalities 19.6% 19.3% 18.5% 18.9% 18.3% 19.0% 19.8% Of which: Direct transfer of revenues 19.3% 19.0% 18.2% 18.2% 17.2% 17.9% 18.5% Private Institutions 0.2% 0.4% 0.4% 0.8% 1.3% 1.6% 1.3% Other transfers 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Net Transfers 32.8% 35.8% 32.3% 33.3% 37.4% 36.8% 37.8% 13. Pernambuco tax revenue to transfers ratio remains high, albeit decreasing. In 2010, the tax revenues to transfer ratio stood at 1.30, compared with an average of 0.90 in the rest of the northeast (Table A3.2). The decrease, occurring from 2004 onwards, is due not to low performance of tax revenues but to higher transfers in recent years, especially from SUS and FUNDEB. 14. The inter-governmental fiscal arrangements between the State of Pernambuco, its municipalities, and the federal Government are deemed adequate. Transfers of expenditures to municipalities are rule-based and represent a fixed amount of 25 percent of ICMS revenues and 50 percent of the property tax on motor vehicles (IPVA) revenues. Transfers to municipalities remained stable at around 19 percent of Pernambuco’s net current revenues (Table A3.3). Pernambuco is a net contributor to FUNDEB: the State of Pernambuco provided up to R$2.0bn and received the amount of R$1.3bn in 2010. 15. Total current expenditure grew at an average annual real rate of 9.3 percent between 2004 and 2010, slightly lower than the average 10.8 percent for total revenues. The Government has been successful in planning and monitoring costs and controlling expenses since 2004. Control over personnel expenditures has allowed the Government to decrease their share of NCR. The increase in goods and services expenses is in part explained by increased investment in health and education, which generate higher maintenance and operating costs. The increase in the resources from the federal Ministry of Health through SUS has also mirrored those higher costs. Finally, interest payments have gone down, as the debt level went down with fiscal consolidation (Table A3.4 and Figures A3.12 and A3.13). 82 Table A3.4: Evolution of Expenditure during 2004-2010 (R$ 2010 thousands) EXPENDITURES 2004 2005 2006 2007 2008 2009 2010 Current Expenditures 9,565,824 10,595,571 11,437,026 12,141,652 13,669,483 14,771,462 16,318,603 Compensation of employees 3,889,429 4,301,130 4,652,096 5,035,070 5,662,744 6,164,323 6,774,262 (%NCR) 55.1% 54.1% 51.5% 51.8% 51.2% 54.8% 54.5% Wages and salaries 2,521,930 2,765,768 3,124,422 3,325,303 3,879,852 4,352,311 4,760,121 Social contributions 1,367,500 1,535,362 1,527,674 1,709,767 1,782,892 1,812,011 2,014,142 Pensions 1,716,751 1,799,060 1,927,985 2,021,724 2,168,146 2,238,577 2,350,922 (%NCR) 24.3% 22.6% 21.4% 20.8% 19.6% 19.9% 18.9% Interest payments (effectively paid) 351,430 350,885 342,071 313,608 284,291 265,398 275,079 (%NCR) 5.0% 4.4% 3.8% 3.2% 2.6% 2.4% 2.2% Transfers to Municipalities 1,385,929 1,535,270 1,672,669 1,836,565 2,019,994 2,141,507 2,457,312 (%NCR) 19.6% 19.3% 18.5% 18.9% 18.3% 19.0% 19.8% Goods and Services 2,222,285 2,609,225 2,842,205 2,934,684 3,534,308 3,961,658 4,461,028 (%NCR) 31.5% 32.8% 31.5% 30.2% 32.0% 35.2% 35.9% Capital Expenditures excl. Debt Amortization 584,769 658,049 870,997 793,326 1,198,034 1,998,227 2,378,738 Net acquisition of non-financial assets 543,077 582,419 777,537 559,514 819,616 1,186,631 1,819,976 (%NCR) 7.7% 7.3% 8.6% 5.8% 7.4% 10.5% 14.6% Other investments in assets 41,692 75,630 93,461 233,811 378,418 811,596 558,762 Total Expenditures excl. Debt Amortization 10,150,593 11,253,620 12,308,023 12,934,978 14,867,517 16,769,689 18,697,341 Source: SEFAZ, WB Calculations Note: Values deflated by IPCA Figure A3.12: Composition of Expenditure, 2004-2010 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2004 2005 2006 2007 2008 2009 2010 Goods and Services Transfers to Municipalities Interest payments (effectively paid) Pensions Compensation of employees Source: SEFAZ, WB Calculations 16. Pernambuco’s net consolidated debt has been falling since 2003. Due to growing fiscal revenues and consistent fiscal adjustment, the net consolidated debt-to-revenue ratio fell steeply from over 104 percent of NCR in 2004 to 39 percent by 2010, well within the LRF limit of 200 percent (Table A3.5 and Figure A3.13). During 2004-2008, Pernambuco made large amounts of amortization. Debt service has been decreasing since 2004, driven by lower interest payments and increasing NCR. The fiscal adjustments led to an increasing gross operating balance, which created space for investments. The State was also able to contract new loans with its improved fiscal and debt situation. As such, the ratio of investment to NCR steadily improved from 5.8 percent in 2007 to 14.6 percent in 2010. 83 Figure A3.13: Evolution of Debt and Debt Service during 2004-2010 120% Net Consolidated Debt 14 14% Debt Service 0.70 R$ 2010 Billions R$ 2010 Billions 100% 12 12% 0.60 10 10% 0.50 80% 8 8% 0.40 60% 6 6% 0.30 40% 4 4% 0.20 20% 2 2% 0.10 0% 0 0% 0.00 2004 2005 2006 2007 2008 2009 2010 2004 2005 2006 2007 2008 2009 2010 Net Consolidated Debt (NCD) - right Net Current Revenue (NCR) - right Interest Payments (right) Amortization (right) NCD / NCR (left) Debt Service / NCR (left) Source: SEFAZ, WB Calculations Note: Values deflated by IGP-DI Table A3.5: Composition of Net Consolidated Debt during 2004-2010 (R$ 2010 thousands) 2004 2005 2006 2007 2008 2009 2010 Consolidated Debt (I) 7,470,212 7,022,446 6,438,093 5,694,732 5,533,318 5,965,315 6,106,126 Contractual Public Debt 7,470,212 7,022,446 6,438,093 5,694,732 5,533,318 5,965,315 6,106,126 Internal 7,037,383 6,602,481 6,013,529 5,314,113 4,988,293 5,435,761 5,654,121 Internal-National Treasury 5,611,879 6,207,089 5,695,289 5,077,872 4,657,082 4,749,306 3,877,794 InternalPublic Banks 1,425,504 395,393 318,239 236,241 331,212 686,455 1,776,327 External 432,828 419,965 424,564 380,619 545,024 529,554 452,005 Judicial Debt (Precatorios) 0 0 0 0 0 0 0 Deductions of Net Financial Assets 0 10,660 84,122 423,431 871,320 886,381 1,307,420 Net Consolidated Debt - NCD (I - II) 7,470,212 7,011,787 6,353,971 5,271,301 4,661,997 5,078,934 4,798,706 Memo Items: Net Current Revenues - NCR 7,183,154 8,452,697 9,544,121 9,935,412 10,982,116 11,825,122 12,435,719 NCD / NCR 104% 83% 67% 53% 42% 43% 39% Note: Fiscal Responsibility Law ceiling: 200%; values deflated by IGP-DI Source: SEFAZ, WB Calculations 17. Pernambuco’s fiscal situation is deemed adequate and in compliance with the prudential limits set out in the LRF since 2004. Over the past decade, all the fiscal indicators improved. Net personnel expenses were stable and net consolidated debt has fallen significantly. All indicators are well within the prudential limits set in the LRF (Table A3.7). As of 2010, the State has met all fiscal targets defined in the rolling three year Fiscal Adjustment Program—PAF—negotiated with the National Treasury Secretariat (Table A3.8). 84 Table A3.6: Evolution of GFS Fiscal Accounts, Pernambuco State (R$ 2010 thousands) 2004 2005 2006 2007 2008 2009 2010 I. REVENUE 10,543,439 11,949,568 13,078,248 13,771,150 15,851,931 17,153,331 19,479,953 Taxes 5,524,250 6,190,581 6,768,615 7,210,436 7,866,307 8,231,031 9,528,773 Social Contributions 1,677,605 1,825,472 2,142,342 2,147,790 2,290,773 2,107,807 2,476,062 Transfers 3,723,480 4,427,924 4,637,768 5,160,053 6,344,033 6,484,564 7,349,792 Other Current Revenues 502,710 510,780 617,123 573,542 973,602 2,119,882 2,100,338 Deductions: Fundef/Fundeb (884,606) (1,005,188) (1,087,600) (1,320,671) (1,622,783) (1,789,953) (1,975,011) II. EXPENSE 9,565,824 10,595,571 11,437,026 12,141,652 13,669,483 14,771,462 16,318,603 Compensation of Employees 3,889,429 4,301,130 4,652,096 5,035,070 5,662,744 6,164,323 6,774,262 Pensions 1,716,751 1,799,060 1,927,985 2,021,724 2,168,146 2,238,577 2,350,922 Interest Payments 351,430 350,885 342,071 313,608 284,291 265,398 275,079 Transfers 1,385,929 1,535,270 1,672,669 1,836,565 2,019,994 2,141,507 2,457,312 Goods and Services 2,222,285 2,609,225 2,842,205 2,934,684 3,534,308 3,961,658 4,461,028 III. GROSS OPERATING BALANCE (I - II) 977,615 1,353,997 1,641,222 1,629,498 2,182,448 2,381,869 3,161,350 (as % of NCR) 13.9% 17.0% 18.2% 16.8% 19.7% 21.2% 25.4% IV. TRANSACTIONS IN NON-FINANCIAL ASSETS 584,769 658,049 870,997 793,326 1,198,034 1,998,227 2,378,738 Net acquisition of non-financial assets 543,077 582,419 777,537 559,514 819,616 1,186,631 1,819,976 (as % of NCR) 7.7% 7.3% 8.6% 5.8% 7.4% 10.5% 14.6% Other investments in assets 41,692 75,630 93,461 233,811 378,418 811,596 558,762 V. NET LENDING / BORROWING (III - IV) 392,846 695,949 770,225 836,172 984,414 383,642 782,612 (as % of NCR) 5.6% 8.8% 8.5% 8.6% 8.9% 3.4% 6.3% VI. PRIMARY BALANCE (V + Net Interest Payments) 632,647 900,333 967,136 1,010,334 1,046,662 474,637 881,638 (as % of NCR) 9.0% 11.3% 10.7% 10.4% 9.5% 4.2% 7.1% VII. TRANSACTIONS IN FINANCIAL ASSETS AND LIABILITIES (370,487) (421,975) (402,274) (388,587) (291,342) 643,124 327,238 New Loans 93,971 80,992 81,098 93,954 235,543 1,176,866 664,395 Amortizations, net (468,293) (510,586) (547,680) (483,606) (530,468) (551,940) (341,086) Amortizations received 455 897 463 294 182 129 133 Amortizations paid 468,748 511,483 548,143 483,899 530,650 552,070 341,219 Asset sales 3,835 7,619 64,308 1,065 3,584 18,199 3,928 TOTAL BALANCE (incl. Intra-Orcamentaria) (VI + VII) 22,359 273,974 367,951 447,585 693,072 1,026,766 1,109,849 Source: SEFAZ, WB Calculations Note: Values deflated by IPCA Table A3.7: Evolution of Fiscal Responsibility Law during 2004-2010 (R$ 2010 thousands) Legal Ceiling 2004 2005 2006 2007 2008 2009 2010 % NCR Net Current Revenue – NCR 7,053,344 7,949,319 9,029,792 9,711,939 11,058,812 11,252,320 12,435,719 Credit Operations Revenues 93,971 80,992 81,098 93,954 235,543 1,176,866 664,395 % NCR ?16% 1.3% 1.0% 0.9% 1.0% 2.1% 10.5% 5.3% Net consolidated Debt 7,335,214 6,594,219 6,013,331 5,152,736 4,694,555 4,832,913 4,798,706 % NCR ?200% 104.0% 83.0% 66.6% 53.1% 42.5% 43.0% 38.6% Debt Service 820,178 862,368 890,214 797,508 814,942 817,468 616,298 % NCR ?11,5% 11.6% 10.8% 9.9% 8.2% 7.4% 7.3% 5.0% Net Personnel Expenses 3,800,277 4,179,703 4,619,432 4,917,146 5,509,672 5,998,525 6,438,063 % NCR Consolidated Expense ?60% 53.9% 52.6% 51.2% 50.6% 49.8% 53.3% 51.8% Executive ?49% 44.5% 43.3% 42.3% 41.6% 41.7% 44.8% 43.7% Legislative ?3% 2.6% 2.5% 2.5% 2.5% 2.5% 2.7% 2.7% Judiciary ?6% 4.9% 4.9% 4.6% 4.5% 4.0% 4.2% 3.9% Public Prosecution ?2% 1.9% 1.9% 1.9% 1.9% 1.7% 1.6% 1.5% Source: SEFAZ, WB Calculations 85 Table A3.8: Fiscal Adjustment Program—Fiscal Targets and Observed Results (R$ million) TARGET 2006 2007 2008 2009 2010 Limit 1.00 1.00 1.00 1.00 1.00 Debt/NCR Path Observed 0.82 0.68 0.60 0.63 0.52 Target 435 410 269 (137) (730) Primary Balance (R$ million) Observed 599 686 534.98 (471) 65.06 Target 60 60 60 60 60 Personnel/NCR (%) Observed 54.17 54.53 53.43 56.59 54.29 Target 5,091 5,748 6,666 7,652 7,652 Own Revenue Collection (R$ million) Observed 5,304 5,927 6,811 7,682 9,867 Target 7.29 11.06 14.56 17.27 22,.53 Investment/NCR (%) Observed 7.51 8.60 12.10 17.70 20.10 Source: SEFAZ Medium-Term Fiscal and Debt Sustainability 18. The projected fiscal and debt paths for the State of Pernambuco are deemed sustainable in the medium term. The baseline scenario projections indicate a sustainable path, with positive primary fiscal balances. Pernambuco’s fiscal balances (the primary fiscal balance, the overall balance, and the gross operating balance) are all expected to record surpluses for the projected period, allowing fiscal space for state investments, while net consolidated debt is projected to fall from 39 percent of net current revenue in 2010 to 20.1 percent by 2020. The debt trend is determined by current revenue and expenditure dynamics, whose difference is the gross operating balance (GOP). After deducting amortization from the GOP, any remaining fiscal resources are assumed to be used for investment. 19. In particular, baseline projections for the period 2010-2020 depict a fiscal framework marked by both revenue and expenditure growth. The principal drivers of revenue growth are taxes (primarily from ICMS, which is heavily dependent on economic growth) and current transfers from the federal Government (from Convenios and FUNDEB). Other current revenues are also increasing, albeit at a lower rate, while capital transfers are constant in real terms. On the expenditure side, growth is being driven by capital expenditures. Current expenditures are rising largely on account of new judicial debt payment obligations (precatorios), increases in employee compensation and goods and services, as well as sub-national transfers to municipalities and to FUNDEB (Table A3.10). Overall, current expenditures are declining as a share of total expenses from 94 percent in 2004 to 84 percent in 2020. 20. In the baseline scenario, the debt dynamic is sustainable and complies with the Fiscal Responsibility Law. Based on data for scheduled amortizations and interest payments, net consolidated debt is projected to rise in real terms in the medium term, as the state investment program is implemented, after which it is expected to fall until 2020 (Figure A3.14). As a share of net current revenue, net consolidated debt and debt service are projected to remain within the Fiscal Responsibility Law limits set by the federal Government. It is important to note that this baseline scenario does not include financing of planned investments after 2013, which will probably require additional new borrowing. However, given that Pernambuco’s debt level as a percentage of NCR is well below the 200 percent limit set in the LRF, this should not affect its 86 projected long-term fiscal sustainability. Debt service payments would remain below 10 percent throughout the forecast period, peaking at about 7.6 percent of net current revenue in 2013, and declining thereafter to 4.6 percent in 2020. Personnel costs are expected to stay below 53 percent of net current revenue for the entire period of projection. (Table A3.9). Table A3.9: Fiscal Responsibility Law Indicators Projections 2011-16 Thousands R$ 2010 Constant Prices Legal Limit 2011 2012 2013 2014 2015 2016 % % % % RCL Amount Amount % RCL Amount Amount Amount % RCL Amount % RCL RCL RCL RCL Total Personnel Expenses 60 6,909,747 52.3 7,047,942 51.7 7,188,901 50.9 7,332,679 50.2 7,479,333 49.4 7,621,626 48.6 Net Consolidated Debt 200 5,007,727 37.9 5,574,491 40.9 5,564,406 39.4 5,672,329 38.8 5,659,033 37.4 5,132,582 32.7 Debt Service 778,141 5.9 922,300 6.8 1,071,506 7.6 955,366 6.5 939,450 6.2 931,794 5.9 Net Current Revenue 13,218,491 13,630,383 14,115,939 14,620,568 15,145,045 15,675,183 Table A3.10: Baseline Fiscal Projections 2011-16, 2010 R$ Millions Projections 2010 2011 2012 2013 2014 2015 2016 I. Revenue (I) 19,480 20,076 21,417 21,362 22,087 22,840 23,601 Taxes 9,529 9,891 10,248 10,676 11,123 11,588 12,061 Social Contributions 2,476 2,526 2,576 2,628 2,680 2,734 2,786 Transfers 8,076 8,322 9,315 8,856 9,160 9,477 9,798 Current Transfers 6,466 6,712 6,954 7,246 7,550 7,867 8,190 Capital Transfers 1,610 1,610 1,610 1,610 1,610 1,610 1,608 Other Current