_l rin oR0 1r-Ym>kn D Za)o o c'a] /Agei0 Pr ILrr, Fii6 Q- * l tG 26101) - ] May 2003 , - .4 w _- - mmm-du~~, r,M*. tiu p4k I ,z, : , - .SII ~ THE WORLD BANK ~~~~ . An Economic and Social Editors A Vicente Fretes-Cibils en a da l Marcelo M. Giugale Jose Roberto L6pez-Calix e New Millennium T HE W OR L D B AN K WASH IN GTO N, DC Copyright (© 2003 The International Bank for Reconstruction and Development / THE WORLD BANK 1818 H Street, N.W Washington, D.C. 20433, USA All rights reserved Manufactured in the United States of America First printing May 2003 1 2 3 4 05 04 03 The findings, interpretations, and conclusions expressed in this paper are entirely those of dth authors and should not be attributed in any manner to the World Bank, to its affiliated organ- izations, or to members of its Board of Executive Directors or the countries they represent. The World Bank does not guarantee the accuracy of the data included in this publication and accepts no responsibility whatsoever for any consequence of their use. The boundaries, col- ors, denominations, and other information shown on any map in this volume do not imply on the part of the World Bank Group any judgment on the legal starts of any territory or the endorsement or acceptance of such boundarics. The material in this publication is copyrighted. Tlhe World Bank cneourages dissemina- tion of its work and will normally give permission to reprodluce portions of the work promptly. Permission to photocopy items for internal or personal use, for the internal or personal use of specific clients, or for educational classroom use is granted by the World Bank, provided that the appropriate fec is paid directly to the Copyright Clearance Center, Inc., 222 Rose- wood Drive, Danvers, Massachusetts 01923, USA; telephone 978-750-8400, fax 978-750- 4470. Please contact the Copyright Clcarance Center before photocopying items. For permission to reprint individual articles or chapters, please fax a rcquest with com- plete information to the Republication Department, Copyright Clcarance Center, fax 978- 750-4470. All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, World Bank, 1818 H Street NW, Washington, DC 20433, USA, fax 202-522-2422, e-mail pubrightsCa)worldbank.org. Cover design: Carol Levie Photograph: Ronald Jones Art: Duenos de /a Noche (1987) by Gonzalo Endara Crow ISBN 0-8213-5545-7 Libray of Congress Cataloging-in-Plublication Data has beea applied for. Contents Preface. xix Editor Biographies .......................................... xxi Acknowledgments .......................................... xxiii Acronyms and Abbreviations .................................. xxv Synthesis ............................................... xxxiii A. Purpose and Organization ................................... xxxiii B. Central Message .......................................... xxxiv C. The Development Agenda-Diagnostic Study and Policies .... ..... xxxviii Preserving Stability with Fiscal Discipline and Accelerating Growth with Competitiveness ............................ xxxix Tax Reform ............................................ xlii Spending Cuts, Reorientation, and Transparency ................ xliv Sustainability of Public Debt ............................... xlv Strengthening the Financial System .......................... xlvi The Oil Sector ........................................ xlviii Commercial Reform ..................................... xlix Development of Basic Infrastructure ........................... li Boosting Sustained and Equitable Social Development ............. iii Building a Quality Government That Serves All Ecuadorans and Fights against Corruption .................................. lx D. The Vision of a New Ecuador ................................. lxv Table 1. Ecuador: A Possible Order of Priorities in the Design and Implementation of Policies for Boosting Economic and Social Development ......... ........................ lxvi Part I Preserving Stability with Fiscal Discipline and Accelerating Growth with Competitiveness 1. Maintaining Stability with Fiscal Discipline and Competitiveness ..... 3 A. Background ............................................... 4 iii iv ECUADOR: AN ECONOMIC AND) SOCIAL AGENDA IN THE NEW MILLENNIUM B. Recent Macroeconomic Performance ............................. 7 C. The Challenges of Maintaining Stability ......................... 12 D. Policy Recommendations ............... .............. 27 E. Conclusion ............................. 34 Policy Matrix .... . ... ....... 37 Annex: Ecuador: Selected Economic Indicators . .40 Box 1. The Economic Transformation Law. 6 Box 2. The Law on Responsibility, Stabilization, and Fiscal Transparency .30 Box 3. Suggestions on a Draft of the Vetoed Law on Competition in Ecuador .35 Figure 1. Relationship between Fiscal Deficits (% GDP) and Inflation, 1980-2002. 5 Figure 2. Macroeconomic Indicators. 8 Figure 3. Credit to the Private Sector (growth rate, percent). 9 Figure 4. Ecuador's Urban Poverty, 1988-2001 .11 Figure 5. Percentage of Four Principal Goods as a Share of Total Exports ... 13 Figure 6. The Effect of Petroleum on the Economy .14 Figure 7. Distribution of Government Revenues (2001) .15 Figure 8. Total External Debt (% GDP) .17 Figure 9. Ecuador's Financial Risk .18 Figure 10. Ecuadoran Migration and Family Remittances ................ 20 Figure 11. Relationship between Productivity and Relative Prices of Tradable/Nontradable Goods ........ .................... 21 Figure 12. Real Bilateral Exchange Rate with the United States, Based on CPI and Unit Labor Costs (1994 = 100) ............. 21 Figure 13. Financial System Indicators ........ ..................... 24 Table 1. Volatility in Ecuador, 1990-2002 ....... ................. 12 Table 2. Index of Economic Freedom ........ .................... 26 Table 3. The Financial Gap of the Nonfinancial Public Sector .... ...... 28 2. Tax Policy and Administration .............................. 43 A. Background ........................ ..................... 44 B. The Three Primary Problems of the Tax Policy ...... ............... 46 The Problem of the Proliferation of Taxes ...... ................ 47 The Recurring Problem of Exemptions ....... ................. 48 The Problem of Preallocations ......... ..................... 52 C. Two Priority Problems for the Tax Administration ..... ............. 54 The Independence of thc SRI ......... ...................... 55 The Efforts of the CAE ............ ....................... 55 D. Recommendations . ........................................ 56 Tax Administration Recommendations ....... ................. 57 CONTENTS V Recommendation Matrix ............. ........................... 60 Annex .................................................. 62 Table 1. Total Income by the Nonfinancial Public Sector and the Central Government, 1995-2002 (expressed as a percentage of the GDP) ........................................ 44 Table 2. Some SRI Management Indicators ........................ 46 Table 3. The Structure of the Tax System ......................... 48 Table 4. Estimated Tax Cost of the Internal VAT Exemptions, 2001 (in millions of U.S. dollars) ................. 50 Table 5. Tax Cost of Exemptions on Customs Tariffs and on the VAT on . Imports, 2000 and 2001 (mlns $US) .51 Table 6. Preallocation Percentages of the ICE Tax Revenues .53 Summary Table of the Tax Revenue Effects of the Recommendations (in percentage of GDP) .58 Summary Table of the Orcler of Priorities of the Recommendations .... ..... 59 3. Debt Administration and Sustainability . . 65 A. Background .............................................. 66 B. Present Debt Structure ...................................... 67 C. Ecuador's Debt Reduction Plan ................ ................. 71 Debt Sustainability Analysis .. 74 D. Policy Recommendations .................................... 76 First Stage: Recouping Credibility . ........................... 77 Second Stage: Modernizing Debt Management . . 77 Recommendations for the Short Term . ........................ 79 Recommendations for the Medium Term . . 80 Policy Matrix .......................... 81 Annex: Public Debt Dynamics .82 Box 1. On Public Indebtedness in the Organic Law on Fiscal Responsibility, Stabilization, and Transparency .73 Box 2. Base Scenario Assumptions .75 Figure 1. Composition of Public Debt .67 Figure 2. External Debt .68 Figure 3. External Debt and Interest Payments by Creditor .69 Figure 4. External Debt by Debtor, 2002 .70 Figure 5. Public Domestic Debt (October 2002) .71 Figure 6. Debt Service for Current Debts, 2003-15 (mlns $US) .72 Table 1. Results of the Public Debt Sustainability Model .76 4. The Banking System ...................................... 85 A. The Postcrisis Financial System: Structure and Depth ...... .......... 86 The Structure of the Banking System ......... ................ 89 vi ECUADOR: AN ECONOMIC AND SOCLAl. AGENDA INTTII NFw MILLENNIUM B. Trends in Bank Balances, Solvency, and Yield ...................... 90 Balance Trends . . ........................................ 90 C. Strengthening Individual and System Risk Management ........... ... 99 Institutional Structure and Management of Cash Risk .......... ... 99 Strengthening Supervision and Regulation .................... 102 D. Issues in the Settlement of Payments and Securitiesl7 ..... ......... 102 E. The Financial Safety Net .................................... 105 F. Policy Recommendations . .................................. 107 Policy Matrix ......................................... 110 Figure 1. Total Bank Assets over GDP .88 Figure 2. Financing Lines Abroad (mlns $US) .96 Figure 3. Gross and Net Recovery Provision Expenditures (mlns $US) .98 Figure 4. "Onshore" Credit (percentage granted in $US) .99 Table 1. Number of Institutions in the Financial Systcm .87 Table 2. The Costs of Restructuring the Banking System (mlns $US) .89 Table 3. Number and Size of Institutions in the Financial Systcm in October 2002 .91 Table 4. Private Banks: Balance Sheet (thds $US and percentages of Total Assets) .93 Table 5. Private Banks: Profit and Loss Statement (thds $US) .95 Table 6. Private Banks: Financial Indicators .97 Table 7. Liquidity in the Banking System .100 5. Petroleum Policy ........................................ 115 A. The Evolution of the Petroleum Sector and I.egal Framework .... ..... 115 B. The Main Problems of the Petroleum Industry in lcuador ..... ...... 119 The Problem of VAT Reimbursement anid Contractual Stability ....... 120 Increasing Petroleum Production ........ ................... 121 Reserves .............................................. 124 General Subsidy for Liquid Petroleum ....... ................. 125 Price and Tax Policy, and Lack of Competitior in the Derivatives Market . ..................................... 125 Investments in Refining ........... ....................... 126 Administrative System for Petroleum Revenues ..... ............ 127 Legal and Institutional Framework .......................... 129 Environmental and Social Impact ........ ................... 130 C. Recommendations and Implementation ....... .................. 131 A Solution to the VAT Problem ........ .................... 131 Increasing the Production of PetroEcuador's Oil Fields ..... ....... 132 CONTENTS Vii Increasing Reserves ...................................... 132 Elimination of Indiscriminate Subsidies for Gas ..... ............ 133 New Price and Tax Policy ........... ...................... 134 Investment in Refin ing ............. ...................... 135 Improvements in the Administration of Petroleum Revenues .... ... 135 New Legal and Institutional Framework ...... ............... 136 Management of Environmental and Social Impact ..... .......... 137 Policy Matrix .................. ....................... 138 D. Economic Results ......................................... 141 Annex 1: Historic Evolution and Description of the Sector .144 Annex 2: Updated Study on Taxes and Subsidies for Derivatives .155 Annex 3: Economic Performance .158 Figure 1. National Petroleum Production and Consumption .123 Figure 2. Price of Products in Terminal (incl. VAT) .126 Figure 3. Petroleum Sector Support to the National Economy (projection through 2007) .142 Table 1. Importance of the Petroleum Sector to the Economy (bins/mlns $US) .116 Table 2. Projections for National Petroleum Production (Mins of bbl) .123 Table 3. Economic Results of Refining and Commercialization (thds $US) .128 Table 4. Petroleum Revenues Distribution Structure (Average 1995-2000) .128 Table 5. Indicators of the Petroproducci6n Affiliate .130 Table 6. Suggested and Current Prices for the Public .134 Table Al. Reserves through December 31, 2001 (Binslmins of bbl) .145 Table A2. Current Petroleum Production (BPD) ........ ............ 146 Table A3. Refining Capacity .149 Table A4. PerroEcuador's Economic Performance (blns/mlns $US) .151 Table A5. Central Government Oil Revenues Headings .152 Table A6. Oil Revenues Distribution Scheme .153 Table A7. Prices FOB US-GULF .155 Table A8. Calculation of Parity Prices for Derivatives ($US/gal.) .155 Table A9. Calculation of Efficiency Prices in Terminal ($US/gal.). 156 Table AIO. Tax Collection: Calculation of Taxes or Current Subsidies ($US/gal.) .156 Table Al 1. Public Efficiency Prices: Calculation of Terminal Prices Eliminating Subsidies Applying VAT and Suggested Consumption Tax ($US/gal.) .157 viii EcUADOR: AN ECONOMIC AND SociAL AGENDA IN THE NEW MILLENNIUM Table Al2. Comparison of Consumer Price Changes ($US/gaQ) .......... 157 Table A13. Estimated Production of Private Companies (BPD) .... ...... 159 Table A14. Production Scenarios (Thds of bbl) ...... ................ 160 Table Al5. State Crude Exports (Thds of bbl) .............. ........ 160 Table A16. Petroleum Sector Support for the Treasury (blns/mlns $US) . .................................... 161 Table A17. Price Sensitivity of Treasury Support (blns $US) ............. 161 Table Al 8. Capitalization of FEIREP ........ ..................... 162 6. Trade Policy and Competition ..............................1 63 A. Precedents ............................................. 164 Liberalization of the Ecuadoran Economy in the 1990s .... ....... 164 B. The Foundations of Ecuadoran Development ...... .............. 168 Recommendations ...................................... 169 Other Recommendations ........... ...................... 175 C. Price Bands ............................................ 177 Recommendations ...................................... l81 D. Technical Regulations . ..................................... 183 A Lack of "Domestic Treatment" . ........................... 183 INEN and WTO Regulations .......... ................... 183 Recommendations ................ ..................... 185 Policy Matrix ............................................ 187 Annex I ................................................ 189 Annex 2 ................................................ 191 Figure 1. Ecuador Trade Composition .165 Figure 2. Evolution of the Effective Rate of Ad Valorem (VAT or TariffJCIF Imports) .166 Figure 3. Percentage of Trade Requiring Prior Authorization .173 Figure Al. Soya Oil .192 Figure A2. Powdered Milk .193 Figure A3. Palm Oil .194 Table 1. Licenses Issued by Institutions .172 Table 2. Variability in Ecuadoran Benchmark Prices, 1998-2001 . 179 Table 3. Types of Ecuadoran Technical Regulations (to October 4, 2001) ........ ................. 184 7. Basic Infrastructure: Water and Sanitation, Electricity, Telecommunications, and Trasport ......................... a95 A. Introduction ................................... 196 Description of the Sectors ................................ 197 B. Diagnosis of the Main Problems and Challenges ...... ............ 204 Water Supply and Sanitation Sector ......... ................ 204 CONTENTS IX Management of Water Resources ....... .................... 213 Energy Sector ......................................... 214 Telecommunications Sector ........ ....................... 219 Transport Sector ........................................ 225 Highway Safety ........................................ 229 C. Sectoral Policy Recommendations ............................. 230 Water Supply and Sanitation Sector ...... ................... 231 Energy Sector ......................................... 235 Telecommunications Sector ........ ....................... 237 Transport Sector . ........................................ 239 Community Infrastructure ........ ........................ 240 Sectoral Action Plan .......................................... 244 Box 1. Stormwater Drainage-A User Surcharge for Improvements in the Context of a Concession Contract ..... .............. 234 Figure 1. Water Supply and Sanitation Coverage in Latin America (in percentage, compared with per capita GDP) ............... 205 Figure 2. Access to Potable Water Supply by Income Level ..... ......... 207 Figure 3. In-home Water Treatment by Income ...................... 208 Figure 4. Aggregate Income and Costs of Water and Sanitation Services ... . 210 Figure 5. Percentage of the Population with Fixed Telephone Line (2001) . 220 Figure 6. Percentage of the Population with Cellular Phones (2001) ....... 220 Figure 7. Competition in the Cellular Phone Market (Sept. 2002) ........ 223 Figure 8. Average Cost per Minute: Cellular Prepayment Plan (Nov. 2002) ......................................... 224 Table 1. Institutions Related to the Water and Sanitation Sector .... ..... 198 Table 2. Water and Sanitation Service Providers (SPs) ................ 198 Table 3. Comparison of Selected Electricity Sectors in Latin America and the Caribbean .................................... 200 Table 4. Coverage of Potable Water and Sewage Services, 1999 (percent) . . 206 Table 5. Operational Efficiency of Water Utilities in Large and Medium-Size Cities .209 Table 6. Distribution of the Telephone Tax and Municipal Expenditure on Water and Sanitation ($US/inhabitant in 2001) .211 Table 7. Machala: Monthly Expenditure on Water Supply and Sanitation Services-Families with and without Home Connection .212 Table 8. Main Characteristics of Distribution Companies in 2001. 215 Table 9. Characteristics of the Ecuadoran Road System by Regions . 226 8. Urban Development ............................. 251 A. Diagnostic Study ......... .................... 252 Urbanization ............................. 252 Land and Housing in Urban Areas .......................... 254 Urban Services ............................. 256 X ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLrNNIUM Economic Vulnerability and Vulnerability to Natural Disasters ...... 259 B. Recommendations .................. ..................... 260 Policy Matrix ............................................... 262 Figure 1. Urbanization in Ecuador in Comparison with Latin America ..... 252 Figure 2. Urban Poverty in Ecuador, 1995-99 .254 Table 1. Percentagc of the Population without Formal Property Titles (1998) .254 Table 2. Housing Ownership Rates in Ecuador and in Other Countries .255 'I'able 3. Effects of the Subsidy on Purchasing Power for Housing .256 Table 4. Housing Conditions in Urban Areas of Ecuador (1998) (percent) .257 Table 5. Access to Water, Sanitation, and Trash Collection in Urban Areas of Ecuador (1998) (percent) .257 Table 6. Tariff and Operation Costs for Water Companies in Ecuador, 2001 (millions of dollars) .258 PiatE RR BoE$tl¶g ES$tnEasib and DEqutabke $cigl dDevelopmenit 9. Education .......................................... 265 A. Introduction ............................................. 266 B. The Educational Systcm: Principal Problems ..... ................ 266 Limited and Unequal Access to Education ..... ............... 271 L.ow Quality of the Education Imparted ..... ................. 275 Serious Difficulties for Financing Education ..... .............. 277 Problems in Sector Administration ...... .................... 279 C. Recommendations . ....................................... 281 Policy Matrix ............................................... 283 Annex ................................................ 286 Box 1. Ecuador's Institutional Framework for the Fducation Sector ..... 267 Box 2. Government Strategies and Initiatives ...... ................ 269 Figure 1: Net Enrollment Rates, by Consumption Quintiles and by Educational Levels ......... ......................... 272 Figure 2. Public Spending on Education by Consumption Quintile ....... 275 Figure 3. Quality of Schools, Based on the Opinion of the Business Sector ....................................... 276 Figure 4. Spending on Education as a Percentage of the GDP in Ecuador and in Latin America and the Caribbean, 1980 to 2001 ........................................ 278 CONTENTS Xl 10. Health ............................................... 293 A. Introduction . ............................................ 294 B. Ecuadoran Health: Characteristics and Diagnosis ..... ............. 297 Problems with Record Keeping and Premature Mortality from Preventable Causes ........... ........................... 297 High Infant Mortality Rates ........ ....................... 299 High Prevalence of Risk Factors for Infant Mortality .... .......... 300 High Maternal Mortality Rates ....... ...................... 301 C. Problems in the Health Services System ...... ................... 301 Background ........................................... 302 Fragmentary Organization and Underutilized Resources .... ...... 303 Insufficient Government Spending and Inequitable Private Spending on Health .......... ........................... 304 Nontransparent Financing ................................ 305 Limited Health Insurance Coverage ...... ................... 306 Inadequate Performance of the Essential Functions of the Ministry of Public Health, Shortfalls of the IESS, and Difficulties in Achieving the Millennium Development Goals ..... ............ 308 Limitations of the IESS Health Area ...... .................. 309 Difficulties in Achieving Millennium Development Goals .... ..... 310 D. Recommendations ........................................ 312 Extension of Access to Basic Services ...... ................... 313 Decentralization for a Better Supply of Health Services .... ....... 314 Sectorial Coordination and the Future for the Ministry of Public Health and the IESS ....... ........................ 315 Policy Matrix ............................................... 317 Box 1. Organization of the Health Sector ...... .................. 303 Figure 1. Relationship between Income and Life Expectancy, 2000 .... .... 295 Figure 2. Correlation between Life Expectancy and Household Consumption, 1999 ...... .................... 296 Figure 3. Mortality by Types of Causes, 1999 ........................ 298 Figure 4. Incidence of AIDS by Sex, 1990 to 2000 .................... 299 Figure 5. Percentage of Income used for Out-of-Pocket Health Expenses, by deciles, 1998 ........... ........................... 306 Figure 6. Mortality in Children under Five Years of Age ..... ........... 312 Figure 7. Maternal Mortality .................................... 312 11. The Social Assistance System ............................... 319 A. Introduction ............................................. 320 B. Principal Features of the Social Assistance System ..... ............. 321 C. Supply and Demand for Social Assistance ...... ................. 322 Vulnerable Groups ........... ........................... 322 xii ECUADOR: AN ECONOMIC AND SOciAL AGENDA IN THE NEW MILLENNIUM Social Risk Management Strategies ...... .................... 329 D. Problems of the Social Assistance System ...... .................. 331 E. Recommendations . ....................................... 336 Increase the Flexibility of the Social Assistance System .... ........ 337 Improve Coordination and Targeting in Existing Programs .... .... 337 Reorient the Bono Solidario Cash Subsidy Program toward Becoming a Program of Conditioned Subsidies ..... ............ 339 F Conclusions .341 Policy Matrix ............................................... 342 Annex: Incidence of Social Assistance Programs (Selected) .... ........ 345 Figure 1. Concentration Curves for Some Social Assistance Programs ...... 333 Table 1. Selected Features of the Social Assistance System's Priority Programs for 2000-01 ........ ......................... 323 Tablc 2. Outstanding Features of the Most Significant Social Assistance Programs . .......................................... 324 Table 3. Targeting of the Bono Solidario Cash Subsidy Program (Individual Beneficiaries) ....... ........................ 335 12. The Pension System .......... ........................... 347 A. System Diagnostic . ....................................... 348 The Institutional Organization of Ecuador's Pension System .... ... 348 Structure of the Pension System Prior to the Reform .... ......... 349 Financial Situation .......... ............................ 351 The Level of the Benefits ........ ......................... 353 Coverage .............................................. 354 The Reform . .......................................... 357 B. Proposed Solutions . ........................................ 358 Problems of Covcrage, in Terms of Broadness and Depth .... ...... 359 The Financial Management of the IESS ..... ................. 362 Partial Implementation of the Reform of the Social Security System . ....................................... 363 Policy Matrix ............................................... 365 Figure 1. Financial Trends in the IESS (as a perccntage of GDP, 1993-2002) ..... ................. 352 Figure 2. Financial Trends: Insurance for Disability, Old Age, and Death (as a percentage of GDP, 1993-2002) ..... ................. 352 Figure 3. Average Benefit per Month per Person, in Dollars, Insurance for Disability, Old Age, and Death: Rural People's Social Security Program; and the Bono Solidario Cash Subsidy 1995-2002 ......................................... 354 CONTENTS xiii Figure 4. Percentage of the Labor Force Participating in Contributive Pension Programs in South Arnerica in and about the Year 2000 ................................... 355 Figure 5. Participation of Active Workers in Ecuador's Pension Systems (as a percentage of the economically active population in each program and in the system as a whole, 1965-2002) ........... . 356 Figure 6. Coverage of Pension Systems with Respect to the Population Age 55 and Older (by age group and in total, 2002) ..... . 356 Table 1. Cost of Increasing Coverage or Benefits under Rural Social Security and under the Bono Solidario Cash Subsidy Program for the Elderly (absolute values and as percentage of GDP) . 361 13. Rural Development .369 A. Introduction ............................................ 370 B. Three Strategic Goals for Rural Development ..... ............... 374 C. Key Issues in Rural Development in Ecuador . 376 D. The Institutional Framework of Rural Development .. ....... 383 E. Conclusions and Recommendations ........................... 384 Recommendations ................ 385 Policy Matrix ............................... ....... .. 388 Figure 1. Yield per Hectare in 2002 (tons) . ................ 372 Figure 2. Agricultural GDP/Total GDP ........ . 372 Figure 3. Producer Price Index ..................... 373 Table 1. Ecuador's Agricultural Trade Balance with Colombia and Peru ........................................ 373 Table 2. Illiteracy Rates, 1999 (percentage of population over age 15) ..... .......... ....... ...... 377 14. The Environment and Sustainable Development .393 A. Introduction ............................................. 394 B. Poverty and the Environment ................................ 394 Environmental Pollution ................................. 396 Natural Disasters .................................. .. 397 C. Sustainable Development ................................... 399 Comprehensive Resource Planning and Management ...... . 400 Natural Resource Management and Economic Growth ........... 401 D. Recommendations ........................................ 404 Environmental Regulation .... ....... ....... .... 404 Environmental Investment ................ .... .... 407 Box 1. Environmental Policy and Management . .403 xiv ECtJADOR: AŽN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Figure 1. Poverty Decilcs in Ecuador's Cantons ...... ................ 395 Figure 2. GDP and Natural Disasters .............................. 398 Figure 3. Soil Use Conflicts ..................................... 406 IPart HHH 1 I3d:g a C ' ,Govemment That Serves AU Ecuadorans a1 IFR~ts againtst Corrsuption 15. The Envirnmen-, and Governance and Corruption .............. 411 A. Governance in Ecuador from a Comparative International Perspective . . 412 B. Corruption and Its Impact . . ................................ 414 The Cost of Corruption ................................. 415 C. Local Government and Decentralization ........... ............. 427 D. Institutional Vulnerability ................................... 430 E. Recommendations ........................................ 432 The Climate for Reforms .......... ....................... 433 Openness, Transparency, and Accountability in Society .... ....... 433 Imperatives for Public Administration ...... .................. 434 A Broad and Inclusive Approach ........ .................... 435 Policy Matrix ............................................. 437 Annex: Governance in Ecuador: Citizens and Public Employees Give Their Opinions ........... ....................... 438 Figure 1. Government Effectiveness (Latin America and the Caribbean Region, 2000-01) .......... .................. 413 Figure 2. The Rule of Law (Latin America and the Caribbean Region, 2000-01) ........................... 414 Figure 3. Control of Corruption (Latin America and the Caribbean Region, 2000-01) ............ ................ 415 Figure 4. Changes 1997-98 and 2000-01 .......... ................ 416 Figure 5. Opinion of Companies on Obstacles to the Development of Their Business ................................... 417 Figure 6. Corruption as a Regressive Tax on Users ....... ............. 418 Figure 7. How Conm-non Is Payment of Bribes to Public Employees? ................................... 422 Figure 8. How Common Is Corruption? (by region) ................... 422 Figure 9. Perception of Honesty ................................. 423 Figure 10. Forms of Corruption .................................. 424 Figure 11. Experience with Corruption . ............................ 425 Figure 12. The Impact of Being Victimized by Corruption (on support for the system) ................................... 426 Figure 13. Evaluation of Municipal Services .......................... 428 Figure 14. Satisfaction with Municipal Services and Locality .............. 429 CONTENTS XV Figure 15. Comparative Attendance at Municipal Meetings and Open Town Councils .......... ........................ 429 Figure 16. Who Responds Better to Local Problems (by locality) .... ...... 430 Figure 17. Willingness to Pay More Municipal Taxes: International Comparison ............................... 431 Figure Al. Pride in the Ecuadorian Political System vs. Pride in Being Ecuadoran ........... ........................ 439 Figure A2. Comparative Support for the System ...... ................ 440 Figure A3. Support for Institutions ......... ....................... 441 Figure A4. Approval of Conventional or Aggressive Forms of ............... Political Participation .......... ........................ 442 Figure A5. Professional Participation and Fear of Crime ..... ............ 443 Figure A6. Participation in a Parents' Committee and Support for the System .............. ......................... 443 Table 1. Frequency and Amount of Bribes (According to Citizens) ...... 420 Table 2. Frequency and Amount of Bribes (According to Companies) ..... 421 Table 3. The Most Serious Problem Faced by the Municipality (by Region) . ......................................... 428 16. The Labor Market and Civil Service in Ecuador ................ 445 A. Introduction .............................................. 446 B. The Labor Market in Ecuador ......... ....................... 447 Employment and Unemployment ....... .................... 447 Labor Income and Salaries ......... ....................... 449 C. Problems in the Private Market ......... ...................... 452 Setting Salaries, Salary Unification, and Incentives for Creating Formal Jobs .......... ......................... 452 Outsourcing and Flexibility in the Labor Market: ..... ........... 454 D. Recommendations for the Private Labor Market ..... .............. 455 Recommendations for Setting Salaries ...... .................. 455 Recommendations on Labor Market Flexibility ..... ............ 456 E. Civil Service in Ecuador ........... ......................... 456 Number of Personnel ........... ......................... 456 Policy Matrix for the Private Labor Market ...... .............. 457 Public Employee Systems in Ecuador ...... .................. 459 Public Sector Salary Expenses ........ ...................... 460 Human Resources Management ....... ..................... 460 Salary Policy . ......................................... 461 F. Principal Problems .463 G. Recommendations ........................................ 466 Recommendations on Salary Reform ........ ................. 466 Recommendations on Human Resources Management and SENDOSEP ...................................... 467 xvi ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Policy Matrix .................. .................... 468 Technical Annex: Detcrmining Real Salaries in Ecuador, 1998-2001 .......................... 469 Annex 1: Civil Service and Administrative Career, Salary Schedules, 1997-2002 .472 Annex 2: Budgetary Classification of Expenditures .474 Annex 3: Basic Salary Schedule for Public Employment Governments, 2002 ......... ....................... 476 Table 1. Active Work Force, Employment and Unemployment in Urban Areas, 1998-2001 ......... ...................... 447 Table 2. Underemployment and Informal Employment in Urban Areas, 1998-2001 (as percentages of employed people) ..... ......... 448 Table 3. Growth of Urban Employment by Sector, 1998-2001 (percentage changes) ............ 448 Table 4. Real Monthly Labor Income in Urban Areas, 1998-2001 (at constant 1998 $US values) .449 'Fable 5. Monthly Labor Income in Urban Areas According to Employment Situation, 1998-2001 (in constant 1998 $US values) .450 Table 6. Labor Income, Average and Minimum Salary in the Private Sector in Urban Areas, 1998-2001 .451 Table 7. Public Employees of Ecuador and Other Selected Countries . 458 Table 8. Number of Government Jobs under the Public Employees System, 2002 .459 Table 9. Personnel Expenses by Type in Five Ministries and Departments, 2002 .462 Table Al. Price Index and Exchange Rate Series ..... ................. 469 Table A2. Monthly Labor Income in Urban Areas, 1998-2001 (at constant 1998 $US values) ....... .................... 469 Table A3. Monthly Labor Income in Urban Areas by Employment Situation, 1998-2001 (at constant 1998 $US values) .... ...... 470 Table A4. Labor Income and Basic and Average Salaries in the Private Sector in Urban Areas, 1998-2001 ...... .................. 471 17. Decentrzantinn ........................................ 479 A. The Principal Problem and the Challenges of Decentralization .... .... 480 B. Diagnosis ............................................... 482 Structure of the State and Intergovernmental Relations .... ....... 482 Administrative Decentralization: Transfer of Powers .... .......... 485 Fiscal Decentralization: Transfer of Resources ..... ............. 487 Management of the Decentralization Process ..... .............. 493 C. Policy Recommendations .......... ......................... 494 CONTENTS Xvii Structure of the State and Intergovernmental Relations . .......... 494 Administrative Decentralization: Transfer of Powers ..... ......... 495 Fiscal Decentralization ................................... 497 Management of the Decentralization Process ................... 501 Policy Matrix ............ ........................ 503 Annex: Special Laws Governing the Transfer of Resources and Revenue-Sharing for the Benefit of Municipalities and Provincial Councils ................................... 509 Figure 1. Subrogation of External Debt (1998) .489 Figure 2. Per Capita Resources Received, by Province (in $US, 1998) . 491 18. The Administration of Justice .............................. 515 A. Persistent Problems ........................................ 516 Lack of Access ... . . .................. 516 Costs ................ 516 Legal Assistance ........................................ 518 Functionality .......................................... 518 Lack of Confidence in the System ........................... 518 B. Recommendations ...... .................................. 522 Legal Reform ................................... .. 522 C. Conclusions ..................... 525 Policy Matrix ............................................ 526 Annex 1: Reforms of the System ................... ........... 530 Annex 2: Institutions ......................... 533 Table 1. Civil Cases Filed in Ecuador's Courts . .516 Table 2. Spending on Justice as a Percentage of the State Budget ......... 517 Table 3. Per Capita Judicial Budget in the Andean Region . .......... 517 Table 4. Breakdown of Spending (2001) . .518 Table 5. Duration of Ordinary Cases (Quito) . ............... 521 Table 6. Cases Completed Compared to Those Entering the System in Pilot Courts (percent) ............................... 522 Bibliography .......................... 535 Preface Ecuador is at a crossroads as it enters the new millennium. Political, economic, and social instability have long affected this country's path of development. Though it is rich in cultural traditions and natural endowments, the stop-go cycles of past pub- lic policies have prevented the country from fully utilizing its potential for economic prosperity and social equity. The newly inaugurated administration has the oppor- tunity to break with the past by defining a development agenda that is based on a shared vision. In this agenda, stability, growth, competitiveness, social development, decentralization, and anticorruption efforts would constitute the mileposts along a road benefiting all Ecuadorans. We at the World Bank feel honored by the authori- ties' invitation to publish this compendium of policy notes for Ecuador that we have prepared and which, from an independent point of view, provides an account of Ecuador's current development challenges, many of the reasons behind those chal- lenges, and some options to overcome them. The analysis here does not claim to provide definitive solutions to all of Ecuador's challenges. Rather, we hope that this volume can enrich the national debate among Ecuadorans as they search for their own solutions to these challenges. The work presented here is organized around three overarching themes: Fiscal Consolidation and Growth, Social Development, and Quality of Government. The main messages within each of these themes are captured in their respective Thematic Chapters, and summarized and brought together in an opening Synthesis. The importance of these three broad themes has become increasingly evident all around the world during the last decade, and has been accentuated by globalization (finan- cial and commercial) and by the information technology revolution. Understanding those forces is critically important because, in the end, their value will be measured by one simple yardstick-their impact on people's quality of life, especially among the poor. Any government operating under these conditions would confront the need for difficult reforms. For Ecuador, the twin-banking and currency-crises that led to dollarization make reform even harder. Current regional and international condi- tions do not facilitate matters, and are unlikely to do so in the near future. The financial crisis in the Southern Cone restricts access to external funding, and sagging global growth is dampening Ecuador's exports. The country is also beginning to feel the impact of the illegal drug trade. Finally, the reforms necessary to consolidate dol- larization are still only half completed. Yet, inaction brings higher costs than action. xix xx ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Without strengthened reform, the Ecuadoran economy risks spiraling into a cycle of recession and increasing poverty. The new government has expressed its determination to address, head on, the challenge of reforms. In the few months since taking office, the administration has rallied early support for some major changes in policy direction in the fiscal, struc- tural, and social areas. We at the World Bank stand ready to support those efforts. We view this as central to our institution's mission of poverty reduction and to our commitment to see Ecuador succeed. This book is the product of the analytical work of a large number of World Bank staff members. It documents Ecuador's main development trends, policies, and options, and places the country in the context of relevant international com- parisons. Extensive dialogue, reflection, and direct operational work widt our coun- terparts in the Ecuadoran government and elsewhere are detailed in this volume, which spells out critical lessons and challenges that are relevant for Ecuador and for Latin America as a whole. Finally, the book proposes policy matrices for each sector and topic, including a proposed sequencing of policy steps. I am extremely grateful for the cooperation and contributions of our many friends in Ecuador to this very important endeavor, both directly and through sev- eral years of working side by side with us. I would like to thank the staff members who have compiled this book-editors, authors, and producers. Their work reveals not only their professional talents, but also, and more importantly, their passion for poverty reduction. Finally, I wish to express our gratitude to the Ecuadoran authorities for giving us the privilege of being partners in their country's quest for development. David De Ferranti Vice President Latin America and the Caribbean Regional Office Washington, D.C. March 7, 2003 Editor Biographies VICENTE FRETES-CIBILS, a native of Argentina, completed his undergraduate work at the Universidad Nacional del Nordeste, in Argentina, and subsequently pursued postgraduate studies at the University of Pennsylvania and North Carolina State University, where he received, respectively, a master's degree in Business Adminis- tration and a Ph.D. in Economics. Following his university studies, he joined the World Bank in 1987 through the latter's Young Professionals Program. Following stints in the Bank's Office of the Vice-President for Europe and the Middle East and its Treasury Department, he served from 1988 to 1992 as Economist in the Office of the Vice-President for West Africa Operations. Subsequently, from 1992 to 1996, he served as Chief Economist in the Department of Operations for Andean Coun- tries, supervising adjustment programs and heading up economic and analytical missions to Bolivia. From 1996 to 2002, Mr. Fretes-Cibils served as Senior Econo- mist for Venezuela, and subsequently for Colombia and Mexico. He is currently Lead Economist in the Poverty Reduction and Economic Management Sector for the subregion of countries that includes Bolivia, Ecuador, Peru, and Venezuela. Additionally, he has taught at Argentina's Universidad Nacional del Nordeste and at North Carolina State University, and has published numerous works addressing top- ics in the areas of finance, applied econometrics, public finance, international eco- nomics, and economic development. MARCELO M. GiUGALE, of Argentine/Italian nationality, obtained his Ph.D. and M.Sc. in Economics from the London School of Economics and his bachelor's degree in Economics from Argentina's Universidad Catolica. Upon completion of his university studies, Mr. Giugale joined the Word Bank in 1989 as an Economist in the Department of Financial Research. From 1990 to 1994, he served as Chief Economist in the Office of the Vice-President for Middle Eastern Operations, supervising structural adjustment programs in Egypt and directing the Bank's post- war reconstruction effort in Lebanon. From 1994 to 1998, Mr. Giugale served as Chief Economist for the Eastern Europe and Central Asia regions, where he was responsible for the Bank's loan portfolio as well as for economic analysis work involving Lithuania and Kazakhstan. From September 1998 to October 2002, he occupied the post of Lead Economist for the Colombia, Mexico, and Venezuela Department. He is currently Subregional Director for the Andean countries of Bolivia, Ecuador, Peru, and Venezuela. In addition, he has lectured at the London xxi XXii ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN ThE NEW MILLENNIUM School of Economics and at the American University in Cairo, and has also pub- lished widely on applied econometrics, finance, business economics, and economic development. Josi ROBERTO LOPEZ-CALX, a native of El Salvador, is Senior Economist in the Economic Policy Group for the World Bank's Latin America and the Caribbean Region. Mr. L6pez-Calix obtained his Ph.D., M.Sc., and bachelor's degrees from the Catholic University in Louvain, Belgium, and an M.Sc. degree with a major in International Finance from the University of Pittsburgh. He began his professional career by working in a number of international organizations, including the United Status Agency for International Development, the Canadian International Develop- ment Agency, the United States Congress, and the Inter-Americanl Development Bank, specializing in macroeconomic policy, econometric analysis, public finance, international migration, and foreign debt management. From 1989 to 1991, Mr. L6pez-Calix served as General Director for the Ministry of Planning's Economic and Social Advisory Group with responsibility for El Salvador's special budget, and in this capacity was a member of the team that designed and implemented structural adjustment policies to govern the transition between the pre- and postwar periods. In 1994, he joined the World Bank in Washington, D.C., where he worked in the Department of Central American Operations. Two years later, he was named Man- ager of the Bank's Office in Guatemala. In 1999, together with Guatemala's Inte- grated Financial Management Project Team, he was awarded the prestigious "Presi- dent James D. Wolfensohn Award." In 2000, he returned to Washington, D.C., and since that time has worked primarily with the Department for Ecuador, Bolivia, Peru, and Venezuela. Mr. L6pez-Calix has been a Visiting Professor at Florida Inter- national University in Miami and has published numerous books and articles on specialized subjects, induding parallel exchange markets, international coordination in macroeconomic policy, public finance, public expenditure monitoring surveys, trade policy and free trade agreements, and family remittanccs. Acknowledgments This volume is the result of a team effort and, as such, it has benefited from an array of invaluable contributions. Our thanks are therefore due to a large number of peo- ple. First, the chapters' authors, for not only providing material of outstanding tech- nical quality, but also for their remarkable effort, even working in record time dur- ing New Year's and Christmas holidays, and thus enriching the Ecuador debate at a crucial time. We consider ourselves fortunate to share this book with these principal authors-Gabriela Arcos, Marcelo Bortman, Robert Buergenthal, Maria Dakolias, Maria Donoso-Clark, Franz Drees, Daniel Dulitzky, Philippe Durand, Jonas Frank, Mario Guadamillas, Dominique Hachette, Anthony James, Emmanuel James, Gio- vanni Majnoni, Yira Mascar6, Eleodoro Mayorga, Alexandra Ortiz, Juan Quintero, Francesca Recanatini, Jeffrey Rinne, Rafael Rofman, Carlos Rojas, Carolina Sanchez-Paramo, Ernesto Sanchez-Triana, Osvaldo Schenone, Mitchell A. Seligson, Ilias Skamnelos, Elaine Tinsley, Eloy Vidal, and Pierre Werbrouck. All authors are affiliated with the World Bank Group unless otherwise indicated in the respective chapter. Other authors of individual chapters are recognized in the credits of each specific chapter. While this book reflects the authors' views (and not necessarily the views of the World Bank, its Board of Directors, or its member countries), its production was institutionally housed at the World Bank. We thus benefited greatly from the gen- eral guidance of Guillermo Perry (Chief Economist for the Latin America and the Caribbean Region) and from the auspices of the office of David de Ferranti (Vice President for Latin American and the Caribbean Region). We also thank McDonald Benjamin, Daniel Cotlear, Andrea Silverman, and Fernando Montes-Negret for their support and comments. We also recognize the importance of and thank the participants of the workshop held on January I 1th, 2003 in Quito, Ecuador. This workshop not only brought together a majority of the authors under one roof for a day of candid discussions but also, and more important, included officials and consultants from both past and cur- rent government administrations. Of the consultants and government officials pres- ent at the workshop, we would especially like to thank the following: Sr. Presidente Lucio Gutierrez, Patricio Ortiz, Luis Felipe Mantilla, Nina Pacari, Nelson Herrera, Luis Macas, Doris Solis, Carmen Tene, Marcelo Cevallos, Marco Paez, Nelson Alvarez, Alberto Andino, Saul Velasco, Ing. Patricio Pugarin, Estuardo Pefiaherrera, Patricio Acosta, Mauricio Calder6n, Antonio Tramontana, Edgar Isch, Augusto Bar- xxiii xxiv ECUADOR: AN ECONOMIC AND SoCIAL AGENDA IN THE NEW MILLENNIUM rera, Hernan Plaza, Victor Acosta, Maria Fuentes, Manuel Chiriboga, Alberto Wray, Gabriel Montalvo, Frederic Pinel, Rosa Maria Torres, Diego Mancheno, Marfa Belen Freire, Oswaldo Aguirre, Mauricio Yepez, Victor Hugo Jij6n, Mauro Teran, Juan Granja, Patricio Ruiz, Rocfo Boh6rquez, Ramiro Galarza, John Arroyo, Javier Game, Pedro Paez, Francisco Hidalgo, Fernando Suarez, A. Polibio C6rdova C., Patricia Carrera, Carlos Arboleda, Bayardo Granjas, Juan Escalante, Mauricio Pareja Cevallos, Fernando Buendia, Mauricio Pozo, Virgilio Hernandez, Jose Vallejo, Horacio Yepez, Lenin Parreiio, Aase Smedler, Fernando Uzcategui, Antonio Albifiana, Juan Villacfs, Mario Acosta, Roberto Salazar, Fernando Alban Bonilla, Romelio Gualan, Benito Suarez, Luis Tapia, David Yuravlivker, and Francisco Andino. Their comments, suggestions, and inputs along with those from the many others who attended this workshop added greatly to this volume. We are especially thankful for the work of Esperanza Berrocal and her entire team from Comunicaci6n Global, Mellen Candage, Robert A. Croese, Richard Crum, Jan D. Gibboney, Andrea Harold, and Carol Levie for their exceptional work in preparing the Spanish version of this publication as well as piecing together the Eng- lish version. We are especially grateful for the work of Michael Geller who gave key support to the editorial process of this work; as well as to Chris Humphrey for hav- ing collaborated on the English version's technical editing for various chapters. The World Bank team in Ecuador should also receive a well-deserved thank-you for their outstanding support and help in coordinating the January 11th workshop in Quito: Gabriela Beltrin, Alexandra Del Castillo, Edmundo Espinoza, Ana Lucia Jimenez, Pilar Larreamendy, Raul Subia, Vinicio Valdivieso, Ana Maria Vicufia, and Ana Maria Villaquiran. Without them, achieving the right environment for these impor- tant discussions would not have been possible. The World Bank team in Washing- ton was also a strong component during this whole process: Oscar Avalle, Sara Calvo, Ivonne Escobedo, Maria Antonieta Gonzalez, Christopher Hale, Patricia Holt, Francisco Irfas, Crummella Myers, Marianella Rivadeneira, Judy Rivers, Ros- alia Rushton, Esther Samuel, Margaret Stroude, and Eduardo Wallentin. Finally, we would like to thank the World Bank publication team. Santiago Pombo-Bejarano and Stephenie DeKouadio supervised the entire process and pro- vided key information and assistance at all stages of publication. The team from Alfaguara, Colombia turned out a wonderful product in Spanish under a high level of stress and a strict deadline. Patricia Endara and Ronald Jones led us to the won- derful artwork of Gonzalo Endara Crow that graces the cover of this volume. Our sincere thanks to all of them. Vicente Fretes-Cibils, Marcelo M Givgale, and Jose R. Ldpez-Cdlix Washington, D.C. April 2003 Acronyms and Abbreviations AADT Annual average daily traffic ADV Added distribution value AFTA American Free Trade Agreement AGD Deposit Guarantee Agency (Agencia de Garantia de Depdsitos) ALADI Latin American Integration Association ALCA Free Trade Zone of the Americas (Area Libre de Comercio de las Americas) AME Association of Municipalities of Ecuador API American Petroleum Institute APRENDO Academic achievement testing BCE Central Bank of Ecuador (Banco Central de Ecuador) BEDE Ecuadoran Development Bank BIRF The International Bank of Reconstruction and Promotions (Banco Internacional de Reconstruccidn y Fomento) BNF National Development Bank (Banco Nacional de Fomento) BPD Barrels per day CAE Ecuadoran Customs Corporation (Corporacidn Aduanero de Ecuador) CAF Andean Corporation of Promotion (Corporacidn Andina de Fomento) CAN Andean Community of Nations (ComunidadtAndina de Naciones) CEDEGE Center for Development of the Guayas Basin CEL Special Bidding Committee CELADE Latin American Demography Center Centro (Latinoamericano de Demografia) CEMs Educational Matrix Centers (Centros Educativos Matrices) CENACE National Center for Energy Control CEPE Centre for Energy Policy and Economics CET Common External Tariff xxv XXVi ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MIl LENNIUM CETUR Ecuadoran Tourism Corporation CFN National Finance Corporation CGC Comptroller General Office (Controloria General de Cuentas) CID Center for International Development Harvard University CIF Cost and Freight CNJ National Council on the Judiciary CNRH National Council on Hydraulic Resources CNT National Transport Council (Consejo Nacional de Transporte) CNTTT National Land Transit and Transport Council CODENPE Council for the Development of the Indigenous Nations and Peoples of Ecuador COMEXI Trade and Investment Council (Consejo de Comercio Exterior e Inversiones) CONADES National Wages Council (Consejo Nacional de Salarios) CONAM National Modernization Council CONAREM National Council for Public Sector Remuneration CONATEL National Telecommunications Council CONCOPE Consortium of Provincial Councils of Ecuador CONELEC Ecuador National Electricity Council (Consejo Electrico de Ecuador) CONSEP National Council for the Control of Substances COPEFEN Coordinator of the Emergency Program to Cope with the El Nifio Phenomenon CORPECUADOR Ecuador Corporation (Corporacidn del Ecuador) CORPEI Exportation and Investment Promotion Corporation (Corporacidn de Promocion de Exportaciones e Inversiones) COSUDE Consejo Superior de Educacion CPC Code of Civil Procedure CREA Center for the Economic Reconversion of Azuay CRM Center for the Reconversion of Manabf CTI Technical Commission on Investrments of the IESS (Comisidn Tecnica de Inversiones) DAC Civil Aviation Office DECEVALE S.A. Depository of Stocks (Depositaria de Valores) DIGMER Maritime Transport Administration DINEPP National Directorate of Continuing Popular Education (DirecciMn Nacional de Educacidn Popular Permanente) ACRONYMS AND ABBREVIATIONS xxvii DNP National Personnel Directorate DVP Delivery versus Payment EAP Population, Environment, and Energy Program ECAPAG Guayaquil Potable Water and Sewage Company (Empresa cantonal deAgua Potabley de alcantarillado de Guayaquil) ECOPETROL Colombian Petroleum Company (Empresa Colombiana de Petrdleo) ECORAE Amazon Development Fund (Fondo para desarrollo de la region Amazonizo) EDAP Pension Savings Deposit Institutions (Entidades Depositarias delAhorro Previsional) EEQ Quito Electric Company (Empresa Electrica Quito) EMAAP Water and Sanitation Municipal Enterprise (Empresa Municipal de Alcantarillado y Agua Potable) EMAAP-Q Water and Sanitation Municipal Enterprise of Quito (Empresa Municipal de Alcantarillado y Agua Potable de Quito) EMELEC Electricity Municipal Enterprise (Empresa Municipal de Electricidad) EMETEL Telecom Municipal Enterprise (Empresa Estatal de Telecommunicaciones) ENAP National Petroleum Enterprise (Empresa Nacional del Petrdleo), Chile ENDEMAIN III Survey on Demographics and Maternal and Infant Health (Encuesta Demografica y de Salud Materna e Infantil) ENFE Ecuadoran National Railway Company ENTEL Telecom State Enterprise EPHF Essential Public Health Functions EPR Effective protection rate ESMAP Energy Sector Management Assistance Programme FASBASE Strengthening and Expanding the Scope of Basic Health Services in Ecuador (Fortalecimiento y Ampliacidn de los Servicios Bdsicos de Salud en el Ecuador) FEIREP Fund for Stabilization, Social and Productive Investment, and Reduction of Public Debt (Fondo de Estabilizacion, Inversidn Socialy Productiva, y Reduccidn del Endeudamiento Publico) FENAJE National Federation of Judicial Officials FERUM Rural and Marginal Urban Electrification Fund FISE Emergency Social Investment Fund xxviii ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN TnE NEW MILLENNIUM FLAR Latin American Reserve Fund FODESEC Municipal Development Fund (Fondo de desarrollo seccional) FONDEPRO Credit Fund for the Development of Production (Fondo de credito para el desarrollo de la produccidn) FONDIFA National Children's Fund FONDVLAL Transportation Fund (Fondo vial) FOPEDEUPO Permanent Fund for University and Polytechnic Development FTAA Free Trade Agreement of the Americas FTA Free trade agreement GDP Gross domestic product GEF Global Environmental Facility GSP General System of Preferences GSRT Gross Settlement in Real Time GUO Global Urban Observatory of the United Nations HDI Human Development Index HRM Human resources management ICE Special Consumption Tax (Impuesto a los Consumos Especiales) ICT Information and commtnications technology IDB Inter-American Development Bank IEOS Ecuadoran Institute for Water and Sanitation Works IESS Ecuadoran Social Security Institute (Instituto Ecuatoriano de Seguridad Social) IMCI Integrated Management of Childhood Illness IMF International Monetary Fund INEC Survey on Employment, Unemployment, and Underemployment INECEL Ecuadoran Electricity Institute (Instituto Ecuatoriano de electrificacidn) INEN Ecuadoran Standardization Institute INERHI Ecuadoran Institute of Hydrological Resources (Instituto Ecuatoriano de los recursos hidrizos) INGALA National Galapagos Institute (Instituto nacional galapagos) INIAP National Institute for Agriculture and Livestock Research (Instituto Nacional de Investigaciones) Agropecuarias INNFA National Child and Family Institute INTERAGUA International Water Services Guayaquil IPP Independent Power Providers ACRONYMS AND ABBREVIATIONS XXiX ISP Internet service provider ISR Income Tax (Impuesto Sobre la Renta) ISSFA Social Security Institute of the Armed Forces ISSPOL Social Security Institute of the Police ITT Ishpingo- Tambococha- Tip utini ITU International Telecommunications Union IVA Value-Added Tax (Impuesto al Valor Agregado) JASS Water and sanitation councils LEXI Law on Foreign Trade and Investment LIBOR London Interbank Offered Rate LMG Law on Free Maternity Care LPG Liquid petroleum gas LRFP Law on Reform of Public Finances LSCCA Civil Service and Administrative Career Law MDMQ Municipality of the Metropolitan District of Quito MDOGs Government ministries, departments, and agencies MEC Ministry of Education and Culture MEF Ministry of Economy and Finance MEM Wholesale Electricity Market MIDUVI Ministry of Urban Development and Housing (Ministerio de Desarrollo Urbano y Vivienda) MIVI Ministry of Housing MODERSA Modernization and Developmenr of Comprehensive Health Services Networks (Modernizacidnny Desarrollo de Redes Integrales de Servicios de Salud) MOP Ministry of Public Works MSP Ministry of Public Health NAP Network access point NFPS Nonfinancial Public Sector NTB Nontariff barrier NTE Trechnical Norms of Ecuador OCP Heavy crude oil pipeline ODEPLAN P'lanning Office OLADE Latin American Energy Organization (Organizacidn Latinoamericana de Energia) ONN National Standardization Agency ORI Children's Rescue Operation (Operacidn Rescate Infantil) OSCIDI Civil Service and Institutional Development Office OTA Trans Andean Pipelines (Oleoducto Transandino) PACMI Supplementary Food Program for Mothers and Infants (Programa de Alimentacidn Complementaria Materna- Infantil) xxx ECUADOR: A.N ECONOMIC AND SOCIAL AGENDA IN TtiE NEW MILLENNIUM PAHO Pan-American Health Organization PANN National Food and Nutrition Program (Progyama Nacional de Alimentacidn y Nutricidn) PDI Children's Development Program (Programa de Desarrollo Infantd) PDM Municipal Development Program PHO Panamerican Health Organization PRAGUAS Water and Sanitation Program for Rural Communities and Small Municipalities-financed by the World Bank PROBONA Native Andean Forests Program PRODEPINE Indigenous and Afro-Ecuadoran Peoples Development Project (Proyecto para el desarrollo de los Pueblos y nacionalidades del Ecuador) PROLOCAL Poverty Reduction and Local Rural Development PROMEC Power and Communcations Sectors Modernization and Rural Services Project PROMECEB Program for Better Quality Basic Education (Programa de Mejoramiento de la Calidad de la EducaciSn Bdsica) PROMSA Program for the Modernization of Agricultural Services (Programa de Modernizacidn de los Servicios Agropecuarios) PRONEPE National Preschool Education Program (Programa Nacional de Educacidn Preescolar) PROST Pension Reform Options Simulation Toolkit PSP private sector participation RER Real exchange rate RISE Ecuadoran Simplified Tax System (Regimen Impositivo Simplificado Ecuatoriano) ROAA Return on average assets ROAE Return on average equity ROSC Report on the Observance of Standard and Codes RUC Centralized taxpayers registry (Registro Unico de Contribuyentes) SAPYSB Sub-secretariat of Potable Water and Basic Sanitation SBS Superintendency of Banks and Insurance (Superintendencia de Bancosy Seguros) SCT Secretary of Communications and Transportation (Secretaria de comunicacionesy transportes) SELBEN Ecuadoran Beneficiary Identification and Selection System (Sistema de Identificacidn y Seleccidn de Beneficiarios) ACRONYMS AND ABBREVIAFIONS XXXI SENATEL National Secretariat of Telecommunications SENDA Secretariat for National Administrative Development SENDOSEP National Secretariat for Organizational Development of the Public Sector SESA Ecuadoran Animal and Plant Inspection Service SGO General Obligatory Insurance (Seguro General Obligatorio) SG sectional government SICA Agricultural Census SIGEF Integrated Governmental System of Financial Statistics SIISE Integrated System of Social Indicators of Ecuador Social Indicators System of Ecuador (Sistema Integrado de Indicadores Sociales de Ecuador) SIV Housing Incentives System SME Small and medium-sized enterprise SOTE TransEcuadoran Pipeline System (Sistema de Oleoducto Transecuatoriano) SPC Service-providing company SPNF Sector Pzublico No Financiero (see NFPS) SP Service provider SRI Internal Revenue Service (Servicio de Rentas Internas) SSC Rural People's Social Security Program (Seguro Social Campesino) SSO Obligatory Social Security (Seguro Social Obligatorio) SUMA Single Environmental Management System SUPTEL Telecommunications Authority SWIFT Wiring Financial Service TROLE I Economic Transformation Law UCV Local Road Works Unit UDENOR Development Unit of the North UOST Trolleybus System Operating Unit URC Credit Restructuring Unir (Unidad de Reestructuracion de Creditos) USAID United States Agency for International Development VAT Value-Added Tax WLL Wireless Local Loop WTI West Texas Intermediate WTO World Trade Organization Synthesis Vicente Fretes-Cibils andJose R. Lipez-Cdlix A. Purpose and Organization In recent years, the World Bank has had the honor and privilege of welcoming incoming administrations of member countries with a series of integrated diagnos- tic studies and policy recommendations in priority areas of social and economic development, with the goal of reducing poverty. This practice is particularly relevant for Ecuador today, where President Lucio Gutierrez has taken office to govern a country that is rich in natural tesources and has enormous potential to combat poverty and improve the well-being of all citizens. However, these tasks will be ham- pered by structural economic and social problems, low competitiveness, corruption, and inefficient use of petroleum resources. Ecuador is still suffering the conse- quences of recent banking and exchange rate crises, which led to the dollarization of the economy. While dollarization helped reverse some of the macroeconomic imbal- ances, it caused greater economic vulnerability to changes in relative prices in the midst of a global and regional slowdown in economic growth. The fundamental challenges facing the country are identified within this book, and the solutions represent a break with the past. This is a proposal for an agenda with a broad and integrated vision of economic and social development in Ecuador. The chapters are grouped into the three thematic categories of the new administra- tion's program: (a) Stability and Growth with Competitiveness, (b) Socially Sustain- able and Equitable Development, and (c) Quality Government and the War on Cor- ruption. Each category includes selected subjects. Within Stability and Growth with Competitiveness, the following subjects are included: fiscal sustainability, tax reform, management of public debt, consolidation of the banking system, expansion of petroleum-related and commercial activities, development of basic infrastructure- electricity, telephone systems, water, and transport-and urban development. Socially Sustainable and Equitable Development contains an analysis of the following sectors: education, health, social safety networks, social security and pensions, rural xxxiii xxxiv ECUADOR: AN ECONOMIC AND SOcLAL AGFNDA IN THE. NEW MILLENNIUM development, and the environment. Within Quality Gov'ernment and the War on Corruption, the following themes are examined: improved governance, civil service reform, judicial reform, and decentralization of public services. These chapters are meant to be informative rather than exhaustive. They strive to initiate a frank and cordial dialogue, and to gather valuablc insights from authorities on all these subjects. The chapters show that the views of the World Bank and the new Gutierrez administration converge in making poverty reduction the central strategic goal of both the new government's agenda and future Bank assistance to Ecuador. This document was written based on the Bank's rich experience in the coun- try, complemented by recent interviews and data gathered during a Bank mission in November 2002, and presented to the incoming authorities in a workshop held in Quito on January 11, 2003. The World Bank appreciates the efforts of both outgo- ing and incoming officials in helping facilitate the preparation of this document. 