Document of The World Bank FOR OFFICIAL USE ONLY Report No. 87120-BR INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PROGRAM DOCUMENT FOR A PROPOSED LOAN IN THE AMOUNT OF US$ 280 MILLION TO THE STATE OF RIO GRANDE DO SUL WITH THE GUARANTEE OF THE FEDERATIVE REPUBLIC OF BRAZIL FOR A STRENGTHENING FISCAL AND WATER RESOURCES MANAGEMENT DEVELOPMENT POLICY LOAN May 05, 2014 Economic Policy Unit 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 i BRAZIL -GOVERNMENT FISCAL YEAR Jan, 1 – Dec, 31 CURRENCY EQUIVALENTS (Exchange Rate Effective as of May, 5) Currency Unit = Brazilian Real US$1.00 = 2.23 ABBREVIATIONS AND ACRONYMS ANA National Water Agency Agência Nacional de Águas BNDES National Bank for Economic and Social Banco Nacional de Desenvolvimento Development Econômico e Social CAGE Office of the Accountant and Auditor Contadoria e Auditoria Geral do Estado General CPS Country Partnership Strategy Estratégia de Parceria com o País CRH-RS Water Resources State Council of Rio Conselho Estadual de Recursos Hídricos Grande do Sul do Rio Grande do Sul DPL Development Policy Loan Empréstimo de Políticas de Desenvolvimento DRH Department of Water Resources Departamento de Recursos Hídricos DRM Disaster Risk Management Gestão de Risco de Desastre EMATER/RS Technical Assistance and Rural Extension Empresa de Assistência Técnica e Company of Rio Grande do Sul Extensão Rural do Rio Grande do Sul FARSUL Agriculture Federation of the State of Rio Federação da Agricultura do Estado do Grande do Sul Rio Grande do Sul FEPAGRO State Agricultural and Livestock Research Fundação Estadual de Pesquisa Foundation Agropecuária FEPAM State Environmental Protection Fundação Estadual de Proteção Ambiental Foundation FRL Fiscal Responsibility Law Lei de Responsabilidade Fiscal GDP Gross Domestic Product Produto Interno Bruto GoRS Government of the State of Rio Grande Governo do Estado do Rio Grande do Sul Sul IADB Inter-American Development Bank Banco Interamericano de Desenvolvimento IBGE Brazilian Institute of Geography and Instituto Brasileiro de Geografia e Statistics Estatísticas IBRD International Bank for Reconstruction and Banco Internacional para Reconstrução e Development Desenvolvimento ICMS Value Added Tax Imposto sobre Circulação de Mercadoria e Serviços ICR Implementation and Completion Results Relatório de Conclusão e Resultados Report INMET National Meteorology Institute Instituto Nacional de Meteorologia IPCA Consumer Price Index Índice de Preços ao Consumidor Amplo IPSAS International Public Sector Accounting Padrões Contábeis Internacionais Standards aplicados ao Setor Público ii IRGA Rio Grande do Sul’s Rice Institute Instituto Riograndense de Arroz IRRF Income Tax Withheld at Source Imposto de Renda Retido na Fonte LDO Law of Budgetary Guidelines Lei de Diretrizes Orçamentárias LOA Annual Budget Law Lei Orçamentária Anual NCD Net Consolidated Debt Dívida Consolidada Líquida NCR Net Current Revenues Receita Corrente Líquida PFM Public Financial Management Gestão de Finanças Públicas PGE State Legal Counselor’s office Procuradoria Geral do Estado PIUMA Master Plan for Irrigation in the Context of Plano Diretor de Irrigação no Contexto Multiple Water Uses in Rio Grande do Sul dos Usos Múltiplos da Agua no Rio Grande do Sul PNAD National Household Survey Pesquisa Nacional por Amostra de Domicílios PPA Multi-year Plan Plano Plurianual PROGESTÃO National Pact for Water Management Pacto Nacional pela Gestão das Águas RS State of Rio Grande do Sul Estado do Rio Grande do Sul SDPI Secretariat of Development and Secretaria de Desenvolvimento e Investment Promotion Promoção de Investimento SDR Secretariat of Rural Development, Fishery Secretaria de Desenvolvimento Rural and Cooperativeness Pesca e Cooperativismo SEAPA Secretariat of Agriculture, Livestock and Secretaria de Agricultura, Pecuária e Agribusiness Agronegócio SEFAZ Secretariat of Finance Secretaria da Fazenda SEMA Secretariat of Environment Secretaria de Meio Ambiente SEPLAG Secretariat of Planning, Management and Secretaria de Planejamento, Gestão e Social Participation Participação Social SOP Secretariat of Public Works, Irrigation and Secretaria de Obras Públicas, Irrigação e Urban Development Desenvolvimento Urbano SWAP Sector Wide Approach Abordagem Setorial Ampla TCE State Court of Accounts Tribunal de Contas do Estado de Rio Grande do Sul TIUMA Territories of Irrigation and Multiple Uses Territórios de Irrigação e Usos Múltiplos WR Water Resources Recursos Hídricos WRM Water Resources Management Gestão de Recursos Hídricos Vice President: Jorge Familiar Country Director: Deborah L. Wetzel Sector Director: J. Humberto Lopez Sector Manager: Auguste T. Kouame Sector Leader: Roland Clarke Team Leaders: Rafael Barroso/ Paula Freitas iii BRAZIL RIO GRANDE DO SUL STRENGTHENING FISCAL AND WATER RESOURCES MANAGEMENT DEVELOPMENT POLICY LOAN TABLE OF CONTENTS LOAN AND PROGRAM SUMMARY 1. INTRODUCTION AND COUNTRY CONTEXT ............................................................................... 1 2. MACROECONOMIC POLICY FRAMEWORK ................................................................................ 2 2.1. RECENT ECONOMIC DEVELOPMENTS IN BRAZIL ........................................................... 2 2.2. BRAZIL’S MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY ..................... 5 2.3. RECENT ECONOMIC DEVELOPMENTS IN RIO GRANDE DO SUL .................................. 6 2.4. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY IN RIO GRANDE DO SUL 11 3. THE GOVERNMENT’S PROGRAM................................................................................................ 13 4. THE PROPOSED OPERATION ........................................................................................................ 14 4.1. LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION ....................... 14 4.2. PRIOR ACTIONS, RESULTS AND ANALYTICAL UNDERPINNINGS.............................. 14 4.3. LINK TO CPS AND OTHER BANK OPERATIONS............................................................... 22 4.4. CONSULTATIONS, COLLABORATION WITH DEVELOPMENT PARTNERS ................ 22 5. OTHER DESIGN AND APPRAISAL ISSUES ................................................................................. 23 5.1. POVERTY AND SOCIAL IMPACT ......................................................................................... 23 5.2. ENVIRONMENTAL ASPECTS ................................................................................................ 24 5.3. PFM, DISBURSEMENT AND AUDITING ASPECTS ............................................................ 25 5.4. MONITORING AND EVALUATION ...................................................................................... 27 6. SUMMARY OF RISKS AND MITIGATION ................................................................................... 27 ANNEX 1: POLICY AND RESULTS MATRIX ...................................................................................... 29 ANNEX 2: LETTER OF DEVELOPMENT POLICY ............................................................................... 33 ANNEX 3: FUND RELATIONS ANNEX ................................................................................................ 42 ANNEX 4: ASSUMPTIONS FOR THE FISCAL AND DEBT SUSTAINABILITY ANALYSIS .......... 43 The Strengthening Fiscal and Water Resources Management DPL was prepared by an IBRD team consisting of Rafael Barroso, Paula Freitas, Gunars Platais, Alberto Costa, Jimena Garrote, Catarina Portelo, Carolina Renart, Fábio Bittar, Joseph Kizito, Frederico Rabello, Angela Porto, Monica Porcidonio, Erwin de Nys, Gilberto Canali and Thadeu Abicalil. iv SUMMARY OF PROPOSED LOAN AND PROGRAM BRAZIL RIO GRANDE DO SUL STRENGTHENING FISCAL AND WATER RESOURCES MANAGEMENT DEVELOPMENT POLICY LOAN The State of Rio Grande do Sul (RS) with a guarantee from the Federative Borrower Republic of Brazil Implementation Agency State Secretariat of Finance (SEFAZ) IBRD Loan Amount: US$ 280 million with a sovereign guarantee from the Federative Republic of Brazil Financing Data Terms: Commitment linked IBRD Flexible loan, with a variable spread, customized repayments, 29.5 years final maturity, 4.5 years grace period, with all conversion options selected and the Front End Fee and Premia for Caps and Collars capitalized Operation Type Single tranche Development Policy Loan (DPL) The Program Development Objective is to improve Government capacity to Program Development mitigate economic volatility in the State of Rio Grande do Sul by supporting Objective and measures to increase resources available to the government and to reinforce the Pillars of the Operation Integrated Water Resource Management framework Pillar 1: Strengthening Fiscal Management Pillar 2: Irrigation and Water Resources Management Main results indicators are: • Percentage of tax expenditure measures under Government control evaluated. Baseline (2012): zero, Target (2015) = 25 percent. • Increase in the share of tax arrears recovered within 60 days of their generation. Baseline (2012): 20.8 percent, Target (2015) = 27 percent • Increase in the share of goods procured, expressed as a percentage of the total value of goods, using price information from the electronic fiscal invoice database. Baseline (2012): zero, Target (2015) = 25 percent. • Increase in the number of managerial cost reports prepared by Government agencies. Baseline (2012): zero, Target (2015) = 14 Result Indicators • New policy instrument to manage contingent liabilities made effective. Baseline (2012): No, Target (2015) = Yes • Increase in the number of medium and small farmers that have adhered to the ‘More Water, More Income’ Program. Baseline (2012): 413, Target (2015) = 3,000 • Increase in the number of river basin plans prepared, approved by the respective river basin committees, including updated information on water availability and users per basin. Baseline (2012): 1, Target (2015) = 12. • New hydro-meteorological stations installed in key river basins with information analyzed by the State. Baseline (2012): zero, Target (2015) = 80. The overall risk rating is moderate. The main risks in this operation are of macroeconomic, environmental and developmental nature. However, none of these Overall Risk Rating risk factors are considered to be major. Aspects relating to other risk factors are judged to be low. Operation ID P148083 v IBRD PROGRAM DOCUMENT FOR A PROPOSED LOAN TO THE STATE OF RIO GRANDE DO SUL WITH THE GUARANTEE OF THE FEDERATIVE REPUBLIC OF BRAZIL FOR A STRENGTHENING FISCAL AND WATER RESOURCES MANAGEMENT DEVELOPMENT POLICY LOAN 1. INTRODUCTION AND COUNTRY CONTEXT 1. This proposed operation is a single tranche Development Policy Loan (DPL), in the amount of US$280 million to the Brazilian State of Rio Grande do Sul (RS). The purpose of this operation is to improve Government capacity to mitigate economic volatility in the State of Rio Grande do Sul by supporting measures to increase resources available to the Government and to reinforce the Integrated Water Resource management framework. The loan will help the State devise and put in practice policies and tools to manage water supply and demands, as a means to make its economy more resilient to the effects and impacts of droughts. On the fiscal side, it will support reforms to improve the Government’s capacity to mobilize revenues and promote expenditure savings, without cutting back services, while acknowledging the major constraints on fiscal policy in Rio Grande do Sul. By providing means to smooth and raise rural incomes, bolstering the revenue base and improving expenditure efficiency. This operation is contributing directly to the World Bank goals of eliminating extreme poverty and promoting shared prosperity. 2. Although Rio Grande do Sul has relatively favorable economic indicators, its recent performance lags that of other States in Brazil. The State Gross Domestic Product (GDP) per capita is estimated at US$14,110; 121.2 percent of the national average. However, from 2002 to 2012, the State has had an average growth rate one percentage point below the national average (2.6 percent vis-à-vis 3.6 percent). The volatility of GDP growth in RS is higher than in Brazil (0.034 versus 0.025), which leads to more volatile Government revenues and expenditures. 3. Contributing to this situation, there are two acute and interconnected problems: poor water resource management and structural fiscal deficiencies. On one hand, constant and severe drought episodes strongly impact agricultural production. Since agribusiness accounts for 30 percent of the State GDP, its higher volatility is transmitted economy-wide. This higher GDP volatility translates into slower growth, lower revenues, higher debt ratios and higher expenditures to make up for the effects of drought, all of which reinforce the structural fiscal deficiencies. The State’s institutional weakness on water resources management prevents it from stabilizing and increasing agricultural production, in particular irrigated agriculture, which is more productive and less prone to fluctuations. A reduction in volatility would lead to more stable GDP and higher growth rates. On the other hand, the structural fiscal deficiencies of the State which are the root of its low investment capacity and poor service delivery, reduces the State ability to autonomously tackle the water problem with its own resources. Thus, this operation addresses these two problems simultaneously, helping the State to generate the resources and capacity it needs to ease this constraint on growth. 4. The main water resource problem is the concentration in time and space of high rainfall. This concentration together with the scarcity of water reservoirs and irrigation facilities leads to recurrent episodes of severe droughts. In the last decade, drought episodes were recorded in five years and in 2012, drought affected 1.8 million people. The potential for irrigation to 1 mitigate problems related to droughts is high. The geography of the State is favorable for the implementation of irrigation: availability of water in perennial rivers, irregular but high rainfall and adequate soil for mechanized crops. In fact, irrigation has been used in the State for more than 30 years mainly for the cultivation of rice in the South. However, the irrigation potential remains largely untapped due to a lack of investment in water and irrigation infrastructure, insufficient institutional capacity for water resource management, lack of hydro-meteorological, piezometric and water quality information and ineffective systems for granting water use rights leading to growing conflict between multiple uses of water resources. 5. On the fiscal front, Rio Grande do Sul has been constrained by high debt, low ability to mobilize revenues and high pressure for public expenditure. As a result, the State faces decaying public services and a lack of resources to invest. The investment ratio in the State is the lowest among all Brazilian states since revenues are used almost entirely to pay for current expenditures and its high debt levels prevent it from borrowing. The low ability to mobilize revenue is explained by relatively high exports (exempt from tax under Federal law), lower ICMS (Imposto sobre Circulação de Mercadorias e Serviços) tax rates than other states, and the extensive use of tax incentives. On the expenditure side, the higher demand is explained by higher 1 budget earmarks and the high debt level. 6. This proposed operation responds to an urgent request to support Rio Grande do Sul. The request came both from the National Treasury Secretariat, the main Federal counterpart of the World Bank in Brazil, and the Government of the State of Rio Grande do Sul (GoRS). In addition, the World Bank and the Inter-American Development Bank (IADB) have agreed to partner to jointly support the Government program in the areas of fiscal and water resources management. This partnership will be for a total amount of US$ 480 million. While the partnership and initial engagement by IADB have framed the operation design, both institutions have retained their autonomy to support different prior actions within the overall Government program. A more detailed description of this coordinated approach is given in Section 4.4. 2. MACROECONOMIC POLICY FRAMEWORK 2.1. RECENT ECONOMIC DEVELOPMENTS IN BRAZIL 7. Over the last two decades, Brazil has made significant advances in terms of economic management, poverty reduction, and social indicators. Growth in employment and labor incomes, as well as the implementation of targeted social assistance programs have contributed to a reduction in the share of Brazilians living below the extreme poverty line of R$70 a month from 10.8 percent in 2001 to 4.3 percent in 2012 2, as well as a reduction in inequality as reflected in a fall in the Gini coefficient from 0.60 to 0.53 over the same period. 8. Brazil’s development is now at a crossroads. The country is gradually recovering from a slowdown that started in 2011. Future growth appears to be limited by structural bottlenecks in infrastructure, human capital, and poor financial intermediation compounded by a burdensome tax system and business environment. At the same time, a growing middle class is drawing attention to the ineffectiveness and inefficiency of public service delivery. Mass demonstrations 1 For example, in the State constitution 35 percent of state revenues are earmarked to education while the Federal Constitution requires 25. 2 Data from PNAD (national household survey) using the extreme poverty line of the Brasil sem Miséria program. 2 in Brazil during June 2013 left little doubt as to the importance of good governance and effective service delivery in Brazil. 