Revenues 1,374 1,388 1,402 1,416 1,430 1,444 1,457 Deductions 1,975 2,050 2,124 2,213 2,306 2,403 2,501 II. Expediture (II) 16,319 16,785 17,336 17,913 18,428 18,968 19,513 Compensation of Employees 6,774 6,910 7,048 7,189 7,333 7,479 7,622 Pensions 2,351 2,322 2,333 2,344 2,356 2,367 2,376 Interest Payments 275 326 389 441 410 381 350 Transfers 2,457 2,551 2,643 2,753 2,869 2,990 3,112 Goods and Services 4,456 4,670 4,885 5,139 5,407 5,688 5,978 Precatorios 5 6 38 46 54 64 75 III. Gross Operating Balance (I - II) 3,161 3,291 4,081 3,449 3,658 3,872 4,088 % of NCR 25% 25% 30% 24% 25% 26% 26% IV. Transactions in Non-Financial Assets 2,379 2,838 3,536 2,819 3,113 3,313 3,506 % of NCR 19% 21% 26% 20% 21% 22% 22% VI. Net Lending / Borrowing (III-IV) 783 452 545 630 545 559 582 % of NCR 6% 3% 4% 4% 4% 4% 4% V. Primary Balance (VI + Net Interest Payments)882 638 838 1,033 937 956 988 % of NCR 7% 5% 6% 6% 5% 5% 5% Memo Item: Net current revenue (NCR) 12,436 13,218 13,630 14,116 14,621 15,145 15,675 Table A3.11: Planned Investment Projects and Financing Arrangements, PAF 2011-13 87 R$ Thousands Start Date Amount BID - APL ARRANJOS PRODUTIVOS 2011 16,622 BNDS - ARENA DA COPA 2011 400,000 PRORURAL III 2011 166,620 MOBILIDADE DA COPA 2011 347,000 PROMETRÓPOLE II 2012 199,944 PROMAS 2011 84,976 BID - SANEAMENTO AMBIENTAL DA BACIA DO IPOJUCA ( US$ 200 MILLION) 2012 333,240 CEF - SANEAMENTO PARA TODOS 2010 (R$ 192.4 MILLION) 2011 192,411 CEF - CONTRAPARTIDA DO PAC I (R$ 300 MILLION) 2011 300,000 CEF - CONTRAPARTIDA DO PAC II (R$ 200 MILLION) 2011 200,000 BIRD - DPL 1 (US$ 500 MILLION) 2012 833,100 BIRD - DPL 2 (US$ 700 MILLION) 2013 1,166,340 CEF - PROJETO HABITACIONAL SUAPE 2011 83,500 BNDES InfraDesenvPE 2011 920,287 AFD MOBILIDADE 2013 600,000 Source: SEFAZ Figure A3.14: Net Consolidated Debt and Debt Service - Baseline Projections Net Consolidated Debt Debt Service 6,000 45% 1,200 40% 5,000 1,000 2010 R$ Millions 2010 R$ Millions 35% 4,000 30% 800 25% 3,000 600 20% 2,000 15% 400 10% 1,000 200 5% - 0% - 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Amortization Interest Payments Net Consolidated Debt Debt Service Gross Operating Balance Primary Balance 6,000 35% 1,000 8% 900 7% 5,000 30% 2010 R$ Millions 2010 R$ Millions 800 25% 6% 4,000 700 600 5% 20% 3,000 500 4% 15% 400 3% 2,000 300 10% 2% 1,000 200 5% 1% 100 - 0% - 0% 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Gross Operating Balance Gross Operating Balance/NCR Primary Balance Primary Balance/NCR Source: SEFAZ, WB Projections 21. Data for the baseline year, 2010, were taken from the Department of Finance (SEFAZ) and were reclassified according to the Government Finance Statistics (GFS) classification. 88 According to the GFS classification methodology, net current revenues include capital transfer revenues (as reported by the Brazilian statistics), which are otherwise excluded in the Brazilian Central Bank’s definition of current revenues. The baseline fiscal projection results for 2010 to 2016 are presented in Table A3.10, while the assumptions used for the projections are found in Table A3.12. Table A3.12: Pernambuco State Fiscal and Debt Baseline Projection Assumptions Variables Assumptions Base year figures - 2010 REVENUES Tax Revenues ICMS Increase with IPCA inflation and GDP growth. IPVA Increase with IPCA inflation and licensed vehicle growth. Other Tax Revenues Increase with IPCA inflation. Social Contributions Increase with IPCA inflation and personnel growth. Current Transfers Federal Current Transfers Increase with IPCA inflation and GDP growth Convenios Increase with IPCA inflation and GDP growth. FUNDEB Increase with IPCA inflation and GDP growth. Private Transfers Increase with IPCA inflation and GDP growth. Capital Transfers Increase with IPCA inflation Other Current Revenue Interest Revenue Increase with IPCA inflation Non Financial Assets Increase with IPCA inflation and GDP growth. Miscellaneous Increase with IPCA inflation and GDP growth. Deductions to Revenue Increase with IPCA inflation and GDP growth. Net Current Revenue (NCR) Current revenue minus deductions to revenue (line above). Net Real Revenue (NRR) Net current revenue multiplied by 0.7862 (the average ratio of NRR-to-NCR for 2004-10). EXPENDITURE Current Expenditure Wages and Salaries Increase with personnel growth and IPCA inflation. Pensions Increase with personnel growth and IPCA inflation. Interest Payments Calculated based on data from Debt Department of SEFAZ. Goods and Services Increase with GDP growth and IPCA inflation. Precatorios Actual values provided by SEFAZ. Subnational Transfers Increase with GDP growth and IPCA inflation. Capital Expenditure Investment in Non-financial Assets Fiscal space left by the gross operating balance after payments of debt. Other Investments Increase with real GDP growth and IPCA inflation. Amortization Calculated based on data from Debt Department of SEFAZ. IBRD Loan US$500 million disbursed in one tranche in 2012 89 Table A3.13: Macroeconomic Assumptions for Fiscal Sustainability Analysis Real GDP Growth Growth Variable IPCA Inflation Exchange Rate Personnel Growth IGP-DI Inflation Year Alternative Alternative Alternative Alternative Alternative Alternative Baseline (Lower) Baseline (Lower) Baseline (Higher) Baseline (Higher) Baseline (Higher) Baseline (Higher) 2010 7.5% 7.5% 1.0% 0.0% 5.9% 5.9% 1.67 1.67 2.0% 3.0% 11.3% 11.3% 2011 3.8% 2.7% 1.0% 0.0% 6.3% 7.6% 1.68 1.69 2.0% 3.0% 5.9% 9.7% 2012 3.6% 2.5% 1.0% 0.0% 4.5% 5.8% 1.68 1.70 2.0% 3.0% 5.0% 8.8% 2013 4.2% 3.1% 1.0% 0.0% 4.5% 5.8% 1.74 1.83 2.0% 3.0% 5.0% 8.8% 2014 4.2% 3.1% 1.0% 0.0% 4.5% 5.8% 1.81 1.83 2.0% 3.0% 5.0% 8.8% 2015 4.2% 3.1% 1.0% 0.0% 4.5% 5.8% 1.88 1.95 2.0% 3.0% 5.0% 8.8% 2016 4.2% 3.1% 1.0% 0.0% 4.5% 5.8% 1.94 2.07 2.0% 3.0% 5.0% 8.8% 2017 4.2% 3.1% 1.0% 0.0% 4.5% 5.8% 2.01 2.21 2.0% 3.0% 5.0% 8.8% 2018 4.2% 3.1% 1.0% 0.0% 4.5% 5.8% 2.07 2.36 3.0% 4.0% 5.0% 8.8% 2019 4.2% 3.1% 1.0% 0.0% 4.5% 5.8% 2.14 2.51 3.0% 4.0% 5.0% 8.8% 2020 4.2% 3.1% 1.0% 0.0% 4.5% 5.8% 2.21 2.68 4.0% 5.0% 5.0% 8.8% Source: EIU, BACEN Focus, WB Staff Calculations Risk Analysis 22. The risk analysis assesses the impact of uncertainty surrounding fundamental variables for Pernambuco’s fiscal outlook. The main risks that could lead to a deterioration in the State’s fiscal balances are related to: (i) fluctuations in macroeconomic variables; and (ii) uncertainty surrounding FPE transfers stemming from federal reform. The objective of the analysis is to establish whether any given shock would have a negative impact on revenues or increase expenditures and compromise fiscal and debt sustainability. Fluctuations in Macroeconomic Variables 23. The analysis examines the impact of fluctuations in key macroeconomic variables (the exchange rate, IPCA and Prices General Index (IGP) inflation, real GDP growth, and personnel growth) on projected fiscal and debt aggregates. Alternative pessimistic scenarios were modeled for each of the variables, the combined outcome of which produces the joint shock analyzed, painting a highly pessimistic scenario for the macroeconomic environment. 24. The macroeconomic assumptions underlying the alternative scenarios are found in Table A3.13 and are explained as follows. The baseline assumptions for the variables are based upon forecasts by the Central Bank of Brazil (BACEN), the Economist Intelligence Unit (EIU) and the IMF World Economic Outlook (WEO). In particular, estimates for the exchange rate, IPCA and IGP inflation were taken from the BACEN Focus Report (as of October 21, 2011) for 2010 and 2011, and from the EIU for 2012-15, and were assumed to remain at their 2015 levels for 2016- 20. Estimates for the real GDP growth were taken from the WEO (September 2011) for 2010 and 2015, and were assumed to remain at their 2015 levels for 2016-20. The alternative scenario assumptions were the baseline level less (or plus) 0.5 times the variable’s standard deviation over 2000-09 for the respective lower (or higher) scenarios for the GDP growth and inflation variables. The alternative exchange rate assumed an additional 20 percent depreciation rate each year. Estimates for personnel growth were provided by SEFAZ, and the alternative was taken to be 1 percent higher. 90 25. The projected fiscal and debt trajectories are deemed sustainable in the scenario of joint adverse macroeconomic shocks. While this pessimistic scenario causes a rise in both revenues and expenditures in nominal terms (due to the inflation component), in real terms both fall. Lower growth rates have large negative impacts on current revenues, which fall by more than current expenditures. The higher personnel growth rate is reflected in higher employee compensation expenses, and interest payments rise due to the deteriorating exchange rate. Nonetheless, despite these adverse effects, both the primary and overall balances remain positive throughout the period, and there is fiscal room for investment expansion. The ratio of debt to net current revenue falls to 22.1 percent of NCR by 2020, compared to 20 percent of NCR in the baseline (Figure A3.15). Figure A3.15: Risk Analysis of the Impact of Macroeconomic Variable Fluctuations Source: WB Staff Estimates Uncertain FPE 26. This analysis models the risks associated with uncertain FPE transfers to the State. FPE transfers represented 27 percent of Pernambuco’s net current revenues in 2010. Yet, a large uncertainty surrounds the future of this revenue source given possible changes to the sharing rule 91 applied in the determination of state-specific transfer amounts. An alternative scenario is analyzed which assumes a 20 percent reduction in the sharing rule percentage from the baseline level, applied in 2013 (Figure A3.16). Figure A3.16: Risk Analysis of Impact of a change in the FPE sharing rule Source: WB Staff Estimates 92 ANNEX 4: POVERTY AND SOCIAL IMPACT ASSESSMENT (PSIA) 1. A Poverty and Social Impact Assessment (PSIA) was undertaken during the period October-November, 2011 with the purpose of exploring the potential distributional effects of policies to be implemented by the Government of the State of Pernambuco. The report comprises two parts. Part one provides the socioeconomic context, through an analysis of the demographic, labor market, economic, social, inequality and poverty dimensions of the State of Pernambuco. It uses the most updated secondary information from the main statistical sources in the country. The focus was more on cross-section than on time-series analysis although both methods were used. Thus, an overview of the State’s socioeconomic conditions was provided as a background to assess the likely impacts of those DPL supported policies on poverty and inequality. Part two contains the stakeholders’ perspectives on each one of the policies to be undertaken by the State with Bank support. This data was compiled through interviews with key stakeholders. The issues and questions approached were based on PSIA methodology that attempts to identify who wins and loses with the policy, why this is so, and how it affects policy outcomes. It also evaluates concerns and possible risks stemming from implementation of the policies, and tries to pinpoint the channels by which benefits and costs are transmitted to stakeholders. The overarching goal of these exercises is to assess whether the proposed policies increase the wellbeing of the State’s population, promote equitable growth across regions and social groups, and are, at their core, pro-poor. 2. The proposed operation is expected to have a positive effect on poverty reduction and social equity, especially in the interior of the State of Pernambuco. The policy priorities for the period 2011-2014 are particularly concerned with a more equitable distribution of the benefits of growth across the State’s twelve development regions. This implies incorporating social groups that did not benefit from the higher growth path of recent years. Thus, the DPL supported policies are focused on strengthening progressive policies that contribute to more equitable development across social groups and regions. This section of the report presents a thorough analysis of the potential impacts of the supported policies on poverty and equity. 3. Pernambuco poverty and socioeconomic disparities are marked traits of its history. Despite notable advances in recent years Pernambuco still faces sharp inequalities and widespread poverty. Furthermore, within Brazil, Pernambuco still lags in many key social and economic dimensions. The State’s Government is conceiving and applying policies to reduce its lag with respect to the country as a whole, and to narrow inequalities within regions and among social groups. The DPL supported policies are targeted to promote a more equitable growth by converting economic expansion into widespread and improved wellbeing. 4. Interviews with key stakeholders concluded that the DPL supported policies (to provide quality education, improve the reliability and security of water supplies, strengthen disaster and risk management, upgrade human capital, strengthen gender equity, support small urban and rural producers, and increase public administration capacity) would have positive distributional impacts across regions and social groups, thus contributing to lower poverty and inequality. Interviews sought stakeholders’ perceptions of the potential distributional impacts of the DPL supported policies, especially on poverty and inequality. They also elicited interviewees’ primary concerns about the main risks associated 93 with the implementation of policies supported by the DPL. Stakeholders interviewed comprised: (i) policy formulators; (ii) policy executioners; (iii) school teachers; (iv) students; (v) school heads; (vi) students’ parents/families; (vii) NGO representatives; (viii) scholars; (ix) managers; (x) members of state councils; and (xi) community leaders. Given the content of some of the DPL supported policies that were related to issues within the Government itself, additional stakeholders were sought from the government apparatus and society at large. In these cases, theoretical and analytical skills were used to trace all effects down. Policy Area 1: Improving the Quality of Life of Pernambucanos Sub-Component 1.1: Provide Quality Education. 5. The full school day (40 hours per week in integral schools) or expanded school hours (32 hours per week in semi-integral schools) will have a positive impact on reducing poverty and inequality, because priority is being given to schools located in relatively backward and poorer municipalities and suburbs, as shown in the specific legal documents. Expansion in the number of school hours targets municipalities with lower Human Development Indexes in the State, as well as suburban areas within cities situated in the MAR. The criterion to create extended instruction hours is the presence of poverty, violence, and weak school performance. To be accepted by a reference school (full day or extended hours) a student must come from the public school system. Other requirements apply. A pattern defines the number of vacancies and a parameter determines that for every thirty thousand inhabitants a school should be available. In secondary schools with extended hours of instruction, the curriculum is adapted to prepare students both for access to higher education and for the labor market, while in secondary fulltime technical schools the major curriculum component targets the labor market. Teachers in both systems are dedicated exclusively to the school they have been assigned to work in. Currently there are 59 semi-integral schools in the MAR and 49 in the interior of the State, and 65 integral schools. In 2011, the Government authorized the functioning of 9 additional integral schools and 14 additional semi-integral schools. 