13B CenEtral Message Since 1979, when it returned to democracy, Ecuador has suffered from high exter- nal vulnerability, poor macroeconomic performance, and poor governance. A suc- cession of external adversities-linked to the volatility of oil prices and violent vari- ations in capital flows-and natural calamities, all in combination with poor economic management, resulted in macroeconomic imbalances, with negative impact on growth and social development. During this period, the country went through four severe recessions (1982-83, 1987, 1989, and 1998-99) and three periods of hyperinflation (1983, 1988-93, and 1999-2000). It incurred a high and unsustainable external debt, reflected in various moratoriums on payments and the recent exchange rate depreciation and banking crises, which destroyed 20 banks that accounted for over 50 percent of banking deposits. These bad economic policies were partly caused by weak and too-often-changing public management, and the governance problems that traditionally characterize oil-producing countries. In the last 23 years Ecuador has had 29 finance ministers, meaning each spent an average of 10 months in the post. In addition, Ecuador has been the Latin American coun- try perceived as having the least control over corruption. Even more important, the last crisis (1998-99) had a devastating effect on employment levels, poverty, and income distribution. While the rate of formal unem- ployment grew from 10 to nearly 15 percent, poverty incidence increased from 34 to 56 percent between 1995 and 1999, and the Gini coefficient increased from 0.52 to 0.54 during the same period. These indicators imply that the number of poor Ecuado- rans grew by over 2 million during the crisis. This crisis severcly affected the rural poor, the indigenous population, and particularly those living in the mountains, where the poverty rate increased by 7 percent just between 1998 and 1999. More than a quarter of a million people emigrated and another half million moved into marginal urban areas within the country. Other human and social development indicators, such as SYNTHESIS XXXV infant mortality, malnutrition, and the school desertion rate, also worsened. The level of deterioration of these indicators reveals the depth of the crisis, and the greater vul- nerability of the poor, both urban and rural, in confronting the loss of income. The Ecuadoran economy has begun to recuperate, but it remains fragile. The adoption of the dollar as the local currency, favorable oil prices, rapidly increasing family remittances, and macroeconomic management with mixed results, have all helped gradually to stabilize expectations. These factors have also helped to gradu- ally eliminate hyperinflation, to begin to restore and reestablish the banking system, reach moderate growth levels, and partially reverse the increase in unemployment and poverty levels. Although economic growth is a necessary condition to combat poverty, it will be insufficient unless it is sustainable and participatory, and includes broad sectors of the most vulnerable population (such as the marginalized indige- nous population). With this challenge in mind, the central question posed in the book is as follows: What should the new government's agenda be in order to ensure abandoning thefail- ures of the past, bringing about Ecuador's economic and social recovery and reducing poverty? The answer to this question is based on three lines of action: * Preserving stability with fiscal discipline and accelerating growth with com- petitiveness; * Boosting sustainable and equitable social development; and * Building a quality government that serves all Ecuadorans and fights against corruption. PRESERVING STABILITY WITH FIsCAL DISCIPLINE AND ACCELERATING GROWTH WITH COMPETITIVENESS. The number one priority for Ecuador continues to be sustained economic growth. Both international experience and the experience of Ecuador itself show that the best tool to combat poverty and protect the most vulnerable cit- izens is to accelerate economic growth. It is estimated that on average, with each 1 percent increase of the gross domestic product (GDP) per capita, poverty is reduced by approximately .7 percent. It will not be easy to keep the economy on a track of rapid growth in the medium term, but it is feasible and can be achieved through the following key actions: * First, guarantee a balanced macroeconomic framework, particularly with ref- erence to public accounts, that fosters stability and private investment, and that allows debt reduction to continue. This means fiscal adjustment through collecting more and spending less, addressing liquidity problems in the short term and solvency problems in the medium term, and lowering interest rates to stimulate greater private investment in the economy. * Second, promote economic expansion and competitiveness by making input markets-particularly the labor market-more flexible, by opening the econ- omy to foreign trade, and by eliminating trade policies that punish exporters. xxxVi ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM These actions should be complemented by finishing the reorganization and reform of the financial system, and by promoting the expansion of financial intermediation, access to credit, and economic growth. • Third, accelerate expansion of the petroleum sector through a legal and regu- latory change to bring about legal and fiscal stability, and promote private investment in the oil fields with the greatest reserves. This expansion should be accompanied by programs and projects that fosters transparency in resource management, and also promote the local population's right to be consulted. The legal framework should include provisions to guarantee better management of the environmental and social impact of the oil industry. At the same time, the regulatory framework should eliminate distortions in the prices of and taxes on combustible fuels. o Fourth, develop physical infrastructure in four main services: water and sani- tation, electricity, telecommunications, and transport (highways and roads, railways, ports, and airports). Owing to fiscal restrictions, the government should facilitate private sector expansion in the provision of these services. This will require legal and regulatory changes with the corresponding adjust- ments in prices and tariffs, the elimination of subsidies (for propane, gasoline, and electricity), and the correction of distortions (such as the lack of incen- tives to increase investment in road maintenance). o Fifth, the government needs to direct its attention to the rapid urbanization process in Ecuador, and the resulting growth of poverty in urban areas. To combat this problem, integral urban development programs should be con- sidered in order to raise the standard of living in marginal urban zones and lower the physical, economic, and social vulnerability of residents. In this con- text, the detection of restrictions on the functioning of real estate markets is a priority, because these restrictions affect accessibility for the poor-and iden- tifying them will permit proposing changes to correct the obstacles con- fronting the poor. BOOSTING SUSTAINABLE AND EQUITABLE SocIAL DEVELOPMENT. Economic growth will be meaningless if Ecuadorans living in poverty (over 7 million) cannot partici- pate in the progress. The government can ensure this participation through the fol- lowing actions: o First, facilitate growth, accumulation of human capital, and the strengthening of the social fabric through dedicating more resources and improving the quality of education and health services, particularly for the poor and indige- nous in marginal urban and rural areas. On top of the recent reduction in gen- eral levels of spending, the public sector is currendy not receiving the corre- sponding returns on resources directed toward education and health. This should be reversed if the intention is to expand coverage and improve the quality of these services. SYNTHESIS xxxvii * Second, the accumulation of human capital should be complemented by eliminating rigidities in markets, particularly the labor market, so that the exchange of goods and services can be achieved with minimal transaction costs, and by promoting an improvement in the income of the poor who have made efforts to improve their education and health (human capital). * Third, the social safety network should improve efficacy and efficiency in pro- tecting these groups. The accumulation of human capital and elimination of labor market rigidities will not satisfy the needs of all Ecuadorans, particularly the marginalized rural and indigenous poor. In the formal sector, the social security system needs to be reformed, with a better separation of different services such as pensions and health, modernizing their institutional frame- work and financial management, and broadening coverage. The coverage of noncontributive regimes needs to be extended to the informal sector (such as Small Farmer Social Security) with better targeting and maximizing of the scarce resources allocated to these programs. * Fourth, despite the prominence of problems brought on by rapid urbaniza- tion, the government also needs to diversify its focus to include poverty in general, especially extreme rural poverty. The preparation of a strategy for the development of multisectoral rural development is needed that is diversified and has a territorial approach. This strategy should have three main goals: (a) social and economic cohesion through development of local space; (b) adjust- ment of agriculture and rural economic diversification; and (c) environmen- tal protection. Ecuador's geographic, economic, and sociocultural diversity means that this strategy must be differentiated and supported by policies that in turn facilitate the following: - development by jurisdiction or rural space, in a participatory form, to cre- ate economic and social cohesion; - the diversification of the rural economy; - the creation of nonagrarian employment through investment in rural and social infrastructure; - competitiveness of the agrarian sector through transference of technology and research; and - environmental conservation through improved territorial organization, reviving methods of soil conservation and appropriate use of natural resources. BUILDING A QUALITY GOVERNMENT THAT SERVES ALL ECUADORANS AND FIGHTS AGAINST CORRUPTION. The new government begins from a weak institutional standpoint, with an image of being highly corrupt and having problems governing. This image negatively affects the new administration's credibility as it designs and tries to implement public policies, and also influences the ability to provide public services. The government should reestablish governability and prevent corruption through the following actions: XXXViii ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN TtiE NFW MILLENNIUM o First, the government should carry out reforms in functions such as supervi- sion, regulation, provision of direct services, acquisition of goods, and con- tracting of services, among others, and promote total transparency. The gov- ernment needs to change incentives and separate economic and political links, promoting public oversight and avoiding, wherever possible, state cap- ture by certain economic interest groups. This will not be an easy task and will require an integral plan, because both governance and corruption have an impact on all aspects of public activity and affect the majority of eco- nomic and social sectors. This difficult task could begin with a governance pact between the state and civil society, and with the development of an anti- corruption strategy. o Second, this pact and strategy should be complemented with the strengthen- ing of the civil service and the deepening of judicial reform. These measures will allow all Ecuadorans, particularly those who are excluded today, to have access to justice. o Third, those who initiate the process of public reform must keep in mind the general context of decentralization and work within this framework. This process faces three challenges to improving public services: (a) improvement of functional decentralization; (b) the transfer of resources and spending competencies to subnational governments; and (c) the delineation of fiscal responsibility of subnational governments, including limits on public debt. C. The Development Aenda-D)agnostic 5=dy a& IPoliciez Ecuador is committed to the Development Goals of the Millennium. These goals were adopted by the international community within the framework of the United Nations for compliance between 1990 and 2015. They cover the areas of poverty, malnutrition, mother-infant health, education, gender equity, and environmental sustainability. Although data are incomplete for projecting the level of compliance with all goals for Ecuador, our calculations are based on an average annual GDP growth rate in the medium term of 2.7 percent. According to World Bank estimates, it is "probable" that Ecuador will reach goals for primary education (100 percent coverage) and malnutrition (50 percent reduction); it is "possible" that Ecuador will meet goals for lowering infant mortality and mortality of children under age five (66 percent reduction), and also goals for sanitation (a 50 percent drop in the number of people without access to potable water). The Bank believes it is "highly improb- able" that Ecuador will meet poverty reduction goals of 50 percent (rates for poverty and extreme poverty). The high sensitivity of these goals-particularly for poverty- to the rate of economic growth demonstrates why Ecuador needs to grow in an accelerated and sustained manner, with rates higher than historical levels, in order to reduce poverty during the next decade. This will be possible only with an inte- grated development agenda. SYNTHESIS XXXiX Preserving Stability with Fiscal Discipline and Accelerating Growth with Competitiveness Sustained growth acceleration can take place only within a context of macroeco- nomic stability and based on a multidimensional agenda of competitiveness. Unfor- tunately, for several decades, instability has been the rule and not the exception in Ecuadoran macroeconomic policy, and as regards competitiveness, the country is a latecomer to reform. Dollarization was especially necessary for Ecuador because it needs to build a new reputation and change its image as a country that historically has been politically unstable. By "lifting the veil" of money, dollarization made it evident that problems were not only fiscal in nature, but also social and financial to an even greater degree. The suppression of monetary policy not only remedied a previous fiscal illusion, but also resolved the financial imbalances introduced by hyperinflation and the depreci- ation of the exchange rate. At the same time, it established new rules for competi- tiveness, and made it clear that only solid structural reforms will consolidate stabil- ity, reactivate the economy, strengthen the financial system, and combat poverty efficiently in the medium term. It is no secret that in 1999 Ecuador's economy was in such a bad state that a suc- cessful dollarization process seemed unlikely. The country had a high fiscal deficit, an unsustainable external debt on which the country had defaulted, exports that depended excessively on oil and were highly vulnerable to unfavorable terms-of- trade shocks, and a banking system in crisis affected by high regional capital flight, which had brought international reserves down to their lowest level. Obviously, this dark landscape was inhospitable for attracting investment. The combination of poor competitiveness and rigid factors markets for the production of services and non- tradable goods (labor and property), made price adjustments that were required to preserve external competitiveness after losing the exchange rate instrument more dif- ficult. Despite all this, and within a short time, Ecuador met two goals through dol- larization: the elimination of hyperinflation and the reestablishment of confidence in the banking system. At the same time the Law of Economic Transformation established minimum conditions and the structural reforms needed to ensure that dollarization was sustainable in the medium term. Ecuador has begun an economic recovery with stability. Economic growth has reached moderate levels (3.6 percent average during 2000-02) and inflation slowly came down to single-digit levels by the end of 2002, after remaining high since 1998. Both of these results are due to a favorable external environment, the recov- ery of the financial system, the reactivation of domestic demand, and the dynamics of relative prices. The favorable external environment has been characterized by high oil prices, low international interest rates, and significant remittance flows from Ecuadorans living abroad. The financial system has seen a marked recovery of bank- ing deposits and a slight drop in nominal interest rates. The increase in domestic demand is due to the sharp drop in inflation, high oil prices, growing remittances, XA ECUADOR: AN ECONOMIC AND SOCiAL AGENDA IN THE NEW MILLENNIUM and the decision by authorities to approve the construction of a new Heavy Crude Oil Pipeline (OCP), which has attracted new foreign investment flows. The adjust- ment of prices has been determined by international inflation, the later adjustment of prices that comes with the postdollarization dynamic, the maintenance of gov- ernment prices for products in the basic food basket, and the expansion of domes- tic demand resulting from the increase in the nominal minimum and average wages in dollars, which practically doubled between April 2000 and October 2002. The economic recovery, combined with emigration and the ensuing remittances, has contributed to the drop in levels of open unemployment and poverty, although these have not returned to precrisis levels. Despite this progress, significant internal and external imbalances still exist. Inter- nally, while current public sector revenue has improved, primary spending remains expansive. Consequently the primary surplus achieved during the year of dollariza- tion has been cut in half Externally, an appreciated real exchange rate and the tem- porary rise of imports related to construction of the new oil pipeline have provoked a strong deficit in the current account of the balance of payments. However, this deficit has been partly mitigated by family remittances from abroad and has been partly compensated for by positive foreign investment flows in capital accounts. As a result, the level of freely available international reserves is still very low (to prevent contingencies), with a tendency to decline, which should be reversed. The structural reforms that should accompany the dollarization process are either absent or inconclusive. Fiscal adjustment is among the inconclusive reforms, as is the strengthening of the financial system, while the promotion of private investment in the petroleum sector is glaringly absent. Other reforms that have not been carried out include trade reform, the promotion of competitiveness, and private participation in basic infrastructure. For their part, the structural reforms that should have accompanied dollarization remain incomplete or nonex- istent. Notable among the incomplete reforms are fiscal adjustment and reforms relating to the strengthening of the financial system. Notable among the nonex- istent reforms are reforms to promote private investments in the petroleum sec- tion, trade reform, reforms to promote competitiveness and private participation in basic infrastructure. The likelihood of the collapse of dollarization in the medium term should not be underestimated. To avoid it, Ecuador must move ahead quickly not only on the fis- cal front but also with the structural reforms needed to counteract the rigidity involved in the unilateral decision to adopt the dollar as legal currency for circula- tion, savings, and payments for domestic goods and services transactions. In view of the loss of control over monetary and exchange-rate policy, and of the inability to "inflate" fiscal imbalances and alter relative prices by depreciating the domestic cur- rency, in order to sustain dollarization Ecuador must simultaneously ensure macro- economic stability through solvency and fiscal stability and introduce flexibility in goods and services markets-particularly for inputs. This course of action would maintain the competitiveness of the country's products on domestic and foreign SYNTHESIS xli markets, while at the same time increasing the individual (and total) productivity of the factors of production. From a macroeconomic perspective, given the initial situation of high public debt (60 percent of GDP in 2002), Ecuador must achieve and maintain significant primary fiscal surpluses tfhat will allow it to lead its stock of debt along a sustainable path-that is, by ensuring short-term liquidity and guaranteeing the country's sol- vency for promptly meeting its public debt service obligations in the medium term. This means making adjustments in order to obtain primary surpluses in the fiscal accounts estimated at an average of 4 to 5 percent of GDP over the next five years, which would bring the stock of debt below 40 percent of GDP at the middle of the decade. The fiscal adjustment must take into account the volatility of tax revenues as a result of the variability in petroleum prices. To offset it, particularly during a foreseeable scenario of future price reductions, it will be necessary to apply auto- matic stabilizers and make more efficient use of the extraordinary resources obtained during the current petroleum boom period. From a microeconomic perspective, and in the absence of control over exchange- rate policy, there is a limited range of instruments available to respond to adverse external shocks or to correct public policy errors in the economy's real sector. Should high rigidity continue in the operations of markets and prices in Ecuador, with high costs not only for production but for goods and services transactions as well, there will be negative effects on competitiveness, economic growth, and job creation, which could also make dollarization unsustainable. The risk lies in the fact that, given the existence of inflexible markets-such as the formal labor market-adjustments to shocks will occur primarily through reductions in amounts produced (and sold), with the corresponding contraction in demand based on inputs, particularly in labor (an abundant factor in Ecuador). This potential situation would not only create pressure to "abandon" the model, in view of increased unemployment, but would also con- tribute to an increase in commercial banks arrears, as a result of the decline in gen- eral economic activity. This would in turn make achieving both fiscal adjustment goals and recovery of the banking system less feasible-creating a vicious circle that would be difficult to break. Two external shocks require particular attention: first, devaluations or depreciations (discrete or continuous) of the currencies of Ecuador's trade partners; and second, appreciation of the dollar against other "strong" curren- cies in the world. In both cases, the "appreciation" of the dollar will have to be offset by increases in productivity and/or by deflationary adjustments in production and transaction costs so as to be able to maintain competitiveness and avoid the loss of markets. In summary, the sine qua non conditions for sustaining dollarization are to achieve and deepen fiscal solvency, expand and introduce flexibility in goods and services markets, and increase the productivity of the factors of production. The Need for Adjustment and Fiscal Discipline Postdollarization fiscal performance has not resolved the main obstacles to sustain- ability in the medium term. On the one hand, the average primary surplus of the xlii ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEw MILLENNIUM Non-Financial Public Sector (NFPS) has been significant but decreasing-it is pro- jected to fall by more than half, from 7.7 percent in 2000 to 4.0 percent in 2002. On the other hand, it has had to cover high interest payments on public debt, leav- ing the authorities with a meager fiscal surplus (close to zero in 2002). The primary surpluses could have been higher if not for the expansive spending on salaries and investment. The lesson is clear: there is no point to saving on debt service through successful renegotiations if these savings are consumed by increases in public spending. Fiscal fragility is rooted in the inherent weaknesses of fiscal revenue and tax pol- icy-rigidity, low quality, and the lack of transparency in spending-and in the per- sistent threat of loss of liquidity and insolvency of public debt. These problems were identified during the approval process of a fiscal law at the end of 2002-the Law of Responsibility, Stabilization, and Fiscal Transparency. An analysis of each of these fiscal problems follows, taking into account the law's content and possible solutions that go beyond mere legal compliance. Tax Reform Fiscal revenue is characterized by the low level of tax collection on non-petroleum- related tax income, which is a consequence of the low Value-Added Tax (IVA) and the excessive number of exemptions, particularly on the Income Tax (ISR), and the high volatility of oil income, which gives fiscal income a procyclical nature. Each dollar drop in the price of a barrel of oil means an income reduction of .4 percent of GDP. Tax policy is highly subject to the different demands of special interest groups, and this is reflected in the excessive use of tax distortions such as the prolif- eration of taxes, exemptions, and earmarking. The proliferation of taxes (more than 80) has a negative impact on tax efficiency because it makes it impossible for officials in power to focus on the taxes that are a priority. The multiple exemptions are part of the inefficient goal of trying to "fine- tune" tax policy. Because of this policy, authorities meticulously choose the sector that should pay benefits to be received by other chosen beneficiaries, robbing the process of transparency, as well as equity and efficiency when assigning resources. Failure is particularly acute in terms of meeting redistributive goals in the case of the IVA, and authorities are also inefficient in promoting socially profitable processes in the case of income tax exemptions or exemptions on customs tariffs. Finally, the excessive preallocations or earmarking (over 50) impedes more efficient use of fiscal resources (1.7 percent of the GDP) and also discourages tax collection efforts on the part of sectional governments (provincial or municipal), as they become accustomed to the bad habit of receiving transferences from the central government. Strengthening of the fiscal position requires various types of tax policy actions. First, we propose increasing non-petroleum-related tax collection by a minimum of 2.5 percent of GDP. This is the amount stipulated in the fiscal law to guarantee a primary surplus that will lower the debt to sustainable levels in the medium term. SYNTHESIS xliii To meet this goal it will be necessary to first approve a series of tax policy measures that will generate approximately 1.4 percent of GDP. One of the most important is to limit sales tax exemptions solely to basic unprocessed foodstuffs. This will allow the cancellation of all other exemptions, particularly on income tax and customs tar- iffs, with a collections effect estimated at 1.1 percent of the GDP. Second, given that the proposed increase in collection is still not enough to ensure a minimal primary surplus, particularly when faced with the perspective of a highly probable drop in oil prices to "normal" historic levels of below $US18 a bar- rel, we also recommend increasing the sales tax. It is estimated that collections would increase by .7 percent of GDP for each additional point that the tax is raised. Third, we propose the repeal of minor taxes. Even if this does not have a signif- icant impact on collections efforts, it will allow tax authorities and contributors to reduce administrative costs and focus on better compliance with sales and income taxes. Fourth, we recommend eliminating all preallocations of sales and income tax for reasons that extend beyond tax collection, with the exception of the payroll tax ear- marked for the Ecuadoran Institute of Social Security. This could be carried out in accordance with Article 22 of the original draft of the fiscal law. Fifth, it would be very beneficial to reverse or prevent the approval of measures of "relaxed tax collection" proposed at the end of 2002, including the donation of 25 percent of income tax to municipalities, the reduction of the percentage of reten- tion in the sales tax source from 1 percent to .1 percent, and the reduction to zero of the tariff on 158 products. The internal tax administration has shown a positive change in orientation in recent years, with tangible results. After reforms in the Service of Internal Income (Ecuador's Internal Revenue Service, SRI, which stands for Servicio de Rentas Inter- nas in Spanish) and the Ecuadoran Customs Corporation (CAE), there has been a notable improvement in the control of evasion in the SRI, although there has not been evidence of significant improvement in the CAE. The SRI's institutional design and the CAE's low performance are both priority matters for tax administra- tion. Any strengthening of the fiscal position will also require tax administration measures such as the following: * Reinforcing the independence of the SRI's directorate, thus preventing the use of its resolutions to introduce new discriminatory tax treatments and genera- tors of distortions, and concentrating its efforts solely on the rigorous collec- tion of taxes created by the laws. * Considering merging the SRI with the CAE, to take advantage of economies of scales and oversee the collection of customs tariffs within the same universe of contributors. * Reforming the Customs Law, incorporating modifications on the customs labor code that will permit a restructuring similar to the one that had positive results in the SRI. xliv ECUADOR: AN ECONOMIC AND SOCIAL AC/ENDA IN THE NEW MILLENNIUM Promoting strict compliance with Law 41 of 1999, with official backing at the highest possible level to apply this control mechanism on contraband and the evasion of sales tax, without exceptions or discretion. Spending Cuts, Reorientation, and Transparency There are three fundamental problems with public spending: it is inflexible (partic- ularly spending on salaries), it is fragmented, and it is not transparent. Inflexibility is an obstacle to containing spending. Fragmentation means spending cannot be efficiently allocated to meet government priorities. And lack of transparency pre- vents adequate control and public auditing, and converts it into an involuntary stimulus for tax evasion. These three problems have reached alarming levels in Ecuador. The rigidity of spending, particularly current accounts, is very severe. For over a decade, primary spending has increased up to around 21.4 percent of GDP This inflexibility is mainly due to the inertia of the public payroll, and excessive income earmarking- oil-related and non-oil-related-written into over 50 current legal regulations. Fragmentation is due to preallocated revenues in 217 sectional (subnational) gov- ernments and multiple objectives mandated by special laws. In 2001, budgetary pre- allocations corresponded to approximately 30 percent of the total of current income, or about 6 percent of GDP. This fragmentation and rigidity of spending leaves meager freely-available resources. If the public payroll is deducted from the total current accounts income (30 percent), from service on the net debt (35 percent), and from preallocations (30 percent), the amount left over is barely 5 percent of the total current accounts income, or the equivalent of 1.2 percent of GDP as of 2001. This tiny percentage of domestic resources reflects serious cash flow problems and means the government cannot formulate a minimum budget for poverty reduction without affecting other programs. Finally, this spending is not transparent because (a) there is no centralized public payroll; (b) controls on preallocated spending are absent; (c) central budget- ary standards are weak, which also fosters decentralized execution without adequate control mechanisms; and (d) there is no integrated system of financial administra- tion that allows control of consolidated spending, not only of the central govern- ment, but also of decentralized entities and sectional governments. There are various elements to spending reform. First, the 2003 budget should be declared a "national emergency" budget, with concrete measures to limit spending and confront the causes of rigidity. To do this the following is proposed: (a) the lim- iting of spending growth to zero in real terms in 2003, implying the establishment of limits on the salary mass, on goods and services, and on investments; (b) the immediate suspension of the salary-indexing mechanism based on projected infla- tion (and not yet carried out) by the National Council for Public Sector Remuner- ation (CONAREM); (c) the approval of a Salary Unification Law with a neutral fis- cal cost; and (d) the repurchase of the most expensive debt in Global Bonds. SYNTHESIS xlv Second, fragmented spending should be consolidated and reoriented toward pri- orities. For this reason it is necessary to explicitly prohibit any new preallocations of income or spending and eliminate nearly all existing preallocations (with the excep- tion of the Ecuadoran Social Security Institute [IESS]). Within the framework of a new decentralization policy, and during the period covering the emergency budget, additional transferences of over 10 to 11 percent assigned to sectional governments should be frozen, with the preparations of a future simultaneous transference of resources and additional competencies, auditing of the subnational debt and the Reprogramming Plan, and new regulations for subnational debt of large cities. Third, budgetary transparency should be institutionalized at all levels of govern- ment by using modern instruments. Once the law is approved, the design and implementation of a modern and consolidated version of the Integrated Govern- mental System of Financial Statistics (SIGEF) is urgently needed. This entity covers sectional governments. Sustainability of Public Debt Ecuador's public debt has been poorly managed for several decades and as a result, the current level of public debt is very high. As a percentage of GDP, it is the sec- ond highest in the region. At the same time it carries a heavy debt load: net service consumes 35 percent of the budget. About 80 percent of Ecuador's total debt is external. The debt has three characteristics that somewhat alleviate the situation: 60 percent of the debt is multilateral and bilateral; only 1.4 percent is short-term debt; and after the restructuring of the onerous external debt in 2000 Brady bonds, 75 percent of the debt was set at a fixed rate, reducing the volatility of debt service. The liquidity situation of Ecuador's public external debt is delicate. The coun- try has immediate problems to resolve over arrears with the Paris Club, estimated at approximately $US 181 million in 2002, and a programmed debt service amount of 8.1 percent of GDP (4.7 percent in amortizations and 3.4 percent of GDP in interest) for 2003 and 2004. To bring the debt to sustainable levels in the medium term, Ecuador will need primary surpluses of 5 percent of GDP. To close the finan- cial gap in the next two years, Ecuador will require additional resources of about 4 percent of GDP. In addition, compared to other deeply indebted Latin American countries, Ecuador has limited administrative institutional capacity to manage their debt: it is strictly operative and not analytical, lacks transparency, and is frag- mented and suffers from a lack of coordination between the Finance Ministry and the Central Bank. Ecuador should develop a debt reduction strategy at the same time as it strength- ens its institutional capacity. This will entail, first, ensuring a financing plan for 2003 and 2004, based on the following: a solid macroeconomic plan with credibil- ity that permits capture of additional resources from multilateral agencies that can be quickly disbursed, a reprogramming of payments with bilateral creditors, and a repurchase of onerous debt held with private creditors. This reprogramming should Xlvi ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM include the goal of eliminating all arrears in 2003. Second, this program should require that the fiscal efforts mentioned above achieve a primary surplus of at least 5 percent of GDP. Third, debt management should be transparent, with regular publication of commitments and payments on debt service, including floating debt as stipulated in the fiscal law. Fourth, Ecuador should strengthen institutional sup- port for debt management with the designation of a highly specialized team with adequate technical assistance. The Competitiveness Agenda Despite dollarization, both competitiveness abroad and the investment climate at home still do not look very promising. Nearly all global indicators show indis- putable and consistent evidence that the competitiveness gaps are significant and growing. Ecuador ranked 54th out of 62 countries evaluated in terms of global com- petitiveness during the World Economic Forum in 2001. In 2002, Ecuador's rank- ing deteriorated even further when it was classified as 73rd among 80 countries, with the highest relative percentage for innovation and the lowest in terms of busi- ness climate, and respect for countries and for laws. The implementation of a competitiveness agenda is critical to the sustainability of the dollarization process in the medium term. In consultation with the private sector, the Central Bank and Ministry of Foreign Trade have proposed Agendas for Competitiveness. However, these agendas lack priorities and a consensus on sequencing, which calls into question the realism of the measures proposed and the difficulties of implementing them. This is why one of the first steps of the new administration should be to design a simplified agenda of policies and laws that arc critical to strengthening competitiveness. This agenda should begin with the revi- sion of the Law of Competitiveness. The agenda should also include support meas- ures to strengthen both the financial system and the petroleum industry, reform commercial policy, develop basic infrastructure, promote internal competition among firms, and eliminate both market entry-level barriers for new enterprises and rigidity of labor markets. Strengthening the Financial System The Ecuadoran financial system has been gradually recovering from the grave twin banking and exchange rate crises of 1998-99, and has been adapting to changes caused by the dollarization of the economy at the onset of 2000. The banking crisis drastically reduced the number of active financial institutions. Meanwhile, dollar- ization and related institutional changes-particularly those caused by the formal absence of an emergency lender-encouraged surviving institutions to favor hold- ing assets and liabilities with the most liquidity in their balances, and promoting a greater concentration of banking. We are just beginning to see the end of the most dramatic part of the restructuring postcrisis process, thanks to the adoption of a new regulatory framework and more efficient supervision. SYNTHESIS xlvii The structure and responsibilities of the supervising authorities have also changed. The banking restructuring process has been a test by fire for the entity charged with guaranteeing deposits (the Agency to Guarantee Deposits, AGD, also known as the Deposit Guarantee Agency-Agencia de Garantia de Depdsitos in Span- ish), and for the Superintendency of Banks and Insurance (SBS). On top of that, dollarization has modified the role of the Central Bank of Ecuador (BCE). In effect, because of the lack of monetary policy within a dollarization scheme, the BCE today focuses on liquidity management of the financial system, both to ensure proper functioning of payment mechanisms and to provide liquidity under similar condi- tions as an emergency lender. In summary, there are important institutional and operational challenges that are blocking a definitive resolution to the crisis in the financial system. Some of the most pressing problems within the credit portfolio are that there is a high concen- tration of large loans in the unproductive portfolio and these are frequently awarded to related parties; the insurance coverage on deposits for many banks in the process of dissolution is too high and distorts the incentives of borrowers, increasing the "nonpayment culture"; portfolio quality has greatly deteriorated and credit contin- ues to contract (the credit portfolio as a percentage of GDP is still half of what it was at precrisis levels); and the cost of credit is higher and small borrowers have access to lower amounts of credit. Another problem is that bank levels of liquid assets are high, which is justified in large part by the contraction of credit mentioned above. The impossibility of cushioning against external shocks through exchange policies, together with the Lack of a lender of last resort, means that these assets are needed so that banks can absorb the terms-of-trade or international interest-rate shocks. This means a considerable additional financial cost. Finally, other relevant problems include the following: the interbanking payment system is still ineffective, the SBS's supervision of the quality of banking assets is also deficient, the role of the SBS and the AGD in the process of resolution and banking liquidation is too weak, and the balance established by public banks in their dual commercial and social function is inappropriate and works against their financial profitability. In response to these challenges, banking credit activities need to be improved. First, we propose more efficient management of banking liquidity through central- ized management. The BCE is a natural candidate for this central role given its cur- rent responsibility in the payment system. Second, the payment system needs to be reformed. The sequence of steps required for this reform should be codified in a public document, and a single net compensation system for checking transactions should be defined. Third, it is vital for the SBS to continue to improve its procedures, particularly those related to the evaluation of credit risk and portfolio supply rules. In addition, it is important to consider the possibility of formulating procyclical provisions as Spain has done, since the Ecuadoran economy is extremely exposed to oil price cycles. It is also very important that SBS authorities be protected legally as they carry out their duties, and to make the legal changes that will allow them to improve pro- xlviii ECUADOR: AN ECONOMIC AND SOCIAL AcFNDA IN THE NEw MILLENNIUM cedures for bank resolution and liquidation. At the same time, the SBS accounting system should be strengthened. Finally, there must be total compliance with inter- national laws governing money laundering (that is, coordinated efforts with related authorities) to increase confidence in the system, ensuring that the SBS can take legal action within a fully integrated legal system. Fourth, we propose a normalization of exit mechanisms for banks. The formal- ization of the roles of the SBS and the AGD in the bank resolution and liquidation process should be strengthened, and the AGD functions revised. The alternative of converting them into a "pay box" should be considered. And fifth, we propose a reform of existing public banks (particularly first-tier banks), limiting their activity to targeted areas where subsidies, if needed, are transparent and minimal. The Oil Sector The strength of the oil sector is the main factor that determines the growth of the Ecuadoran economy, but it suffers from very serious distortions. The solution requires important actions that in turn depend on a large dose of political will. Some of the main problems in this sector are as follows: • Lack ofjudicial andfiscal stability. Perhaps the most recent example is the elim- ination in August 2001 of the right to reimbursemcnt of the IVA, which oil companies have been receiving for their exports. The previous administration was not sufficiently diligent in finding a solution to this problem, which seri- ously affects investments in the short and medium term. Without a quick solution, the IVA problem will reduce the fiscal impact hoped for when the new heavy crude oil pipeline (OCP) becomes operative. o Low production offields with the greatest reserves and a low level of exploratory activity. The level of investment in the exploration and development of this sector does not match its potential. Important oil reserves have been found, particularly in fields operated by PetroEcuador, and with new transport capa- bilities these could be put into production. The new investments should help resolve significant environmental liabilities, and work within programs and projects that respect the consultation rights of local populations. Their bene- fits should also be subject to a new framework of income distribution. o Numerous distortions in the prices and taxes of combustiblefuels. This is reflected in the prices and subsidies for natural gas (GLP). The management of oil income is totally incompetent, and this provokes distortions and promotes a fragmented and unproductive use lacking in transparency. The legal and insti- tutional framework of the sector is outdated. PetroEcuador's monopoly does not allow nondiscriminatory treatment that would provide access to mar- kets-treatment necessary to attract foreign investment and modernize refineries, improve product quality, and reduce the current elevated costs of commercialization and marketing. SYNTHESIS xlix The following measures are proposed. First, there should be an immediate solu- tion to the IVA problem, adopting international arbitration or another procedure to resolve this conflict as quickly as possible. Second, PetroEcuador's oil fields should increase production. The Law of Hydro- carbons contains several legal provisions that could be applied so that private enter- prise can participate with PetroEcuador in oil activities. One possible framework is the formation of mixed-ownership corporations. A private investing partner for the Petroproduccidn enterprise could be found through an international bidding process. Third, oil reserves should be increased. This will require the adoption of a new contract model; the recommendation here is to use the participation model. Fourth, prior legislation should be complemented by a new legal and institu- tional framework that suppresses PetroEcuador's monopoly, favors competition, and provides incentives to invest in refineries and new distribution and marketing instal- lations. A new legal framework should include provisions to rationalize responsibil- ities and ensure better management of the environmental and social impact of oil operations. Fifth, the elimination of distortions in pricing policies is proposed to provide greater fiscal income, eliminate contraband, and eliminate the government's need to perform the onerous task of managing the price of combustible fuels. At the same time a targeted GLP subsidy should be established to compensate the poorest in the country. The proposed bono gas-cash payments to be given to families that cur- rently receive the Bono Solidario (cash transfer)-is a good option, and can be improved upon. Sixth, the system of preallocations of oil income should be revised and made more transparent, with the final identification of funds and accounting done as needed. In the amendment to the fiscal regulations proposed above, the government should establish new rules for oil income, promoting the gradual elimination of ear- marking and promoting the optimal use of oil income. The government should cre- ate a permanent virtual database for income management that is universally accessi- ble, in order to guarantee complete transparency. And seventh, legal dispositions should be established to eliminate extrabudgetary spending in the oil sector and prohibit public indebtedness based on projected crude oil sales. Commercial Reform Commercial reform is fundamental to promoting nontraditional exports. While it is true that oil exports will continue to be the main engine of growth in Ecuador for the present decade, with the extension of extraction and oil export through the com- ing OCP, the diminishing role of oil and its replacement by nontraditional exports can be foreseen to occur in less than two decades. Unfortunately, a strong anti- export bias is blocking the development of nontraditional exports. This bias is not new and should not be erroneously attributed to dollarization, but rather has been I ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN TIIE NEW MILLENNIUM generated by the discriminatory support given to certain nonproductive sectors that have been favored by an import substitution policy based on high tariffs and other nontariff barriers. This situation is preventing these sectors from modernizing and competing based on profitability. The combination of Ecuadoran tariff levels and tariff dispersion comprises such a wide and diverse range of effective protection rates that they escape government control. Tariff structure totally lacks rationality, desir- able in an efficient import substitution policy. The generalized Ecuadoran custom of protecting "final goods" with a higher tar- iff than that established for inputs, raw materials, and capital goods used in direct and indirect production, generates effective protection rates (the true protection of the aggregated value of final goods) that are unjustifiably high and vary among prod- ucts. These rates benefit the sectors with the most efficient lobbies in terms of gain- ing the desired protection, but are not necessarily the most beneficial to the coun- try's consumers. In addition, the tariff protection provided to many agricultural, agroindustrial products and derivatives, through a "Price Band System" that favors 138 different products, does not function efficiently. Very few bands comply with the goal of reducing price volatility, and if they comply with it, they cannot do it simultaneously with two other objectives of the bands-defending producers and consumers against the price distortions prevailing in international markets, and link- ing domestic prices with international prices. The Bands System used constitutes an ad valorem variable rate that lacks transparency, and has an upward bias that severely punishes Ecuadoran consumers, particularly the poorest. It has not slowed the ten- dency of prices to increase in the medium term. The anti-export bias is reinforced by the discriminatory application of nontariff barriers such as prohibitions, licenses, technical norms, customs procedures, cus- toms evaluations, norms on origin, safeguard measures, and public purchases. The import licenses are one of the most notable nontariff barriers. They arc distributed in a nontransparent manner through a tortuous and fraudulent process. They are still applied to more than 20 percent of Ecuadoran imports, and are concentrated in the health and agricultural sectors. The majority of these licenses contradict the norms of the World Trade Organization (WTO). The lack of a national procedure for the application of technical norms is particularly insidious because an additional protectionist measure is added by not applying these norms to domestic products similar to the imported products. Several measures are recommended to solve these problems. First, the customs tariff should be simplified to two rates of 5 and 10 percent. To the extent to which these efforts are successful and the 0 percent rate is eliminated, the fiscal impact would be neutral. The recent Latin American tendency is toward this type of struc- ture and level. The measure would also have the advantage of homogenizing the effective protection rates, and would signify a huge step toward compliance with the future demands of the Free Trade Agreement of the Americas (FTAA). Second, prior authorizations that did not register commercial activity from 1991 through 2000 (or 919 tariffs) and prior authorizations with a specific prerequisite SYNTHESIS li (health and phytosanitary, among others) should be immediately eliminated. A sin- gle license is sufficient. Those remaining that require prior authorization should be submitted for technical analysis to justify remaining on the list of applicable licenses. If they do not pass this test, they should be eliminated from the legally mandated list. Third, the number of bands should be drastically reduced, and they should be submitted to markers for an eligibility test applied to imports, and sensitive to the volatility of external prices. In the medium term, given that these bands are incom- patible with WTO and FTAA norms, they should be eliminated. Fourth, an increase in the productivity of the agricultural sector, especially the sector with export potential, should become a focus of permanent public effort, through technology development and transfer, particularly for small and medium producers. Fifth, 759 existing obligatory technical standards should be evaluated to decide on their future. At the same time, the "deregulation or dismantling" process of oblig- atory norms should be carried out in a parallel manner with the "regulation or set- ting up" of the "WTO Regulation" system, information on which is found in the pertinent WTO legal documents. At the same time, laboratories should approve the test for ISO norm 17025. Sixth, the draft of the Law of Competitiveness should be approved with minor modifications to accelerate the process, and supported with reinforced efficiency of customs controls and reduced corruption. Development of Basic Infrastructure The development of physical infrastructure represents another fundamental chal- lenge for Ecuador because of its direct impact on growth, poverty levels, and the quality of life for the most vulnerable population. Four sectors require urgent atten- tion: water and sanitation, electricity, telecommunications, and transport (highways and roads, railways, ports, and airports). The sectors of water and sanitation, electricity, telecommunications, and trans- port confront problems such as low coverage (particularly in rural areas), efficiency and quality of services, an uncertain mobilization of resources for new investments and, with the exception of the electricity sector, incomplete institutional and regu- latory frameworks. In general terms, the national government should address these challenges by seeking greater local, national, and international private sector partic- ipation, by consolidating institutional and legal arrangements. Above all, in the water and sanitation sectors and transport, the government should use central trans- ferences of resources to encourage service providers to improve service and increase coverage. In addition to these problems, the water and sanitation sector is characterized by low recovery of costs through charges, a high dependency on transferences from the central government to cover the deficit, and the lack of an integral national system of water resources. Given that all water and sanitation services comes from decen- lii ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM tralized providers that depend on municipal governments, the central government has two main instruments for improving the quality and efficiency of services and ensuring their extension to rural and urban populations that do not yet have cover- age: reforming the use of central transferences to provide incentives for profitability among service providers, and perfecting the legal and institutional framework. The most urgent problems of the electricity sector also include inefficiency that is attributable to an incomplete reform process, institutional vulnerability, the uncertain sustainability of the wholesale electricity market, the rate readjustments needed to ensure the financial sustainability of this sector, and incomplete implementation of sectoral environmental policy. To confront these challenges it is imperative to reacti- vate the participation of the private sector in distribution and generation; moderate or eliminate state interference in the regulatory entity Companla EkIctrica del Ecuador (CONELEC); normalize the wholesale electricity market's financial situation; reiniti- ate the adjustment of rates with the appropriate "lifeline"-type protection for poorer households; confront the problem of the Empresa Elictrica del Ecuador (EMELEC) enterprise; develop a strategy for rural energy-, and consolidate planning and sectoral environmental management systems, particularly in the Ministry of Energy and Min- ing and in CONELEC. In addition to the general problems of national infrastructure, the telecommuni- cations sector faces specific challenges induding artificially low, unsustainable local rates for fixed telephone service; lack of competition in the cellular telephone mar- ket, leading to user costs that are among the highest in the region; and very limited Internet access. It is essential for the government to consolidate the institutional and legal framework and encourage greater private sector participation, attracting private capital to Andinatel and Pacifitel in order for them to make the investments the sec- tor requires and to break up the duopoly in the cellular market. The challenges in the transport sector include the poor condition of the highway network, the poor condition of local roads and the lack of transit services to rural areas, environmental problems, incoherent and insufficient sectoral and modal plan- ning, and insufficient capacity and resources available to sectional governments to maintain provincial and local highways in the context of the decentralization process. The national government must contract maintenance services on the basis of results and promote private sector participation through microenterprises to maintain and pave rural roads, foster the creation of mixed ownership cooperatives for rural trans- port, award prizes for the best performance by sectional governments, improve envi- ronmental management in each sector, and transform the Ministry of Public Works into a new Ministry of Transport with regulatory and planning functions. Urban Development The "urbanization" of poverty has brought with it the "marginalization' of the cities, especially the large and medium-size ones. The percentages of population living in slums in Quito (30 percent) and Guayaquil (60 percent) are significandy higher than those found in other Latin American cities of a similar size. The situation in SYNTHESIS liii certain medium-size cities in the Sierra is also of concern. This has obvious implica- tions for the proliferation of social problems, crime, and violence. Living conditions in marginal areas are extremely precarious: houses are made of impermanent materials and sometimes even of items scavenged from trash; families live in overcrowded conditions with several persons sleeping in a single room and several families living in each dwelling, in many cases with no sewage hookup or running water. Statistics show that these conditions are most severe in the Sierra. The great number of recent natural disasters in both Quito and in Guayaquil makes living conditions even more precarious for the poor. The formal housing market has problems of both supply and demand. On the one hand, the poorest population does not have sufficient income to live in accept- able housing, while on the other hand, the prices of developed land are inflated because of urban planning regulations and deficient market conditions. While land partially prepared for development may cost between $50 and $60 per square meter, completely undeveloped land in marginal areas costs $4 per square meter, the only price accessible to the poorest population. The Housing Incentives System (SIV), created in 2000 to improve this situation, provides direct subsidies on demand, but has managed to benefit only the richest 40 percent of the population. An urban development policy should consider several factors. First, a compre- hensive urban improvement program should be designed and implemented based on current and foreseeable quantitative and qualitative deficiencies in housing. This program should be national in scope, and have the fundamental goal of improving living conditions in marginal areas and reducing the physical, economic, and social vulnerability of the people living in these areas. It should be implemented by the municipalities, thus promoting a high degree of community participation. Second, the workings of urban land markets in the big cities must be reviewed to determine the obstacles hampering the availability of serviced land to the poorest population. Third, a system for preventing disasters must be designed and implemented at the national, municipal, and neighborhood levels. Such a system must be based on geo- referenced information systems, risk maps, technical training, public education, and institutional mechanisms that enable the integration of the different agencies that make up "the system." Fourth, it is advisable to examine the distribution of respon- sibilities for providing urban services, in order to locate and remove bottlenecks, redefine responsibilities among the different state agencies, and boost the capacity of municipal governments to understand, analyze, and reduce urban poverty. Boosting Sustained and Equitable Social Development High rural-to-urban migration, natural urban growth, and the country's deteriorat- ing macroeconomic situation in the 1990s have led to increased urban poverty in Ecuador. Whereas in 1995, 19 percent of urban dwellers were poor, in 1999 this fig- ure had jumped to 42 percent-more than double. It is clear that poverty is no longer only rural, and in fact is becoming increasingly urban in Ecuador: 33 percent liv ECuADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NFW MILLENNIUM of the country's poor lived in cities in 1995, while the 1999 figure was 48 percent, which means that almost half the poverty in the country was in urban areas. At the same time, social spending has declined. During the 1990s, there was a significant reduction in spending on education and health. Education spending dropped from 6 percent of GDP in the 1980s to 2.7 percent in 2000, and health expenditures dropped to 1.7 percent, far below the 2.8 percent spent in 1990. Meanwhile, spending on social protection has risen to 1.5 percent of GDP in recent years (not including the hydrocarbons subsidy). The health and education sectors share similar problems in terms of poor cover- age and low-quality services, especially for poor and indigenous people in the urban periphery and rural areas. There are no anticyclical social programs in Ecuador, despite the country's having an oil-based economy subject to great fluctuations in international prices. The main social protection program is the Bono Solidario and various food assistance programs. The social security system is the traditional "pay-as-you-go" type, combining pensions and health care. It maintains a financial surplus thanks to a young, formal labor force, payment of low benefits, poor coverage, and low-quality health services. This surplus has attracted the interest of several actors, especially the national gov- ernment, which has deposited a large part of its reserves here, and private groups that have demanded the creation of social programs that have not been very well focused, such as the Seguro Social Campesino (Rural People's Social Security Pro- gram, SSC), a noncontributory fund for pensions and health services to benefit rural groups in selected areas of the country. Education Despite the great advances in primary coverage at the national level, major chal- lenges remain in the area of education: 11 percent of the population over age 15 is illiterate, and the net rate of primary school attendance is close to 90 percent. This drops to 51 percent in secondary school and 14 percent in higher education, There are great differences in coverage between rural and urban areas and between indige- nous and nonindigenous populations. The system is unbalanced at all levels: the poor and indigenous school-age population is at a great disadvantage compared to the rest of the population, and basic, diversified, and university education are aimed mainly at the urban population with above-average income. The quality of basic education is quite low. Results of academic achievement test- ing (APRENDO) show deficiencies in the quality of teaching at the basic level. This involves factors related to the educational establishment, teachers, and the socioeco- nomic conditions in which students live. Limited access of students and teachers to scholastic materials affects student results. Nearly a third of primary schools have only one teacher, who in most cases has not been trained in multigrade methodology. As a result of the severe reductions in public spending, the necessary investments have not been made in the education sector, the maintenance of infrastructure is minimal, teaching supplies provided are insufficient, and teacher salaries have been SYNTHESIS IV reduced. Spending on education is very poorly balanced: the fifth quintile of the population with the lowest income receives 12 percent of public spending, while the fifth quintile with the highest income receives 25 percent. The sector has serious problems of governance and administration. The system is characterized by high turnover of top-level authorities; the Ministry of Education and Culture (MEC) has administrative units with identical functions; the administration is excessively centralized; there is little communication among the MEC, its provin- cial offices, and schools; the selection, hiring, and promotion of teachers is an opaque process; the distribution of teachers is not adequate (there are too many teachers in some areas and not enough in others); and the salary structure for teachers has no relation to the objectives of improving the quality and balance of the system. Solving these problems requires comprehensive educational reform. First, all Ecuadoran children should have access to and should complete basic education, and should have access to better-quality schooling. Programs aimed at increasing cover- age must be focused on groups that are now underserved, such as those with the low- est income levels and those living in rural and indigenous areas. The MEC must consider innovative choices of methodology, such as "tele-high school," to reach the most underprivileged groups. Second, to improve quality, the MEC must evaluate different options or strate- gies to attract new teachers on an ongoing basis, design a plan to provide the edu- cational system with at least the minimum teaching materials that are necessary, and institutionalize the APRENDO system for measuring results, while giving special attention to strengthening bilingual education in the country. Third, public spending on education must be gradually increased to 1980s lev- els-that is, 6 percent of GDP. Fourth, it is essential that the sector be better managed in order to properly allo- cate economic resources and achieve the desired results. At the same time, pilot decentralization projects must be initiated, offering greater autonomy to the educa- tional system and greater parent participation in school management. Health As in education, there are numerous coverage problems in the health sector. About 30 percent of the population still does not have access to basic health services. More than two-thirds of the population does not have formal health insurance and the Ministry of Public Health (MSP) and other public institutions are unable to provide service to almost half of these individuals-precisely those with the worst health indicators. Insufficiently attended births and lack of access to basic health care are the main factors responsible for an unbalanced epidemiological profile. A direct result of poor coverage is reflected in high infant and maternal mortal- ity rates and premature births. It is estimated that for every 100,000 births, 160 mothers die as a result of complications related to pregnancy, birth, or postnatal problems, and 4,300 children die before their first birthday. Deaths due to infec- tions and violence that particularly affect the young population are as common as Ivi ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM mortality due to cancer, and interregional differences in these indicators are so great that life expectancy in the province of Pichincha is 15 times as high as in the Ama- zon provinces. Public health spending is insufficient and private spending is unfairly distributed. Private spending represents 80 percent of all health spending, and it is the poorest people whose income is most proportionally affected by this expense (up to 40 per- cent of their income). Reform of the health sector requires a number of actions. First, we propose that the Law on Free Maternity Care (LMG) be strengthened and broadened. A model must be established that avoids duplication of coverage and promotes the broaden- ing of coverage, while considering the social and cultural factors that limit the demand for basic services. Second, coverage by the SSC must be increased along with that of the LMG. The SSC's financial limitations are too great for it to be broadened to cover the remain- ing 3 million people, but the mother-child population not covered currently may benefit from the services provided under the LMG. Third, we propose that basic health services be included through the Bono Soli- dario for the retired and disabled: preventive and informational services, outpatient treatment, and hospitalization for prevailing acute illnesses, and a basic package for chronic illnesses and surgery. This would provide coverage to approximately 230,000 pensioners and 8,000 disabled persons who have no other resources for medical attention. Fourth, the essential functions of the MSP must be redefined, shifting from its role as a supplier of services to a new role as an organism accrediting establishments, monitoring the quality of services, creating a health monitoring system, and provid- ing training in order to intervene in situations of epidemiological risk, among other tasks. As part of the redefinition of the MSP's functions, service provision arrange- ments could be established with the Ecuadoran Social Security Institute (IESS). Fifth, we propose creating a regulatory framework for developing a system of regional health services networks with levels scaled according to their complexity. The MSP installations, decentralized establishments, and the SSC would all partic- ipate, and at the local level would focus their efforts on primary care and programs for providing basic services. Sixth, we propose broadening SSC coverage, possibly creating a new insurance program for the poor population, which would consolidate and progressively replace the benefits of the LMG and the provisions of the Bono Solidario. Protecting the Most Vulnerable The banking and exchange rate crises have generated new demands for social assis- tance. The most vulnerable groups facing chronic poverty have been joined by groups requiring temporary social assistance. In 2001, Ecuador planned to spend close to $264 million on 22 Priority Social Programs (PSPs), which represents about 1.5 percent of GDP, similar to the average in the countries of the region. About 60 SYN'lTHESIS Ivii percent of this amount was allocated to two programs for transferring cash: the Bono Solidario and the Beca Escolar (Educational Scholarships). The two most important programs immediately became the School Breakfast and Lunch program-$US24 million-and the Bono Solidario-$US154.5 million, in 2001. Though the subsi- dies for the consumption of natural gas and gasoline are not included among the 22 PSPs, they came to about $US500 million for 2000. This social assistance network has its problems. Its functions (and budget) are not countercyclical-that is, they do not have the ability to expand in times of crisis and contract in normal circumstances. This manifests itself in the absence of PSPs with established minimum spending levels, and in the lack of a mechanism for automat- ically updating the list of beneficiaries. The network also contains several programs with regressive spending, and lacks consistent criteria for maintaining a steady focus. This is not an exception in the area of social spending; in fact, a high percentage of spending on universal social programs ends up benefiting rhe population with higher-than-average income (for example, energy subsidies or school meals). Also, targeted programs vary in their effectiveness in reaching the lowest-income groups, and do not use consistent targeting criteria (for example, the Bono Solidario and National Child and Family Institute [INNFA] programs). Several programs cover vulnerable groups inadequately, despite their multiple interventions. Finally, the Bono Solidario has several flaws: it does not have a mechanism that enables it to include new beneficiaries; there were errors in its original focus on the target popu- lation; there is a lack of clarity in the program's objectives and benefits are insuffi- cient; and it does not generate mechanisms for ending dependence on the Bono. The lack of an evaluation of the impact of the Bono prevents a more complete overview of its performance. To improve the social assistance network, we propose the following. First, its flex- ibility must be increased. For example, the establishment of minimum budgets for certain PSPs would enable it to set up a "virtual" social assistance fund with pro- tected amounts within the budget to resist cyclical fluctuations. Second, the creation of a clearly counter-cyclical program, for example, in pub- lic works, is feasible. This should offer a sufficiently low salary to attract only very poor persons in crisis. Third, it is crucial to improve the coordination and targeting of existing pro- grams. To do so, we suggest adopting a single criterion for targeting social assistance programs. Fourth, it is necessary not only to increase, but also to redirect the Bono Solidario toward a conditioned subsidies program. The Bono should be oriented toward pro- tecting the health of children and pregnant women in poverty. Social Security The Ecuadoran social security system has problems with coverage, management, and institutional status. The coverage of the active and elderly population protected by the formal system (the Obligatory Social Insurance of the IESS) is one of the low- lviii ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THIE NEW MILLENNIUM est in the region. An overview of other noncontributory programs, such as the SSC and the Bono Solidario, reveals broader coverage, but their benefits are too small to constitute effective protection for the elderly. Another problem is the IESS's uncer- tain financial balance. The IESS counts as active a state debt corresponding to con- tributions that have not been deposited for more than a decade. The amount of this debt differs significantly depending on whether it is calculated by the IESS or by the Ministry of Economy and Finances. Furthermore, IESS reserves are not clearly sep- arated or earmarked for health, old age, disability, and death, making it possible that there are invisible cross-subsidies. Another issue is that the state is legally obligated to contribute 40 percent of pensioner benefits each year, even when the IESS pen- sion program has a surplus, thus generating unnecessary fiscal pressure. The legal status of system reform presents another problem. In November 2001, a new Social Security law sanctioned a new institutional design that was to be immediately imple- mented. However, its full application was blocked by a decision of the Constitu- tional Court, which in turn was overruled by the judicial system. As a result, the new law is only partially applicable, and the IESS has opted to apply certain aspects of it while ignoring others at its own discretion. We propose several measures to correct these deficiencies. First, the amount paid out by the SSC (and the Bono Solidario) must be corrected to levels close to 50 per- cent of the poverty line. This would mean redefining a strategy for broadening SSC coverage and noncontributory payments. Second, there must be a quick resolution of the differences between the IESS and the government regarding the government's debt to the IESS, based on clearly presented documentation. Third, we propose effectively separating the accounts and reserves of the IESS according to type of insurance. Fourth, an amendment should be made to correct the Law Reforming the Social Security to eliminate its current confusions and errors and to completely sep- arate pension and health policies. Consideration could also be given in this amend- ment to reducing the percentage contributed by the state, thus reducing fiscal pres- sure on it. This could become effective once the state has paid its pending debt with the IESS. Fifth, in the medium term, an integrated coverage model should be applied, extending coverage to segments of society now excluded, especially the poor and the elderly. Rural Development Three essential factors highlight the importance of rural development for Ecuador: (a) the economy's high dependence on natural resources, including agricultural products, hydrocarbons, and forest and mining products; (b) the concentration of poverty in predominantly rural areas; and (c) the great natural, social, and cultural wealth and diversity in the rural areas of the country. The contribution made by natural resources from four sectors (agriculture, mining, forestry, and hydrocar- bons) comes to about 40 percent of GDP. However, not enough environmental care is taken in the exploitation of these resources, nor are the resulting benefits fairly shared. The result is the accelerating degradation of soils, rivers, and coasts, SYNTHESIS lix and a great economic gap between rural and urban areas. Despite the severity of this situation, public policies dealing with rural development in Ecuador have suf- fered from a lack of coordination, excessive fragmentation by sector and central- ization, resulting in inefficient public and private investment. Many rural policies have concentrated on the agricultural sector, while little attention has been given to other areas. Therefore, a new set of policies must be established to guarantee the sustainabil- ity of natural resources, reduce rural poverty, and recognize the value of the cultural and natural wealth of the rural sector. The emphasis on agricultural production as the engine for rural development is shifting in favor of diversified production, links between the rural environment and the cities, access to markets as an engine for growth, and the development of local capacity. At the same time, centralized admin- istrative approaches are being replaced by demand-driven processes and local deci- sionmaking, in which the aim is to try to discover and incorporate antipoverty strategies proposed by the beneficiaries themselves in their own surroundings. In this context, with a view toward diversified economic growth and reduced rural poverty, a strategy of diversified, multisectoral rural development with a terri- torial approach must be designed. This strategy would have three main goals: (a) economic and social cohesion through the development of local spaces, (b) changes in agriculture and rural economic diversification, and (c) environmental protection. Ecuador's geographic, economic, and sociocultural diversity requires that this strat- egy take a variety of forms and be backed by development policies focusing on par- ticipatory action in local or rural spaces to foster economic and social cohesion; diversification of the rural economy; nonagricultural job creation through invest- ment in rural and social infrastructure and fostering a competitive agricultural sec- tor through up-to-date technology and research; and promoting environmental pro- tection through better regulation of land use, recovery of land conservation methods, and other uses of natural resources. This strategy will also require an institutional structure that facilitates the coor- dination of the different institutions involved. The institutional regulations that can guide this effort must be based on cooperation among the national public sector, the private sector, the rest of civil society, municipalities and provincial governments, and local governments; coherence among the regulations and activities of the differ- ent institutions; programming based on the strategic plans of each jurisdiction; and financial allocations based on the concept of "additionality" as incentives for guar- anteeing the implementation of strategic plans. Environment The problem of poverty in Ecuador is exacerbated by two key variables: environ- mental pollution and natural disasters. Any strategy for the country's economic growth and social development will depend on controlling the degradation of the biophysical environment and on the sustainable management of natural resources. Controlling pollution and preventing the effects of natural disasters on the popula- Ix EcuADoR: AN ECONOMIC AND SociAL AGENDA IN THE NEW MILLENNIUM tion both demand the highest priority and greatest attention on the part of envi- ronmental authorities. There are two basic ways the state can intervene to develop environmental pol- icy: environmental regulations, and environmental administration and investment. Environmental regulation includes different tools such as economic instruments, direct regulation, and administrative procedures. Environmental administration and investment include the management of state-owned assets and environmental investment in sectors that face the environmental conditions associated with poverty in Ecuador. Among the choices of tools for environmental regulation, the development and strengthening of command-and-control regulations merits special attention, partic- ularly regulations on zoning ordinances and land use, monitoring of water and air quality, management of dangerous wastes, and final disposal of solid wastes. At the international level, instruments for strategic environmental evaluation are also used to define environmental investment priorities in the various sectors. To reduce rural vulnerability to natural disasters, investment in structural and nonstructural damage prevention resources is urgently needed. Structural measures include resettlement of populations living on flood plains, public works for flood control, use of wetlands as buffers against flooding, and public works to control erosion and stabilize embankments. Nonstructural measures include regulating land use, designing pro- grams for responding and attending to emergencies, and equipping and preparing the population for such events. Building a Quality Government That Serves All Ecuadorans and Fights against Corruption The problems of poor government and