9. The recent economic slowdown now appears as much structural as cyclical. Initially, tighter monetary and fiscal policies in 2011 weakened domestic demand at the same time as external demand was dampened by protracted weakness and uncertainty in advanced economies and slowing growth in major emerging markets. However, as the slowdown continued throughout 2012, policy became looser and the external environment strengthened, structural factors such as the tight labor market and high cost of production, have become increasingly important. While the slowdown was felt across the board, it was industry that slowed most (industrial production declined by 6.4 percent between mid-2011 and end-2013) due to weak domestic demand, a relatively strong real exchange rate and the structural bottlenecks referred to earlier. The poor performance of industry was also mirrored in the weakness of investment demand. 10. Inflation remains high. Headline inflation reached 5.9 percent in 2013, accelerating to 6.2 percent in March 2014. Inflation is higher for goods whose prices are not controlled, running at 7.0 percent (compared with 3.4 percent for regulated prices) as well as for non-tradable goods (8.1 percent). The rate of inflation reflects in part capacity constraints, and a structurally tight labor market (due to skills mismatches and changing demographics). As a result, even at low rates of growth, demand-pull factors have played an important role. Cost-push factors such as automatic minimum wage adjustment and price shocks (especially food) have also contributed to inflationary pressure. 11. Fiscal and monetary policies responded to slow growth and high inflation. Over the past decade Brazil’s three-pillared macroeconomic framework (flexible exchange rates, inflation targeting and fiscal prudence) gained credibility. The fiscal stance has been loosened with primary surplus declining from 3.1 percent in 2011 to 1.8 percent in February 2014. However fiscal policy was tightened in February 2014 with the announcement of cuts of close to 1 percent of GDP to meet a primary surplus target of 1.9 percent of GDP. With inflation close to the 6.5 percent upper limit of the target range, monetary policy was also tightened and the interest rate has been raised by 375 basis points between April 2013 and April 2014 to 11 percent currently. 12. External instability has led the exchange rate to depreciate and became more volatile. The current account deficit widened to 3.7 percent of GDP in February 2014 from 2.4 percent in 2012. At the same time FDI failed to fully cover the gap reaching 2.9 percent. The difference was covered by portfolio investment which has reached 1.1 percent of GDP. The beginning of the tapering of monetary policy by the Federal Reserve has led to additional pressures on the exchange rate (as in other emerging markets). The Central Bank of Brazil responded with an intervention plan consisting of purchasing interest rate swaps and a foreign exchange repurchase program. While these interventions contributed to limiting exchange rate volatility, they also left the authorities with a non-deliverable short position with a notional value of US$ 84 billion as of February 2014. This compares to a stock of reserves of US$ 363 billion. Higher interest rates and reduced taxes on capital inflows also supported the currency. 13. While concerns have emerged about the interventionist nature of recent economic policies, Brazil’s macroeconomic framework remains adequate and robust. In recent years, economic policy has appeared more interventionist. Attempts to control inflation by administering prices and reducing taxes, together with other discretionary tax incentives, 3 subsidies to energy and state-owned banks as well as slower growth and increased social demands have reduced the primary surplus. This in turn has complicated the task of curbing inflation. Indeed this combination of factors underpinned the downgrade by Standard and Poor’s of Brazil’s sovereign credit rating to the lowest investment grade on March 24. However, recent fiscal adjustment and moves to accelerate the auction of oil and infrastructure concessions indicate a clear recognition of the importance of market-oriented policies by the Government. The downgrade is likely to strengthen the Government’s focus on such market oriented policies. Table 1 - Brazil: Selected Economic Indicators and Projections: 2006 - 2017 Projections Indicator 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 National Accounts (annual real percent change) Real GDP Growth 6.1 5.2 -0.3 7.5 2.7 1.0 2.3 2.0 2.6 3.5 3.5 (in percent of GDP) Gross domestic investment 18.3 20.7 17.8 20.2 19.7 18.2 18.4 18.5 18.7 18.9 19.2 External Sector Current account 1.6 -28.2 -24.3 -47.3 -52.5 -54.2 -81.5 -74.8 -73.2 -74.1 -78.9 Merchandise trade balance 40.0 24.8 25.3 20.1 29.8 19.4 2.3 7.8 19.8 22.7 21.5 Exports (fob) 160.6 197.9 153.0 201.9 256.0 242.6 242.4 259.4 281.4 304.0 324.1 Imports (fob) 120.6 173.1 127.7 181.8 226.2 223.2 240.1 251.6 261.6 281.3 302.6 Nonfactor services, net -13.2 -16.7 -19.2 -30.8 -37.9 -41.0 -47.5 -48.0 -51.5 -54.6 -56.1 Income and current transfers, net -25.3 -36.3 -30.3 -36.6 -44.3 -32.6 -36.4 -34.6 -41.6 -42.3 -44.3 Direct investment, net 27.5 24.6 36.0 36.9 67.7 68.1 64.0 60.0 61.7 64.8 68.0 Portfolio equity, net 1 24.8 -7.3 39.7 43.9 16.0 3.3 2.7 3.4 3.5 3.5 4.2 Gross international reserves 180.3 193.8 238.5 288.6 352.0 373.1 358.9 363.0 367.8 371.6 374.4 Current account (% of GDP) 0.1 -1.7 -1.5 -2.2 -2.1 -2.4 -3.6 -3.5 -3.3 -3.1 -3.1 General Government (in percent of GDP) Total Revenues and Grants 35.7 36.9 34.9 37.2 36.6 37.2 37.2 36.9 37.2 37.1 37.2 Total Expenditure 38.4 38.2 38.0 39.9 39.1 40.0 40.5 39.7 39.2 38.8 38.5 Current Expenditure 36.6 36.0 35.8 35.9 36.7 37.5 37.7 36.9 36.4 35.9 35.5 of which: Net Interest payments 6.1 5.5 5.3 5.2 5.7 4.9 5.2 4.7 4.7 4.1 3.4 Capital Expenditure 1.8 2.2 2.2 4.0 2.5 2.6 2.8 2.9 2.9 2.9 3.0 Primary Balance 3.5 4.1 2.2 2.5 3.2 2.1 1.9 1.8 2.7 2.3 2.1 Overall Balance -2.7 -1.4 -3.1 -2.7 -2.5 -2.8 -3.3 -2.8 -2.1 -1.8 -1.3 Gross Public Sector Debt 65.2 63.5 66.8 65.0 64.7 68.0 66.3 64.2 61.6 58.6 55.5 of which: Domestic Currency 60.6 58.4 63.2 62.1 62.2 65.4 63.2 61.0 58.2 55.2 52.2 of which: Foreign Currency 4.6 5.1 3.7 3.0 2.7 3.1 3.1 3.2 3.4 3.5 3.3 Prices (annual percent change) GDP Deflator 5.9 8.3 7.2 8.2 7.0 4.9 7.7 5.7 5.2 4.7 4.5 Consumer Price Index (eop) 4.5 5.9 4.3 5.9 6.5 5.8 5.9 5.8 5.5 5.3 5.0 Memorandum items: Nominal GDP (in R$ billions) 2661.3 3032.2 3239.4 3770.1 4143.0 4402.5 4836.4 5214.3 5628.1 6098.8 6596.4 Total External Debt (% of GDP) 17.5 15.9 17.4 16.4 16.2 17.9 18.8 20.8 21.0 21.4 20.6 Note 1: Porfolio equity does not include debt securities Source: IMF, BCB, IBGE, EIU, WB Calculation 14. Brazil’s financial system has remained sound and resilient. Following a period of rapid credit growth, asset quality indicators broadly stabilized during 2012 and recently reported some improvement. As of February 2014, around 4.3 percent of household loans and 1.9 percent of corporate loans were classified as non-performing. Lower interest rates in recent years eased pressures on borrowers, keeping delinquencies at manageable levels. A moderated increase in delinquency cannot be ruled out as interest rates in Brazil are rising. The banking system appears to be well-cushioned to withstand losses, with loan loss provision coverage at 170 percent of nonperforming loans as of December 2013, compared with 160 percent recorded last June as nonperforming loans fell. Moreover, the solvency ratio remained considerably above the 11 4 percent minimum regulatory requirement, at 16.6 percent in November 2013. However, rising private sector external debt levels, largely reflecting increased issuance of bonds by corporates and banks, have raised concerns about the capacity of some companies to carry their debt. 2.2. BRAZIL’S MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY 15. The growth prospects for the Brazilian economy remain muted, with 2.3 percent growth recorded in 2013 and a slightly lower growth rate expected for 2014 with a gradual increase to 3.5 percent thereafter. After a 3.5 percent monthly contraction in December 2013, industrial production recovered in the two consecutive months, reporting 1.1 percent growth in the last 12-months to Feb-2014. Consumer confidence stabilized in March after three consecutive drops. Investment, which declined in 2012, has rebounded in 2013 and will be aided by an increase in infrastructure investment and the preparations for upcoming mega events. The contribution of net external demand will likely remain dampened given global developments as well as the current crisis in Argentina, which is an important market for Brazilian manufactured exports. The depreciation of the Real should have a positive impact on the current account. 16. Inflation is expected to remain a challenge. A key factor is the role of the labor market which remains tight. It is characterized by low unemployment (5.1 percent in February), scarcity of skilled workers and labor hoarding due to low flexibility caused by structural issues affecting mobility and wage setting (such as indexation of the minimum wage to inflation and GDP growth). Government efforts to address skills gaps should help address some of these concerns in the medium term, although more will be needed to raise labor market flexibility. Other factors that may contribute to inflation include the pass-through of the recent depreciation of the currency and also the end of restraint of administrated prices, which have been running at 1.5 percent in 2013, but have started to rise as fuel prices are brought near to world market levels and energy subsidies are phased out. On the other hand, the recent monetary policy tightening will help subdue inflationary pressures. Inflation expectations also remain high, standing at 6.3 percent for the coming 12 months in early April. 17. The external environment continues to pose a risk to Brazil’s outlook for near-term growth. Continuation of an uneven recovery in advanced economies and a slowdown in emerging markets, may translate into lower external demand for Brazil’s exports. Like other emerging market economies, Brazil also remains vulnerable to market sentiment posing a continued risk to FDI and especially portfolio flows, particularly given the relatively high share of some government bonds held by non-residents and the possible impact of the unwinding of unconventional monetary policy in the US. Nonetheless, Brazil’s vulnerability to external events is likely to remain moderate due to its high reserves (US$ 363 billion), the low share of short- term debt in total external debt (around 21 percent), the large role of foreign direct investment (2.9 percent of GDP in Feb-2014) in financing the current account (-3.7 percent of GDP in Feb- 2014). 18. Downside contingencies and social pressures for improved public services also pose risks to the fulfillment of fiscal targets. The achievement of primary surplus targets are in jeopardy if the growth rate of current expenditures is not curtailed and if activity turns out more sluggish than expected. Other potential fiscal risks include Government efforts to stimulate the economy through specific incentives for particular sectors, the subsidy to energy prices which cost around R$ 20 billion in 2013, sporadic tax relief for selected industries, and quasi-fiscal activities by the National Bank for Economic and Social Development (BNDES), which received 5 R$ 39 billion in transfers from the Treasury in 2013. More generally, pressures for improved public services and mandatory payments for Congressional Budget Amendments may also create stronger expenditure pressures. Also, political tensions between Congress and the Executive and the coming election year pose further risks of pressures to the fiscal stance. 19. In spite of these risks and challenges, Brazil’s overall macroeconomic framework is currently adequate for the purposes of this operation. Brazil’s policy framework continues to provide the Government with the flexibility to respond to economic crises. While the continuation of inflation pressures and the recent deterioration of fiscal outturns have raised concerns, the authorities remain committed to inflation control and fiscal prudence. Gross public sector debt is expected to decline in the future, given the levels of the primary surplus, despite difficulties in maintaining fiscal balance in the face of large investment needs and popular pressures for improved service delivery. Moreover, flexible exchange rates and relatively large foreign reserves provide Brazil with a buffer to shifts in market perceptions and an associated turn-around in capital flows – as the recent episode of market turbulence has suggested. 20. Brazil’s medium to longer-term outlook will critically depend on its ability to tap into a large unrealized growth potential and remove structural bottlenecks. These bottlenecks include: the need to accelerate and strengthen the quality of human capital formation; reduce the tax burden; increase the effectiveness of public spending; raise public and private investment to address infrastructure bottlenecks; developing a private long-term capital market; a more flexible labor market; and a more agile business environment that promotes internal competition and external competitiveness. Addressing these bottlenecks would lay the foundations for productivity growth. 2.3. RECENT ECONOMIC DEVELOPMENTS IN RIO GRANDE DO SUL 21. Rio Grande do Sul is the southernmost State in Brazil. It has a population of 11.2 million people in 2012, distributed in an area of 0.28million Km2. The State has 5.6 percent of the country population and 3.3 percent of the land area. State GDP amounted to US$151.7 billion in 2012 or 6.7 percent of Brazil’s GDP. Per capita GDP was thus US$14,110. Poverty and extreme poverty incidence are below the national average, but above the southern region average. In 2012, the incidence of poverty was 4.2 percent, while the figures for the region and the country stood at 3.7 and 9.4 percent respectively. For incidence of extreme poverty, numbers are 2.2, 1.9 and 4.3 respectively. More importantly, RS has failed to reduce poverty at the same rate as of the rest of the country. The annualized growth rate of the bottom 40 percent mean income has been 6.1 percent from 2004 to 2011. 22. The State of Rio Grande do Sul has significant regional diversity. The majority of the population and GDP is concentrated in the axis formed by the capital, Porto Alegre and the Mountain region. The Southern part is characterized by large landholdings dedicated to irrigated rice farming. The Northwestern and Center-West regions are characterized by the existence of small landholders and family-owned farms dedicated to rain-fed crops. These last two regions have been losing population and participation in State GDP, while all three regions have a higher incidence of poverty. 23. Services represent the largest sector in the economy. It accounted for 62.1 percent of the value added in 2010. Industry is the second largest sector with 29.2 percent, while agriculture is responsible for 8.7 percent. A key feature of the economy is the importance of exports. In 2012, exports represented 11.4 percent of State GDP and constituted 9.8 percent of Brazil’s 6 exports by July of 2013, positioning the State as the third largest exporter in the country, after the States of São Paulo and Minas Gerais. 24. The agricultural sector is of great importance to the State. Despite the small share of agricultural production (8.7 percent) in the State, its share is larger than the country average of 5.3 percent. Moreover, it is estimated that the agribusiness complex accounts for 29.5 percent of the State GDP 3 and 17.2 percent of employment. For example, the tobacco, leather and shoes and the food industries purchase at least 80 percent of their inputs from local suppliers. The main crops in terms of area are: soybean, corn and rice; while in production value the order is soybean, rice and tobacco. The main agricultural exports in 2012 were soybean, meat and rice 4. 25. Irrigation is by far the main use of water in Rio Grande do Sul. Nonetheless, less than 7 percent of rural properties have irrigation facilities, evidencing the high dependence of agriculture on rainfall. Favorable soil conditions and average yearly rainfall above 1,500mm provide a promising perspective for the expansion of irrigated agriculture. Soy and rice are cultivated on over 1 million irrigated hectares in the Southern and Southwestern regions. Although dry summers seem to have become more frequent in the last 12 years, they have not heavily impacted rice production as farmers have invested in water storage infrastructure. 