6. For students, this policy will widen access to quality secondary education and improve chances of access to university education, which has been lower for poor youth coming from the public school system. Better education and qualifications will also increase students’ employability and income prospects when they decide to enter the labor market. Higher returns to human capital will broaden access to goods and services that may lead to improved wellbeing. The feeling of belonging to a respected academic community also increases the students’ self-esteem and leads to social recognition. In 2010, reference schools performed better (3.56) in IDEPE test scores than regular schools (2.09). 7. The extended hours of school may also reduce youth involvement with drugs (trafficking and consumption), violence, and other illegal activities, as well as potentially reducing unwanted teenage pregnancy, particularly in the poorest municipalities and suburbs. Extended hours have potential poverty and social impacts on parents and students’ families at large. One potential impact is the increase of inter-generational social and economic mobility, which starts by improving the current chances for social and economic upward mobility for students of poor families. Families’ prospective wellbeing is also increased through 94 higher potential family labor force participation, which raises permanent family income and thereby widens access to goods and services. In addition, increased school hours can reduce the probability that young people become involved in drug trafficking or consumption, street violence, or early pregnancy—all situations that impose high emotional and social costs on the family unit. Finally, family members’ enrollment in good and valued schools improves self- esteem and social status in the local community. 8. Teachers are also expected to benefit because they earn more for working longer hours and are granted a bonus conditional on results, based on schools’ test scores (IDEPE). Interviews with teachers and parents indicated a unanimous belief that longer school hours and the exclusive dedication of one teacher to one school provided better guidance to students. Students argued that it allowed for more academic interaction and created a stronger esprit de corps. Stronger ties between students and teachers could also bring teachers closer to students’ parents and make them more knowledgeable about the problems students face at home. In turn, this greater closeness between teachers and local families could raise teachers’ social status in the local community, improving their self-esteem, and stimulating their commitment to the policy’s overarching goals. Teachers unions, which are usually resilient to this kind of policy, stand to reap rewards because the reforms reinforce their classical discourse on the need to improve the quality of public education, working conditions, and pay. In addition, the union stands to gain in membership, since the Government will need to hire more teachers to achieve the policy objectives during the period 2011-2014. This additional employment and wage income (including more bonuses) can be expected to result in increased demand for goods and services in the local economies. 9. The community at large is expected to benefit from the policy, since it upgrades its social and intellectual capital, provides a better quality labor supply to meet local labor market needs, and is likely to reduce the number of young people involved in drugs and crime. Thus, policies are progressive and promote equitable growth. Strong community support is expected to arise from the collective awareness that the reform enhances intellectual capital, economic opportunities, and community prestige. 10. Primary concerns and perceived risks. For secondary students there is an opportunity cost of a (typically low paid) job in the local labor market. This poses the risk that students get a job to become less dependent on parents’ income, especially if the student’s family is poor. Interviews revealed a temporary resistance of first year students to the extended school hour policy, due to a cultural bias that values teenagers’ income independence. However, by continuing to attend school and by abiding by its academic rules, students came to appreciate that it generated economic opportunities for upward social mobility and higher status. 11. Students of poverty stricken families face higher risk of dropout due to critical survival needs that encourage young people into either the labor market or illegal activities. Some families stated during interviews that they either pressed students to drop out of school or to reduce their hours of attendance so that they could get a job, in order to contribute to household incomes. The majority of families, however, have encouraged young students to stay in school, due to the awareness that this policy would enhance family’s economic, social, and cultural opportunities. There was also a family awareness that extended school hours would help 95 families to keep their youth away from drugs, violence and unwanted pregnancy. Nevertheless, schools’ heads stated great difficulties in attracting parents to the regular school meetings. with the majority of attendees being mothers or grandmothers. 12. Within the teaching community there is a potential risk stemming from lack of motivation and belief in the policy’s goals, strategies and instruments, which could compromise the final outcome by undermining the quality of education. However, the interviews indicated that teachers currently support the policies. The teachers union has the potential power to block initiatives and create difficulties for the advancement of the policy. But despite some criticisms, the union currently perceives that the policy will strengthen the institution and reinforce its agenda. Sub- Component 1.2: Improve Water Security and Increase Reliability of Water Supply 13. The water resources management policy actions supported by the DPL, focused on the improvement of water security and reliability of supply, can also be expected to have a net positive impact from a distributional perspective. The poor population suffers the most from water scarcity and from intermittent water supply. Poor people are also most vulnerable to heavy rainfall and flooding since they are disproportionately concentrated in hills, lowlands, and river margins that are more prone to this kind of natural disaster. 14. For the poor population, unreliable water is related to higher morbidity, especially among infants and children. Since water is intermittent, the poor population usually saves water in (often open) devices that are efficient vehicles for transmitting diseases of hydro origin, such as dengue. Saved water may also be contaminated by organic or inorganic materials, making it potentially unsafe for drinking, washing, bathing, cooking, and other household uses. Unreliable water supply also affects groups in the middle and upper social classes. These groups, nevertheless, obtain water from wells or private suppliers—an option that is not economically feasible for most of the poor. 15. The MAR experienced years of water rationing. Recently, the Pirapama system started to pump water to those areas previously subjected to intermittent supply.39 Rationing also affects the interior, especially in the semi-arid region. In the rural areas of the interior where the majority of the population is poor, the problem is aggravated during periods of irregular rainfall or severe drought. 16. The MAR and the regions closer to seashore (North and South ―Matas‖) are subjected to heavy rain and the risk of severe flooding. The poor urban populations who live in risky areas suffer the most, especially those who reside along the river margins that cross some of the most important cities of the territory. In 2010, flooding caused devastation to these areas, especially in the south of the State. There were avoidable deaths and casualties, in addition to severe damage to the social and economic infrastructure, commerce, industry, and private property. The reconstruction plan is still under way and has been costly to the State Treasury. One of the lessons learnt by the Government is that prevention programs cost less than disaster 39 In Metropolitan Recife, increased water pressure on old pipes caused many to burst. The number of leakages rose leading to additional wastes of clean water. 96 response and can protect lives and property. Recently created, the State Water and Climate Agency (APAC) is responsible for implementing and regulating the hydro resources of the State, except those related to the construction of dams and reservoirs. 17. The new framework and the creation of APAC will favor poor urban communities and rural areas. Those poorer areas have been traditionally affected by unreliability of water supply and water related natural disasters. This policy response was elaborated through consultation with stakeholders at the State and municipal levels. 18. Expected Benefits. Improved access to regular safer water will benefit urban populations, particular the poorest, whose access is limited due to poor water availability or the high cost of private suppliers. A reduction in infant disease/mortality and general morbidity can be expected as a result of improvements in the sanitary conditions of poor households. Under the new policy, the urban poor might spend less on water despite higher consumption, because official tariffs are lower than the prices charged by private suppliers. If this is so, more income will be left for other expenses, a discrete but meaningful gain for poor wage earners. Regular water availability may have an indirect effect on housing assets, by boosting the market value of homes that were previously without a regular supply.40 19. Better risk prevention can be expected to improve the quality of urban life. Municipal master plans that reserve high risk sites for social and leisure activities, as opposed to housing and commerce, can help to prevent the human, economic, and social costs of displacement of urban populations that have settled in lowlands, hills, river margins, and other vulnerable areas. 20. For urban businesses, regular water supply increases productivity and profits in activities where water is a critical input, such as the beverage industry and restaurants. This improves product quality, making them safer for human consumption and reduces overheads (since water acquired from private suppliers is more expensive). Furthermore, regular and safe water supply can lead to the growth of enterprises in which water is a critical input— whether the expansion of existing businesses, or the creation of new enterprises. 21. For farmers, especially poorer farmers located in the arid backlands of the State, increased and regular water supply reduces the adverse economic effects (such as poor harvests and herd losses) stemming from irregular rainfall and severe droughts. In sectors where water is a critical input to sustainable productive process, policy implementation and improved regulation may warrant water supply for the production of food crops and for the export-oriented agro-industrial businesses located in the interior of the State. For poor farmers engaged in family agriculture, predictability and regular water supply helps to prevent price collapses as a result of natural disasters. This helps to assure food supply for self-consumption and for the market, sustains income and employment, and potentially increases the market value of otherwise dry and unproductive land. In the rural sector, there is also a time-use gain for the 40 A house with water can be expected to be worth more than a house without it, as confirmed by interviews for the PSIA. 97 poor, especially women, who typically spend non-negligible amounts of time collecting and transporting water. 22. There are also possible losers resulting from this policy. Private suppliers will face a declining demand for water trucks that supplied households, farmers, and firms as a result of intermittent water availability. Narrower water markets for private suppliers will mean that they will likely face tougher price competition and reduced profits, which might lead to layoffs. Market value of private suppliers may decrease as a result of better service delivery by the public sector. 23. Primary Concerns and Perceived Risks. Alternative suppliers may oppose this policy since the increase in the efficiency of the system could reduce business for them. Indeed, poorer people tend to buy water from alternative suppliers whenever the system does not satisfy their demand. Data shows that they do so at higher prices than the prices that would eventually be charged under the new system. There is thus a surplus appropriated by the poorest. 24. This policy is implemented in close coordination with the municipal governments, especially with civil defense. Thus, the role of municipal government is essential to the sustainability and long-run success of the policy. A fear of short-run losses as a result of displacement from risky areas may lead to resistance from the population. There is a risk that after the occurrence of a natural disaster the population would return to occupy the areas they were displaced from. Municipal governments would have to prevent this, in addition to allocating these sites to alternative uses. Some of those interviewed voiced a concern that populations would return to vulnerable areas and that municipal governments would not follow through with adequate urban planning. 25. There is also a risk that the civil defense of the municipal governments, especially in those municipalities with a higher than average risk of recurrent natural disasters, might not be adequately prepared to deal with crisis situations where readiness is essential to avoid further losses and damages to households, infrastructure, and productive activities. 26. The rural population may also lose some natural assets such as waterfalls as a result of interventions designed to stabilize water supply to the urban and rural communities. This possible loss does not threaten the successful implementation of the policy. Sub-Component 1.3: Improve Disaster and Risk Management 27. The risk and disaster management policies supported under the operation can be expected to have a large pro-equity impact. Sub-component 1.2—improving the security and reliability of the water supply—is strongly connected to this disaster and risk management sub- component. The poorer population should benefit the most from these policies since it is disproportionately concentrated in the most vulnerable areas of the State, especially in the three development regions comprising the coastal areas. Interviews and data show that the poorest social groups are hardest hit by natural disasters, since wealthier households can afford to both live in relatively protected areas and protect their lives and property from potential losses. 