high levels of corruption in Ecuador are leg- endary and contribute to poor public services. Moreover, it is worrisome that com- pared to recent developments in Latin America as a whole, almost all indicators of governance and control of corruption in the country have shown significant and constant deterioration since 1998. The most dramatic changes can be seen in the quality of the country's regulations, civil society control and participation, effective government, respect for the law, and control of corruption (for which Ecuador has the lowest rating of any country in the region). While Ecuadorans are proud of themselves, they express a generalized lack of confidence in national government institutions and a slightly higher level of confidence in subnational governments. On a scale of 0 to 100, the confidence of Ecuadorans in their political system was 37, among the lowest ratings in Latin America. The results of recent surveys, one by the University of Pittsburgh/Cedatos/ Gallup and another by the World Bank, confirm that corruption is a very serious problem, especially in the awarding of contracts and when receiving public services. The frequency of bribery varies according to the service provided, and it is less com- mon among local government services. Nonetheless, if decentralization continues SYNTHESIS lxi and efforts are not made to establish appropriate controls, people believe that the level of municipal corruption could increase. Evidence shows that corruption wors- ens poverty and inequality, since the income of the poorest users is proportionally more affected by bribery, which does not necessarily translate into better-quality services. Also, this phenomenon is a disincentive to the population, and limits access to public services. As a result, it is estimated that corruption reduces the state's potential tax income by about a third, rerouting it inappropriately to private hands. A reform program must focus on both the public sector and the civil service. International experience suggests that public institutions with merit-motivated staff, transparent management, efficient anticorruption mechanisms, high morale, and the will to carry out reforms, both perform better and are capable of significantly reducing corruption. In general, a multidimensional reform plan focusing on three areas is necessary: (a) strengthening existing regulations and institutions in the fight against corruption, which covers not only the public sector, but also the private sec- tor and civil society in general; (b) educating the population regarding the people's right to supervise public functions, which implies the development of mechanisms for monitoring public spending, guaranteeing the population-especially Congress, the media, and civil society organizations-easy, permanent access to fiscal accounts; and (c) improving governance to prevent corruption in its various forms, whether administrative or linked to specific areas such as purchasing from and contracts with public agencies. Each form of corruption is associated with a specific institutional weakness and thus requires an equally specific solution. In accordance with this general approach, we propose several short-term meas- ures, including a Governance Pact between the state and civil society. The partici- pation of political parties and civil society in the Pact must be actively encouraged by forming an executive committee with broad powers and a clear mandate to design and implement an anticorruption strategy. The Pact must be complemented by similar efforts on the part of the government, aimed at reforming the public administration, such as developing new procedures for providing updated budget information, hiring staff, establishing public service quality standards subject to sanctions if not met, and quickly and reliably reporting corruption. Given their spe- cial importance, offers and contracts for public purchasing must be published regu- larly and immediately on the government's Web site, including all information relat- ing to its decisions in this area. In the medium term, complementary measures would include modernizing budget management to make it accessible to citizens in electronic form, and regu- lating finances and contributions to political campaigns to make them transparent and to prevent "state capture" by specific economic interests. Similarly, it is impor- tant to ban or strictly limit the use of state resources for political campaigns. It is also essential to strengthen mechanisms for administration, control, and public moni- toring of sectional governments, taking advantage of citizens' more moderate per- ception of corruption at these levels of government. Finally, a National Transparency Campaign would have to be part of the ongoing task of reeducating the populace. Ixii ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Labor Markets and the Civil Service Ecuador's dollarization led to a complete transformation of the role of the labor mar- kets, since it meant that their external and internal competitiveness no longer depended on devaluations. This has made a flexible and productive labor market a central feature of sustained economic growth. Also, as mentioned, an efficient civil service is essential in the fight against corruption and to achieve significant improve- ments in the provision of public services. Labor indicators show there has been some recovery from the impact of the end- of-century crises. Formal employment declined until 2000, then gradually rose to around the 1998 level. This recovery is partial, however, and hides deeper effects such as that of half a million Ecuadorans (the most economically active population) emigrating to other countries; the continuous migration from the countryside to the cities; and the fact that the underemployment rate remains three times as high as in 1998, which reflects that a growing number of workers work fewer than 40 hours a week (visible underemployment), or are paid less than their stipulated wages (invis- ible underemployment). The growth of income and real wages shows a similar trend: a steep drop in 1999, followed by a slight recovery to above 1998 levels (both in nominal and real 1998 dollars), with a relatively greater increase in thc informal sec- tor than in the formal sector. Although the Economic Transformation Law simplified wage policy in the pri- vate sector and introduced new and more flexible forms of hiring through hourly and temporary contracts, the system continues to be excessively rigid. On one hand, the Sectoral Tables, based on the minimum wage established by the National Wages Council (Consejo Nacional de Salarios, CONADES), involve automatic indexing which, in case the parties do not reach an agreement, grants a minimum annual increase similar to the inflation rate projected for the following year. These increases not only have nothing to do with productivity, but also act as just the starting point for additional increases negotiated within each sector or as part of collective agree- ments. This indexing mechanism, while desirable as a means of quickly lowering inflation, becomes a serious obstacle to competitiveness when inflation stabilizes near international levels. On the other hand, the proliferation of temporary work agencies (about 200 created in recent years, covering about 10 percent of formal employment)-a phenomenon known as "outsourcing"-does not allow for ade- quate monitoring, worsens labor relations, and makes it difficult to ensure that the minimum labor requirements are being met by the companies doing the hiring. The civil service also presents serious problems. First, the proliferation of salary perks and contracting under inappropriate categories (services) makes it practically impossible to determine the exact number of workers and the size of the payroll, while raising the cost of "base" salary increases granted by the government. Also, the regulations promulgated by the new CONAREM are virtually irrelevant (more than 150 regulations in less than three years). No agency controls the public payroll, thus leading to ad hoc bilateral labor negotiations between each public institution and the Ministry of the Economy and Finances. The situation is chaotic. SYNTHESIS Ixiii Special attention must be paid to wage levels and the degree of labor flexibility. We propose two measures for the private sector. First, future wage increases must be brought in line with increases in work productivity, simplifying the wage negotia- tion process by no longer revising wages according to predicted inflation, minimiz- ing the role of the "sectoral tables" and establishing a single minimum wage. Second, sufficient labor flexibility must be guaranteed in the formal sector without imposing excessive costs on workers and reducing the nonwage costs of formal employment through better regulation of the use of temporary work agencies by companies car- rying out permanent activities, promoting the use of temporary and by-the-hour contracts when this is necessary, and eliminating the rule on redistributing 15 per- cent of profits to workers. Regarding the civil service, the fundamental goal of the new government must be to begin to rationalize the public sector. The draft of the proposed Wage Unifi- cation Law (Ley de Unificacidn Salarial) is a good start, though it could be improved. In the context of wage unification, it is advisable to maintain wage sup- plements based on geographic location for doctors and teachers to guarantee min- imum health and education services in remote areas. Wage unification must also be combined with a process for restructuring public employment-reducing person- nel if necessary-and reinforcing the system for controlling public hiring by means of a centralized register, as proposed in the draft of the Wage Unification Law, in the SIGEF. Judicial Reform Despite the progress made in specific areas of judicial reform, people do not have confidence in the formal Ecuadoran justice system because it is not easily accessible, is slow and inefficient, and is perceived as vulnerable to corruption. These problems, in turn, are associated with the low level of professional training received by those who operate the system, limited resources, and the use of inadequate administration and control models. The initial stage of the Comprehensive Reform Plan, approved in 1996 and revised in 2001, has been completed, and is aimed at laying the ground- work for bigger future changes. But it has not yet managed to improve the admin- istration of justice to a degree perceptible to the public. In this context, the private sector and the rest of civil society are convinced that a coherent and comprehensive process is essential to achieve medium-term results. This involves actions aimed at recovering public confidence in the administration of justice, improving the professional quality of judges, increasing efficiency in the management of justice, and broadening access to justice. Such a process must enhance what has already been achieved, using it as starting point. This will neces- sitate a reconsideration of regulations, operators, costs, infrastructure, and adminis- tration and management systems. It will also necessitate a reconsideration of the structure of the judicial system and of institutions such as the Constitutional Court and the Justice Ministry, each formally independent but which have an impact on the judicial system. WXiV ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM IDecentrafization The main problem of the Ecuadoran public administration system is that central- ized decisionmaking has negatively affected the quality of services. Decentralization can-subject to certain rules and principles-contribute to solving this problem. Since the provincial and municipal councils are closer to users of services, these councils could provide more creative and efficient solutions than the central gov- ernment. Ecuador faces three main challenges on the road to decentralization: (a) clearly defining areas of responsibility for a second tier of public administration (functional decentralization)-comprising regional development agencies, executive units, social funds, and attached bodies-in relation to the provincial and municipal coun- cils; (b) modifying the transfer of resources to include transfers of authority; and (c) managing local government debt with fiscal responsibility, sustainability, and trans- parency. Without rules and a framework of clear incentives, decentralization cannot be maintained. The four most important recommendations for reinforcing decentralization are as follows: First, at the intermediate (provincial) level of government, we propose that a transition strategy be implemented in which dependent, decentralized bodies must report to elected authorities-that is, the Prefect and the Provincial Council. At the ministerial level, this means appointing provincial sectoral managers (decen- tralized ministerial area) with a list of three candidates proposed by the Prefect; and at the level of regional development bodies, establishing the Directorate according to the provincial prefects that correspond to each jurisdiction, with a representative of the central government. The budget must be approved by this new Directorate. Second, regarding the special law transferring 15 percent of the central govern- ment's current income, we propose that the exact amount transferred be determined and that this transfer process be carried out transparendy. If the central government has the fiscal room to raise transfers beyond the current 10 to 11 percent, and once the budget emergency is over, transfers should be made based on the additional income effectively received, and these resources should be pegged to the simultane- ous transfer of powers and the delivery of results. Third, regarding subnational debt, we propose regulating this in a transparent process to promote fiscal responsibility, which means rescheduling debt with munic- ipalities and provincial councils with excessive debt and reporting this in the gov- ernment's annual budget document. We also suggest publishing the debt write-offs made in the past five years; researching and publishing different ways that local gov- ernments can acquire debt (contingencies, floating debt); and requiring that outside agencies give an independent credit rating for new loan applications from the three biggest cities. Fourth, we propose introducing safeguards to the system for contracting transfers of powers in order to clarify responsibilities and rights at each level of government. This means limiting access to the program for transferring powers by requiring that subnational governments meet minimum standards of accounting, budget manage- SYNTHESIS IXV ment, and regular financial reporting-and completing the transfer agreements with clauses stipulating financial calculations (debt, investments), sanctions for noncom- pliance, the reversibility of the transfers, and dispute settlement procedures. D. The Vision of a New Ecuador This book highlights the difficult fiscal and debt situation faced by the new Ecuado- ran officials, and the limitations they themselves see in terms of being able to imple- ment ambitious development while maintaining fiscal discipline. For that reason, the extensive agenda described above requires correct prioritization and sequencing, possibly beginning with measures to consolidate fiscal sustainability and deal with urgent foreign debt commitments. This could be accompanied by a prioritization of spending and the preparation of institutional reforms-especially ones such as the Governance Pact, aimed at eradicating corruption and strengthening governance on the basis of consensus, participation, and active social monitoring-giving the new government an image that suggests change and transparency. The officials should, to the extent possible, avoid giving in to pressures of a populist nature, which usually have a high fiscal cost with only a brief impact on demand. Not only the design but also the implementation of the agenda must be consistent. We believe that a solid start on the part of the government will enable it to earn the political capital to make further medium-term advances in the reform agenda. To facilitate this work, we have attached a set of suggestions for priority action. The intention is not for all of these to be adopted; rather, they represent an independent opinion of the work involved in developing a government agenda. The World Bank recognizes the com- plexity of creating this vision of a new Ecuador, and will continue to offer its sup- port to officials in the design and implementation of its strategy for economic and social development aimed at reducing poverty. Table 1. Ecuador: A Possible Order of Priorities in the Design and Implementation of Policies for Boosting Economic and Social Development FIRST STAGE Protecting the Macroeconomic Framework Send Early Confidence-Building Signals Make Poverty Reduction an xplicit Priority • Pass an austere 2003 budget o Review and widely publicize the state of o Approve greater spending on education and " Announce tax reform (with compensatory fiscal accounts health in 2003 m social measures) " Approve a solid and credible o Replace the gas subsidy with a more specifi- o Reverse "relaxed tax collection" policies macroeconomic program cally focused subsidy o o Announce the amalgamation of SRI with o Announce a 2003 plan for financing " Increase and apply conditions to Bono Customs within one year foreign debt Solidario benefits o At least freeze overall salary mass - Settle disputes with the oil companies o Approve spending on priority social (zero growth) in real terms " Make privatization and deregulation programs at least similar to 2002 levels 0z priorities on the agenda 0 - Pass the Labor Unification Act (Ley dce Unificacidn Laboral) with neutral fiscal cost and give up automatic wage indexing ( and mandatory application of the Sectorial Tables The First Steps toward Accelerated Growth Design and Initiate the Strategy against Poverty Put Governance at the Top of the Agnda z o Approve new forms of contracts with oil " Combine the coverage of the Rural o Sign a Governance Pact z companies to allow mixed investment People's Social Security program (SSC) " Present a Plan for Fighting Corruption and o Restart electric rates adjustment and the Free Maternity Care program a National Transparency Campaign o Allow Andinatel and Pacifictel to take part o Institutionalize the APRENDO program to " Approve a Law on Oil Income Trans- z in private ventures monitor advances in the quality of education parency o Approve an amended Competition Act and " Complete the participatory evaluation and " Post acquisitions and quarterly reports on simplify the business registration process focus of the Priority Social Programs the fiscal situation on the government web- • Eliminate preallocations, marginal taxes, and (and the Bono) site Z pre-import licenses that have specific Evaluate the feasibility of insurance for the * Turn the Ministry of Public Works into a prerequisites elderly, of health care for the retired and regulatory body and create a Concessions Evaluate state-owned banks and stiffen disabled through the Bono Solidario, and of Office regulations on precautionary monitoring a cycle-resistant social employment program * Unify payrolls in an SIGEF module * During the fiscal emergency, freeze contri- * Approve unified municipal financial system butions by sectional governments above the regulations 10-to-I1 -percent level, increasing them * Complete design of reformed judicial afterward, based on new responsibilities system * Clear up the state's debt to the IESS and clarify the Law Reforming the Social Security System SECOND STAGE Develop Measures for Consolidate Stability and Growth Implement Poverty-Reduction Strategy Rural and Urban Development * Simplify customs tariffs, reduce the number * Refocus spending on longer-term social * Design Urban Improvements Plan of bands, and eliminate pre-importation objectives * Prepare a Disaster Prevention System authorizations * Reevaluate the state's contribution to the * Create technological and financial * Eliminate most of the 759 technical IESS and its links with the Ministry programs with export potential for the regulations and use WTO regulations of Health agricultural sector * Complete the reform of the hydrocarbons * Begin transferring budget resources on sector the basis of results * Centralize BCE liquidity management and * Expand virtual SIGEF to other reform payment system public bodies * Improve banking systems for resolution * Regulate subnational debt, modify and liquidation system for taking on powers, and * Complete sectoral reforms and crossed develop transition strategy at subsidies in infrastructure mid-ministerial level * Pass Water and Sewage Act Part I Preserving Stability with Fiscal Discipline and Accelerating Growth with Competitiveness Maintaining Stability with Fiscal Discipline and Competitiveness1 Jose R. Ldpez-Cdlix Ecuadorfinds itself at a crossroads. Dollarization has allowed the country to overcome hyperinflation, restore confidence in the banking system, and lifi the veil of money that prevented itfrom seeing clearly the serious imbalances in the fiscal, financial and real sectors that plagued its economy. Based on that achievement, and on their countrys tem- porary boom in petroleum revenues and remittances, the new authoritiesface a dilemma. They must either take the path of austerity and competitiveness, achievingfiscal disci- pline as a prerequisite for the structural changes needed to raise Ecuadors productivity and eliminate serious distortions in domestic markets, or once again squander the coun- try' petroleum riches with expansive, anachronistic, and corrupt spending policies that protect private incomes. The known effects on demand of the latter course might be pos- itive in the short term but are undoubtedly disastrous in the medium term, as demon- strated by the crisis of 1999. Although this dilemma is independent ofdollarization, there is no doubt that such an exc-hange system is unsustainable if the latter course isfollowed. 1. Jose R. L6pez-Calix is a principal economist at the World Bank. The chapter was prepared with the valuable research assistance of Elaine Tinsley and Branko Maric. The author appre- ciates the contributions rnade by Norbert Schady (Poverty), Carolina Sanchez-Paramo (Labor Markets), and James Hanna (Competitiveness) as well as the valuable suggestions of Vicente Fretes-Cibils, Sara Calvo, and McDonald Benjamin. He is also indebted to the authorities at the Central Bank of Ecuador, Mauricio Yepez, Leopoldo Baez and Francisco Hidalgo; as well as the Ministry of Economy and Finance, Mauricio Pozo, Gilberto Pazmifio, Daniel Badillo; Roberto Salazar, Diego Mancheno, and Mauricio Pareja for their support in the preparation of this chapter and for their comments at the seminar held in Quito on January 11, 2003. At the request of the authorities, this chapter was updated with the new statistical information in the national accounts available as of January 22, 2003. 3 4 ECUADOR: AN ECONOMIC AND SocILu AGENDA IN THE NEW MILLENNIUM A0 Background Since its return to democracy in 1979, Ecuador has been characteri˘d by high external vulnerability, weak macroeconomic performance, and ungovernability. Successive external shocks-tied to reductions in petroleum prices or violent fluc- tuations in the country's capital flows as in 1998-and natural disasters have com- bined with poor macroeconomic management reflected in high fiscal deficits. These developments often preceded very high rates of inflation (Figure 1) and foreign exchange instability. This led the country to four severe recessions (1982-83, 1987, 1989, and 1998-99); three hyperinflationary periods (1983, 1988-93, and 1999-2000); high and unsustainable external debt reflected in various payment moratoria; and a recent twin crisis-in foreign exchange and banking-that destroyed 20 banks holding 40 percent of bank deposits. Misguided policies were the result of unstable government administration and the traditional ungovernabil- ity that is characteristic of the petroleum countries. In 23 years, Ecuador had 29 finance ministers who remained in office an average of 10 months, and was the country with the least perceived control over corruption in Latin America (see chap- ter 15 on Governance and Corruption). The twin crisis led to formal dollarization of the country in 2000 (Box 1). This chapter analyzes recent macroeconomic per- formance, challenges on the horizon, and possible solutions. Ecuador dollarized not by choice but as the inevitable way out foCr dealing with its twin crises in 1999. The country was very far from having met all the pre- conditions for successful dollarization, including a solid fiscal position; sustainable public debt; a diversified export structure to accommodate unfavorable shocks to its terms of trade; a sufficiently high level of international reserves (at least to cover the monetary base) as a mechanism for absorbing capital outflows; a sound and com- petitive banking system under strong supervision to prevent the formation of con- tingent liabilities; flexible markets for nontradable production factors-particularly labor and real estate-to accommodate the price adjustments required to preserve the competitiveness of the nontradable goods sector or adjust them in case of reces- sion; and a suitable climate for attracting investment that would provide access to technology and respect for the law. Despite these disadvantages, dollarization allowed the country to achieve two short-term objectives. It brought down hyperin- flation and restored confidence in the banking system. The law also explicitly indi- cated the minimum conditions under which Ecuador should gradually achieve sus- tainable dollarization in the medium term. The crisis of 1998-99 had a devastating effect on poverty levels. The inci- dence of poverty (the headcount) increased dramatically from 34 to 56 percent of the population between 1995 and 1999 (Parandekar, Vos, and Winkler 2002). This means that the number of poor people grew by more than two million during the crisis. Similarly, the number of people living in extreme poverty (that is, people whose income is insufficient to cover basic needs) increased from 12 to 21 percent in a similar period. The crisis hit rural areas most severely, especially in the highlands Figure 1. Relationship between Fiscal Deficits (% GDP) and Inflation, 1980-2002 2 z 120- 4 100 U . . Deficitright scale) --2 80*1 E - 60 jil --4 40- . < . [ .Inflation (left scale) M HAD \ 20- ROLD-S R:N . \ - 20. .OLD~S BORJA DURAN BALLENWBUCARAM 0-HURTADO FEBRES CORDERO .- RU ~~~~~~~~~~~~~NOBOA 0 , , . S i . , i . ; -12 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 '00 '01 '021 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 '00 '01 '02 Z Deficit -4.7 -5.6 -6.7 -0.06 -0.56 1.91 -5.16 -9.48 -5.29 -1.21 0.47 -0.56 -1.15 -0.11 0.6 -1.13 -2.97 -2.55 -5.7 -4.7 1.32 -0.3 0 a Inflation 11.9 14 16.2 47.8 32.8 28.1 23 29.4 57 78.1 48.5 48.8 54 46.4 27.5 23 24.4 30.7 35.8 52 95.8 20 9.7 Source: Gallardo (2001); World Bank. 6 ECUADOR: AN ECONOMIC AND SOCLAL AGENDA IN THE NEW MILLENNIUM Box 1. The Economic Transformation law Approved by Congress in March 2000, the Law contains measures for transi- tioning to dollarization and a program of structural reforms, most of which are still incomplete. These measures are as follows: o Dollarization: prohibits the issuance of new sucres, except coins; obli- gates the Central Bank to a fixed exchange rate (25,000 sucres per $USI) and to withdraw all sucres in circulation; and requires all companies to convert their accounting to dollars. o Interest rates- approves a debt conversion mechanism called desagio to transfer all dollar loans and deposits to lower interest rates, which is also appli- cable to prior debt issued in dollars for a short period; and approves a proce- dure for establishing maximum legal interest rates in the banking system equal to the London interbank offered rate (LIBOR) plus country risk (as deter- mined by the Central Bank), plus four percentage points. o Financial reforms: strengthens and introduces flexibility in financial supervision, placing legal limits on the immunity of senior officials, and giv- ing greater autonomy to the Superintendency to intervene in troubled banks and dispose of the assets of closed banks; it establishes a limit of $US8,000 on the previously unlimited guarantee on deposits; and establishes provisions for restructuring private sector debt to the banking system. o Public spending and deficits: the fiscal deficit cannot exceed 2.5 percent of GDP, and the three-year moving average must be limited to zero; the meas- ure establishes a limit on increases in current spending; and establishes provi- sions to make government contracting more transparent. o Privatization: allows the construction of a new heavy crude oil pipeline (OCP) by a private consortium; and authorizes the privatization of telephone companies and the sale of 51 percent of the shares in state electricity compa- nies. o Labor marketr approves a reform making it possible to hire hourly work- ers at a minimum salary of $US0.50 per hour, as well as provisions making it possible to unify extra benefits based on base salary. where the rate increased by 7 percentage points between 1998 and 1999 alone. The degree of deterioration in these indicators reveals the depth of the crisis and the greater vulnerability of the rural poor in dealing with their income losses. The sub- sequent emigration of more than 300,000 people-3 percent of the labor force- since 1997 made the country a significant recipient of family remittances. These remittances improved national income; had a positive effect on the balance of pay- MAINTIAINING STABILITY WITH FISCAL DISCIPLINE AND COMPETITIVENESS 7 ments, financing the current account and contributing to the accumulation of reserves; and in particular allowed for improvements in private consumption that partially offset the decline in real salaries. In addition, emigration artificially reduced unemployment, although at the price of eroding the country's human capital (and its social capital in rural cornmunities) in the medium term. B. Recent Macroeconomic Performance The Ecuadoran economy is recovering from the crisis but continues to be frag- ile. The adoption of the dollar, combined with favorable prices for petroleum, strong family remittances, and macroeconomic management with mixed results, has helped to gradually stabilize expectations, eliminate hyperinflation, begin the reor- ganization and reestablishment of the banking system, start up a fragile economic recovery, and reverse the increases in unemployment and poverty levels. This section summarizes recent trends in the economy (see also Figure 2 and the annex). In the year 2000, the first year in the transition, economic growth was slight and hyperinflation reached its highest point. The rate of growth was 2.8 percent and inflation was more than 90 percent. This latter figure was the result of the adjustments in the exchange rate and in relative prices that accompanied dollariza- tion and of excessive monetary expansion in sucres in the preceding year. However, the macroeconomic balances improved noticeably: the fiscal accounts showed a strong primary surplus of 7.7 percent of GDP, thanks to higher petroleum revenues and salary compression in dollars (derived primarily from the depreciation in the exchange rate). For its part, the current account showed an exceptional surplus equal to 6.3 percent of gross domestic product (GDP) as a result of good petroleum prices, low growth, the lack of bank credit, and exchange rate depreciation. Bank deposits were unfrozen in the first half of the year but bank credit remained stagnant (Beck- erman and Cortes 2002). The relief of the external position led to successful nego- tiation in March 2002 of the Contingency Agreement with the International Mon- erary Fund for $US304 million. This agreement was key to ensuring multilateral financing that same month, in order to substitute new 12- and 30-year Global Bonds for the old Brady bonds and Eurobonds at a discounted value of 60 centavos to the dollar (above their value on the secondary markets) in August, and to resched- uling the debt with the Paris Club in September of the same year. By late Decem- ber 2002, Ecuador's external position, measured in terms of "excess freely disposable reserves," had gone from a deficit of $US254 million in 1999 to a surplus of $US776 million. Economic recovery began and hyperinflation ended in 2001. Benefiting from a positive external environment characterized by high petroleum prices, low inter- national interest rates, and significant flows of remittances, GDP grew 5.1 percent in 2001 and an estimated 3.0 percent in 2002. Average annual inflation fell to 38 percent in 2001, and was down to single digits by late 2002. The recovery is lFigwre 2. Macroeconomic Indicators Real economic growth (annual percentage) Inflation and reserves 19 199 100%- 1000 5 0/,2I 80% 50 00/0. F -7 r-i60%- -100/0'Lif50 0% ' .-500 1997 1998 1999 2000 2001 2002 1997 1998 1999 2000 2001 2002 x GP GDI Inflation - Excess reserves (US$M) ..~~~~~~~~~~~~~~~~~~t Nonfinancial public sector (as percentage of GDP) Balance of payments (as percentage of GDP) 15 10.0 C 10 5.0 5 0.0 0 -5.0 -5 --10.0 0 -10 -15.0 1997 1998 1999 2000 2001 2002 1997 1998 1999 2000 2001 2002 l Primary balance c NFPS balance Eo Current account L[ Foreign investment Real effective exchange rate (Base: 1994=100) Salaries and Employment (percent) (1995 = 100) i 175- 1251 120 150-- 125- ~~~~~~~~~~~~~~~~~~100 [ 7f 100- 75- 75-~~~~~~~~~~~~~~7 50 .50 9 . 10 1997 1998 1999 2000 2001 2002 1997 1998 1999 2000 2001 2002 r Real effective exchange (- appreciation) l = Unemployment (right scale) - Real salary (left scale) Source: BCE, IMF, and World Bank estimates. MAINTAINING STABILITY WITH FISCAL DISCIPLINE AND COMPETITIVENESS 9 explained by the increase in domestic demand (particularly private demand), stim- ulated in turn by high petroleum prices; growing remittances; the increase in nom- inal minimum and average salaries in dollars, which practically doubled between April 2000 and October 2002; and the slow reactivation of private credit (Figure 3) consistent with recovery of the banking system. Construction of the OCP has also attracted new flows of foreign investment. The slow deceleration of inflation corre- sponds to the behavior expected of a recently dollarized economy, in which the rate of prices tends to be determined by international inflation, the lag in relative price adjustments,2 control of certain managed prices that belong to the basic basket, and expansion of domestic demand. Economic recovery and migration have helped to bring employment/unemployment rates practically back to their January 1998 lev- els, but underemployment continues to be three times as high as its pre-crisis level, reflecting more profound changes in labor markets (See chapter 16 on the Labor Market and Civil Service in Ecuador). Figure 3. Credit to the Private Sector (growth rate, percent) 40 30 20 10I - I 0 -10 -20 -30 -40 -50 96 97 98 99 00 01 02 Source: BCE and World Bank estimates. 2. The initial and significant increase in prices-and the slow and gradual decline after dol- larization-is not an experience unique to Ecuador. Many Soviet republics experienced the same phenomenon when establishing their Currency Boards. This is explained by the difficulty of determining the "correct" exchange rate. On the one hand, there may be sig- nificant undervaluation of the domestic currency at the rate selected, especially if the cur- rency has depreciated significantly during the months preceding dollarization (Beckerman and Cortes 2002). On the other hand, there is the risk of overvaluarion of the domestic currency to the point that it is not credible to economic agents. Ecuador chose the risk of undervaluation. 10 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEw MILLENNIUM Postdolarization fiscal performance has been m-ixed, expansive in terms of spending and positive in terms of revenues, which has made it impossible to achieve medium-term fiscal sustainability. The primary surpluses of the Nonfi- nancial Public Sector (NFPS) have been declining. From 7.7 percent of GDP in 2000, they are projected to fall by more than half, to 4.0 percent of GDP, in 2002. These surpluses have been almost exclusively the result of an increase in current rev- enues-from petroleum and taxes-which have fluctuated irregularly between 2 and nearly 5 percentage points of GDP as compared to 1999. Unfortunately, these revenues have had to cover a heavy burden of interest on public debt, which left decreasing and meager positive global balances during these three years-close to zero in 2002 (see the annex).3 In addition, the primary surpluses would probably have been higher if not for the expansive behavior of current primary spending. Spending on salaries and on goods and services almost doubled compared to predol- larization levels-from $US1.181 billion and $US511 million in 1999 to $US2.083 billion and $US923 million in 2002-and investment spending regained its high crisis level of more than 6.5 percent of GDP in 2002. External balances have also shown mixed results. After the strong capital out- flow of 1999, and capital recovery in 2000, "excess freely disposable international reserves" have declined two years in a row, and are projected to be about $US400 million in 2002. However, this result conceals very important changes in the com- ponents of the balance of payments. On the one hand, the balance in the current account went from a surplus of 6.3 percent in 2000 to a high deficit of a projected 6.6 percent for 2002. More than 80 percent of this imbalance corresponds to the deficit in the trade balance. Short-term factors that explain this are the "boom" in demand that accompanies extraordinary petroleum earnings and import consump- tion financed by remittances; diseases and difficulties in accessing European markets that have affected the exportable supply of Ecuadoran shrimp and bananas, respec- tively; the appreciation in the real rate of exchange; and the temporary increase in imports that typifies the construction of the OCR On the other hand, positive fac- tors in the current account have been the decline in the net interest payments on external debt (nearly $US500 million) and rapid growth in family remittances-the second most important source of foreign currency, about 5.4 percent of GDP in 2002, which financed a large part of the accelerated growth in demand for imports during the postdollarization period. For its part, the capital account shows tempo- rary foreign investment inflows for construction of the OCP; these are estimated by the authorities to be about 3 percentage points of GDP for 2002. 3. It should be noted that fiscal surpluses in the NFPS do not include extraordinary oudays to support the recapitalization of the banks, equal to an estimated 1.5 percent of GDP in 2001 and 1.0 percent in 2002, with which they would become a deficit. The 2002 sur- plus includes the floating debt estimated to be $US722 million in late 2002 ($US181 mil- lion in arrears to the Paris Club and $US541 million in accounts payable, the breakdown of which is unknown) according to top officials. MAINTAINING STABILITY WIl'H FISCAL DISCIPLINE AND COMPETITIVENESS 11 The beginning of economic recovery made possible a decline in urban poverty levels between 2000 and 2001. The employment survey shows a clear 20 percent decline in poverty levels between 1990 and 1997, followed by a sharp increase of nearly 17 points in 1998 and 1999 as the result of the crisis, and subse- quently a partial recovery of about 12 points starting in 2000 (still not reaching the rates seen in 1997) (Figure 4). The same survey estimates that the decline in poverty between 2000 and 2001, measured on the basis of incomes, affected both rural areas and cities to an almost identical degree (Le6n 2002)4. Figure 4. Ecuador's Urban Poverty, 1988-2001 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% X C\ O - S rn 'I' VI\ \0 tr- X 07i - 00 00 allG GE GE G EN \ Go N o Co C>N O O _N _N _N _N _N _N _N _N _N _N ON cSON 0 Source: Le6n (2002), based on Surveys of Employment, Unemployment, anid Underemployment. 4. With respect to measuring poverty according to income, the calculations can be done on the basis of two sources. First, the Urban Survey on Employment, Unemployment, and Underemployment has been conducted each year since 1987. Up to 1999, it covered only urban areas, while as of 2000 it covers both urban and rural areas. Second, since March 1998, the Central Bank of Ecuador has been conducting an employment survey each month in the country's three major cities (Quito, Guayaquil, and Cuenca). To calculate poverty according to income, the poverty line has been set at $US2 per person per day. This has the advantage of facilitating comparison with other countries. Poverty measured according to income has serious disadvantages in comparison with poverty measured according to consumption. Income generally fluctuates cyclically (particularly in rural areas) and is more subject to measurement errors. However, in Ecuador measurements of poverty according to income are indispensable in that they make it possible to track the evolution of poverty since 1999. 12 ECUADOR: AN ECONOMIC AND Soc AL AGENDA IN THE NEw MILLENNIUM C. The Chalenges of Maintaining §tability The transition to dollarization has allowed Ecuador to achieve its immediate objec- tives of eliminating hyperinflation, with rates slowly approaching international lev- els, restoring some degree of confidence in the banking system, and beginning the economic recovery. However, its more medium-term objectives are still to be attained: achieving fiscal and external sustainability as preconditions for its program of key structural reforms for consolidating the recovery, strengthening financial sys- tems, and improving competitiveness within a context of changes in relative prices. This section summarizes the most serious macroeconomic challenges to be faced in the next four years. Ecuador's fiscal position is weak It is weak for three principal reasons: the high volatility and procyclical character of revenues, particularly petroleum revenues; extreme rigidity, low quality, and lack of transparency in spending; and the high degree of illiquidity and insolvency of public debt. The volatility and procyclical character of ta= revenues remain excessive. Although general economic volatility has declined under dollarization, the behavior of inflation, tax revenues, and the terms of trade continues to be an exception (Table 1). The volatility of Ecuador's terms of trade was not only more than five times as high as the regional average in the second half of the 1990s (19.2 versus a regional average of 3.4 percent) but has also increased by 20 percent in the period after dollarization. It is thus obvious that the Ecuado- ran economy's high degree of dependence on international petroleum prices Table 1. Volatility in Ecuador, 1990-2002 1990s 2000-02 Change Real GDP 3.2% 1.3% -61% NFPS Balance' 1.7% 0.6% -65% Current revenues/GDP a 1.0% 1.3% 29% Petroleum 1.4% 0.9% -35% Nonpetroleum 1.3% 1.8% 38% Primary spending/GDP a 0.6% 1.1% 86% Inflation 12.1% 43.1% 256% Monetary base 23.4% 5.5% -77% Terms of trade 19.2% 23.1% 20% Real salary growth b 10.8% 6.9% -37% Growth in private consumption 3.5% 0.9% -74% Notes: Volatility defined as standard deviation, in percentage terms, of the above-mentioned variables. a. Data since 1995. b. Data since 1997. Source: World Bank estimates. MAINTAINING STABILITY WITH FiscAL DISCIPLINE AND COMPETITIVENESS 13 makes it very sensitive to external shocks. After Venezuela and Trinidad and Tobago (also petroleum countries), Ecuador has the third-highest concentra- tion of (in excess of 60 percent) exports in a few traditional products in Latin America (Figure 5). This high degree of dependence on petroleum prices is shown in various ways (Figure 6). For example, (i) the correlation between petroleum prices and economic growth is obvious; (ii) the correlation between petroleum prices and tax revenues is even higher (a coefficient of 0.66 in the period 1990-2002); and (iii) for each dollar reduction in the international price per barrel of oil, exports fall by 0.6 percent of GDP and tax revenues fall by 0.4 percent of GDP (Artana 2002), which also reflects their procyclical behavior. It is not surprising that petroleum tax revenues would show strong swings: in terms of GDP, they grew from 3.9 percent in 1998 to 9.2 percent in 2000, falling later to a projected 5.7 percent of GDP in 2002 (see the annex). Spending remains expansive, to a large extent because of budgetary iner- tia. Contrasting with the highly variable behavior of revenues, primary spend- ing shows close to zero volatility since the mid-1990s, which reflects its rigid- ity and explains its expansion (Table 1). Between 1997 and 2002, despite the crisis and subsequent dollarization, primary spending in the NFPS continued its upward trend. In GDP terms, it grew from 19.4 percent in 1997 to 19.9 percent in 2000, and since that time has increased by 1.5 percentage points up to 2002, reaching 21.4 percent of GDP (see the annex). Obviously, this reflects the absence of any adjustments.5 There are three principal reasons for budgetary inertia: the generous mechanism for indexing salaries based on pro- Figure 5. Percentage of Four Principal Goods as a Share of Total Exports Argentina Brazil Chile - Colombia Ecuador _ 1995 Mexico E _ _*19-955 l ParaVieauy =1_ Trinidad and Tobago _ l VeUnreuzueala = - = _ - Central America Caribbean_ __ _ _ 0 10 20 30 40 50 60 70 80 90 Source: World Bank. 5. Alternatively, this figure could include the late recognition of floating debt that has been carried over for years, at about 0.3-0.4 percent of GDP. 14 ECUADOR: AN ECONOMIC AND SocIAL AGENDA IN THiE NEW MILLENNIUM Figure 6. The Effect of Petroleum on the Economy ;30- Growth and petroleum prices 15 r 25- lo0 B o20 0 5- v O -10 1987 1989 1991 1993 1995 1997 1999 2001 = GDP (%) Petroleum price Petroleum prices and fiscal income 30 35 U25- 1-5~ 020r ~~~15- - -- p~~~~~~~~~1 510- 1995 1996 1997 1998 1999 2000 2001 2002 0 Tax0revenues(%GDP) -Petroleumprice(rightscale) Petroleum exports and trade balance - US$M 3000- 2000- 1000- -1000- 197 19 1999 2000 200 2002 -2000- -3000- Petroleum exports Trade balance Source: World Bank estimates. jected inflation that was adopted after dollarization; the many benefits associ- ated with increases in the base salaries of public employees, which act as a multiplier (see chapter 16 on the Labor Market and Civil Service in Ecuador); and the ex ante preallocation of "projected" tax revenues in the pro forma budgets contained in more than 50 applicable legal provisions, which make readjustments difficult once they are approved (see chapter 2 on Tax Admin- istration and Policy). T The rigidity of spending becomes extreme when debt service payments are added to it. If we subtract from total current revenues spending on pay- roll (30 percent), preallocated revenue (30 percent), and debt service pay- ments (35 percentincluding net amortization), the remaining freely disposable MAINTAINING STABILITY WITH FISCAL DISCIPLINE AND COMPETIT IVENESS 15 balance for nonsalary primary spending is barely 5 percent of the budget, which was equal to about 1.0 percent of GDP in 2001 (Figure 7). In practice, this percentage amounts to a small budgetary contingency reserve. This flexi- ble amount of internal resources that the authorities have to finance invest- ment or purchases of goods and services (particularly social spending) by the central government is negligible. Given the seasonal nature of tax revenues and the unpredictability of external disbursements, this situation contributes to continuous cash problems. Thus, the inflexibility of spending makes it impossible to adequately plan cash outlays and to redirect spending effectively and efficiently to the priority objectives of a new poverty reduction strategy.6 Government spending is highly fragmented and thus uncoordinated, sub- ject to weak controls, and lacking in transparency. The preallocation of some 30 percent of income to more than 50 different agencies and 242 sec- tional governments (provinces and cantons) that are not subject to any regu- lar coordination, monitoring, or evaluation mechanism leads to fragmented execution of spending,7 a lack of control over spending, and creates serious obstacles for transparency in spending. The limited number of studies done on the quality of spending in Ecuador is precisely a reflection of its lack of transparency. Financial management is decentralized by law to executing Figure 7. Distribution of Government Revenues (2001) Freely disposable funds 5% Salaries Preallocated 30% revenues i_ ~ ~ ~ ~ ~ r - ~~~30% Debt service 35% Source: World Bank based on Gallardo (2001). 6. For example, note that the Solidarity Bond alone used resources equal to 0.7 percent of GDP in 2001, which would be equal to more than half of freely disposable funds. 7. The fragmentation of spending is understood in the broad sense, that is, based on the pre- allocationi of revenues. 16 EcUADOR: AN ECONOMIC AND SociAL AGENDA IN THE NEW MILLENNIUM agencies, but is carried out under an integrated financial information system (known as SIGEF in Spanish) that covers a nonconsolidated budget, encom- passes only a portion of spending by the central administration, excluding the decentralized and sectional agencies,8 and reveals spending actions late and not in a virtual format. The absence of control and transparency is deeply rooted. For example, the Social Security Institute did not publish its financial balance sheets for five years and was operating without any external oversight (it now operates under the Superintendency of Insurance). The municipali- ties, for their part, did not publish their financial statements, either. In turn, while the pro forma budget is not approved before the start of the year, budg- ets are closed out more than a year after the end of the year, with subsequent verification by the Office of the Comptroller even later. Public debt is illiiquid and very high. The stock of total external debt was estimated at 65.7 percent of GDP in 2002, more than twice the level of exports of goods and services and the highest in Latin America after Argentina, before that country's crisis (Figure 8). Public debt represented 60 percent of GDP that year. The burden of external public debt service is exces- sive, which creates continuous problems of illiquidity and increases the risk of default. Approximately one out of every three dollars entering the Treasury is used to pay external debt. As of the end of 2002, the spread of Ecuadoran bonds is the second highest in the region with an upward trend: above 1,850 basis points-above Brazil and the average for Latin American bonds-and has been increasing since April 2002, when the government failed to reach an agreement with the IMF (Figure 9).9 Ecuador also has immediate liquidity problems with arrears to the Paris Club estimated at $US181 million at the end of 2002, and a scheduled amount of debt service of about 8.1 percent of GDP (4.7 percent in amortizations and 3.4 percent in interest for 2003-04). About four-fifths of total debt is external debt. Of this, some 65 percent is official debt-40 percent multilateral and 25 percent bilateral-making it somewhat less vulnerable to changes in emerging markets and offsetting the country's lack of access to international markets. Finally, nearly two-thirds of domestic debt consists of bonds issued by the Deposit Guarantee Agency (AGD) and the National Finance Corporation (CFN) to cover the costs of bank interventions during the banking crisis. The outlook of the three major risk-rating agencies is that the country's ability and desire to pay have improved with dollarization, but with a CCC+ (Standard & Poor's) or Caa 2 (Moody's) rating, Ecuador is still not eligible for a level of investment that 8. SIGEF covers about 84 percent of central government spending. 9. Note that the spread did reduce significantly after dollarization, but it remains very sensi- tive to internal and external events. MAINTAINING STABILITY WITH FIscAL DISCIPLINE AND COMPETITIVENESS 17 Figure 8. Total External Debt (% GDP) 160- 9 z ~~~~~~~~~~1997 *2000 120 80 40 .' #U E C) U I'~~~J o~~~~~~~ Sourrc: World Bank. would allow it to issue new sovereign bonds on international capital markets in the near future.10 Family remittances have led to a positive transformation in the Ecuadoran economy but have had some adverse effects that should be corrected. Ecuador has become one of the principal recipients of remittances in Latin America (Central Bank of Ecuador [BCE] 2000). It receives about $US 1.4 billion in remittances each year, equal to 5.4 percent of GDP in 2002. This inflow of capital has relaxed the restriction on foreign exchange, improving private consumption, which had been affected by the decline in real salaries during the crisis, and helping to alleviate the decline in incomes. Ecuadoran remittances have five distinct characteristics in com- parison with the trend in Latin America (Figure 10): (i) remittances intensify with a rather delayed migration toward the end of the 1 990s; (ii) they are concentrated in three regions of the country-Azuay (Cuenca), Guayas, and Pichincha, with a clear predominance of the first-that receive about two-thirds of the remittances; (iii) nearly half (45 percent) of the remittances do not come from the United States; (iv) a relatively higher percentage is invested in housing; and (v) in per capita terms they are the third highest in Latin America, with a positive effect on the rapid recov- ery of precrisis income and poverty levels. Despite these positive aspects, remittances 10.A risk rating of C means that the issuing institution has obvious deficiencies, probably related to the quality of its assets or the poor structuring of its accounts (fiscal in this case). This leads to a considerable degree of uncertainty and reasonable doubts regarding the institution's ability to confront additional problems in the future. Figare 9. Ecuador's Financial Risk x 5000 4500 Moraroria f Il 4000 I i-ri 3500 3000 K4 Z z J-- 111~~~~~~~~~~~~ Agreemen~~Lti Aerc 12/29/1998 5/29/1999 10/29/1999 3/29/2000 8/29/2000 1/29/2001 6/29/2001 11/29/2001 4/29/2002 9/29/2002 2 Source: JP Morgan. r r- z MAINTAINING STABILITY WITH FISCAL DISCIPLINE AND COMPETITIVENESS 1 9 also have some macroeconomic effects that are quite similar to those of the coun- try's petroleum boom periods and that contribute to (i) a change in relative prices, given that the inflow of foreign currency increases the demand for and prices of trad- able goods; (ii) an increase in the real exchange rate, as measured by the decline in the ratio of prices for tradable and nontradable goods; and (iii) a deterioration in the trade account of the balance of payments, owing to the decline in exports (particularly nontraditional exports) and the increase in imports that result from exchange appreciation. However, there are two important differences between the remittances and the petroleum booms: their duration, in that remittances tend to provide a more permanent positive external shock-usually 7-10 years-than booms; and the productive use of resources, given that in comparison with petro- leum earnings, higher percentages of remittances tend to be consumed in invest- ments in nontradable goods, rather than in imports. Both differences make remit- tarices a welcome phenomenon, the use of which can be maximized. Of the adverse effects of increased remittances, the change in relative prices to the detriment of tradable goods is the principal problem to be corrected. Goods whose prices are determined by international markets are known as "tradable" goods and goods whose prices are determined by the domestic market are known as "nontradable" goods. The change in the relative prices of tradable and nontradable goods in a dollarized system is one of the possible approximations of the real exchange rate. An increase in the real exchange rate may be due to a decline in productivity in the production of tradable goods as well as to an increase in prices for nontradable goods. In Ecuador, after dollarization, the productivity ratio of these two sectors dete- riorated, primarily affecting the tradables sector. At the same time, the ratio of rela- tive prices for tradable/nontradable goods rose in 2000, propelled by an increase in prices for tradable goods that were affected by the sharp depreciation in the sucre. However, it subsequently fell because of constant, although smaller, increases in prices for nontradable goods (Figure 1 1).I1 The result of both trends has been an appreciation in the real exchange rate (see Figure 2). Note that estimated real appre- ciation is much lower when calculated on the basis of unit labor costs (8.1 percent) than when calculated on the basis of consumer price indexes (62 percent), in the case, for example, of Ecuador's principal trade partner-the United States-between 2000 and 2002 (Figure 12). In any case, this change in relative prices is a manifestation of a deterioration in Ecuador's external competitiveness that should be corrected.12 11 .The labor productivity series (product/labor) are constructed using data on urban employ- ment rather than national employment because the latter is only available for 2000 and 2001, whereas product is national in that there are no urban product series. The price series use the BCE's producer price index for tradable goods and the urban consumer price index, also produced by the BCE, for nontradable goods. Thus, both indexes are approx- imations of real values. 12.Another manifestation of the loss of competitiveness was the evolution of nontraditional exports, which reached an annual growth rate of 20 percent in 2001, but a rate close to Figure 10. Ecuadoran Migration and Family Remittances Remittances per capital (in U.S. dollars) Ecuador: Emigrants and remittances Ecuador aL ,. 12%- 100 0. Dominican Republic - 10%- 80 . 8%- 1 0 El Salvador I 60_o 60 °o Braz,0 4% \ 40 c Mexico U0 - 90 91 92 93 94 95 96 97 98 99 00 01 02 0 50 100 150 200 250 300 350 E Remittances(%ofGDP) -Annualeemigrants n z 0 Remittances received Remittances: Estimate by country of origin (Distribution in dollars, 2000) O ~~~~~~~~~~~~~~~Others ,lg 15%0 Rest of the country Azuay y 38% 46% Italy U.S. 10% 45% z Spain ; Guayas Pichincha 30% ' i 11% 5% Z z Source: BCE and World Bank estimates. m C MAINTAINING STABILITY WITH FISCAI. DISCIPLINE AND COMPETITIVENESS 21 Figure 11. Relationship between Productivity and Relative Prices of Tradable/Nontradable Goods 2.0 1.8 1.6 1.4 oo 1.2 0.8 0.6 0.4 - Productivity: Tr/Ntr 0.2 - Prices: Tr/NTr 0.0 1998 1999 2000 2001 Yea-r Source: World Bank, based on data from the BCE and Urban Employment Surveys. Figure 12. Real Bilateral Exchange Rate with the United States, Based on CPI and Unit Labor Costs (1994 = 100) 180 - 160 - 140 - 120- 100 _ 80 1994 1995 1996 1997 1998 1999 2000 2001 2002 -Labor costs -CPI Source: World Bank, based on data from the BCE and Urban Employment Surveys. zero in 2002. The tax authorities indicated that the latter figure reflects to some extent a significant underassessment of exports, which is explained by tax evasion. 22 EcuADOR: AN ECONOMIC AND SOCIAL AGENDA IN THIE NEw MILLENNIUM The external position is weak. Given the inflexibility of the exchange rate, Ecuador must also find alternative mechanisms for absorbing real and financial shocks. Its high degree of dependency on a few primary products makes it more vul- nerable to deterioration in its terms of trade. In addition, the development of mech- anisms for absorbing financial shocks, typical of a dollarized economy, is nonexist- ent. There are three options: "abundant" international reserves in the Central Bank; contingent credit lines with multilateral agencies; and resources from a counter- cyclical stabilization fund. • The level of Freely Disposable InternationaR Reses-ves is declining. Although the amount of international reserves required under dollarization is lower than under a flexible exchange rate system, because the monetary sup- ply is always greater than the monetary base and the traditional role of the lender of last resort no longer exists, it is advisable to increase this amount in order to avoid minor contingencies.13 "Excess" freely disposable reserves in Ecuador recovered slowly in 2000 with multilateral support anid debt restruc- turing but the current level is low (close to $US400 million) and the trend downward (see the annex).14 o After the crisis in Argentina, the possibilities for obtaining contingency lines from abroad are minimal. Nor has the United States shown any inter- est in implicitly sharing its seniorage with dollarized countries. o The recently created Petroleum Fund will not have any significant money until 2004 and the amount it can be expected to have to meet contin- gencies is marginal. The Fund for Stabilization, Social and Productive Investment, and Reduction of Public Debt (FEIREP) was created with the recently approved tax law. According to the law, the funds that go to FEIREP will be primarily funds from the OCP that do not derive from lower utiliza- tion of the Trans-Ecuadoran Pipeline (SOTE) for light petroleum. Given the delay in completing the construction of the OCP until late 2003, this means 13.Note that the role of lender of last resort was unsuccessful in avoiding the banking crisis prior to dollarization. We speak of "minor" contingencies that do not include the possi- bility of a large number of depositors withdrawing their deposits from the banks. Should that happen, either interest rates would have to rise to extremely high rates in an attempt to recapture deposits or another banking crisis would occur. 14. "Excess" reserves, a concept that is appropriate to a dollarized system, results from deduct- ing from the total amount of freely disposable reserves from the internal liabilities of the Central Bank, which include the currency and paper it issues as well as the deposits of commercial banks in the Bank. Excess reserves increase in parricular when the government makes deposits to the Single Treasury Account, and thus these deposits become a key vari- able/goal of the macroeconomic program. MAINTAINING STABILITY WITH FISCAL DISCIPLINE AND COMPETITIVENESS 23 that a very small amount of funds will be transferred in 2004 and thereafter to FEIREP In addition, according to the law, only 20 percent of the funds in FEIREP will have a countercyclical function, and thus the amount for con- tingencies will be marginal. The financial system remains vulnerable. The Ecuadoran financial system has made a remarkable recovery since the crisis of 1999, with stable growth in deposits in the banking system and credit to the private sector since the negative levels of 1999. However, there are still various critical areas that need improvement. Some key problems are as follows (Figure 13):'5 * Real active interest rates are slightly positive, while passive rates remain negative and do not strengthen financial intermediation. Real active inter- est rates were negative during the hyperinflationary episode and only became marginally positive again starting in 2002. * The decline in nominal interest rates after dollarization has been late in coming and limited, and has not provided sufficient stimulus for eco- nomic recovery. With dollarization, the elimination of exchange risk should have allowed for a rapid and significant decline in nominal interest rates, but this did not happen. Between April 2000 and late 2002, the decline was slight-barely 3-4 percentage points, and less than the nearly 5 percentage point decline in international interest rates.'6 However, as inflation has fallen and the financial system has been strengthened, the rates have gradually fallen. As of late 2002, with a lending rate of 12 percent and inflation at 9 percent, Ecuador's real active rates are slightly lower than the prime rate in the United States. * The liquidity of commercial banks remains high and continues to fluc- tuate. The net liquidity of the banks (the ratio of funds available to deposits up to 90 days) recovered noticeably in late 2000, but since that time has fluc- tuated in a high and broad range of 30-45 percent. This behavior reflects the banks' preoccupation with having provisions that would allow them to meet their obligations in the event of a run on deposits. * The delinquent portfolio percentage is high and credit for housing or microenterprise remains stagnant. Ten percent of the portfolio is delin- quent. This average conceals the difficult situation that some commercial 15.Chapter 4 on the Banking System analyzes this subject in detail. 16.At the end of an inflationary episode, commercial banks tend to raise real interest rates in order to generate greater revenues and recover part of the losses from the decapitalization, in real terms, that occurrecl during the episode. This happens because interest rates never increase as much as prices during crises. Figure 13. Financial System indicators Active interest rates in Ecuador a Interest rates and nominal interest rate (%) Percent 40 Nominal rates 20 Nominal rates. Ecuador 20- 0 . 15 -20 10 . -40-'--~ 0 *.' Real rate Prm R USA -800 -100 .. ,. - - .0 . . . . . 0 0 , - r Go, C% GEl CO 0 CD O\ O G ' g O O O O cO 0 0 0 0 000 ON cN ON 0 0 0c 0 0 0) 0 0 Z -d -i v - _1 A -l . (d M, IV ) Net liquidity coefficient of Banking system arrearso 100% - private banks (Portfolio past due/total portfolio) n (December 99-September 02) 14 I F 80%- 12 - - 60% ~~~~ ~ ~~10 - __ _ _ _ _z 40% 8 - - 40%-H6 20 %h fl 0 0 k| u q 1 lii Iil H11 4 -1 ___ __ __ __ __ __ __ __ __ __6 |_ 0% - , ,.o u N 1- C- *u eq Fl Iq ClNc r , > c 5C ~~~~ 0~~~~~~~~ 0 ~ ~ ~ ~ ~ c, C Z rz a. Nominal and real active rates are from the Superintendency of Banks of Ecuador. Source: Central Bank of Ecuador; Superintendency of Banks of Ecuador; IMF. MAINTAINING STABILITY wiTH FIScAL DISCIPLINE AND COMPETITIVENESS 25 banks went through with extremely high levels of delinquency. The highest proportion of credit continues to be concentrated in the segment with the most delinquency-commercial credit-with only a marginal amount (less than 10 percent) goes to housing or microenterprise, two sectors that make intensive use of unskilled labor, and whose reactivation would encourage eco- nomic recovery (Multiplica 2002). Both trends reflect, on the one hand, the difficulty that economic agents encounter in meeting their debts and not seek- ing rollovers and, on the other, the banking system's limited trust in granting medium-term credit, despite dollarization. External competitiveness has not improved and the investment climate con- tinues to be discouraging. Perhaps the other element that is key to dollarization in Ecuador in the medium term is growing gaps in competitiveness and rigidities in the country's factors markets. Earlier we analyzed the loss of competitiveness due to the trend toward real exchange appreciation as a result of the decline in the ratio between prices for tradable and nontradable goods. Another option is to focus on the global analyses of a country's competitiveness. Generally, global classifications and their rates should not be a source of great concern, but this is not the case in Ecuador. Almost all indicators provide evidence that the country's competitiveness gaps are significant and growing in most areas in comparison with other medium- income countries-and there is no evidence that domestic conditions are conducive to reversing these trends. For example, the Global Competitiveness Report of the World Economic Forum provides an overview of a country's basic competitiveness in terms of its macroeconornic situation, public institutions (corruption, contracts, and respect for law), the quality of its business environment, technological innova- tion, and computer technology. In 1999, Ecuador ranked 54th out of the 62 coun- tries rated. In 2001, it ranked 68th of the 75 countries evaluated, with a relatively higher grade (59th) for innovation, and lower grades for the quality of its business environment (72nd) and for contracts and respect for law (73rd). This trend con- tinued to deteriorate in 2002 when Ecuador ranked 73rd of the 80 countries con- sidered. Similar indicators are found in the Heritage Foundation's Index of Eco- nomic Freedom, which also shows a deterioration in the country's relative position, which went from 72nd in 1999 to 117th in 2002, ranking ahead of only Cuba and Venezuela in the region (Table 2). The breakdown of the index's components indi- cates that the country's situation has worsened, particularly in terms of its invest- ment climate and property rights, and has improved slightly in terms of its fiscal sit- uation. The rigidities in labor markets represent another important challenge. Labor flexibility is critical to the sustainability of dollarization, particularly as a mechanism for adjusting to unfavorable shocks. Initially, the private sector labor market became somewhat more flexible after the crisis of 1999. The approval of the Economic Transformation Law made it possible both to diversify hiring methods and to unify the many benefits based on one's base salary in the private sector, thus setting a good 26 ECUADOR: AN ECONOMIC AND SOCiAL AGENDA IN THE NEW MILLENNIUM Table 2. Index of Economic Freedom Foreign Relative Tax Monetary direct. Property position burden policy investment rights 1999 2002 1999 2002 1999 2002 1999 2002 1999 2002 Argentina 14 38 2.0 3.0 2.0 1.0 2.0 2.0 2.0 3.0 Bolivia 49 45 3.5 3.5 3.0 2.0 2.0 1.0 3.0 4.0 Brazil 95 79 3.0 3.5 5.0 3.0 3.0 3.0 3.0 3.0 Chile 14 9 3.0 3.0 3.0 2.0 2.0 2.0 1.0 1.0 Colombia 55 58 3.0 3.0 4.0 3.0 2.0 2.0 3.0 4.0 Costa Rica 69 43 3.0 3.0 4.0 3.0 2.0 2.0 3.0 3.0 Cuba 158 153 3.5 3.5 5.0 5.0 5.0 5.0 5.0 5.0 Ecuador 72 117 3.0 2.5 5.0 5.0 2.0 3.0 3.0 4.0 El Salvador 19 17 1.5 2.0 3.0 1.0 1.0 2.0 2.0 3.0 Guatemala 43 55 1.5 2.0 3.0 2.0 3.0 3.0 3.0 4.0 Honduras 106 88 2.5 2.5 5.0 3.0 3.0 3.0 3.0 3.0 Nicaragua 118 88 3.0 3.5 5.0 3.0 2.0 2.0 4.0 4.0 Panama 35 45 3.0 3.5 1.0 1.0 2.0 2.0 3.0 4.0 Paraguay 62 79 2.0 2.0 3.0 3.0 1.0 2.0 4.0 4.0 Peru 39 53 3.0 2.5 4.0 2.0 2.0 2.0 2.0 4.0 Dominican Republic 80 72 2.0 1.5 3.0 3.0 3.0 3.0 4.0 4.0 Uruguay 43 41 3.5 3.5 5.0 3.0 2.0 2.0 2.0 2.0 Venezuela 95 130 2.0 2.5 5.0 5.0 3.0 3.0 3.0 4.0 Note: the range from 1 to 5 goes from best to worst. Source: Heritage Foundation. precedent for the public sector, but reform in the latter did not happen. Labor law on Ecuador's civil service is still focused on promoting labor stability rather than on encouraging the efficient delivery of services, which would encourage growth and competitiveness. This is particularly true of the civil service, which has two areas that urgently need improvement: salary policy and the number of public employees. In general, salaries are not freely determined in the informal markets, but rather by a National Salary Council. The result is that real salaries have not fallen during the postdollarization period, despite the downward trend in labor productivity (see the annex). In addition, in civil service in particular, because of the proliferation of allo- cations (general and specific), each official increase in the base salary of a public employee sets off a chain of complex multiplier effects. This makes it impossible to precisely estimate in advance the cumulative effect of official increases. Nonetheless, it is estimated that salary increases have been high, from 60 to 10 percent above the preceding salary level (see chapter 16 on the Labor Market and Civil Service in Ecuador). For its part, public employment is without any effective controls. The exact number of public employees is unknown. Because there is no centralized con- MAINTAINING STABILITY WITH FIScAL DISCIPLINE AND COMPETITIVENESS 27 trol of payroll, the number is approximated indirectly based on budgetary alloca- tions. The state's authority to manage civil service has deteriorated completely since the Secretariat for National Administrative Development (SENDA) was dissolved in 1998. The lack of central control also applies to state companies, decentralized agen- cies, and sectional governments. D. Policy Recommendations Perhaps the greatest achievement of dollarization in the medium term has been to eliminate the "veil of money" and reveal problems in the fiscal, real, and financial sectors more convincingly. With the suppression of monetary policy, the gradual elimination of the distortions caused by hyperinflation, and the assumption of contingent liabilities from the banking crisis, the fiscal, currency exchange, and price "illusions" have to a great extent disappeared, forcing the authorities to deal with correcting fiscal imbalances. This is why under a dollarized scheme, financial leveraging is the first and only way to gain credibility and keep inflationary expec- tations low. In turn, dollarization made even clearer the need for the program of structural reforms that Ecuador has postponed for decades. Combining fiscal discipline with the implementation of structural reforms is no longer just an option. Indeed, it is a critical requirement for consolidating macroeconomic stability and reactivating the economy by strengthening the finan- cial system, improving competitiveness, and eliminating market distortions in the medium term. A credible approach to correcting fiscal imbalances by improving prudential supervision, eliminating trade barriers, and introducing flexibility in fac- tors markets is the best route in terms of economic policy. These reforms would have been essential for Ecuador even if the country had not dollarized, and will continue to be so even if the government should voluntarily decide to "de-dollarize" in the future. The previous section identified the principal problems. We present below the principal recommendations for overcoming these obstacles and holding on to the achievements attained. The governments first macrofiscal priority is to deal with the economy's illiquidity and develop a plan to close the country's financial gap for 2003. In 2003, Ecuador has total net financial requirements'7 in the amount of $US2.150 billion, which after including already scheduled financing, leaves a gap of financing to be identified of $US871 million (Table 3). The heaviest burden comes from mul- tilateral and bilateral debts, which together represent more than 90 percent of total external debt amortization and two-thirds of total public debt amortization over the 17.This is stated as "net" because it does not include $US827 million in interest on public debt, half of which is for payment of AGD and National Development Corporation bonds. 