26. Competition with the demand for human consumption occurs during summers with lesser than average rainfall. Dry summers seriously affect medium and small-size production and income in the Northwestern region where corn, soy and beans are the main crops, besides dairy production. The region shows a good potential for irrigated agriculture. During dry periods, urban water supply is hampered by competing uses and poor water quality requiring intervention from the authorities to guarantee proper water supply for human consumption. Other than agriculture, the State waters are used for power generation in the Northern region and for navigation. Both uses do not raise any major conflict with other water uses. Figure 1 – Brazil and Rio Grande do Sul GDP Figure 2 –Rio Grande do Sul GDP and Agriculture growth rates: 2003 – 2012 growth rates: 2003 – 2012 10% 60 50 8% 40 6% 5.2% 30 20 4% 3.2% 2.7% 10 2% 0.9% 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 0% -10 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 -20 -2% -1.8% -30 -4% -2.8% -40 RS Brasil GDP Agriculture Source: IBGE and FEE Source: FEE 27. State GDP performance is highly correlated with agricultural production and thus with droughts. The volatility of GDP growth in RS is higher than in Brazil (0.034 versus 0.025). This volatility is explained by the agricultural sector, which is then transmitted to the whole economy (see Figure 1 and 2). Therefore, years of slower growth in the State than in the country 3 Fundação de Economia e Estatística, 2003. Notas metodológicas sobre o dimensionamento do PIB do agronegócio do Rio Grande do Sul. 4 Agricultural production and employment data are from 2012 and were obtained from IBGE. 7 are associated with more severe drought episodes, like in 2012, 2008 and 2005. In particular, the 2012 drought was the most severe in the last 60 years. Direct losses were estimated at more than US$2.7 billion (R$ 5.3 billion), according to FARSUL (Federation of Agriculture of Rio Grande do Sul). As a result, agricultural GDP shrank 27.6 percent and overall GDP contracted by 1.8 percent. 28. After a decline in 2012, economic activity rebounded in 2013 and the State is set to regain part of the previous year’s loss. GDP growth in the first nine months of the year stood at 6.6 percent vis-à-vis Brazil’s growth of 2.4 percent. Growth was pushed by the agricultural sector, which expanded by 48 percent in the same period. Industrial production increased by 6.4 percent from January to October, while growing 1.5 percent in Brazil in the same period. Broad retail sales grew 6 percent in the State and 3.4 percent in Brazil. 29. Debt levels are high for historical reasons. RS was one of the most indebted states in the 1990s, when the Federal Government renegotiated the state debts. The debt had originated from a strategy of avoiding fiscal adjustment by increasing debt since the 1980s. As a result, the total State debt amounted to R$ 51.7 billion in 2012 (equivalent to 218 percent of Net Current Revenues (NCR) and 17.4 percent of GDP), out of which 85 percent was with the National Treasury. In addition, debt service as a share of NCR is high, albeit declining. In 2008, it represented 18.4 percent of NCR, but has declined to 11 percent of NCR in 2012, in line with the limit set by Senate Resolution. 30. Rio Grande do Sul has been complying with the Fiscal Responsibility Law (FRL). Payroll expenditures as a share of NCR are 51.2 percent vis-à-vis a limit of 60 percent. The limit over new loans (16 percent of NCR) and guarantees (22 percent of NCR) were obeyed too. The Net Consolidated Debt (NCD) to NCR ratio has been over the 200 percent limit since the inception of the FRL. However, according to the law, RS has until 2016 to gradually bring this ratio down to 200 percent. Therefore, the debt limit for RS is set as a declining path, with the goal of reducing the excess between the NCD/NCR ratio observed in 2000 and the 200 percent threshold by 1/15th every year. Since 2008, the State has brought the debt ratio under this declining limit and is thus in compliance with the FRL (see Figure 3). 31. The State’s revenues are composed mainly of own source revenues. Total revenues reached R$ 32.3 billion in 2012, out of which 77 percent were from tax revenues and only 11 percent from transfers. Revenues fluctuated broadly in response to both national and subnational GDP. Extraordinary factors in 2007 (reduction of ICMS tax rates) and in 2011 (comparison base in 2010 was augmented by extraordinary revenues) explain deviations from this pattern. Revenues posted double digit growth in 2008 (11.8 percent) and 2010 (12.9 percent), years of great economic growth in the country, and showed slow or negative growth in 2009 and 2011. 32. The difficulty in mobilizing revenues translates in one of the lowest tax collection rates among Brazilian states. Tax collection as a share of GDP stood at 8.4 percent in 2012, ranking 22nd out of 27 states (see Figure 5). The low comparative tax burden is a reflection of the higher export and out of state sales share, wide use of tax expenditures and lower tax rates than other states. Out of four categories: energy, fuel, telecom and alcoholic beverages; RS has the lowest rate for two of them and the second lowest for the other two. In 2008, only 49 percent of the State’s industrial production was sold internally, leaving the full ICMS amount to the State. The remainder was either sold to other states (37 percent), leaving the State with only part of the ICMS, or was sold abroad (11 percent), which is tax exempt. Due to the revenue forgone as tax 8 expenditures, actual revenue represented only 65 percent of potential revenue in 2011. 33. The State’s main expenditure is compensation of employees (including both current and retired employees). It reached R$ 16.6 billion in 2012 (see Table 2) and has averaged a real growth rate of 3.8 percent from 2006 to 2012. Retired employees made up to R$ 7.2 billion in 2012 and the pension system registered a R$ 6.1 billion deficit in 2012. Headcount has increased 3 percent in 2012, but it is roughly at the same level as of 2006. Payroll expenditure has been growing above revenues since 2010, as a share of NCR it has grown from 47 percent to 51.2 percent, as a result. In terms of government functions, main expenditures are on health, education and public security. Table 2 - Rio Grande do Sul Statement of Government operations: 2008-2012 R$ Million (2012 constant values) % of Subnational GDP 2008 2009 2010 2011 2012 2008 2009 2010 2011 2012 I. REVENUE 28,007.1 28,239.7 31,796.9 31,495.5 32,300.9 11.3% 11.1% 11.2% 10.6% 10.9% Taxes 21,171.9 21,082.4 24,072.8 24,024.6 24,900.7 8.6% 8.3% 8.5% 8.1% 8.4% ICMS 18,000.0 17,394.4 19,426.1 20,069.7 20,730.5 7.3% 6.8% 6.8% 6.8% 7.0% IPVA 1,246.0 1,744.2 1,639.0 1,719.5 1,841.7 0.5% 0.7% 0.6% 0.6% 0.6% Others 1,925.9 1,943.9 3,007.6 2,235.4 2,328.5 0.8% 0.8% 1.1% 0.8% 0.8% Social Contributions 1,448.7 1,507.9 1,564.6 1,739.4 1,778.3 0.6% 0.6% 0.6% 0.6% 0.6% Transfers 3,730.9 3,596.5 3,897.1 3,760.9 3,578.0 1.5% 1.4% 1.4% 1.3% 1.2% Current Transfers 3,621.9 3,384.8 3,658.2 3,672.1 3,481.7 1.5% 1.3% 1.3% 1.2% 1.2% Capital Transfers 109.0 211.7 238.9 88.8 96.3 0.0% 0.1% 0.1% 0.0% 0.0% Other Current Revenues 1,655.7 2,052.9 2,262.4 1,970.7 2,043.9 0.7% 0.8% 0.8% 0.7% 0.7% II. EXPENSE 24,583.5 25,271.4 27,593.0 28,653.9 31,528.5 10.0% 9.9% 9.7% 9.7% 10.6% Compensation of Employees 13,623.3 14,019.9 15,048.9 15,678.5 16,615.8 5.5% 5.5% 5.3% 5.3% 5.6% Interest Payments 329.6 239.6 184.6 131.3 1,485.5 0.1% 0.1% 0.1% 0.0% 0.5% Other Current Expenditures 10,287.5 10,654.7 11,801.3 12,248.8 12,707.8 4.2% 4.2% 4.2% 4.1% 4.3% Transfers to Municipalities 5,397.7 5,465.6 6,025.0 6,184.3 6,404.1 2.2% 2.1% 2.1% 2.1% 2.2% Goods and Services 4,889.9 5,189.0 5,776.2 6,064.5 6,303.7 2.0% 2.0% 2.0% 2.1% 2.1% FUNDEB Net Loss 343.1 357.3 558.2 595.3 719.4 0.1% 0.1% 0.2% 0.2% 0.2% III. GROSS OPERATING BALANCE (I - II) 3,423.6 2,968.2 4,203.9 2,841.6 772.3 1.4% 1.2% 1.5% 1.0% 0.3% % of NCR 16.0 13.9 17.4 12.0 3.2 16.0 13.9 17.4 12.0 3.2 IV. TRANSACTIONS IN NON-FINANCIAL ASSETS 818.3 781.5 2,177.0 1,164.2 1,223.2 0.3% 0.3% 0.8% 0.4% 0.4% Investiment in Non-Financial Assets 737.2 706.1 2,095.6 929.7 980.8 0.3% 0.3% 0.7% 0.3% 0.3% Investment in Financial Assets 81.1 75.4 81.4 234.5 242.5 0.0% 0.0% 0.0% 0.1% 0.1% V. NET LENDING / BORROWING (III - IV) 2,605.3 2,186.8 2,026.9 1,677.4 -450.9 1.1% 0.9% 0.7% 0.6% -0.2% VI. PRIMARY BALANCE (V + Net Interest Payments) 2,674.4 2,129.2 2,015.6 1,689.2 932.3 1.1% 0.8% 0.7% 0.6% 0.3% % of NCR 12.5 9.9 8.3 7.1 3.9 12.5 9.9 8.3 7.1 3.9 VII. TRANSACTIONS IN FINANCIAL ASSETS AND LIABILITIES -2,099.0 -2,198.4 -2,204.0 -2,201.5 -197.5 -0.8% -0.9% -0.8% -0.7% -0.1% New Loans 1,476.1 0.0 889.3 261.0 943.7 0.6% 0.0% 0.3% 0.1% 0.3% Amortizations, net (3,580.5) (2,234.3) (3,098.0) (2,467.7) (1,183.7) -1.4% -0.9% -1.1% -0.8% -0.4% Asset sales 5.3 35.9 4.7 5.2 42.5 0.0% 0.0% 0.0% 0.0% 0.0% VIII. GROSS FINANCING NEEDS (Net Debt Service - VI) 975.2 47.5 1,071.1 790.3 1,634.5 0.4% 0.0% 0.4% 0.3% 0.6% % of NCR 4.6 0.2 4.4 3.3 6.8 4.6 0.2 4.4 3.3 6.8 VIII. OVERALL BALANCE (VI + VII) 575.4 -69.2 -188.4 -512.3 734.8 0.2% 0.0% -0.1% -0.2% 0.2% Source: GoRS and WB calculations 34. Expenditures have grown as a result of mandates by Federal legislation, unforeseen demands and because of autonomous policy decisions. Health expenditures have increased by 86 percent in nominal terms from 2009 to 2012 and are expected to increase by 52 percent until 2014 in order to comply with the Federal legislation which has redefined health expenditures for earmark purposes 5. A federally mandated minimum wage for teachers was also fixed by national legislation in 2008 however, current wage in the State is below the minimum. As a result, teachers’ wage will increase by 29 percent until 2014. Nonetheless, the State will still not 5 All states are required to spend 12 percent of revenues on health. Non-compliance with the health earmark and the teacher’s minimum wage can cause sanctions to public officials, but no fiscal sanctions are lifted upon the state. 9 comply with the legislation. It is estimated that to bring the State into compliance would cost an additional R$ 2.5 billion. Lastly, from 2010 to 2012, as a response to the severe drought, the GoRS had to spend R$ 190 million to remedy its effects. 35. As a result of low revenue mobilization, expenditure pressures and high debt, public investment levels are the lowest in the country. Public investment, which accounts for both financial and non-financial assets, summed R$ 1.2 billion in 2012 or 5.2 percent of NCR (see Figure 6). Furthermore, the State’s own resources available for investments totalled only R$ 755 million in 2012, around 3.2 percent of NCR. Since the State is heavily constrained to borrow in the short term, the only possibility for the State to invest more is by increasing its Gross Operating Balance. Figure 3 – Net Consolidated Debt/ Net Current Figure 4 – Payroll Expenditures/ Net Current Revenues: 2006-2013 Revenues: 2006-2012 260% 53% 51.9% 52% 51.2% 51.2% 250% 51% 240% 50% 49.4% 230% 48.8% 49% 220% 48% 47.0% 210% 47% 46.4% 46% 200% 45% 190% 44% 2006 2007 2008 2009 2010 2011 2012 2013 43% NCD/ NCR Limit 2006 2007 2008 2009 2010 2011 2012 Source: GoRS Source: GoRS Figure 5 – Brazilian States Tax Burden (as a % of Figure 6 – Brazilian States Public Investment (as a GDP): 2012 % of NCR): 2012 14% 30% 12.1% 25.1% 12% 25% 10% 8.4% 20% 8% 5.8% 15% 6% 10% 4% 5.2% 2% 5% 0% 0% Espiríto Santo Amapá Amazonas Mato Grosso do Sul Santa Catarina Minas Gerais Pará Sergipe Rio Grande do Sul Pernambuco Goías Rio de Janeiro Maranhão Tocantins Acre Alagoas Piauí Bahia São Paulo Rio Grande do Norte Paraíba Rondônia Paraná Ceará Roraima Distrito Federal Mato Grosso Espiríto Santo Mato Grosso do Sul Santa Catarina Amazonas Sergipe Amapá Minas Gerais Rio Grande do Sul Goías Tocantins Maranhão Pará Rio Grande do Norte Pernambuco Rio de Janeiro Rondônia Acre Paraná Paraíba Piauí Mato Grosso Alagoas Bahia São Paulo Ceará Roraima Distrito Federal Source: STN. WB Calculation Source: STN. WB Calculation 36. Intergovernmental fiscal relations are adequate. Transfers are mostly rule-based, with the rules being written in the Constitution or laws. The rules are public and known in advance, and their application is overseen by the Court of Accounts. Under the Fiscal Responsibility Law and complementary Senate resolutions borrowing by States is prohibited if: (i) the Net Consolidated Debt exceeds twice the Net Current Revenue in the case of States or 120 percent in 10 the case of municipalities (ii) new credit operations exceed 16 percent of NCR; and (iii) debt service exceeds 11.5 percent of NCR. Borrowing is also prohibited if it violates the debt reduction schedules. Finally, bail-outs of subnational governments are prohibited and none has been registered in the last 15 years. State government fiscal accounts are under rigorous scrutiny of the National Treasury Secretariat. Revenues and Expenditures assignment are broadly matched with gaps being covered by specific transfers by the federal government mostly on education and health. The current debate over intergovernmental finance reforms will not change these characteristics in the next few years. 2.4. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY IN RIO GRANDE DO SUL 37. GDP per capita in Rio Grande do Sul has been maintained at around 120 percent of the national average. The challenge for RS is to maintain its position within Brazil, while being able to better leverage growth opportunities. These opportunities are emerging mainly in the shipyard and oil supplies production sectors around the Rio Grande port in the southeast of the State. Other growth opportunities are coming from the expansion of the pulp and paper industry, wind power and IT. On the other hand, traditional manufacturing sectors such as shoes, leather and furniture face challenges from competition with producers from low wage countries. Lastly, in agriculture the challenges are to expand irrigated agriculture, modernize rice production and incorporate small landowners from the Northwestern region in the agribusiness production chain. 38. Three scenarios were constructed to simulate the trajectory of fiscal and debt outcomes. The first or baseline scenario includes the most probable assumptions, incorporating the effects of changes in policies or rules that are already in place. The second scenario is a variation of the baseline, in which it assumes the same hypothesis as the baseline, except for an adjustment of the interest accrued on the renegotiated debt with the Federal Government. It is assumed that it will be adjusted starting in 2014 by changing the interest rate on debt to the consumer price index (IPCA) plus an interest rate of 4 percent, as provided in the draft law (PLC 238) in Congress (representing in practice a reduction in interest costs to the State) 6. The third scenario is constructed as a worst case scenario where the State is hit by an external shock in 2014 and contingent liabilities materialize. The shock causes revenues to remain flat in nominal terms for two years, (an impact greater than any past shock) and the liability relating to the teachers minimum wage raises payroll expenditures in education by R$ 2.5 billion in that same year. Detailed assumptions for each scenario are provided in Annex 4. 39. The baseline projection shows a more difficult fiscal situation from 2013 to 2015. This is evidenced by the reduction in the operating balance to an average of 0.8 percent of NCR in this period as compared to an average of 10.9 from 2010 to 2012. This deterioration is the result of higher expenditures and revenue shocks. As a result, the maintenance of the already low investment level will depend more on external sources (loans and capital grants) in this period. The situation however is expected to improve from 2016 onwards since a few legally mandated expenditures will not increase as rapidly as in the past and the bulk of the wage increases would have been incorporated. The realization of these more benign fiscal outcomes depends on the Government carrying out a less expansionary fiscal policy. Due to legal and political limitations, 6 A more thorough assessment of the proposed changes can be found in the recent report Impact and Implications of Recent and Potential Changes to Brazil’s Subnational Fiscal Framework (P132347 and Report No. ACS5885). In short, the report shows that RS would be a net gainer from the reforms in both scenarios analyzed. 11 this would be translated into a slower growth rate in payroll for employees other than education and public security and a slower growth rate in goods and services expenditures other than health. 40. The expected debt trajectories under the two first scenarios are sustainable. The NCD to NCR ratio is expected to fall under the 200 percent threshold in the short term in both the baseline and in the PLC 238 scenario. In terms of debt to GDP, the ratio currently around 16 percent will decline constantly over time, reaching less than 10 percent by 2025 and 2024 in scenario 1 and 2 respectively. The debt deleveraging would occur roughly at the same pace as in recent years, but would occur even faster in the second scenario due to better refinancing terms. In addition, in the PLC 238 scenario the debt residual with the Federal Government 7 to be refinanced would be much lower, thus translating in a lower debt service burden. For example, in 2028 the debt service is expected to take up 12.5 percent of NCR in the baseline scenario and 9.4 percent if the draft law is approved. 