98 Notwithstanding this fact, the State, however, has the constitutional duty to protect all members of society irrespective of social class—an implicit goal of the policies supported by the DPL. 28. Disaster and risk management policies are also expected to reduce the economic and human costs associated with population displacement in the semi-arid zone of the State. The same level of exposure tends to result in higher relative losses for poorer populations, particularly with regard to tangible and non-tangible assets. Losses can carry potentially long-run implications, such as those associated with the interruption of schooling or health services. As the PSIA shows, the map of disaster risk exposure overlaps with the poverty map. Thus, reducing the magnitude of the impact of extreme events, through the policies supported by the operation, has clear pro-poor implications. 29. This policy has been conceived and implemented in close connection with municipal governments. Full implementation requires both vertical coordination among the three levels of government and horizontal coordination among secretariats and agencies of the State Government. All relevant stakeholders were consulted, especially at the municipality level, where local civil defense represents the crucial first line of response. 30. Expected Benefits. For the urban population, especially the poorer, improved disaster and risk management policies can ensure increased survival and fewer casualties resulting from natural disasters. It can also lower the probability of contracting natural disaster-related diseases, in particular, water-borne illnesses. In addition, it can reduce the losses to household assets. 31. One of the most important gains of this policy is not related to ex-post losses but to the forging of increased community awareness of risk. Higher levels of community consciousness can enable risk prevention through improved ex-ante measures. In the long run, a culture of risk awareness enables the incorporation of robust infrastructure and appropriate land use in urban planning, thereby lowering the human, economic, and social costs of unsuitable land use. 32. For rural communities, especially those in the semi-arid areas that are more likely to face water scarcity, this policy aims to provide improved access to water and social protection in the occurrence of droughts, thereby reducing the vulnerability of the rural poor to adverse climate events. 33. Urban economic activity is likely to benefit from early warning systems and other preventive measures that reduce losses to goods, facilities, stocks, machinery, and employment resulting from natural disasters. This will help to preclude deep damages to the local economy and allow for faster economic recovery of disaster stricken areas. In emergency situations caused by floods or droughts, risk management policies provide coordinated and immediate assistance to rural or urban communities through public service delivery of such essentials as vaccinations and food. Interviews indicated that (in the light of recent experiences of drought and floods) such policies have the support of associations of rural producers, rural workers, unions, and NGOs. 99 34. Primary Concerns and Perceived Risks. One perceived risk is that if municipal governments do not play their part, the community may not get the full benefits of the risk management policies. Municipalities may fail, for instance, to preclude the return of households and businesses to risky sites after the occurrence of natural disasters. Civil society engagement will help to hold municipal governments to account for delivery of their responsibilities with regard to risk management. Policy Area 2: New Economy—Expanding Opportunities for Pernambucanos Sub-Component 2.1: Promote Job Creation through the Development of Human Capital 35. The promotion of economic development and job creation, through the policies supported by the DPL, is expected to be positive for all stakeholders. The labor market in Pernambuco is tight. Unemployment is falling, job creation is growing fast, and labor earnings are rising. Skilled and semi-skilled labor are becoming scarce, especially in the construction business, as a consequence of huge investments in infrastructure, productive activities and housing. In the next five to seven years, public and private investors are committed to invest around R$53 billion in the State. Out of this total, 77.4 percent will be located in the MAR and three-fourths are in the industrial sector. 36. The State has not been able to supply the manpower demanded. Many workers are coming from other states and even from abroad. Pernambuco’s labor market profile is characterized by low schooling and low skills. This is due to historically poor (although currently improving) educational records, both in elementary and secondary schools. At 18 percent (according to the 2010 census), illiteracy is high, and 50.2 percent of people aged 10 and over (according to the 2009 PNAD) have between one and eight years of schooling. 37. This mismatch between supply and demand means that many Pernambucanos are unprepared to take advantage of the jobs offered by the State’s emerging economy. This also means that a non-negligible share of GDP is not transformed into income for those living within the State’s territory. Interiorization and internalization represent important tactics to transform economic progress into increasing wellbeing for all Pernambucanos. 38. The State’s economy is currently experiencing a boom in the civil construction business, with a significant portion of new demand for labor concentrated in this sector. However, as investments mature, labor demand will shift to occupations typical of a modern industrial economy (for example, oil and gas, petrochemicals, shipbuilding, and pharmaceuticals). The State’s labor force must be better qualified to take jobs in these emerging sectors. 39. Preparing Pernambucanos to take full advantage of the new opportunities in a changing and modernizing economy will help to promote equitable, pro-poor growth. The Government has taken measures to match human capital to local job market demand, with an emphasis on professional education. Accordingly, it has transformed six regular secondary state schools into schools of professional education. In addition, the State Government has created a Labor Secretariat to conceive and implement policies to boost human capital within the State. In 100 interviews, stakeholders indicated their belief that the policies supported by the DPL will have a progressive impact, benefiting the poor. 40. Expected Benefits. Students of professional education will get improved skills for local labor market entry, broadening their employability and increasing their access to higher education. Either outcome leads to higher income prospects and broad access to good and services. Besides, upgraded professional students are likely to be kept away from drugs, violence and early pregnancy. Furthermore, such polices raise their self-esteem and prestige within the local community. 41. For the labor force at large, these policies are expected to increase employability, and reduce long-term unemployment and informality that result from lower schooling and skills. In addition, they may raise labor earnings, thus contributing to reduced poverty and inequality. Increased human capital is an input for higher firm productivity that may also be appropriated by workers if it grows faster than real wages. These policies both increase the supply of local qualified labor to firms, eliminating the marginal cost of importing qualified workers from elsewhere and reduce cannibalization among firms in their eager search for workers to fulfill open job vacancies. Furthermore, such policies internalize income by providing qualified labor to the new productive chains, and reduce urban violence and drug addiction by creating sound economic and social alternatives. 42. As positive social and economic externalities resulting from these government policies reach the local communities, especially in the interior, the policies can be expected to attract the support of civil society, since they are convergent with many of these organizations’ goals. The PSIA analysis thus concludes that labor unions, entrepreneurs associations, families, and NGOs are all likely to effectively support these policies. 43. Primary Concerns and Perceived Risks. Stakeholders identified three relatively minor concerns and risks. The first is that students may criticize or oppose this policy if secondary professional schools do not prepare them equally well to access colleges and universities, a valued cultural asset. The second concern is that if trained workers do not get a job as a result of labor market mismatches, they might blame the policy for their failure. The third is that a scarcity of instructors might result in a failure to meet demands: instructors will have to train other instructors; and still the number of available instructors may not meet the anticipated demand. Sub-Component 2.2: Increase Opportunities through Greater Gender Equity. 44. The gender policies supported by this DPL, including the support to the establishment of the Secretaria das Politicas Mulheres (SecMulher) as a permanent secretariat and the implementation of partnerships with other sectors, are estimated to enhance economic, social and cultural opportunities for women in a non-regressive way. 45. Despite efforts to increase endowments for women in Pernambuco, serious problems persist. For example, maternal mortality remains very high with a rate of 76.4 deaths per 100,000 live births, based on 2008 data. Women are overrepresented among the unemployed, 101 have a lower labor force participation rate (44.3 percent) and lower share in the total employment (43.9 percent) compared to men, and are heads of households in increasing numbers. Women also have substantial income gaps with respect to men in the state’s labor market (1.60). Women usually have greater schooling years (6.07), but social and economic adverse mechanisms impede them from transforming this advantage into better jobs and higher incomes. Teenage pregnancy remains a serious problem in Pernambuco. Evidence suggests that pregnancy before the age of 20 has negative implications for mothers and their children’s future opportunities in society.41 In Pernambuco, the pregnancy rate for girls aged 15 to 19 was 74.4 per 1,000 live births, which ranks as the fourth highest in northeast Brazil. At between 6 and 7 per 100,000, the female homicide rate in Pernambuco remained high throughout the past decade. Thirty-four percent of females in Pernambuco reported having experienced physical violence, while 14 percent reported sexual violence at least once in their life (WHO, 2005). Unemployment and lower income makes women more dependent on their male partners and increases the probability of being subjected to domestic violence. Women are also more vulnerable to sexual assaults and few seek assistance either for fear or for lack of awareness of their rights. 46. Being of afro-descent, among other attributes, puts women at an even greater disadvantage. If a woman is illiterate, afro-descendent, head of household with small children, works in family agriculture, and lives in the semi-arid interior of the State, she will have a very high probability of being extremely poor in addition to being overexposed to risky situations. 47. While the State has maintained a Special Secretariat for Women since 2007, its role and impact has been limited to only two major areas of activity: (i) rights-based training of women; and, (ii) job training in non-traditional sectors for women in rural areas of the State through the Chapeu de Palha program. The State Government has strengthened its institutional framework aimed at promoting gender equality by creating a permanent Women’s Secretariat to replace the former temporary Secretariat, as evidenced in the legal documents. The permanent Women’s Secretariat (SecMulher) is able to advance more vigorously gender mainstreaming in the public sector, while expanding its focus to other pressing gender issues in Pernambuco—namely, violence against females, gender education, and health. 48. The SecMulher aims at the socio-political strengthening of disadvantaged women, by reducing employment and income gaps, increasing human capital, improving awareness of their rights, and helping them to obtain the necessary documentation to enter the formal labor market. Its policies are linked to a network of other government agencies and institutions (police stations, hospitals, schools, shelters). Policies were elaborated in consultation with major stakeholders. 49. Reducing and preventing violence against women is also an important area of focus for SecMulher. Pernambuco currently has five shelters to assist women victims of violence. The State is planning to open new ―model‖ shelters that will provide additional services and attention to victims. 41 Teenage pregnancy is often correlated with higher poverty rates and lower economic opportunities of the mother, as well as lower educational outcomes of the child. However there is little empirical evidence on whether these correlations represent causal links or the direction of any causality. 102 50. The SecMulher is planning to accelerate the implementation of municipal entities to facilitate the articulation of policies and programs with a gender perspective, as well as training staff from municipal secretariats on gender issues. The SecMulher plans to open 30 new entities—currently they have 111—in order to cover all the 185 municipalities in Pernambuco by 2015. 51. These policies have a pro-poor tendency because they seek to reduce poverty, promote gender equity, and increase women’s opportunities through better qualification for the labor market, social protection, and improved citizenship. 52. Expected Benefits. Policies are expected to produce the following benefits and results:  Enhancing economic, social, and cultural opportunities for women, thus reducing poverty and gender inequality.  Narrowing wage and occupational gaps in women’s work in relation to men, thus reducing labor market discrimination.  Promoting women’s citizenship and strengthening their self-esteem, especially in adverse social and economic situations, thus increasing their empowerment.  Protecting women who are victims of domestic or street violence, thus reducing emotional and psychological costs.  