28 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM next three years. Given the specific composition of its debt, it is clear that the liq- uidity of Ecuador's public finances is critically dependent on (i) developing and car- rying out a sound and credible macroeconomic program; (ii) implementing a pro- gram of structural reforms that will allow the country to obtain rapidly disbursing and freely disposable funds from the multilateral agencies, which could close the gap; and (iii) rescheduling its bilateral external debt with the Paris Club. One of the objectives of this rescheduling should be the prompt elimination of all pending arrears in 2003. Table 3. The Financial Gap of the Nonfinancial Public Sector 2001 2002 2003 2004 2005 Financing required 1915 2150 2116 1534 1534 NFPS deficit 0 0 0 0 0 NFPS deposits f 49 0 100 100 100 Amortization 1121 1105 1294 1304 1304 External 731 672 816 904 865 Internal 390 433 479 400 439 Other 745 1045 722 130 130 Arrears 285 655 181 Accounts payable 122 541 Assist., banking sector 300 268 0 Other ab 160 0 0 130 130 Financing identified 1915 2150 1245 1087 1031 NFPS surplus f 155 215 237 259 137 Internal financing c 335 278 130 237 259 External disbursements d 584 472 873 578 613 Governments 85 148 100 100 IDB 92 111 124 124 WB 26 71 94 129 CAF 96 250 175 175 IMF 143 150 0 0 Others 30 144 85 85 Other 841 1185 5 13 22 Cumulative arrears 407 181 Floating debt 122 541 Other b,' 312 463 Financing gap 0 0 871 447 503 Notes: a. includes payments to IESS. b. Excludes $US240M in 2002 for advance purchase of petroleum, which became a financing requirement in 2003. c. Internal financing means domestic bonds and disbursements. d. Since 2003, data from BCE. e. Financing gap. f. Starting in 2003, possible goals to be negotiated with the IME Source: BCE and World Bank estimates. MAINTAINING STABILITY WITH FISCAL DISCIPLINE AND COMPETITIVENESS 29 The government's second macrofiscal priority is to deal with its insolvency risk, taking steps that will allow it to obtain the high primary surpluses needed to pay interest on its debt. Ecuador has scheduled interest payments that will fluc- tuate at about $US800-900 million (3.5 percent of GDP) over the next four years. Meeting these payments is synonymous with complying with a fiscal standard: the recentdy approved Law on Responsibility, Stabilization, and Fiscal Transparency (Box 2). The two fundamental objectives of this law are to achieve a goal of sustainable pub- lic debt in the medium term (40 percent of GDP)-with an intermediate reduction goal of 16 percentage points of GDP in the next four years-and to create the FEIREP, the petroleum fund designed to repurchase commercial debt (12- and 30- year Global bonds) and to play an countercyclical fiscal role. Under a basic scenario, a debt sustainability analysis indicates that the primary fiscal surplus needed to achieve the intermediate goal of reducing the debt is above 5 percent of GDP in 2003 and 2004 (see chapter 3 on Debt Administration and Sustainability). Note that although the law does not specify what fiscal efforts would lead to achieving this goal, it does at least suggest combining a number of countercyclical fiscal resources, equal to 2.5 per- cent of GDP (the intermediate value in the range of revenue variation in recent years). Given that the law lacks any essential elements for leveraging the fiscal sur- plus goal, a third priority is to supplement it. On the revenue side, a tax reform is suggested for the purpose of increasing the level of nonpetroleum receipts by a minimum of 2.5 percent of GDP, the amount suggested by the tax law. This will require at least three actions: (i) approving a series of tax policy measures that will generate approximately 1.4 percent of GDP, based primarily on limiting VAT exemptions exclusively to unprocessed basic foods and home rental and eliminating all other exemptions, particularly those on income tax and customs duties, with an estimated effect on collections of about I percent of GDP (see chapter 2 on Tax Administration and Policy); (ii) increasing the rate of the VAT given the possibility that petroleum prices will fall to their "normal" historic levels-below $US 18/bar- rel-considering that each additional point in the rate would generate increased col- lections of about 0.7 percent of GDP; and finally but no less important, (iii) not approving the "tax relief" measures proposed by the outgoing government in the last quarter, including donating 25 percent of income tax (ISR) to municipalities, reduc- ing the withholding at the source percentage on the VAT from 1 to 0.1 percent, and reducing to zero the duty on 158 products. A fourth priority is to adjust and reallocate spending and make it transpar- ent. The lessons learned in the three years of transition should be utilized so as not to continue postponing fiscal adjustment of spending. The only way to achieve sig- nificant primary surpluses is to adjust current and capital spending, redirecting the savings to key priorities of the government's strategy. There are three aspects to a reform of government spending. It is recommended that an emergency budget phase be dedared in order to contain spending. The 2003 budget should be declared a national emer- 30 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Box 2. The lLaw on Responsibility, Stabilization, and Fiscal Transparency This legislation was approved in late 2002. It has several objectives: to reduce public debt, contribute to stabilization and fiscal sustainabiity, use the savings by directing it to investments that encourage economic and social develop- ment, and establish regulations on public finances and transparency for effi- cient management and effective citizen oversight. The law approves the fol- lowing commitments: o There will be a multiyear plan at the start of each government for a period of four months to guide spending and investment and establish quarterly goals for each institution in the NFPS that can be monitored. o Central primary spending may not grow by more than a real rate of 3.5 percent per year. o The total central government deficit, without petroleum export rev- enues, will be reduced by 0.2 percent each year. o The debt/GDP ratio will fall 16 percentage points during the period 2003-06, and a similar provision will be applied to subsequent years until the ratio reaches 40 percent. o The real value of the state's debt to the Ecuadoran Social Security Insti- tute (IESS) will be paid off in four years. o For sectional (provincial and municipal) governments: Total annual lia- bilities must not be greater than 100 percent of revenues, and debt serv- ice must be less than 40 percent of total revenues. o Resources from the budget surplus and revenues from the OCP (incre- mental based on the not lower utilization of the SOTE for light petro- leums) will be the principal source of the FEIREP. o FEIREP resources will be distributed as follows: 70 percent to repur- chase external debt and pay off debt to the IESS, 20 percent to stabilize petroleum revenues until reaching 2.5 percent of GDP and to cover emergencies, and 10 percent to education and health. o The MEF will establish an official information and dissemination sys- tem, as will the sectional governments. o The annual budget will include the quarterly projection of revenues and tax spending (and budget headings to offset it), the list of productive and unproductive assets, contingent liabilities and fiscal risks, and an estimate of profits from state companies and autonomous systems. MINrTAINING STABILITY WITH FiscAL DISCIPLINE AND COMPETITIVENESS 31 gency budget and developed under strict austerity rules. This means con- fronting rigidities in spending. Various measures are suggested for achieving this: (i) limiting increases in spending to zero in real terms in 2003, which means establishing limits (possibly negative limits in nominal terms) on spending for salaries, goods and services, and investments; (ii) immediately suspending the application of the mechanism that automatically indexes salaries to projected (rather than actual) inflation that is used by the National Council on Public Sector Remuneration (CONAREM) and replacing it with a new restrictive mechanism; (iii) approving a Salary Unification Law with a neutral tax cost, which can lead to finding extraordinary external financing; (iv) immediately freezing the hiring of new permanent public employees and reviewing existing positions; and (v) using FEIREP funds to repurchase the most expensive debt in Global Bonds so as to reduce annual interest pay- ments. * It is recommended that fragmented spending be consolidated and redi- rected to priorities. This will require (i) explicitly prohibiting any new preal- location of revenues or expenditures; (ii) eliminating all existing prealloca- tions, except that for the Ecuadoran Social Security Institute (IESS); (iii) consider freezing the current transfer of 10-11 percent to sectional govern- ments during the emergency budget period, and (iv) condition future trans- fers (once the emergency budget has ended) on the concomitant transfer of responsibilities, the auditing of sub-national debt, and the requirement of evaluation by independent rating agencies before allowing further debt by large cities. * It is recommended that budgetary transparency be institutionalized at all levels of government and that it be strengthened with modern tools. Hav- ing approved the law, it is now urgent to design and implement a modern and consolidated version of the SIGEF, its principal instrument. The tax law also calls on sectional governments to "establish their own information systems for citizen oversight and reporting to the Ministry of Economy and Finance (MEF)." However, the implementation of a similar provision has proven to be chaotic in other Latin American countries that have seen a proliferation of incompatible systems supported by different computer platforms. The future version of SIGEF, supported by a single modern computer technology, must consolidate the accounts of the nonfinancial public sector-including the decentralized agencies and the sectional governments-and provide not only user-friendly access to the budget through a virtual user network but also bet- 18.Another of the law's problems is that the process for preparing the indicated mulriyear budger (as of January 31 of the month when the new government takes office) is inap- propriate given the serious problems with closing out the budget for 2001 and 2002, with late preparation of the 2003 annual budget, and the lack of transparency in spending. It 32 ECUADOR: AN ECONOMIC AND SocIAL AGENDA IN THE NEW MILLENNIUM ter control of compliance with established physical and financial policy goals.18 For the future, a fifth priority will be to amend the law to leverage greater fiscal discipline and reduce the burden of external debt. The law has various goals that are not sufficiently restrictive. For example: o The goal of reducing the nonpetroleum central deficit by 0.2 percent of GDP per year has a marginal impact. This deficit was -5.2 percent of GDP in 2002, and it would take decades to eliminate the deficit. This low annual objective could be increased. O The goal of 3.5 percent growth in central primary spending is inconsistent with a policy of spending austerity. In addition, productivity trends in the tradable goods sectors are negative and do not justify this. This goal should be reduced. o The law should reestablish a provision on the primary earnings of sectional governments and place limits on the their internal indebtedness. In addition, the law's limits on external indebtedness for the sectional governments (100 percent of total revenues for debt, and 40 percent of total revenues for debt service) are too high. International practice suggests 100 percent in the first case, but with respect to current revenues only (thus eliminating capital rev- enues that are usually extraordinary), and 25 percent in the second case. o The potential revenues of the FEIREP over the next four years are too limited to efficiently perform a countercyclical function: less than $US100 million each year projected for the period 2004-07.'9 Thus, we suggest that it would be better to allocate these funds exclusively to the debt repurchase fund. A sixth priority is the required strengthening of the extenmal position. The downward trend in excess freely disposable reserves increases the vulnerability of a recently dollarized system with a banking system that is still being restructured. To turn this situation around, it would be highly advisable to gradually accumulate a reserve "cushion" of about $US900-1,000 million.20 This would make it possible to provide extraordinary financing should it be needed to deal with situations such as a sharp drop in petroleum prices, a regionalized outflow of private capital, or mini- would be best to postpone budget preparation until mid-2003, with a plan to approve it for the period 2004-07, in conjunction with preparation of the year 2004 budget. The possibility of preparing the budget on a participatory basis, as Peru is already doing, could be explored. 19.This estimated amount does not include the funds that the Congress allocated to FEIREP to cover the state's debt to the IESS. 20. Note that the financial projection envisions an annual increase of $US 100 million in gov- ernment deposits in the Single Account of the Nation, which deposits are in turn part of "excess freely disposable reserves." MAINTAINING STABILITY WITH FiscAL DISCIPLINE AND COMPETITIVENESS 33 deposit runs on bank in the process of restructuring. Given that the projected FEIREP funds are minimal, that the recommendation is that they be used exclu- sively for debt repurchase, and that the chances of obtaining contingent credit lines overseas are nil, a possible alternative for financing this cushion would be to use a portion of the future revenues from the pending privatization program, which cur- rently go exclusively to the Solidarity Fund (see chapter 7 on Basic Infrastructure). A seventh priority is to mitigate the change in relative prices. Improving external competitiveness requires eliminating the bias against exports, promoting the diversification of nontraditional exports. In recent years, Ecuador has seen an appreciation in its real rate of exchange that is not favorable to its exports. There is a series of mutually consistent policies that Ecuadoran authorities could implement to generate a depreciation in the real rate of exchange, which would be favorable to its exports. These policies include (i) reducing government resource requirements with fiscal consolidation, which would lower interest rates and stimulate private investment; (ii) accelerating trade liberalization in order to increase the demand for tradable goods (see chapter 6 on Trade Policy and Competition); (iii) increasing national savings with a total reorganization of the financial system (see chapter 4 on the Banking System), development of the capital market, and reform of the social security system (see chapter 11 on the Social Assistance System); and (iv) promot- ing global external competitiveness with the measures indicated below. To the extent that this pro-export agenda is implemented, it will also be possible to achieve a reduction in the deficit in the trade balance and in the current account of the bal- ance of payments. The eighth priority is to implement an effective agenda of external competi- tiveness. In consultation with the private sector, the authorities have proposed a Competitiveness Agenda with eight themes (BCE 2002a). The agenda is compre- hensive, but its priorities and sequence still need to be defined and consensus must still be built with the private sector, making it difficult to implement the agenda. Ask- ing for simultaneous progress in so many areas weakens its content in practical terms. This is why one of the first steps the new administration should take is to develop a trimmed-back agenda of policy and laws to strengthen competitiveness, to be com- pleted in the first 12 to 18 months. This agenda should give priority to reformula- tion of the Law on Competitiveness adopted by Congress and vetoed by the past president (Box 3). The agenda could include measures needed to support the finan- cial system, trade policy, and private participation in infrastructure as mentioned above, in addition to measures on developing human capital (see chapter 9 on du- cation) and rural development (see chapter 13 on Rural Development). Added to this are activities in three specific areas: internal competition among companies, entry into the market, and labor markets. These areas include the following measures: * Promoting domestic competition. In the vetoed Law on Competition, the concept of competition should be clarified, the autonomy of the Competition Council should be improved, and the role of the Consultative Council, cur- 34 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM rently in the Ministry of External Trade, Industrialization, Fishing and Com- petitiveness (MICIP), should be clarified. • Eliminating barriers to entering the market. Attracting new companies promotes technology and new investment. However, a recent survey estab- lished the existence of 62 different steps that are needed to register a business in Ecuador, certainly one of the highest figures in Latin America. A drastic regulatory and administrative simplification is needed to lower the legal and operational barriers to the creation of new businesses, which extends to the agencies responsible for the registration of businesses, taxes, employment, health, and environmental licenses. o Flexibilization of labor markets. Chapter 16 on the Labor Market and Civil Service in Ecuador examines the reforms needed to improve salary policy, labor mobility, and the redeployment of the labor force among firms, and between the public and private sectors. In addition to this are reforms to the public vocational training system, which should encourage training in firms so that they can attain the necessary technical and administrative standards that are essential to their competitiveness. Beyond focusing on specific policies, an effective agenda must be one that can be monitored as a process. This means an explicit determination of intercompany com- petitiveness goals-defined primarily in terms of changes in product/service design, quality, cost, and delivery times. Corporate cluster organizations use a similar methodology to establish standards and monitor the evaluation of goals by the Competitiveness Council, analyzing policy options to improve its impact. E. Conduasion Ecuador's stability and recovery are promising, but fragile. Its fiscal and external posi- tion is vulnerable, in part because of its structural characteristics of high volatility in response to real or financial external shocks, in part because of the still heavy burden of its external indebtedness, and in part because of the persistence of expansive spending policies that have resulted in meager fiscal surpluses and high current account deficits. The probability that dollarization will collapse in the medium term is not negli- gible. Factors such as a drop in petroleum prices, loss of neighboring markets due to competitive exchange rate depreciations, or regional capital flight which indirectly impact the Ecuadoran economy are some of the foreseeable external shocks which would affect the economy to a greater or lesser degree, depending on how prepared the country is to face them. Thus, the future credibility of the country's economic program will not be achieved by the mere existence of a foreign exchange provision, but rather through a combination of consistent and credible policies that make it possible to provide appropriate management of the waning of the current petroleum boom, which may happen at any moment. MAINTAINING STABILITY WITH FiscAL DISCIPLINE AND COMPETITIVENESS 35 Box 3. Suggestions on a Draft of the Vetoed Law on Competition in Ecuador The vetoed law represents an excellent starting point for an initiative designed to strengthen Ecuador's private sector. However, from an international per- spective, certain aspects of the initiative need to be developed further and made clearer: * Types of conduct that are considered "illegal per se" (Art. 6) are not clearly differentiated from those that are to be considered punishable under the "rule of reason" (Art. 8). In effect, some behaviors (such as price discrimination and linked purchases) are examples used in both articles. It is highly recommended that "cartel" type conduct by com- panies be clearly distinguished from behaviors considered as abuse of a dominant position. * Institutionally, neither the independence of the government's antimo- nopoly authority (Consejo Ecuatoriano de la Competencia-CECON) nor its separation from the investigative and prosecutory body (the Superintendencia de Compafilas through the Intendencia de Competencia) is clearly established. For example, one of the functions of CECON (Art. 19) is to "establish national policies for the promotion and defense of competition, in accordance with the guidelines established by the President of the Republic..." In addition, the Director of the Secretariat has a subordinary Superintendency-the Superintendency of Com- panies-and also presides over CECON. International experience indi- cates that this type of institutional design increases the risk of state "cap- ture" and reduces effective compliance with the law. * Clarification of the role of the Consultative Council (Art. 20) and its relationship with CECON should prevent an overburdening of the agency and its mandate (Art. 7). The European Union and the antimo- nopoly authority of the Netherlands have tried to reformulate a similar provision. After the presidential veto and reformulation of the law, the new adminis- tration should make these revisions and proceed to discuss them with the pri- vate sector. Without seeking to be exhaustive, this chapter provides key elements for a sound and credible program for the next four years. It is essential to close Ecuador's imme- diate financial gap and resolve the insolvency of its debt position. Both tasks require the strong leveraging of the economy's fiscal discipline with tax reform, an austere 36 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM national emergency budget, and the repurchase of the debt using funds from FEIREP as prerequisites for fiscal sustainability. Improving prudential supervision of the financial system and strengthening the country's external position will also allow Ecuador to create a financial "cushion" of contingent resources for liquidity pres- sures on the banking system or outflows of capital owing to regional movements. In real terms, the objective is to adjust the relative prices of tradable and nontradable goods in order to promote a depreciation of Ecuador's real rate of exchange. This means, on the one hand, a comprehensive reform of its trade policy to eliminate the anti-export bias and correct the many and chronic distortions that still "protect" its economy-and on the other, closing competitiveness gaps by stimulating the factors of production: making labor markets more flexible, eliminating barriers to the domestic market in order to attract technology, and promoting human resources training and development. The risk of a failure to reform the real sector is that, given the existence of inflex- ible markets-such as the formal labor market-adjustments to shocks will occur primarily through reductions in production, with the corresponding contraction in demand derived from inputs, particularly labor. This potential situation will not only create pressure to "abandon" the model, in view of increased unemployment, but will also contribute to an increase in commercial bank arrears, as a result of the decline in general economic activity. This in turn would make achieving the goals of both fiscal adjustment and recovery of the banking system less feasible-creating a vicious circle that would be difficult to break. In summary, the sine qua non-condi- tions for sustaining dollarization are to achieve and then deepen fiscal solvency, introduce flexibility in goods and services markets, and increase the productivity of the factors of production. Policy Matrix z Measures z Short term Medium z Problem (first six months) term Progress indicators Objectives/goals CA High illiquidity and Design and implement Meet program goals Program performance Maintain stability, gain large financial gap a sound and credible during all indicators credibility, obtain multilateral macroeconomic management financing, and open Paris Club program negotiations Risk of insolvency of Achieve primary fiscal Goal achieved Reduce debt/GDP by a medium-term debt surplus of at least 5 minimum of 16 percentage percent of GDP in points as of 2007 2003-04 Low, volatile, and Approve tax reform Tax laws submitted to and Raise the nonpetroleum tax procyclical fiscal Review inherited tax approved by Congress burden by at least 2.5 percent z resources relief measures of GDP 0 Excessive, fragmented Declare a 2003 Prohibit any new Real salary indexation Adjust, consolidate, and spending that is not national emergency hiring of permanent equal to 0 percent redirect spending in a context transparent budget public employees and Amendments to law of greater budget transparency Establish spending evaluate existing submitted to and and an established poverty z limits (zero real growth positions approved by Congress reduction strategy - in 2003) Repurchase Global Gradual transfer of Suspend indefinitely Bonds resources to subnational automatic salary indexa- Transfer resources governments as they tion mechanism based on assumption comply with the new Prohibit new pre- of new functions, plan national investment allocations and to reschedule sub- policy exemptions, and national debt submit bill to (contingent included) (Matrix continues on the following page.) Policy Matrix (continued) %u Measures Short term Medium Problem (first six months) term Progress indicators Objectives/goals eliminate most and new rules for preallocations and future debts con- exemptions that are tracted by large cities not constitutional Modernize SIGEF o Suspend during emergency phase of subnational transfers m in excess of 10 per- 0 cent of current 0 revenues if there is n no information on their use, and transfer functions in con- ° junction with resources Approve an improved > SIGEFE z Tax law is not Prepare amendments Amendments to the law Strengthen fiscal discipline and > sufficiently restrictive, to the Law submitted to and reduce the burden of external does not have potential Use FEIREP to approved by Congress debt for collecting counter- repurchase debt z cyclical funds, but does have potential for debt repurchase p The change in relative Approve fiscal Complete financial Contain greater appreciation in Z prices in favor of measures reorganization the real rate of exchange prices for non- Eliminate customs Develop capital tradable goods and noncustoms market z (trending to barriers Reform social appreciation in security Z the real rate of Z exchange) harms external competitiveness Vulnerable external Establish annual goal Goal achieved Create a contingent liquidity position for increase in NFPS cushion of $US1 billion deposits in the Single Account (at least $USIOOM) Low competitiveness Select three to five New agenda and laws Establish the priorities of the and poor investment key priorities of submitted to and approved Competitiveness Agenda w climate the agenda by Congress Approve Law on a Internal Competition n Complete an inventory Create the single window Window in operation in Eliminate barriers to the of existing barriers and for recording and early 2004 creation of businesses the institutional approving new regulations reform plan Approve the Salary Amend labor laws Law submitted to and Increase the flexibility of labor Unification Law Develop plans approved by Congress markets and provide training Design plan for Plans underway through firms company training Annex ]Ecuador Selected EEconomic Indicators (As a percentage of GDP, unless otherwise indicated) 1997 1998 1999 2000 Est. 2001 Est. 2002 Proj. 2003 I. National Accounts Gross National Investment 21.5 25.3 14.7 20.1 25.7 27.2 26.4 Gross National Savings 18.4 15.9 20.5 26.4 23.2 20.6 20.1 Financing Gap 3.0 9.3 -5.7 -6.3 2.4 6.6 6.3 Government Investment 3.1 3.6 3.8 2.9 3.5 4.5 3.7 Government Savings 3.5 0.4 0.9 6.9 7.5 7.3 7.9 o Government Savings Gap -0.4 3.2 2.9 -4.0 -3.9 -2.8 -4.2 0 Private Investment 18.4 21.7 11.0 17.2 22.1 22.7 22.7 Private Savings 14.9 15.5 19.6 19.5 15.8 13.4 12.2 Private Savings Gap 3.4 6.1 -8.6 -2.3 6.3 9.4 10.5 II. Nonfinancial Public Sector 0 Current Revenues 21.6 19.1 22.5 27.6 24.7 25.7 26.6 Taxes 7.8 8.5 9.1 11.7 12.3 12.3 12.3 Petroleum Revenues 5.4 3.9 6.2 9.2 6.4 5.7 6.5 6 Current Spending 18.2 18.9 21.2 21.0 17.3 18.5 18.7 z Interest 4.3 4.2 8.1 6.6 4.7 3.6 3.6 Capital Spending 5.5 5.2 6.0 5.5 6.7 6.5 5.5 z Primary Balance 2.2 -0.9 3.4 7.7 4.6 4.0 5.4 Global Balance -2.1 -5.1 -4.6 1.0 -0.1 0.4 1.8 Z NFPS Balance without Petroleum -7.5 -9.0 -10.9 -8.1 -6.5 -5.2 -4.7 III. Balance of Payments GNFS Exports 25.8 21.5 31.6 37.1 27.1 24.3 22.2 GNFS Imports 24.4 27.2 22.1 28.2 29.0 30.9 28.9 Trade Balance 2.5 -4.3 10.0 9.2 -1.4 -5.3 -5.6 Remittances 2.7 3.4 6.5 8.3 5.8 5.4 5.4 z Current Account Balance -3.0 -9.3 5.7 6.3 -2.4 -6.6 -6.3 Current Account Balance z without Petroleum -5.4 -9.5 -0.2 -5.6 -7.2 -11.4 -10.5 Direct Investment 2.9 3.6 3.8 4.5 6.3 4.9 4.3 ;y Reserves* - - -1.5 4.9 2.8 1.6 2.3 IV. Indicators of credit capacity ** Total External Debt/GDP 63.9 70.5 97.6 85.1 68.5 65.7 60.8 Total External Debt/Exports 248.1 327.5 309.4 229.4 252.9 270.7 273.5 Total External Debt Service/Exports 97.6 151.3 125.0 202.4 118.6 114.9 124.8 Memo: GDP Growth 4.1 2.1 -6.3 2.8 5.1 3.0 3.5-4.0 GDP in $US $23,636 $23,255 $16,674 $15,934 $21,024 $24,507 $26,725 Q Z -. No data available. w *Excess freely disposable international reserves. Includes arrears and adjustment for exchange rate variation and differs from records in balance of payments in that the latter does not include earlier payments or refinancing. 0 Source: Central Bank of Ecuador, MEE and IME Information updated as of January 22, 2003. 3 2 Tax Policy and Administration' Osvaldo Schenone The three principal tax policy problems in Ecuador are lack of simplicity, a small tax base, and an inefficient use of resources. The reasons behind these problems are, first, the proliferation of taxes, a trend that lacks transparency and hides inequity and inefficiency in the allocation of resources. A second reason is the tax exemptions, which introduce dis- tortions and do not comply with any of the tax policy objectives, especially with respect to redistribution in the case of the Value-Added Tax (VAT)(Impuesto al Valor Agre- gado-IVA) and are inefficient in achieving the goal of promoting socially equitable undertakings in the case of ISR (Impuesto Sobre la Renta-Income Tax) exemptions or import duties. Finally, a third reason is the tax revenue preallocations, which do not allow for the efficient use of tax resources and discourage the collection effort by those jurisdictions that prefer to count on transfersfrom the central government. A tax simpli- fication-by abolishing minor taxes; broadening of the base through the elimination of exemptions; and reorienting taxes, through the elimination of preallocations-would result in lower administrative costs for collecting taxes, an increase in tax revenues, and more efficient allocations. Regarding tax administration, the two most serious problems are the inadequate institutional design of the Internal Revenue Service (Servicio de Rentas Internas-SRI), whi.ch makes it vulnerable to constant pressures from private interests, and the poor anti-evasion efforts by Customs, which has not been reformed and, consequently, has not had the same dynamism as SRI, in spite of the fact that they share the same computer system. Good practice would suggest reinforcing the independence of the SRI and merging with Customs under a single authority. 1. Osvaldo Schenone is a tax specialist and World Bank consultant. He is professor of eco- nomics at the Universidad de San Andres, Bueonis Aires, Argentina. 43 44 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN 1HE NEW MILLENNIUM A ]Backgrouind The advent of the new millennium not only brought a new monetary system-that is, dollarization-to Ecuador, but also put an end to the deficit in the Nonfinancial Public Sector (NFPS, SPNF in Spanish), which characterized the final decades of the last century, by generating a primary surplus through primary cost containment (as a percentage of GDP) and an increase in tax revenues, primarily VAT. The NFPS comprises the central government, the municipal governments, the Ecuadorian Social Security Institute (Instituto Ecuatoriano de Seguridad Social-IESS), and a multitude of other public enterprises. The income from taxes and non-taxes (pri- marily from oil) of the NFPS have, during recent years, amounted to 22 percent of GDP, with a recent tendency to increase, as indicated in Table 1. This table also shows the portion of the income received by the central government under the headings of income from oil and income from taxes. The income from taxes, in turn, are shown in the table, separating, on the one hand, the taxes collected outside the SRI and, and on the other hand, the taxes collected by this Service-that is, ISR, VAT, ICE (Impuesto a los Consumos Especiales-Special Consumption Tax), and others. As indicated in Table 1, the increased income by the central government and, in general, by the entire Nonfinancial Public Sector is primarily due to the increase in VAT revenues, since the increase in ISR, ICE, and others were significantly less, in terms of percentage of GDP, as of the middle of the last decade. VAT revenues account for more than 60 percent of all SRI collections. Table 1. Total Income by the Nonfinancial Public Sector and the Central Government, 1995-2002 (expressed as a percentage of the GDP) Central Government Taxes Within the SR1 Non-financial Public Outside Year Sector Total Oil the SRI Total ISR VAT ICE Other 1995 22.7 15.5 5.9 3.7 6.0 2.0 3.0 0.5 0.4 1996 21.8 15.7 7.3 2.7 5.6 1.9 3.0 0.4 0.4 1997 19.9 13.8 5.3 2.5 6.0 1.8 3.2 0.7 0.4 1998 17.2 13.2 3.8 3.2 6.2 1.8 3.6 0.5 0.3 1999 20.8 13.2 4.4 1.3 7.6 0.6 3.4 0.5 3.0 2000 25.8 17.4 6.7 1.1 9.6 1.6 5.4 0.6 2.0 2001 23.4 17.9 5.8 1.5 10.6 2.6 6.8 0.8 0.4 2002(e) 24.2 18.0 6.0 1.4 10.6 2.5 6.9 0.9 0.4 (e). Estimate. Source: Actual preparation from the database of the Ministry of Economy and Finance, SRI, in E Andic and A. Mann, Report on the Internal Revenue Service of Ecuador. Tax Revenue andAdministrative Policy (Salto Project), May 2002; and J. Bour, D. Artana, and F. Navajas, Fiscal Problems in Ecuador (International Development Bank), September 2002. TAx POLICY AND ADMINISTRATION 45 At present, the tax income of the central government not administered by the SRI consists primarily of customs tariffs, collected by CAE (Corporacidn Aduanero de Ecuador-Ecuadorian Customs Corporation).2 The SRI director is a member of the CAE board, in what may be interpreted as an indicator of the intention to merge the two institutions, which, up until this date, has not yet occurred. The fact that the improvement in the VAT collection efforts has not been accom- panied by a parallel improvement in ISR may be attributed to several factors, one of which is the zigzagging policy of first abolishing and then re-adopting the ISR in 1999. Another factor is that, as indicated in a later section, in recent years the ISR has suffered the effects of repeated and varying exemption proposals with greater severity than other taxes. The tax administration also shows a change in orientation during the final years of the last decade. The SRI was created in December 1997 as a replacement for the discredited Internal Revenue Office. Likewise, in 1998, the CAE was created as a replacement of the previous National Customs Office. At the time of its creation, the SRI did not have a central taxpayers' registry-only several registries at the dif- ferent regional offices throughout the country. This used to make it possible for a delinquent or tardy taxpayer to simply register at another regional office, and avoid punishment for previous delinquencies. A number of improvements have been made since then. A centralized taxpayers registry (Registro O}nico de Contribuyentes-RUC) has been created, with 1.1 million registrants (80 percent of them individuals and 20 percent legal entities). The num- ber of personnel was reduced and training was increased. More than 95 percent of the print shops authorized to print sales and withholding receipts were verified in 2002 (with an electronic authorization system for printing invoices, which reduces the time duration of the process-including taxpayer verification-to just a few minutes). The large taxpayers (approximately 3,000 companies, which generate around 80 percent of SRI revenues) are subject to special procedures, since a special unit for attending to their needs is not considered necessary. And finally, the management indicators show satisfactory levels for 2001 and 2002, as indicated in Table 2. The SRI is making use of third-party information to increase taxpayer compliance. Cross-checks performed during 2001 and 2002 detected approximately 100,000 per- sons not registered in the RUC. The fact that companies and public entities are sub- ject to VAT, offers excellent possibilities for cross-checking information, because when these entities request a reimbursement of VAT credits, they automatically reveal their identities to their suppliers. Because of the large volume of purchases made by the state, the volume of resultant cross-checked information is also very large. 2. Other sources of tax income, which are of lesser significance in terms of size, are two taxes on transportation and oil by Sistema de Oleoducto Transecuatoriano (TransEcuadoran Pipeline Systen [SOTE]), administered by the Central Bank, and the taxes on lubricants and aviation fuel for international service and the airport tax, administered by the Civil Aviation Office. 46 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MiLLENNIUM Table 2. Some SR1 Management Indicators 2001 2002 Debt collected versus outstanding debt 23% 41% Forced collections versus collections under management 1.7% 2.8% Taxpayers who declare nothing versus taxpayers who declare a gain 47.2% 41.4% Taxpayers who declare versus taxpayers who should declare 43.4% 33.5% Notifications to actual non-filers versus (special) non-filers 94% 89% Notified taxpayers with cross-checked differences versus planned notifications 47% 91% Source: SRI. As a result of cross-checking the information, however, delays have been created that have to be resolved. The cross-checked information of ISR and VAT declara- tions by one taxpayer and the various taxpayers who buy and sell among themselves, have been delayed and the results from the cross-checked declarations of 2000 are not yet available. The SRI is a proponent of the strategy of limiting to a minimum any visits to companies, in order to avoid needless discussions (which, it is feared, could lead to opportunities for corruption) among its auditors and the accountants of the com- panies, and has replaced said visits with information cross-checks and subsequent notifications of irregularities to the taxpayers. Even though the SRI has the legal power to contract private collection agencies, it refrains from using them because a large number of the delinquent accounts come from the old Internal Revenue Office and it has not yet been possible to verify the legitimacy of the claims. The so-called Ecuadorian Simplified Tax System (Rdgimen Impositivo Simplifi- cado Ecuatoriano-RISE), an initiative for small producers and informal vendors, is pending legislative action. According to this initiative, these taxpayers would pay a monthly sum based on their estimated income, and they would not be obligated to maintain an accounting system, but they must issue and receive invoices. The SRI estimates an annual income from this of approximately $US20 million, or 0.1 per- cent of GDP. 13. The Three IPrimary IProbhlenms of the Tar PoRicy The main difficulty of Ecuadorian economic policy is its subordination to immedi- ate political urgencies. The Economic and Public Investment Balance from January 2000 to January 2003 provides a good example: "Once the goal of economic stabil- ity was reached, the national political front became complicated again. By not hav- ing a political party or a majority in Congress, the government was obliged to incur TAx POLICY AND ADMINISTRATON 47 expenses and recruit economic authorities that provided it with greater discretionary space. This produced a reduction in the primary fiscal surplus which would have been better used as a contingency fund, but which unfortunately was used to guar- antee the short term political governability in the absence of a long-term national pact."3 In the specific issue of tax policy, this subordinarion led to the creation of multi- ple taxes to satisfy the demands of different interest groups, while at the same time conceding exemptions for the same purpose. With the same desire to expand inter- est group accommodation, what remains of tax revenues after exemptions is preal- located to different beneficiaries. This delicate balancing act leaves few resources for the government to be able to provide public goods and infrastructure to benefit the entire population, rather than a few interest groups. Even though various problems exist with the Ecuadorian tax system, three stand out owing to their importance and the urgency with which they require a resolution. They are the proliferation of taxes, tax exemptions, and preallocation of tax rev- enues. Among the problems not chosen for detailed treatment in this chapter-despite their importance-are the limited progressiveness of personal income tax and the collection repercussions of reduced customs tariffs.4 The Problem of the Proliferation of Taxes Even though nearly all of the country's tax revenues stem from 10 different taxes, and half of them (VAT, ISR, ICE, customs tariffs, and the vehicle tax) generate more than 75 percent of the tax revenues, the SRI has identified more than 80 taxes according to the classification shown in Table 3. This situation implies unnecessarily high administrative costs for both the tax- payers and the administration. It discourages payment on the part of the taxpayers, and supervision on the part of the tax authority. The proliferation of taxes demonstrates the need to "fine-tuning" the tax policy, carefully selecting which sector must pay the benefits received by the ones selected- which also requires detailed exemptions and, possibly, also exceptions to the exemp- tions. This type of tax policy lacks transparency and hides inequity and inefficiency in the allocation of resources. Without pretending to be an exhaustive list, some well-known examples are as follows: (1) the tax on company assets by the Superin- tendency of Companies, which then receives and uses those same taxes; (2) financial societies also being subject to the asset tax, which is allocated to the Superintendency 3. D. Badillo and R. Salazar, Economic and Public Investment Balancefrom January 2000 to January 2003 (Ministry of Economy and Finance, November 2002), p. 5. 4. The reasons why the customs tariffs must be reduced and made more uniform are treated in the chapter on Commerce and Competitiveness. 48 ECUADOR: AN ECONOMIC AND SOCIAl AGENDA IN THE NEw MILLENNIUM Table 3. The Structure of the Tax System Benefieiaries Number Central Munic- Type of Tax of Taxes Gov. palities Pro= Others Income and Capital Earnings Tax 5 3 1 1 Payroll Tax 1 1 Property and Net Worth Tax 26 1 l 1 2 12 Real Estate Transfer Tax 24 8 2 14 Financial Asset Tax 6 1 5 Sales Tax on Goods and Services 17 7 3 7 VAT 1 1 ICE 7 6 1 Telecommunications 1 1 Electricity 4 4 Public Entertainment 3 1 Betting 1 2 Foreign Trade Tax 1 1 Various Taxes 4 2 1 1 Totals 84 15 24 4 41 Note. The Others category is composed of an enormous variety of institutions. For example, the Guayaquil Beneficence Council, the State University of Guayaquil, the Guayas Transit Commission, the Ecuadorian Social Securiry Institute, the Osvaldo Loor Foundations, the Potable Water Company, the National Promotion and Development of Sports, the Superintendency of Companies, the Superintendency of Banks, the Ecuadorian Tourism Corporation, the National Children's Fund, and so on. Source- SRI. of Banks; (3) the tax on the total assets of Act 006-88, which is allocated to the municipalities; (4) the tax on luxury and first-class hotel assets, which is allocated to the Ecuadorian Tourism Corporation (CETUR); and (5) the additional tax of Act 92-88 on bank profits of Act 92-88 whose tax revenues are allocated to the National Children's Fund (FONDIFA). The Recurring Problem of Exemptions Tax policy is constandy confronted by the challenge of exemptions. Despite the dif- ficulty in eliminating them, Ecuador has been successful in reducing exemptions between 1999 and the first half of 2001. But following this period, within the space of a little more than one year, renewed efforts have been made to reinstate them. During the first period, the ISR exemption was eliminated for the financial sec- tor on the income from securities and shares issued by the government, for cooper- 3. It should be noted that some of those "reforms of the state," while necessary, would reduce fiscal costs only in the medium- and long-term (and may increase them in the short-run, for example, because of related severance payments). TAX POLICY AND ADMINISTRATION 49 atives and provident societies (except for the ones established by farmers or officialy recognized indigenous people) and the for promoting development (directed pri- marily at tourism and industrial endeavors). As well, the list of items subject to VAT was replaced with a tax list of VAT-exempt services (fundamentally, housing rentals and financial services)-which, therefore, leaves all other services subject to VAT. Nevertheless, since the middle of 2001, initiatives to create new exemptions have become more intense. The most important of these are as follows: * To exempt interest on mortgage loans from ISR. * To defer the VAT payments on the import of goods until the sale or use of such goods generate a tax debit against which the VAT can be credited. * To reinstate exemptions in the tourism sector (with the feature-still under discussion-of allowing the acquisition of shares in a tourism project to be deductible from the ISR to be paid by the purchaser of the shares). * "Tax-free zones" of large geographic dimensions (significant parts of a province or county) in which companies would be exempt from most taxes, regardless of the final destination of their products (internal market or export) .5 * The Export and Investment Promotion Corporation (Corporacidn de Promo- cidn de Exportaciones e Inversiones-CORPEI) granting a subsidy up to 5 per- cent on the freight on board (FOB) value of the exports. * A reduction of 1 to 0.1 percent of the retention that the buyers of agricultural goods for export charge the producers, at the expense of the ISR to be paid by the latter. * Generous deductions on the payment of ISR. The SRI has called this set: of initiatives "the dismantling of the tax base." In spite of the importance with which the authorities perceive the problem of the ISR and VAT exemptions, a tax cost calculation of these tax expenditures has not been made. A team of outside consultants began a quantification study on this matter in mid- November, 2002. Aside from the results that may be obtained through these estimates, provisional calculations of the internal VAT exemptions can be made right now (that is, exclud- ing the VAT on imports) on the basis of a sample of 3,055 large taxpayers during 2001, which represents 84 percent of the SRI tax revenues. This provisional estimate is presented in Table 4, and indicates a tax cost on account of the internal VAT exemptions of approximately $US237 million; or 1.1 percent of GDP for the year 2001. Approximately half of this comes from the commerce and industry sectors. 5. Hence the quote marks around the expression "tax-free zone," since the term is usually reserved for places where goods are produced only for export. 50 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Table 4. Estimated Tax Cost of the Internal VAT Exemptions, 2001 (in nillions of U.S. dollars) Taxable Export of income Income Exempted Tax Total goods and before actually estimated eredit on Fiscal Sector Income services exemptions taxed income purchases cost Agriculture 1,339 363 976 86.6 889.4 533.6 42.7 Commerce 7,162 507 6,655 5,148.6 1,506.4 903.8 72.3 Construction 523 1 522 467.8 54.2 32.5 2.6 Energy and gas 572 0 572 89.9 482.1 289.3 23.1 Energy and mining 571 431 140 65.3 74.7 44.8 3.6 Finance and insur. 1,499 63 1,436 1,190.0 246.0 147.6 11.8 Industry 5,468 899 4,569 3,469.9 1,099.1 659.5 52.8 Others 25 1 24 13.0 11.0 6.7 0.5 Comm. Services 3,089 909 2,180 1,982.4 197.6 118.6 9.5 Transp. and comm. 1,405 30 1,375 998.7 376.3 225.8 18.1 Total 21,654 3,204 18,450 13,512.4 4,936.6 2,962.2 237.0 Notes: (1) The tax credit for purchases was estimated as 60 percent of the estimated exempt income. (2) The fiscal cost was calculated as 12 percent of the difference between the estimated exempt income and the tax credit for purchases. Source: Ministry of Economy and Finance. An alternative estimate is shown in the annex, using National Accounts data, giv- ing as the combined result of the exemptions and tax evasion a tax cost of 1.9 per- cent of GDP. This result is not inconsistent with a tax cost of the exemptions of 1.1 percent of the GDP. Attributing the tax cost to the exemption on the basic food items and relating that to the entire agricultural sector (and admitting that this is an overestimate), it can be concluded that the remainder of the exemptions imply a tax cost of at least $US195 million for 2001, or approximately 0.9 percent of GDP. The exemptions on customs tariffs and VAT on imports,6 according to an esti- mate for 2000 and 2001, are concentrated in five tax codes which account for 93 percent of these types of exemptions, shown in Table 5. Their tax cost represents approximately $US123 and 148 million (for 2000 and 2001, respectively), or 0.7 percent of the GDP of these years, without including the exemptions for commer- 6. The exemption of VAT on imports has a limited tax revenue effect, since the majority of the import operations are not performed by end users, but by wholesalers, with the result that when they pay VAT they would claim the corresponding tax credit when they sell the products to retailers. In this way, the net VAT collection on import operations tends to disappear and show up as VAT on domestic operations (that is, in the retail sales to the end consumer). TAx POLICY AND ADMINISTRATION 51 Table 5. Tax Cost of Exemptions on Customs Tariffs and on the VAT on Imports, 2000 and 2001 (mlns $US) Cost and Freight (CIF) Value Tax cost of imports rate Code number and name of the exemption 2000 2001 Tariff VAT 2000 2001 407-Exempt from VAT 712.8 848.4 12% 85.5 101.8 395-Pharmaceutical products 29.0 27.0 5% 12% 5.0 4.6 464-Public sector 115.2 161.9 10% 12% 25.3 35.6 343-Public secror donations 1.8 11.6 10% 12% 0.4 2.6 413-Exempt from VAT (Public sector) 59.1 30.5 12% 7.1 3.7 Total 917.9 1,079.4 123.3 148.3 Note: The tariff is the average of the tariff positions involved. Source: Ministry of Economy and Finance. cial agreements, such as the Andean Community Nations (Comunidad Andina de Naciones-CAN), or the Aladi, as indicated in the same table. Nevertheless, as explained in the footnote, it would be an overestimate of the tax cost of the exemptions to include the VAT exempted from imports. Leaving only the exempted tariffs in the previous calculation, the final cost of the exemptions are estimated at 5 and 10 percent, respectively, for 2000 and 2001, on the imports under Codes 395, 464, and 343. This makes for a total tax cost of between $US13 and 18 million, or approximately 0.1 percent of the GDP, for 2000 and 2001, respectively. The exemptions based on trade agreements, on the other hand, represented a tax cost, in 2001, of approximately 90 percent of the tariff revenues of that year-or 1.4 percent of GDP-broken down as: * Exemptions by CAN: $US247 million; * Exemptions for trade with Chile: $US18 million; * Exemptions for trade with Mexico: $US 11.2 million; * Exemptions for trade with Argentina: $US6.2 million; and * Exemptions for trade with Brazil: $US12.8 million. The promoters of exemptions generally draw on two arguments. First, the exemptions promote certain select activities whose competitiveness must, presum- ably, be safeguarded and increased through tax or tariff policies; and second, the argument of equity. The first argument is generally used when exemptions to the ISR or to the customs tariffs are proposed, while the second argument is used for proposing exemptions on VAT, for a variety of products. Neither of the two arguments are particularly valid. Promoting business through tax or tariff exemptions requires the identification of those ventures whose promo- 52 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM tion would be beneficial to the society as a whole and not only to the investors involved. The errors of identification that might result would be too cosdy for tax- payers who were not selected. Furthermore, there is no mechanism to ensure that only involuntary and honest mistakes would be committed which thereby opens up opportunities for corruption and is another disadvantage of the exemption policy. Exemptions on customs tariffs have, in general, strongly prejudicial effects on the economic efficiency, as they can generate widespread protection and, therefore, can create business opportunities that may be be profitable, but are disastrous to the national economy.7 The equity argument in favor of exemptions also has limited validity. VAT exemptions on popular consumer goods constitute a highly inefficient way of intro- ducing progressiveness into the tax system. Although it is generally true that the exempted consumption represents a greater percentage of the total consumption by poorer families, it is the richer homes that benefit more from the exemptions. In the case of Ecuador, it was calculated in 1999 that out of every 100 sucres the tax office did not collect because of the exemptions on education, books, health, transporta- tion, water, and electricity (in other words, except basic food items, house rental and financial services) 43 sucres benefited the richest 25 percent of the population and only 14 sucres benefited the poorest 25 percent.' Techniques have to be found to get the 14 sucres to the poorest sector, without, automatically, having to award the rich- est sector with 43 sucres. Moreover, VAT exemptions complicate the tax administration for the taxpayers and the SRI alike. Taxpayers who sell exempted products as well as taxed products have to attribute the credits for VAT paid on their purchases on some of their sales, thereby complicating the accounting system of the business. Furthermore, the exemption creates a temptation to claim all of the VAT credits, as if all of the pur- chases were dedicated to the supply of taxed products. This gready complicates the taxation task of the SRI and the CAE. The Problem of Preallocations Income preallocations, whether they are from tax revenues or oil, are found scattered throughout 50 pieces of legislation-laws, decrees, or ministerial agreements. In 2001 there were 32 preallocations from tax revenues and 25 preallocations from oil income. The amount of preallocated tax revenues for that year were $US303 million, that is, 1.4 percent of GDP, of which 81 percent corresponded to VAT and ISR ($USI 12 million to VAT and $US 133 million to ISR). 7. This matter is discussed in detail in the Commercial and Competitiveness chapter. 8. G. Kopits, E. Haindl, E. Ley, and J. Toro, Ecuador: Modernization of the Tax System (Inter- national Monetary Fund, Department of Public Finances, November 1999), p. 24. TAX POLICY AND ADMINISTRATION 53 The percentage of the preallocated VAT revenues is 12 percent (1.5 percent to SRI, 10 percent to the Permanent Fund for University and Polytechnic Develop- ment (FOPEDEUPO), and 0.5 percent to the state universities), which is approxi- mately equal to the average percentage of the preallocation of all taxes, which, for 2001, reached 14.3 percent of total tax revenues.9 In the case of the ISR, the percentage of preallocation is at least equal to 28.5 per- cent of the tax revenues designated for various purposes. But furthermore, each tax- payer has the right to request, in writing to the tax authority, that up to 25 percent of the tax said taxpayer pays be transferred to the municipality where he or she main- tains his or her home. If all of the taxpayers would make use of this right, 53.5 per- cent of the ISR's tax revenues would be preallocated. Preliminary data for 2002 indicate that, possibly because of the use the taxpayers make of this right, the average percentage of preallocation of all taxes increased to approximately 19 percent of the total tax revenues. As an example, the ICE preallocations are shown in Table 6. Of the six categories of goods and services subject to taxes, only one (telecommunications) does not pro- vide any income for to the central government. All of the others provide income that fluctuates between 83.5 percent and 89.5 percent of their respective tax revenues, as can be observed in the last row of the table. The preallocations of the customs tariffs consist of 3 percent for the Water Resources Council and 3 percent for the CAE. The other 94 percent goes to the cen- tral government. Preallocation procedure prohibits the tax resources from being oriented to where their productivity is greatest. It promotes inefficient, and possibly also inequitable, use of the tax resources. The problem is particularly dire in the case of the funds allocated Table 6. Preallocation Percentages of the ICE Tax Revenues soft Cigarettes Beer drinks Alcohol Telecomm. Luxuries Hospital Equipment 10 10 10 10 - 10 Free Maternity Care 3 3 3 3 - - Osvaldo Loor Foundation - - - 2 - Internal Revenue Service 1.5 1.5 1.5 1.5 1.5 1.5 Potable Water Company - - - - 65.67 - National Sports - - - - 32.83 - Central Government 85.5 85.5 85.5 83.5 - 88.5 Source: Ministry of Economy and Finance. 9. See J. Gallardo, Tax Reform: Guarantyfor the New Generations (Ministry of Economy and Finance, August 2001), p. 53. 54 ECUADOR: AN ECONOMIC AND SOCIAL. AGENDA IN THE NEW MILLENNIUM to regional governments, since the automatic transfers discourage these governments from collecting their own taxes, thereby promoting irresponsible expenditure behav- ior, since the governments do not have to face the political costs of collecting taxes. In March 2001, the government sent the parliament a bill for a Fiscal Discipline and Prudence Act, whose Article 22 abolishes "the preallocations in the same way in which they were established." Likewise, the bill legislated that "the General State Budget for the year 2002 would compensate, in the same amount, the Public Sec- tor entities or organisms for the aLlocation actually received by them during the pre- vious year." The proposed preallocation elimination mechanism attempted to soften the tran- sition, preventing the public sector entities or organizations from suddenly experi- encing a shortage of financing." Nevertheless, this component of the bill was not approved, leaving the preallocation regime unchanged. C. Two IPriority Piroblems for the Taz A6ministration After the SRI and CAE reforms at the end of the last decade, a notable improvement was observed in the tax evasion control of the former, while the latter did not show evidence of significant improvement. The institutional designs of the SRI and the CAE are the most pressing issues of the tax administration. Other matters are less urgent and of a more operational nature, such as the adop- tion of a checking account for each taxpayer, and for each type of tax, so that pay- ments and reimbursements may function in the same way as a bank account. As a result, tax evasion control should improve, since the payments of each taxpayer and for each type of tax could be electronically reported to the SRI without delay. The delay in processing the information cross-checks needs to be resolved, as the results of the tax returns of 2000 are still not available. Likewise, in the tax returns of 2001, filed in April 2002, taxpayers have been detected who wrongly calculated the rein- vestment deduction into the ISR, but at this writing (November 2002), they have not been notified yet. Finally, a prompt adoption of filing tax returns via the Inter- net must be taken into consideration. 10.Kopits and others, Ecuador: Modernization of the Tax System (International Monetary Fund, Department of Public Finances, November 1999), p. 14. This proposal is consis- tent with the recommendation included in this study: not exceeding the proportion of preallocated revenues by the Constitution to the sectional governments effectively reached in 1999 (9 percent of the current income, instead of 15 percent preallocated), and not exceeding the preallocarion for educational expenses above the effectively reached per- centage in 1999 (12.5 percent of the current income, instead of 30 percent preallocated). Finally, the abolition of all other revenues preallocated by law was recommended, except the revenues of the Ecuadorian Social Security Institute. TAX POLICY AND ADMINISTIlATION 55 The Independence of the SRI The SRI board consists of six members with voice and vote, and the executive direc- tor of the SRI, with voice but no vote. The members of the board are as follows: The Minister of Finance (with two votes in case of a tie); the Superintendent of Com- panies; the Superintendent of Banks; the Undersecretary of the Budget; the Minis- ter of Industrialization, Commerce, Integration, Fishing and Competitiveness; and one representative of the private sector. This board needs to be reinforced to put it into a better position to resist pres- sures (from the public sector itself and, naturally, from the private sector) that tend, without breaking the law, to satisfy objectives outside of the scope of collecting taxes-such making a profit promoting the competitiveness of a given sector, or improving the equity of the distribution of tax revenues. These may all be noble aims, but they are outside the objective of tax collection-which should be the exclusive goal of the SRI-and may impede its effective. The Efforts of the CAE The anti-evasion efforts of the CAE has not had the same dynamism as that of the SRI, in spite of the fact that it shares the computer system that was upgraded and modernized by the SRI before sharing it with the CAE. This includes online infor- mation from the moment the merchandise is shipped from the point of origin, in such a manner that the taxes can be paid and the merchandise liberated from cus- toms at the moment of arrival in the port, preventing all storage problems and their corresponding delays." CAE has not been completely reconstructed, as was the case for the SRI, which practically replaced all of its personnel. CAE failed to replace hardly anyone, since the labor regulations prevent the dismissal of employees, unless the department within the CAE is abolished in which the employees work. (The managers, for example, are appointed for four years and cannot be removed by the board, even for negligence or other type of substandard performance). The possibility of overhauling the CAE should be considered, or an evaluation should be made concerning the advantages of merging this institution with the SRI, without endangering the efforts of the latter. The tax reform legislation of March 2001 merged the two institutions, but Congress rejected this initiative as a result of strong pressure from the importation sector. Later, in November 2001, the partici- pation of the executive director of the SRI as president of the CAE board was approved by law. 11. Payment by the taxpayer is immediately recorded in the network of banks, which also pre- vents possible fraud at the bank counters. This computer system also provides better con- trol of temporary admission mechanisms and tax deposits for merchandise. 56 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM A bill is currently before Congress on the Reform of the Internal Customs Act, which incorporates labor reforms that would allow a personnel restructuring similar to that of the SRI. Law 41 of 1999 provides that the merchandise in warehouses or storage areas may be inspected to verify whether the property is backed by documents proving merchandise ownership (commercial invoice if it is national, or a shipping bill in the case of international shipments). These documents must also be shown by trans- porters who move the merchandise from one place to another. The absence of these documents provides permission for seizure of the merchandise and to uncover cases of evasion of VAT or contraband. This procedure has practically not been used in Ecuador. Decided official backing for the observance of this law coupled with an adequate reform of the Internal Customs Act could be a substitute for the disappearance of the Customs Office and its merging with the SRI. D. Recommenmdalios The tax revenue value of this set of recommended tax and administration policies would be approximately 1.2 percent of GDP. If this increase in tax revenues were not sufficient for the macroeconomic balance, it would be recommended to increase the VAT rate, since each percentage point (within the scope of an existing rate) added to this rate is estimated to generate an increase in tax revenues of approxi- mately 0.6 percent of GDP. . The adoption of these recommendations would produce a less complicated tax system that is broad-based and consistent with an efficiently functioning economy. ELIMINATION OF MINOR TAXES. We recommend that the collection and disburse- ment of these minor taxes be eliminated. It is well known that the financial effects of their elimination would be of little significance, but the design of an orderly elim- ination strategy would require more detailed knowledge of the structure of each of these taxes. Their elimination would allow the tax authority and taxpayers to reduce administrative costs and to concentrate on the truly important taxes. The tax rev- enue effect is ambiguous, since an improved compliance with the important taxes may provide greater tax revenues than the one generated by the minor taxes whose elimination we are recommending. ELIMINATION OF EXEMPTIONS. We recommend that VAT exemptions only be applied to unprocessed basic food items and residential rentals that are in addi- tion to a primary home. Consequently, we recommend the elimination of exemp- tions on agricultural input items (such as seeds, balanced feed, tractors, fungi- cides, herbicides, plows, harrows, and so on); on financial services; different types of paper, books, and magazines; medicines and their raw materials; on trans- TAX POLICY AND ADMINISTRATION 57 portation services, electricity, water, and sewage; public entertainment events; professional services; tolls; fumigation services; on the cooling and storage of foods and on all other services used in the preparation of foods or other goods. This list is not exhaustive., but it illustrates the exemptions to be eliminated in order to leave only on unprocessed basic foods and residential rentals that are not people's only home. The tax revenue increase of this elimination is estimated at 0.9 percent of GDP. We also recommend the elimination of the ISR exemptions. The calculations of the tax revenue effect of this elimination have not yet been performed, but the Min- istry of Economy and Finance, the Central Bank, and the SRI are committed to gathering the necessary information. Likewise, we recommend the elimination of the customs tariff exemptions. Although the primary purpose of this elimination is not an increase in tax revenues but to reduce protection, an additional estimated tax income of 0.1 percent of GDP would be obtained. ELIMINATION OF PREALLOCATIONS. We recommend the elimination of the majority, if not all of the preallocations, except for the payroll tax, which is allocated to the Ecuadoran Social Security Institute (see the chapter on the Policy on Preserving Fis- cal Stability and Competitiveness). The gradual application of this measure could take place in the manner described in Article 22 of the Discipline and Fiscal Pru- dence Act of March 2001. This measure would have the effect of permitting (although not guaranteeing) a more productive use of tax resources. The amount involved in 2001 is $US1 12 mil- lion of VAT and $US 133 of ISR, plus other preallocated taxes up to a total of $US303 million (1.4 percent of GDP). This is in addition to a better use of these tax resources based on greater productivity for the public sector and for the econ- omy as a whole. In this manner, the total benefit of the elimination of preallocations may be estimated as the productivity increase multiplied by the total amount of pre- allocated funds. If the increase in productivity consists of 10 percentage points, the elimination of the preallocations will be equivalent to having more resources in an amount that is equal to 0.15 percent of GDP Tax Administration Recommendations APPROVE THE RISE (ECUADORAN SIMPLIFIED TAX SYSTEM) LEGISLATION. This meas- ure would allow greater control over the suppliers of small taxpayers in the system, because they have to have invoices from their suppliers. As the number of taxpayers in RISE grows, it will be more difficult for the suppliers to avoid registration with the SRI, since the demand for invoices will be greater for sales made to taxpayers in the RISE. It is estimated that at the outset of its implementation, this measure will generate a tax revenue of $US20 million, or 0.1 percent of GDP. 58 ECUADOR: AN ECONOMIC AND SOCLAL AGENDA IN THE NEW MILLENNIUM CORRECT DELAYS IN INTERNAL PROCESSES. Delays on account of information cross- checking (among different taxes of the same taxpayer and among different taxpay- ers) must be reduced, as must the delays in sending notifications to taxpayers regard- ing incorrect tax returns. REINFORCE THE INDEPENDENCE OF THE SRI BOARD. The purpose for this recom- mendation is to prevent the SRI resolutions from being used as instruments for introducing discriminatory and distorted tax treatments. The SRI must not get involved in satisfying any objective other than the strict collection of the taxes cre- ated by law. In particular, the competitiveness of any sector, or the promotion of industry, agriculture, or a given region should never be an element of judgment in the deliberations of the SRI board of directors. CONSIDER THE MERGER OF THE SRI WITH THE CAE. Because VAT contributors make up the major part of taxpayers who pay customs duties, and because they are satisfactorily controlled by the SRI, this institution could take advantage of economies of scale to also supervise the collection of customs duties from the same group of taxpayers. Certainly, this result could also be undertaken through a narrow collaboration between SRI and CAE. The question is whether this collaboration could be more easily obtained under a single authority that governs both institu- tions.'2 AMEND THE CUSTOMS ACT. The Customs Office labor system should be reformed, which would permit a restructuring similar to the one that has worked so well at the SRI. PROMOTE A STRICT COMPLIANCE WITH LAW 41 OF 1999. This evasion control mech- anism of VAT and contraband requires official backing at the highest level so that it can be applied without exceptions or discretion. Summary Table of the Tax Revenue Effects of the Recommendations (in percentage of GDP) Reduction of VAT exemptions 0.86 Reduction of customs duty exemptions 0.09 Elimination of preallocations 0.15 Ecuadoran Simplified Tax System 0.09 Total 1.19 12.ln 1999 the International Monetary Fund recommended the evaluation of this merger. See Kopits and others, Ecuador: Modernization of the Tax System (International Monetary Fund, Department of Public Finances, November 1999), p. 9. TAX POLICY AND ADMINISTRATION 59 Summary Table of the Order of Priorities of the Recommendations Essential and Immediate Medium-Term Recommendations Recommendations (during 2003/2004) - Elimination of exemptions - Elimination of minor taxes - Elimination of preallocations - Considering the SRI-CAE merger - Correction of the delays in cross- - Promoting the strict compliance with checking information in the SRI Law 41 of 1999 - Reinforcing the independence of the - Approval of the RISE SRI board of directors - Amending the labor system of the Customs Act Recommentdation Matrix Probkms Policy Measures (including annual Short Term Medium Term tax cost-if applicable) (UntilJune 2003) (2003-07) ProgressIndicators Objectives/Goals Exaggerated number Eliminate the minor Gradually eliminate Approval of repealed laws. Reduce adminisrrative costs for of minor taxes, of low taxes and their corres- the minor taxes. the tax authority and for the tax revenues and ponding collections. t taxpayers. preallocations. Exemptions of ISR, VAT (except Eliminate the ones Completely eliminate Approval of repealed laws. Reduce distortions in the unprocessed basic that create less exemptions (except economy; increase the tax foods, financial services, conflict politically. unprocessed foods, revenues by 0.95 percent z and home rental), financial services, of GDP. 0 and customs tariffs. and home rentals). Preallocation of taxes Eliminate the ones Completely eliminate Approval of repealed laws. Increase productivity of the o (except preallocations that create less preallocation (except use of fiscal resources by 0.15 C to the Ecuadorian conflict politically, the Ecuadoran Social percent of GDP. n Social Security Institute). Security Institute-IESS). Small producers and Adopt the Ecuadoran Approval of the law. Reduce the informality and merchants that are Simplified Tax System generate tax revenues of 0.09 not taxpayers. (RISE). percent of GDP. z Vulnerability of the Strengthen the SRI Prevent erosion of the tax base x SRI to private interest institutionally. through administrative means. Z pressures. Stagnation of CAE Evaluate the merger Improve contraband control. efforts. between the CAE and 2 the SRI. Delays in information Start resolving the Complete elimination cross-checks and in delays. of the delays and sending out notifications prevent causing ° to taxpayers. new delays. Labor System of the Approve a legal Restructure Customs Z Customs Act. reform that allows personnel, similar to the restructuring of the way it was done the personnel situation. at the SRI. Z z 62 ECUADOR: AN ECONOMIC AND SocIAL AGENDA IN THE NEW MILLENNIUM Ainime. An alternative estimation of the tax cost of the VAT exemptions is presented here. Utilizing the information from the Final Consumption of Households on the National Accounts, a maximum potential VAT income can be estimated, which will be different from the tax income observed, for two reasons: exemptions and evasion. Value in milUiom Potential Final Consumption of Households of dollars Tax Revenues Bananas, coffee, and cacao 53.88 6.47 Grains 54.00 6.48 Flowers 18.45 2.21 Other crops 408.24 48.99 Breeding animals 229.14 27.50 Forestry and lumber 14.26 1.71 Fish and shellfish 183.40 21.99 Mineral products 2.63 0.32 Meat and meat products 728.71 87.45 Processed fish and shellfish 104.31 12.56 Oil and fats 204.83 24.58 Milk products 236.01 28.32 Grain milling and bakery products 549.04 65.89 Refined sugar 127.93 15.35 Candies and chocolates 67.99 8.16 Other foods 185.18 2.22 Drinks 384.12 46.09 Tobacco and cigarettes 52.21 6.27 Textiles and clothing 844.93 101.39 Wood products 26.24 3.15 Paper and related products 184.88 22.19 Petroleum products 197.02 23.64 Chemical products 620.41 74.45 Rubber and plastic products 109.06 13.09 Nonmetal minerals 39.45 4.73 Products made of metal 209.83 25.18 Machinery and equipment 319.75 38.37 Transportation equipment 201.40 24.17 Other manufactured items 401.86 48.22 Electriciry and water 142.20 17.06 Hotels and restaurants 438.23 52.59 Shipping and storage 1,216.34 145.96 Mail and telecommunications 329.15 39.50 Financial and insurance services 130.98 15.71 Home rentals 683.88 82.07 Other activities 51.24 6.15 Public administration 10.36 1.24 Education 274.80 32.98 TAx POLICY AND ADMINISTRATION 63 Value in milions Potential Final Consumption of Households of dollars Tax Revenues Social and health services 182.05 21.85 Other social, personal, and domestic services 138.88 16.66 TOTAL 10,357.52 1,242.90 Source, Central Bank of Ecuador. Using the 2000 data, it is calculated that the tax income results together with exemptions and evasion end up being equal to the difference between $US 1,242.90 million and the effective tax income for this year, $US893.4 million; that is, $US349.5 million, or approximately 2.2 percent of GDP. The estimated amounts in the text of this report, which attributes a tax cost of 1.3 percent of GDP to the exemptions, is not inconsistent with the results of this annex. 