41. In the worst case scenario, the NCD to NCR ratio is expected to breach the FRL limit, however the State would be expected to undertake tougher adjustments and bring debt back into compliance with the FRL. The debt ratios would experience a shift upwards until 2023, declining afterwards even without any adjustment measures. However, due to the binding debt limit embedded in the FRL, the State would be unable to borrow more and thus forced to adjust its budget and get back in compliance with FRL faster than anticipated by the projections. Lastly, it is worth noting that even in this scenario, the debt to GDP ratio always remains below 30 percent, evidencing that even in this worst case considered, the debt would still be manageable. Figure 7 – Net Consolidated Debt (as a % of Figure 8 – Net Consolidated Debt (as a % of NCR): 2008 - 2030 GDP): 2008 – 2030 320% 30% 280% 26% 240% 22% 200% 18% 160% 14% 120% 10% 80% 6% 40% 2% 0% 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030 -2% 2013 2015 2017 2019 2021 2023 2025 2027 2029 Baseline PLC 238 Worst Case Scenario FRL Limit Baseline PLC 238 Worst Case Scenario Source: GoRS and WB calculation Source: GoRS and WB calculation 42. Risks to the baseline scenario relate to changes in the intergovernmental fiscal framework and contingent liabilities. The State would be a net gainer from the intergovernmental reforms under discussion. ICMS revenues would grow in net terms and the State would see its oil royalties revenues increased with the change introduced by law, but 7 Starting in 1997, most state debts were refinanced by the Federal Government for 30 years with a cap on debt service. Any payments in excess of the cap would be capitalized, the so-called residual, and paid in 10 years with no cap, after the original maturity date. 12 currently suspended by the Supreme Court. The main contingent liability relates to precatórios 8, whose definitive payment rules are being discussed in the Supreme Court, which might demand a faster payment schedule than the current one. In addition, unknown contingent liabilities might become new precatórios in an amount higher than the forecasted one. Another relevant contingent liability is the implementation of the teachers’ minimum wage, which is incorporated in the worst case scenario. In addition, this minimum wage has an adjustment rule that makes it grows above inflation every year, adding pressure to the Government budget. Other important contingent liabilities might arise from the civil servants retirement scheme. Table 3 - Rio Grande do Sul Statement of Government operations: 2013-2020 R$ Million (2012 constant values) % of Subnational GDP 2013 2014 2015 2016 2017 2018 2019 2020 2013 2014 2015 2016 2017 2018 2019 2020 I. REVENUE 37,196.5 40,965.8 43,933.9 47,345.2 51,021.9 54,994.1 59,287.0 63,892.1 11.2% 11.4% 11.4% 11.4% 11.4% 11.4% 11.4% 11.4% Taxes 28,542.3 31,596.0 34,081.8 36,695.3 39,510.4 42,542.7 45,811.4 49,321.2 8.6% 8.8% 8.8% 8.8% 8.8% 8.8% 8.8% 8.8% ICMS 23,849.3 26,483.4 28,559.7 30,755.0 33,118.9 35,664.6 38,405.9 41,357.9 7.2% 7.4% 7.4% 7.4% 7.4% 7.4% 7.4% 7.4% IPVA 2,065.4 2,228.3 2,403.0 2,587.7 2,786.6 3,000.8 3,231.5 3,479.8 0.6% 0.6% 0.6% 0.6% 0.6% 0.6% 0.6% 0.6% Others 2,627.6 2,884.3 3,119.0 3,352.6 3,604.8 3,877.3 4,174.0 4,483.4 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% Social Contributions 2,018.7 2,252.0 2,441.5 2,620.0 2,813.1 3,022.4 3,252.8 3,485.6 0.6% 0.6% 0.6% 0.6% 0.6% 0.6% 0.6% 0.6% Transfers 4,171.6 4,715.4 4,801.5 5,198.8 5,626.4 6,095.3 6,605.1 7,159.1 1.3% 1.3% 1.2% 1.2% 1.3% 1.3% 1.3% 1.3% Current Transfers 3,971.6 4,315.4 4,601.5 4,998.8 5,426.4 5,895.3 6,405.1 6,959.1 1.2% 1.2% 1.2% 1.2% 1.2% 1.2% 1.2% 1.2% Capital Transfers 200.0 400.0 200.0 200.0 200.0 200.0 200.0 200.0 0.1% 0.1% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% Other Current Revenues 2,463.8 2,402.4 2,609.2 2,831.1 3,072.1 3,333.7 3,617.7 3,926.2 0.7% 0.7% 0.7% 0.7% 0.7% 0.7% 0.7% 0.7% II. EXPENSE 36,647.9 40,836.1 43,952.8 47,012.2 50,389.1 54,028.3 57,965.3 62,026.1 11.0% 11.4% 11.4% 11.3% 11.2% 11.2% 11.1% 11.1% Compensation of Employees 18,862.1 21,041.8 22,812.6 24,480.2 26,284.9 28,240.5 30,392.6 32,568.4 5.7% 5.9% 5.9% 5.9% 5.9% 5.8% 5.8% 5.8% Interest Payments 2,431.9 2,861.0 3,095.9 3,319.0 3,558.2 3,812.8 4,066.1 4,310.1 0.7% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% Other Current Expenditures 14,525.2 16,016.4 17,057.8 18,150.2 19,400.9 20,741.2 22,177.4 23,715.5 4.4% 4.5% 4.4% 4.4% 4.3% 4.3% 4.3% 4.2% Transfers to Municipalities 7,352.4 8,146.0 8,784.6 9,459.8 10,187.0 10,970.0 11,813.2 12,721.2 2.2% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% Goods and Services 7,172.7 7,870.4 8,273.2 8,690.3 9,214.0 9,771.2 10,364.2 10,994.3 2.2% 2.2% 2.1% 2.1% 2.1% 2.0% 2.0% 2.0% FUNDEB Net Loss 828.8 916.9 986.5 1,062.9 1,145.1 1,233.7 1,329.2 1,432.2 0.2% 0.3% 0.3% 0.3% 0.3% 0.3% 0.3% 0.3% III. GROSS OPERATING BALANCE (I - II) 548.5 129.7 -18.9 333.0 632.9 965.8 1,321.7 1,866.0 0.2% 0.0% 0.0% 0.1% 0.1% 0.2% 0.3% 0.3% % of NCR 2.0 0.4 -0.1 0.9 1.7 2.3 3.0 3.9 2.0 0.4 -0.1 0.9 1.7 2.4 3.0 3.9 IV. TRANSACTIONS IN NON-FINANCIAL ASSETS 1,373.6 1,500.2 947.2 1,369.2 1,660.8 1,989.4 2,137.7 2,296.3 0.4% 0.4% 0.2% 0.3% 0.4% 0.4% 0.4% 0.4% Investiment in Non-Financial Assets 1,115.0 1,228.0 658.5 1,064.4 1,338.3 1,648.5 1,777.2 1,915.2 0.3% 0.3% 0.2% 0.3% 0.3% 0.3% 0.3% 0.3% Investment in Financial Assets 258.6 272.2 288.7 304.8 322.5 340.9 360.5 381.1 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% V. NET LENDING / BORROWING (III - IV) -825.1 -1,370.6 -966.1 -1,036.2 -1,027.9 -1,023.6 -816.0 -430.3 -0.2% -0.4% -0.2% -0.2% -0.2% -0.2% -0.2% -0.1% VI. PRIMARY BALANCE (V + Net Interest Payments) 1,498.5 1,375.9 2,009.1 2,156.1 2,397.3 2,649.6 3,103.5 3,725.8 0.5% 0.4% 0.5% 0.5% 0.5% 0.5% 0.6% 0.7% % of NCR 5.4 4.5 6.1 6.1 6.3 6.4 7.0 7.8 5.4 4.5 6.1 6.1 6.3 6.5 7.0 7.9 VII. TRANSACTIONS IN FINANCIAL ASSETS AND LIABILITIES 922.7 1,397.6 966.1 1,036.2 1,027.9 1,023.6 816.0 430.3 0.3% 0.4% 0.2% 0.2% 0.2% 0.2% 0.2% 0.1% New Loans 1,441.0 1,615.5 1,742.0 1,958.5 2,215.9 2,387.4 2,429.4 2,294.2 0.4% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.4% Amortizations, net -563.3 -565.5 -826.0 -974.9 -1,243.3 -1,421.9 -1,674.4 -1,927.9 -0.2% -0.2% -0.2% -0.2% -0.3% -0.3% -0.3% -0.3% Amortizations received 17.3 18.3 19.3 20.2 21.2 22.3 23.4 24.6 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Amortizations paid 580.6 583.8 845.3 995.2 1,264.5 1,444.2 1,697.8 1,952.5 0.2% 0.2% 0.2% 0.2% 0.3% 0.3% 0.3% 0.3% Asset sales 45.0 347.6 50.1 52.6 55.2 58.0 60.9 64.0 0.0% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% VIII. GROSS FINANCING NEEDS (Net Debt Service - VI) 2,886.9 3,312.0 3,801.2 4,167.2 4,668.4 5,095.0 5,593.8 6,083.9 0.9% 0.9% 1.0% 1.0% 1.0% 1.1% 1.1% 1.1% % of NCR 10.4 10.8 11.5 11.7 12.2 12.4 12.6 12.7 10.4 10.8 11.6 11.8 12.3 12.4 12.7 12.8 VIII. OVERALL BALANCE (VI + VII) 2,421.1 2,773.5 2,975.2 3,192.3 3,425.2 3,673.2 3,919.4 4,156.1 0.7% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% 0.7% Source: WB calculation 43. In conclusion, the GoRS’s expenditure program and fiscal arrangements between the Federal Government and the GoRS are adequate for the purpose of this operation, and the GoRS’s debt has been assessed as sustainable, although not without risks, in a very adverse environment. 3. THE GOVERNMENT’S PROGRAM 44. The Government’s program is embodied in its Multi-Year Plan (PPA) 2012-2015. The overarching Government objective is to induce sustainable growth, reducing social and regional inequalities. The plan was constructed around four axes: (i) investment, employment and income growth, (ii) regional development, (iii) improve quality of life and eradicate extreme poverty; and (iv) improve citizenship and promote republican and peaceful values. The plan has 13 objectives, including objectives 3.1 and 2.3, which are respectively: to strengthen the State’s investment capacity; and to strengthen economic, logistical and energy infrastructure, while 8 Precatórios are judicial claims filed against the state where a judgment was issued against it (that is, GoRS lost the case). As a result, the state has to pay a court-ordered amount of money in reparation 13 ensuring environmental sustainability, are the most relevant to this operation. 4. THE PROPOSED OPERATION 4.1. LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION 45. The policies supported by the proposed operation are fully in line with the PPA. The Program Development Objective (PDO) of this operation is to improve Government capacity to mitigate economic volatility in the State of Rio Grande do Sul by supporting measures to increase resources available to the government and to reinforce the Integrated Water Resource management framework. The PDO, is therefore, fully aligned with the Government’s strategic objectives as outlined above. More specifically, this DPL contributes directly to the Government’s objective 3.1 (to strengthen the State’s investment capacity) and 2.3 (to strengthen economic, logistical and energy infrastructure, while ensuring environmental sustainability). In addition, this proposed operation will also contribute indirectly to three other government objectives, which are: raise the rate of investment growth, employment and income; promote regional development; improve the quality of life and eradicate extreme poverty. 46. The fiscal pillar will contribute to strengthening the State’s investment capacity, while the irrigation and water resources management pillar will support strengthening economic, logistical and energy infrastructure, while ensuring environmental sustainability. The fiscal pillar aims to promote savings in expenditures or increase revenues, which will ultimately increase the resources available for investment. The irrigation and water resource management pillar will focus on promoting sound irrigation policies and strengthening the State Water Resources Management System, enhancing capacity for planning and operation of water infrastructure. This operation is connected with the Bank’s broader goals since it aims to reduce macroeconomic volatility which disproportionately hits the poor, while the second pillar is targeted to more impoverished regions and families in the bottom 40 percent of the income distribution. 47. The Implementation and Completion Results Report (ICR) for the last Rio Grande do Sul DPL provided two critical lessons for this operation. The first is the need for a strong social coalition for structural reforms. In particular, in the last DPL the Bank supported a bold reform program, some parts of which could not be fully implemented due to lack of support in the State legislative and organized civil society groups 9. Therefore, this operation tries to focus on measures that are feasible to implement in the short term and are likely to be sustained. The second lesson is on the timing of the loan. This operation will support the Government through the last year of the current Governor and also the beginning of the next administration and in a period of fiscal stress, allowing the Government to maintain public investments and the Bank to maintain a policy dialogue with the next Government. A general lesson also applicable to this operation is the importance of reinforcing Government ownership of the operation. 4.2. PRIOR ACTIONS, RESULTS AND ANALYTICAL UNDERPINNINGS Pillar I. Strengthening Fiscal Management 48. The common theme of the fiscal pillar is to increase revenue and promote expenditure savings. The policy actions aim to increase revenues, not by raising tax rates, but 9 The reform of the civil service pension system that was supported by the first DPL, but not implemented during the DPL was later implemented by the current administration. 14 by improving collection efficiency. On the expenditure side, this pillar supports policy action that seeks to generate expenditure savings. These savings can be obtained in the short term, through actions on procurement policy, or in the long term through actions on costing, tax expenditures and contingent liabilities. 49. The prior actions in the fiscal management pillar build upon components of the Bank’s previous DPL, by supporting complementary policy actions. With the first DPL the Bank helped the GoRS to adopt more modern procurement techniques and estimate the cost of its tax expenditure measures. Following up, this operation is supporting the improvement of mechanisms by which the public sector surveys the prices practiced on the market and the gradual implementation of tax expenditures benefit analyses. 50. The GoRS is one of the most transparent and advanced states in Brazil in the estimation of tax expenditures. With Bank support, the State has started to estimate and publicize annual amounts of tax expenditures broken down by several classifications. The high amount of tax expenditures is a particularly acute problem for Rio Grande do Sul given all other constraints it faces to mobilize revenues. The Government has a broad mandate to assess the effectiveness of tax expenditures. 51. The Bank will thus support the Government in enacting a policy to assess new tax expenditures gradually. Currently, tax expenditures pledges are received by SEFAZ and analyzed with no standard procedure and then submitted, although not formally, to the Secretary and the Governor for decision. The Government wants to improve this process by issuing a legal rule to determine that all tax expenditures pledges are evaluated ex-ante and contain: (i) a clear objective and (ii) at least one effectiveness indicator. In addition, the GoRS will commit to periodically reevaluate these tax expenditures measures and the result of such evaluations would have to be formally submitted to the Secretary. This policy will be effective for new tax expenditures, but is expected to encompass most of the tax expenditures over time since current tax expenditures have expiration dates and would have to go through the new process to be renewed. • Prior Action #1: The Government of Rio Grande do Sul has improved its assessment procedures for new tax expenditures. • Results: Percentage of tax expenditure measures under Government control evaluated, according to the new procedures. 52. The stock of tax arrears in Rio Grande do Sul is high. Tax arrears amounted to R$ 30 billion in 2012, which is equivalent to 121 percent of annual tax revenues. This problem is not limited to Rio Grande do Sul. In São Paulo, the ratio between tax arrears and tax revenues reached 185 percent in 2012. Some of the causes behind such a high ratio are out of the control of the State such as the slowness of the judicial system and the difficulty to sequester assets from delinquent taxpayers. However, other reasons behind the poor performance of collection of tax arrears in Rio Grande do Sul, such as inefficiencies in the procedure to enforce payments, can be addressed by the State. 53. The GoRS has taken several initiatives to expedite the collection of unpaid tax obligations. For example, tax agents were asked to accumulate small value claims against the same debtor before filing judicial claims. In addition, SEFAZ has resorted to alternative and more cost-effective collection methods. These initiatives are guided by a number of strategic 15 guidelines. These guidelines include: expediting actions of the Secretariat as soon as arrears are incurred, expediting internal work flows in order to reduce time required for internal processing and focusing efforts on the cases with highest recovery likelihood and highest values. All these guidelines exist as tacit knowledge, but are not formalized. New formal operating procedures will need to be developed to institutionalize these policies. The prior action supported by the DPL will help SEFAZ consolidate all its tax arrears efforts in one policy document, making explicit the strategic directives and requires the preparation of an operations manual for tax arrears enforcement. As a result of its implementation, it is expected that not only tax arrears recovery will increase, but also the policy will become institutionalized and sustainable. It is expected that such policy will increase revenue by R$45 million per year. • Prior Action #2: The Government of Rio Grande do Sul has established procedures to guide the recovery of tax arrears, reducing processing time and prioritizing cases with high values and high probability of recovery; and criteria to measure results of tax arrears recovery actions. • Results: Increase the share of tax arrears recovered within 60 days of their generation. 54. Rio Grande do Sul has made advances in procurement practices with Bank support. In the previous DPL, the Bank supported the strengthening of the central procurement unit, which promoted the adoption of more modern procurement methods such as reverse price auctions and price registry. Subsequently, the unit was elevated to the category of undersecretariat and new permanent staff was recruited. In addition, this central unit has been carrying out analysis to substantiate decisions about the cost effectiveness of grouping and consolidating procurement processes, as well as, policies to increase the participation of small and medium enterprises in Government purchases. 55. The next step to improve procurement processes is to work on how the Government obtains price information to conduct its procurement processes. Currently, the State has no structured price survey to inform its procurement processes. Therefore, the employee responsible for the procurement process has to conduct a phone survey with three suppliers, identifying himself and thus biasing the survey. As a result, procurement processes in general start with prices set at a level higher than the average market price, which depending on the competitiveness of the process might lead the Government to purchase items above market price. In order to resolve this asymmetry of information, the GoRS is drawing on the electronic fiscal invoice database that registers the price of all transactions subjected to ICMS taxation in the State. This information is being passed to public employees in charge of procurement and used to set initial prices and also to negotiate further discounts in the final price in case these prices diverge significantly from the ones in the database. The Government has used this information on a pilot basis and in order to expand its usage, is gradually including bar code information in its procurement catalog. Therefore, it will be able to match the bar code it has on its procurement catalog with the bar code provided by the suppliers and make sure the correct price information is being used. In order to do that, the Government is resorting to Federal regulations which require that some classes of products like pharmaceuticals to have bar code. By doing this, it is also addressing legal constraints to wider use of such information namely the claim that requiring universal product coding information from suppliers deters wider competition. The existing mandatory use of bar code in the market is sufficient for the Government to achieve the proposed results. 