Raising women’s awareness of their rights and providing them with the necessary documentation to secure social protection and better insertion in the local economy, thus opening up new opportunities. 53. These policies also imply substantial gains for society at large. A narrower gender gap should result in lower income inequality and lower poverty. SecMulher’s emphasis on municipalities in the interior of the State will lessen cultural biases in favor of men in regions where gender prejudices are traditionally stronger. These policies also create the social conditions to reduce violence against women and increase broader awareness of women’s rights. Women are becoming increasingly organized and are capable of reinforcing the policies of SecMulher by obtaining political support from associations and NGOs with similar agenda. 54. Primary Concerns and Perceived risks. A major concern is related to the difficulties women face when confronted with discrimination and violence, especially sexual assaults. Feelings of fear and guilt can inhibit women from seeking assistance and obtaining protection. However, this policy aims to confront this problem by promoting women’s awareness of their rights so as to help overcome feelings of self-blame that result from gender-based violence and discrimination. Since the policies require vertical coordination as well as horizontal coordination, interviews reflected a concern that the National Secretariat for Women—the federal level institution in charge of national gender policies—might be extinguished. Sub-Component 2.3: Promote Economic Development through Support to SMEs and Rural Producers 55. Description and Challenges: Economic growth in Pernambuco is highly concentrated geographically, and has a weak link to local suppliers. Currently, 74 percent of 103 the GDP of the State is produced in the coastal area, in an area that encompasses 17 percent of the State territory and 57 percent of the population. The sectoral composition of the economy favors demand for relatively unskilled labor and shows low productivity growth. The strategy to attract investment to the Suape port complex has been accompanied by a definition of strategic sectors that will be supported and eventually linked to the main growth drivers. In following this strategy, the expectation is to maintain growth above the national average, increasing the state’s share in national GDP, and reducing its gap in relation to the national per capita GDP. 56. A State Development Agency is being established to foster economic and social development by supporting micro, small and medium-size enterprises and rural producers in local production chain. The State of Pernambuco Development Agency (Agência de Fomento do Estado de Pernambuco, or AGEFEPE) has received an initial capital of R$30 million. Its mandate covers a wide range of actions, all related to the provision of support for entrepreneurship, with a specific gender component. It focuses on value chains that can supply large private firms and government, strengthening also access to technology, quality control protocols, commercialization networks, and managerial training. 57. Micro, small and medium enterprises (MSME) have a significant weight in the economy of Pernambuco. In 2009, micro and small firms alone (i.e. not including medium sized firms) accounted for 32.2 percent of employment, 22.6 percent of wage income, and 84.8 percent of the total number of formal enterprises in the State. However, they face many difficulties in accessing credit and obtaining support for their production initiatives. Most of these enterprises are located in the urban settings, especially in the commerce and service sectors, producing and trading goods and non-tangibles for local markets. There are weak input-output relations between these firms and the larger ones operating in the State. Typically, productivity is low and profit margins are small. These firms compete fiercely with each other to keep their local markets and, in sectors such as commerce, are frequently wiped out of business by larger firms. Thus, these firms are weak and vulnerable to adverse economic conditions and competition. 58. The new incoming large industries will open up investments opportunities as a result of forward and backward linkages. New productive chains can be taken up by local entrepreneurs, provided they are competitive. MSME firms will have to innovate, adopt new technologies, set up commercialization chains and update management models so as to produce high quality inputs to supply the new large undertakings at competitive prices. 59. Small rural producers are usually poor, devoted to family agriculture, and vulnerable to price fluctuations and to climate related events, especially droughts. Some produce for the market. They have limited access to rural credit through the National Program to Strengthen Family Agriculture and Bank of Northeast Brazil. Their insertion into the local productive arrangements is one of AGEFEPE’s main objectives. 60. AGEFEPE will facilitate access to federal funds devoted to similar objectives. Once the agency is in full operation, it will be able to command a portfolio ten times greater than its own capital, with minimum risk for the State. Thus, the structure and financing of the agency 104 does not represent a fiscal burden. The creation of the Development Agency is aligned with the objectives of generating more jobs, and of better distributing the benefits of growth. 61. Policies fostering MSME development would have a positive effect from the distributional perspective, by reducing bankruptcies, broadening commercial chains, enlarging profits, creating jobs and increasing wage income. Thus, such policies tend to be progressive and pro-poor. 62. Expected Benefits. Given the nature of the priority sectors, the strategy implies an important growth in the demand for technical (medium skill) workers, and thus a reduction of unemployment and poverty in the interior of the State. A specific line of activity is devoted to supporting gender-related priorities: providing services to women entrepreneurs under competitive conditions; and emphasizing support in sectors that generate demand for female labor. The policy’s both aims at the ―interiorization‖ of development and internalization of its benefits through support for micro, small and medium sized enterprises and small rural producers. 63. With respect to MSMEs, the new agency will support firms to fill gaps in the productive chains of the State economy. Local firms would then supply inputs to the larger ones already in operation or to those that are coming to settle in the State. The agency would also provide stimulus for MSMEs to supply goods and services to the local governments. In both situations, the agency’s role is to support and provide incentives for promoting entrepreneurship among MSMEs. However, providing lower cost credit is the final stage because it is conditional on measures to improve management, product quality, and competitiveness. 64. For small rural producers, this policy would facilitate access to comparatively cheaper credit either supplied by federal development and commercial banks or by the agency itself. Usually small rural producers are family-based undertakings located at the bottom of the socioeconomic scale. AGEFEPE would foster the growth of local employment and income, providing the basis for an expanded local market, especially in the interior. By prioritizing the interior of the State and some disadvantaged social groups, this policy reduces rural-urban and metropolitan-interior gaps, and promotes equitable growth and a fairer distribution of the benefits of development. 65. Micro, small and mid-sized enterprises associations support this policy because it enhances economic opportunities for all of them. The group has political voice (Small and Medium Enterprise Forum) and leverage to hold both the executive and the legislative branches of the State Government to account for the policy’s sustainability and effectiveness. In addition, small rural producers associations scattered in the interior of the State would fully support this policy due to its emphasis on increasing income and job creation jobs in the most backward regions of the State. 66. Primary Concerns and Perceived Risks. The risks to AGEFEPE are similar to those faced by development banks. The agency is supposed to play a modest role in comparison with the former Development Bank of Pernambuco (Bandepe) that was privatized in 1998. However, once credit operations are realized, there are always market risks as well as default risks that 105 should be minimized by the rules and constraints set by Brazil’s Central Bank, which issued the authorization for the agency to operate. The major risk according to some stakeholders is that the institution may be headed by a politician instead of a technocrat. There is consensus that the agency must be led by a professional, experienced in the promotion of MSMEs. There is also a concern that the demand for credit will be much greater than the initial capital endowment of R$30 million would allow. However, AGEFEPE will potentially be able to mobilize funds four times greater than its initial endowment, and it is estimated that the State Government will gradually increase its participation up to R$108 million by 2015. Policy Area 3: Increase Public Administration Capacity for Generating Results for Pernambucanos 67. The Bank supports efforts to increase the effectiveness and efficiency of public management in Pernambuco as a means of enhancing equity and expanding opportunities for all Pernambucanos. A more effective tax administration, which reduces evasion, will increase the redistribution capacity of the State through the generation of more resources. Improvements in budget management aim to allocate and execute more resources in the strategic priorities identified by a participatory process. Finally, the consolidation of Pernambuco’s Management Model, which strengthens the link between planning and budgeting, promotes a participatory and coordinated approach, and monitors outputs and outcomes of policies and programs, is crucial to increase the state’s effectiveness and efficiency. Sub-Component 3.1: Improve ICMS Tax Revenues without Increasing Tax Burden on Firms and Citizens, to Expand Fiscal Space for Investment and Promote Private Sector Development 68. The strengthening of the tax administration capacities of the State is based on mechanisms that do not imply an increase of tax burden on the poor. The estimated increase in revenues due to improved tax administration, spent equally across households, would have a progressive effect. If the extra revenue is spent according to existing priorities, the pro-poor effects would be substantial. Despite recent strong increase in revenues, there is considerable space for enhancing efficiency and effectiveness of the ICMS tax administration, the main source of revenue controlled by the State. Therefore, modernization and automation of processes are needed to allow for a more efficient and effective control of ICMS compliance. The State needs to build and mobilize public savings to finance its investment portfolio. To do so without increasing the tax burden, the Government has to increase the effectiveness of its tax collection system. The DPL supported policy would change tax procedures so as increase tax revenues. 69. Two major efforts have been undertaken for strengthening controls of the ICMS administration: (i) the implementation of the new fiscal control system, Sistema de Escrituração Fiscal (SEF-2); and (ii) the implementation of automatic forecasting and tax substitution system for selected products with the highest risk of evasion, representing close to 30 percent of ICMS tax collection. 70. The implementation of SEF-2 will increase the quantity and quality of sales information, substantially reducing fiscal evasion. The establishment of an automatic 106 forecasting and tax substitution system for selected products will allow the State to perform more strategic and effective physical controls to reduce evasion and promote voluntary tax compliance. Expected Benefits. For the Government, the main benefit will be to provide more resources to finance priority policies, without creating a new tax or raising existing ones. For society at large, new tax procedures create an environment less favorable to tax evasion. Society will benefit if it gets better public services and more efficient public resource allocation as a result of the improved tax procedures. 71. Primary Concerns and Perceived Risks. Stakeholders perceive price increases as a potential risk, since ICMS is an indirect tax. Producers depending on price elasticity for their products and on market conditions might pass on heavier tax payments to consumers. The adoption of these procedures was not and will not be preceded by consultations with tax payers. There is a risk that tax payers might resist to the new procedures and regulations (for instance, through increasing tax evasion) since they already perceive the tax burden as high. Sub-Component 3.2: Improve Efficiency of Allocation and Execution of PPA and Budget to Make Sure Public Expenditure Reflect Pernambuco’s Strategic Priorities 72. Pernambuco has made important progress towards linking its planning and budgeting processes. The State of Pernambuco moved from a fragmented budget planning process that followed standard increases across the board and was based on inputs, to a new Management Model. Since 2008, Pernambuco defined strategic priorities following the Government’s plan and outcomes from participatory regional meetings. The strategic priorities that result from this process inform the preparation of the PPA and budget formulation of individual institutions on an annual basis, aligning the allocation of public expenditures to the state’s policy priorities. By 2010, the planning process had fully incorporated the strategic priorities into the budget formulation phase, but budget execution continued to follow in a traditional input-based structure. The new regulation needed to eliminate the practice of making changes on a daily basis as a result of poor budget formulation, while providing the Government with space to address contingencies or changes in assumptions that occur during the fiscal year. 73. The DPL supports the State’s actions to improve the efficiency of budget allocation and execution. The Plano Plurianual (PPA) and budget are now being formulated and executed to reflect Pernambuco’s strategic priorities. The participatory process for the PPA—identifying strategic priorities and linked to budget formulation through the State’s Management Model— has now been further improved through measures that contribute to ensuring resources are effectively spent on the Government’s policy priorities. 74. These measures increase the cost effectiveness of public spending. Increasing efficiency and effectiveness in the use of public funds increases society’s wellbeing and it has positive distributional effects. 