3 Debt Administration and Sustainability' Elaine Tinsley Ecuador is no stranger to inefficient public debt management; during the last 30years it has been struggling to control the enormous burden ofservicing its debt. Part of the prob- lem lies in the fiscal structure the country inherited from the military regime: a big bureaucracy coupled with dependence upon highly volatile oil revenues, subsidies, and earmarked expenditures. However, there are other reasons: persistent badfiscal manage- ment practices, including sizable wage hikes in the public sector; inflation; and the dis- torted exchange policies of the past. All of these factors have conjoined to make fiscal accounts especially vulnerable to external crises, compelling the country to restructure its debt on two occasions. Thefirst was in 1994, after a seven-year suspension of debt serv- ice, with the introduction of Brady bonds, and the second in 1998, when the government became thefirst country to default on its Brady bonds, necessitating restructuring in the form ofglobal bonds. Any new external debtpolicy will be irrelevant withoutfiscal dis- cipline, which means achievingsignificantprimary surpluses in the nextfewyears. If this prerequisite is met, good debt administration will be the other side of the coin of success- fully attaining efficient management and lowering debt profile andfinancial cost. Proper debt management will improve credibility on the basis of thefollowing: a strictfiscal dis- cipline will reduce Ecuadors currently very high sovereign risk classification, which in turn impacts private sector competitiveness; it will buy back debt or reschedule the exist- ing debt service, especially that which is most onerous to the fiscal accounts; and mod- ernize the countrys debt management team. 1. Elaine Tinsley is an economic policy analyst for the World Bank. The author wishes to thank the following individuals from the World Bank: Lenin Parrefio, Katy Yinez, Alfredo Astorga, and Silvia Burbano-and especially, from the Public Credit Office of the Min- istry of Economy and Finance, Mauricio Pareja and Gino Minoli. 65 66 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM A. 3ackgound Ecuador's present public debt problems can be traced back to the 1970s, when large- scale oil exports enabled the military government of the time to finance large investments and boost public sector employment. Oil revenues also made it possi- ble to provide subsidies to the electricity sector and to domestic oil consumption. As a result, public expenditure experienced a sharp increase between 1972 and 1975. In 1975, owing to a number of external shocks, including El Nifio and the low prices of crude oil, public revenues declined. Instead of raising taxes or reducing expenditures, the government attempted to cover its deficit by borrowing, which led to a rapid increase in the volume of public debt. In the early 1980s, in the aftermath of monetary tightening in the United States, the situation worsened because of the resulting high interest rates on variable debt and increased public wages. In 1982, the combination of high interest rates, the recession, and the deterioration of fiscal accounts, compelled the government to devalue its exchange rate, which in turn generated a series of devaluations that increased the external debt service obligations of the private sector (mainly commercial banks). In 1983, to relieve pressure arising from the banking sector's debt burden, the government assumed most of the private external debt, swapping it for a debt in sucres , a move that considerably increased the volume of public debt. In the following years, economic volatility and poor fis- cal management generated high fiscal deficits, which finally led to the suspension of public debt service from 1987 to 1994. During that period debt slowly climbed, mainly through accumulation of arrears. In 1994, the authorities reached an agree- ment with its private creditors to restructure the debt with the issuance of $US6 bil- lion in Brady bonds, an agreement supported by the multilateral agencies which helped by financing the guarantee for the bonds. After the restructuring, Ecuador's external public debt totaled $US13.5 billion or 80 percent of GDP, making it one of the highest debt burdens in Latin America and the Caribbean (Figure 1). In 1998, the high debt situation, combined with the collapse of oil prices, the effects of El Nifno, and the resulting banking crisis led to a loss of confidence in the economy and a downward spiral of the exchange rate. Although each devaluation enabled the government to garner more petrodollars to service its deteriorating fis- cal account, the increase in the dollar denominated debt stock counteracted what- ever benefits the devaluation could generate. The situation became unsustainable and in August 1999, Ecuador defaulted on its debt obligations, making it the first country to default on its Brady bonds. After the default, in July 2000, Ecuador offered to swap its Brady bonds and Euro bonds, valued at $USO.60 on the dollar, for new 12- and 30-year bonds. The thirty-year global bonds would pay an initial coupon of 4 percent, increasing by one percentage point annually up to a maximum of 10 percent in 2006. In exchange for an additional discount on the value of the debt, 12-year bonds were offered at a 12 percent fixed coupon. The offer was accepted and the debt stock in bonds dropped from $US6.5 billion to $US3.9 billion. DEBT ADMINISTRATION AND SUSTAINABILITY 67 Figure 1. Composition of Public Debt 18 - 140 16 - 120 14 - 12 1X00 I70 75 8 8 0 5 0 8 Dl60 6 40 2 ~~~~~~~~~~~~~~~~20 0 70 75 80 85 90 95 00 Domestic External - Debt (percentage of GDP), RHS Source: International Monetary Fund (IMF). This chapter examines some of the main topics relating to public debt manage- ment in Ecuador. The second section describes the structure of the public debt. The third section suggests some guidelines for a debt reduction plan based on a debt sus- tainability analysis model. Finally, the fourth section offers recommendations aimed at improving the level and administration of the public debt. B. Present Debt Structure Ecuador's total external debt amounts to $US 15.7 billion (64 percent of GDP). Of this amount, 71 percent is public debt and 29 percent is private. While nearly all of the official external debt is medium- or long-term, short-term debt is only signifi- cant in the composition of the private debt (45 percent). Thus, although private sec- tor debt is relatively small, its short-term debt represents 13 percent of total exter- nal debt, and accordingly could impact the economy to some degree in the event of regional capital flight. Public debt is $US14 billion. About 80 percent is external debt, and 20 percent internal. Almost all of the external debt is medium- or long-term, and only 7 per- cent short-term. Thus, only 1.4 percent of total public debt is short-term. This long- term debt maturity structure avoids some of the risks associated with the refinanc- ing of short-term debt, though its high interest rate results in a much heavier debt load. Despite renegotiation of its debt, Ecuador continues to have the highest pub- lic debt/GDP ratio in the region after Argentina. Net debt service of the country's debt (including disbursements) consumes about 35 percent of the budget. 68 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEw MILLENNIUM PUBLIC ExTERNAL DEBT. Since the 1990s, public external debt from multilateral loans has practically doubled, while bilateral debt has remained almost constant. Taken together, the two represent 60 percent of external debt. Brady bonds (the main component of external debt to the private sector) represent another 36 percent (Figure 2). Before 2000, about 60 percent of external debt was at variable interest rates and the remaining 40 percent was fixed. Renegotiation of the Brady bonds reversed these percentages: at present 75 percent of the external debt is fixed and 25 percent is variable. Though the foregoing helps reduce volatility of debt service, the government must still bear high interest rates for a long period unless restructured. It is estimated that interest payments on the external debt will total $US581 mil- lion in 2002, or 2.4 percent of GDP, and the global bonds represent half that amount and one-third of total external debt (Figure 3). This is not surprising, con- sidering that Brady bonds are the most onerous in terms of interest. Of the public external debt, the Central Government is the primary debtor responsible for 88 percent of the debt, while the public financial sector represents 9 percent, and public companies and subnational entities account for the remaining 3 percent (see Figure 4). Subnational entities have little chance of mobilizing external funding, partly because of limited administrative capability, but also because of the country's non-payment culture. Since all payments in the Nonfinancial Public Sec- tor (NFPS) are channeled through the Public Credit Office of the Ministry of Econ- omy and Finance (MEF), the government is ultimately responsible for ensuring that these payments are made. Although many entities are punctual in their payments, others, especially electrical utilities, either do not pay or are consistently late. Figure 2. External Debt 14.0 12.0 - 10.0 8.0 6.0 - 4.0 2.0 - 0.0 -~.. ..... ..U.._ ............... 0.0 I,- . 90 91 92 93 94 95 96 97 98 99 00 01 02 Ol Multilaterals El Bilaterals O Banks O Suppliers Source: Ministry of Economy and Finance (MEF). Figure 3. External Debt and Interest Payments by Creditor External Debt Stock by Creditor, 2002 Interest Payments to Creditors, 2002 Z Global bonds Others Others Global o 34% 6_ bonds z 45% z Bilateral Multilateral Bilateral Multilateral 23% 37% 18% 33% Source: BCE, MEF. 70 ECUADOR: AN ECONOMIC AND SOCiAL AGENDA IN THE NEW MILLENNIUM Figure 4. External Debt by Debtor, 2002 Financial Others Fmanclal3% public sector 9% Central government 88% Source: MEF, Statistical Bulletin 68. PUBLIC DOMESTIC DEBT. Of the $US2.7 billion public domestic debt, almost half ($US 1.2 billion) relates to the Deposit Guarantee Agency (Agencia de Garantia de Depositos-AGD), created to rescue the banking system during its crisis. With a nom- inal interest rate of 9.4 percent, AGD bonds are the most onerous of the internal public debt and they mature in 2014. The holder of this debt is the Central Bank (BCE) and the interest payments on these bonds constitute that entity's main source of income. The second source of debt is dollar bonds. The public domestic debt fig- ures do not include debt to the Ecuadoran Social Security Institute (Instituto Ecua- toriano de Seguridad Social-IESS), which is estimated at $US2 billion. Unlike other countries, Ecuador's public domestic debt is not especially vulnera- ble, since almost 50 percent of it is with the Central Bank and only 7 percent is short-term. This debt, however, is more sensitive to changes in interest rates: approx- imately 58 percent of the domestic debt bears a fixed rate, 30 percent is linked to LIBOR, and 12 percent has other variable rates. Overall, interest rates on the domestic debt stock vary from around 5 percent to 12.5 percent, with an average of 8.7 percent for fixed rate and 8.8 percent for variable. (See Figure 5.) While the current structure of the domestic debt is adequate, it still faces vul- nerabilities. Cash management problems compel the government to stretch legal limits to the maximum on issuing Treasury Certificates (currently this is capped at 1 percent of the previous year's GDP). Moreover, owing to the country's low capac- ity to absorb such issues and the concentration of a small number of buyers, the gov- ernment's situation remains vulnerable and desperate, forcing it to accept high inter- est rates in order to cover its cash flow problems. DEBT SERVICE. Public debt service in 2003 and 2004, exceeding $US2 billion, or approximately 33 percent of revenues each year, is troublingly high (Figure 6). Of the total public debt service for 2003-04, multi- and bilateral payments constitute almost 50 percent of the load, domestic debt nearly 30 percent, and global bonds DEBT ADMINISTRATION AND SUSTAINABILITY 71 Figure 5. Public Domestic Debt (October 2002) 100% U Others 80%o 3 Treasury certificates 60% 0 Filanbanco 40% - * CFN * Dollar 20% - bonds *AGD 0% - Source: MEF. about 20 percent. On the other hand, Ecuador is facing serious liquidity problems. The intensive amortization of domestic debt for the capitalization of Filanbanco and medium-term dollar bonds will be particularly high, at $US478 million in 2003, though it will drop to $US270 million in 2004. In the medium term, external amortizations will rise sharply in 2007, when the buy-back of 10 percent or more of 2012 global bonds is due to kick in, represent- ing $US125 million each year until maturity. This amount is equivalent to 15 per- cent of current amortizations and its burden must be handled with timely planning. In the short term, interest payment on global bonds represents a sizable proportion of debt service. Every quarter a Brady bond payment comes due, causing peaks in total debt payments (for example, these abruptly jump from $US22 million to $US123 million from one month to the next), with traumatic impact on cash flow management. C. Ecuador's Debt Reduction Plan In approaching the high levels of public indebtedness, the Law on Government Fiscal Responsibility outlines the core goal of a debt reduction plan: reduce debt to 40 per- cent of GDP by the year 2010 (Box 1). The law fails to indicate how this goal is to be achieved, but includes two complementary measures to reduce the debt. The first is to limit spending in order to restrict any future indebtedness, and the second is to buy back its debt with surplus oil revenues generated from the second oil pipeline. The law provides two approaches to reduce the debt, the first is by limit spend- ing and the second by repurchasing expensive debt. The first approach limits spend- ing by two rules. The first rule place a cap of 3.5 percent on real non-interest expen- Figure 6. Debt Service for Current Debts, 2003-15 (mlns $US) Amortizations Interest Payments 1400 1400- 1200 X 1200 1000 10 800 - GO O 600 - 600 400 -_ _ _ _ __ _ _ _ __ _ _ _ 200 ,.-- 200 ggr= =__. 2000 2003 04 05 06 07 08 09 10 11 12 13 14 15 2003 04 05 06 07 08 09 10 11 12 13 14 15 n0 z 0 oMultilaterals oBilaterals oBanks oProviders oDomestic oMultilaterals oBilaterals oBanks oProviders o Domestic Debt Service o 2500 2000 1500 -->= m 1000 ___ z 1500 100 500 - ;- -^-> 0_; =; =____ _ ___ Z 2003 04 05 06 07 08 09 10 11 12 13 14 15 5 oMultilaterals oBilaterals oBanks oProviders oDomestic c Source: MEF, BCE. DEBT ADMINISTRATION AND SUSTAINABILITY 73 Box 1. On Public Indebtedness in the Organic Law on Fiscal Responsibility, Stabilization, and Transparency Art. 5 Reduction and limitation of public indebtedness. * The Ministry of Economy and Finance will implement a permanent public debt reduction policy, aimed at a minimum 16 percentage point reduction in the ratio between the total public debt balance and the GDP during the four-year governmental period reckoned from January 15, 2003. The same policy shall apply to subsequent four-year periods until a debt/GD]' ratio of 40 percent is achieved. * Once it reaches the 40 percent debt/GDP ratio, the level of public indebtedness will not be allowed to exceed this limit or percentage. Sourre: Law No. 72. RO/589 ofJune 4, 2002. diture growth. Since this rate is equivalent to our medium-term GDP projections, in essence, the cap will maintain expenditures as a fixed proportion of GDP, except in years of high growth when this proportion will diminish or vice-versa. The sec- ond rule requires that the non-oil-related fiscal deficit be reduced by 0.2 percent per year until it reaches zero. F[owever, given that the present non-oil-fiscal deficit is 4.5 percent, it will not reach zero for 22 years, which renders the rules irrelevant. The two rules thus bring little pressure to bear to contain spending. The second approach reduces the debt by placing the royalties derived from the marginal increase in private production (that is, over and above what is being cur- rently transferred via the first pipeline) into the oil fund (FREIRIP). Of these amounts, 70 percent will be allocated to buy back debt, 20 percent will go into an oil stabilization fund, and the remaining 10 percent will go to social and health spending. Of the 70 percent earmarked for buy-back of the debt, only up to 15 per- cent can be used to reimburse social security debt. The remaining 85 percent would be used to buy back external debt, that is, the 2012 Brady bonds,-which are cur- rently the most expensive debt. In addition, once the oil stabilization fund reaches 2.5 percent of GDP, these funds will also be applied to debt repurchasing. FREIRIP funds are not expected to materialize until 2004. Within the framework of the Law on Fiscal Responsibility, the Ministry will pres- ent its Debt Reduction Plan next February. At the same time, the Law provides that the Technical Secretariat, in this case the Central Bank, will support this task by (a) supplying the figures; (b) submitting technical reports with recommendations for policies to be adopted with respect to the debt, such as the debt buy-back policy; (c) submitting reports to Congress; and (d) implementing a transparent debt buy back system. 74 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Debt Sustainability Analysis Based on the medium-term goal stipulated by the law, our debt sustainabiity analy- sis determines what primary deficit is required to attain a debt level of 40 percent of GDP, which also could combine with reasonable, attainable financing parameters. The model includes maximum non-interest expenditure growth of 3.5 percent and debt buy-back with resources from the oil fund. We have also verified that the model meets the condition of the plan to reduce the non-oil-related fiscal balance by an average 0.2 percent annually. Box 2 lists the assumptions of the base scenario. THE MODEL. The model starts with the government's amortization plan. Interest payment is calculated from the current level of debt and newly contracted debt. A public spending path is projected (on the basis of the fiscal law) and non-oil income (set as 20 percent of GDP), making it possible to arrive at an initial primary surplus. Then the target primary surplus corresponding to the declining annual debt/GDP ratio is calculated. Next, the difference between the target and initial primary sur- pluses is calculated as the additional fiscal effort required, which can take the form either of reduced spending or higher taxation. Finally, after subtracting amortiza- tions from the total fiscal balance (corresponding to the target primary surplus), the remainder represents the extra financing required. The additional fiscal effort and the extra financing are substitutive, that is, a lower additional fiscal effort means greater financing requirements and vice-versa. RESULTS. In order to reduce the debt/GDP ratio from 57 percent to 51 percent in 2003, the government needs an estimated primary surplus of 4.4 percent of GDP and extra financing of 3.4 percent. Neither this fiscal adjustment nor the necessary amount of financing are by any means figures to be taken lightly. The picture is sim- ilar for 2004. Because of the recent adjustment in GDP, it is quite probable that Ecuador will achieve its goal of 40 percent of GDP before 2010, as the country also has an aggres- sive amortization plan. Nonetheless, in order to accomplish that goal, the country must obtain successive primary surpluses of approximately 3.7 percent of GDP over the years 2005-08. (See Table 1.) Thus, Ecuador's debt problem is one both of solvency and of liquidity. Though prospects for 2003 seem daunting, this is partly due to the existing debt, which increases financing needs for 2003. It should be noted that as the debt stock diminishes, the debt service/GDP ratio also gradually decreases. The upside of the fiscal law is that it places a ceiling on spending; however, as has been noted, this ceiling is not sufficiently restrictive, requiring an additional fiscal effort, either via increasing revenues or reduc- ing expenditures, and this is only possible with a solid policy commitment. Our analysis also shows that the oil fund will have a marginal impact on debt buy-back. First, the government has modified what it believes will be maximum use of the pipelines to 600,000 barrels per day, that is, 200,000 barrels fewer than its DEBT ADMINISTRATION AND SUSTAINABILITY 75 Box 2. Base Scenario Assumptions 1. GDP growth will be 4 percent for 2004 and 2005, and 3.5 percent for the 2006-10 projection period. 2. Inflation is exogenous and will decline to 2 percent over the long term. 3. Debt buy-back will begin in 2004 with the 2012 global bonds, which are the most onerous part of the debt, as they carry an interest rate of 12 percent. 4. Complete rollover of the domestic debt, which assumes disbursements from domestic debt equivalent to 1 percent of the GDP of the previous year will be reimbursed the following year. This is in keeping with cur- rent directives stipulating that treasury certificates cannot total more than 1 percent of the GDP of the previous year. 5. Average price of oil will be $US18 per barrel for 2003-10. 6. The new pipeline will go on line and start contributing to the oil fund in 2004. 7. Debt to the IESS is not included in internal debt, although resources from the fund will be diverted to pay it. 8. Non-oil-dependent fiscal revenues will be kept constant at 20 percent of GDP. 9. Nonfinancial spending will comply with the new law and will not climb to more than 3.5 percent annually in real terms (though this law applies to nonfinancial spending of the central government, it is also being applied as a spending limit for the nonfinancial public sector). 10. The conflict concerning the oil VAT'rebate will delay investments by private companies by one year. Production by these companies will reache 108 million barrels or 295,000 barrels per day in 2007, which represents the use of only 65 percent of the heavy crude oil pipeline's (OCP) capacity. Petroecuador will increase its investment by $US140 million per year, its operating costs will rise 4 percent, and its produc- tion will reach 91 million barrels in 2007. The gas subsidy will be elim- inated as of 2003. 11. Of the 70 percent earmarked for debt reduction, a maximum of 15 per- cent will be used to reimburse the IESS. original projections. This will inevitably reduce the expected windfall in government oil revenues. Second, the fund's resources will depend on the marginal increases in oil production over those of the existing pipeline. Third, the problems that have arisen in resolving the controversy surrounding the VAT rebate dispute between the government and the oil companies have delayed investments in the oil fields, caus- 76 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Table 1. Results of the Public Debt Sustainability Model BASE CASE 2002 2003 2004 2005 2006 2007 2008 2009 2010 Key Assumptions Prelim. Proj. Nominal GDP (bln $US) 24.5 26.7 28.3 30.1 31.7 33.5 35.4 37.4 39.4 Real growth (%) 3.0 3.5 4.0 4.0 3.5 3.5 3.5 3.5 3.5 GDP deflator (%) 13.1 5.4 2.0 2.0 2.0 2.0 2.0 2.0 2.0 Key Results (as a percentage of GDP) Primary balance 4.0 4.4 4.5 3.9 3.8 3.7 3.5 3.3 3.1 of which fiscal effort 0.4 1.0 0.4 0.4 0.4 0.5 0.5 0.5 Interest payments 3.6 3.4 3.5 3.4 3.3 3.2 3.0 2.8 2.6 Overall fiscal balance 0.4 1.0 1.0 0.5 0.5 0.5 0.5 0.5 0.5 Balance less oil exports -3.8 -2.8 -2.4 -2.8 -2.7 -2.6 -2.4 -2.2 -2.0 Required financing 0.0 3.4 2.7 3.2 2.5 2.4 1.7 1.5 1.3 Total debt/GDP ratio 57.1 51.4 47.4 44.2 41.4 38.7 36.1 33.7 31.5 Total debt service/ GDP ratio 8.0 7.8 7.3 7.1 6.3 6.1 5.3 4.8 4.4 Source: MEF, IMF, and the World Bank. ing a marginal increase in production than initially expected. Thus, at $US294 mil- lion, buy-back of the external debt will be more modest during 2004-07 than the originally estimated $US712 million. D.), IPollicy Recommendaimonn Management of the public debt is an important indicator for predicting the eco- nomic future of a country, since a government's debt portfolio is usually the biggest portfolio and hence can pose a considerable risk to the general balance sheet of the government and the financial stability of the country. Although it is possible that debt will not be the initial cause of a crisis, the structure, currency, and composition of its maturity can contribute enormously to aggravating a crisis. The better a coun- try can manage its debt, the less vulnerable it will be to external crises capable of destabilizing an economy. This is even more critical in a dollarized system, since there are few alternative policies to absorb the impacts. And, since solid manage- ment of the public debt is not sufficient in and of itself, it must be complemented by prudent fiscal policies. The transformation of Ecuador's public debt management style must pass through two main stages. The initial stage consists of strengthening investors' con- fidence in the new government's commitment to pay its debt. The second stage con- DEBT ADMINISTRATION AND SUSTAINABILITY 77 sists of modernizing management of the public debt, which brings with it reduction of the debt and the burden of servicing it. Accompanied by steady fiscal discipline, this should lead to reopening access to international markets in, one hopes, a not- too-distant future. First Stage: Recouping Credibility A number of rating agencies reduced their risk classifications of Ecuador in recent months owing to problems they foresee for the country in covering its financial needs, which are indeed significant for 2003 and 2004. Amortizations alone will consume on average about 4 percent of GDP, and interest payments another 3.5 percent. Further complicating the situation is the fact that the local market is highly saturated with domestic bonds, meaning the government has few available instru- ments to raise additional funds. In this environment, accessing new debt will be more expensive, particularly if markets perceive a high probability of default. For this reason, the sooner the government succeeds in obtaining a contingency agreement with the International Monetary Fund, the stronger the signal to the investment community that it can cover its financial requirements in the next two years. An agreement with the Fund will allow new multilateral disbursements to help cover capital amortizations and open the possibility of debt rescheduling with the Paris Club. Based on that fact, the government must maintain an austere fiscal regime to meet its financing needs if it wishes to achieve the primary surpluses men- tioned above. It should be observed that an average oil price higher than $US 18 will partially reduce the value of the required additional fiscal effort or financing need and vice-versa. On the other hand, since most of the government's bilateral debt comprises debts with the Paris Club, a conversion or rescheduling is feasible. With regard to global bond and fixed-interest debt, the government should concentrate on rescheduling or buying back the most onerous debt with new borrowings. In view of recent uncer- tainties in the country, bond prices are low, hence it is a good opportunity to buy back. Logically, both recent initiatives can be implemented once the government has signed the agreement with the IMF and improved its credibility sufficiently to be granted more advantageous conditions. Second Stage: Modernizing Debt Management Although the focus of Ecuador's current public debt management is on its immedi- ate reduction, the country will also have to strengthen its administrative capability to manage it. The government needs to develop the institutional capability to man- age and direct the debt portfolio in such a way as to take its cue from the goals of New Zealand's debt management goals: "identify a low-risk portfolio of liabilities consistent with the government's aversion to risk and negotiate efficiently to achieve and maintain that portfolio"-that is, reduce the cost of debt. 78 ECUADOR: AN ECONOMIC AND SOCLAL AGENDA IN THE NEW MILLENNIUM Ecuador's present public debt management is at a rudimentary stage when com- pared to other countries of Latin America and the Caribbean. The Public Credit Office of the Ministry of Economy and Finance is in charge of debt operations, in terms of both issuance and authorization of payments. Its function is primarily oper- ational and it performs practically no analysis of risk management. The Public Credit Office responds to the financial needs of the Budget Office (Oficina de Pre- supuesto), either issuing bonds or Treasury certificates to help cover the financing deficit and loans sought by the government. Given the weaknesses of this office, the Central Bank is the entity responsible for debt analysis. Before the office can process any debt, the Central Bank must approve it, with the exception of debts issued among public sector entities. The Central Bank issues a report examining conditions and assessing the macroeconomic effect of the potential new debt. Though it gen- erally approves most debt requests, the BCE has on occasion rejected some and forced the government to find alternative financing, including ordering the suspen- sion of deposit accumulations, drawing down the deposits, or requesting funds from other public institutions that have deposits. Debt analysis is therefore done at the micro level - one loan at a time and only prior to approval. The Central Bank does not analyze the overall debt profile, nor does it evaluate contingency options in case of external shocks. Weak institutional capability is common in public debt management within emerging economies. To confront it, one initial step is to create clear and strategic directives to manage the debt profile other than establishing reference levels for liq- uidity, interest rates, and, to a lesser degree, their exchange composition. For exam- ple, Colombia has reference levels for liquidity (less than 15 percent of unsolved debt must mature within one year, while average maturity must be five years or more); interest rates (less than 13 percent must carry a floating rate); and composition of the debt (83 percent in $US, 13 percent in euros, and 4 percent in yens). Ecuador, on the other hand, has practically no guidelines or norms limiting the level of its domes- tic debt, although in practice the debt is limited by the relative saturation of the mar- ket. The issuance of debt in Ecuador is exclusively to satisfy immediate financial needs, as opposed to creating a sustainable medium-term debt profile. As a second step to modernize debt management, a debt manager position could be created, to monitor compliance and also to advise oni adjustments to the debt structure when necessary. Because it is important that the government commits to maintain a certain public debt structure, the manager should be given a high degree of independence. At present, the team in charge of debt responds to the needs of the Treasury and of the budget offices, no matter how precarious the evolution of the debt profile. In the end this is a counterproductive arrangement. The debt manager, though he or she must be sensitive to the needs of the country, must have the authority to protect the integrity of the debt structure. Thus, fiscal policies must be coordinated with the debt manager to limit spending growth based on the country's manageable debt capacity. DEBT ADMINISTRATION AND SUSTAINABILITY 79 A third step would be the creation of a highly professional team responsible for debt management. Appropriate for the second most indebted country in Latin America, its creation would help to improve the government's credibility, espe- cially considering that there have been no institutional changes in debt manage- ment since the country's default in 1999. The lack of a debt management team is an impediment not only to the possible reduction of the cost of debt, but also to the identification of risks and their anticipation, which helps create a more stable profile for public debt. So far, political support for the formation of this team has been small. It is, however, a necessary step toward achieving best practices for debt management. Finally, Ecuador could work out alternative strategies to lessen the effects of eco- nomic volatility, such as issuance of anti-cyclical bonds-that is, bonds that are read- justable according to the price of oil (following Mexico's example) or bonds that are readjustable according to the GDP (following Bulgaria's example)-whose pay- ments are made only when oil prices or the country's growth show positive devel- opment, thus reducing returns when the former show poor performance. Though the premium of this kind of insurance can be high, it could help relieve Ecuador's vulnerability to fluctuations in the price of oil. If the government is able to meet the above-described stages and continues to demonstrates solid fiscal management, Ecuador should be able to access interna- tional markets, in which case it would obtain various benefits that would improve the conditions of its public debt. First of all, placing on international markets would enable the country to access a wider pool of buyers. This would eliminate some of the monopolistic pressures that it currently confronts from only having access to a few national institutional actors. Second, the government would not crowd out the private sector in the domestic market, which would facilitate access to credit and would lower business costs. Recommendationsfor the Short Term * Secure the financing plan for the year 2003 by creating a solid, credible macroeconomic program. Renegotiate outstanding arrears with the Paris Club. Supplement these measures with possible debt buy-back or reschedul- ing of the most onerous debt. * Increase the liquidity cushion of public finances with a fiscal adjustment that eliminates the uncertainties affecting public debt management. * Improve the transparency of the debt structure and payments. These must be public knowledge. The change would accomplish a number of things: first, it would enable citizens to monitor the performance of public servants; second, it would demonstrate future financial requirements; and third, it would improve the country's credit image among foreign investors, who maybe over penalizing the country. 80 ECUADOR: AN ECONOMIC AND SocIAL AGENDA IN THE NEW MILLENNIUM Recommendations for the Medium Term • Create guidelines and reference levels to generate a debt profile that is appro- priate for a dollarized, oil-dependent country. o Create a highly professional and politically independent team charged with managing the debt, headed by an independent debt manager and explicitly charged with the task of reducing the cost of debt service and developing an appropriate performance curve (as in the examples of Chile and Brazil). This includes improving the technical capability of the Ministry of Economy and Finance, in particular the Office of Public Credit. Policy Matrix Policy measures Short term Medium term Problems (to June 2003) (2003-07) Progress indicators Objectives/goals Very high debt service Approve solid macro- Punctuality in payments. Gain initial credibility with during 2003-04. economic program. foreign investors. Identify sources of additional financing and urgent cutback measures in spending z or increase in revenues. High level of Maintain high fiscal Buy back onerous Decrease in interest Reduce debt/GDP ratio by at indebtedness. surpluses, limit increases external debt. payments/revenue least 16 percent in 2007. in spending. Improve cash flow over time. Reduce global bond debt as Reduce debt stock management to Evolution of credit percentage of total debt. with Paris Club. prevent bond satura- indicators. tion in local market. Develop capital market. Inadequate strategy Ensure timely pay- Create guidelines to Reduction of the spread Reduce risk and the cost of for medium-term ment of debt and determine objective on the country's debt. public debt. debt management. elimination of arrears. indebtedness structure. Greater transparency in Decrease debt risk premium. (Gains derived from Regularly publish Create the job of the decisionmaking Recoup international credibil- good debt management public debt indica- Debt Manager process with regard to ity and obtain access to could cover greater tors, increasing Create a professional debt strategy. international markets. personnel costs.) their transparency. team to administer the debt and improve the technical capability of the Office of Public Credit. Annex Public Debt Dynamics 2002 2003 2004 2005 2006 2007 2008 2009 2010 Assumptions Est. Proj. Proj. Proj. Proj. Proj. Proj. Proj. Proj. GDP (Bln $US) 24.5 26.7 28.3 30.1 31.7 33.5 35.4 37.4 39.4 Real GDP growth (%) 3.0 3.5 4.0 4.0 3.5 3.5 3.5 3.5 3.5 GDP deflator (%) 13.1 5.4 2.0 2.0 2.0 2.0 2.0 2.0 2.0 Interest rate on new debt 8.0 8.0 8.0 8.0 8.0 8.0 8.0 8.0 0 Oil price ($US per barrel) 21.30 18.00 18.00 18.00 18.00 18.00 18.00 18.00 18.00 Results (percentage of GDP) Primary balance 4.0 4.4 4.5 3.9 3.8 3.7 3.5 3.3 3.1 0 Additional fiscal effort 0.4 1.0 0.4 0.4 0.4 0.5 0.5 0.5 z Interest payments 3.6 3.4 3.5 3.4 3.3 3.2 3.0 2.8 2.6 0 Fiscal balance 0.4 1.0 1.0 0.5 0.5 0.5 0.5 0.5 0.5 Balance less petrol revenues -3.8 -2.8 -2.4 -2.8 -2.7 -2.6 -2.4 -2.2 -2.0 z Financing required 3.4 2.7 3.2 2.5 2.4 1.7 1.5 1.3 C Total debt 57.1 51.4 47.4 44.2 41.4 38.7 36.1 33.7 31.5 ° Debt service 8.0 7.8 7.3 7.1 6.3 6.1 5.3 4.8 4.4 Model Primarybalance 971 1,177 1,279 1,180 1,211 1,246 1,241 1,238 1,239 Z 0 Interest payments 873 918 995 1,029 1,052 1,078 1,064 1,051 1,042 > Interest payments, existing debt 873 881 892 856 810 771 700 640 589 Z Interest payments, new debt 0 36 104 173 243 307 364 411 453 Fiscal balance 98 259 283 150 159 168 177 187 197 Z Net amortization of existing debt 109 1,164 1,063 1,102 959 971 795 747 691 Financing (new debt issue) 10 905 779 951 800 803 618 560 493 Debt service 982 2,082 2,058 2,131 2,012 2,049 1,859 1,798 1,733 lmplicit interest rate 6.2 6.7 7.4 7.7 8.0 8.3 8.3 8.3 8.4 C Level of Public Debt (Mln $US) 13,985 13,725 13,442 13,292 13,133 12,965 12,788 12,602 12,404 r,1 New debt 905 1,684 2,636 3,436 4,239 4,857 5,418 5,911 Existing debt 13,985 12,820 11,758 10,656 9,697 8,726 7,931 7,184 6,493 Domestic 2,521 2,172 2,040 1,854 1,746 1,645 1,606 1,562 1,529 External 11,464 10,648 9,718 8,802 7,951 7,081 6,325 5,621 4,964 Debt buy-back 0 0 26 51 76 97 97 97 97 Fiscal Accounts (Mln $US) o Primary balance 971 1,177 1,279 1,180 1,211 1,246 1,241 1,238 1,239 > Additional fiscal effort 94 0 132 136 144 160 178 202 Z Core primary balance projected 1,083 1,004 1,047 1,075 1,101 1,081 1,060 1,037 Petrol rcvenues 1,427 1,340 1,373 1,419 1,465 1,465 1,465 1,465 Non-petrol revenues 4,915 5,345 5,670 6,015 6,350 6,703 7,077 7,471 7,887 Primary expenditures 5,217 5,689 6,006 6,341 6,694 7,067 7,460 7,876 8,314 Non-petrol primary balance -419 -251 -61 -194 -208 -219 -224 -227 -225 Non-petrol primary balance (percentage of GDP) -1.71 -0.94 -0.22 -0.64 -0.65 -0.65 -0.63 -0.61 -0.57 Petrol revenues (Min $US) 1,390 1,427 1,383 1,459 1,547 1,628 1,628 1,628 1,628 Petrol revenues - to Fund 0 0 43 85 128 164 164 164 164 Petrol revenues - to Budget 1,390 1,427 1,340 1,373 1,419 1,465 1,465 1,465 1,465 Production (million barrels) 148 150 162 175 188 199 199 199 199 PetroEcuador 82 84 86 88 89 91 91 91 91 Private 66 66 77 88 99 108 108 108 108 FEIREP details Royalties from OCP (FEIREP) 0 0 43 85 128 164 164 164 164 =>20 percent to stabilization fund 0 0 9 17 26 33 33 33 33 =>70 percent to debt buy-back 0 0 30 60 90 115 115 115 115 to IESS 0 0 5 9 13 17 17 17 17 External debt buy-back 0 0 26 51 76 97 97 97 97 =>10 percent to social spending 0 0 4 9 13 16 16 16 16 oo 4 The Banking System' Mario Guadamillas, Giovanni Majnoni, and Yira Mascaro' Ecuadors financial system has been recoveringfrom the serious crisis of 1998 and 1999 and adapting to the changes involved in the dollarization of the economy in early 2000, which eliminated the sucre as the local currency (and thusformalized the systems de facto heavy dollarization). Nevertheless, the characteristics of the system that emergedfrom the crisis differfrom those of the past, not only in their impact on individual banks, but also in the dollarizationr effect on the institutional framework. The crisis has drastically reduced the number of active financial institutions, while dollarization and associated changes have led surviving institutions to hold their assets in a more liquid form owing to the absence of a lender of last resort, and depositors have consequently preferred more liquid deposits. This change in asset composition has also led to a greater concentration of the banking sector, as the institutions seek to compensate the high proportion of low- yield liquid assets through larger-scale operations. The country is coming to the end of the most dramatic period of the postcrisis restructuring process that led to the adoption of a new regulatory framework and more efficient supervision. The structure and responsi- bilities of the supervisory authorities have also changed. Not only has the process of restructuring the banking system been a trial by firefor the agency in charge of deposit insurance, the Deposit Guarantee Agency (Agencia de Garantfa de Dep6sitos-AGD) andfor the Superintendency of Banking and Insurance (Superintendencia de Banca y Seguros-SBS), but dollarization has also changed the traditional role of Ecuadors 1. This chapter was written by Mario Guadamillas, Giovanni Majnoni, and Yira Mascar6, with the research assistance of Ilias Skamnelos (all with the World Bank). The authors acknowledge the collaboration of the Ecuadorian authorities and the useful comments of Macdonald Benjamin, Fernando Montes-Negret, and the participants in the seminar in Quito on Economic Policy Notes. 85 86 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN TIHE NEW MILLENNIUM Central Bank (Banco Central de Ecuador-BCE). Now, instead of functioning as a director of monetary policy, with dollarization, the Central Bank has the role of central manager of the system' liquidity, to ensure that the payments system functions well and to provide liquidity under conditions similar to those of a last resort lender. This chapter documents the progress of Ecuador's banking system over the last two years, highlighting economic policy actions that can help consolidate the progress achieved and lay the foundations for a stronger system. Section A describes the effects of the crisis on the structure of Ecuador's financial system, with a particular focus on the banking sector and its greater concentration as a result of the restructuring process. It also provides an estimate of the cost of the restructuring process that includes the management of the AGDand other parallel efforts such as the recent asset recovery process by the Credit Restructuring Unit (Unidad de Reestructuracidn de Creditos-URC) with its single representative. Section B analyzes the trends in bal- ances and yield of private banks and their present prospects. Section C evaluates pol- icy issues that authorities are currently considering to strengthen the banking system's capacity to resist exposure to the external shocks typically involved in dollarization. The main theme is proper management of the system's overall liquidity position by strengthening the existing liquidity fund to make it more effective. Section D con- siders the actions required to ensure that the banking sector truly functions as a prin- cipal provider of means of payment within the new dollarized economy. Section E briefly analyzes the characteristics of the safety net that will be in place once the liq- uidity fund is reformed and the AGD is restructured. Section F concludes with a list of policy actions included in the matrix of recommendations. A. The Postcrisis Financial System: Structure and Depth Ecuador's financial system underwent a serious, twin crisis (financial and exchange) in 1998 and 1999, which drastically reduced its size. The total number of 82 finan- cial institutions in 2002 is down 30 percent from 1998 (Table 1). Specifically, 12 of the 38 private banks that were in business four years ago are now under AGD administration, along with 4 finance companies, for a total of 16 institutions. These banks, along with Filanbanco (the system's largest in 1998) and other institutions now closed, held 50 percent of the system's total deposits in 1998.2 This reduction brought the level of the system's intermediation in October 2002 to half its 1998 value (measured as total assets over the GDP-see Figure 1), and the reduction was especially marked following the closing of Filanbanco in 2001 (in liquidation since July 2002). The value of the performing loan portfolio dropped to 11 percent of GDP, with only two-thirds channeled to the commercial and industrial sector. 2. SBS Annual Report, 2001. THe BANKING SYSTEM 87 Table 1. Number of Institutions in the Financial System Dec. Dec. Dec. Dec. Mar. 1998 1999 2000 2001 2002 Financial intermediation 114 104 89 85 82 Private banks Operating* 38 28 26 21 21 Operating with public capital 2 2 Offshore 15 18 10 8 6 Operating abroad 4 4 4 4 4 State-owned banks Operating 1 1 1 1 1 Second tier 1 1 1 2 2 Finance companies 23 19 14 13 12 Savings and loan associations 25 26 26 27 27 Mutual associations 7 7 7 7 7 Other institutions in the financial system 72 68 67 61 62 Exchange houses 13 13 13 8 8 Bonded warehouses 8 7 7 7 7 Public institutions 5 5 5 4 4 Credit cards 1 1 1 1 1 Securitization houses 1 1 1 1 1 Insurance companies 42 39 38 38 39 Reinsurance companies 2 2 2 2 2 Institutions under reorganization 4 15 16 16 16 Banks 1 12 12 12 12 Finance companies 2 3 4 4 4 Mutual associations I Institutions in liquidation 22 24 29 33 34 Banks 3 2 2 2 2 Finance companies 9 9 12 12 13 Mutual associations 3 4 4 4 4 Saving associations 2 2 2 2 2 Exchange houses 1 1 2 6 6 Bonded warehouses 3 4 4 4 4 InsLirance companies 1 2 3 3 3 Total general 212 211 201 195 194 Includes Filanbanco, which enitered liquidation beginning in July 2002. Source: SBS. The crisis had high fiscal costs aside from its direct effects on the system, with serious macroeconomic consequences such as the drastic fall in GDP (see the sec- tioni on macroeconomics). The Deposit Guarantee Agency (AGD)-created in December 1998 as a result of the difficulties experienced by Filanbanco (in the first round)-has been managing the financial institutions that entered a reorganization 88 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Figure 1. Total Bank Assets over GDP 50% 45% 40% 35% 20% 15% 10% 0%- 1998 1999 2000 2001 2002 Source: BCE. process after the crisis to recover or sell off assets to pay the deposit insurance.3 By late October, the AGD had paid at least the first $US25,000 of all individual deposits in the institutions it is managing, for a total payment of over $US800 mil- lion (Table 2). Based on preliminary figures for the assets and liabilities of banks under AGD management, plus the cost of capitalizing Filanbanco (which was ulti- mately handled outside the AGD) and Banco Pacifico (open), the total outlay to date is estimated at $US2 billion (approximately 12 percent of the 2001 GDP). This does not take into account the opportunity cost of money that resulted from the freezing of deposits in early 1999, or other costs of the negative impact on the econ- omy in various areas. The Credit Restructuring Unit (URC) made progress in recov- ering the portfolios of banks under reorganization and by December, after six months work, had managed to restructure approximately half of the total $US400 million representing the value of the largest loans. The cost may be lower, depend- ing on how many additional assets can be recovered or sold off, although time makes 3. The AGD was created with broad powers for restructuring banks with access to deposit insurance, but this capacity was transferred to the SBS by two laws enacted in 2000 (the Ecuadorian Economic Transformation Act and the Investment and Citizen Participation Promotion Act). In January 2000, several characteristics of deposit insurance were also modified, including the elimination of the cxisting unlimited coverage, imposing a maxi- mum coverage limit equivalent to four times the per capita GDP, while excluding deposits in offshore institutions. THE BANKING SYSTEM 89 Table 2. The Costs of Restructuring the Banking System (mins $US) AGD Assets Liabilities Total assets 2,154 Assets to be sold* 800 Auctions implemented** 100 Recovered portfolio*** 599 Recoverable portfolio 655 Total liabilities 1,601 Debts paid 832 Debts outstanding"555 769 Capitalization of banks 1,350 Banco del Pacifico 250 Filanbanco 1,100 Actual cost at in December 2002 2,251 EXPECTED COST (Appraisinig Assets assets at 100%) 797 Notes. * Estimated. Mainly includes buildings. 't Excludes allocated assets awaiting sale. As of October 31, 2002. " Includes: primary and secondary depositors; debts for foreign trade, not guaranteed by the risk central; amounits owed to other institutions (open and closed). Source: The authors' estimates based on AGD and SBS data. this process increasingly more difficult (see the section on recent institutional efforts at debt restructuring). The Structure of the Banking System By October 2002, the 22 existing private banks had 82 percent of the total financial assets in the country (Table 3), concentrated in turn in the four largest banks (which held 63 percent of the total assets in private banks). These banks include Banco Paci- fico (the largest in 1998), which is state-owned (by the BCE) as a result of its restruc- turing, but has been under the administration of a team of international bankers that has improved its operations.4 The total private banks also include two mid-size for- eign banks (Citibank and Lloyds) that remained in Ecuador. Another two foreign banks left the system by selling their assets to other banks or through mergers (ABN- 4. The restructuring of this bank's operations is still in progress, but has already logged sig- nificant achievements. It continues to work with two consultants from the international team that managed the bank until October. 90 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM AMRO and ING), owing to the high risk they faced following the crisis (aggravated by a climate of high instability and heavy banking losses by foreign banks in neigh- boring countries) and because they had not achieved sufficient scale to justify oper- ating as retail banks. The remaining institutions have a small share in the system, par- ticularly the state-owned banks-Corporaci6n Financiera Nacional (CFN), Banco Nacional de Fomento (BNF), Banco del Estado, and Banco Ecuatoriano de la Vivienda-whose operations are directed toward specialized areas of production. Given the structure of the sector, the consolidation process is likely to continue. In addition to the concentration of the banking subsystem, the majority of insti- tutions are members of financial groups, which further concentrates the financial sys- tem as a whole. These groups include private banks (typically a group's main com- ponent), foreign branches, finance companies, securities houses, fund administrators, real estate companies, insurance companies, bonded warehouses, and computer serv- ice companies. The offshore banking that had predominated prior to the crisis and contributed to the system's deterioration, lost importance with the exit of almost half the private banks to which it was associated, via reorganization, merger, or liquida- tion. By the end of 2002, the four offshore banks that were still open belonged to the largest banks in the system,5 although their growth was limited by the new restriction that each offshore bank had to keep assets under their levels of March 2000. Four new foreign banks have entered the system, operating almost exclusively abroad-as opposed to the offshore banks, which focused on operations with Ecuadorian banks-and are under the supervision of the authorities of the countries in which they are based (namely, Colombia and Peru). These four institutions belong to the financial group of the largest private national bank, Pichincha (which holds 27 per- cent of total assets in private banks), which in turn owns two other, small, private banks through one of these institutions operating abroad. Owing to Pichincha's rapid growth by acquiring banks that experienced troubles during the restructuring process and to foreign banks' deciding to leave the system over the last few years, the Pichin- cha group is now the system's largest, with 35 percent of the total assets of the finan- cial groups. The owners of this group also own the system's largest finance company (Diners Card), with 64 percent of all finance company assets, which reveals the high degree of concentration resulting from the crisis management. B. Trends in Bank Baiances, Solvency, amd ielld Balance Trends Balance sheets show that banks have recovered since the period following the crisis, to a large extent through an improved macroeconomic environment that brought 5. Formally, there are five offshore banks (see Table 1) if one includes Banco Continental, which is not operating. Table 3. Number and Size of Institutions in the Financial System in October 2002 Total Net credit Investments Deposits with z assets Portfolio net the public 7 Thousands Thousands Thousands Thousands Number of $US % of$US % of $US % of $US % Total in the country 69 6,951,074 100% 3,559,719 100% 996,496 100% 4,919,225 100% Private banks 22 5,726,339 82% 2,683,543 75% 890,550 89% 4,242,060 86% o/w PICHINC-A 1,529,505 22% 707,217 20% 195,905 20% 1,189,434 24% GUAYAQUIL 841,932 12% 353,185 10% 136,744 14% 567,203 12% PACIFICO* 621,985 9% 154,366 4% 190,377 19% 325,709 7% PRODUBANCO 601,615 9% 314,666 9% 89,569 9% 463,060 9% State-owned banks** 2 493,020 7% 310,365 9% 54,842 6% 192,464 4% Finance companies 11 327,201 5% 231,689 7% 16,459 2% 199,872 4% Savings and loan associations 27 246,481 4% 176,089 5% 19,715 2% 169,091 3% Mutual associations 7 158,033 2% 158,033 4% 14,930 1% 115,739 2% Total institutions abroad 9 1,284,057 100% 571,169 100% 393,683 100% 946,248 100% Offshore 5 476,937 37% 222,260 39% 146,467 37% 367,113 39% Operating abroad 4 807,120 63% 348,910 61% 247,215 63% 579,135 61% Total 78 8,235,131 4,130,888 1,390,179 5,865,474 Memoriam: Second- tier state-owned banks 2 433,634 73,637 181,711 1,351 Notes: Pacdfico with public capital. - Does not include second tier. Source: SBS. 92 ECUADOR: AN ECONOMIC AND SOciAL AGENDA IN THE NEW MILLENNIUM higher GDP growth and lower inflation (see the Chapter 1). Nevertheless, credit growth is still restricted owing-on the supply side-to the banks' need to maintain liquidity surpluses against the macroeconomic uncertainty heightened in this elec- tion year and to the greater caution of the banks that survived the crisis and experi- enced a severe deterioration of their portfolios. On the other hand, the gradual improvement in portfolio quality has been reflected in greater yields for banks. Total assets of private banking rose by 16 percent over the first 10 months of 2002, reaching $US5.726 billion by October (Table 4). Productive assets (loan and investment portfolios) rose slightly to 63 percent of total assets (in other countries they are 80-90 percent), while investments accounted for 25 percent of the banks' total productive assets. Approximately half of all investments are in the public sec- tor, largely as a result of the crisis resolution process.6 The buyers (large banks) received bonds from the government as productive assets, in the absence of a qual- ity portfolio. The government's debt exposure is concentrated in large banks (par- ticularly in Banco Pacifico, with a 28 percent share of its assets). This increases the risk for these banks in the event the fiscal situation deteriorates. Private investments are mostly placed abroad (close to 100 percent of total investments with the private sector, according to data from the largest banks), as are available funds (including cash, bank deposits, and reserves in the Central Bank), in order to keep the high liquidity that allows them to deal with potential bank runs.7 The 2002 election campaign and the lack of a true last resort lender in the system increased the perception of a high risk of liquidity for the banks, resulting in the maintenance of a liquidity "cushion" that reached $US 1.1 billion in October 2002. These liquid assets accounted for 23 percent of total assets, restricting portfolio growth during the year and negatively affecting yields. The banks reported their intention to restrict portfolio growth at least until the second quarter of 2003, con- tinuing the high liquidity that prevailed during 2002, until the new government better defines its economic policies. The total gross portfolio grew by 16 percent during the first 10 months of 2002, in contrast to a 3 percent decrease for the prior year, and remained concen- trated (62 percent) in the commercial sector, although the year saw a healthy 6. This is the result of either the government bonds that some banks, such as Pacifico, received as capital contributions, or of the acquisitions or mergers by some large banks that absorbed others experiencing difficulties. 7. For example, by mid 2002 the system's largest bank had 19 percent of its deposits with- drawn in one month owing to a perception of system instability, but it was able to man- age with the surplus liquid funds it regularly maintains. The run on Pichincha may have had more to do with the perception of macroeconomic and political risk than with a par- ticular risk of the bank, because during the crisis it had been on the receiving end of the "flight to quality" along with other surviving banks. Pichincha also has by far the greatest number of branches in the system (almost 150), which facilitates massive withdrawals. THE BANKING SYSTEM 93 Table 4. Private Banks*: Balance Sheet (thds $US and percentages of Total Assets) Dec. 2001 Oct. 2002 TOTAL ASSETS 4,928,812 100% 5,726,339 100% AVAILABLE FUNDS 1,077,508 22% 1,115,639 19% INTERBANK OPERATIONS 1,480 0% 3,120 0% NET INVESTMENTS 729,046 15% 890,550 16% With the private sector 304,394 6% 336,632 6% With the public sector 306,152 6% 436,913 8% Of limited availability 146,976 3% 131,025 2% NET CREDIT PORTFOLIO 2,151,682 44% 2,683,543 47% Gross portfolio 2,601,952 53% 3,016,617 53% Commercial 1,826,930 37% 1,879,947 33% Consumer 529,981 11% 863,406 15% Housing 245,041 5% 237,632 4% Microenterprise 0 0% 35,632 1% (Provisions for bad debts) -450,270 -9% -333,074 -6% FI)XED ASSETS 255,637 5% 324,905 6% OTHER ASSETS 713,459 14% 708,582 12% o/w: Allocated goods 42,874 1% 88,164 2% TOTAL LIABILITIES 4,549,522 92% 5,143,995 90% DEBTS TO THE PUBLIC 3,669,223 74% 4,265,304 74% Sight deposits 2,530,676 51% 2,929,933 51% Term and other deposits 1,138,546 23% 1,335,371 23% INTERBANK OPERATIONS 51,412 1% 4,000 0% OTHER LIABILITIES WITH COST 442,211 9% 462,831 8% o/w: Foreign lines 256,283 5% 222,584 4% CONVERTIBLE OBLIGATIONS & CONTRIBUTIONS FOR CAPITALIZATION 169,717 3% 194,655 3% OTHER LIABILITIES 216,960 4% 217,205 4% NET WORTH 379,290 8% 582,344 10% TOTAL LLABILITIES & NET WORTH 4,928,812 100% 5,726,339 100% TOTAL UNPRODUCTIVE PORTFOLIO: 456,882 9% 287,213 5% Commercial 297,578 6% 204,809 4% Consumer 45,655 1% 62,293 1% Housing 113,649 2% 18,281 0% Microenterprise 0 0% 1,829 0% Notes: *Includes Pacifico, with public capital. Data to October is preliminary. Source: SBS. increase in financing for the consumer sector (Table 4). Banks focused their new loans on the consumer sector, which had grown more than 60 percent by October 2002. This growth was largely because large companies-including many multina- tional companies that accounted for much of the banks' commercial portfolio-had 94 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM chosen to take direct lines of credit from abroad as international interest rates dropped. The improved economic growth also favored the consumer portfolio. The housing portfolio decreased, reflecting the banks' preference for shorter-term place- ments. These patterns predominated for banks of all sizes. The microfinance port- folio also benefited from the year's macroeconomic recovery, but remained at low as a proportion of the system's total portfolio.8 The quality of the net portfolio improved significandy. The nonperforming pro- portion of the portfolio (problem loans plus portfolio not earning interest) to gross portfolio dropped from 17.5 percent in December 2001 to 9.5 percent in October 2002 (Table 6). This was due to the increase in the productive portfolfi during the year and to the sustained increase in provisions that cover 116 percent of the non- performing portfolio (up from 99 percent coverage in December 2001).9 By type of loan, the nonperforming portfolio (problem loans plus portfolio not earning interest) is concentrated in commercial loans, but less than its share in the total gross portfo- lio. Furthermore, both the commercial and the housing portfolios, stable in absolute value, saw their share in this total decrease, while the mature consumer portfolio dou- bled its share-reaching 20 percent of the total nonperforming portfolio. During 2002, the improvement in portfolio quality also benefited from the activ- ities of the Credit Restructuring Unit (URC).'° Since late 2001, the URC had made use of a single representative to facilitate the restructuring of cases for $US 1.357 bil- lion (45 percent of the Filanbanco portfolio, 14 percent of the Pacffico portfolio, and 18 percent of the total portfolio of the banks administered by the AGD). By early December the URC had restructured 85 percent of the total portfolio value and estimates predicted that 95 percent of the debts transferred to the URC would be restructured by the December 20, 2002 deadline. Debts restructured in the last few weeks are mainly those of Filanbanco (which accounted for 40 percent of the unstructured debt in mid-November). The accounts that make up these restructured debts are few but sizeable. In terms of funding, private banks continue to have little access to foreign lines of credit, as in the crisis period (Figure 2). Only six banks had positive balances by 8.The microfinance sector is mainly covered by two banks (Pichincha and Solidario), which account for 75 percent of the total, followed by one savings association (Ecuarorial), which accounts for 13 percent. Authorities are focusing on the recent rise in microfinance, partic- ularly considering that the savings associations are the institutions that best survived the cri- sis. Furthermore, a study done by the International Project Consult (IPC) found great mar- ket potential for rural agricultural financing through saving associations and banks interested in the sector (see Proposed Strategic Plan for Long-Term Development for Ecuador, 2002). 9.Using as a reference the portfolio classified as C, D, and E as the systerrs most risky, the present coverage of constituted provisions is 83 percent and the deadline has passed for constituting the provisions required by the latest increase in the provisions rule in 2001. 10. Supported by the World Bank's technical assistance loan to the financial sector. THE BANKING SYSTEM 95 Table 5. Private Banks*: Profit and Loss Statement (thds $US) Oct. 2001 Oct. 2002 Interest and discounts earned 383,857 173,954 Interest accrued 158,588 49,588 NET MARGIN OF INTEREST 225,268 124,366 Income and commissions for service 160,167 67,879 Expenses and commissions paid 69,808 14,606 GROSS FINANCIAL MARGIN 315,627 177,639 Operating expenses 348,336 150,361 Other net operating income 61,309 25,469 NET OPERATIONAL MARGIN BEFORE PROVISIONS 28,600 52,746 Provisions 123,250 27,851 NET OPERATIONAL MARGIN -94,650 24,895 Net extraordinary income 69,050 28,270 PRE-TAX PROFITS -25,600 53,165 Taxes and employee profit-sharing - 10,371 EARNINGS OR LOSS FOR THE BUSINESS YEAR -25,599 42,794 Memorandum: Operating expenses/gross financial margin 1.10 0.85 Provisions/grossfinancial margin 0.39 0.16 Notes: *Includes Pacifico, with ptblic capital. Source. SBS. the end of 2002,11 while deposits from the general public were concentrated in sight deposits (70 percent of the total), revealing the preference for short-term assets owing to recent political and macroeconomic uncertainty. In fact, by mid-year high volatility was evident in system deposits, with withdrawals concentrated in mid-size banks, including foreign banks. The drop in deposits with foreign banks was largely due to the loss of a few, but large, accounts (some of them multinational compa- nies). Driven by the marked increase in sight deposits, the majority of system deposits are at terms of under 90 days, and a high percentage are in deposits of under $US5,000 (63 percent of sight deposits). The average volatility remains high, and is even higher for at least one of the foreign banks and other small banks.'2 Conse- quently, the ratio of liquid assets to total assets was at a high 20 percent, sufficient 1 . Including only one small bank, Solidario, which focuses on the microfinance sector and maintains broad access to fireign lines of credit from multilateral agencies. 12.The SBS calculates the average volatility based on monthly data on variations in each component of deposit liabilities in the last 18 months, weighted by their percentage of the total. Volatility reached 18 percent in 97 percent of the cases, with certain banks having much higher volatility rates (24 percent for Citibank). 96 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Figure 2. Financing Lines Abroad (mlns $US) 800 - 600 - 400- 200- o0 Dec. Sep. Jun. Mar. Dec. Sep. Jun. 1997 1998 1999 2000 2000 2001 2002 Source: BCE. to withstand a monthly withdrawal of 30 percent of banks' liquid liabilities, although the liquidity index (liquid assets over liquid liabilities, as defined by the SBS) was at its lowest level of the last 12 months. Solvency Banks have also improved their solvency by capitalizing profits, in some cases (as with the second largest bank, Banco Guayaquil) with significant contributions of new capital from shareholders.13 The strengthening of bank capital resulted in sol- vency indexes above the 9 percent regulatory minimum for all banks, with 11.8 per- cent for the system by October 2002. This index is also positive considering the time schedule imposed for reducing the ratio of primary to secondary capital, which must be brought to the 1:1 ratio established by Basel by March 2003. Several banks have already met, or are close to meeting, this ratio, while the system as a whole main- tains a ratio of 1:1.10. Yield The management of private banking during the first 10 months of the year brought an improvement in profit generation as well as improved levels of solvency. This was evident despite the maintenance of high liquid balances, partly attributable to much lower expenses for provisions in 2002 as compared to 2001 (from 39 to 15 percent of the gross financial margin-see Table 5). Interest expenses were also significantly 13.This includes the capitalizations of Banco Pacifico since 2001, which came to $US250 million in February 2002, including contributions for future capitalization of $US152 million-which will double the present paid capital of $US 155 million. THE BANKING SYSTEM 97 Table 6. Private Banks*: Financial Indicators Oct. 2002 Solvency Required capital / assets weighted by risk 11.80% Primary capital/ assets weighted by risk 6.40% Capital/ assets 9.40% Quality of the assets Portfolio C, D & E / gross portfolio 13.40% Unproductive portfolio */ gross portfolio 9.50% Provisions/ portfolio C, D & E 82.70% Liquidity Liquid assets (Ist.) / total assers 22.50% Liquid assets (2nd.) / total assets 23.90% Liquid assets (Ist.) / liquid liabilities (lst.) 30.40% Liquid assets (2nd.) / liquid liabilities (2nd.) 29.00% Net portfolio/ deposits 62.90% Yield Net margini of interest / gross income 40.00% Operating cost / gross income 48.30% Operating cost / average assets 3.40% Return on average assets ROAA 1.00% Return on average equity ROAE 11.20% Notes: 'Includes Pacifico, with public capital. Source. SBS (preliminary data) and the authors' estimates. lower, partly through the effect of lower international deposit rates, although income from interest in October 2002 was also down, but to a lesser extent. Profits approximated $US42.8 million in the first 10 months of the year, com- pared to a loss of $US25.6 million in December 2001, which was affected by the enormous losses of the Banco Pacifico-reversed in 2002 through its capitalization and rationalization of expenses."4 Improved yield levels are partly attributable to the fact that coverage of the nonperforming portfolio had already increased significantly in 2001, requiring lower expenditures for provisions in 2002. Nevertheless, the high cost of maintaining liquidity continues to decrease the banks' capacity for profit generation, which in turn restricts the reduction of lending rates (to be addressed later in this document). Banks have dealt with the crisis by diversifying their sources of income genera- tion, increasing income from commissions (which is more stable), and offsetting the lower relative growth of their loan portfolios. In some banks extraordinary income 14.The return on average equity (ROAE) was 11.2 percent, while the return on average assets (ROAA) was 1 percent. 98 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM was particularly significant, especially income from the recovery of asset write-offs that were able to offset the expense for provisions. In effect, Figure 3 shows the total expenses for provisions and the same expenses after income from recoveries-with negative balances indicating a net income, illustrating the effect of high recoveries for some banks. This could reflect a very aggressive portfolio write-off policy, or unexpected recoveries via the debt restructuring plans undertaken during the year. Between December 2001 and October 2002, the spread (measured as the differ- ence between the average lending and borrowing rates, and excluding Filanbanco) dropped from 10 to 8 percent, owing largely to a marked reduction in operating costs. In effect, during this period operating costs (including personnel expenses) as a percentage of average assets were reduced from 7 percent to 3.4 percent. This reduction in operating costs is crucial because, as with most countries in the region, operating costs make up the principal component of the spread and are partially off- set by greater operating income not originating in interest. 5 Figure 3. Gross and Net Recovery Provision Expenditures (mlns $US) 2,500 2,000 _,500 L 1,000 average FMles (fosfo ners ivnoy flaso eGross bu fc s 500u -500 <== Net -1,000 -1,500 0- u 5 0 00 -.' 00u FM CS 0 0 0 ~ ~ -~ .~ * 'c o- 4 , U 0 cies - -~ ~ ' -n rh d U ~~~~-0 ~~~~ o CS o "r U 0 U~~~~ Source: SBS. 1 5.The accounting breakdown of the spread was done with reference rates instead of with average rates (flows from interest /inventory of loans or deposits) because of inconsisten- cies in the data with the recent cha-nge of the accounting plan. This exercise reveals that operating costs account for over half the spread and are offset in part by non-interest income (fee income). These patterns are similar to those in other countries in the region (see Dick, "Banking Spreads in Central America: Evolution, Structure, and Behavior," Harvard Institute for International Development, Discussion Paper No. 694, April 1999. THE BANKING SYSTEM 99 C. Strengthening Individual and System Risk Management Institutional Structure and Management of Cash Risk The need for a high proportion of liquid assets and the corresponding concentra- tion of the banks' investment portfolio in foreign bonds are closely associated with the official dollarization of January 2000. Nevertheless, the maintenance of these high liquidity ratios is also typical in countries that have a high defacto dollarization, as Ecuador had prior to 2000, with over 60 percent of the banking portfolio denom- inated in dollars in 1998 and 1999 (Figure 4). The progressive loss of monetary effectiveness in processes of high dollarization16 reduces the monetary authority's capacity to protect the economy from external shocks and leads banks to maintain their assets in more liquid forms. In Ecuador, excessive liquid holdings have at least two negative effects on the economy. The first is that they reduce the funds available for long-term investment, which has negative effects on bank yield. Second, the need to keep these liquid assets abroad reduces the amount of internal savings that can be invested domestically. For both reasons this issue has become an important economic policy question: How can banks reduce holdings in liquid assets beyond the level required by a dollarized economy? The remainder of this section addresses this question. Figure 4. "Onshore" Credit (percentage granted in $US) 80% 60%- 4~~~~~~~~~~~,1l Dec. Dec. Dec. Dec Dec. Dec. Dec. 1992 1993 1994 1995 1996 1997 1998 Source: SBS. 16. See Patrick Honohan and Anquing Shi, "Deposit Dollarization and the Financial Sector," World Bank, WPS 2748, October 2001. 