16 • Prior Action #3: The GoRS has mandated the use of price information from the electronic fiscal invoice database as a reference price to inform its procurement processes of goods. • Results: Increase the share of goods procured, expressed as a percentage of the total value of goods, using price information from the electronic fiscal invoice database. 56. The GoRS is at the forefront of developing a costing policy applied to the public sector. Rio Grande do Sul, like other Brazilian states, is developing its costing policy to comply with Federal legislation following the International Public Sector Accounting Standards (IPSAS). However, the GoRS is in a more advanced implementation stage in relation to other states. Moreover, its policy allows the State to deal with the issues of expenditure efficiency and cost-effectiveness using more advanced techniques. One of the advantages is the creation and utilization of the cost center concept, which allows the State to allocate a larger share of its costs in a direct way, avoiding cost apportionment to overhead expenses. In addition, since the cost center is the lowest administrative level (there are around 20,000 cost centers in the GoRS) it is easier to match cost and services and retrieve early cost-effectiveness figures, even before the State moves to the actual costing of public services, which is the next step planned. 57. The objective of the costing system is to generate information for Government agencies that can be of managerial use. The challenge however is to promote behavioral change and foster the use of costing information for budget and public management improvement. Therefore, the GoRS through its internal control agency is requesting that all line secretariats that have implemented the costing policy and system for more than a year in 2014 – 14 in total – to produce a managerial report using costing data to be included in the agencies’ annual report. Moreover, the report would necessarily highlight the practical effect of the cost analysis (expenditure reduction, productivity increase, etc) and would also be published in the State Transparency Portal. • Prior Action #4: The GoRS has mandated all of its agencies that have implemented the Cost Policy and System for more than one year to prepare, as part of their annual report, a managerial cost report. • Results: Increase in the number of managerial cost reports prepared by Government agencies. 58. A related debt problem is the issue of contingent liabilities. The two main sources of contingent liabilities in the State are judicial claims regarding labor contracts of public employees and taxes and social contributions that are not paid in a timely fashion, becoming a contingent liability because the moment of the payment is uncertain and the value and form of payment might be disputable. This last problem is more prevalent in the so-called indirect administration which encompasses public foundations and state owed enterprises, which have more autonomy and less oversight from State Treasury, even though they are not fully autonomous institutions. Currently, the State lacks control and oversight over the managerial decisions that are a potential source of contingent liabilities. Moreover, the State also lacks proper control over the contingent liabilities that are in a more advanced stage, i.e., judicial actions that are being discussed and can generate new and unforeseen expenditures to the State. This lack of control and information compromises the State’s fiscal management since policy decisions might not be effected due to last minute expenditures generated by contingent liabilities. 17 59. The GoRS has instituted a working group to propose a policy to manage contingent liabilities. The overall policy directive is on control and prevention, avoiding the creation of new liabilities. The policy will aim at identifying and monitoring contingent liabilities as well as estimating their impact. This will require new work routines from internal control and PGE as well as a systematic flow of information between PGE and SEFAZ. It will also set the appropriate measures to mitigate its impact and create a decision mechanism for policy actions that might generate contingent liabilities. Lastly, accounting rules in the process of implementation will require that such liabilities be recorded in the balance sheet and might be part of the Net Consolidated Debt capped by the FRL, highlighting the importance of this policy. The development and implementation of such policy will result in a more comprehensive understanding of the State fiscal situation and reduction in the accumulation of future contingent liabilities. • Prior Action #5: The GoRS has created a policy to identify and estimate the fiscal risks created by contingent liabilities, and prevent and mitigate their fiscal impact. • Results: New policy instrument to manage contingent liabilities made effective. Pillar II. Irrigation and Water Resources Management 60. This pillar has the objective of promoting sustainable irrigation and strengthening the State Water Resources Management (WRM) System. It supports policy actions that promote adequate strategic planning for sustainable irrigation aimed at generating income and economic development. From the water resource management perspective, it supports policy actions that strengthen water resource management institutions, planning and tools, enhancing integration among the water resources management system and its multiple users. 61. GoRS has made efforts to improve water security and to enhance irrigation planning and implementation. In Rio Grande do Sul, irrigated agriculture and increasing water storage capacity are significant means of preventing seasonal water scarcity related to drought. The State has since taken important policy decisions, notably the elaboration and approval of the State Irrigation Policy. Given the importance of irrigated agriculture to the State, it has become clear to the GoRS that will be critical for the State to integrate this policy with the State’s water resources policy as well as with future proactive and coordinated drought preparedness initiatives. 62. The State Irrigation Policy responds to a long-lasting demand from the agricultural sector to have a comprehensive irrigation policy. The Law sets the principles, objectives and instruments (including research and development, technical assistance to water users, information system, etc) for the State intervention and priorities. It establishes that the irrigation policy must be implemented in accordance with the principles of the State water resources policy; and uses the river basin as unit for planning and implementation. Priorities include production of food and special support to family farmers and areas of lower income and social development, also focusing on areas under low or irregular rainfall distribution. 63. The Law also establishes a statewide ‘Master Plan for Irrigation in the Context of Multiple Water Uses in Rio Grande do Sul (PIUMA) as a key planning mechanism for irrigated agriculture. This Plan requires the participation of the different entities of the State Water Resources System (i.e. the State Water Resources Council – CRH-RS, the river basin committees, and the Department of Water Resources – DRH), in consultation with the entities 18 representing the irrigators. The Plan includes a diagnosis of the current condition of irrigated agriculture and its potential for sustainable growth, based on a set of parameters including projections of water availability and demands of other water users. Importantly, it is expected to propose guidelines and priorities for the granting of water use rights and environmental licensing for the irrigated agriculture sector. The Law envisages that more detailed irrigation plans will be elaborated as a result of the PIUMA, at the level of the Territories of Irrigation and Multiple Uses (TIUMAs). Said irrigation plans need to be aligned with the WRM plan of the river basin, in which the corresponding territories are situated. 64. The State Irrigation Law establishes an Irrigation Policy Management Council. The Council is composed of nine entities (SEPLAG, SOP, SEMA, SEAPA, SDR, SDPI, IRGA, FEPAGRO and FEPAM) and has a wide-range mandate that includes: (i) coordinating and integrating the actions of the public sector related to irrigation, (ii) establishing the norms and decrees to implement the State Irrigation Policy, (iii) approving the PIUMA and its subsequent more detailed irrigation plans for each territory (TIUMA) defined within a river basin, (iv) consolidating and coordinating the public irrigation programs, projects and actions at the State level to implement the Irrigation Policy, and (v) managing the State Irrigation Fund established by the Law. 65. The State Irrigation Policy will be implemented through different programs, projects and actions to be established by law or regulation. One of the initiatives is the ‘More Water, More Income’ Program 10 that was created by law upon approval by the State Assembly in May 2013 to promote the use of irrigation methods, as a way to enhance drought resilience of the agricultural sector, in order to increase the productivity and income of smallholders and medium- size farmers (i.e. maximum irrigated area of 100 ha per producer). Its main features comprise: (i) support for granting environmental licenses and temporary rights for water use, including for small water storage ponds (i.e. surface area below 10 ha) to facilitate initial procedures for access to credit, and (ii) subsidies 11 for irrigation equipment and the construction and/or enlargement of small water storage ponds for irrigated agriculture 12. 66. The More Water, More Income Program activities focus on the Northwestern region, where it is estimated that only two percent of the agricultural production and three percent of farmers currently use irrigation techniques. The Program aims at achieving an additional 100,000 ha of irrigated area in a period of three years. In addition, the Program foresees training and capacity strengthening of: (i) engineers, to ensure adequate designs of irrigation projects, and (ii) agricultural producers, to ensure efficient irrigation practices and a rational management of water, including during drought and limited water availability conditions. In the next two years, it is expected that the Program will benefit over 3,000 medium 10 The Program was instituted in March of 2012 by Decree; it became a law upon approval by the State Assembly in May of 2013. The State Irrigation Policy Management Council will ensure that the program is made compatible with the State Irrigation Policy Law, ensuring alignment with the Policy’s principles, objectives and guidelines. 11 There are three lines of credit available with payment periods varying from eight to twelve years. The Government will reimburse the first and last annual installments of the financing in a proportion of 100% for small family farmers; 75% for medium size farmers and 50% for other farmers. In addition, subsidies will be calculated over a maximum amount of R$ 500 thousand loan and the amount of subsidies that the Government is allowed to commit in every given year is capped at R$ 45 million. 12 The temporary environmental licenses and water rights are granted under these special circumstances with the objective of facilitating the application procedures for access to credit. The full process for receiving environmental licenses and water rights will need to be followed for renewal of the licenses and rights after four years. 19 and small farmers located in the Northwestern region of the State. • Prior Action #6: The GoRS has reinforced its commitment to sustainable irrigated agriculture practices by aligning its ‘More Water, More Income’ Program with its Irrigation Policy and its Water Resources Policy. • Results: Increase in the number of medium and small farmers that have adhered to the ‘More Water, More Income’ Program. 67. The implementation of the State Irrigation Policy will need to be consistent with the State Water Resource Policy. This requires a coordinated planning effort between irrigation and water resources management both at the State level (PIUMA with the State Water Resources Plan) and at the level of the river basin and sub-basins (territorial irrigation plans with the river basin plans). At the project level, the use of water for irrigated agriculture will require the previous grant of water use rights by the DRH. In addition, practices that ensure a sustainable irrigation policy will need better knowledge of the surface and groundwater availability as well as decision support systems to ensure proper water allocation and minimize conflicts among users. Well trained personnel, information systems, and capacity building are the main factors to promote development. 68. Strengthening of the State’s Water Resources System is crucial. DRH will require considerable capacity strengthening to be able to analyze and process the growing number of water use rights for irrigation, and to lead the integration of the irrigation and water resources planning efforts across the State. DRH is responsible for integrating the State Water Resource System, which includes the CRH-RS, the river basin committees, and DRH itself. DRH is also: (i) providing technical assistance to the Water Resources Council, (ii) in charge of issuing water rights in State rivers, (iii) coordinating the implementation of the State’s WRM plan, (iv) regulating the operation of the hydro-meteorological network and database, (v) maintaining a State Water Resource Information System along with National System and (vi) setting up and maintaining a register of water users. 69. The GoRS has initiated a staff recruitment effort and approved incentive schemes for WRM institutions. DRH has thus far been unable to carry out its functions properly, for several reasons, including lack of technical and administrative staff, adequate career plans and incentive structures, as well as deficiency of data, equipment and tools to estimate water availability and water uses in the basin and determine water use rights. By agreeing to launch a recruitment process that would result in a six-fold increase of DRH’s permanent technical staff (i.e. from the current number of 8 to 48), the State has committed itself to substantially strengthen its institutional framework for WRM both at the central level and the river basin level, recognizing the importance of a sustainable use of water resources to enhance the drought resilience of the agricultural sector. This was preceded by a State decision to provide an additional bonus of 60 percent over the base salary levels of DRH staff. 13 • Prior Action #7: The GoRS has strengthened the institutional capacity of its Department of Water Resources through the approval of an enhanced staff organogram and the launch of the corresponding recruitment process. • Results: River basin plans completed, discussed and approved by the river basin 13 The total estimate impact of both measures: the bonus and the new hires is R$ 4.1 million in 2014 and R$ 5 million in 2015, which is equivalent to 0.01 and 0.02 percent of the projected NCR for the respective years. 20 committees, with the supervision and facilitation of the DRH team. 70. Although State hydrology is good, conflicts among water uses, especially irrigation versus urban and rural water supply tend to become more frequent and severe if the water resource policy instruments are not implemented. From the standpoint of investors, a sound legal and technical basis for water resource planning and management vis-à-vis investment decisions would be expected. The increment in water resource management capability and effectiveness should contribute to reduce investment risks. In this regard, the State is advancing with the completion of the State Water Resources Plan, which will be established by law by early 2014, the preparation of eight river basins plans (only one of the twenty-five State river basins currently has a completed water resources plan), the diagnosis of water availability by river basin, the contracting of the State Water Resources Information System, including a decision support mechanism for the issuance of water rights; and the installation of 120 new hydro- meteorological stations in key river basins. 71. The State of Rio Grande do Sul is also introducing performance benchmarking mechanisms to consolidate the State Water Resources System. The State has committed to enhancing its Water Resource System in a more comprehensive way by adhering to the National Pact for Water Management (PROGESTÃO). This is a results-based program designed and implemented by the National Water Agency (ANA) that helps the States to define the current level of development of their Water Resources System, as measured against the objectives and instruments established by the Federal Water Resources Law, and define annual targets for a five year period, which are discussed and approved by the State Water Resources Council. This agreement between the State and the Federal level requires the State to benchmark itself against other states and is expected to lead to substantial measurable improvements in the State’s legal and institutional framework for water resources; planning; information and decision support tools; and operational instruments (e.g. water use rights, water pricing, drought preparedness plans etc.). It comes with some financial support from the Federal level to help achieve the targets, but it requires primarily that the State coordinate the different interventions of the public sector related to water resources management. • Prior Action #8: The GoRS adhered to the National Pact for Water Management, which establishes, inter alia, targets for improving the Borrower’s legal and institutional framework for water resources; planning, information and decision support tools; and operational instruments, including water availability, water use rights, water pricing and drought preparedness plans; and signed an agreement with the Guarantor’s Water Agency committing to comply with specific water resource management targets in exchange of financial support. • Results: Hydro-meteorological stations installed in key river basins with information analyzed by the State. 