75. Expected Benefits. As public resource allocation becomes more effective and efficient, better provision of public services at lower costs should result from the policies 107 supported by this DPL. The State Government will benefit from the effective implementation of its strategic priorities, from the increased efficiency in the allocation of public funding for delivery of strategic projects and programs, and from reduced transaction costs within the State’s public sector. Costs per unit of public services delivered will, in theory, be lowered, allowing for more resources to be spent elsewhere, especially in programs and projects that may benefit the poor and/or reduce inequality. These measures will also provide the Government with tools to evaluate and monitor the implementation of strategic policies and upgrade the prestige of the political elite, a valuable asset in open societies once it recognizes that governance is improved and that it might be rewarded by the ballot. 76. Primary Concerns and Perceived Risks. This policy offers no risk. There is usually some internal resilience to changing budget and planning procedures if such changes demand pro-active steps from well-rooted civil servants. Such resistances can be overcome through positive systemic incentives. Sub-Component 3.3: Improve Capacity to Plan and Implement Public Policies through Institutionalization of Pernambuco’s Management Model 77. Pernambuco has improved its capacity to plan and implement public policies by taking initial steps for the institutionalization of the State’s Management Model. Strengthening SEPLAG through the implementation of the planning, budgeting and management career development and the creation of the Management Institute represents important milestones towards this goal. The State also has taken steps toward the long-term goal of developing its human resources so as to strengthen the public administration’s capacity to deliver. The Management Institute will help maintain high quality management across the administration and institutionalize performance management. 78. Expected Benefits. For the Government, this reform will increase the quality of public administration and enhance the efficiency and effectiveness of public spending. By increasing the productivity of civil servants it raises the quality of public expenditure and improves the results of government actions. The Government considers the Management Model a crucial tool for the successful implementation of strategic policies that are contained in the PPA. For society at large, benefits will arise from the strengthened capacity of the State’s civil service, leading to improvements in the delivery of strategic public services. There is broad societal support for this measure due to its expected impact on the quality of public expenditure and the provision of key public services. 79. Conclusion. Given Pernambuco’s demographic, economic, labor market, inequality, and poverty profile, and taking into account stakeholders’ perspectives on the anticipated distributional impacts, benefits, and risks, it is concluded that the policies to be supported by the DPL are expected to have positive, progressive and pro-poor impacts, thus promoting more equitable growth in the State. 108 ANNEX 5: GENDER AND POVERTY IN PERNAMBUCO42 1. Pernambuco, alongside Brazil as a whole, has made remarkable headways in terms of growth, poverty reduction, and improved social indicators in the past decade. Data reveal that Brazil’s poverty rate declined significantly, from 29.1 percent in 2006 to 22.1 percent in 2009.43 In Pernambuco, the reductions in the levels of poverty were even more striking than those for the northeast and for Brazil as a whole, falling from 48.6.9 percent in 2006 to 38.3 percent in 2009. 2. Reducing poverty and promoting equity is one of the central challenges for Pernambuco. Indeed, despite this progress, poverty rates are still among the highest and social indicators (in particular infant and maternal mortality, as well as illiteracy) are among the lowest in Brazil. Thanks to improvements in healthcare access and sanitation, infant mortality in Pernambuco has been declining since the 1990s from close to 60 deaths per 1,000 live births to 17.2 deaths per 1000 live births in 2009. However, Pernambuco’s average is still far from the national average for 2009 (14.8 deaths per 1,000 live births) and slightly worse than the average for the northeast region (17 deaths per 1,000 live births) (Figure A5.1).44 Furthermore, maternal mortality rates have not shown any progress. After taking a path of decline in the late 1990s they started increasing again in 2005 to levels similar to those in the late 1990s (Figure A5.1). Figure A5.1: Rates of Maternal and Infant Mortality in Pernambuco 80 70 Maternal Mortality 60 50 Infant Mortality 40 30 Maternal 20 Mortality_NE 10 Infant Mortality_NE 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: Authors’ calculations using DATASUS 42 This annex was prepared by Erik Alda (LCSPP) with valuable comments from Miriam Muller (LCSPP). It attempts to shed light on basic questions about poverty in Pernambuco while trying to maintain a gender lens. This note, however, does not address all the areas related to poverty because data for important correlates such as voicelessness, powerlessness, and security are not available, so for quantitative analysis this note uses a constricted definition of poverty as the having insufficient income, low levels of education, l o w l e v e l s o f employment, poor access to public services, social assistance, and poor health (see Verner 2004). 43 For the purposes of this analysis we use the World Bank 4USD/day moderate poverty line. As a result, percentages may differ from those using Brazil’s official moderate poverty line. Unless otherwise specified, poverty rates are for head of household. 44 Source: Authors’ calculations based on data from Ministry of Health. Tabnet/DATASUSS 109 3. Adult illiteracy in Pernambuco declined alongside the headcount poverty and infant mortality rates, demonstrating significant improvements in the past two decades. Reducing illiteracy is central in the quest for poverty reduction and long-term sustainable development. Thanks to continuous investments in education, Pernambuco reduced its illiteracy rates by ten percentage points from 23.2 percent in 2006 to 21.5 percent in 2009. Illiteracy continues to drop, albeit at a slower pace, declining from 23.2 percent in 2006 to 21.5 percent in 2009. Furthermore, while this rate for Pernambuco is slightly better than the average of 23.7 percent for the northeast, it is still lagging behind the average of Brazil as a whole (17.5 percent). 4. Women constitute the majority in the overall population (51.9 percent) and the ratio of women to men is higher in Pernambuco (1.07) than the national average (1.04). Women prevail in the urban population (52.7 percent), while men constitute the majority in the rural areas (51.4 percent). By crossing data on gender, age group and location it can be seen in Table A5.1 that among children, the share of males is higher than females in urban areas and slightly lower in the rural setting. Among youth, the proportion of males is higher than females in both locations. However, for adults, proportions are reversed in the urban areas and are slightly lower for women than for men in the rural areas. The elderly prevail among women who live both in urban and rural locations. This is because death rates among men (7.2 per thousand inhabitants) are higher than for women (5.2), according to the 2010 Census data. The higher ratio of women to men in the urban population stems from higher mortality rates among men, particularly among the youth as a result of urban violence. This is particularly true in the MAR, where intended and violent lethal crimes (46.3 per 100,000 inhabitants) were higher than the State average in 2010 (39.8).45 This was the highest rate among all twelve development regions of the State. Table A5.1: Population by Gender, Age and Location of Household (2010) Gender by age Pernambuco (%) Total Urban Rural Total Total 100 100 100 Children 25.7 24.6 30.1 Young 18.5 18.2 19.7 Adult 45.1 46.5 39.5 Elderly 10.7 10.7 10.6 Male Total 100 100 100 Children 27.1 26.3 29.9 Young 19.2 18.9 20 Adult 44.3 45.6 39.6 Elderly 9.5 9.2 10.4 Female Total 100 100 100 Children 24.3 23 30.3 Young 18 17.6 19.4 Adult 45.9 47.4 39.4 Elderly 11.8 12 10.9 Source: Censo Demográfico (2010)/ IBGE (1) ages: Children (14 years or less); Young (15-24 years old); Adults (25-59 years) and Elderly (Above 60 years old) 45 Data on intended lethal violence is provided by the Secretaria de Defesa Social of the state of Pernambuco, 110 5. While gender inequalities are narrowing, they continue to impede the full development potential of the province. Looking at the whole population, whereas in Brazil women continue to be poorer than men in 2009, in the northeast Brazil and in Pernambuco, this trend has reversed and, in 2009, women were marginally less poor than their male counterparts both in the northeast and in Pernambuco (Figure A5.2). A similar pattern is observed in terms of illiteracy. In 2009, females had lower levels of illiteracy than males, with 20.5 percent and 22.7 percent, respectively. These rates are better than the average for northeast Brazil, but still significantly below the national average (see Table A5.2). Figure A5.2: Headcount Poverty Rates by Gender for Brazil, Northeast, and Pernambuco 60 48.9 48.4 48.4 49.1 50 39.2 39.2 38.3 36.7 40 31.9 27.9 30 21.1 24.1 20 10 0 Male_Pernambuco Female_Pernambuco Male_Northeast Male_Brazil Female_Brazil Female_Northeast 4USD Pov. Line_2006 4USD Pov. Line_2009 Source: Authors’ analysis using PNAD 2006 and 2009 Table A5.2: Average Rates of Illiteracy for 2009, by Gender Male Female Pernambuco 22.7% 20.5% Northeast 25.4% 22.1% Brazil 17.5% 16.8% Source: Own analysis with PNAD for 2009 6. Gender disparities are particularly enduring in terms of poverty reduction. The Poverty Headcount (P0) measures the share of people who live below a poverty line—4USD per day in this case. However, in order to assess whether the situation of the poor has improved, we use the square poverty gap (P2) measure. The P2 poverty measure shows that poverty fell by almost 4 percentage points, from 18.3 in 2006 to 14.3 in 2009. Moreover, the P2 poverty measure for both males and females has also improved significantly for the same period. Females, however, continue to perform worse than their male counterparts for both 2006 and 2009. Furthermore, the square poverty gap analysis reveals that, in Pernambuco, both male and female Pernambucanos fare slightly worse than their counterparts in the states of the northeast Brazil and significantly worse than males and females than for Brazil as a whole (Table A5.3). 111 Table A5.3: Squared Poverty Gap (P2), 2006 and 2009 2006 2009 Male Female Male Female Pernambuco 17.83 18.56 13.89 14.78 Northeast 17.91 18.64 13.59 14.55 Brazil 9.97 10.67 7.43 8.19 Source: Own calculations based on PNAD for 2006 and 2009 7. Race is a strong determinant of poverty in Brazil, with both black and mulatto male and female-headed households poorer than their white counterparts. Indeed, there are large differences in the levels of wellbeing among males and females of different racial backgrounds (PNAD, 2009). The poverty headcount ratio (P0) shows that 41.1 percent of households headed by black or mulatto females are poor, compared to 29.4 percent of households headed by white females. A similar trend is observed for black and mulatto heads of household (43.1 percent are poor) compared to their white counterparts (31.5 percent). These differences persist over time: comparing 2006 to 2009, both male and females—whites, blacks, and mulattoes— experienced a decline in their levels of poverty of 10 percentage points on average; but the differences among them remained constant during this period. While the progress in reducing poverty for both males and females in Pernambuco is commendable, the black and mulatto population remain overrepresented in lower income quintiles (Figure A5.3) Figure A5.3: Gender and Racial distribution of the population by Income quintile (%) 40 35 30 25 Male_Black 20 Male_white 15 Female_Black 10 Female_White 5 0 1 2 3 4 5 Income quintile Source: Authors’ calculations based on PNAD for 2009 8. Location is another key determinant of poverty in Pernambuco: both males and females living in rural areas are significantly poorer than their counterparts living in urban areas, with differences between male and female more pronounced in rural settings. The P0 measure shows that poverty is deeper in rural areas. Rural poverty in Brazil has historically concentrated in the states of the northeast (IFAD, 2007). The rural poor are primarily small farmers and often are faced with the harsh conditions of semi-arid zones, which make income-generating activities 112 very difficult. As a result, subsistence production predominates over other activities. According to the most recent data available, both males and females living in rural areas of Pernambuco are on average 20 percentage points poorer (see Table A5.4). Table A5.4: P0 Rates by Gender and Location (Urban-Rural) P0 Male P0 Female Rural 53.7 45.1 Urban 34.3 35.7 Source: Authors’ calculations based PNAD for 2009 9. Educational attainment is also strongly correlated with poverty and has differentiated gender implications in Pernambuco. Education is a key asset for poverty reduction and Pernambuco has made important progress towards increasing educational attainment. Increased educational attainment can improve the livelihoods of the poor and reduce the likelihood of becoming poor. Moreover, higher levels of education are associated with lower levels of fertility, which, in turn, are correlated with a lower likelihood of falling into poverty (Verner, 2004). In Pernambuco, females seem to do better as their level of education attainment increases. Indeed, data reveal that girls consistently perform better in school than boys do. They have, on average, more education than their male peers, with 6 and 5.5 years of education, respectively.46 10. Young female heads of household are more likely to be poor and unemployed—a worrisome Catch-22 situation, given that, in 2006, 80.7 percent of female household heads were under 25 years of age in Pernambuco. There are high risks of trans-generational transmission of inequalities of opportunities. Seventy-three percent of households headed by a female younger under 25 years of age are poor in Pernambuco, compared to 55 percent of households headed by a young man. By contrast, households headed by females over 25 years of age are less likely to be poor (33 percent) than households headed by their male counterparts (37 percent). According to the PNAD, in 2009, a quarter of the females in the labor market in Pernambuco were working as domestic workers, followed by commerce, and education. Men were mostly employed in commerce, construction, and agriculture and farming sectors (Table A5.5). 