100 ECUADOw: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Owing to the difficulty of establishing precisely the proper level of liquidity the system needs, the following exercise is based on a level of liquid reserves similar to that already maintained by the banks as a whole. Nevertheless, the exercise seeks to achieve a more efficient way to manage liquidity in the system, based on the alter- natives currently under consideration by the Central Bank. Table 7 presents the value of banks' liquid assets in December 2001, which exceeded 25 percent of total reservable deposits. The Central Bank was also maintaining deposits equivalent to an additional 7 percent as a result of the required 4 percent mandatory reserves and funds in the liquidity fund (2.9 percent). In general, the reductioni of the liquid assets that banks maintain could result in lower lending rates (for a given margin of net interest) or greater bank yield (keep- ing the lending rate constant). In the former case, improved credit conditions would tend to increase access to credit, while in the latter, a greater bank yield would tend to reinforce the soundness of the system. The right side of Table 7 presents a differ- ent allocation of the liquidity that could result from access to reserves managed by the Latin American Reserve Fund (FLAR by its Spanish acronym) via a contingent line of credit, which could be as high as $US41 0 million (based on Ecuador's cur- rent participation in the FLAR). A centralized management of liquidity could offer the opportunity to invest, for example, the $US410 million in high yield bonds, permitting a reduction of the lending interest rate. On the other hand, if banks were to decide to keep lending rates constant, they could achieve a better bank yield. Based on a 5 percent spread Table 7. Liquidity in the Banking System Situation in Hypothetical Dec. 2001 scheme MilL $US Yo deposits MilL $US % deposits Private funds 932 25.7% 522 14.4% Voluntary reserves 54 1.5% 54 1.5% Available funds (net of reserves) 878 24.2% 468 12.9% Public funds 251 6.9% 661 18.2% Reserves (mandatory) 145 4.0% 145 4.0% Liquidity fund 106 2.9% 106 2.9% Contribution from Corporaci6n Andina de Fomento 70 1.9% 70 1.9% Contribution from the banks 36 1.0% 36 1.0% Contingent credit 0 0.0% 410 11.3% Total liquidity 1,183 32.7% 1,183 32.7% Memorandum: Reservable deposits 3,623 100.0% 3,623 100.0% Source: SBS, BCE, and the authors' estimates. THE BANKING SYSTEM 101 between portfolio yield and the yield of liquid assets, profits could increase by $US20 million. The overall result would probably be even stronger than foreseen here. In fact, a centralized reserve fund would bring the total quantity of liquidity reserves lower than its level of early 2003. A public scheme of greater liquidity provisions, however, faces two fundamental difficulties that must not be underestimated because they require changes in the legal framework. The first requirement for the viability of a greater "Liquidity Fund" is to instill, in the commercial banks, full confidence in the Central Bank's capacity to man- age this fund with the required level of confidentiality. Furthermore, to date, the legal restriction that prevents the Central Bank from managing trusts has made it necessary to delegate management of the liquidity fund to the CFN, a state-owned bank expe- riencing problems in its balances. In addition, the Central Bank's share in ownership of the third-largest bank in the system (Banco Pacifico) makes the former subject to potentially significant conflicts of interest that could potentially hinder the full effec- tiveness of the liquidity fund. A second requirement is the need for close monitoring of the liquidity fund's investment policies, which could be delegated to a reputable financial institution that would act as trustee and even as administrator of these funds. The reform of the liquidity fund centers on addressing the need for a more effi- cient management of the liquidity "supply" and therefore does not directly solve the problems resulting from a volatile liquidity "demand." One of the factors that could most stabilize this demand is effective supervision of the banks' liquidity position and of bank solvency in general. In fact, one of the more relevant reasons behind bank liquidity squeezes is when the banks have losses while they are at the bottom of the cycle. These affect their capital position and lead them to sell off their most liquid assets. Consequently the stabilization of the banks' demand for liquidiry could be improved with procyclical provisioning policies that increase the volume of reserves against portfolio losses during periods of high portfolio growth (and high bank yield) and reduce it during periods of weak or negative growth (and low bank yield). Over the last two years, the high level of provisions created to deal with the exces- sive nonperforming portfolio following the crisis has prevented Ecuador from con- sidering the requirement of additional procyclical provisions. Even so, for an econ- omy such as Ecuador's, with high exposure to cyclical variations in oil prices, a procyclical provisioning policy is an important option to consider. Based on Spain's successful experience, a dynamic provisioning process causes banks to put aside larger amounts during periods of expansion up to a given level. Using these accum- mulated reserves in low periods would avoid reductions of capital and liquid assets and, consequently, reductions of credit. Efficient management of liquidity depends, to a great extent, on the existence of excellent relations with foreign correspondent banks, considering the low liquidity of Ecuador's financial activities and the considerable quantity of liquid investment that the country's banks maintain abroad. That is why it is very important that legislation on money laundering be established before a negative assessment of existing regula- tions can generate a sudden cooling of relations with foreign correspondent banks. 102 ECUADOR: AN ECONOMIC AND SOCLAL AGENDA IN THE NEW MILLENNIUM Strengthening Supervision and Regulation In the last two years, the SBS has been immersed in an important plan to improve supervision of the banking system, including the introduction of a new Standard Chart of Accounts (in operation since July 2002), which provides a clearer and more reliable source of information on the financial position of the banks. On-site and off-site supervision procedures have been reviewed in detail (including recently a CAMEL analysis that laid the foundations for an early warning system that helps expedite taking corrective measures), with a focus on risk analysis that is more in line with the best international practices. Resolutions were issued for market risk analy- sis, concentrating first on putting into effect liquidity risk analysis, with reports from the banks beginning in January 2003 (a three-month testing period). The next areas of concentration are (new) operational risk and credit risk (improving practices implemented in the past). The SBS has also been moving toward a consolidated approach to supervision, but this is still in progress. In addition, the SBS has restructured its organization to provide a greater har- mony between its supervision practices for all the institutions it oversees. In doing so, it has been able to better coordinate its on-site and off-site supervision, which are not integrated into the new structure, and to seek a more timely intervention or investigation into issues brought to light by either of the two areas working together. System monitoring seems to have improved with the new inspections performed this year under new criteria centered on risks, and the SBS hopes to be able to perform at least one supervision of each bank per year. (It has already completed the arduous process of training its personnel in the new rules of play). To complement these efforts and improve transparency by increasing the reporting by the authorities, we recommend that the SBS provide a detailed report of its activities in its annual report. On the other hand, the effort to improve bank supervision has led the SBS to give less attention to problems in other sectors, particularly the insurance sector (which the authorities acknowledge). Because there is a high degree of concentration in the system between banking and nonbanking institutions, it is important to strengthen supervision of the latter and other institutions, despite their smaller size. ID). lIssues in the Settdement of ]Payments and Securities'7 An analysis of a more efficient management of bank liquidity must not neglect con- sideration of its effects on the functioning of the payments system. The system's effectiveness and security level for large transactions, along with the dematerializa- 17.This section was prepared on the basis of the report, "Assessment and Observations on the Payments and Securities Clearance and Settlement Systems of Ecuador," September 2002, which was produced in the context of the Initiative on Compensation and Clearance of THE BANKING SYSTEM 103 tion and easy transfer of financial assets used as (enforceable) collateral, are funda- mental elements for reversing the incentives for foreign investment to obtain basic liquidity services. Nevertheless, Ecuador's payments system is characterized by the lack of Real Time Gross Settlement (RTGS), as well as the lack of an effective asset depository that can allow for an effective method of Delivery Versus Payment (DVP). The security of financial transactions and assets could be increased signifi- cantly by putting into effect some policy actions, such as those discussed below. Cash and checks are the means of payment most commonly used in Ecuador. In addition to the check clearinghouse, the Central Bank operates a funds transfer sys- tem through its current accounts, either through SWIFT or over the counter with a mix of manual and automatic procedures. Those systems are being reformed at pres- ent. In addition to operating low-value payments, the check clearinghouse also processes high-value payments, which entails considerable risk for the payments sys- tem. One of the purposes of reforming the payments system is to launch a RTGS system to reduce the main risk in high-value transactions. However, this system in turn requires a highly efficient management of liquidity to prevent liquidity risk and the problems associated with a gridlock in the system. To eliminate principal risk in high-value transactions, it is not enough to launch and run the RTGS. The Central Bank, in cooperation with private financial inter- mediaries, must take an active approach, establishing adequate incentives for high- value payments to be cleared through the RTGS and not through the check clear- inghouse. One fundamental requirement for this to occur is increased efficiency of the payments system as a whole and, specifically, endowment of the RTGS with the proper characteristics. The following is a list (though not exhaustive) of issues to be considered: scarcity of total liquidity in the system; unequal distribution of liquid- ity, limited functioning of the interbank monetary market; lack of intraday credit; the Central Bank's limited capacity under the current monetary and exchange framework to deal with liquidity problems; and possible preference of institutions for a net settlement system or, in a gross system, for end-of-day deferral of pay- ments." The reform also calls for establishing two high-value systems, the RTGS and the Net Value Payments System, which doesn't seem to be an efficient solution for a country with Ecuador's characteristics. A net system of high value would not reduce principal risk, unless it establishes costly mechanisms to mitigate the risk, nor would it lead to payments in real time. In addition, the securities market in Ecuador is clearly dominated by public secu- rities, fundamentally government bonds and Treasury certificates. The settlement of Payments and Securities of the Western Hemisphere (IHO, see http://www.ipho- whpi.org/). For detailed aspects of the evaluation of these systems, we recommend con- sulting the above-cited document. 18.Some specific proposals to resolve some of the problems mentioned here can be found in the report mentioned in the previous footnote. 104 ECUADOR: AN ECONOMIC AND SoCLAL AGENDA IN THE NEW MILLENNIUM securities is far from efficient because they are transferred through the delivery of physical certificates. The depository institution, DECEVALE S.A., created in 1994 by the two stock exchanges, has not been operating except for a very specific issue of CFN securities and the securities regtilator has recently suspended its operations because of financial troubles. Nevertheless, the Central Bank is only capable of transferring ownership of securities apart from their payment. In other words, it does not have a DVP system. This fact is not only relevant for the settlement of cap- ital market transactions, but also for the management of liquidity in the financial system. Specifically, it hampers the development of a collateralized interbank mon- etary market for which the setdement of securities through DVP is fundamental and which requires a connection between the deposit of securities and the RTGS system. The efficient establishment of a securities depository requires dealing with a number of urgent issues-which institution(s) should be the depositor(s), what ownership structure should the depositor have, and so on. The lack of consensus on these basic questions usually leads to a significant delay in the improvement of sys- tems, as has occurred in Ecuador, with negative consequences for the development of the financial system. Because of public interest in this issue due to its implications for fiscal and monetary policy, systemic liquidity management and risk manage- ment, and capital market development, the pertinent government authorities (Cen- tral Bank, the securities regulator, and the Ministry of Finance) must take the lead in defining, establishing, and implementing a centralized securities depository. The proposed solution must be adapted to the existing legal framework (or the latter must be modified if the chosen course does not fit it) and must carefully consider the subject of corporate governance to ensure that the system functions efficiently and allows equal access to all participants. The 4 percent reserves for eligible deposits plus the existing 1 percent on the part of the liquidity fund could be insufficient to provide the liquidity required for the proper functioning of the payments system. Also, in the context of reform of the payments system, the launching of a RTGS system that has the virtue of eliminat- ing principal risk increases the system's liquidity needs and requires meticulous man- agement. The interbank monetary market is not very active and system liquidity is distributed through a system facilitated by the Central Bank. Each quarter, the Monetary Council approves the quantity of Central Bank securities that can be issued ($US30 million for the third quarter of 2002), using a formula that takes into account the level of international reserves. This quantity is in turn the quantity of funds that the Central Bank is authorized to inject into the market through open market operations (basically using securities issued by the government as collateral), thus permitting the redistribution of liquidity between the banks. This liquidity dis- tribution system may not be sufficient for the functioning of the new payments infrastructure. The reform of the payments system currently in process must take into account not only the objective of improving the provision of payments services, but also broader objectives such as improving the system's liquidity distribution through an THE BANKING SYSTEM 105 efficient working of the interbank monetary market and the development of the securities market, among others. Preparing a strategic vision document that identi- fies these and other objectives would help to expand the sphere of influence of the payments system reform and would thereby improve the security and efficiency of the financial system. It's not only the operating aspects that are important; the reform must also consider providing a proper legal and regulatory framework and establishing a function of oversight of the settlement systems, which is normally the responsibility of the Central Bank. This entails a far-reaching reform involving many participants. It requires a high degree of coordination among regulators and cooperation with the private sector and with all stakeholders in general. Some organizational change with regard to the existing arrangements through the Central Bank's interinstitutional committee could help. Therefore, the Central Bank's coordination with other participants could change from being merely informational, as it now is, to a more active participation in the discussion and design of the reform, which is very important in broadening the reform's framework. It is necessary to bring the users of the new systems into the process. The Central Bank must be prepared to establish and exercise, with the proper legal basis, the function of oversight of the payments systems. It is not enough to launch and implement the reform; the Central Bank must seek a way to continuously improve the systems and be attentive at all times to its proper opera- tion owing to the implications of systemic risk and efficiency of the financial system. E. The Financial Safety Net This discussion of liquidity management has already introduced the more general question of how Ecuador could adapt its "financial safety net" to the needs of a dol- larized economy. The new role of the Central Bank and of the SBS in managing and stabilizing liquidity requirements is only part of a more general problem, which this section will analyze. The three main components of the safety net are usually identified as (a) lender of last resort, (b) deposit insurance, and (c) banking supervision. In Ecuador the three government institutions discussed above (BCE, AGD, and SBS) have been pro- foundly affected by the crisis. Their roles in the new dollarized financial structure has also been changed several times, while alternatives are being evaluated for each one's future role in the system. Under the alternative that seems to have the highest degree of consensus among the authorities,19 the Central Bank could keep its central posi- 19.The main elements of this are addressed in the document. "Una propuesta de plan estrat6gico de desarrollo de largo plazo para el Ecuador," prepared in July 2002 as part of a joint committee that is analyzing the new architecture in Ecuador, composed of the Cen- tral Bank, the SBS, and the Ministry of Economy and Finance. 106 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM tion in the management of the payments system and of the system's liquidity needs, the AGD could be reduced to a pay box that delegates the settlement and solution of responsibilities to the SBS, while the SBS would maintain only responsibility for individual-but not systemic-interventions in the financial sector. Under the new scheme, the Central Bank would be responsible for managing the overall liquidity of the economy, including being responsible for supervising the payments system and managing system liquidity. The main obstacles to the success- ful functioning of the payments system appear to be technical in nature, such as the dematerialization of the financial paper. There are also several legal matters with regard to system liquidity that would have to be resolved in order to ensure that this management can be delegated to the Central Bank. Also, the Central Bank's man- agement role could be affected by the potential conflict of interest associated with its ownership of Banco del Pacifico. The Central Bank is aware of this issue and has delegated the administration of Pacffico to international consultants and is awaiting a change in the trend of withdrawal of foreign investment from Latin American banks, which could facilitate the privatization of Banco del Pacifico. The alternative that is being explored, to reduce the AGD to a pay-box mecha- nism, could be accelerated if the AGD is relieved of responsibility for managing the remaining assets in banks under reorganization. In this case, the AGD would focus on strengthening the deposit insurance fund (with the premiums that are being charged to active banks), instead of having to use these premiums to pay the debts of banks under reorganization. The resolution of banks outside of the AGD was already put into practice at the time of the response to Filanbanco's second and final fall, which ended with its placement in liquidation in July 2002. Meanwhile, other schemes under consideration call for the possibility of the AGD handing over the management of the portfolio and the sale of allocated goods and buildings to an international professional administrator. This could expedite the collection of the portfolio based on scale issues (and better technologies) and on the lack of a rela- tionship between this potential institution and the system's debtors (particularly the largest). Finally, the SBS has had a greater sphere of activity with regard to the restruc- turing of banking. The strengthening of its internal processes of supervision and the use of new manuals for on-site and off-site supervision in its recent inspections is having positive effects on the institution's reputation-which is crucial to increasing confidence in the system-and thereby giving support to the institu- tional project of liquidity management proposed by the monetary authorities.20 Another important matter is ensuring that supervisors have legal protection against lawsuits having to do with the performance of their duties. The high turnover in personnel in recent years is probably linked to the lack of this protection. (There 20.These efforts have been supported by the World Bank's technical assistance loan to the financial sectoL THE BANKING SYSTEM 107 have been about two superintendents per year, despite the fact that the position has a six-year term. Another crucial requirement is that improving the quality of banking supervision requires strengthening the legal framework governing the process of bankruptcy in the corporate sector and increasing the protection currently provided to creditors (within Latin America, only Haiti provides less protection than Ecuador2"), as well as the bankruptcy law and the law concerning chattel and real property collateral. This would also increase incentives for lending, as has been the case with the improved availability of information provided by the credit register, although the credit register could be complemented by a credit bureau that also analyzes data from the real sector (especially with the rise of consumer loans). Within the legal sphere, it is also important to develop an antitrust law in keeping with the best international practices, to provide effective protection of the market. F. Policy Recommendations The double impact of the twin crises and the official dollarization of the system have required, and will continue to require, important institutional and operational adjustments to the financial system. The main issues to be addressed are summarized below. * The need to improve banks' prudent credit activities, providing greater access. Large loans, frequently made to related parties, form a high propor- tion of the nonperforming loan portfolio. The broad coverage of deposit insurance for many of the banks undergoing processes of resolution distorted incentives for debtors, promoting a "nonpayment culture." The result has been a heavily deteriorated portfolio quality (with the ratio of credit portfolio to GDP at half its precrisis level); the cost of lending has risen, while small debtors have had much fewer opportunities for access to credit even consid- ering that typically have less access to the formal sector. The challenge of increasing access to credit is even greater in dollarized economies owing to the circumstances described earlier, but this access could be improved by means of the policies discussed below. * A more efficient management of banking liquidity. The reduced possibil- ity of softening external shocks via economic policy makes dollarized economies more exposed to shocks resulting from exchange or of interna- tional interest rates. This vulnerability, together with the lack of a lender of last resort, leads banks to maintain a higher level of liquid assets. However, an 21.See Galindo, Arturo, "Creditor Rights and the Credit Markets: Where Do We Stand?" IADB Working Paper. March 2001. 108 ECUADOR: AN ECONOMIC AND SocALL AGENDA IN THE NEW MILLENNIUM efficient management of system liquidity could free up some of these assets, which would permit increasing the quantity of resources available for pro- ductive uses. Centralized management of system liquidity could also permit access to contingent lines of credit on better terms. The Central Bank is a nat- ural candidate for this central role owing to its present responsibility for the payments system. Separating this function from the responsibility of central- ized management of liquidity does not appear to be efficient and could nega- tively affect the provision of a public good such as liquidity. Therefore it is crucial to reduce the legal impediments and to eliminate the potential conflict of interest that could weaken the effectiveness of the Central Banlks actions. Reforms of the payment systems. The provision of liquidity cannot be suc- cessful if there is not an effective payments system. Consequently, the sequence of policies needed to reform the payments system must be codified in a public document. The essential steps include the following: introducing the Real Time Gross Settlement (RTGS) system; ensuring availability of a security deposit to achieve the dematerialization and which allows for carry- ing out DVP procedures; and, finally, defining a single net clearance system for check transactions. A delay in reforming the payments system will inevitably lead to the change of position of the country's payments services in a time horizon that, for a dollarized economy, may not be very long and would deprive the local banking system of an additional source of profit. o Banking supervision and regulation. The banks' large holdings of liquid assets cannot be reduced solely through interventions related directly to liq- uidity, because one of the principal reasons behind bank runs is a lack of con- fidence in the quality of bank assets (aside from reasons of macroeconomic instability). Therefore it is vital that the SBS continue to improve its proce- dures, especially in relation to the evaluation of credit risks (urging banks to also modernize these processes) and in relation to the rules of portfolio provi- sioning. Accordingly, it is important to consider the possibility of establishing procyclical provisions as Spain has done, seeing that Ecuador's economy has characteristics of high volatility. Legal protection for SBS authorities in the performance of their functions is also vital, as are legal changes that allow for the improvement of the systems of bank resolution and liquidation. At the same time, the SBS's reporting must be strengthened. Finally, to increase con- fidence in the system and to prevent potentially dramatic consequences for the management of system liquidity-such as the suspension of correspon- dent reports between national and foreign banks-will require full compli- ance with international standards to prevent money laundering (coordinating efforts with the pertinent authorities), ensuring that the SBS can carry out legal actions in this regard within a fully integrated legal system. • Codification of exit mechanisms for banks. The formalization of the role of the SBS and of the AGD in the process of bank resolution and liquidation must be strengthened and the AGD's functions must be revised, considering THE BANKING SYSTEM 109 the alternative of converting it into a pay box. The latter would consider the resolution of the management of assets of banks undergoing reorganization through a specialized foreign agency, to permit a greater return and less ero- sion of the debtors' will to pay. Reform of state-owned banks. Owing to the difficult equilibrium that state- owned banks must establish in their dual commercial and social function, it is important to consider reforming the existing banks (particular the first-tier banks), limiting their activity to focalized areas where subsidies, if needed, are transparent and minimal. This effort would have to include an evaluation of alternatives for the development of the microfinance market that has been undergoing development (particularly with the greater success of the savings and loan associations in surviving the crisis) and of rural financing. This last option presents good market potential, which could motivate institutions (even formal ones) already leaning toward these sectors to improve sustainable access to credit and other financial services, based on extensive international experience (as in Bolivia, for instance). Policy Matrix Policy measures and progress indicators Areas offocus and goals Short Term (to June 2003) Medium Term (2003-07) LIQUIDI7TYFUND Legal authorization permitting the BCE Transfer of management to the BCE could to manage trusts. The present law does not increase public confidence in the permit this, which is why the CFN was Liquidity Fund. assigned the role of trustee for management of the liquidity fund. z Definition of a new organizational Create the Financial System Oversight Create an agency to manage the technical part G 0 structure for management of the Committee comprising the BCE, SBS, of the liquidity fund. z liquidity fimd. Coordinator of and the Ministry of Economy and 2 responsibilities between the lender of Finance. last resort and the bank supervisor. Efficient exchange of information Prepare for the creation of a "data bank" ° between the BCE, SBS, AGD, and the that the different agencies can access. oversighit committee (to be created). :> c) Reduction of the Central Banks conflict Sustain progress in the bank's Revise the plan for the bank's privatization in Z of interest as owner of Banco Pacffico. restructuring plan. the medium term. AGD Finalization of AGID activities related Contract with external consultants to sell assets 2 to the crisis. Payment of outstanding to prevent their rapid erosion, permitting the liabilities, sale of portfolio and other assets. payment of pending accounts. Restructuring of the AGED. Allowing it to Revise its structure, consider converting 5 focus on partial deposit insurance. it into a pay box. SUPERINTENDENCY OF BANKING Legal protection for the superintendent Modify the Banking Act, to include and other functionaries in performing explicit protection. their duties. Improvement of the SBS's reporting Include a section in its Annual Report with statistics that reflect the oversight activity of the SBS. Compliance with international Introduce a law to bring the country into Introduce regulations to be carried out by banks standards against money laundering compliance with Financial Action and insurance companies. (coordinating efforts with the related Task Force (FATF) principles of authorities). Guaranteeing that the SBS money laundering. can carry out legal actions in this sphere within a fully integrated legal system. Strengthening of mechanisms for credit risk analysis, for both on-site and off-site inspections (to improve analysis systems in banks). PROTECTIONFOR DEBTORS Introduction of Bankruptcy Act in line Perform an analysis of corporate with the best international practices. insolvency (Insolvency Report on the Redefine the legal framework for the Observance of Standards and Codes property rights of creditors in the [ROSC]). restructuring of debts. PAYMENTS SYSTEM Formulation of a strategic vision of the Formulate a strategic vision of a report from the payments system beyond operational Central Bank for the settlement of payments aspects, focused on improving payment and securities that is comprehensive and goes (Matrix continues on the follo wing page) Policy Matrix (continued) Policy measures and progress indicators Areas offocus and goals Short Term (to June 2003) Medium Term (2003-07) services. Extend the scope of the reform to beyond operational aspects. include legal issues, the oversight function, i securities, government payments, and so on. C: Legal aspects: protection of the payments Perform in-depth review of the legal 0 systems against individual bankruptcy, framework for a payments system and purpose of liquidation, legal basis for design a plan of action for implementing collateral, legal recognition of the the necessary reforms. Incorporate 0 estimation of net balances, and so on. into the legal framework all aspects z identified for increasing the soundness of the payments system. n Creation of a system of Real Time Gross Follow the guidelines set down in the strategic Setdement. Significant risks because vision document to establish the different 0 high-value payments are made through elements necessary for modernizing the checks. The funds transfer system between payments system. Central Bank accounts sriU contains manual processes that reduce its effectiveness. Securities depository. The failure to Establish the function of securities depository develop the function of securities based on the guidelines set down in the strategic depository does not allow a Delivery vision document, with a connection to the z Versus Payment (DVP) system. This high-value funds transfer system.n puts limitations on management of K system liquidity because the lack of this function hinders the development of an z interbank monetary market with collateral. Establishment by the Central Bank Have the Central Bank establish the function of of the oversight function. There is no oversight of the payments system and coordinate legal capacity and no practical oversight with other regulators (on the subject of of the payments system by the Central securities, for examnple). Bank. A reform cannot be considered Z complete unless this function has been activated, which permits controlling the risks and periodically checking that the liquidation arrangements are efficient and secure at all times. Coordination by the Central Bank Establish a mid-level committee that with other related parties. There is room provides better liaison between the for improvement in the existing high-level committee and the present organizational arrangements through technical committees. the Central Bank's Interinstitutional Committee. 5 Petroleum Policy' Eleodoro Mayorga The importance of the petroleum sector to the Ecuadoran economy is undeniable. Given the weight of external debt and the need to generate fiscal resources, there is an urgent need to increase exports and reduce inefficiencies in this sector. The country has consid- erable proven reserves, and by the end of 2003 will also have acquired the greater trans- port infrastructure it needs. However, the sector still suffers from serious structuralprob- lems: a legal. contractual and institutional framework that preserves PetroEcuador's monopoly and limits access to capital and technology; distortions in the management of oil profits; high costs resulting from low operational efficiency in the state enterprise; low quality products sent to market at a high cost; and atsor;n.on.;nn ntal record that needs resolution in order to open vast regions of the country to sustainable development. The new government needs to undertake profound sectoral reforms. The most urgent - __-- I_---L I .L--fTJL_. A ILl r__I /TAT' - -------- - _L. I_.L acumtnin-ctuade slving treI problrn lIJ ulv'idue-Adued t ix C v'AT I reimburserneri, ŁULC LULK of stability in the judicial system for investors, the elimination of the gas subsidy, and the adoption of a formula to allow PetroEcuador to form partnerships with private compa- niesfor operations in its most important oilfields. A. The Evolution of the Petroleum Sector and Legal Framework The importance of the petroleum sector to the Ecuadoran economy cannot be over- stated, as it comprises approximately 15 percent of GDP and a third of state revenues. Petroleum and its derivatives account for an average of 40 percent of total exports, a 1. This chapter was elaborated by Eleodoro Mayorga Alba, the World Bank's main petroleum .co norr.ist, and Horacio Yepez, forld Bank consulatant.. 116 ECUADOR: AN ECONOMIC AND SOcIAL AGENDA IN THE NEW MILLENNIUM number expected to rise in future years given the productive potential of this sector. Table I reveals the fragility of the trade balance, and in general of Ecuador's economy as export volume and oil prices fluctuate on the international market. It is probable that the year 2002 will close with acceptable gains because of sustained oil prices. Since 1971, the year in which the first Law on Hydrocarbons was passed, the srare has rnken on a maior role in sectoral management and operations. With the exception of exploration and production activities that are also carried out by pri- vate companies, PetroEcuador maintains a monopoly over wholesale industrializa- tion an.d commcrcialization of petroleum derivatives. H- investments are subject to the dispositions of the Finance Ministry within the state's general budget. Annex I contains a historical chronology, as well as a detailed description of the sector. Proven reserves are estimated at 4.6 billion barrels, of which Petroproducci6n- PetroEcuador's affiliate for exploration and oil and gas development-controls nearly 75 percent, including the majority of light crude oil fields. The state enter- prises' production has decreased markedly from a maximum of 120 million barrels (bbl) in 1994 to 80 million bbl per year owing to a lack of investment and transport capacity. Private sector support for national production is nearly 65 million bbl. This means a national daily average of 400,000 barrels per day (BPD), limited by pineline capacitv with Petroproducci6n accounting for 56 Dercent, and private com- Table 1. importance of the Petroleum Sector to tme -Economy (blns/mins $US) 1995 1996 1997 1998 1999 2000 2001 Crude oil exports 1.395bl 1.520bl 1.411bl 789m 1.312bl 2.144bl 1.722bl Export of petroleum derivatives (in millions) 134.5 227.9 145.9 134.0 167.4 298.4 177.7 Total crude exports anJ derivatives I.C29blI 1.748l 1 C57bl 922. r0 1., -9blI 2 b 1.9bl Percentage of exports 34.9 35.9 29.6 22.0 33.2 49.6 40.6 Percentage of GDP* 14.6 14.0 14.0 13.5 14.6 15.0 14.6 Total Petroleum Revenues 1.329bl 1.574bl 1.269bl 912.9m 1,048bl 1.460bl 1.347bl Revenues from crude exports (millions) 683.2 939.4 625.5 249.5 745.6 1.286bl 990.1 Revenues from sale of derivatives (millions) 645.8 635.1 644.4 663.4 303.1 173.1 357.2 Percentage oc public revenues 29.0 33.8 26.9 22.7 29.8 35.4 27.4 Includes mining, which makes an insignificant contribution to the petroleum sector. Source: Central Bank Statistical Information and PetroEcuador Statistics. PETROLEUM POLICY 117 panies for 44 percent. When comparing reserves to production, one observes that private companies own 25 percent of reserves, and yet currently contribute nearly half of total production. The majority of private investment in exploration and development of new reserves is carried out through participation contracts. This modality, which was incorporated in the Law on Hydrocarbons in 1993, has allowed contracts in which private companies assume all risks, investments and costs, and share production with the state at a proportion of approximately 75 percent and 25 percent, respec- tively. In 1993, the modality of Contracts for Marginal Fields was also adopted which utilizes the participation model, while allowing private companies access to reserves discovered in small fields (which make up less than 1 percent of national production). In 1998 the former administration tried to incorporate the Joint Ven- tures modality into the law, in order to allow private companies to partner with Petroproducci6n to operate large fields. Although the National Congress supported this initiative, its initial economic conditions were modified and it was later declared partially unconstitutional-and became null and void. During recent years there have been few initiatives to seek new private invest- ment. The Operational Alliances was one such initiative, and was utilized to develop two Petroproducci6n fields in which private enterprise provided a variety of services and financing in return for payment-making the viability of the alliance depend- ent on increased production. The most recent attempt at contracting the manage- ment of producing fields is the proposal to Chile's National Petroleum Enterprise (ENAP-Empresa Nacional del Petrdleo). There was no call for tenders, based on the privilege of state companies to sign specific service contracts directly. The govern- ment sent a reform bill to Congress to try to incorporate this privilege into the law, but apart from a specific contract with ENAP, the reform was rejected. For 10 years petroleum production has been limited by transport capabilities. With the exception of the small AGIP pipeline, PetroEcuador and the private com- panies are using the TransEcuadoran Pipeline System (SOTE-Sistema de Oleoducto Transecuatoriano), with a capacity of 390,000 BPD of petroleum with a graviry of 23.70 API.2 In addition, PetroEcuador can transport a volume of nearly 50,000 BPD in agreement with the Colombian Petroleum Company (ECOPETROL- Empresa Colombiana de Petrdleo), to Tumaco via the TransAndean Pipeline. The crude transported via this pipeline is 290 API, the quality level required by the La Libertad refinery. Transport from Tumaco to la Libertad is by ship. Limitations on pipeline capabilities have made it necessary to mix light and heavy crudes. In order to end these limitations, in February 2001 the government authorized the construction of a heavy oil pipeline (OCP) through a consortium composed of 2. The API grades are an American Petroleum Institute measurement used to define the spe- cific gravity of oil. The greater the API, the lighter the product, meaning the higher the content in gasoline, diesel, and white products, the higher the price. 118 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM the main private companies operating in the country. The OCP will be able to trans- port up to 518,000 BPD of 18 to 240 API. It mainly follows the SOTE route and flows into a new sea terminal as in Balao Esmeraldas. In contractual terms, OCP construction should wrap up in June 2003, but owing to work stoppages caused by environmental groups and local communities, it is expected to begin operating in September 2003. Available transport capacity will increase to approximately 960,000 BPD with the OCP. The state monopoly and lack of investments have also seriously affected activi- ties. Primary refining capacity is currendy 175,000 BPD. Refining production in the hands of Petroindustrial does not completely meet domestic demand (135,000 BPD), meaning the state must import gasoline, diesel, and LPG. The Amazon and La Libertad refineries only have atmospheric distilling units, and even though the Esmeraldas refinery has some conversion capacity, production of residuals in the three refineries exceeds local demand. These residuals are exported at a low price. Petroindustrial derivatives and imports are distributed through the internal mar- ket by Petrocomercial, the owner of the network of ducts and terminals for storage and distribution. Petrocomercial provides products to vendors at the same price fixed by the President of the Republic in all terminals. As regards sale price to the consumer, the presidential decree establishes a maximum margin of 18 percent on the sale price in the terminal, applied by nearly all distributors, without price or margin competition. In terms of environmental and social management, industry activities are regu- lated by the environmental standards for hydrocarbon operations approved in Feb- ruary 2001. The main modification to this code was to raise environmental stan- dards to international standards, with special emphasis on re-injection of formation water, emissions monitoring, flaring of associated gas, and permanent environmen- tal auditing. The Department of Environmental Protection in the Ministry of Energy and Mining (Direccidn de Proteccidn Ambiental del Ministerio de Energia y Minas-MEA%) is the entity that supervises compliance with these standards. The law establishes the right of indigenous peoples and communities to partici- pate in consultations. The legal dispositions to support application of this right have just recently been promulgated. To date, companies have been managing social issues through direct negotiations with communities. The lack of a code of standards compounded by the enormous socioeconomic needs in petroleum zones that have not been met by the government, has forced firms to carry out public works and dis- tribute resources in order to be able to operate and avoid suffering costly delays in their work. And this is despite the fact that companies already pay an Ecodevelop- ment tax to benefit these regions. The tax amounts to $US0.35/bbl and will reach $US0.50/bbl by 2005 in the eastern fields. There is no evidence that the taxes paid or the support provided by companies has significandy contributed to development in the oil-producing region. In 2002, oil profits amounted to more than $US 1.5 billion, and this sector's con- tribution to the state budget averaged 28 percent. Revenues distribution has become PETROLEUM POUCY 119 more complicated because of the series of preallocations established for each revenue segment: exemptions, forner consortium production, service contracts, and so on. The lack of transparency in resource management, which takes place outside the framework of the state budget, is a serious problem. Starting in 2003, however, the large preallocation to the Armed Forces from oil royalties will be eliminated. The Fund for Petroleum Stabilization was one effort to develop a contingencies fund, and it accumulated resources when the price of crude exceeded $US20 per bbl. However, these resources have also been subject to preallocations. Finally, given the expected increase in production when the OCP begins operations, a Fund for Stabi- lization, Social and Productive Investment, and Reduction of Public Debt (FEIREP- Fondo de Estabilizacidn, Inversidn Socialy Productiva, y Reduccidn del Endeudamiento Publico) has been established. FEIREP's goal is to repurchase external public debt at market value, and stabilize revenues earmarked for health and education. B. The Main Problems of the Petroleum Industry in Ecuador The petroleum sector in Ecuador suffers from inefficiencies and distortions that limit the country's economic growth. The first series of problems are related to the need to increase investments in exploration and production. These increases should come primarily from the private sector, given public sector limitations and in par- ticular limitations on the state-owned company. The following measures are required in order to develop the production of proven reserves and to capitalize on the existence of increased transport capabilities by the end of 2003: * Ensure legal and economic stability of contracts, beginning with the resolu- tion of the VAT problem for oil companies operating in the country. * Find a contractual formula within the framework of current laws that allows PetroEcuador to partner with private companies to develop reserves in the most important oil fields. * Develop new reserves, as well as those already proven and those resulting from the exploration of new areas. In commercialization and other activities, price and tax distortions should be eliminated, as should PetroEcuador's defacto monopoly, thus favoring competition both in refining (as opposed to importing products) and in product distribution and marketing. Without these improvements the state will lose tax revenues, and con- sumers will continue to pay high prices for low quality products. Some of these measures are as follows: * Eliminate the LPG subsidy. * Redefine the price and tax policy on consumption of fuels in a way that facil- itates the entry of new companies. 120 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM 0 Seek private investments for refining activities. Many of these measures are complementary and some can be taken without changing laws. In addition to these measures, other sectoral actions include: o Revising the current petroleum revenues management scheme to ensure trans- parency, and eliminate corruption and the inefficient use of petroleum rev- enues. • Revising the industry's legal and institutional framework, separating the role of the state-acting as guardian of the public interest by administrating rev- enues and as guarantor of a petroleum industry that is committed to sustain- able development-from PetroEcuador's role, that should remain focused on maximizing the profitability of state assets in the sector. o Improving the management of social and environmental impact. Ecuador is a country with very sensitive environments in petroleum zones, where a highly costly environmental liabiliry has accumulated. Indigenous culture should be supported and the quality of life of indigenous peoples should be improved. These groups have been affected particularly negatively by indus- try activities. The Problem of VAT Reimbursement and Contractual Stability The VAT exemption on imports enjoyed by oil companies is contained in the Law on Hydrocarbons, while the exemption for petroleum services is in the Law on the Internal Tax Regime. In 1998, an interpretation of the Law on Hydrocarbons at the customs level resulted in companies being forced to pay sales tax on their imports. In 1999, the Tax Regime Law was reformed, with the elimination of the sales tax exemption for petroleum services, and the rate was increased from 10 to 12 percent. Until August 2001, companies received reimbursement of the value-added tax paid on crude exports, like any other exporter in the country. In that month, the Inter- nal Revenue Service (SRI) introduced a reinterpretation of the tax law, differentiat- ing, in terms of treatment, between the hydrocarbon industry and all other export industries. This meant that private oil companies stopped receiving the VAT reim- bursement. The economic impact of this measure, according to the companies, will reach over $US200 million by the end of the year. PetroEcuador has ignored the companies' complaints regarding this situation, even though it has a contractual obligation regarding retribution to the contractor in the event that the tax regime was changed. This should have been applied at least in order to compensate for the rise in the VAT rate from 10 to 12 percent. With respect to the change in interpretation by the IRS, companies have presented administrative and legal complaints. They believe that the reimbursement of VAT should apply to all exporters because this tax should not be exported. The companies PETROLEUM POLICY 121 also oppose the revoked exemption on the fundamental basis that these contracts were established based on economies that did not take such a change into account. At one time, the outgoing administration decided to let the SRI resolve the con- flict. The SRI argues that the oil companies have been reporting costs illegally in some cases. There have been three judicial verdicts that have only taken into account the recognition of the 2 percent increase in the tax rate. In other words, the verdicts have ratified the nonreimbursement position, considering a rate increase, and not the entire revoked VAT exemption, as the only factor that affects the economic sta- bility of contracts. As the conflict continues, positions have lost clarity, mixing arguments such as the illegality of re-interpretation with accusations of tax evasion. With the goal of seeking a solution, the option of international arbitration has been proposed. The state has accepted the principle of arbitration with reservations, and still does not agree with Occidental Petroleum on how to proceed. Encana, a company that was negatively affected by the court ruling, has indicated its intention to seek interna- tional arbitration. The negative impact of these tax measures on the country's economy, and specif- ically on the petroleum sector, is significant. The companies are downsizing their investment plans, which will directly affect production in both the short and medium terms. If the VAT problem is not resolved, this will also block revenues from new investment and will even affect company participation in the reactivation of Petroproducci6n's current oil fields. Increasing Petroleum Production Private Companies At present, private firms maintain field operations that represent 26 percent of the countrys reserves. The prospects of production by private companies has been affected by VAT problems, which is reflected in greater idle OCP capacity, at least in the short term. The following scenarios can be foreseen in the medium term: * The first scenario corresponds to a low rate of growth of production that would increase from 180,000 BPD in 2002 to 240,000 BPD in 2004, reach- ing a level of 295,000 BPD in 2007. This scenario is based on a voluntary reduction of company investment because of the lack of stability in the judi- cial system in general, and particularly on a lack of resolution of the legal con- flict over VAT. * The second scenario-which assumes that the new government will resolve the VAT problem quickly during the first weeks of its mandate-would allow companies to accelerate the investment process, and production could jump from 180,000 BPD in 2002 to 290,000 BPD in 2004, and hit 420,000 BPD in 2007. 122 EcUADOR: AN ECONOMIC AND SocALp AGENDA IN THiE NEW MILLENNIUM Considering that on average, 30 percent3 of private production belongs to the state, the difference in the fiscal terms between these two scenarios is more than $US500 million-which translates to more than 45 million barrels that the state would no longer receive as part of its participation. This is sufficient reason for the government to urgently seek a solution to the VAT problem. Petroproducci&n During the last four years, the national company has been operating under restric- tions that have caused a drop in production averaging 6.1 percent annually, costing the country over 45,000 BPD of petroleum, which represents nearly $US700 mil- lion in fiscal terms. If these limitations on PetroEcuador's financial and technologi- cal resources continue, based on the current 10 percent decline in production, only one-third of remaining proven reserves will be recovered in the next 20 years. The drop in Petroproducci6n's production is not due to the geology of the oil fields (which have sufficient reserves), but due to the state's deficient management of an industry that is extremely technical. Political interference has been the norm, with emphasis on meeting short-term objectives and permitting different economic and social interest groups, as well as unions, to pressure the company. The com- pany's maintenance of its facilities is very poor. It has lost key technical personnel over the years and has not gained access to new technologies. There is very little planning, and serious deficiencies exist in administration and operational capacity caused partly by the loss of financial autonomy because the entity is bound by the Public Budget Law. The collective contract, which covers all employees and estab- lishes significant compensation in the case of either termination or resignation, is another factor that has diminished the efficiency of this state enterprise. At the present time, PetroEcuador does not have the necessary technological know- how to execute, evaluate, and interpret the results of the perforation of horizontal wells, improved recovery, and 3D seismnic campaigns. Investments in these activities have been only partially successful. However, no significant participation on the part of private companies, which have the capital and technology required, has been per- mitted. This is because political and labor union actor s have waved the flags of nation- alism and identified this sector as "strategic," in order to block opening initiatives. The little private participation in production development efforts is centered in five marginal oil fields and two medium-sized fields that are part of the Operative Alliance system. Meanwhile, the joint ventures option in large fields was thrown out following the distortions introduced in the National Congress during the approval of the Trolley Laws of 2001. If Petroproducci6n continues to operate the most important reserves in the coun- try with the same financial and technological restrictions, it probably will not be 3. This is over 30 percent even if state participation represents 25 percent in participation contracts, when participation in marginal oil fields and the equivalent of the AGIP con- tract is consolidated. PETROLEUM POLICY 123 Figure 1. National PetroleLum Production and Consumption Millions of bbl. 60 - 40 - 20 1998 1999 2000 2001 2002 R Private UI Perroecuador - Consumer Source: PetroEcuador. able to increase production. However, this scenario could change significantly if the private sector actively participates. If conditions are provided to attract private investment both in PetroEcuador's areas and the areas contracted out-that is, sce- nario 2 in Table 2-and restrictions on transport are lifted by the end of 2003, national production could double in the next four years. Petroproduccion's exploration activities have not achieved significant results in recent years. Reserves of fields nor yet in production are not very promising (180 million bbl), and possible reserves are not substantial (75 million bbl). These fields contain many areas that are governed by environmental restrictions on exploration, with Imuya's prospects standing out. Table 2. Projections for National Petroleum Production (Mlns of bbl) 2002 2003 2004 2005 2006 2007 NATIONAL TOTAL Scenario 1 148 150 173 179 183 191 Scenario 2 148 150 192 226 254 280 PETROPRODUCCION Scenario 1 82 84 85 86 84 83 Scenario 2 82 84 86 93 106 127 PRIVATE COMPANIES Scenario 1 65 66 88 93 99 108 Scenario 2 66 66 106 133 148 153 124 ECuADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM The Case of the ITT Fields In 1993, Petroproducci6n discovered heavy crude reserves in several fields called Ishpingo-Tambococha-Tiputini (ITT), in the central-eastern part of the Amazon. The last perforations and studies indicate the existence of a significant volume of reserves (1.4 billion bbl.). The geographic and environmental situation of ITT and the quality of crude oil with a high sulfur content means it is necessary to budget high levels of investment and to keep in mind that production cannot begin until seven years of investment have been completed. The interest of Petro- producci6n in becoming an active partner in the project, and determining the form of execution and deciding phases ofproduction, have delayed the project's definition. Both for this project and others, private investment requires opera- tional autonomy. Reserves It is the state's responsibility to ensure that the flow of oil revenues in the long term equally benefits current and future generations of Ecuadorans. For this reason, it is necessary to begin new exploration, particularly when one considers that it takes from 5 to 10 years for reserves to reach the production stage. In the most favorable investment scenario, we can foresee significant production increases by 2007, based only on reserves already proven. After that date, there could be a reduction in pro- duction if the ITT fields are not being worked, and if there are no discoveries in other areas. After the eighth round of bidding, carried out in 1998, no new blocks have been contracted. There are three blocks in the east that were adjudicated in the seventh and eighth rounds to the Burlington, CGC, and Tripetrol companies. These planned explorations have not begun because the first two companies have had problems with the communities, and because of legal problems in the case of the third company. Apart from the direct contracting carried out by Petroproducci6n with ENAP for the exploration and exploitation of the three medium-sized fields currently in production, it does not seem feasible or appropriate to carry out new direct contracts with state enterprises when this option has been expressly rejected by the National Congress. The outgoing administration has delayed the ninth round, and modified its scope several times. The blocks up for bidding in the eastern region have been taken off the list, with the round being limited to blocks in the offshore region. In addi- tion to the political waffling, the lack of specific regulations has made it impossible to carry out a consultation process with communities living in the blocks of the east- ern region-a necessary prerequisite to begin the project. However, it is worth not- ing that thanks to the efforts to build consensus, the outgoing government has promulgated a regulation for community consultations that will facilitate initiating these processes in the new exploration and production zones. PETROLEUM POLICY 125 General Subsidy for Liquid Petroleum With the recent increase in oil prices and the prices of derivatives, the net effect of taxes paid by consumers and hidden subsidies that currently govern the sale of fuels has an estimated fiscal cost of more than $US300 million annually. This number includes the general subsidy for gas, as well as minor subsidies for diesel and fuel oil. Gasolines are the only products that are being taxed effectively. A detailed estimate of the prices of current economic efficiency is presented in annex 2, along with a comparison with current prices. These calculations are based on crude prices in the West Texas Intermediate (WTI) of $US27,515/bbl, which are relatively high owing to the problems caused in the international market by the cur- rent situation in Venezuela. LPG requires a karge percentile price increase to reach its price of economic effi- ciency4 (347 percent). In addition to fiscal cost, the way the subsidy is currently applied to both LPG and other products means that the total value earmarked under this subsidy indiscriminately benefits the rich as well as the poor, without targeting to improve the quality of life of the most needy, which should be the pri- ority objective. Various governments have tried unsuccessfully to eliminate the gas subsidy, but they have not been able to implement compensatory measures that would convince the population to accept price increases. On some occasions, after deciding to increase the price of the product, governments have had to back down and reduce them in order to quell popular protest. There are various alternatives for targeting this subsidy. The outgoing administration has left a plan in place that would permit selling LPG at an economic price of import parity, while introducing a special coupon for the poor simultaneously. This way those in need of financial assistance can continue to buy the cylinder of LPG and pay the current subsidized price. Price and Tax Policy, and Lack of Competition in the Derivatives Market The state monopoly and the fixing of fuel prices by decree are the main characteris- tics of the petroleum derivative market in Ecuador. The elimination of the LPG sub- sidy opens the doors to efficiently organizing the tax system for fuels. This can be done without substantially changing the prices for the public, since the correction needed on diesel prices (16 percent) and fuel oil (13 percent) could be staggered while waiting for the international market to stabilize. The fundamental objective is to eliminate price fixing by the state, and basically letting prices respond to interna- 4. The economic efficiency price corresponds to the cost of opportunity. In this case the price is calculated taking into account the cost of importing each combustible fuel, plus the local costs of services until they are sent to the Petrocomercial terminal. 126 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Figure 2. Price of Products in Terminal (ind. VAT) Cents $US/gallon 140 - 120- 100 80 60 40 20 Super Extra Diesel Fuel Oil GLP O Terminal price + VAT, without O Economic price + VAT distribution and marketing profit margins Source: PetroEcuador. tional market variations. There are experiences with price adjustment mechanisms that allow the state to withdraw, and that absorb the inopportune price fluctuations on the international market, without affecting consumers. Decisionmaking on taxes and profit margins of commercialization are closely linked to decisionmaking on prices. In Ecuador it is important to revise the value of the Special Consumption Tax (ICE) and liberalize the profit margins for product distribution and marketing in a way that permits the entry of private companies in a competitive manner. Commercialization activities of derivatives are carried out by Petrocomercial, with the private sector exclusively handling retail commercialization of derivatives at a fixed price established by the government. This is reflected in the absence of a competitive market, which forces the final user to accept rigid price and quality options. Investments in Refining In Ecuador, the consumption of derivatives is 135,000 BPD, compared with a refin- ing capacity of 175,000 BPD. However, there is a national production deficit in PETROLEUM POLICY 127 gasoline, diesel, and LPG, and imports are needed to meet internal demand. At the same time, the excess procluction of residuals needs be exported. It is estimated that imports this year will hit $US360 million, a number that will continue to grow in future years. Petroindustrial's refineries generate a high volume of residue to the detriment of production of white products, owing to its configuration and the crudes it processes. The quality of fuels is very low. Both gasoline and diesel have a high sulfur content, and gasolines are low in octane. In Ecuador, a diesel is sold containing up to 7,000 ppm of sulfur, while the Latin American average is approximately 400 ppm, and in western European and U.S. markets the goal is to have a ceiling of 30 ppm by 2005. The refineries want to modernize their equipment to cut production costs and reduce the negative environmental impacts they are causing. In short, they should increase productivity. These actions have not been undertaken because of the lack of political decisionmaking, poor administration, low levels of investment, and pres- sure from labor unions. The current price policy does not provide incentives for investing in private refineries as prices are discretional rather than fixed by competi- tion. This is compounded by limits on access to storage and transport infrastructure at reasonable rates for new wholesale companies. Without the possibility of inte- grating into the market, investors are not willing to participate in refining activities. The state monopoly on refining activities and commercialization has generated costs for the Treasury, not only because of the existence of subsidies but also because of PetroEcuador's inefficiencies. Between the years 2000, 2001, and 2002, the accu- mulated losses of the sector were over $US 1.7 billion. Administrative System for Petroleum Revenues From the beginning, the administration of the resources from the petroleum sector has been subject to inadequate and politicized management, converting collection and allocation of resources into a true labyrinth with each passing year. The govern- ment has found petroleum revenues to be a never-ending source of resources to meet all types of fiscal needs. In addition, revenues for the state budget are estimated based on high oil prices,5 and total debits are adjusted to this estimate. This situa- tion implies high risk during periods when oil prices are low because of the fiscal deficits produced. At the same time it does not permit rational management of ever- growing public expenditures. The breakdown of petroleum revenue allocation for the period 1995-2000 illus- trates that the management of profits from hydrocarbon activity is centralized (only 3.8 percent is directly allocated to sectional governments), and that preallocations 5. The price used in the state budget corresponds to the price of Eastern crude, which is the WTI price minus a quality differential. For the year 2003, an estimated price of between $US18 and 22/bbl. is being debated. 128 ECUADOR: AN ECONOMIC AND SoCIAL AGENDA IN THE NEW MILLENNIUM Table 3. Economic Results of Refining and Commerciaiation (thds $US) 1998 1999 2000 2001 2002 REVENUES 1,174,474 964,941 1,156,661 1,321,511 1,491,115 Internal sales (*) 1,025,173 782,696 838,002 1,116,664 1,280,379 Export of derivatives 149,301 182,245 318,659 204,847 210,735 Debits 1,177,685 1,305,570 2,051,815 1,728,076 1,920,171 Import of derivatives (**) 440,105 302,722 320,135 347,581 361,904 Cost of crude (***) 474,919 724,878 1,457,029 1,084,899 1,225,500 Commerciali- zation costs 106,216 112,406 111,064 116,375 131,456 Industrialization costs 156,446 165,563 163,587 179,221 201,311 NET -3,212 -340,629 -895,154 -406,565 -429,057 (*) Does not include value of VAT on products. (**) In 1998, the compensation value of crude was considered. (**) Refinery crude has been valued at international prices. Source: Elaborated by the author based on PerroEcuador's statistics. lack definition (a large quantity of resources allocated to various institutions is in the category "Others"). (See Table 4.) In comparison with other countries of the Andean region, the Ecuadoran system of revenues distribution shows less transparency, and leads to inefficient manage- ment of petroleum revenues. For example, allocations to institutions outside of budgetary control in other countries are 2 percent less on average, while in Ecuador it is greater. The resources allocated to social funds in Ecuador are also clearly insuf- ficient, at only 3.3 percent of total. Table 4. Petroleum Revenues Distribution Structure (Average 1995-2000) Central government 62.14% Provinces 1.42% Municipalities 2.40% Social support funds 3.30% Others 30.94% Source: Population, Environment, and Energy Program (EAP), 'Comparative Study of Distribution of Petroleum Revenues," Energy Sector Management Assistance Program (ESMAP), February 2002. PETROLEUM POLICY 129 One of the measures already taken is the elimination of preallocation of resources for the Armed Forces, which now receive resources through the state's regular budget. However, there is still much to be done in order to improve the current sys- tem's transparency. ECORAE, a fund created to help develop social programs and conserve the envi- ronment in the Amazon region, has not produced the expected results. Thirty per- cent of the revenues from this production-based fund is transferred to provincial councils of the region, 60 percent goes to municipalities, and 10 percent to the Insti- tute for Regional Ecodevelopment in the Amazon (Instituto para el Ecodesarrollo regionalAmazonico). The regional government has oriented its resources to maintain a bureaucratic system, and to develop urban areas, rather than specifically targeting zones affected by petroleum-related activities. The Fund for Petroleum Stabilization was created along with other initiatives allocating resources to specific funds. The goal is to take precautions against exter- nal shocks that could result from a fall in crude prices, accumulating resources when crude prices go over $US20/bbl. This fund has not met its goal because revenues generated have also been preallocated to the Amazon Highway (35 percent) and the Public Investment Fund (65 percent). Finally, the current administration has estab- lished a new preallocation for a fund called Stabilization, Social and Productive Investment, and Reduction of Public Debt. The resources for this fund come from PetroEcuador's crude exports which are transported by the OCP, as long as they are not derived from lesser utilization of the SOTE. The fund will be used to repurchase external debt, to stabilize petroleum revenues, and for education and health. In this case, even though the Law's goal is worthy of praise, the amounts needed to fully comply with objectives do not match realistic expectations for production. Legal and Institutional Framework The sectoral law, in effect since 1978 and reformed many times, was structured based on the premise that the petroleum sector is strategic and that exploitation is the sole duty of the state. The state carries this out directly, and only exceptionally delegates the task to private companies. This is why the development of the coun- try's petroleum sector depends on PetroEcuador's performance. In the case of Petroproducci6n, operational costs have been rising continuously, since production is dropping and since there is no oversight and no accounts pre- sented to the Ministry of Finance, which usually charges PetroEcuador on the basis of estimated costs. An even greater problem is that investments are not made in accordance with the approved budget, and projects are discretionally managed by the authorities of the day. (See Table 5.) With the external commercialization of crude, contracts are adjudicated on the basis of premium that companies offer under a pre-established differential between eastern crude and the WTI. This differential is frequently modified, which is rea- sonable considering the fluctuating market conditions, but does not offer trans- 130 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILENNIUM Table 5. Indicators of the Petroproducci6n Affiliate 1998 1999 2000 2001 2002(C) Operational costs $US/bbl 1.41 1.09 1.31 1.97 2.44 Production MM bbl 101.4 89.5 85.0 82.9 82.2 Investments/budget 40% 77% 83% 55% 68% (*) Estimated. Source: Petroproducci6n's Economic Budget of expenditures and investment. parency since it is based on PetroEcuador's internal studies, which often involve a large dose of subjectivity. PetroEcuador's contracting system is slow and not very transparent. On average, six months are needed for contracting. Bidding processes are frequently canceled for lack of bidders, contracts are subscribed without a bidding process, and pressure is exerted on adjudicating bodies. The assignment of a state role to PetroEcuador, as counterpart and control entity for petroleum contracts, has had a negative impact on the company's relationship with private companies and on the success of new initiatives with private participa- tion. PetroEcuador, because it competes with the private sector for better projects, suffers from a conflict of interest and has tried to maintain the institutional status quo. In practice, this hurts the state's needs and plans. The frequent change of administration, political intervention in company man- agement, the lack of an auditing system for officials, and inefficient control mecha- nisms have all created a system where responsibility is low. All of these factors work against proper utilization of the country's hydrocarbon resources. Ecuador is competing at a disadvantage compared to other countries in the region that have reformed their laws and have separated the roles of (i) the Ministry as the definer of sectoral policy; (ii) the regulating entities and/or the entities charged with representing the state in the definition of incentives and contractual frameworks that attract foreign investment to explore and produce hydrocarbons; and (iii) the national petroleum industry acting within a framework of financial autonomy and competition during all phases. Environmental and Social Impact The petroleum industry in Ecuador carries out activities in a fragile environmental and social context. Very little attention was paid to these matters during certain operations, and as a result, large environmental liabilities have accumulated. Perhaps the most notorious problem is the treatment and elimination of formation water that is a by-product of the production of crude oil. Crude spills are frequent, and mud perforation pools and/or pools of formation water are visible on eastern oil fields, and should be eliminated. Radical measures must be taken to prevent this PETROLEUM POLICY 131 problem from growing. Lessons can be learned from the experience of PetroE- cuador's pilot project with rhe private company now charged with processing and re- injecting formation waters on the Shushufindi field. The flaring of associated gases is also a pernicious practice on the production fields of PetroEcuador. The gas plant at Shushufindi has a idle capacity of 60 percent, equivalent to 15 million cubic feet of associated gas per day. This contrasts with the volume of gas that continues to burn in the Amazon, easily more than 50 million cubic feet daily. The negative consequences of gas flaring are environmental as well as economic. The full utilization of the Shushufindi gas plant will allow an annual 20 percent (1.2 million barrels) reduction in imports of LPG. Projects that take advan- tage of the LPG of associated gas and that improve electricity generation on oil fields should also be made feasible; as in the case of the Sacha field and others in the east. Environmental regulations contemplate developing participatory-type monitor- ing of operations, but there is no capability to do this. It is important to evaluate the resources needed by the Sub-secretariat of Environmental Protection, and at the same time, seriously explore options for more participatory monitoring involving indigenous and local populations. Government support for regions affected by petroleum exploitation in terms of preallocations is limited and not very transparent. Companies, in return for com- pensation, exchange permits to operate, and then carry out public works that are defined by the communities according to their immediate needs. In practice this does not translate into support for real sustainable development that increases the standard of living and that allows implementation of feasible sustainable projects in these regions. C. Recommendations and Implementation A series of recommendations are presented below, as well as a framework indicating priority, the entity responsible, and compliance indicators for the recommended activities. A Solution to the VATProblem The VAT problem is in the hands of the new government and needs to be resolved as quickly as possible, whether by adopting international arbitration or another pro- cedure. Measures that are adopted should be implemented administratively in the short term, and which will require rulings by the SRI make them operative. If the government opts to return nonreimbursed amounts, we recommend nego- tiating a plan of financing with private firms, such as a payment linked to future production increases. We suggest taking advantage of this situation to clarify the tax regime applicable to companies, not only in the present but also in the future, in such a way that 132 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEw MILLENNIUM Ecuador provides transparency, clear rules, and security to current and new foreign investment. It would be useful to provide detailed information to the IRS in the case of new petroleum contracts, before they are signed. Increasing the Production of PetroEcuador's Oil Fields The new government should take immediate action to allow an increase in produc- tion. Private sector support is absolutely necessary given the business environment in Petroproducci6n. The Law on Hydrocarbons contains various legal provisions that can be applied in these cases, allowing the private sector to participate in petro- leum-related activities with PetroEcuador.6 The specific modality should satisfy the different sectors of public opinion and be attractive to investors. In order to ensure rapid implementation, this modality should be completed without the intervention of the National Congress. One scheme that fits the needs described above is the establishment of joint ven- ture companies, a form of contracting used by PetroEcuador when working with small firms (for example, Austrogas and Lojagas). This type of company acts as a limited liability company in which a state institution and a private company are stockholders. In each area of production (Sacha, Shushufindi, Aguarico, Auca, Lake Agrio, and Libertador-so of which cover several fields), a joint venture would be set up. Petroproducci6n would be the stockholder that capitalizes the firm with petroleum reserves, installations, and personnel, and obtains a percentage of shares. The search for a private stockholder could be done through international bidding, and would require at least three offers for each area thus guaranteeing transparency. The competing offers would be formulated as a single figure representing an annual bond fixed for several years. In calculations, the bond should include the cost of dealing with priority environmental liabilities. Increasing Reserves Once the problems affecting private investment are resolved, particularly those related to the legal security and stability of the tax regime, and once there is greater transport capacity combined with new regulations governing prior consultation with the local population, we recommend planning new tendering for blocks. Approximately 50 percent of the country with oil potential has not been explored, and there is a need to incorporate new reserves in coming years to make up for the decline in production. 