72. Results from various sectoral studies informed the focus and design of the DPL (see Table 4 for a summary of analytical work underpinning the operation). Table 4 - DPL Prior Actions and Analytical Underpinnings Pillar Analytical Underpinnings Pillar 1 - Strengthening • Brazil Intergovernmental Finances. Impacts and implications of recent and Fiscal Management potential changes to Brazil`s subnational Fiscal Framework. (Araujo, J and 21 Barroso, R., WB 2013) • Reform Priorities for Subnational Revenues in Brazil. (Ter-Minassian, T., Inter-American Development Bank Policy Brief IDB-PB-157, 2012). • Handbook on Best Practices on Tax Expenditures Measurement (CIAT 2011) • Beyond the Annual Budget. Global Experiences with Medium-Term Expenditure Frameworks (WB 2013) • Review of International Practices for Determining Medium Term Resource Needs of Spending Agencies. Bottom-up Costing for Medium Term Expenditure Frameworks in Brazil and Indonesia. Governance Partnership Facility Trust Fund Project. (WB, Forthcoming) • Fiscal Risks: Sources, Disclosures and Management (IMF/ FAD, May 2008 Pillar 2 - Irrigation and • The Effects of Droughts on the Economy of Rio Grande do Sul: a Water Resources Multisectoral Approach. (Fochezatto, A. and Grando, M. Z., Fundacao de Management Economia e Estatistica, Texts for discussion no62, May 2009) • The Drought of 2011/2012 and its Influence on the Agricultural Production of Rio Grande do Sul: Technical Note No.10 (06/06/2012) CEMETRS /FEPAGRO/SEAPA • Master Plan for Irrigation in the Context of Multiple Water Uses in Rio Grande do Sul. Obstacles to irrigation development in RS: Environmental licensing and concession. (Meirelles, F., April 2013) • First State Water Resources Plan of Rio Grande do Sul. (SEMA, August, 2013) 4.3. LINK TO CPS AND OTHER BANK OPERATIONS 73. The proposed operation is fully consistent with and closely linked to the objectives of the World Bank Group’s Brazil Country Partnership Strategy (CPS) 2012-2015 (Report No. 63731-BR) discussed by the Executive Directors on November 1, 2011. This new DPL will be an important component to support the CPS outcomes across all four key pillars: (a) strengthen public and private investment; (b) improve service delivery to the poor; (c) strengthen regional and territorial development; and (d) support the effective management of natural resources and the environment. 74. The proposed operation is complementary to the existing Project to Strengthen Public Investment (SWAp). This DPL, through its fiscal pillar, aims to strengthen fiscal management, which tends to increase the resources available for public investment. The SWAp takes a bottom up approach to public investment focusing on enhancing the efficiency of public investment by improving its planning and implementation. In addition, the Environmental and Disaster Risk Management (DRM) technical assistance components analyze the other side of the rainfall variability problem which is flooding. Lastly, the SWAp is also supporting the modernization of the pension management unit, which will have positive effects on fiscal management. 4.4. CONSULTATIONS, COLLABORATION WITH DEVELOPMENT PARTNERS 75. The PPA and the Budget were developed through a participatory process, consulting with a broad range of stakeholders. The State System of Popular and Citizen Participation is a space for participatory democracy in which people elect their priorities for inclusion in the Budget, which will be forwarded by the executive power to be voted in the 22 Legislative Assembly. This process encompasses public hearings, regional and municipal assemblies, regional forums and voting open to all citizens, by electronic means and polls. About 1 million people participated in the voting process, more than 10 percent of the State population. 76. The consultations with local communities formed the basis for the prioritization of actions in the PPA, which are totally aligned with both the fiscal and the irrigation pillars of the DPL. In particular, the water management policies supported by this operation have been broadly discussed with key stakeholders – including different water users, representatives of several River Basin Committees, farmers’ organizations, local authorities, Non-Governmental Organizations, etc. – through a series of regional workshops and consultations and by means of a web-based portal in which all Technical Notes and consultation reports have been made publically available and revised according to the inputs received 14. These efforts have also been supported by the SWAp. In addition, WBI has been supporting the State in its transparency and consultative efforts. 77. As the International Monetary Fund (IMF) does not work directly with sub-national governments, no direct collaboration with the IMF is expected. This DPL does, however, comply with the guidelines for coordinating with the IMF on development policy lending. 78. IADB is an important and active development partner in the State. It supported the State Government on fiscal issues with the PROCONFIS 1 operation. IADB is also currently supporting the State with a technical assistance loan (PROFISCO), focused on fiscal management. 79. This operation is a partnership with the IADB operation PROCONFIS 2. This IADB operation is a two tranche loan for an amount of US$200 million. The objective of the operation is to contribute to the State economic development through the strengthening of water resources management and support to the fiscal consolidation initiated with the previous operation. IADB is supporting a total of 40 prior actions in the areas of water resources and fiscal management. The Bank and IADB are supporting the same Government program, although through different prior actions. Nonetheless, a few prior actions are identical as is the case of prior action 8, which was proposed by the WB team to the State and later included in the IADB policy matrix as well. 5. OTHER DESIGN AND APPRAISAL ISSUES 5.1. POVERTY AND SOCIAL IMPACT 80. The policy actions supported by this proposed DPL are expected to have a positive impact on poverty as they will contribute to fiscal sustainability, foster social accountability and improve water management with potentially positive impacts on agriculture. The PSIA relies on the analysis of secondary data and on the outcomes of public consultations previously held by the GoRS with key stakeholders and focuses on the expected distributional impacts of Prior Action # 6 (State Irrigation Policy), #7 (State Irrigation Policy Management Council), and # 8 (“More Water, More Income” Program) supported under Pillar 2. These policies will have the most direct impacts upon small landholdings and family farmers, which are over-represented among the state`s poor people and responds for 80.5 percent of the 1.2 million people dependent from agriculture in their livelihoods. 14 The information on this highly participatory approach for designing the referenced policies is available at www.piuma-rs.coop.br. 23 81. Family farmers have become increasingly vulnerable to cyclical droughts as their earnings rely mostly on rain-fed or dry-land farming. Family agriculture has shown large fluctuations in production and faced a trend towards impoverishment. This trend can be attributed mostly to the fact that summer crops are very sensitive to seasonal droughts. These droughts affect 98 percent of the small family farmers, reducing the productivity of family agriculture and resulting in losses of 5 to 8 percent of GDP every five years. Historically, the strategy of family producers has been to endure losses in critical dry years and benefit from wet years, but this strategy has become increasingly costly for them as production costs and productivity have increased with the adoption of new technologies. Consequently, small family farmers have recently faced a trend towards impoverishment and increased social vulnerability. 82. Pro-poor distributive effects can be expected from these policies as they may have a larger positive impact on the livelihood of the small family farmers than on the incomes of medium and larger farmers. Small producers have less capital as well as access to credit for expanding water storage and irrigation systems. They are also the most vulnerable to climatic events as their assets and savings are comparatively smaller to face the losses in dry years. Additionally, due to the agricultural calendar year, the period of harvesting of their main crops extends over the dry season and their summer crops are most dependent on the availability of water. Consequently, their earnings and recovery capacity are the most impacted by the losses they incur due to cyclical droughts. The information available shows that replacing rain-fed crops in dry fields for irrigated fields may bring productivity gains equal to 244 percent in maize, 158 percent in beans and 85 percent in soy beans (their main summer crops) among the small family farmers. 15 Overall, the combined social and economic outcomes of these policies are expected to be positive for the poor and vulnerable population in most deprived rural areas as they will (a) increase their resilience in face of cyclical droughts, (b) improve their adaptive capacity to climate change, (c) protect their livelihood strategies from fluctuations in the productivity of their main productions, and (d) make their incomes more stable and sustainable. In addition, since these family farmers are mostly in the initial 40 percent of the income distribution, the increased income brought about by the policy actions supported, will help fight the impoverishment trend they are facing and boost shared prosperity. Due to the relevance of agriculture in Rio Grande do Sul, they are also expected to impact positively the State economy16. 5.2. ENVIRONMENTAL ASPECTS 83. No significant environmental impact is expected from Pillar 1, while net positive impacts are expected from Pillar 2. Implementing a more efficient irrigation practice entails several positive impacts. An increase in the farmers productivity and avoidance of crop loss due to lack of water are perhaps the top socio-economic reasons for adopting such a scheme. The most obvious positive environmental impact is conservation of water resources. However, irrigation can cause increased groundwater recharge due to deep percolation losses. These losses may cause inter alia rising water tables, waterlogging, increased soil salinity and nitrate leaching. Using techniques such as aspersion or drip irrigation, water can be directed with more precision to the plant and thus increase efficiencies to 70% or more (losses of 30% or less). 15 Estimates for the average gaps between dry and irrigated crops in the last ten years made by the State Secretary of Agriculture, Livestock, and Agro-business (SEAPA) available at the website http://www.agricultura.rs.gov.br/conteudo/1032/?Mais_%C3%81gua%2C_Mais_Renda. 16 The full PSIA analysis is available on the project’s files. 24 Increasing productive land area through irrigation has however the added impact of an increase in the use of agricultural chemicals. The main crops planted in Rio Grande do Sul (corn, soy, rice and beans) use fertilizers, herbicides and pesticides. By increasing the land area under cultivation there will be an increase in the use of these chemicals which have several negative, widely known, environmental impacts (human health, wildlife, biodiversity, water pollution). 84. The State has institutional capacity for environmental management and protection, however available capacity and resources are weak, resulting in operational limitations and poor staffing. The overall environmental impact of the DPL will be positive, if the potential beneficial actions are expanded and strategies to neutralize the likely adverse impacts such as the release of agricultural bi-products into the environment are adopted. These strategies should have two foci: an increase in the operational capacity of the environmental governance system and a close coordination with the water and agricultural sectors. 85. Rio Grande do Sul has advanced environmental laws, and is in the process of strengthening its management systems. The State’s performance in critical areas such as water resource management, environmental licensing and other control and supervision activities has been poor. For example, the head of Water Rights Concession indicated that in November 2013, there was a back log of 24,000 concession requests. With exception of a few academic studies, the State does not have a detailed water balance per region nor hydrodynamic models that would inform those assigning water rights. River basin committees are only starting to mobilize and are still far from obtaining this critical input to inform their river basin management plans. The State has recognized this situation and is currently undergoing a recruitment initiative to increase its total staff by 197. The Secretariat of Environment is seeking to strengthen its licensing and environmental compliance capacity. Through the technical assistance component of the SWAP, the Bank is supporting the implementation of SIRAM, the new Integrated System of Environmental Regularization and Compliance, as well as the Ecological and Economic Zoning (EEZ). SIRAM will integrate the information systems of the three environmental agencies of the state: SEMA, FZB and FEPAM and thus significantly improve the state’s licensing and enforcement capability. By using the findings and recommendations of the EEZ the state through the Water Basin Committees will avoid inappropriate land use and thus increase resiliency. 86. The State has serious issues with water quality. This has resulted from the very low percentage of sewage treatment, the release of agricultural by-products into the environment and serious contamination in industrial zones. The environmental liability of these sites is significant and the State through several Government agencies is working to identify possible solutions. 87. Despite the drawbacks faced by the State in enforcing the environmental regulation, the advances made and the improvements underway give confidence that the State will be in a position to manage environmental impacts. 5.3. PFM, DISBURSEMENT AND AUDITING ASPECTS 88. A robust legal framework provided for in the Constitution and other laws serves as the basis for Brazil’s Public Financial Management (PFM). The legal framework provides for a strong PFM mandate at the sub-national level. The framework provides for a clear definition of the responsibilities and institutional arrangements of Federal and sub-national entities. In addition, the Court of Accounts (Tribunal de Contas do Estado - TCE) is responsible for external scrutiny and the legislature plays an external oversight role. The budget classification system is governed by Federal rules that are consistent with international standards. The budget 25 preparation process is orderly, and promotes participation by all key stakeholders. The State has consistently met deadlines for the preparation of key budget documents and for submitting them to the legislature for consideration and approval. 89. The State’s performance in accounting for and recording transactions is strong because accounting rules and regulations are generally respected. The State’s information system, FPE, is also adequate for most purposes. The FPE enables the identification of all resources transferred from the Treasury to the service delivery units and also provides information on the transfer of goods procured and distributed centrally. The financial programming process is currently working well. The use of the single treasury account model of cash management and a clear allocation of responsibility for managing it, facilitate the performance of bank reconciliations on a regular and timely basis. 90. The State’s PFM environment features strong internal rules and controls on commitments. However, a number of weaknesses still limit the effectiveness of the internal audit function which is responsible for providing management assurance on the functioning of the internal control system. The accounting and internal audit functions are housed within the same department in SEFAZ, known as the Contadoria e Auditoria Geral do Estado (CAGE). However, the weaknesses in the system and the consequent use of ancillary systems by some service delivery units may introduce some element of risk and weaken the internal control environment. 91. There is a high level of financial information transparency due to the extensive use of the internet. The State has consistently been able to prepare timely, high quality financial statements. FPE also make it possible to collect, maintain and generate the financial data necessary for this task. Some exceptions have been identified by TCE, but these have not been judged as material enough to impair the overall consistency and usefulness of the financial reports. 