46 In Pernambuco, the P0 is 44.3 percent for household heads that are illiterate, compared to 36.4 percent for those headed by a person who is not illiterate. When looking at gender differences, the data reveal interesting results. Households who are headed by illiterate males are poorer than those headed by illiterate females with 61.5 percent and 56.7 percent, respectively. By contrast, households headed by females who are literate are slightly poorer compared to males, with 43 percent and 41.2 percent, respectively. Differences in the P0 for heads of households with no education and heads of households with primary education appear much larger for males than for females. Data reveal that for 2009 38 percent of male household heads with primary education are poor compared with 47 percent of their male counterparts who have no education. By contrast, 4 2 p e r c e n t o f f e ma l e s w i t h p r i ma r y e d u c a t i o n c o m p l e t e d a r e p o o r , c o m p a r e d t o 4 6 p e r c e n t o f f e ma l e s w i t h n o e d u c a t i o n . Household heads that h a v e c o m p l e t e d s e c o n d a r y education are far better off: in 2009, only 21.8 percent of male household heads with secondary education were poor, compared to 29 percent of females with the same level of education. Finally, both male and female household heads with 12 or more years of education are far less likely to be poor: only 6 percent of these female household heads are poor compared to 6.7 percent of males. 113 Table A5.5 : Percentage of People Employed by Sector and Gender Female Male Agriculture, cattle farming, fisheries. 5.74 21.31 Fishing 0.08 0.43 Mining -- 0.17 Manfacturing 8.42 9.97 Electricity, Water, and Gas 0.15 0.75 Construction 0.61 11.11 Commerce 16.45 20.45 Hotels and Restaurants 4.97 3.27 Transport, Warehouse, and Communications 1.15 7.15 Financial markets 0.92 1.15 Real State 5.74 8.99 Public Administration and Defense 6.96 7.06 Public Education 9.72 2.07 Social Services and Health 7.19 1.72 Other activities related to community and social services 7.19 2.93 Domestic worker 24.71 1.46 Extraterritorial organizations -- -- Source: Own calculations based on PNAD for 2009 11. The employment situation for female-headed household has worsened in Pernambuco. While the situation for female-headed household may not be reflective of the entire gender dynamics at play in labor markets, it has strong implications for equity and poverty reduction, as such households tend to face higher degree of vulnerability to shocks and variations. In 2009, 8.9 percent of female heads of households were unemployed compared to 4.1 percent of male heads of households. The data reveal that the unemployment rate for females has worsened since 2006, when it was 6.3 percent. Females in Pernambuco not only suffer from higher levels of unemployment but those who are employed also receive lower income compared to men. In 2009, women received 82 percent of the income earned by men. Even more striking is the fact that women with 12 or more years of education earned income that was only 54 percent of their male counterparts.47 The challenge for Pernambuco is to expand the access to the labor market to women, especially to non-traditional sectors that present high earnings potential (such as construction), while reducing the existing income gap between males and females. 12. In Pernambuco, the existing gender wage gap between females and males represented the equivalent of a -10 percent hourly wage differential in 2009. The summary statistics of the independent covariates presented in Table A5.6 reveal that in 2009 the mean log hourly wages were 1.21 for females and 1.32 for males. Females tend to work significantly less hours than males. Males worked almost 42 hours/week compared to 37.1 hours/week for females—a difference of 5.1 hours/week. Females, however, reported half a year more in education than males. 47 IBGE, PNAD 2008/2009: http://www.ibge.com.br/estadosat/temas.php?sigla=pe&tema=sis_2010 114 Table A5.6: Mean Value of Variables between Female and Males in Urban areas in Pernambuco (2009) VARIABLES Male Female Gender Gap Hourly Wages (log) 1.32 1.21 -0.11 Age 30.00 33.22 3.22 Age_2 1292.39 1535.46 243.07 Race (Black =1 ) 0.64 0.60 -0.04 Primary Education completed 0.05 0.05 0.00 Secondary Education completed 0.18 0.20 0.02 Tertiary Education completed 0.05 0.07 0.02 Employed in Social sector 0.04 0.08 0.04 Employed in Services 0.15 0.14 -0.01 Employed in Agriculture 0.04 0.01 -0.03 Employed in Industry 0.12 0.03 -0.09 Employed in other sector 0.09 0.05 -0.05 Number of weekly hours worked 42.06 37.11 -4.95 Number of children <18 0.88 0.84 -0.04 13. The gender wage gap reflects many characteristics of the socioeconomic situation of males and females in Pernambuco, varying greatly across racial groups, occupations, and industries, and location. Table A5.7 reports the estimates from the general human capital model for urban areas in Pernambuco. Levels of education and job characteristics are shown to be important factors for wage determination in Pernambuco. However, gender appears to be the single most significant factor for wage determination. The positive and statistically significant coefficient (male=1) shows that men receive significantly higher wages than females after controlling for other factors. The large coefficient implies that males earn, on average, 38 percent more per hourly wage than females in urban areas in Pernambuco. Other covariates, such as race, also appear to be important in determining wages. Findings reveal that blacks or mulattoes in Pernambuco make 22 percent less than their counterparts. 115 Table A5.7: General Wage Models for urban areas in Pernambuco in 2009 VARIABLES Hourly Wages (log) β Std. Error Gender (male = 1) 0.382*** (0.0213) Age 0.0330*** (0.00515) Age_2 -0.000334*** (5.99e-05) Race (Black =1) -0.227*** (0.0202) Primary Education completed 0.0179 (0.0367) Secondary Education completed 0.383*** (0.0230) Tertiary Education completed 1.199*** (0.0331) Employed in Social sector 0.222*** (0.0455) Employed in Services -0.0138 (0.0395) Employed in Agriculture -0.569*** (0.0586) Employed in Industry 0.0871** (0.0417) Employed in other sector 0.419*** (0.0427) Number of weekly hours worked -0.0132*** (0.000691 ) Number of children <18 -0.0254*** (0.00956) Constant 0.721*** (0.115) Observations 5,708 R-squared 0.398 Standard errors in parentheses. *** p<0.01, ** p<0.05, * p<0.1 14. Analysis on the 2009 PNAD shows the largest gender-gap to be coming from education, as the returns appear to be larger for men than for women. Table A5.8 reports the estimated wage function by males and females in urban areas in Pernambuco in 2009. The same wage regression (dividing the data by sex in order to analyze the gender wage gaps in the labor market) shows returns to education to be larger for men than for women—both for secondary (β = .453) and (β = .261), and tertiary education (β = 1.362) and (β = .996), respectively—despite the fact that females have, on average, higher levels of education than men. The return to the sector of employment varies widely according to sector. Not surprisingly, having children younger than 18 years old at home implies a decreasing rate of return for both males and females. 116 Table A5.8: Gender Specific Wage Models in urban areas in Pernambuco (2009) VARIABLES Male Female β Std. Error β Std. Error Age 0.0342*** (0.00669) 0.0331*** (0.00804) Age_2 - (7.71e-05) - (9.50e-05) 0.000328*** 0.000374*** Race (Black =1 ) -0.237*** (0.0268) -0.206*** (0.0304) Primary Education completed 0.0935** (0.0460) -0.0890 (0.0600) Secondary Education 0.453*** (0.0302) 0.261*** (0.0355) completed Tertiary Education completed 1.362*** (0.0464) 0.996*** (0.0473) Employed in Social sector 0.125** (0.0592) 0.0681 (0.114) Employes in Services 0.0602 (0.0436) -0.310*** (0.112) Employed in Agriculture -0.532*** (0.0624) -0.801*** (0.168) Employed in Industry 0.102** (0.0448) -0.106 (0.119) Employed in other sector 0.398*** (0.0472) 0.250** (0.116) Number of weekly hours -0.0149*** (0.000980) -0.0116*** (0.000970) worked Number of children <18 -0.0172 (0.0120) -0.0391** (0.0159) Constant 1.059*** (0.148) 1.027*** (0.197) Observations 3,285 2,423 R-squared 0.413 0.381 Standard errors in parentheses. *** p<0.01, ** p<0.05, * p<0.1 15. Decomposing the gender wage gap using the Oaxaca-Blinder methodology shows that the human and job characteristic factors explain more than 40 percent of the entire gender gap in urban Pernambuco. The Oaxaca-Blinder decomposition methodology is used to flesh out the contribution of endowments and coefficients to wage determination for males and females in Pernambuco. The analysis shows that when that male-weighted value is applied as the reference group, the human and job characteristic factors explain more than 40 percent of the entire gender gap in urban Pernambuco (A5.9).48 48 ((1.219/2.626)*100 = 46.4%) 117 Table A5.9: Oaxaca-Blinder decomposition of the gender wage gap in urban areas in Pernambuco for 2009 VARIABLES Overall Endowments Coefficients Interaction Age -0.00638 -0.0442 0.000203 (0.0106) (0.424) (0.00198) Age_2 0.00640 -0.0819 0.000899 (0.00890) (0.217) (0.00268) Race (Black =1 ) 0.0129*** 0.0204 -0.00170 (0.00341) (0.0264) (0.00223) Primary Education -0.00181 -0.0159** 0.00354* completed (0.00111) (0.00664) (0.00195) Secondary Education 0.00361 -0.0545*** -0.00153 completed (0.00550) (0.0133) (0.00236) Tertiary Education 0.0738*** -0.0358*** -0.0198*** completed (0.0124) (0.00674) (0.00486) Employed in Social sector 0.0204** -0.00443 -0.00927 (0.00976) (0.0100) (0.0210) Employes in Services 0.0110 -0.110*** -0.0675*** (0.00798) (0.0357) (0.0224) Employed in Agriculture 0.0268*** -0.0172 0.0136 (0.00407) (0.0115) (0.00909) Employed in Industry -0.0146** -0.0510 0.0299 (0.00653) (0.0313) (0.0184) Employed in other sector -0.0214*** -0.0298 0.00800 (0.00473) (0.0252) (0.00691) Number of weekly hours 0.0937*** 0.146** -0.0210** worked (0.00841) (0.0601) (0.00876) Number of children <18 0.00207 -0.0222 0.00262 (0.00152) (0.0202) (0.00247) Female 1.219*** (0.0185) Male 1.407*** (0.0163) Difference -0.189*** (0.0247) Endowments 0.206*** (0.0203) Coefficients -0.333*** (0.0258) Interaction -0.0621*** (0.0213) 118 16. Although, females continue to lag behind males in virtually every area, the Government of Pernambuco has been committed to building a more gender equitable society, notably through the SecMulher. The proposed DPL aims at supporting the Government of Pernambuco in that effort. The decision of the Pernambuco Government to make the Special Secretariat of Women’s Affairs a permanent secretariat and, concurrently, to add resources and reorganize its organizational structure adds stature and influence to the institution. Until these changes were made, the special Secretariat had limited authority to act. This authority extended to two areas: (i) advocating for greater emphasis being placed on issues related to women in the public policy arena; and (ii) providing training for females in rural areas, through the Chapeu de Palha program. Box A5.15: The Chapéu de Palha Program The Chapéu de Palha Program was created in 2007 with the objective of reaching families in the Zona Canavieira (sugarcane producing region) who are unemployed in between harvests and strengthen rural populations’—and particularly females’—productive, social and political capacities. Vocational training for females is a special focus of the program and activities are implemented in partnership with SENAI (Serviço Nacional de Aprendizagem Industrial) and SENAC (Serviço Nacional de Aprendizagem Comercial). SecMulher has organized a course to train females in non-traditional sectors (i.e. mechanics, construction, electricity) with the objective of changing the prevailing gender- specific obstacles to accessing the labor market in non-traditional sectors. A condition for participation in these courses is the completion of a rights literacy course that addresses basic concepts of citizenship, human rights, and gender equality. The trainings started in 2007 in the Zona Canavieira (sugarcane producing region) and were expanded to the São Francisco Valley in 2009 and to the Agreste in 2010. Another expansion of the project is planned for 2011 to reach women in the coastal areas of Pernambuco. By becoming a full secretariat, there will be a substantial increase in the number of women trained annually: 4300 females will have received vocational training in 2011, whereas in 2010 1,215 women received training. Moreover, there is an interest from SecMulher to absorb the full execution of this program as of 2012. 17. SecMulher now has authority to expand the activities of the secretariat to other key gender issues such as violence against females, increasing resources for education, and expanding health services. These are necessary actions if the goal of economic empowerment of women is to be achieved. In addition, SecMulher’s influence within the government has grown, enabling it to facilitate gender mainstreaming gender and establish gender-coordinating units in other sectors. 18. Two noteworthy agreements are under preparation with the Secretariats of Education (SecEdu) and Health (SecSaude), with a signature expected to take place in early 2012. The first is a partnership with the SecEdu to create gender units in all full-time schools, where gender sensitization activities are implemented with students and teachers. Five pilot units are already in place and there are plans to expand this to other full-time schools as well as 14 vocational training schools, reaching a total of 116 municipalities and more than 70,000 students by the end of SecMulher’s current term. The second agreement is a partnership with the SecSaude to define and implement strategic actions providing comprehensive assistance and 119 services to females in areas such as preventing violence, screenings for cervical, breast, and skin cancer, and providing training on gender issues to municipal health secretaries and coordinators. 19. SecMulher is also developing an Action Plan for Women Living in Metropolitan Areas (Plano de Mulheres Metropolitanas) to establish government policies, priorities, and programs targeting women. This innovative and participatory program will use both the Internet and social networks to gather and disseminate information to women in urban areas. SecMulher has also focused its attention on reducing and preventing violence against women, and on providing services to them. At present, Pernambuco has 5 shelters to assist women who are victims of violence. New ―model‖ shelters are being planned to expand services to victims. Additional plans have been developed to build 19 regional women’s police stations by 2015. This is approach will enable women residing in remote areas to have access to police services.49 There are already programs in place to offer training workshops on gender sensitization for police officers and law enforcement and social service providers in the criminal justice sector. The present plan calls for training 1,000 people per workshop and a total of 6 workshops until 2014. 