6. It is estimated that investments potentially attracted by the optimization of current fields within the proposed framework could amount to more than $US1 billion, which would increase current production from 225,000 BPD to 347,000 BPD for the year 2007, or 60 percent more than current levels (see annex 3). PETROLEUM POLICY 133 The launching of a new oil round requires the adoption of an appropriate con- tract model, and proceeding to the necessary consultation and environmental stud- ies. We recommend the participatory contract model for bidding, because its appli- cation is immediate (it does not require legal modifications), the companies have accepted it, and it has not been questioned. It is significant that criticisms received have had to do with modified contracts. This framework would allow the government to launch a broad round that includes the blocks identified in the east and on the coast, as well as a specific project to develop the ITT fields. This recommendation requires immediately initiating con- sultations with the communities in the area of influence of the blocks to be bid on, establishing principles for participation and concrete benefits for communities. These principles should be laid out in the terms of reference. In order to avoid questions about the validity of modified contracts, the new contracts should be standard and their final version should be the product of a consensus among the different actors- the Ministry of Energy, companies, the General Accounting Office, and the SRI. Elimination of Indiscriminate Subsidies for Gas An increase in the price of a cylinder of 15 kilos of LPG from its current value of $US 1.60 to the estimated economic price of $US7.157 is recommended; at the same time a targeted direct subsidy should be established to compensate the poorest. No law is required for this adjustment since the fixing of fuel prices is the responsibiliry of the President of the Republic. There are two alternatives for the proposed compensation. The first consists in the creation of a gas cash payment that would be paid along with a social cash pay- ment currently in existence and that approximately 1,200,000 families are already receiving. This payment would be worth $US10 monthly, which would cover the increase in cost for gas usage equivalent to 21 cylinders annually per family. The sec- ond possibility is to hand out 21 coupons annually to these same families receiving the social cash payment, which would allow them to purchase a cylinder at the for- mer price of $US1.60. In consolidated fiscal terms, the elimination of the subsidy would save $US245 million, assuming that the benefit is received by the nearly 50 percent of the popu- lation that currently receives the Solidarity cash payment. After subtracting the cost of the gas cash payment of $US144 million annually; the state would reduce fiscal costs by $USIO1 million a year. The increase in the LPG price to its efficiency price would considerably reduce the utilization of this fuel for purposes other than cooking, such as running motors 7. The economic price of $US5 per GLP cylinder mentioned frequently in the press is the average of the price of real opportunity ($US7.16/cylinder) for the volume of imported LPG (that is, two-thirds of the market), and an accounting cost price for national LPG production (that is, one-third of the market) 134 ECUADOR: AN ECONOMIC AND SOCiAL AGENDA IN THE NEw MILLENNIUM or heating water, for which other types of energy can be used (for instance, fire- wood). At the same time, contraband to neighboring countries would be eliminated making it highly probable that benefits would be greater. New Price and Tax Policy As in the case of subsidies, we recommend that the government make hidden taxes on products more transparent. This will require sending a legal reform to the National Congress to create a new tax on special consumption (ICE) in cents per gallon of the product. Table 6 presents the suggested ICE values by product and prices for the public. With the exception of LPG, which will lose its indiscriminate subsidy, one advan- tage of the proposed scheme is that it does not imply a substantial modification of the price of gasolines, but simply adjustments in the prices of diesel and fuel oil that could be adjusted according to price fluctuations in the international market. After adjustments in prices and the tax regime, we suggest continuing with the liberalization of the market. Tariffs on imports should be eliminated, which means opening the market to private imports of derivatives, with the possibility that pri- vate companies have access to transport infrastructure and storage facilities. In the short term they would utilize installations owned by Petrocomercial, and later their own installations resulting from new investment. In order to make this proposal feasible, Petrocomercial must be forced to offer transport services via ducts, storage, and other means needed by firms interested in commercializing products. The Ministry of Energy and Mining would publish the transport and storage tariffs that Petrocomercial8 would charge, and these should be competitive. Given the size of the Ecuadoran market, in order to avoid the estab- lishment of private monopolies on distribution and commercialization, the qualifi- Table 6. Suggested and Current Prices for the Public ICE Price suggested suggested-current* $USIgaL $US/gaL Commentary Super 25.0 140.8-141.6 No change Extra 7.0 111.7-112.1 No change Diesel 0.0 97.0-83.6 Slight increase Fuel Oil 0.0 61.5-54.6 Slight increase LPG 0.0 97.5-21.8 Important increase Price for the Public = Terminal price + (VAT + ICE) + Margin for distribution and marketing. 8. According to the study, "An Analysis of Fuel Products Pipeline Tariff Structure for Trans- portation, Storage, and Maritime Terminal Usage," by Booner and Moore, 1999, prepared by CONAM. PETROLEUM POLICY 135 cation of firms interested in activities should not be too rigorous in terms of size. On the other hand, in no way should this easing of requirements mean noncompliance with operational and environmental standards. These must be followed and super- vised by the National Directorates of Hydrocarbons and Environmental Protection, respectively. Producers and commercial agents would increase with the reduction of entry bar- riers and opening to imports. In the medium term this would surely result in improvements in the quality of products and services offered, as well as a reduction in profit margins for distribution and marketing that are currently too high-oscil- lating between 10 and 18 percent. Investment in Refining The establishment of joint venture companies is both politically and economically viable as an option to modernize refineries. The proposed scheme requires that the state cede a percentage of its property to qualified private companies, and in exchange these companies would make needed investments and cover operational costs, labor costs, and environmental measures. The private company would be selected through international bidding managed by the Special Bidding Committee (CEL), with a minimum of at least three offers. The company that offers the great- est economic value for the stocks offered would win the contract. In terms of economic efficiency, it is more advantageous to build new refineries rather than increase imports to meet local demand. A local refinery can acquire raw material at lower prices and does not have to pay transport costs. Since refining is a competitive industry, the new refineries would require detailed economic feasibility studies, and these should only be done through private initiatives. In order to achieve this, the need for special authorization from the executive branch to imple- ment these projects should be eliminated. Improvements in the Administration of Petroleum Revenues The incoming government should prepare a Law on Transparency of Petroleum Revenues that eliminates preallocations and classifies revenues in accordance with industry reality. The list of participants in preallocations should be submitted to the General State Budget and the resources to be allocated should respond to real needs. However, during a first stage, the amounts for preallocation would remain within the state budget until an evaluation is completed. This would reduce opposition to a project of this nature. Distribution of petroleum revenues should respond to the following criteria, among others: * Decentralization, which means part of the revenues goes toregional and local governments, with those affected by hydrocarbon activity having the greatest 136 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM weight. The parochial councils would be the first benefited by this, followed by municipalities and prefectures, thus modifying the current scheme. 0 Development of indigenous communities. In the medium term, in order to be applied this case requires training and strengthening of indigenous organiza- tions so that they can develop sustainable projects in which they invest the resources that they are administering. o Stabilization Funds. With respect to having a real Fund for Petroleum Stabilization, the government should adopt the policy of fixing a conservative price for the state budget, backed up by a legal reform.9 All surpluses derived from a higher price should be used to cap- italize this fund, which would help to mitigate the negative cyclical effects of the world petroleum market. The same reform should stipulate that this fund must be used to compensate for diminished revenues in periods of low prices and perhaps to lower the pressure of the foreign debt. Legal dispositions should be established to ensure rigorous fiscal management that eliminates extrabudgetary spending, and to bind all state institutions to rev- enues calculated exclusively based on realistic prices and production during the period. All debt based on anticipated payments from crude sales should be prohib- ited. Finally, the law should contemplate the creation of a permanent information bank on revenues management that is universally accessible, in order to guarantee transparency. New Legal and Institutional Framework A structural reform for this sector is a priority in order to comply with the mandates of the constitution, which establishes that the state should exploit this natural resource through companies (public or private, national or foreign) that are efficient and competitive. Conditions should be created that spur competition, free enter- prise, cooperation, and that penalize monopoly-type practices and any that distort or impede the market's free functioning. This means that state enterprises in the hydrocarbon sector cannot constitute monopolies. Their presence should not impede the participation of other companies in the sector under the same condi- tions. The decision to carry out such a reform also means the elaboration of a new Law on Hydrocarbons and a new Law on PetroEcuador. The first law should make MEM the exclusive representative of the state, and provide continuity to the institutional strengthening of operational and environmental entities, while seeking to totally reduce political interference and promoting the execution of state plans and invest- ments in the long term. On the other hand, the new law should assign PetroEcuador 9. It is suggested that the price remain under $US17/barrel. PETROLEUM POLICY 137 the specific role of "oil company," with the same rights and obligations as any other private firm. Structural reform of the sector should be widely debated and implemented in the medium term, without losing sight of the fact that the reform must comply with goals to increase national and foreign investment in the sector, increase fiscal rev- enues, generate employment in the industry, improve environmental and security conditions, and improve international competitiveness of all productive sectors either directly or indirectly linked with the hydrocarbon industry. Management of Environmental and Social Impact The new government should take actions that allow reparation of environmental lia- bilities. This opportunity could be used to introduce specific clauses in contracts with private firms to increase production. These clauses could fix a minimum amount of investment to be deducted from production bonds fixed for mixed enter- prises. They should take into account the execution of priority environmental repa- rations. This recommendation is also applicable to refineries. The MEM should establish a procedure that permits adequate utilization of gas and limitations on flaring, in accordance with the new regulations. In social terms, it is important that the state develop an integral program to ben- efit communities, making them economic participants that would benefit from the operations. The channeling of economic resources should guarantee sustainability of development proposed in the long term, especially in the postpetroleum era. This implies a process of support for strengthening communiry organizations such as business entities capable of administering and generating their own resources, in addition to other actions. Policy Matrix 00 Policy measures Short term Medium term Problems (by June 2003) (2003-07) Progress indicators Objectives/goals Reimbursement of Acceptance of Signing of arbitration Solve legal conflict in short petroleum-VAT and international procedure. term. lack of fiscal stability. arbitration. Legal disposition. Legal clarification of Provide legal and tax regime tax treatment of oil stability/Increase private 0 companies. investment. Agreement to pay VAT Formation of a Distribute the fiscal cost of to companies. negotiations commission. payments over time. 0 z Low production in Presidential announce- Public announcement of Increase production, capturing 0 the fields with greatest ment of the opening of the formula to be used. private investment and new X reserves. PetroEcuador fields ro technologies without state private investment. investment. Preparation process for Expedition of regulations, 0 international bidding. bidding process and contracts. Low level of Launching of a new Resolution creating the Engage in greater exploratory z exploration activiry. round of bidding CEL. activity to replace oil reserves. processes including the ITf project. Preparation for inter- Expedition of regulations, Z national bidding process bidding process, and including previous contracts. consultation. z Indiscriminate LPG Increasing the cylinder Presidential decree. Reduce fiscal costs by more subsidy. price of LPG and create than $US100 million/year gas cash payment. without affecting the poor. Hidden taxes and lack Revision of tax on Sending an "urgent" legal Offer higher quality products of competition in special consumption disposition to Congress, and allow the entry of activities. of combustibles. rectifying the creation of competitors into the market. the ICE. Obliging Petrocomercial Reform of laws governing to offer services to third Petrocomercial and MEM parties and charge non- agreement on tariffs. discriminatory tariffs. Low refining capacity Eliminating need for Legal disposition that Initiate new investments in and inefficiency of executive authorization eliminates the need for refining, transport, and storage. current installations. of new installations. presidential authorization. Preparation of inter- Issuing of regulations, Improve technological and national bidding process bidding process, and productive capacity of current for private investment contracts. refineries. in refineries. Poor administration Presidential definition Public announcement. Achieve equity in distribution, of petroleum-related for a new law. and better control and auditing revenues. systems. Elaboration of a draft Document turned in of the Law on by CONAM to the Transparency through Presidency and sent to broad consultation. National Congress. Allocation of petroleum- Proposal of the Ministry Achieve sustainable related benefits to of Environment and development of the oil- affected communities. Social Welfare. producing region. (Matrix continues on the ollowing page.) Policy Matrix (continued) Policy measures Short term Medium term Probems (by June 2003) (2003-07) Progress indicators Objectives/goals Outdated legal and Presidential definition Public announcement. Define roles, modernize institutional framework of a new legal and legislation, and dynamize of sector, institutional framework secto r. to reform the sector. Elaboration of draft of CONAM document 0 Law on Hydrocarbons submitted to the and PetroEcuador and Presidency and sent to discussion. the National Congress. 0 Poor management of Quantifying the repair Inventory carried out by Reduce environmental 0 environmental and of environmental the Sub-secretariat of liabilities. social impact. liabilities. Environmental Protection. Proposal to manage Consideration in Mitigate environmental impact formation water in the bidding tender. of operations. 0 eastern fields. Proper use of rich gases Procedures manual Eliminate contamination and in the oil fields of the published by the give added value to gas. Amazon. Ministry of Energy. z PETROLEUM POLICY 141 D. Economic Results The new government must try to resolve tax inefficiencies and distortions that block the entry of needed capital and technology. It must do this in order to capitalize on the advantages of this sector-such as proven reserves, the OCP, and the consulta- tion law. There will be a substantial increase in this sector's contribution to the national economy if the VAT problem is solved, the generalized gas subsidy is elim- inated, and a formal consensus is adopted that allows PetroEcuador to partner with private firms to operate the most important fields in the country. To evaluate the result of the proposed measures, a model was developed to cal- culate how much the sector will contribute to the national economy over the next five years. Two scenarios were considered. The first assumes that the required meas- ures are not taken, in particular the needed elimination of the LPG subsidy; that the VAT problem is not resolved; and that PetroEcuador continues to manage the largest petroleum reserves with its current limitations. The second scenario assumes that the subsidy is eliminated, the VAT problem is resolved, and a formula is estab- lished to permit the entry of private companies into the eastern oil fields. The details of this hypothesis and calculations are in annex 3. Based on conservative estimates of oil prices ($US22 for a barrel of crude based on the WTI) and production projections based solely on proven reserves, the solu- tion of short-term problems would raise production from 148 million barrels this year to nearly 280 million in 2007. Without counting the benefits from investments in terms of employment and regional development, the annual contribution of the sector to the Treasury would increase by 50 percent, from $US1.5 billion now to nearly $US2.4 billion in 2007. However, if the status quo is maintained and the solution to sectoral problems is delayed, the new government runs the risk of squan- dering the true potential of this important resource, and will continue to receive the same amount without any increase. According to Figure 3, in accumulated terms the sector's contribution over the next five years (2003 through 2007) could rise from $US7.9 billion to $US 10.1 bil- lion. In addition, if the conditions for oil prices remain high on the international mar- ket and the WTI average rises from 22 to 25 $US/bbl, the sector's contribution to the Treasury would still not increase significantly unless rules change in order to encourage private investment and the LPG subsidy is eliminated. In scenario 1, even with the highest prices there would only be a very insignificant average increase to the Treasury of $US 130 million. In scenario 2, however, despite a decrease in the price of crude on the inter- national market, there would be a very significant increase in the sector's contri- bution to the Treasury, with the greater increase in production both on the PetroEcuador fields and on fields operated by contractors, combined with the elimination of the subsidy. In 2002, the Treasury received approximately $US 1.6 billion, and this would rise to $US2.4 billion by 2007, coming from the cash 142 ECUADOR: AN ECONOMIC AND SOCLAL AGENDA IN THE NEW MILLENNIUM Figure 3. Petroleum Sector Support to the National Economy (projection through 2007) Millions of $US 2,500 - 2,000 - 1,500 - 1,000 - 500 0< 2002 2003 2004 2005 2006 2007 7- Scenario I-Accumulating 1 Scenario 2-Accumulating $US7.9 billion $US 10.1 billion flow produced by the private sector through greater production and annual bonds. IS As for benefits to petroleum revenues that can be attributed to the OCP, the first factor is state participation in the increase in production of companies that will be transported by the OCP, whose resources go to the FEIREP. Second, if SOTE freed up transport capacity, this would permit a production increase in the PetroEcuador fields mainly through new private investment. The FEIREP is mainly capitalized with state revenues from crude transported by the OCP, which is not done at the expense of SOTE." Seventy percent of the fund's value would go toward reducing external debt. There is no doubt that this fund has 10.Annual bonds come from private contributions for the establishment of mixed capital firms. 11.1n order to calculate FEIREP's revenues, we take the production surplus from private companies for 2003 (180,000 BPD) as a percentage of state participation (30 percent), and deduct transport costs and the ECORAE tax. PETROLEUM POLICY 143 a direct correlation with production levels. In scenario 2, where private investors participate more aggressively in the industry, 50 percent more is capitalized than in scenario 1. Given the high level of foreign debt (with a market value of over $US4 billion), the resources that the FEIREP can accumulate over the next five years- $US500 million in scenario 1 or $US1 billion in scenario 2-would still only mar- ginally meet the fund's original goal. This reality makes it all the more necessary to undertake broader sectoral reform providing incentives for private investment in the petroleum sector, beginning with the exploration and development of new reserves, as well as other activities. 144 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Annei l Historic Evolution and Description of the Sector Petroleum production in Ecuador began in 1925. In 1971 the first Law on Hydro- carbons was expedited, which created the state company CEPE, which was respon- sible for the management of all petroleum-related activities including storage, trans- port, refining, and commercialization of derivatives. CEPE also was responsible for exploration and production phases at the same time as Texaco, along with other small companies operating through contracts with the state. In 1989, PetroEcuador was created to replace CEPE, as well as its affiliates Petro- producci6n, Petroindustrial, and Petrocomercial, responsible for each stage of the industry. The goal was to create efficient enterprises, with financial, operational, and administrative autonomy, as well as their own contracting regulations for goods and services. With the exception of exploration and production activities that are also executed by private companies, PetroEcuador maintains a monopoly on the whole- sale industrialization and commercialization of petroleum derivatives. Since 1992, PetroEcuador's investments have been subject to the dispositions of the Ministry of Finance within the general state budget. The agencies that control the operational and environmental aspects of hydrocarbon activities are the National Directorate of Hydrocarbons and the Department of Environmental Protection, both responsible to MEM. Petroleum Reserves The proven reserves that can be recovered resulting from exploration in Ecuador are estimated at 7.7 billion barrels, of which 4.7 billion barrels remain to be extracted. These reserves are calculated in MEM's official statistics with an average recovery factor of 36 percent for PetroEcuador and 22.5 percent for private companies. The difference in recovery factors between Petroproducci6n and the companies, despite the fact that the deposits are in the same basin, is due solely to political management rather than technical management of these factors. The type of amortization of investments used in contracts is based on production units over total reserves. This is why there is an interest in reducing the reserves held by private companies in order to accelerate the recovery of investments, and thus make future negotiations of con- tracts and fields possible. As calculated in official statistics, most of the proven reserves belong to Petro- producci6n (74 percent). These are of a higher quality than the reserves in the hands of private companies, in terms of API gravity. The undeveloped Ishpingo and Pungarayacu fields are among Petroproducci6n's prospective fields. The Eden-Yuturi and Palo Azul projects are also within areas where private companies operate and should also be developed. In addition, there are still 16 other fields with reserves oscillating between 1 and 30 million barrels of PETROLEUM POLICY 145 Table Al. Reserves through December 31, 2001 (Blns/mlns of bbl) Petro- Produccidn Private companies Total Proven 6.133 bln 1.561 bln 7.695 bin Remaining 3.425 bln 74% 1.204 bln 26% 4.629 bin Oil fields in production 2.080 bln 775 mln 2.855 bln Fields not in production 1.345 bln 428.6 mln 1.773 bln Probably 259 min 77.34 mln 336.46 min Possible 92.58 mln 344 mln 436.6 mln Remaining reserves depending on gravity Less than 20° API 1.107 bln 760 mln 1.868 bln Greater than 200 API 2.318 bin 443 mln 2.761 bln Recovery factor 35.89% 22.50% Source: Figures for crude perroleum and gas reserves in the country through December 31, 2001, provided by the National Directorate of Hydrocarbons, Petroproducci6n, Administration of Oil Contracts. low gravity crude. Finally there are possible reserves in prospective explorations that are under 100 million bbl, most below 20° API gravity. The Amistad fields are the only ones with natural gas reserves, amounting to over 345 billion cubic feet. Greater amounts of gas continues to be produced in the Ama- zon, despite few initiatives for its utilization. Exploration and Production PetroEcuador Since 1990, PetroEcuador has been responsible for the operation of areas in the PetroEcuador-Texaco Consortium-mainly the Sasha, Shushufindi, Auca, and Cononaco fields. This is in addition to the fields discovered through exploratory activity, particularly the Libertador field. PetroEcuador also maintains the option of broadening exploratory activities to zones that are not under contract with private companies. In 1993, Petroproducci6n discovered heavy crude reserves in a series of ITT fields, in the central-eastern zone of the Amazon. During 2000 and 2001, additional drilling confirmed reserves of 1.4 billion barrels, 14° API, according to statistics still not updated in official data. These reserves will require investments of approxi- mately $US3.7 million for development. It is estimated that the ITT project could hit a production peak of 205,000 BPD. 146 ECUADOR: AN ECONOMIC AND SOcIAL AGENDA IN THE NEW MILLENNIUM Petroproducci6n's production has progressively decreased from a maximum of 120 million barrels in 1994 to a current level of 80 million barrels per year owing to the lack of transport capacity, the growing deterioration of its installations, and a lack of investment that would permit access to modern extraction methods. PetroE- cuador possesses a large quantity of remaining reserves in fields in production, where technical operations are not at an adequate level. The private sector share of national production is more than 60 million barrels. In other words, a national average of 400,000 barrels daily, or 56 percent of the total, can be attributed to PetroEcuador, and 44 percent to private companies. When we compare reserves to production, we find that private companies possess a quarter of the proven reserves and currently contribute nearly half of total production. Contracting with Private Companies The concession contract Texaco operated under and the partnership that City main- tained for the Tarapoa block were characterized by high income tax (87.31 percent), and by relatively complex fiscal clauses. These contracts are not currently being applied: the Texaco contract ended in 1991 and the City contract was renegotiated and modified to a participation contract. Between 1982 and 1988, under the "Service Provision modality," six rounds of bidding were carried out. These risk contracts were characterized by the reimburse- ment of investments and costs, and a service payment on each barrel of oil pro- duced. Currently there is only one service provision contract in effect, with the AGIP company for Block 10. In 1993, participation contracts were included in the Law on Hydrocarbons, with two bidding rounds administered by a high-level collegial body (Special Bid- ding Process Committee-CEL), which included the Armed Forces and the Gen- eral Accounting Office. These rounds permitted the signing of nine contracts in Table A2. Current Petroleum Production (BPD) Company August 2002 September 2002 A. Petroproducci6n 219,860 56.5 223,870 56.0 B. Private 169,154 43.5 176,217 44.0 Marginal fields 21,994 5.7 21,961 5.5 Shared fields 16,091 4.1 14,946 3.7 Participation 99,545 25.6 104,923 26.2 Services 30,219 7.8 33,023 8.3 Peninsula 1305 0.3 1,363.6 0.3 Total (A + B) 38,9014 100.0 400,087 100.0 Source: Petroproducci6n Reports, 2002. PETROLEUM POLICY 147 which state and private companies shared crude production in proportions of approximately 25 percent and 75 percent, respectively. The private company runs the risks, makes investments and pays costs. It should be pointed out that during the seventh round, the contract for the exploration and exploitation of gas in the gulf of Guayaquil, where reserves were discovered in 1982, was signed. In several of the blocks in the hands of private companies, important deposits have been discovered that were shared with the Petroproducci6n blocks. Long nego- tiation processes have been required to establish the economic conditions for the exploitation of these blocks, and these processes have been criticized. In 1993, the modality of Contracts for Marginal Fields was also incorporated into the Law on Hydrocarbons. This modality follows the participatory model, shar- ing the particularity that private companies can have access to the additional opera- tion and exploration of small fields (that is, fields that represent less than 1 percent of national production) with reserves that have been discovered. In 1999, five con- tracts were signed that are currently being executed. In 1998, the government decided to incorporate the Joint Ventures contract modality into the Law on Hydrocarbons, to permit partnerships between Petropro- ducci6n and private companies to operate in large fields-Sacha, Shushufindi, Lib- ertador, Auca, and Cononaco. Although this initiative of the former government was approved by the National Congress, its initial economic conditions were mod- ified. The decision was later declared partially unconstitutional, and the Joint Ven- tures modality became inapplicable. During recent years, there have been few initiatives to attract private investment for exploration and production; although it is worth noting the process of operational alliances used to develop two fields in medium-sized Petroproducci6n fields. These alliances consist of contracting a firm that provides a wide range of services and financ- ing, and the terms of payment for services depend on the increase in production. The most recent attempt to develop a new form of contracting to manage PetroEcuador's fields under production was by the Chilean enterprise ENAP This model adjudicated an exploration/production contract in three small fields not open to tender, based on the state company privilege that allows the state to sign specific service contracts directly. The government sent an urgent reform package to Con- gress to try to incorporate this new modality into the Law on Hydrocarbons. The reform project was rejected. Crude Oil Transport With the exception of the AGIP pipeline that ends in Baeza, PetroEcuador and the other companies use a series of secondary pipelines that flow to storage facilities at Lake Agrio to transport their production. From this point, the TransEcuadoran Pipeline System (SOTE), built by Texaco and turned over to PetroEcuador in 1989, begins. SOTE has a transport capacity of 390,000 barrels daily of oil that is 23.70 API grade, and includes storage facilities in Lake Agrio (with a capacity of 1.5 mil- 148 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEw MILLENNIUM lion barrels) and Port Balao Esmeraldas (with a capacity of 3.2 million barrels), plus the sea export terminal. Also, in agreement with ECOPETROL, PetroEcuador can transport a produc- tion volume of approximately 50,000 barrels daily to Port Tumaco via the Transandean Pipeline. The crude transported by this pipeline is grade 29 API, the level of quality required by the La Libertad refinery. Transport from Tumaco to La Libertad is done by ship. The Transandean Pipeline is frequently and inconveniently paralyzed because of attacks by the Colombian guerrillas. The private companies have a greater production capacity than their current out- put. However, this is a very heavy crude (below 200 API), which requires diluting to be transported through the SOTE. This situation, in addition to the fact that Petro- producci6n has significandy decreased its production of light crudes, is affecting the private companies. The issue of mixing heavy crudes with light crudes is viewed as negative for the country because of various factors such as the following: o A crude mix as a final product (eastern crude-23.80 API) has a price on the international market that is lower than the price obtained for light and heavy crudes sold separately. It is worth noting that the majority of private compa- nies produce heavy crude, which would imply a mix that is detrimental to the state. However, no formal studies have been done to prove this. o The majority of companies produce a heavy crude, and receive a lower qual- ity crude in Port Balao. In order to estimate how many barrels equal the com- pany's crude in barrels of eastern crude, the factor "k," a constant in petro- leum contracts, is applied. This factor has been questioned because it is believed that it benefits companies while hurting PetroEcuador. To date, no government decision has been made on how to proceed with renegotiation. O The Esmeraldas refinery receives crude that is 23-24' API, which is of lower quality than what should be processed (27-28' API). This situation leads to a smaller quantity of clean products being produced, and a greater quantity of residuals of lower commercial value. In order to resolve this problem of the crude mix, and mainly to end the limitation on transport capacity that has lasted nearly 10 years, in February 2001, the government authorized the construction of a heavy crude pipeline (OCP), granting permission to a consortium made up of the main private oil companies operating in the country. The OCP is designed to transport up to 518,000 barrels of oil daily with a grav- ity of 18 to 24' API. It mainly follows the SOTE route, and flows into a new sea terminal also at Port Balao Esmeraldas. Construction of the OCP should begin in June 2003 according to the contract; however, the work has been paralyzed because of the reaction of environmental groups and some local communities. It is hoped that operations will begin in September 2003. With the OCP, the available trans- port capacity of the country will reach over 960,000 barrels a day. PETROLEUM POLICY 149 Refining The current primary refining capacity is 175,000 BPD. This does not meet internal demand, meaning that gasoline, diesel, LPG, and high-octane naphtas are all imported. The Amazon and La Libertad refineries only have atmospheric distilling units. Even though the Esmeraldas refinery has a certain conversion capacity, production of resid- uals in the three refineries exceeds local demand and is exported at a low price. The LPG plant in the Shushufindi complex has a capacity of 500 tons per day. It is now producing at 40 percent of its capacity because of the insufficient capture of gas from the oil fields. Even though Ecuador needs LPG, much of the gas associated with the oil rich in LPG is burned in the fields, mainly those run by Petroproducci6n. In 2001, PetroEcuador set up a project so that private companies could invest in its three refineries, installing high conversion plants that allow the processing of atmospheric residuals and raise the level of production of light products (gasolines, diesel, and LPG). The project's bidding process has not been successful because of economic uncertainty. Distribution, Commercialization, and Prices The PetroEcuador crude that does not go to the refineries is sold by the Interna- tional Commerce Management of this company, mainly done through traders.'2 The offers solicited from the traders use the West Texas Intermediate (WTI) crude price as a base, with an adjustment for differential of quality that PetroEcuador establishes based on monthly studies. The differential has fluctuated across a range of $US3 to 8 per barrel. Petroindustrial's production of derivatives and the volume imported are distrib- uted to the internal market by Petrocomercial. The affiliate owns practically the entire pipeline network, as well as storage and distribution terminals. Petrocomercial pro- vides the products to buyers at the same sale price in all terminals, as fixed by the Pres- Table A3. Refining Capacity Refinery BPD Esmeraldas 110,000 Amazon -Shushufindi 20,000 La Libertad 45,000 Total 175,000 Source: PetroEcuador Statistics, 2001. 12.Traders are private firms dedicated to the sale of crude oil and petroleum derivatives. 150 ECUADOR: AN ECONOMIC AND SOCLAL AGENDA IN THE NEW MILLENNIUM ident of the Republic. The buyers are private companies with a network of distribu- tors that also must be approved by Petrocomercial. They must comply with size demands-for example, a minimal national network of gasoline stations. As regards sale price to the consumer, the current presidential decree establishes a maximum margin of 18 percent on top of the terminal sale price. In practice, nearly all distrib- utors sell at the terminal price plus 18 percent, and there is no price competition. In the case of LPG, over 60 percent of demand is covered by imports. LPG is stored in tankers and then transported to the Tres Bocas terminal near the city of Guayaquil, and from there to the El Salitral terminal for storage and later distribu- tion. Petrocomercial grants traders a global rate that includes transport in bulk, stor- age, packing, distribution, public sale, and replacement of cylinders and valves. The traders also have to be approved by Petrocomercial. The access of new competitors is limited by infrastructure and distribution network requirements, which include the capacity to sell at least 300 metric tons daily. Environmental and Social Regulation The development of petroleum industry activities involving environmental and social management is regulated by the Environmental Regulations on Hydrocarbon Opera- tions, the latest version of which was approved in February 2001. The main modifi- cation introduced was the raising of environmental standards to international levels, with special emphasis on the injection of formation waters, emissions monitoring, and ongoing environmental auditing. The Directorate of Environmental Protection of the Ministry of Energy is the entity that supervises compliance with this legislation. Since July 1999, a Law on Environmental Management has been in existence. Through the Ministry of the Environment, this law regulates the execution of indus- trial projects, mainly in protected areas, and requires that an environmental license be obtained. The legal framework establishes the rights of local communities, particularly indigenous peoples, to consultation and participation. The regulations that ensure the orderly application of this right have been concluded thanks to a tripartite effort by the government, the industry, and communities. To date, social issues included in the regulations have been managed by different companies through direct negotia- tions with communities. The previous lack of a specific regulation, in addition to basic needs that the government is ignoring and that are evident in the zones of influ- ence of petroleum activities, has forced firms to carry out public works and provide economic resources. This is the only way that they can develop activities without suf- fering costly setbacks because of community resistance to projects, resulting in delays. This is the case despite the fact that oil companies are already paying an ecode- velopment tax to benefit oil zones. This year that tax is $US0.35 on each barrel pro- duced, and it will reach $US0.50 on each barrel produced in eastern fields in 2005. The fruits of this financial support from companies is not evident in terms of any significant development. PETROLEUM POLICY 151 Management of Petroleum Revenues Annual petroleum sector revenues are over $US1.5 billion, with the main revenues coming from crude exports and sales to the internal derivatives market. The debits correspond to PetroEcuador's costs, and derivative imports. It is worth pointing out that this figure does not include taxes paid directly to the SRI by contractors. The petroleum sector's contribution to the state budget is significant, averaging 28 percent. The distriburion of petroleum revenues has become more complicated over the years, because of a series of preallocations that have been established by each revenues segment, whether they are exemptions, ex-consortium production, service contracts, tariffs on pipelines, or similar. The classification of oil revenues is broken down into 30 apparent revenue sources. Based on this analysis we can determine that these same sources could be reduced to eight real sources corresponding to con- tract type, type of Petroproducci6n activity, derivative exports, internal sales, and transport. The reason for this extensive classification is the multiple preallocations that have been legally established over the years. This classification continues to use revenue concepts that are out of synch with reality. The lack of transparency in resource management, which operates outside the framework of the state budget, is the most detrimental aspect. However, starting in 2003, the significant preallocation of oil revenues to the Armed Forces will be elim- inated, alleviating this somewhat. The Fund for Petroleum Stabilization was one of the efforts made to set up an economic contingency fund that accumulated resources when the price of crude went over $US20 a barrel. At the present time, resources from this fund are subject to a new preallocation. Finally, given the expectation that oil production will increase with the operation of the OCP, the FEIREP has been established to repur- chase public foreign debt at market value, and stabilize oil petroleum revenues ear- marked for education and health. Table A4. PetroEcuador's Economic Performance (blns/mlns $US) 1998 1999 2000 2001 2002(*) Revenues (**) 1.839 bl 1.866 bl 2.289 bl 2.294 bl 2.535bl Debits 926.7 ml 817.7 ml 829 ml 946 ml 1.052bl Net balance 912.9 ml 1.048 bl 1.460 bl 1.347 bl 1.483bl Percentage of national budget 22.7 29.8 35.4 27.4 25.0 *) Estimates. (v") The VAT from the domestic fuels market is not included in revenues. Source: Author's own calculations based on PetroEcuador's statistics. 152 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Table A5. Central Government Oil Revenues Headings 1 Revenues from service enterprises 18 Exports from marginal fields 2 Revenues from specific service 19 Company marketing; provision of enterprises services 3 Additional per barrel of exported 20 Export of petroleum derivatives crude 21 Internal sale of petroleum derivatives 4 Crude export royalties 22 Liberation of debt resources 5 - PetroEcuador 23 SOTE transport fee 6 - State participation Oil investment fund 7 - Marginal fields 24 - Pipeline export and transport 8 Ex-consortium PetroEcuador exports 25 - Domestic sale of derivatives 9 Northeastern PetroEcuador exports 26 Social and economic stabilization and Exports with state participation: development 10 -With city 27 Surpluses 11 - With YPF 28 Others not specified 12 - With Canada Grande 29 Law 24 (Corpei) 13 - With Keer McGee 30 Petroleum stabilization fund 14 - With Occidental 15 - With Vintage Oil 16 - With Perez Company 17 - With Lumbaqui Oil Source: State budget, 2002. Table A6. Oil Revenues Distribution Scheme : Source: Petroproducci6n Reports, 2002. Addit.3 Fxport Int. sale imports 0 Direct. deriva- SOTE 5 sucres deri- SOTE+ Decree n Participants export Royalties tives fee bbl exp. vative prod 337 1.Central Government XXX XXX XXX X)DC XXX XXX XXX 1.1. Direct collection X X X X X X X 1.2. Ministry of Health X 1.3. Ministry of Labor X 1.4. Law 02 X X X 1.5. Law 18 X X 1.6. 100% of 15% royalties X 1.7. 10% oil investments X X X X 1.8. Economic Stabilization, Agreement 107 X 1.9. Law on Agricultural and Livestock Roadway Administration X X 2. Descentralized Agencies XXX XXX XXX XXX 2.1. ISSFA (LAW 169) X 2.2. FAE X 2.3. Defense Council UDN) XX XX a. JDN 8% exports X b. JDN others X X 2.4. ECORAE (Law 20) X 2.5. State university participation X 2.6. Private univ. X 3. State Enterprises XXX XXX XXX XXX XXX 1. PetroEcuador XXX XXX XXX XXX XXX Total PetroEcuador costs: XX XX XX XX XX a. Restitution costs X X X X X (Table continues on the following page.) Table A6. (continued) Addit. Export Int. sale imports Direct. deriva- SOTE S sucres deri- SOTE+ Decree Participants export Royalties tives fee bbL exp. vative prod. 337 b. Costs of services x c. Costs of participation-specific services. X d. 10% Petroleum invest. 2. FERUM (Solidarity Fund) X o 4. Sectional Bodies XXX XXX XXX XXX > 1. FODESEC X Z 2. Provincial councils X 0 3. Esmeraldas development X X Napo Esmeraldas and Sucumbfos Particip. X X : 4. Law 40 5. Finance Sector 1. State bank X 2. BEV X 9 3. Central Bank X 4. IECE X 6. Petroleum Stabilization Fund X X X Source: State budget, 2002. z I PETROLEUM POLICY 155 Annex 2 Updated Study on Taxes and Subsidies for Derivatives Table A7. Prices FOB US-GULF According to $US/bbl $US/gaL original study Super gasoline 31.995 76.18 69.19 Extra gasoline 29.353 69.89 64.19 Diesel 29.654 70.60 65.79 LPG 20.987 51.09 51.09 70% propane 19.736 30% butane 23.905 Fuel oil (2% S) 21.27 50.64 29.51 Residuals (exp.) 19.135 WTrI 27.515 Eastern crude 21.735 Source: PetroEcuador International Commerce, based on Platts, November 2002. Table A8. Calculation of Parity Prices for Derivatives ($US/gal.) Price Price FOB Financial of export Freight Insurance CIF Leakage cost Storage parity Super gasoline 76.2 3.12 0.069 79.37 0.346 0.69 0.76 81.16 Extra gasoline 69.9 3.12 0.064 73.07 0.321 0.64 0.76 74.79 Diesel 70.6 3.59 0.066 74.26 0.263 0.66 0.76 75.94 LPG 51.1 20.00 0.051 71.14 0.409 0.51 1.15 73.21 Fuel oil 50.6 50.64 50.64 Source: Freight, insurance, leakage, and financial costs taken from international standards, according to previous World Bank studies. 156 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Table A9. Calculation of Efficiency Prices in Terminal ($US/gal.) Transport services Price terminal Parity price and average storage (*) without taxes Super gasoline 81.16 3.08 84.25 Extra gasoline 74.79 3.51 78.30 Diesel 75.94 2.76 78.70 LPG 73.21 3.13 76.34 Fuel oil 50.64 1.63 52.27 (*) According to a study on tariffs on services prepared by Booner and Moore for CONAM. Note: Petrocomercial's present costs are not considered because it is a monopoly. Source: World Bank calculations. Table Al0. Tax Collection Calculation of Taxes or Current Subsidies ($US/gal.) Effliciency terminal Present price Tax Annual Value $US terminal without Present (hidden) conssump. taxes price VAT P VAT subsidy thous. gals. (stbsidies) Super gasoline 120.00 84.25 35.75 12.86 22.89 63000 14,423,400 Extra gasoline 95.00 78.30 16.70 10.18 6.52 477540 31,151,526 Diesel 76.00 78.70 -2.70 8.14 -10.85 726180 (78,773,240) LPG 7.51 76.34 -68.83 0.80 -69.63 352825.58 (245,682,026) Fuel oil 52.00 52.27 -0.27 5.57 -5.84 436955.53 (25,536,929) Total (304,417,269) Source: World Bank calculations. PETROLEUM POLICY 157 Table All. Public Efficiency Prices Calculation of Terminal Prices Eliminating Subsidies Applying VAT and Suggested Consumption Tax ($US/gal.) Efficiency terminal price Suggested Suggested Average Suggested without consumption terminal profit public sale VAT VAT tax price margin prie Super gasoline 84.25 10.11 25.00 119.36 18% 140.84 Extra gasoline 78.30 9.40 7.00 94.69 18% 111.74 Diesel 78.70 9.44 0.00 88.15 10% 96.96 LPG 76.34 9.16 0.00 85.50 14% 97.47 Fuel oil 52.27 6.27 0.00 58.55 5% 61.47 Source: World Bank calculations. Table A12. Comparison of Consumer Price Changes ($US/gal.) Suggested Current public public Variation sate price sake price Net Percentage Super gasoline 140.84 141.60 -0.76 -0.53% Extra gasoline 111.74 112.10 -0.36 -0.32% Diesel 96.96 83.60 13.36 15.99% LPG 97.47 21.80 75.67 347.11% Fuel oil 61.47 54.60 6.87 12.59% LPG 15 kg cylinder 7.15 1.60 5.55 Source: World Bank calculations. 158 ECUADOR: AN ECONOMIC AND SocIAL AGENDA IN THE NEW MILLENNIUM Annez 3 Econolmic Performance General Terms In order to evaluate the possible impact of recommendations, we present two sce- narios of the possible evolution of the petroleum sector between 2003 and 2007. These scenarios are based on the following hypotheses and projected values: o The price of crude is based on West Texas Intermediate (WTI), assuming that it will go down from the high values of the last three years, averaging $US22/barrel between 2003 and 2007. o Eastern crude, the mix currently transported by SOTE (23.90 API) is esti- mated at $US18 per barrel, with a differential of $US4 per barrel of WTI. o Light crude is defined as the new petroleum to be transported by SOTE, with a gravity around 28 0 API, and an estimated price of $US22 per barrel. o Heavy crude will be transported by the OCP and has been estimated at $US 15 per barrel, with a differential of at least $US8 per barrel, in relation to WTI. o Import prices of derivatives will fluctuate with crude prices. 0 There will be 4.5 percent annual growth in domestic demand for derivatives. o The OCP's tariff for PetroEcuador will be $US 1.50 per barrel. 0 There will be no changes in refining capacity. o The OCP will begin its operation at the end of 2003. Impact can be meas- ured only at the start of 2004. o The projection of production is based on proven reserves. Neither production at ITT fields (development will take at least an estimated seven years), nor production from new reserves (recent exploration) has been included. Scenarios Scenario 1 a Oil companies will not increase their investments because the VAT problem has not been resolved. 0 Petroproducci6n will continue efforts to increase production under the cur- rent framework, and with exclusive state investment similar to current levels. o The LPG subsidy will be maintained. Scenario 2 O In the short term, the government will resolve the VAT problem, and with congressional approval, clarify tax treatment of oil companies in the short and PETROLEUM POLICY 159 long term. This will directly affect investment levels of private companies, increasing production. * Petroproducci6n will enter into partnership with private companies through the legal disposition of joint venture enterprises, and receive new technology and investment for its productive fields. * The LPG subsidy will be eliminated, compensating the poorest with a gas cash payment equivalent to the difference between the efficiency price and the current subsidized price. Petroleum Production and Export Performance If Petroproducci6n continues to produce under current conditions, there will be small increases that will help to avoid a natural decline of the fields currently in oper- ation by 2007, and maintain current production levels. On the other hand, with the opening to the private sector, production levels could increase by over 50 percent with the incorporation of new technology-a recovery mainly attributable to reser- voirs and an investment volume estimated at $US1 billion. Private companies could increase their current production 1.3 times by 2007, if legal stability can be guaranteed for the investments that they would need to make. If this stability is not ensured, the rhythm of growth will be much slower, or 64 per- cent, which in daily production barrels amounts to 295,000. It is worth noting that by 2007, the OCP would only be operating at 60 percent of its capacity. In terms of national production, the difference between these two scenarios by the year 2007 is an average of 245,000 BPD. Current daily production of 400,000 BPD would increase from 522,000 BPD in the first scenario to 767,000 BPD in the second scenario. Table A13. Estimated Production of Private Companies (BPD) 2004 (with OCP) 2007 Companies 2002 Scenario I Scenario 2 Scenario I Scenario 2 Agip 35,000 40,000 40,000 40,000 40,000 Repsol 30,000 50,000 60,000 60,000 75,000 Encana 40,000 50,000 60,000 60,000 80,000 Oxy 30,000 45,000 60,000 65,000 100,000 Vinitage 5,000 5,000 7,000 7,000 10,000 Perenco 15,000 15,000 18,000 18,000 28,000 Perez Company 3,000 13,000 18,000 18,000 58,000 Others 22,000 22,000 27,000 27,000 29,000 Total 180,000 240,000 290,000 295,000 420,000 Source: Author's estimates based on current production and reserves. 160 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNTUM Table A14. Production Scenarios (Thds of bbl) 2002 2003 2004 2005 2006 2007 National Total Scenario 1 147,928 149,650 173,375 178,850 182,500 190,530 Scenario 2 147,928 149,650 191,625 226,300 253,675 279,955 Petroproducci6n Scenario 1 82,228 83,950 85,775 85,775 83,950 82,855 Scenario 2 (*) 82,228 83,950 85,775 93,075 105,850 126,655 Private Companies Scenario 1 65,700 65,700 87,600 93,075 98,550 107,675 Scenario 2 65,700 65,700 105,850 133,225 147,825 153,300 (*) As of 2005, this will include 100 percent of the production generated throuLgh the transformation into joint venture companies. Source: World Bank calculations. Export Balance The total production by Petroproducci6n and state participation in the crude pro- duced and refined by companies will generate an export balance that will increase starting in 2004, when the OCP begins operating. By 2007, in the case of scenario 1, there should be an increase of 13 million barrels. In scenario 2, the export of state petroleum decreases, starting in 2005, because the model foresees the transformation of Petroproducci6n into joint venture com- panies, which would provide resources directly through a cash payment system. The bidding processes should take into account Petroindustrial's priority need to pur- chase the crude it requires for refineries at international prices, if it so desires. Table A15. State Crude Exports (Thds of bbl) 2002 2003 2004 2005 2006 2007 National Total Scenario 1 44,938 46,660 55,055 56,698 56,515 58,158 Scenario 2 44,938 46,660 60,530 10,890 19,103 26,860 Petroproducci6n Scenario 1 82,228 83,950 85,775 85,775 83,950 82,855 Scenario 2 (*) 82,228 83,950 85,775 27,923 31,755 37,997 Private Company Support Scenario 1 19,710 19,710 26,280 27,923 29,565 32,303 Scenario 2 19,710 19,710 31,755 39,968 44,348 45,863 (-) Crude Refining -57,000 -57,000 -57,000 -57,000 -57,000 -57,000 (') Starting in 2005, we have considered 30 percent of their production, since rhey would be joint venture companies compensated with cash payments. Source: World Bank calculations. PETROLEUM POLICY 161 Petroleum Revenue Results The following table presents performance in terms of contributions to the Treasury, including VAT received on the sale of derivatives. It excludes both income tax and VAT paid by oil contractors, as we have no information on this sector. Table A16. Petroleum Sector Support for the Treasury (blns/mtns $US) 2002 2003 2004 2005 2006 2007 Total Total Scenario 1 1,637 1,532 1,580 1,598 1,588 1,610 9,544 Scenario 2 1,637 1,638 1,807 2,053 2,215 2,385 11,733 Refining and Sale of Derivatives (t) Scenario 1 -275 -273 -286 -280 -262 -243 -1,620 Scenario 2 -275 -23 -28 -15 11 39 -292 Crude Production Scenario 1 1,912 1,805 1,866 1,878 1,850 1,852 11,164 Scenario 2 1,912 1,661 1,835 2,068 2,203 2,346 12,025 Gas Payment 0 -145 -145 -145 -145 -145 -723 (') Includes VAT from the domestic derivatives market, at the terminal level. Source: World Bank calculations. In scenario 1, contributions to the Treasury are stable because the increase in PetroEcuador's revenues resulting from the rise in production and participation is lost (a) through the drop in crude prices on the international market, and (b) because of the increase in imports to meet growing internal consumption through subsidized prices. This is why contributions would fall from $US 1.6 billion in 2002 to $US1.5 billion in 2003, and remain below $US1.6 billion until 2007. If petroleum prices remain high on the international market and the WTI aver- age is revalued to around 22 to 25 $US/bbl, sector support for the Treasury would not grow significantly in this scenario, since during the period 2003-07, there would only be an average increase of $US130 million annually. Table A17. Price Sensitivity of Treasury Support (blns $US) 2002 2003 2004 2005 2006 2007 Total Scenario 1 (WTI = $ 22) 1.637 1.532 1.580 1.598 1.588 1.610 9.544 Scenario I (WTI = $ 25) 1.637 1.671 1.712 1.727 1.711 1.731 10.189 Source: World Bank calculations. 162 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM This scenario is different from scenario 2. Despite the drop in crude prices on the international market, the large increase in production (both on PetroEcuador's fields and fields operated by contractors), coupled with the elimination of the subsidy, will generate a significant increase in tax contributions over the next five years. The Trea- sury received approximately $US 1.6 billion in 2002. In 2007, it would receive the equivalent of $US2.3 billion, which would come from the cash flow produced by private companies through greater production and annual cash payments.13 Fund to Reduce Public Foreign Debt One example of the benefits of oil revenues attributable to the OCP is state partic- ipation in the increase of production by companies that will transport their oil through the OCP. These resources will be allocated to FEIREP, as summarized below. Also, the liberation of transport capacity by SOTE will allow production increases in PetroEcuador's fields mainly through new private investment. FEIREP is capitalized primarily through all state revenues coming from crude oil transported by the OCP, which do not result from reduced use of SOTE.'4 Seventy percent of the fund's value will be allocated to reducing foreign debt. There is no doubt that there is a direct correlation between this fund and production levels. As shown in Table Al 8, in scenario 1 less than 50 percent of the amount in scenario 2 is capital- ized. In scenario 2, private investment participates much more aggressively in the oil industry. The surplus obtained for FEIREP in scenario I corresponds to 5 percent of fiscal contributions from the petroleum sector, and is 10 percent in scenario 2. Table A18. Capitalization of FEIREP 2002 2003 2004 2005 2006 2007 Total Thousands of barrels Scenario 1 - - 6,570 8,213 9,855 12,593 37,230 Scenario 2 - - 12,045 20,258 24,638 26,280 83,220 Millions $US Scenario 1 0 0 85.7 106,8 128.1 163.7 484.3 Scenario 2 0 0 157.2 263.3 320.3 341.6 1,082.4 Source: World Bank calcuations. Given the high level of foreign debt (with a market value of over $US4 billion), with the resources that the FEIREP can accumulate over the next five years ($US500 million in scenario 1 or $US1 billion in scenario 2), the fund would still only mar- ginally meet its original goal. This reality highlights the need to adopt a much more aggressive private investment policy in the petroleum sector. 13.Annual cash payments come from private support to establish joint venture companies. 14. In order to calculate FEIREP revenues, we took the surplus of production from private companies for the year 2003, (180,000 BPD), as a percentage of state participation (30 percent), and deducted transport costs and the ECORAE tax. 6 Trade Policy and Competition' Dominique Hachette Ecuadorspotentialforfuturegrowth lies in its nontraditional exports as the countryfaces the prospect of exhausting its oil reserves in the 2020s. To boost nontraditional exports, the existing bias against exports must be significantly reduced. This bias originates in the competition for scarce resources where excessively protected subsectors are favored over imports in the agricultural, mining, and manufacturingsectors, and in the measures that directly affect Ecuadoran exports both within the country and in the countries to which products are exported. The protective blanket is disguised as tariff and nontariff barriers. The former include tariff of all kinds (one of which is the price band); among the lat- ter are regulations on origin, prohibitions, restrictions and licenses, safeguard measures, antidumping and compensatory measures, technical regulations, and policies contrary to competition. To eliminate the bias against exports it is necessary to reduce both the level and the dispersion of tariff barriers that exist today; carefully review ties with the Andean Community of Nations to determine to what extent membership in this club does not benefit the country in net terms; revise and continue to reduce agriculturalprice bands, licenses, and any other nontariff barrier that imposes eliminable direct or indirect costs on the production of exportable goods; and give 'domestic treatment" to imports andfor- eign investment, which implies a profound review of the current application of technical regulations to guarantee a competitive framework for all productive activities in the country. 1. Dominique Hachette is a professor at the Pontificia Universidad Cat6lica de Chile and World Bank consultant. The author would like to thank Fernando Suarez of the Ministry of Economy and Finance for his very valuable aid and Jose R. L6pez-Calix and McDon- ald Benjamin of the World Bank for their valuable comments and suggestions. 163 164 ECUADOR: AN ECONOMIC AND SOcIAL AGENDA IN THE NEW MILLENNIUM A. lPrecedents Liberalization of the Ecuadoran Economy in the 1990s Ecuador is increasingly participating in world trade. Exports and imports, as a per- centage of GDP, increased from 53 percent in 1991 to 59 percent in 2001. Exports have diversified (Figure 1): the proportion of nontraditional products has increased, but the country continues to be highly dependent on oil (41 percent). Agricultural and agroindustrial exports represent 60 percent of non-oil exports. Imports of consumer goods have increased more than others, which is a clear sign of greater economic open- ing (see Figure 1). Markets for Ecuadoran exports have diversified to some extent, though the U.S. market continues to dominate. The Latin American Integration Asso- ciation (ALADI) has overtaken the United States as the most important origin of imports but there have not been dramatic changes in the destination of exports. The most significant change in the destinations and origins of trade flows may well be the greater presence of the Andean Community of Nations (CAN), which has become Ecuador's second most important trade partner. Specifically, Peru has become an important market for Ecuadoran exports and Colombia has become a major source of imports. Membership of these countries in the CAN has had devi- ating (negative) effects in Ecuador, but also positive ones in terms of generating trade, as well as acting as a significant force for the creation of markets. Customs tariffs-which in turn are a variant of the Common External Tariff (CET) of the CAN-have stabilized at a range of nominal rates: 0, 3, 5, 10, 15, 20, and 35 percent. This scaling has been justified as an "incentive for added value,"2 as it concentrates production input at low tariff rates and final consumer goods at high rates. This latter tariff is now being reviewed. What is covered by each rate is con- stantly changed by the impact of a great number of agreements and commitments in which Ecuador is involved. This is also the case of its CAN partners. The "effec- tive tariff," as measured by fiscal income as a percentage of imported value, dropped from 10.6 percent in 1998 to 6.5 percent in 2001 (Figure 2). The 10.6 percent rate recorded for 1998 is atypically high, likely owing to the combination of the VAT and the Safeguard Clause (tariffs) established and eliminated the following year and possibly thanks to greater efficiency at customs (controlled at that time by the mil- itary). However, potential tax collection is above 6.5 percent and is likely closer to 9 percent since the weighted tariff for imports has been closer to this figure. However, as transactions within the CAN and with Chile have increased, this percentage today overvalues the fiscal ceiling for customs. The simple average of the nominal rates of the other CAN countries is homoge- neous, but the effective rates are not, ranging in the year 2000 from 7.5 percent in 2. It is interesting to note that in Ecuadoran practice, tariff levels are inversely proportional to the added value being protected. Figure 1. Ecuador Trade Composition H 0 Exports by groups of products Exports by groups of products 1991 2001 Nontraditional Z 8% Petroleum 0 Petroleum Nontraditional 41% 40% 30% m - L. ~~~~~~~~~~~~~~~~~~~~~0 Traditional 52% . Traditional 29% Imports by main headings Imports by main headings 1992 Consumer 2001 Consumer g products products 16 26% 38C%pt Fuel Fuel 38% 4% Capital 6% 31% Raw materials 42% Rwmaterials 37% Source: Central Bank of Ecuador. ON 166 EcUADOR: AN ECONOMIC AND SocLAL AGENDA IN THE NEW MILLENNIUM lf~ C) C1 0~~~~~~~~~~0 cc, C.' C.' 0 o~~~~~~~or TRADE POLICY AND COMPETITION 167 Colombia to 11.3 percent in Peru and 11.5 percent in Venezuela. Bolivia, with only two tariff rates (5 and 10 percent), collected an average 5.4 percent, similar to Ecuador, which has tariffs from 0 to 35 percent. In 1994, through Decision 370 of the Cartagena Agreement, Ecuador adopted the CET, which establishes four levels-5, 10, 15, and 20 percent-and covers all tariff needs. And in 1995, the country formalized its membership in the World Trade Organization (WTO). Tariff ceilings were then established and in order to establish them in the WTO, the formula CET + 10 percentage points was used, except for automobiles, chemical products, and certain agricultural and agroindus- trial products. Ecuador also acquired commitments in five main areas, most of which have now been met. However, the sensitivity of the agricultural sector led to the adoption of a mechanism for variable tariffs known as the Andean Price Band System (see section C of this chapter), which sets tariffs that fluctuate between 35 and 95 percent, depending on the product. This system is applied to 148 tariff sub- headings. The commitments acquired by Ecuador with the WTO regarding tariff contin- gencies were met before 2001. The country benefits from tariff concessions in the framework of the General System of Preferences (GSP) and the Global System of Preferences among developing countries, the objective of which is to favor processes of industrialization and accelerated growth. Although the CET approved by three countries in the subregion (Colombia, Ecuador, and Venezuela) sets out essentially to standardize national tariff rates in order to consolidate a tariff union, in practice each country has presented a set of "differentiations" that effectively obliterate the content of Decision 370. For exam- ple, Ecuador applies differentiating factors3 to 1,414 tariff subheadings under the "Not Produced" heading, to which tariffs between 0 and 15 percent are applied. This tariff is being reviewed and the CAN wants both Bolivia and Peru to partici- pate in the definition and implementation of the new CET to strengthen the inte- gration of Andean nations. Exports have grown slowly (an annual average of 4.1 percent for 1990-2001), reaching their peak to date in 1997, at $US 5.3 billion, then falling owing to fluc- tuations in the price of oil, problems with banana marketing, and sanitary problems with shrimp prodiuction. Imports grew at an annual average of 3.4 percent in the same period and hit a record of $US 5.6 billion in 1998, before falling sharply to $US 3.0 billion in 1999 as a result of the economic crisis that struck the country (and the subsequent freezing of bank deposits), which was eliminated in 2000. Since then, there has been strong growth in imports-which, nonetheless, cannot be con- sidered a new medium-term trend, but for now simply a recovery of previous levels. The trends noted above have led to an increasingly negative balance of trade that naturally worries many Ecuadoran economic actors. Dollarization is considered by 3. Differences with respect to the CET agreed to between CAN and the rest of the world. 