92. The mandate to audit the financial statements is vested by the Constitution in the TCE, which is largely able to carry out audits of a reasonable scope. Recently, it has been able to submit reports to the legislature in a timely manner. Recommended actions are usually implemented. 93. As a result of the above review, the Bank’s conclusion is that the PFM environment in State of Rio Grande do Sul is adequate to support the proposed operation. In addition, the Government’s development strategy and actions undertaken to implement reform actions are a satisfactory reflection of its commitment to improving the PFM environment. 94. The control environment governing the Central Bank’s operations within which the loan’s foreign exchange would flow continue to be adequate. This conclusion is based on reviews undertaken by both the IMF and the Bank. The IMF’s Safeguards Assessment of the Central Bank of Brazil concluded that it does not present any widespread vulnerability that could compromise the safeguarding of Fund 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 continued to be adequate. The Bank examined the audited Financial Statements for the years ended December 31, 2006 to 2012 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. 26 95. The proceeds of the loan will be disbursed against satisfactory implementation of the DPL program. Once the loan is effective, disbursements will be made by the Bank into an account maintained by the State in Banrisul, a commercial bank, deemed acceptable to the World Bank as it is: (a) financially sound; (b) authorized to maintain the account in the currency agreed between the World Bank and the State; (c) audited regularly, and has received satisfactory audit reports; (d) able to execute a large number of transactions promptly; (e) able to perform a wide range of banking services satisfactorily; (f) able to provide a detailed statement of the account; (g) part of a satisfactory correspondent banking network; and (h) charges reasonable fees for its services. The account will be denominated in foreign currency and will not form part of the foreign exchange reserves. However, the Central Bank will be informed of the deposit. The State will ensure that upon the deposit of the loan proceeds 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: (i) the loan proceeds were received into the foreign currency denominated account, and (ii) an equivalent amount was credited to the account that finances budgeted expenditures. Such a 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 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 required. 5.4. MONITORING AND EVALUATION 96. The preparation of this loan is being led by the Secretariat of Finance, which is also responsible for the coordination and monitoring of this operation. Given the reforms supported by this DPL, the operation will be executed by the following Secretariats: • Pillar I - Fiscal Management: (i) Secretariat of Finance (SEFAZ), (ii) Secretary of Administration and Human Resources (SARH), and (iii) Legal Counselor’s Office (PGE); • Pillar II - Irrigation and Water Resources Management: (i) Secretariat of Public Works and Irrigation (SOPE), (ii) Secretariat of Agriculture (SEAPA), and (iii) Secretariat of Environment (SEMA). 97. Monitoring and evaluation activities will rely heavily on existing indicators known to the client, thus, enhancing ownership and reducing the need to set up additional resources for tracking the results indicators for this operation. A manual will be developed together with the client before negotiations detailing the methodology and sources for all indicators. The implementing agency will be responsible for receiving and consolidating the information pertaining to all indicators. 6. SUMMARY OF RISKS AND MITIGATION 98. The main risks in this operation are of macroeconomic, environmental and developmental nature. However, none of these risk factors are considered to be major and thus are rated moderate. Aspects relating to other risk factors are judged to be low. 99. Macroeconomic Risks at the Country Level. In the last year, Brazil’s macroeconomic environment deteriorated due to weaker than expected growth, inflationary pressures, and the weakening of the Real. Nonetheless, levels of public debt remain sustainable and the existing reserves have allowed the Government to defend the exchange rate. The principal 27 macroeconomic risk is a prolonged stagnation of the economy which could lead to rising debt levels and would also affect the fiscal balance in Rio Grande do Sul. A more turbulent economic environment might reduce the resources available for the Government to pursue its efforts towards integrated water resources management. A mitigating measure to budget cuts on water resources is the existence of a dedicated fund. 100. The main environmental risk lies in the ability of the Government to effectively enforce environmental rules. Brazilian environmental legislation is considered to be advanced for middle income countries and safeguards the Bank’s concerns with the environmental impact of the operation; however, the lack of information for example on the hydrological balance and the insufficient staffing might prevent the State to achieve the operation’s objective within acceptable environmental parameters. The GoRS is putting in place several mitigating measures. It is hiring new permanent civil servants to the Secretariat of Environment, information gaps on water resources are being addressed through the commissioning of new hydrometereological stations and the development of a system to support the decision of granting water use rights. The Bank is also supporting this effort through the technical assistance component of the SWAP operation. 101. The developmental risk of the operation is more related to political economy factors. Rio Grande do Sul is a State with a tradition of not reelecting its governors, thus political cycles tend to be shorter and policies might be more easily reverted by the incoming administration. In order to mitigate the risk of policy reversal, the Bank is supporting policies that are framed under a national policy such as the costing policy and the PROGESTAO. In addition, the supported policies constitute very technical and specific reforms that are fully owned by the civil servants cadre in both Government agencies and thus are not likely to face setbacks during an eventual Government transition. 102. The overall risk of this operation is considered to be moderate. All major risks identified have adequate mitigating measures and the remaining risks are worth taking by the operation. 28 ANNEX 1: POLICY AND RESULTS MATRIX Prior Actions Results Pillar 1: Strengthening Fiscal Management Prior action #1: The GoRS has improved its assessment procedures for new • Percentage of tax expenditure measures under Government control tax expenditures. evaluated, according to the new procedures. Baseline (2012) = zero; Evidence: Service Order (Ordem de Serviço) No 005 from the Target (2015) = 25 Undersecretary of Revenue from March, 24th 2014 Prior action #2: The GoRS has established: (a) procedures to guide the • Increase the share of tax arrears recovered within 60 days of their recovery of tax arrears, reducing processing times and prioritizing cases with generation high values and high probability of recovery; and (b) criteria to measure Baseline (2012) = 20.8%; results of tax arrears recovery actions. Target (2015) = 27% Evidence: Directive (Portaria) No 55 from the Undersecretary of Revenue from December, 30th 2013 Prior action #3: The GoRS has mandated the use of price information from • Increase the share of goods procured, expressed as a percentage of the the electronic fiscal invoice database as a reference price to inform its total value of goods, using price information from the electronic fiscal procurement processes of goods. invoice database. Baseline (2012) = 0; Evidence: State Decree 51.200 from February, 7th 2014 Target (2015) = 25 Prior action #4: The GoRS has mandated all of its secretariats that have • Increase in the number of managerial cost reports prepared by implemented the Cost Policy and System for more than one year to prepare, Government agencies as part of their annual report, a managerial cost report. Baseline (2012) = 0; Target (2015) = 14 Evidence: Normative Instruction (Instrução Normativa) CAGE No 01 from March, 28th 2014. 29 Prior Actions Results Prior action #5: The GoRS has created a system to identify and estimate the • New policy instrument to manage contingent liabilities made effective fiscal risks created by contingent liabilities, and to prevent and mitigate their Baseline = No; fiscal impact. Target = Yes Evidence: State Decree 51.153 from January, 24th 2014. Pillar 2 – Irrigation and Water Resources Management Prior action #6: The GoRS has aligned its ‘More Water, More Income’ • Increase in the number of medium and small farmers that have adhered to Program with its Irrigation Policy and its Water Resources Policy. the ‘More Water, More Income’ Program Baseline (2012) = 217 (small landholders) and 57 (medium landholders); Target (2015) = 3,000 (small landholders) and 300 (medium landholders). Evidence: Law 14.244 from May, 24th 2013. Prior action #7: The GoRS has strengthened the institutional capacity of its • River basin plans completed, discussed and approved by the river basin Department of Water Resources through the approval of an enhanced staff committees, with the supervision and facilitation of the DRH team. organogram and the launch of a corresponding recruitment process. Baseline (2012) = 1; Target (2015) = 12 Evidence: Law 14.477 from January 23rd 2014 and decision included in file No. 010210-24.00/13-2 (Despacho do Governador), by the Governor for recruitment process from February, 7th 2014. Prior action #8: The GoRS adhered to the National Pact for Water • New hydro-meteorological stations installed in key river basins with Management, which establishes, inter alia, targets for improving the information analyzed by the State. Borrower’s legal and institutional framework for water resources; planning, Baseline (2012) = 0; information and decision support tools; and operational instruments, Target (2015) = 80 including water availability, water use rights, water pricing and drought preparedness plans; and signed an agreement with the Guarantor’s Water Agency committing to comply with specific water resource management targets in exchange of financial support. Evidence: State Decree No. 50.741/2013, dated October 14, 2013 and Contract 114/ANA/2013 signed in December 31st 2013 and published in the Federal Government Official Gazette in January, 15th 2014. 30 31 32 ANNEX 2: LETTER OF DEVELOPMENT POLICY 33 ESTADO DO RIO GRANDE DO SUL GABIN£TE DO GOVERNADOR OF.GG/S.n.JUAJ- 013 Porto Alegre, 21 de marco de 2014. CARTA DE POLiTICAS Ilustrissimo Senhor Dr. JIM YONG 10M MD. Presidente do Banco Intemacional para a Reconstru~llo e Desenvolvimento -BIRD Washington, D.C. Senhor Presidente: Ao cumprimenta-lo, cordialmente, come~o esta carta ressaltando o importante apoio que o Banco lntemacional para a Reconstrut;ao e Desenvolvimento - BIRD tern prestado a programas de refonna e modemiza~io da Administra~o Publica em toda a America Latina, auxiliando iniciativas que representem o fortalecimento das institui~oes e tragam beneficios diretos para os cidadaos. No conjunto de programas de desenvolvimento do Estado do Rio Grande do Sui ja apoiados com desembolsos realizados pelo BIRD, cumpre destacar o PNMRE - Programa de Restaura~lo e Manuten~o de Rodovias Estaduais (1997); o PRE - Programa de Reforma do Estado ( 1997); o Pro-Rural - Programa de Manejo dos Recursos Naturais e de Alfvio a Pobreza Rural (1997) e o Reestrutura~ao-RS, Programa de Reestrutura~ao da Divida e Sustentabilidade Fiscal para o Desenvolvimento (2008). Atualmente esta em fase de execu~lo, com financiamento do BIRD, o Proredes-RS - Programa de Retomada do Desenvolvimento do Rio Grande do Sul, que tem por finalidade apoiar o Executive Estadual do Rio Grande do Sui na implementa~ao de a~oes que ampliem a oferta e melhorem a qualidade e eficiencia de servi~os e bens publicos e consolidem os avan~os fiscais e macroeconomicos obtidos, com o objetivo de retomar o desenvolvimento do Estado, reduzindo as desigualdades regionais. Os resultados positivos obtidos nos programas acima mencionados recomendam a defini~!o do Banco Intemacional para a Reconstrut;ao e Desenvolvimento - BIRD como parceiro dessa nova opera~ao de credito vinculada ao Programa de Consolida~o do Equilibrio Fiscal para o Desenvolvimento do Estado do Rio Grande do Sul - PROCONFIS RS II - que se destina a implementar a~Cies estrategicas de gest!o e de apoio ao equilibrio fiscal, condit;~s essenciais para a sustentabilidade e competitividade, alem de um componente especifico para o fortalecimento da gest!o da area de recursos hfdricos. 34 ESTADO DO RIO GRANDE DO SUL GABINETE OD GOVI!RNADOR Nesse contexto, o Estado do Rio Grande do Sui, por meio de seu representante legal, o Govemador do Estado, vern solicitar ao Banco urn "Emprestimo baseado em Politicas de Desenvolvimento- Development Policy Loan- DPL", no valor de US$ 280 milhoes de dolares am.ericanos, a ser desembolsado em tranche (mica. A colabora~ao do Banco estani direcionada ao ajuste estrutural das contas estaduais visando aumentar a capacidade de investimento publico, especialmente em infraestrutura, propiciando maior competitividade, ao mesmo tempo em que buscaremos tambem a melhoria da gestio e qualidade dos investimentos publicos estaduais na area de recursos hidricos. As fortes varia~~es na produyilo agricola gaucha estiio relacionadas diretamente com os seus periodos de secas, cuja frequSncia, com maior ou menor intensidade, ocorre cinco vezes a cada dez anos. A seca mais recente, por exemplo, de 2011-2012, resultou numa reduy!o de 28% no desempenho do setor agricola, com perdas adicionais na industria de transfonnaylo, o que foi dctenninante para o desempenho negativo do PIB gaucho de 2012 da ordem de -1,8%. Alem disso, o govemo estadual distribuiu mais de R$ 160 milhoes nos Ultimos tres anos em programas para mitigar os impactos das secas, o que dificulta sobremaneira manter wn cenano fiscal sustentilvel. Com efeito, as a~es de politicas das duas grandes areas objeto deste DPL se completam, uma vez que o equilibria fiscal est& muito vinculado ao fortalecimento da gestao dos recursos hidricos, e, por outro lado, uma boa perfonnance fiscal gera mais recursos para investimentos diretos na area de recursos hidricos. Pode-se destacar ainda, que o fortalecimento da gestio e os investimentos nestas duas areas, pelas suas caracteristicas, geram retorno muito rapido ao Estado. Assim sendo, o Estado do Rio Grande do Sui concentrani esforyos na area fiscal, com a operacionaliza~o de a~oes de politicas para aumento da receita e redUI;Ilo do gasto publico. De outra parte, na area de aguas, as ~oes serilo voltadas, especialmente, para a melhoria da gest!o e qualifica~ao dos investimentos e no aumento do aporte de recursos nesta importante area, o que trara enonne retorno para o nosso Estado, em beneficia de nossa populayao. A seguir, exponho os antecedentes que motivaram esta solicita~ao, como tambem as refonnas estruturais previstas nessa operayao. I- Antecedentes Restri~l5es ao desenvolvimento do Estado do Rio Grande do Sui: 0 Rio Grande do Sui tern uma popula~llo de aproximadamente I0,6 milhoes de habitantes, segundo os dados preliminares do Censo 2010, representando 5,60% da populayao do Brasil. 0 Produto Intemo Bruto (PIB) do Estado foi de R$ 296,3 bilhOes, em 2012, representando 6,7%, do Pm nacional. 0 Rio Grande do Sui e a quarta economia do Brasil pelo tamanho de seu Produto lntemo Bruto (PIB), superado apenas pelos estados de Sao Paulo, Rio de Janeiro e Minas Gerais. 35 ~ ESTADO DO RIO GRANDE DO SUL GA81NETE DO GOV!IINADOR Nos Ultimos anos, o Rio Grande do Sul vern apresentando perda de espa.yo economico no cenano nacional. 0 Estado ocupa uma boa posi~o com referencia a diversos indicadores, mas nao tern conseguido crescer no mesmo nivel do pais, que consolida wn padrao novo de desenvolvimento economico e social. A economia gaucha vern apresentando sinais de perda de dinamismo. 0 baixo nfvel de investimentos publicos vern tornando mais dificil para o Estado capitalizar os projetos nacionais de acelera~o do desenvolvimento. Nesta ultima decada, a participa~o do PIB do Rio Grande do Sul no PIB do Brasil apresenta uma trajet6ria de redu~ilo. Em 2002, o Estado representou 7,1% do PIB nacional, chegou a representar 7,3% no ano seguinte e, em 2012, a participa~o foi de 6,7%. A infraestrutura existente permanece insuficiente para elevar a competitividade do Estado e necessita de investimentos publicos e privados para sua ampliatyao. 0 nivel de investimentos vern sofrendo wna redu~lo de participatyiio no o~amento estadual, impondo urn obstaculo ao crescimento economico, agravando as deficiencias na infraestrutura e prejudicando o potencial de crescimento da arrecadatylo tributaria. Registro novamente, a grande dependencia da economia gaucha do setor agropecuano, e, por consequ~ncia, neste contexto, da importAncia dos nossos recursos hidricos. Apesar dos eventos climaticos extremos, especialmente das estiagens, que se sucedem com muita frequencia, nas areas ditas de sequeiro, onde se cultiva na primavera- verio cerca de 5,6 milMes de hectares de soja, milho, fwno, feijAo e horticolas, etc., temos menos de 2% irrigados. 