20. The decision to create a permanent secretariat has, naturally, raised expectations that change will occur and that there will be increased capacity to respond to growing needs regarding gender equity. Analyzing the information obtained at the upcoming Conferencias Estaduais e Municipais das Mulheres will help the SecMulher gauge the magnitude of needs from women in Pernambuco. Addressing these needs remains one of SecMulher’s most important priorities for this term of office. 21. The SecMulher is aware of the fact that becoming a permanent secretariat implies increasing the capacity to respond to the growing number of demands related to gender issues. The information gathered during the upcoming Conferencias Estaduais e Municipais das Mulheres will help SecMulher gauge the number and quality of demands from women in the State. However, SecMulher is already planning ahead to be able to respond to these demands as follows: i) Establish 12 coordinating agencies throughout the State. The objective is to bring SecMulher’s policies and programs to all territories and municipalities of Pernambuco through a layered approach that emphasizes state presence at three levels, including regions and municipalities, so that citizens can have full access to the services offered by the secretariat. ii) Support the establishment of entities at the municipal level to articulate actions and programs with a gender perspective and train staff from municipal secretariats on gender issues. This program started in 2007 and there are currently 111 entities state-wide. Efforts accelerated in 2011, with the 49 The fact that SecMulher is working closely with the police to open more women’s police stations is significant since women’s police stations have been closed in another state—Sao Paulo closed several women’s police stations in the interior of the state as part of the restructuring of the police force. 120 objective of opening of 30 entities a year, so as to reach all 185 municipalities in Pernambuco by 2015.50 iii) In addition to the 12 coordinating agencies, SecMulher is currently discussing the feasibility of establishing two Centros de Aceleracao do Desenvolvimento da Mulher. The main objective of these multi-sectoral centers is to accelerate the socioeconomic development of females in Pernambuco. To achieve these objectives, the centers will bring together different government secretariats and civil society organizations. 22. To be able to implement those new initiatives, SecMulher has expressed interest in seeking assistance from the Bank to initiate new programs and strengthen their capacity to respond effectively to new demands. 50 During election year the objective is to open 20 only. 121 ANNEX 6: FUND RELATIONS NOTE IMF Executive Board Concludes 2011 Article IV Consultation with Brazil Public Information Notice (PIN) No. 11/108 August 3, 2011 Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case. On July 20, 2011, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Brazil.51 Background 1. Brazil has made remarkable strides over the last decade, emerging as a leading actor on the global economic stage. A strong policy framework and sustained political commitment to reduce inflation and public debt levels has increased the resilience of the economy to external shocks. Moreover, the increased macroeconomic stability, combined with well-targeted social policies, has allowed the country to take advantage of favorable external conditions over the past decade to accelerate growth and reduce poverty and inequality to historic lows. 2. The economy has recovered strongly from the crisis growing last year by 7.5 percent, with the unemployment rate falling to historic lows of 6.4 percent in May this year, and output estimated to now be above potential. Activity has been moderating since the middle of last year, but buoyant domestic demand has contributed to some widening of the current account deficit to 2.3 percent of Gross Domestic Product (GDP) in 2010, notwithstanding the very favorable prices for Brazil’s key commodity exports. Moreover, strong demand and tightening labor market conditions, combined with commodity price shocks, have led to rising inflation. Indeed, inflation reached the top of the 2.5–6.5 percent inflation target band in May. 3. Credit has been growing fast for several years now, reflecting in part a process of financial deepening, with the credit-to-GDP ratio rising from 24 percent of GDP in 2004 to 46 percent of GDP in 2010. Bank credit to the private sector continues to grow rapidly, rising by 20 percent in April 2011. Lending by private banks, which fell sharply during the crisis, has rebounded very 51 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. An explanation of any qualifiers used in summing up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm. 122 strongly. Meanwhile, public bank lending, which was ramped up during the crisis to offset the fall-off in private lending, also continues to expand at a rapid pace. Responding to concerns about excessive risk-taking in some market segments, the authorities late last year introduced various macro-prudential measures aimed at moderating credit growth. 4. Brazil remains a favored destination for international investors, reflecting in part its favorable economic prospects and high yields. Net capital inflows have been accelerating and reached US$52.6 billion through end-April, almost twice as high as over the same period in 2010. Foreign direct investment flows have increased sharply in recent months, reflecting mainly investments in large projects, while external borrowing by banks and corporations rose fast earlier in the year. To manage inflows, the authorities have used all parts of their policy tool kit. With the exchange rate appreciating to high levels, intervention has continued with purchases of about US$37 billion in the spot market in the first half of 2011. As such, Brazil’s reserves have reached US$335 billion at end-June, the sixth largest holding in the world. The authorities have also been introducing various capital flow management measures that have gradually gained some traction in moderating incentives for capital flows. 5. The authorities have been gradually withdrawing policy stimulus. The monetary policy target rate was raised by 200 basis points during April-July 2010. After a mid-cycle pause of several months, the policy rate has been increased again by 150 basis points since the beginning of the year, to reach 12.25 at end-June. Fiscal policy ended up providing a substantial procyclical stimulus in 2010 as the economy was already recovering. However, the authorities earlier this year announced a package of spending reductions (relative to the initial budget) equivalent to 1.2 percent of GDP and a primary surplus target of about 3 percent of GDP for 2011. Combined with plans for reducing Treasury transfers to the development bank BNDES, this should contribute to a withdrawal of fiscal stimulus in the current year. Executive Board Assessment 6. Executive Directors commended the authorities for their sound macroeconomic management and strong policy framework, which increased Brazil’s resilience to external shocks, spurred economic growth, and promoted greater social equity. Directors agreed, however, that although the outlook remains broadly favorable, there are signs of overheating. Accordingly, they stressed the importance of further calibrating the policy mix to address near-term macroeconomic pressures. 7. Directors welcomed the authorities’ decision to phase out the fiscal stimulus introduced during the crisis. They considered that additional fiscal tightening would support disinflation and the management of capital inflows, while reducing the need for raising further Brazil’s already high interest rates. Directors supported the authorities’ decision to reduce the exceptional funding provided to the National Development Bank, in view of the rapid credit expansion. 8. Directors supported the tightening of monetary conditions by the central bank to contain inflation risks. They agreed that, while the pick-up of inflation reflects in part commodity price shocks, strong demand and labor market pressures have also been key factors. Directors welcomed the central bank’s commitment to tighten monetary policy as needed to meet the midpoint of the inflation target band by end-2012. 123 9. Directors agreed that overall financial soundness indicators are favorable. They stressed, however, the need for heightened vigilance against financial risks, given the pace of credit growth and continued reliance on external borrowing. Directors observed that macro-prudential policies have played a helpful role in slowing credit in some segments, but a few Directors noted that such policies may need to be applied more broadly to gain traction. Directors commended the authorities for steps taken to ensure a smooth transition to new international standards under Basel III. They also welcomed the authorities’ decision to undertake a Financial Sector Assessment Program (FSAP) update next year. 10. Directors took note of the authorities’ pragmatic use of the policy toolkit for managing capital inflows. Macroeconomic policies have been appropriately tightened, the exchange rate has appreciated substantially, and official foreign exchange reserves have increased. Directors considered that the authorities’ use of capital flow management measures has been appropriate. However, a number of Directors cautioned that these measures are prone to circumvention, while many Directors noted that attendant costs should also be taken into account and pointed to their distortionary effects. Many Directors recommended that further macroeconomic policy adjustment be part of the response to large capital inflows. 11. Directors underscored the need to tackle longstanding structural rigidities. They encouraged the authorities to implement key fiscal reforms, including increasing budget flexibility, reforming the state VAT system, and implementing the social security reform. Directors noted that measures to improve the business climate and enhance competitiveness would lower structurally high interest rates and boost long-term growth prospects. 124 ANNEX 7: STATEMENT OF LOANS AND CREDITS Brazil: Expanding Opportunities, Enhancing Equity in the State of Pernambuco Difference between expected and actual Original Amount in US$ Millions disbursements Project ID FY Purpose IBRD IDA SF GEF Cancel. Undisb. Orig. Frm. Rev’d P112074 2012 BR Upgrading and Greening the Rio de 600.0 0.00 0.00 0.00 0.00 600.0 0.00 0.00 Janeiro Urban Rail System AF P126537 2012 BR Sergipe Water Project 70.3 0.00 0.00 0.00 0.00 70.3 0.00 0.00 P112073 2012 BR Energy and Mining Sector 49.6 0.00 0.00 0.00 0.00 49.6 0.00 0.00 Strenthening Project - META P106768 2012 BR Federal Integrated Water Sector 107.33 0.00 0.00 0.00 0.00 107.33 0.00 0.00 P101504 2011 BR Rio de Janeiro PSM/Fiscal MST 18.67 0.00 0.00 0.00 0.00 18.63 0.66 0.00 P111665 2011 BR Bolsa Familia 2nd APL 200.00 0.00 0.00 0.00 0.00 200.00 34.99 0.00 P106702 2011 BR- RJ Munic Fiscal Consolid DPL 1,045.00 0.00 0.00 0.00 0.00 500.00 -545.00 0.00 P118540 2011 BR Integr. Solid Waste & Carbon 50.00 0.00 0.00 0.00 0.00 50.00 0.00 0.00 finance P120391 2011 BR Santa Catarina Rural 90.00 0.00 0.00 0.00 0.00 88.64 -1.13 0.00 Competitiveness P095171 2011 BR-Federal Univ. Hospitals 150.00 0.00 0.00 0.00 0.00 150.00 0.26 0.00 Modernization P122391 2011 BR (MST) Bahia Health and Wtr Mgt 60.00 0.00 0.00 0.00 0.00 60.00 15.00 0.00 (SWAP) P108654 2011 BR-Rio de Janeiro Urban and Housing 485.00 0.00 0.00 0.00 0.00 195.00 -290.00 0.00 DPL P108443 2010 BR Pernambuco Sustainable Water 190.00 0.00 0.00 0.00 0.00 184.38 19.77 0.00 P099469 2010 BR SP Sust Rural Dev & Access to 78.00 0.00 0.00 0.00 0.00 77.81 17.00 0.00 Markets P106703 2010 BR (APL2) 2nd National Environmental 24.30 0.00 0.00 0.00 0.00 23.29 -0.95 0.00 P101508 2010 BR SP Water Reagua 64.50 0.00 0.00 0.00 0.00 64.33 4.33 0.00 P106663 2010 BR-RJ Sustainable Rural Development 39.50 0.00 0.00 0.00 0.00 29.83 6.32 0.00 P106390 2010 BR Sao Paulo Feeder Roads Project 493.43 0.00 0.00 0.00 0.00 29.23 -307.64 0.00 P104995 2010 BR SP METRO LINE 4 (PHASE 2) 130.00 0.00 0.00 0.00 0.00 129.68 0.00 0.00 P114204 2010 BR Municipal APL5: Santos 44.00 0.00 0.00 0.00 0.00 41.48 20.26 0.00 P116170 2010 ELETROBRAS Distribution 495.00 0.00 0.00 0.00 0.00 493.76 0.00 0.00 Rehabilitation P113540 2010 BR Sao Paulo Metro Line 5 650.40 0.00 0.00 0.00 0.00 584.77 -64.00 0.00 P111996 2010 BR AIDS-SUS 67.00 0.00 0.00 0.00 0.00 66.83 8.77 0.00 P118410 2010 BR RJ Mass Transit II 211.70 0.00 0.00 0.00 0.00 163.81 120.18 0.00 P006553 2010 BR Mato Grosso do Sul Road 300.00 0.00 0.00 0.00 0.00 92.97 -206.28 0.00 P106208 2010 BR SP APL Integrated Wtr Mgmt 104.00 0.00 0.00 0.00 0.00 96.25 51.64 0.00 P106765 2009 BR Pernambuco Educ Results& 154.00 0.00 0.00 0.00 0.00 67.38 15.15 0.00 Account. P107146 2009 BR Ceara Inclusive Growth (SWAp II) 240.00 0.00 0.00 0.00 0.00 35.20 17.76 0.00 P107843 2009 BR Acre Social Economic Inclusion 120.00 0.00 0.00 0.00 0.00 68.55 -2.81 0.00 Sust D P110614 2009 BR Fed District Multisector Manag. 130.00 0.00 0.00 0.00 0.00 114.44 75.06 0.00 Proj. P099369 2009 BR: Sergipe State Int. Proj.: Rural Pov 20.80 0.00 0.00 0.00 0.00 13.02 12.14 0.00 P088716 2009 BR Ceara Regional Development 46.00 0.00 0.00 0.00 0.00 43.47 1.05 0.00 P104752 2009 BR Health Network Formation & 235.00 0.00 0.00 0.00 0.00 227.41 75.23 0.00 Quality Im 125 P094315 2009 BR Paraiba 2nd Rural Pov Reduction 20.90 0.00 0.00 0.00 0.00 18.47 12.29 0.70 P094199 2009 BR Municipal APL4: Sao Luis 35.64 0.00 0.00 0.00 0.00 30.86 -3.03 0.00 P089929 2008 BR-(APL) RS (Pelotas) Integr. Mun. 54.38 0.00 0.00 0.00 0.00 29.36 16.40 0.00 Dev. P089013 2008 BR RGN State Integrated Water Res 35.90 0.00 0.00 0.00 0.00 20.55 20.04 0.00 Mgmt P088966 2008 BR Municipal APL: Recife 32.76 0.00 0.00 0.00 0.00 28.73 23.68 -2.06 P083997 2008 BR Municipal APL3: Teresina 31.13 0.00 0.00 0.00 0.00 24.67 15.12 0.00 P095626 2008 BR (MST) AltoSolimoes Bsc Srvcs and 24.25 0.00 0.00 0.00 0.00 9.55 5.72 0.00 Sust P106038 2008 BR (APL2)Family Health Extension 83.45 0.00 0.00 0.00 0.00 56.33 51.74 0.00 2nd APL P101324 2008 BR Sao Paulo Trains and Signalling 662.91 0.00 0.00 0.00 0.00 157.75 45.73 0.00 P082651 2008 BR-Second Minas Gerais Dev't 1,437.00 0.00 0.00 0.00 0.00 102.60 -354.80 96.28 PArtnership P089011 2007 BR APL 1 Para Integrated Rural Dev 60.00 0.00 0.00 0.00 0.00 40.08 40.08 0.00 P095460 2007 BR Municipal APL1: Uberaba 17.27 0.00 0.00 0.00 0.00 2.44 2.49 0.00 P093787 2007 BR-Bahia Integr.Hway Mngmt. 100.00 0.00 0.00 0.00 0.00 5.26 -8.52 0.00 P092990 2006 BR Bahia State Integ Proj Rur Pov 84.35 0.00 0.00 0.00 0.00 20.93 -9.00 0.00 P081436 2006 BR - Road Transport Project 501.25 0.00 0.00 0.00 59.95 44.09 104.04 0.00 P089440 2006 BR-Bahia Poor Urban Areas Integrated 49.30 0.00 0.00 0.00 0.00 24.18 24.18 0.00 Dev P006449 2006 BR-Brasilia Environmentally 57.64 0.00 0.00 0.00 0.00 12.76 12.76 1.62 Sustainable Total: 9,59,996.32 0.00 0.00 0.00 59.95 5,411.20 - 133.30 977.62 BRAZIL STATEMENT OF IFC’s Held and Disbursed Portfolio In Millions of US Dollars Committed Disbursed IFC IFC FY Approval Company Loan Equity Quasi Partic. 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