0 PIB do Rio Grande do Sul apresenta grande volatilidade ao Iongo do tempo, o que causa impactos negativos na economia e reduzindo o potencial de crescimento no longo prazo. A principal causa dessa oscila~ao e a ocorrencia frequente de estiagens que provocam grandes quebras na produ~o agricola, com reflexos no setor industrial e de servi~os. Portanto, queremos avantyar nesta area de aguas, com fortalecimento dos instrumentos de gestiio, das estruturas envolvidas, do planejamento, da capacita~io e em investimentos diretos. Aspectos rJScais: 0 Rio Grande do Sul, desde sua adesao ao Programs de Reestrutura~ilo e Ajuste Fiscal - PAF com o govemo federal, do advento cia Lei de Responsabilidade Fiscal - LRF e cia exitosa operatyao de reestrutura~o da Divicla Estadual com o BIRD, apresentou uma trajet6ria de melhora substancial nos seus indicadores fiscais. No entanto, a necessidade de reduzir o endividamento do estado, somado a outras restri~oes fiscais, fizeram com que os investimentos apresentassem uma trajet6ria decrescente de partici~io na execu~o Or98ffientaria do Estado. 0 nivel de investimentos alcan~ado pelo Rio Grande do Sul e signi ficativamente inferior aos obtidos na media 36 ESTADO DO RIO GRANDE DO SUL GABINETE DO GOVERNADOR nacional. Em 2009 (ultimo ano disponivel), segundo dados disponibilizados pela Secretaria do Tesouro Nacional (STN), o nivel de investimentos nacional, media dos estados federados, ficou em 15,1o/o da receita Hquida real, enquanto que no Rio Grande do Sui, este percentual foi de 3,83%. 0 engessamento das a~lSes do Estado em politicas de desenvolvimento, com a continua redu~io dos investimentos publicos, represents um obstaculo ao potencial de crescimento economico do Rio Grande do Sui no Iongo prazo, reduzindo a possibilidade de expans!o da base tributavel e consequentemente da fonte de receitas do Estado. D - Reformas Estruturais Associadas ao Programa 0 objetivo geral do PROCONFIS RS II e a consolida~io e sustentabilidade do equilibria fiscal do Estado no medio e Iongo prazo, por meio de medidas que apoiem o fortalecimento da gestilo fiscal, com aumento da receita pr6pria do Estado e da melhoria da qualidade do gasto, bem como o fortalecimento da gestio e do nivel de investimentos na area de aguas, permitindo assim ao Estado incrementar OS nfveis e a qualidade do investimento publico em beneficio de sua popula~io. Pretende-se estruturar o Programa em duas grandes areas, fiscal e de recursos hidricos, contendo, preliminarmente, em sfntese, as seguintes a~lSes. 1) Na area fascal: a) Estabelecimento de diretrizes para realizar avalia!j:Oes peri6dicas de novas despesas fiscais; b) Estabelecimento de diretrizes estrategicas para orientar a recupera-;ao de impostos atrasados; c) lnstitui~io de uma politica de utiliza-rao de informa~es da nota fiscal eletronica como referencia de ~os nos processos de aquisi~ao do Estado~ d) Implanta~o, de fonna gradativa, nos 6rgaos estaduais, de relat6rio de custos na sua pres~o de contas anual para as wridades que ja implementaram o sistema. e) Instituic;ao de uma politica para identificar, avaliar, prevenir e mitigar o impacto dos passivos contingentes. l) Na area de aguas: f) Cri~ao do Programa "Mais Agua, Mais Renda", facilitando o acesso ao credito e subsfdios para os pequenos agricultores e promovendo o uso de tecnicas de irrigac;io mais eficientes; g) Reestruturac;ao do Departamento de Recursos Hfdricos - DRH, da Secretaria do Meio Ambiente, com a cria~io de novas compet~ncias para os cargos de: agronomo, meteorologista, ge6logo, hidr6logo e biologo. Alem disto, devera ocorrer o lan~ento de concurso publico para recrutamento de pessoal para o DRH; h) Adesao ao "Pacto Nacional para a GestAo da Agua", que estabelece metas para melhorar a estrutura legal e institucional do Estado para os recursos hidricos, planejamento, informa~ao e ferramentas de apoio adecisao. 37 38 UNOFFICIAL TRANSLATION OF.GG/SJL/UAJ - 013 Porto Alegre, March 21, 2014. LETTER OF DEVELOPMENT POLICIES Your Excellency, Dr. Jim Yong Kim MD. President of the International Bank for Reconstruction and Development - IBRD Washington, D.C. Mr. President, I would like to cordially salute you and start this letter by emphasizing the significant support that the International Bank for Reconstruction and Development - IBRD has been providing for reform and modernization of Public Administration programs in Latin America by supporting initiatives, aimed at institutional strengthening and bringing direct benefit to citizens. With regards to development programs already supported by IBRD disbursements in the State of Rio Grande do Sul, the following should be noted PNMRE – Program for Renovation and Maintenance of State Highways (1997); PRE – Program for State Reforms (1997); Pro-Rural Program - Natural Resources Management and Rural Poverty Alleviation (1997) and the Debt Restructuring and Fiscal Sustainability Development Program (2008). The State is currently implementing the Proredes–RS – Rio Grande do Sul Development Resumption Program, which aims to support the Government of Rio Grande do Sul in implementing actions that will expand the supply, improve the quality and efficiency of public goods and services and consolidate fiscal and macroeconomic progress with an aim to resume State development and thus reduce regional inequalities. The positive results obtained in the above mentioned programs position the International Bank for Reconstruction and Development - IBRD as a partner for this new operation, linked to the Program for Consolidation of Fiscal Equilibrium for the Development of the State of Rio Grande do Sul - PROCONFIS RS II, which aims to implement strategic and fiscal management actions to support fiscal equilibrium jointly with a specific component for strengthening water resources management, which are essential conditions for sustainability and competitiveness. In this regard, the State of Rio Grande do Sul, through its legal representative, the Governor of the State, requests the Bank a "Development Policy Loan - DPL", in the value of US$280 million (U.S dollars) to be disbursed in a single tranche. The Bank’s collaboration is directed at the structural adjustment of the State accounts aimed at increasing public investment capacity, particularly in regards to infrastructure, providing greater competitiveness, while we also seek to improve the management and quality of State public investments in water resources. The strong variations in the State’s agricultural production are directly related to periods of drought, which occur with greater or lesser intensity, on average five times every ten years. The most recent drought from 2011-2012, resulted in a 28 percent reduction in production of the agricultural sector’s, with additional losses in the manufacturing industry, which played a determinant role for the state GDP growth of -1.8 percent in 2012. Furthermore, the Government has spent over R$160 million in the last three years on drought mitigation programs, which greatly undermines the maintenance of a sustainable fiscal scenario. Therefore, the policy actions of the two major policy areas of this DPL complement each other since fiscal equilibrium is closely linked to strengthening the management of water resources, and on the other hand, a good 39 fiscal performance generates more resources for direct investments in water resources management. It may be emphasized that due to their character, strengthening management and investments in these two areas, will result in a rapid gain for the State. In this regard, the State of Rio Grande do Sul will focus on the fiscal sector, particularly in the implementation of policy actions to increase revenue and reduce government spending. In the water sector, the actions are geared in particular towards improving management and qualification of investment and increasing the flow of resources in this fundamental field, which again will result in, a large return for the State and citizen benefit. In what follows, I lay out the reasons that motivated this request, as well as the structural reforms proposed for this operation. I – Background Restrictions on Rio Grande do Sul’s Development Rio Grande do Sul has a population of approximately 10.6 million, representing 5.6 percent of the Brazilian population, according to data from the 2010 census. The Gross Domestic Product (GDP) of the State was R$296.3 billion in 2012, representing 6.7 percent of the national GDP. Rio Grande do Sul is the fourth largest economy of Brazil, exceeded only by the States of São Paulo, Rio de Janeiro and Minas Gerais, in terms of GDP value. In recent years, Rio Grande do Sul has shown a reduction in economic space in the national scenario. The State is well ranked in reference to several indicators, but has not been able to grow at the same pace as the country, which currently consolidates a new pattern of economic and social development. The state economy has shown signs of lack of dynamism. The low level of public investment has made participation on national projects for accelerated development more difficult. In the last decade, Rio Grande do Sul’s GDP share in Brazil's GDP has showed a declining trajectory. In 2002, the State accounted for 7.1 percent of the national GDP, peaking at 7.3 percent the following year and in 2012, the share was 6.7 percent. The current infrastructure remains insufficient to increase State competitiveness and thus need public and private investments in order to be scaled up. Investment has suffered a reduction in State budget participation thus imposing an obstacle for economic growth, aggravating the weaknesses in infrastructure and hindering the potential growth of tax revenues. I hereby emphasize the State’s economy reliance on the agricultural sector and therefore, in this context, the importance of our water resources. Despite the extreme climate events, particularly droughts, which take place often in non-irrigated areas, wherein 5.6 million acres of soybeans, corn, tobacco, beans and vegetables are cultivated during spring-summer seasons, we have less than 2% of this area irrigated. Rio Grande do Sul’s GDP has showed high volatility throughout time, causing negative impacts on the economy and reducing long term potential growth. The main cause of this behavior is the frequent occurrence of droughts, causing major reductions in agricultural production and thus impacting the industrial and service sectors. Therefore, we would like to advance in the water sector through strengthening management instruments, planning structures, training and direct investments. Fiscal Aspects Since its adhesion to the Restructuring and Fiscal Adjustment Program - PAF with the Federal Government, the inception of the Fiscal Responsibility Law - LRF and the successful operation of the State Debt restructuring with IBRD, Rio Grande do Sul has exhibited an improving trend in its fiscal indicators. However, the need for State debt reduction, in conjunction with other fiscal constraints, resulted in a reduction in investments as a share of the state budget. The investment rate attained by Rio Grande do Sul is significantly 40 lower than those attained nationally. In 2009 (latest data available), according to data released by the National Treasury Secretariat (STN), the average investment rate of all states, was 15.1 percent of the Net Real Revenue, while in Rio Grande do Sul, this ratio was 3.83 percent. The rigidity faced by the Government in implemeting development policies actions, along with continued reductions in public investment, has been an obstacle for Rio Grande do Sul’s long run economic growth potential, therefore reducing, the possibility of expanding the tax base and consequently State revenue. II – Structural Reforms Associated to the Program The overall goal of PROCONFIS RS II is the consolidation and sustainability of the State’s fiscal equilibrium in the medium and long term, by strengthening fiscal management through supportive measures such as; an increase in the State’s own revenue, an improvement in the quality of expenditure and strengthening management and raising the level of investments in the water, thus allowing the State to increase its levels and quality of public investment for the benefit of its population. The program is structured in two major areas; fiscal and water resources, containing preliminarily, in summary, the following actions: 1) Fiscal area: a) Establishment of guidelines for conducting periodic reviews of new tax expenditures; b) Establishment of strategic guidelines to direct the recovery of tax arrears; c) Establishment of a policy for the use of information retrieved from the electronic fiscal invoice system as a price reference in the procurement processes of the State; d) A gradual implementation of costing reports in the State agencies annual statement of accounts for the agencies that have already implemented the system. e) Establishment of a policy to identify, assess, prevent and mitigate the impact of contingent liabilities. 2) Water sector: f) Creation of the "More Water, More Income" Program by facilitating access to credit and subsidies for small farmers and promoting the use of more efficient irrigation techniques; g) Restructuring of the Department of Water Resources – DRH of the Secretariat of the Environment, with the creation of new competencies for the positions of: agronomist, meteorologist, geologist, hydrologist and biologist. In addition to this, it is foreseen launch of a recruitment process for the DRH; h) Adhesion to the "National Pact for Water Management", which sets targets to improve the legal and institutional structure of the State for water resources, planning, information and tools to support decision. With the reforms supported by IBRD in these two areas, we seek to remove the barriers mentioned above: the constraints to investment and State development, resulting in substantial improvement in the fiscal situation, creating an opportunity for the State to achieve a new level of investments. Lastly, the State of Rio Grande do Sul, through its legal representative, reaffirms its commitment in favor of the Consolidation of the Fiscal Equilibrium Program of the State referred to in this letter, at the same time in which we thank the technical and financial support from the International Bank for Reconstruction and Development - IBRD - to be exerted by the requested loan and which would represent a valuable support for the sustainability of the implementation of the reforms in the state of Rio Grande do Sul, enabling its development and benefiting the population as a whole. Cordially Yours, TARSO GENRO Governor of State 41 ANNEX 3: FUND RELATIONS ANNEX A Satisfactory assessment letter from the Fund was received dated March 19, 2014. 42 ANNEX 4: ASSUMPTIONS FOR THE FISCAL AND DEBT SUSTAINABILITY ANALYSIS Assumptions Scenario 1 (Baseline) Scenario 2 (PLC 238) Scenario 3 (Worst Case) Revenues ICMS ICMS is assumed to grow with State GDP and inflation, ICMS revenues are kept flat with elasticity greater than 1 only in the short term. In in nominal terms from 2013 addition, energy prices are assumed to grow above inflation to 2015. After that, ICMS is in 2014 and fuel prices are assumed to be adjusted in the assumed to grow with State end of 2013. GDP and inflation. IPVA and others IPVA and others are assumed to grow with State GDP and inflation, except for IRRF (included in others), which is assumed to grow with payroll expenditures. Contributions Contributions is assumed to grow with payroll expenditures Capital Transfers Set at R$ 200 million yearly, except for 2014 in which the State expects to receive R$ 400 million FPE FPE grows according to Federal Government projections, but taking into account the gradual reduction in the State coefficient from 2.35 to 2.19, in accordance to the law enacted in 2013. Other Transfers Other transfers are assumed to grow with national GDP and inflation. Other current revenues They are assumed to grow with inflation and GDP, except for the interest revenue which grows only by inflation. Extraordinary revenues R$ 250 million in 2013 and R$ 300 million in 2014 are included due to a tax arrears amnesty program and a debentures issuance respectively Expenditures Payroll Payroll increases by 3 percent yearly plus the impact of the Same assumptions as in wage increases already passed into law. After that, they are previous scenarios plus assumed to grow with inflation, except for workers other increase in education payroll than education and security which from 2016 to 2018 by R$ 2.5 billion in 2014. would see its wage grow below inflation. Interest payment and debt Payments are obtained from debt sustainability analysis with loan amounts and cost of amortization loans provided by the State. Transfers to municipalities Increase in line with shared taxes (ICMS and IPVA) Goods and Services – Health expenditures are set to increase markedly in 2013 and 2014 in response to federally Health mandated expenditures and then increase in line with tax and transfers revenues as mandated by law Goods and Services - others This expenditures grows at 70% of inflation from 2013 to 2016 and then in line with inflation. Investments in non-financial Investments are expected to fall to 2 percent of NCR in 2015 and then grow gradually until assets reaching 4 percent of NCR. Investments in financial 2013 set at the average of the last two years and then increases with inflation and GDP assets New Loans New loans are set at a level to cover net borrowing and net amortization payments until 2020 and then new borrowing is kept constant. New loans are assumed to be contract with multilateral institutions (2/3) on average at Libor plus 1 percent spread and 1/3 with BNDES at TJLP plus 1.1 percent spread. Asset Sales Increases with inflation. 43