168 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM many to be the main culprit behind this trend. However, other important consider- ations cannot be ignored: fluctuations in the price of oil, problems in the banana market, recovery from the crisis of 1999 (which provides more incentives to imports than to exports), foreign remittances, the unfreezing of bank deposits in 2000, and statistical problems with the measurement of exports. These reasons do not imply that the negative trend (since 2000) in the real exchange rate (RER) has not played its part in the growing trade imbalance (elasticity in prices or real exchange rates for exports stands at 20, while at only 8.6 for imports).4 Also, the long-term contracts that are typical of the oil market protect these exports from short-term fluctuations in the RER. B. The Foun6dations of lEcuadoiran lQDeveRopment Given the poverty and poor distribution of income, Ecuador must increase its eco- nomic activity (measured by GDP). Given the small size of its domestic markets and the limited technological capac- ity of its human and nonhuman capital, the country cannot depend only on indus- trial development to accelerate economic growth. The country needs sectors that have potential for growth and that, on one hand, offer comparative advantages, and on the other, a large external market. Ecuador has underutilized resources that can be used for export. These are to be found in overprotected and inefficient sectors (mostly in the manufacturing sector), in sectors with no comparative advantages (the automotive sector among others), in sectors that use resources inefficiently and manage them badly (public enterprises well known for their inefficiency), in poorly regulated or insufficiently controlled sectors (telecommunications), and even in corruption, which uses resources that cre- ate no added value productive employment. However, to depend to a greater extent on exports, Ecuador must, as its first pri- ority, eliminate or at least significantly reduce the existing bias against exports. This bias is generated by all the discriminatory support received by other pro- ductive sectors through trade policy that supports sectors that substitute imports through tariffs, as well as through nontariff barriers (NTBs) that are discriminatory in their purpose or in their application, such as prohibitions, technical regulations, customs procedures, customs valuations, rules on origin, safeguard measures, public purchases, and so on-all of which provide "support" or an implicit subsidy to cer- tain sectors or products to the detriment of the potential and existing exporting sec- tor. This is encapsulated in the concept of the effective protection rate (EPR), which differs from the nominal protection rate because input, raw materials, and capital 4. The price effect is stronger than the volume effect. TRADE POLICY AND COMPETITION 169 assets benefit from a lower tariff than that established for the final product. If the tariff on input to be used by the producer to manufacture the final product were the same as that paid for the final product when imported, the effective protection rate would coincide with the nominal tariff rate-which would indicate, in this case, the "real" degree of support for the production of the final product. If the Ecuadoran tariff system had a single tariff for all tariff subheadings, the effective protection rate would be the same for all domestic products, "final" or otherwise, and the EPR would be the same for producers of importable goods. One important exception would remain: exportable products that cannot be pro- tected domestically because of WTO restrictions and which would have to pay the single existing tariff on the use of their input. This would result in a negative EPR, while for other sectors it woLdd be positive or equivalent to the nominal tariff. Dis- crimination against exports would therefore continue. The bias against exports would diminish, but would not disappear. Even the application of a "drawback" or simple payment (like the one recently created) would not entirely eliminate the bias against exports because positive support would remain reflected in the tariff, while the exportable product would receive zero support at best. In order to entirely eliminate discriminatory treatment and bias against exports, the single tariff rate must be zero. Any barrier that favors one sector disfavors the other sectors. It is therefore ideal to have as neutral a trade policy as possible. Given the above, some short- and medium-term trade policy recommendations for Ecuador in the general context of reducing the bias against exports follow. The most immediate goals are (i) greater efficiency in the allocation of resources, (ii) greater stimulation of non-oil exports, (iii) reduction of incentives to evade taxes and deal in contraband, (iv) greater simplification in order to eradicate corruption, and (v) greater transparency. Recommendations The main goal of tariff policy must be to reduce simultaneously the number and dis- persion of tariffs in the coming years. The CAN countries are now renegotiating the CET and have considered maintaining 0, 5, 10, and 20 percent, transferring many input items and intermediary goods and capital (to which rates of 15 or 20 percent are now applied) to rates 0 or 5 percent. Although this reduction in dispersion is a step in the right direction, the change in the composition of coverage of tariff sub- headings is a step toward increasing the average number of low-earning headings in terms of dispersion of the Effective Protection system, which is undesirable from the perspective of reducing the bias against exports. The CAN countries have negotiated 62 percent of tariffs, which covers only 33.4 percent of the combined gross national product. Therefore, the most important third of tariff subheadings is yet to be nego- tiated, since this affects two-thirds of national production. This is a good time to take a step in this direction. Furthermore, doing so would be a step toward the American Free Trade Agreement (AFTA), which today remains on the distant hori- 170 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM zon, owing to Ecuador's failure to comply with several market access regulations (price bands, licenses, and so on). Ecuador must also keep in mind that both Bolivia and Peru have maintained three and four tariff rates, respectively (10, 5, and 0 percent in the case of Bolivia and 4, 7, 12, and 20 percent in the case of Peru) and have not shown enthusiasm for the CET options discussed in the CAN. We propose 5 and 10 percent5 or some other option that is close to these figures. The proposal is coherent with the considerations discussed above but is not very attractive from the fiscal perspective, unless it is accompanied by serious efforts to reduce contraband and increase the efficiency of customs management (appendix 1). To the extent that these efforts are successful and the 0 percent rate is eliminated, the fiscal impact of this proposal will be neutral. It would not be fiscally neutral if the 0 percent rate were maintained. Although this is not the solution preferred by the Andean Community, Ecuador, together with Bolivia and Peru, has the weight to move the CET in the right direction. Also, Ecuador could take unilateral action in this area, making use of its status as a "less developed economy" within the Com- munity and fall back on the "differentiations" allowed by Decision 370, which establishes the conditions by which each country establishes differences in the CET structure of the CAN. Bolivia did this and has a lower and less disperse tariff system than the existing Ecuadoran system. Ecuador should make important adjustments to the price bands that have given the nonexporting agricultural sector significant protection (though less than that received by the manufacturing sector-about 10 percent, but very disperse) and have therefore made their contribution to the bias against exports. This issue of price bands will be dealt with in section C. It will be useful, as long as a bias against exports remains, to continue strength- ening special customs regimes such as temporary admission, industrial deposits, temporary exportation, commercial deposit, transit, and stock replenishment. The drawback system received more support in 2002, when an automatic returns system was created for up to 5 percent of gross exported value. Also, the drawback system is increasingly out of favor with the WTO and the most recent free trade agreements (FTAs) in Latin America. It has the inconvenience of being seen by some countries as an export subsidy and therefore must be used cautiously. Ecuador should elimi- nate or simplify prior authorizations, licenses, and permits for importation. The country should carefully adjust tariff and nontariff barriers in order to elim- inate their protectionist impact. A few of these still exist in Ecuador. Minimum prices exist in the context of price bands for agricultural products (see the following section). There are also bans on the importation of used automobiles and textiles. There is national legislation on compensatory safeguard measures (as part of the Law on Foreign Trade of 1997), on import licenses, and on technical regulations. 5. See Hachette (2000). TRADE POLICY AND COMPETITON 171 Ecuador should reduce the protectionist bias of licenses and of the institutions that issue them. Although automatic licenses have been abolished, some imports require prior authorization either by the Ministry of Trade, Industry and Integra- tion; the Ministry of Agriculture; or the Consejo de Comercio Exterior e Inversiones (COMEXI)-and these bodies have sometimes refused to issue this authorization for the importation of rice, corn, other meats, dairy products, frozen fowl, turkey, and to a lesser extent, apples and fresh fruit. These institutions can (and do) prohibit or permit the importation of some of the sensitive products mentioned above (for example, sugar), under the contingencies system, charging the applicable VAT. Via contingencies, Ecuador allows limited entry of 17 agricultural products such as sorghum, wheat, corn, parts of fowl, turkey, powdered milk, and soy flour.6 Although this technique is attractively billed as "guaranteeing or stabilizing national consumption," it is protectionism in practice; therefore it should disappear entirely and be used only in circumstances duly justified before the COMEXI. Safe- guards have also been imposed on the importation of industrial products such as matches, steel, and tires. To make matters worse, importers of agricultural products must obtain two per- mits to import agricultural products: one from the Ministry of Agriculture and the other from the Ecuadoran Animal and Plant Inspection Service (SESA), which car- ries out zoo-phyto-sanitary control. Despite the usefulness of this, on the whole it has been used in such a way that it is often considered protectionist. SESA has also banned the importation of agricultural and meat products that use modern biotech- nology. The purpose of this ban is unclear and appears to be an example of SESA's support of a protectionist policy in favor of Ecuadoran agriculture. Pre-embarkation inspections, though necessary, result in longer delays than those caused by customs inspections. Spot checks are also carried out. These actions cause delays of six to eight weeks while merchandise is being held, which raises the cost of input for all productive sectors and reduces the competitiveness of exports, since it is equivalent to an additional tax on exports and imports, with predictable protec- tionist results. The commitments acquired by Ecuador when it gained entry into the World Trade Organization require eliminating the existing bans on the importation of cer- tain used articles (automobiles, tires, clothing). Although Congress is studying a draft law to eliminate the ban on importing used automobiles, this law has not yet been passed. The environmental concerns relating to this are well founded. How- ever, the most efficient way of facing them is to require that used cars meet certain standards in order to enter the country (for example, as done by the Californian Environmental Protection Agency), rather than banning their importation. 6. For 2001, a contingency was established for hard corn and another for sorghum, very sim- ilar to the previous year. 172 EcUADOR: AN ECONOMIC AND SocIAL AGENDA IN THE NEW MILLENNIUM These licenses represent a serious barrier to the transparency necessary in the rules of play; they have led to Ecuador's receiving a poor grade in the Economic Freedom index in recent years and delayed the country's preparations to enter ALGA. Ecuador has intensely and increasingly used this nontariff mechanism to manage its international trade. In September 2001, imports made under 1,424 tar- iff headings required prior authorization; this represented 21 percent of all tariff headings and were concentrated in the health and agriculture sectors. The Ministry of Health has exclusive control over authorizations for 614 tariff headings (43.1 per- cent of all headings requiring licenses), and the Ministry of Agriculture and Live- stock handles 473 headings (33.2 percent of the total). This means that the two institutions are exclusively responsible for 76.3 percent of prior authorizations estab- lished in Ecuador (Table 1). In total, they affect about 9-10 percent of Ecuador's total trade (see Figure 3). There are no exportation licenses. Between 1991 and 2000 there were no imports of goods under the 919 remain- ing tariff headings requiring authorization. Since this was not due to any de facto ban, these headings can be eliminated as unnecessary. Table 1. Licenses Issued by Institutions Present % Institutions situation 96 AccumuLated Ministry of Public Health 614 43.1% 43.1% Ministry of Agriculture and Livestock 473 33.2% 76.3% National Council for the Control of Substances (CONSEP) 78 5.5% 81.8% Ministry of Agriculture and Health 69 4.8% 86.7% Armed Forces Joint Command 39 2.7% 89.4% General Office of the Merchant Marine 32 2.2% 91.6% Automotive Development Act 21 1.5% 93.1% Ministry of Health and CONSEP 20 1.4% 94.5% Atomic Energy Commission 16 1.1% 95.6% Ministry of Health and COMEXI 15 1.1% 96.7% Ministry of Public Works 14 1.0% 97.7% Civil Aviation Office 11 0.8% 98.5% Small Indusrries Development Act 6 0.4% 98.9% Ministry of Energy and Mines 4 0.3% 99.2% Ministry of Agriculture and CONSEP 3 0.2% 99.4% Ministry of Agriculture and Joint Command 3 0.2% 99.6% Ministry of Foreign Trade 3 0.2% 99.8% Ministry of Health and Joint Command 1 0.1% 99.9% Ministry of the Government I 0.1% 99.9% Ministry of Agriculture, Health, and CONSEP 1 0.1% 100.0% Total 1,424 100.0% Source MICIP, Sub-secretariat of Foreign Trade. Figure 3. Percentage of Trade Requiring Prior Authorization H 0 12.0% % 10.0% 8.5%o 87 9.1%9 9 4 8.0% 6.1% + t 6.5 6.1% 91 6.0% _ Z . 4.0% 0 2.0% z 0.0% I I I 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Percentage of trade requiring prior authorization Source: MICIP. 174 ECUADOR: AN ECONOMIC AND SociAL AGENDA IN THE NEW MILLENNIUM It must also be kept in mind that a third of the tariff headings require an addi- tional license at the same time, relating to health, zoo-phyto-sanitary, or national defense controls. No reasonable explanation has been found for this double proce- dure, each part of which is discretional and unclear. Prior authorizations may be legitimately be used as a safety or security mecha- nism-for the health of the population or of the country's fauna and flora, or for national defense. However, they can also be used improperly as a protectionist instrument. It is difficult to classify the legitimate use of licenses because there are so many qualitative factors involved, but it is even more difficult to draw the line between legitimate and illegitimate uses. In any case, illegitimate use is equivalent to increasing the protection of products that substitute imports.7 Making the applica- tion of the rules of play more transparent would help reduce the discretional use and calibrate their eventual impact on the protection of each sector. According to licenses users, this mechanism is used to maintain public adminis- tration jobs (of those responsible for issuing the licenses), which generates unneces- sary costs preventing free competition in the domestic market-as well as increasing the cost of imports, which is expressed in delays in the issuing of licenses or else bribes to reduce these delays. This also carries a social cost in terms of inefficiency, since there are fewer imports to benefit consumers owing to the effect of the tariff implicit in the license. These two costs come to about $US 37 million a year, about 13 percent of the value of the imports affected.' The largest surcharge for users was estimated at about $US 25 million a year, which represents the obligatory move- ment of users to the license-issuing mechanism; the difference represents the social or welfare cost. Given the above, we recommend the following: o Since they are redundant, prior authorizations that did not register commer- cial movement between 1991 and 2000 (that is, 919 tariff headings) should be eliminated.9 o Prior authorizations with specific prerequisites (health, phytosanitary, among others) should be immediately eliminated; a single license is sufficient. o The other headings requiring prior authorization must undergo a process of technical analysis to justify their continued presence on the list of applicable 7. That is, to the extent that domesric products identical to imported ones are not subject to the same controls-then for lack of "domestic treatment" even a "legitimate" control becomes an implicit additional tariff. 8. Hachette (2001)' appendixes 1 and 2 of this chapter. 9. This recommendation is further justified as the current practice represents a potential threat to the protection of historically captive markets. Imported products whose impor- tation is prohibited have been excluded from this analysis. TRADE POLICY AND COMPETITION 175 licenses. If they do not pass this test, they must be eliminated from the list of mandatory authorizations. * Prior authorization must be maintained for products subject to importation prohibitions, as long as they meet the same obligation indicated in the previ- ous paragraph within the same time frame. * Free access to prior authorization should be guaranteed to any importer. * Strengthening the Ecuadoran Agriculture and Livestock Service (SESA), which participates in issuing licenses, is necessary and urgent. The Service requires independence and a larger budget. Given the problem of SESA's lim- ited infrastructure, a tendering process has begun with private laboratories. This is being carried out through the Methodology, Standardization, Accred- itation, and Certification (MNAC) program with World Bank financing (see more details and recommendations in section D of this chapter devoted to Technical Regulations). Other Recommendations DOMESTIC COMPETITION. The liberalization of foreign trade will amount to no more than words if not accompanied by domestic liberalization. The benefit of lib- eralization is to be able to make use of input and final consumer goods at lower prices through commercial opening and greater domestic competition. However, monopolistic and discriminatory practices continue in Ecuador. The practice of exclusive trade arrangements appears to continue even though the Law on Foreign Trade and Investment (LEXI) banned it (Article 6). If importers are in connivance with domestic producers (or are representatives of products produced in the coun- try) who do not want foreign competition, the result is maintaining the status quo in terms of protecting national production, or even increasing it (for example, the virtual ban of individuals bringing new cars into the country from abroad). There have also been cases in which the installation of a competitive foreign business (a foreign supermarket) has been arbitrarily blocked. The arbitrary application of tech- nical regulations reinforces the monopolistic structure of Ecuadoran markets (see section D). A draft Law on Competition has recently been rejected by Congress, making it difficult to transparently, efficiently, and competitively open the market. The draft must be reconsidered as soon as legally possible. Customs. There is considerable movement of contraband in Ecuador,'° though esti- mates of its volume are subject to doubt and must be used with caution. Contra- band indicates that the rules of play are too complicated and not transparent enough and highlights inefficient management of customs, ports, and airports and the lack of domestic competition. A Customs Act was passed in 2001. It does not get to the IO. Estimates range from 40 percent to 100 percent of imported value in the same year. 176 EcuADoR: AN ECONOMIC AND SocIAL AGENDA IN THE NEW MILLENNIUM roots of the problem but at least makes it mandatory to report to the Internal Rev- enue Service (SRI); another law was in the hands of the previous President for his approval. Greater transparency and simplicity in the rules of play (lower and more homogeneous tariffs and the elimination of nontariff barriers) would help reduce the problem of corruption and increase fiscal income. This requires greater central control, perhaps through greater dependence on the Internal Revenue Service based on the principle that customs is a national service-that is, not only a provincial one-after a profound overhaul of the personnel involved. Random inspections by the fiscal police could be increased, as long as honesty is the outstanding quality of this corps. The aurhorities could study the experience of Mexico, which suffered similar endemic problems. There is no single solution except for a radical simplifi- cation of the VAT, which comes at a high fiscal cost. We recommend establishing precise goals for increasing customs income. This could be 5 percent a year, duly corrected according to exchange rates. The beneficial effects of tariff reform will be proportional to the flexibility and depth of reforms in the labor and financial markets, making foreign investment more attractive and improving infrastructure. Greater trade liberalization will have more positive and profound effects if the need for rapid reallocation of resources among products and sectors is not slowed by inefficient complementary markets (for example, lack of financing). These issues deserve more attention. The success of tar- iff reform depends to a great extent on profound reforms in the labor and capital markets, customs, infrastructure, and so forth. This is all the more urgent since, through dollarization, the country has lost a policy instrument-the nominal exchange rate. Finally, international competitiveness depends on many variables that are pre- requisites for successful exportation. The macroeconomic framework has improved since dollarization and the introduction of greater fiscal discipline. At the micro- economic level, the competitive atmosphere is lamentable; port services continue to be of low quality, with little innovative capacity; and industrial technology is unso- phisticated since neither capital nor trained personnel are available (which is wors- ened by the emigration of skilled workers). Also, given their high level of protection, executives receive little systematic technical or professional training. This is particu- larly worrying in the case of state enterprises where incentives are often counterpro- ductive and do not stimulate efficiency. "The rule of law is fragile and does not provide adequate protection to property rights, according to the U.S. State Department, and judicial authority is subject to external pressures and corruption....... State bureaucracy is complex, oversized, and often inefficient (see the issue of licenses discussed above). The banking and finan- cial sectors have not emerged from the crisis that hit them in 1998 and 1999. This 11. Economic Freedom Index, 2002; Heritage Foundation; and others. TRADE POLICY AND COMPETITION 177 limits investment in the export sector, particularly investment involving risk. The Law on Foreign Investment of 1998 guarantees the same treatment for foreigners and for nationals, except for certain geographical limitations on foreigners in fishing and broadcasting. Ninety-six percent of recent investment has been in the oil and mining sectors. Ecuador's inflation rate, which is higher than the international aver- age, continues to be an obstacle to the competitiveness of all of the country's pres- ent and potential exports. For these reasons, Ecuador receives a low grade and a low ranking in the Competition Index: 72nd of 75 countries studied. C. Price Bands THEORETICAL JUSTIFICATION. Agriculture is one of the main sectors of the Ecuado- ran economy (12 percent of GDP). More than a third of the population depends directly on it; it is one of the main sources of employment in the country (7.3 per- cent of total employment in 1998); and it is socially important as it employs most of the indigenous population. It is also a sector with underutilized export potential and as the Ecuadoran economy has opened to the exterior, the domestic economy has become more sensitive to the outside world, whose prices, technology, and mar- kets increasingly affect Ecuadoran agriculture. In fact, there are two kinds of agri- culture: modern and traditional. The former is forceful, dynamic, highly productive, and makes flexible use of new technologies available in the rest of the world, mak- ing it competitive and therefore export-driven and able to stand up to competition from similar foreign products. However, this subsector remains small. Traditional agriculture, meanwhile, has low productivity and little modern input, which makes it impossible to achieve low costs; be flexible, dynamic, prosperous; or an engine for growth. It is also strongly protected, which has been an obstacle rather than an incentive for rapid modernization. As part of national production agriculture must, like other sectors of the econ- omy, respond to the challenges of economic opening to the outside world (see sec- tion A), guided mainly but not entirely by trade policy. Although it is desirable for trade policy to send out uniform signals to all productive sectors in order to take the best possible advantage of the few existing productive factors so that they can be allocated in the most productive and most efficient way, the range of trade policy tools applied to agricultural imports is more diverse than those applied to imports in other productive sectors. One of the reasons traditionally given for this is the need to moderate the volatility of prices and income. Moderating the volatility of international prices is important, among other rea- sons, in order to improve the use of agricultural land, moderate undesirable fluctu- ations in agricultural income, reduce the risks inherent to the activity, and therefore, stimulate investment in the sector (product) thus increasing the productivity of the land. Price bands have generally been the main tool for moderating volatility, as is the case in Ecuador today. 178 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM The advantage of these bands is that, if applied transparently, symmetrically, and neutrally, they do not distort long-term signals aimed at better allocation of agricul- tural land. Specifically, Ecuador, like the other CAN countries, has made use of them since 1996, within the Andean Price Band System, which justifies their use to (i) defend products and consumers against the natural instability of agricultural prices, (ii) defend products and consumers against price distortions in the international mar- kets, and (iii) link domestic prices with international ones. Decision 371 (CAN) provides a detailed description of the price band mechanism. This is a mechanism for stabilizing domestic prices by establishing a price "floor" and "ceiling" between which the cost of a specific product is to remain. Stabilization is theoretically achieved by applying a (variable) tariff surcharge when the importa- tion (or reference) price plus the "standard" tariff is below the floor price, or reduc- ing this tariff to zero when the price rises above the ceiling of the band. The mech- anism used in the Andean Price Band System to stabilize the cost of imports is harmonized in the Andean subregion. Bands are applied to products from third countries that are not members of the Andean Community of Nations (CAN). They do not apply inside the CAN and are applied to 138 products. Twelve of these are benchmarks to which the rest are linked. Reference prices are established weekly by the Secretariat of the CAN and surcharges may not be greater than the difference between the VAT and the WTO consolidated tariff, that is, between 20 and 95 per- cent. Although the six years that have passed since the creation of the bands may be too short a period to demonstrate whether or not their effect has been neutral, it is unlikely that this has been the case; rather, they have tended to be protectionist.12 Although this is a sporadic measurement, it is unlikely that all the pertinent agri- cultural prices have been affected simultaneously by international events that have pushed up estimates of the effective protection of all the products involved. These figures are a call to attention, if nothing else. To be neutral in the long term, price bands must not mix concerns regarding fluctuations with others regarding external subsidies, dumping, and other distor- tions that they are supposed to be combating. Such mixes hide high rates of protec- tion at the cost of a more expensive basic food basket, while blocking the develop- ment of new agricultural exporting companies whose input includes products favored by the bands. 12.An example of this is that Ezquerra and Elorza (Andean Community) have estimated effective protection rates of 80.6 percent for production in agroindustrial bands and 66.5 percent for production in agricultural bands (cited by F. Suarez 2001). A protectionist bias can also be deduced from the fact that most reference prices plus taxes are higher than the band ceilings and that the consolidated tariff, which is higher than the legally applicable VAT is usually applied. TRADE POLICY AND COMPETITION 179 In practice, the CAN systematically applies a surcharge to the reference price, while taking care not to exceed the WTO consolidated tariff (see appendix 2, which gives examples of three price bands). The result is that the practical application of these bands in the CAN prevent them from being neutral, have a protectionist bias, and contradict their reason for being and even their very name. The reference price plus the variable surcharge calculated weekly by the CAN turn out in most cases to be independent of the existing band (that is, they fall outside the band-Table 2, column 6). However, for this reason, most of the bands do not have any practical purpose and could be eliminated without in the least changing the prices corrected by the VAT plus the surcharge. If the price bands effectively played their part as a buffer against volatility, in the form in which they were designed and have been implemented in different coun- tries, nearly 100 percent of the reference prices corrected by the VAT plus the per- tinent surcharge would fall within them. However, as column 6 of Table 2 shows, 64 percent of pertinent prices fall outside these bands. Only two exceptions are to Table 2. Variability in Ecuadoran Benchmark Prices, 1998-2001 Standard Relative Standard Relative Coincidence, pIMP deviation variation deviation variation pMP = outside in the coef in the price coef Pw"0 the price reference (reference plus (price plus (% of band (% Produet price price) taxes taxes) cases) of cases) Palm oil 167.6 34.9 159.1 26.6 67.0 95.6 Soya oil 132.6 29.2 138.1 23.6 70.3 92.3 Rice 10% broken 55.2 19.6 34.7 8.2 37.4 76.9 White sugar 36.8 14.2 47.9 12.7 78.0 49.5 Pork 307.1 22.1 260.5 13.8 49.5 79.1 Barley #2 8.1 6.4 7.9 4.7 44.0 53.8 Powdered milk 140.5 7.3 85.4 3.1 0.0 100.0 Yellow corn 9.7 8.5 11.6 6.9 75.8 22.0 White corn 17.7 14.6 17.2 9.8 48.4 56.0 Soya beans 26.2 11.7 20.9 6.9 72.5 45.1 Durum wheat 11.7 8.3 11.7 6.1 82.0 9.8 Chicken parts 134.5 19.2 230.3 17.5 86.8 93.4 Notes: PIMP corresponds to the reference price plus the applied tax. PWTO corresponds to the price resulting from the application of the maximum allowable tax allowed according to agreements with the World Trade Organization (WTO). a. Cases in which the maximum allowable tax according to WTO agreements was applied. 1. For all products, except durum wheat, 1991 statistics were used (two a month from Janiuary 1998 to September 2001 and one for October 2001). In the case of durum wheat, statistics include only the period from January 1998 to July 2000 (61 statistics). 2. Relative Variation Coefficients are the Standard Deviation divided by the average of the series and multiplied by 100. In this way, they can be interpreted as the percentile variation in terms of the average of the series of prices. 180 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM be found (yellow corn and durum wheat). The extreme case is that of powdered milk, with 100 percent of import prices falling outside the band; palm and soy oil and chicken parts are similar cases.13 In addition to significantly reducing the "use" of the bands, this way of establishing import prices prevents, by definition, the desir- able neutrality of the bands. This also makes them incompatible with current WTO regulations and probable ALCA regulations. The high frequency of "coincidences" between import prices and prices corrected by the WTO consolidated tariff (second-last column of Table 2), without managing to "fit" prices into the corresponding band, indicates a lack of transparency in the use and estimation of surcharges. The CAN does not provide precise justification for this, except "the need to compensate for 'outside distortions."' The arbitrariness hid- den in the implementation of the system, as well as the comments above, cast doubts on the value of the price bands, since concerns about outside distortions seem to take precedence over concern for stability. Nonetheless, the system that has been implemented has made prices more stable: variation in prices corrected with VAT and variable surcharges is 30 percent lower than for reference prices (columns 2 and 4, Table 2). The narrowness of the bands is also striking. This may be because prices fluctuated little in the past. If this hypothesis is correct, it would significantly reduce the justification of the bands. It is more likely that this narrowness is more the result of calculation mechanisms (see Decision 371). Given the irrelevance of price bands, and despite the peculiarities of CAN methodology, the influence of medium-term price trends has not been reduced (see, for example, palm and soya oils and durum wheat in Hachette [2001, appendix V1). The inflexibility observed in the bands is the result of their long memory (more details can be found in appendix 2 of this chapter). The application of surcharges to reference prices plus VAT that are above the floor price, but within a band, or above the ceiling price, illustrates the protection- ist vocation of the bands (for example, broken rice in 1998, soya beans, and palm oil) and their irrelevance. This is also true of the application of surcharges-which, instead of being used to reach the floor of the band, reach its ceiling and even go above it (this is the case for all benchmarks). Given the above, there are several clear implications and recommendations. Implications It is unlikely that any single instrument such as bands can efficiently and simulta- neously correct fluctuations in outside prices and in income: on average, they reduce both a little. Nor can bands simultaneously compensate for the "subsidies and other distortions in outside markets," "guarantee domestic availability," (arguments used by the Ministry of Agriculture to justify the bands), and also "link domestic prices 13.Details in Hachette (2001, appendix V). TRADE POLICY AND COMPETITION 181 to international ones." Most countries that use them also have antidumping tools or safeguards that they apply independently of price bands in cases of international dis- tortions. This is approved in Article 8 of LEXI. 4 In the Ecuadoran case, in light of the handling of price bands, it is understandable that the lack of transparency in the mix of simultaneously applied instruments causes other countries to retaliate in the form of safeguards (exporter complaints). The upward bias of the bands has hit Ecuadoran consumers hard, especially the poorest, since they spend more on food as a proportion of their income than the rich. This phenomenon has been especially severe since 1996.15 The fact that so many "related" substitutes and complements were included in the bands system provides the agroindustrial sector with an effective and extremely arbitrary structure and level of protection. Also, the more frequently surcharges are used and the longer the memory of the band is, the less domestic prices will be linked to international prices. It is also important to distinguish between the "long-term" trend toward falling agricultural prices and short-term trends. Regarding the former, the reaction should be to modify agricultural production and not increase surcharges. This can happen only if the agricultural sector opens more to the outside world, so that international prices do not send false signals to domestic producers. The mechanisms discussed above are justified only in order to deal with the latter. These issues must be studied in depth. Agriculture is not a static sector; it depends on what happens in other sec- tors and, vice-versa, its development is important in order to efficiently substitute imports and develop new exports. Recommendations Ecuador should drastically reduce the number of bands. At least two-thirds of them do not pass the minimum tests of efficiency. Along with them, all references to related goods should be automatically eliminated. The great number of bands also presents administrative problems, makes the establishment of prices more rigid and may create pressures to maintain them for reasons of "self-sufficiency" (corn and sugar, for example), adding to the social cost of their inefficiency. If some bands are maintained, they should affect only commodities that have more open, complete, and efficient international markets (there is no sense in a band for 14."(l)mports will not be subject any taxes other than tariffs, if applicable, value added tax, the tax on special consumption, compensatory rights or antidumping or the application of safeguard measures that may be temporarily adopted to prevent unfair trade practices in the framework of the WTO regulations..." 15.During 1985-95 (along with other agricultural policies) there was practically no bias in the bands applied; therefore, agricultural policy should not have had the redistributive effects of the kind mentioned above. 182 EcUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM chicken pieces'6 and only importable goods. Bands should be eliminated if (1) their reference prices are stable; (2) they are not commodities; and (3) they are not importable. Examples include bands for powdered milk, durum wheat, palm oil (not importable), chicken pieces, pork, barley, rice (10 percent broken), soya oil, and goods related to these. Ecuador should establish a clear and definitive separation of the objectives of the bands. The country should use the remaining bands only for balancing purposes (not protectionist ones) and use surcharges only in cases of dumping or foreign sub- sidies demonstrated on a case-by-case basis and only for a short time. This must be subject to an exhaustive review, which should be carried out by an organization not associated with the CAN in order to guarantee its objectiviry. If some bands are maintained, they must be wide and flexible, with a short memory, and be subject to correction. In order to guarantee long-term neutrality, it is unwise to mix considerations of variability with others regarding foreign subsidies, dumping, and other distortions. Such mixes hide high rates of protection at the cost of a more expensive basic food basket, while blocking the development of new agricultural exporting companies whose input includes products favored by the bands. Ecuador must strengthen private or mixed insurance mechanisms such as futures markets (for commodities such as corn), options, long-term contracts, diversifica- tion of production, vertical integration, swaps, credit, and so on, either independ- ently or in conjunction with other CAN countries or other third countries. Independent of the above, there must be a permanent effort to increase competi- tion in the agricultural sector, focused especially on small and medium-sized owners. Joining the ALCA necessitates a profound review of the mechanisms that support agriculture. Given current WTO regulations, such as removing price bands, the only tools left are special (emergency) safeguards and WTO consolidated tariffs. The for- mer, if negotiated taking full advantage of the Doha Round, could be applied to a small subset of the products to which they are now applied. Applying the consoli- dated tariff would increase the cost of the food basket (and of effective protection) according to the historical data used to estimate it. If this method were applied, the price with the WTO tax added would be higher than the effective price in 61 per- cent of the cases studied. This means that Ecuador, in the context of the Doha Round, should adjust both the level and the structure of the consolidated tariffs, reducing their deviation and their average level. This decision could be made in con- junction with the other CAN countries. Ecuador does not appear willing to adjust the bands and other instruments as long as the United States does not ease its Farm Bill. The best case would be for rationality to prevail or that the weight of an agro-alliance among the CAN coun- 16.And less sense in bands for products related to chicken pieces-see Hachette (2001, appendix V). TRADE POLICY AND COMPETnON 183 tries, the Cairns group, the EU, and the WTO "convince" the United States that the future of globalization depends on greater liberalization of agriculture in the entire world. D. Technical Regulations A Lack of "Domestic Treatment" Technical regulations began in Ecuador with the regulations for applying the Weights and Measures Act, laid out in Ministerial Agreement number 628 of March 1997, published in the official register in June of that year. These regulations, which could benefit Ecuadorans, have since then been a source of discrimination against imported products and a mechanism for reducing competition between domestic and foreign products. Also, with the "Regulations Substituting the Regulations on Goods that must comply with Ecuadoran Technical Regulations, Codes of Practice, Regulations Res- olutions and Mandatory Technical Regulations," published in June 1998 through Executive Decree number 1526, the Inrerinstitutional Committee is responsible for including the specific products that must comply with technical regulations. There are 2,096 Ecuadoran Technical Regulations (NTEs): 757 are mandatory and 1,339 are optional. Five categories claim 53.7 percent of the total: food tech- nology is the largest group (534 regulations, or 25.5 percent of the total); the oth- ers are construction materials, chemical technology, mechanical systems and com- ponents, and petroleum-related technology and other similar technology (Table 3). Unjustifiably, these are applied in a discriminatory fashion and only to imported products, making them another example of protection of the domestic sector. INEN and WTO Regulations When Ecuador joined the WTO, it officially adopted the Standardization Code. This code establishes that Technical Regulations are voluntary and must not consti- tute unnecessary obstacles to trade. Decree 401, the legal grounds for "Metrology, Standardization, Accreditation, and Certification" (MNAC), published in Official Register number 87 on Mary 30, 2000, establishes (i) in article 11, that the official standardization agency, the Ecuadoran Standardization Institute (INEN) will mon- itor compliance with the guidelines established in the Good Practices Code for the Preparation, Adoption, and Application of Regulations; and (ii) in article 13, that the Ministries must support standardization efforts under the guarantee and super- vision of the National Standardization Agency (ONN). Furthermore, Decision 419 (376) of the Andean Community ratifies the Volun- tary Nature of the Andean Regulations and specifies that these must constitute unnecessary obstacles to trade. However, the effective application of the "Regulations 184 ECUADOR: AN ECONOMIC AND SociAL AGENDA IN THE NEW MU1I ENNIuM Table 3. Types of Ecuadoran Technical Regulations (to October 4, 2001) Ecuadorian Technical Regulation (NTE) ICS Description number % 67 Food technology 534 25.5 91 Construction and building materials 230 11.0 71 Chemical technology 132 6.3 21 Mechanical systems and components for general use 120 5.7 75 Petroleum and related technology 112 5.3 25 Manufacturing engineering 94 4.5 87 Painting and color industries 90 4.3 13 Environmental and health protection; Security 88 4.2 77 Metallurgy 75 3.6 23 Fluid systems and components for general use 74 3.5 59 Textile and tanning technology 62 3.0 65 Agriculture 52 2.5 29 Electrical engineering 45 2.1 43 Automotive engineering 42 2.0 83 Rubber and plastics industry 41 2.0 85 Paper technology 39 1.9 81 Glass and ceramic industry 31 1.5 97 Domestic economy; Entertainment; Sports 31 1.5 55 Packaging and distribution of articles 28 1.3 61 Clothing industry 28 1.3 7 Mathematics; Natural sciences 24 1.1 79 Wood technology 22 1.0 17 Metrology and measurement; Physical phenomena 21 1.0 1 General; Terminology; Standardization; Documentation 20 1.0 35 Information technology; Office equipment 16 0.8 11 Health care technology 15 0.7 3 Sociology; Services; Organization and management 14 0.7 93 Civil engineering 9 0.4 19 Testing 2 0.1 27 Energy and heat transfer engineering 2 0.1 53 Materials management equipment 2 0.1 100 Reserved I 0.0 Total 2,096 Source: INEN. Substituting the Regulations on Goods that must comply with Ecuadoran Technical Regulations, Codes of Practice, Regulations, Resolutions and Mandatory Technical Regulations," results in imported products not receiving domestic treatment. This means that INEN regulations amount to the discretional application of quasiprohib- itive tariffs only to imports, since these regulations are not applied to similar domes- tic products. Therefore, this asymmetry constitutes the most damaging nontariff bar- TRADE POLICY AND COMPETITION 185 rier applied by Ecuador to its imports.'7 This skewed application of WTO regula- tions, and the spirit in which it is done, implies a surreptitious use of different tariffs for imports that suffer from the mandatory application of INEN regulations, which adds social costs to those already created by tariff policy and by other nontariff bar- riers. It also reinforces the monopolistic power of domestic industries (whichever one holds the capital), significantly limiting competition in the country's markets. Even if the mandatory regulations applied were "transparent," this would not eliminate the discrimination against foreign products as compared to domestic products. It would be preferable (that is, more transparent) to establish a tariff equivalent to the cost of this discrimination and add it to the existing customs barriers. The other invisible effect of this discrimination is the loss of state control over the commercial treatment of each imported product. It is now impossible to have a pre- cise idea of the most probable overall impact of trade barriers (tariff and nontariff). It is essential that Ecuador "disassemble" (deregulate) its current system of mandatory standardization in favor of a voluntary and optional standardization sys- tem regulated in accordance with WTO regulations. INEN regulations are based on considerations of risk (primarily security and health), while the application of "WTO Regulations," based on the same parameters, requires that a "technical justi- fication" be issued. This "technical justification" makes it quite difficult to apply the barrier, thus making the market more flexible and open. Many of Ecuador's cur- rently applicable regulations would not meet the requirements of "WTO Regula- tions. It will be impossible for the Ministry of Foreign Trade, Industrialization, and the Fishery to come to Agreements on the Mutual Recognition of Certificates of Con- formiry to Regulations with the competent authorities of other countries-agree- ments that would facilitate Ecuadoran exports and imports. Recommendations The country should technically evaluate the 759 mandatory INEN Ecuadoran Trade Regulations to decide if they should be mandatory in the future. If they do not pass this test, they should automatically be declared optional. The same study should include an analysis of the impact of eventually moving from one category to another. It would be best for the regulations to be declared optional, ipso facto, with the pos- sibility of once again becoming "mandatory" only after passing the pertinent test. Along with the process of "deregulating or disassembling" mandatory regula- tions, preparation must be made for the process of "regulation or assembly" of the system of"WTO Regulations," notification, and information, as is stated in the per- tinent legal documents. 17. It is true that the most developed countries with the most diverse imports have more tech- nical regulations, but they are not mandatory. 186 ECUADOR: AN ECONOMIC AND SOCIAL ACENDA IN THiE NEW MILLENNIUM The above recommendations suggest that Decree 401 must be quickly modified so as to make it transparent, so that through new regulations it can include the necessary elements to comply with WTO procedures, and to "regulate" its WTO application. The final objective of this must be to effectively apply "domestic treatment" to Ecuadoran imports and to eliminate everything that contradicts WTO Regulations. Laboratories responsible to MNAC (Decree 401) must pass the ISO 17025 Stan- dard test-a sine qua non condition for the "accreditation" required in order to guar- antee international acceptance of the certificates they issue (see phyro-sanitary con- trols). Also, with standard "WTO Regulations" commonly adopted, these requirements can be "homologated." This would allow products to enter Ecuador that cannot do so at present. To the extent that certain mandatory standards are maintained, the Ministry of the Economy must be sure that these are also applied to domestic products classi- fied under the same UIIC as imported products. If the domestic product does not comply, the imported product should automatically be exempted from the corre- sponding VAT. The relevant ministries and institutions should be responsible to the MNAC for compliance with the "domestic treatment" principle. The MNAC would act before the COMEXI in defense of importers and would be responsible for guar- anteeing compliance with the above proposal. If applied, these suggestions would be the right step toward the greater competitiveness of Ecuadoran exports and compli- ance with WTO regulations. Policy Matrix Policy measures Short term Medium term Objectives/goals Bias against exports (to June 2003) (2003-07) Progress indicators A- Bias against exports < Inefficiency due to high Apply two rates: Tariff changes; lower average Improve allocation; reduce bias 2 tariff level and great 5 and 10%. weighted level and standard against exports. g C tariff dispersion. Fiscal deviation. neutrality with increased i productivity at customs. 2 Bands do not meet goals. Eliminate ineffective Replace bands with List of eliminated bands. Improve agricultural bands: durum wheat, mechanisms permitted productivity. powdered milk, and by WTO. so on. Existence of licenses; Eliminate double Conduct technical List of eliminated licenses. Add transparency, reduce use not transparent licenses and licenses analysis to justify bureaucracy and corruption, and managed without importation remaining licenses. reduce importation cost. discretionally. registration. Free access to licenses. Lack of competition Double volume of Eliminate contingencies, Indicators of contingencies Achieve greater productivity in traditional remaining bans, and other given by WTO. agriculture. contingencies. restrictions. Inefficiency and Increase effective Continue efforts. A' Fiscal income as Reduce contraband, corruption at customs. control of imports percentage of imports corruption, and A fiscal at customs. by 5% a year. income. Monopolized markets. Present law on com- Create regulatory Monitored cases. Boost competition. petition to Congress. agency. 00 Policy Matrix (comtinued) x Policy measures Short term Medium term Objectives/goals Bias against exports (to June 2003) (2003-07) Progress indicators A- Bias against exports "Domestic Treatment" Make "mandatory" Make "mandatory Number of cases dealt Establish domestic treatment. not given when regulations applicable regulations" applicable with. applying technical to domestic products to domestic products n regulations. under the same UIIC. under the same UIIC. C Inadequate application Disassemble mandatory Complete disassembly. Number of cases dealt Eliminate unnecessary of regulations. system and make it with successfully. mandatory character of optional. regulations. 0 Capacity of control Approve ISO 17025 Number of approvals. Strengthen system, quality of 0 laboratories standard test for service, and foreign confidence. insufficient. laboratories responsible > to MNAC. Strengthen SESA. (0 z z E TRADE POLICY AND COMPETITION 189 Annex 1 Estimate of the Social Cost of Licenses and Inefficiency at Customs Licenses We will explore three different costs: (i) the difference between the effective price of importation and the economic cost of the same product to the importer (including the cost of delays in issuing the license, or the opportunity cost of the imported goods-which here we will assume to be the same); (ii) the social cost of the ineffi- ciency of licenses, which is traditionally measured by the triangle of welfare based on the demand for imports; and (iii) the transfer of the importer to "customs." This is directly proportional to the imports affected and to the financial cost of a hypo- thetically average six-month delay. Assumptions: * Imports affected (8 percent of total imports-3400mm), that is, 292mm in 2000. * Financial cost (17 percent annual interest rate). 292*0,17/2=25mm (1) Social or Welfare Cost (CB), equivalent to CB= R*ilm*AM Estimating elasticity in the demand for imports also requires certain assump- tions. It is elasticity "derived" from the elasticity of domestic demand and of domes- tic supply, the former with the inverse proportion of the value of imports weighted in demand, and the latter weighted by the inverse value of imports as a percentage of supply: D/M = 5 (2000 value for domestic accounts) and O/M = 4 (difference with 1 - M=D - 0). If we also assume a unit value for the elasticity of demand and 0.2 for domestic supply, the results are as follows: Where R=O.17/2 Surcharge 0: Supply M=292mm Imports D: Demand rTm=5.8 Elasticity of demand for imports AM=M*ilm*R=144 CB=(R*AM)/2= 12 TOTAL ANNUAL COST OF LICENSES IN $US mm: 25+12=37 Customs The methodology is similar to that used to estimate the cost of inefficiency of licenses: they are variants on the same theme, that is, a surcharge on imported value (and in this case, exports as well). Another difficulty is coverage. Here, coverage is the sum of total nonpetroleum imports and exports. Since R could not be estimated 190 EcUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM in $US, a welfare cost (CB) could not be obtained and therefore the result is an underestimate of the sum of the costs caused by both inefficiencies. However, the first cost we call "transfer cost" applies only to importers subject to license in the pre- ceding paragraph, while here it applies both to importers and exporters. This is the only estimate made here resulting in an underestimate of the real cost of inefficiency at customs. The transfer of the importer and exporter to "Customs" is directly proportional to total nonpetroleum imports and exports in a single year (2000) affected by and bearing the financial cost of a delay assumed to be six months on average. The cost of "transfer" is simply CT= [X+Mnp]*R CT: cost of transfer X+Mnp=5884 X: exports; Mnp: nonpetroleum imports R: or surcharge due to inefficiency; The information provided by import and export agents indicated that the sur- charge of costs owing to inefficiency at customs was in the order of 15 percent. Since it was difficult to confirm this, we prefer to present scenarios: R Alternative Surcharges (%): 1 5 10 15 CT (million) 59 294 588 883 The most realistic scenario, according to the author, would be an arithmetic aver- age of the two main scenarios: (294 + 588) /2 = 441 per year TRADE POLICY AND COMPETITION 191 Annex 2 The three bands shown in Figures Al through A3 clearly illustrate several of the points explained in the text: Soya oil: a) This illustrates, at least, the incompatibility of long memory and maintaining the link between domestic and international prices. b) A protectionist bias is present from the moment when the tariff placed on the reference price coincides with the WTO consolidated tariff c) Furthermore, only 8 of 48 examples fall within the band, which shows the irrelevance of the band. Recommendations: * Eliminate the band or at least make it much more flexible (shorter and broader memory) Powdered milk: a) No example (reference price plus tax) falls inside the band. b) The outside price is very stable, meaning there is no justification for applying an instrument for reducing volatility and, therefore, for a band. c) Extremely high tariff with no justification. Recommendations: * Eliminate the band. * Lower the consolidated tariff. Palm oil: a) Comments and recommendations similar to those applicable to the soya oil band. b) It is difficult to imagine how the price band has "defended producers and con- sumers against the distortions of prevailing prices in the international mar- kets." Figure Al. Soya Oil 960 860 0 760 D 660 0z0 560 z C~~~~~~~~~~~~~~~~~~~~~~~~~~~f ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ - 460 A z 360 z 2G0~~~ .... - - - … _ n e t ew o_m _ 0 r2 17 a, N_N ol C, 1 0 - - - - - - -r -\ - - Oo C: Monrhs -Floor pricer -Cciling price ---Reference price -o-Price with taxes WTO ceiling price Sourc: World Bank calculations. Figure A2. Powdered Milk 4100 _ o z 3600 > 3100 )OK 2600 2100 1600 C', C' C' C' C' 1 C' 1 C' 1 C. 1 C' C' 1 C'C ' 'C C 'C ' .,C'C, ~ 9' C 0 0 0 00 0 0 0 ~ 0 0 : 0 0 . 0 0 0 0 0 0 0 0 . ~00 000000 000000000-0 0 0 0 0- -0 0 0 0- Months -Floor pricer -Ceiling price -&-Reference price --Price with taxes ---WTO ceiling price Source: World Bank calculations. 194 ECUADOR: AN ECONOMIC AND SoCIAL AGENDA IN THE NEW MILLENNIUM 10-01 ° 10-60 . 10-80 I0O-LO 10-90 Q 10-l'0 8 x 66~~~~~1-60 4- 10-10 00-lA 00-01 . 00-60 00-80 - 00-90 0 00-60 00-~0 00-10 - 66-ZA I 66-I1 1 66-01 66-60 66-80 66-LO a ~~~~~~~~~~66-90 4 66-60) 661'0 66-60 66-ZO 66-10 86-Z I ) 86-I1 86-01 86-60 86-80 86-LO 86-90 86-60 =ca 0 ~~~~~~ ~~~~~~~~~~~~~~~~861'0O 86-Z0 0 86-10 0- c 4- \l'f ' Cl ~~~~~~~~~14~~~~~~~~~~~~~~~~ 7 Basic Infrastructure: Water and Sanitation, Electricity, Telecommunications, and Transport' Franz Drees, Philippe Durand, Eloy Vidal, and EmmanuelJames The water and sanitation, electricity, telecommunications, and transport sectors face problems ofpoor coverage (especially in rural areas), inefficiency andpoor quality ofserv- ices, insufficient resources for new investment and-with the exception of the electrical sector-incomplete regulatory and institutional frameworks. In general, the national government mustface these challenges by encouraginggreater local, national, and inter- national private sector participation, by consolidating institutional and legal frame- workds and-especially in the water supply/sanitation and transport sectors-using resource transfersfrom the central government to encourage service providers to improve services and coverage. In addition to these problems, the water and sanitation sector is characterized by poor recovery of costs through tariffi, and high dependence on transfers from the central gov- ernment to cover deficits. An, integrated national water resource management system is also lacking. Since all water and sanitation services are provided by decentralized providers that depend on municipal governments, the central government has two main tools at its disposal to improve the quality and efficiency of services, and to extend cover- age to urban and rural populations not yet. served; It can leverage central government transfers to encourage cost-effectiveness among service providers, and it can improve the institutional and legalframework. I. This chapter was prepared by Franz Drees (coordinator, senior sanitary engineer), Eloy Vidal (lead telecommunications engineer), Emmanuel James (senior financial analyst, transport), and Philippe Durand (lead energy specialist). Carlos G6mez (telecommunica- tions assistant), and Fernando Lecaros (World Bank energy consultant) made key contri- butions. The authors would like to thank Marfa Angdlica Sotomayor, Oscar Alvarado, Musa Asad, Samuel Taffesse, and Ernesto Sanchez-Triana for their support. 195 196 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM The most significant problems in the electricity sector include the ineffectiveness of an incomplete reform process; institutional vulnerability; the questionable sustainability of the wholesale electricity market; the needfor rate adjustments to ensure the sector'sfinan- cial sustainability; and the incomplete implementation of the environmental policy applicable to the sector. To face these challenges, it is essential to reactivate private sector participation in distribution and generation; modernize or eliminate state interference in the CONELEC regulatory authority; regulate thefinancial situation of the wholesale electricity market; reinitiate rate adjustments with appropriate "lifeline" protection for low-income households; deal with the problem ofEMELEC; develop a rural energy strat- egy; and consolidate environmentalplanning and management systems in the sector, par- ticularly in the Ministry of Energy and Mining and in CONELEC. Beyond the generalproblems shared by various infrastructure subsectors, the telecom- munications sector faces specific challenges including artificially low, unsustainable local rates forfixed telephone service; lack of competition in the cellular market, resulting in user costs that are among the highest in the region; and very limited Internet access. It is essential that the government consolidate the institutional and legalframework and pro- mote greater private sector participation, attracting private capital to Andinatel and Pacifictel so that they can make the large investments that the sector requires, and in order to break the duopoly in the cellular market. The challenges in the transport sector include the poor state of the highway system; the poor state of rural roads and the lack of transport services in rural areas; environmental problems; inconsistent and deficient sectoral and modalplanning; and insufficient capac- ity and resources at the localgovernment level to maintain provincial highways and local roads in the context of the decentralization process. The central government should con- tract maintenance services on the basis of results andpromote private sector participation through microenterprises that maintain and pave rural roads, fomenting the creation of mixed capital cooperatives for rural transport and performance incentives for local gov- ernments. It should also improve the environmental management of the sector, and trans- form the Ministry ofPublic Works into a new Ministry of Transport with normative and planning functions. A. Introduction The development of basic infrastructure is a fundamental challenge for Ecuador. An improvement in the quality of life for the population depends on it, as does eco- nomic growth. This chapter presents a summary of the situation facing Ecuador at the end of the year 2002 in four key sectors that comprise a significant part of its public infrastructure: water and sanitation, electricity, telecommunications, and transport (highways and roads, railroads, ports, and airports). This section provides an overview of the sectors, including their actors, legal and regulatory framework. The following section then summarizes the main challenges facing the four sectors. Finally, policy recommendations are given for each of these sectors and for rural BASIC INFRASTRUCTURE 197 community infrastructure. The main recommendations are summarized in a short- and medium-term action plan. Several of the challenges facing the sectors (especially coverage and service qual- ity) are closely linked both to urban growth and the country's urban-ruralpopulation structure. On one hand, between 1995 and 2000, Ecuador had an urban growth rate of 3.6 percent, compared to the 2.1 percent average for South America. On the other, despite strong population growth in urban areas, Ecuador continues to be one of the most rural countries in South America, with only 63 percent of its popula- tion living in urban areas, compared to the regional average of 80 percent. These two facts pose a double challenge: first, the need to mobilize significant investment for rural areas, where the coverage of services is generally lower than in urban areas; and second, the urgent need to restructure urban service providers (including public util- ities) in all infrastructure sectors, so that they are able to efficiently meet the techni- cal and financial challenges posed by rapid urban growth (see chapter 8 on Urban Development Policy). Description of the Sectors Water and Sanitation HISTORY. The structure of the water and sanitation sector in Ecuador from the 1950s to the 1980s was characterized by centralized planning, primarily by the Ecuadoran Institute for Water and Sanitation Works (IEOS). From the time of its creation in 1965 until its abolition in the mid-1990s, the IEOS built, operated and maintained potable water systems at the national level, financed by central govern- ment resources coming mostly from oil exports. When these resources diminished in the early 1990s, the central government decided to transfer the systems it had built to municipalities and communities. These communities would operate and maintain the system as part of a broader nationwide decentralization and modern- ization process. The IEOS was replaced by the Sub-secretariat of Potable Water and Basic Sanitation (SAPYSB) of the Ministry of Urban Development and Housing (MIDUVI), and its staff was sharply cut from about 2,500 public employees in the early 1990s to 148 in August 2002. Along with this reduction and supported by two studies by external consultants in 1999 and 2002, the SAPYSB began a still unfin- ished transformation of its role from that of a direct implementing agency to that of a sector promoter andfacilitator: Its new role meant it was in charge of planning the development of the sector; establishing policies and setting standards; providing technical assistance to municipalities, communities, and operators; and developing and maintaining a sector information system. THE INSTITUTIONAL STRUCTURE AT THE CENTRAL GOVERNMENT LEVEL. In addition to the SAPYSB, several other institutions have overlapping functions related to the sector (see Table 1): 198 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MlLLENNIUM Table 1. Institutions Related to the Water and Sanitation Sector Institution Functions MIDUVI/SAPYSB Formulates sectoral policies, establishes norms, and defines the development strategy for the sector at the national level. Ministry of Public Health Regulates the quality of potable water. Ministry of the Environment Responsible for environmental protection and conservation and for controlling of water pollution. National Council on Water The CNRH comprises 8 regional development Resources (CNRH) authorities responsible for water resource management including granting water abstraction rights. Ecuadoran Development Channels resources to municipalities. Bank (BEDE) SERVICE PROVIDERS (SPS). As a result of decentralization in the 1990s, Ecuador today has a very large number of SPs, with utilities in big and medium-size cities, and municipal water and sanitation services in small cities (see Table 2). A few small municipalities have created SPs legally independent of municipal government (and theoretically with financial autonomy). However, most have decided to provide water and sanitation services to in cantonal capitals directly via municipal depart- ments, whose staff is frequently shared with other services whose income and expen- ditures are not separated from the municipality's overall budget. In rural areas, water and sanitation committees (ASS) provide water supply (and sometime sanitation) in small communities, usually with very limited technical support from the munic- ipal government. Table 2. Water and Sanitation Service Providers (S§Ps) Number of Pop. Pop. growth Population municipalities Type of SP (millions) in the 1990s > 1 million Guayaquil, Guayaquil: Concession 3.35 +2.3% 1.7 million; (INTERAGUA- International Water Services) Quito, Quito: Municipal utility 1.6 million] (EMAAP) 100,000- 12 11 municipal utilities and 1.92 +7.8% 300,000 1 municipal department (Loja) 30,000- 37 8 municipal utilities and 0.80 -2.2% 100,000 29 municipal departments < 30,000 169 Municipal departments 1.30 +3.5% Rural areas n.a. Approx. 2,000 JASS 4.72 +0.9% TOTAL 220 12.09 +2.1% BASIC INFRASTRUCTURE 199 Electricity MAIN FEATURES OF THE SECTOR. According to the census of November 2001, 96.6 percent of the urban population of Ecuador has electrical service, compared to only 77.8 percent of the rural population and the overall national average of 89.7 per- cent. In December 200], nominal installed generating capacity for public service was 3,270 MW, of which 53.1 percent come from hydroelectric power plants and the rest from thermal power plants burning bunker or diesel fuel. In December 2000, 660.5 MW installed capacity was registered for independent generators.2 In 2001, total gross production was 11,072 GWh (excluding production by inde- pendent generators). The 8,103 GWh of energy that was billed was divided as fol- lows: residential sector (35.8 percent), industrial sector (26.1 percent), commercial sector (17.4 percent), public lighting (7.8 percent), other uses (11.2 percent), and large consumers (1.7 percent). Energy demand grew at an average of 5 percent a year between 1990 and 2001, and an average 4-5 percent yearly increase in demand is projected over the next 10 years. Distribution losses are very high-23 percent in 2001-and have remained practically constant throughout the past decade. The national transmission system consists of two 230 kV rings and 138kV radial lines. The transmission system operates under difficult conditions, owing to congestion and weaknesses in certain parts of the system. There are 20 distribution companies, the largest of which are the Empresa Eectrica Quito (EEQ) with 26 percent of total billed electricity, and the Municipal Electricity Company (EMELEC) in Guayaquil, with 28 percent of total invoiced electricity. In addition to the national grid, there are two small independent distribution systems (Sucumbfos and Galapagos). The average electrical rate for consumers in June 2002 was 8.6 cents per kWh.3 There is a cross subsidy for low-income residential customers who consume less than the res- idential average for each distribution company. This residential average ranges from a low of 48 kWh/consumer month (Empresa ElIctrica Bolizvar) to 190 kWh/con- sumer month (EMELEC).4 Table 3 provides a comparison of the electricity sector in selected Latin American countries. SECTORAL REFORM. The reform of the electricity sector goes back to 1996, when the Electricities Sector Act was passed. The achievements to date include: Restructuring of generation. Seven new generating companies (Hidropaute, Hidroagoyan, Hidropucara, Termoesmeraldas, Termopichincha, Elecaustro, and Electroguayas) have been created from the assets of the former INECEL, 2. National Electrification Plan 2002-11, CONELEC. 3. Source: CONELEC statistics for 2001 and first half of 2002. 4. Source: Chart of distribution by frequencies, issued October 2001, CONELEC. Table 3. Comparison of Selected Electricity Sectors in Latin America and the Caribbean C CD Total Per capita Flectricity installd consump- Average electricity prices Population Per capita Coverage capacity Thermo tion kWh/ June 2002 (US cents/kWh) 2001 GDP ($US) System 2001(%) 2001 -hydro year/ Resi- Commer- Indus- Country (miUlions) 2001 $US owner* Urb. Rural Total (MW) generation (%) person dential ci trial Bolivia 8.5 990 P 78 25 57 1227 0.9 407 5.8 9.2 4.6 Chile 15.2 4590 P 100 80 97 10269 1.0 2599 8.1 7.7 5.4 Colombia 43.1 2020 P/G 13141 0.4 817 7.7 6.8 6.8 0 Costa Rica 3.9 3810 G 100 97 1715 0.2 1533 6.5 9.4 7.4 Cuba 11.2 G 95 4411 15.4 1068 12.6 10.0 7.6 Ecuador 12.2 2130 GIP 97 78 90 3136 06 667 8.7 8.6 8.1 El Salvador 6.4 2000 P/G 99 45 76 1135 1.5 587 12.3 13.6 3.6 2 0 Paraguay 5.6 1440 G 83 7429 0 796 5.2 5.5 3.5 t Peru 26.1 2080 P/G 75 5906 0.18 700 9.3 6.3 5.9 Dom. Rep. 8.6 2130 P/G 3081 6.8 809 8.2 8.3 9.7 Z a Uruguay 3.3 6000 G 2105 0 1918 11.2 9.8 5.5 C 0 *P = Private; G = Government. n Sourre: OLADE. z r z z BAsic INFRASTRUCTURE 201 which was liquidated. While these companies were established as public lim- ited companies, the State still holds the majority stake through the Solidarity Fund (FS). Moreover, EMAAP (the utility of Quito) owns a small electrical plant. In addition to the above, there are three private power providers (IPP) including Electroecuador Inc., Electroquil, and Machala Power, which repre- sented 16.5 percent of installed capacity and 18.4 percent of annual produc- tion in October 2002. * Transmission. A national transmission company, Transelectric S.A., was cre- ated to develop the national power grid. * Distribution. INECEL's stake in the existing distribution companies was transferred to the FS. EMELEC, a private company since 1925, had to be placed under the administration of the Regulatory Authority because of its financial and legal problems. * Creation of a wholesale electricity market. In April 1999, a wholesale elec- tricity market was created in which contracts are made between generators and distributors and, the system operates on the basis of cost statements made by the generators. The CENACE (National Center for Energy Control) is responsible for standards and procedures. * Legal and regulatory framework. After its founding, CONELEC (the regu- latory and supervisory authority), with the support of the National Modern- ization Council CONAM, prepared all the essential technical regulations for the functioning of the sector. It also developed several detailed procedures necessary for the functioning of the wholesale electricity market, and for mon- itoring service quality. * Organization of a regulatory authority. The regulations governing the wholesale electricity market and the components of the electrical rates that do not depend on market processes (transmission and distribution), are regulated by CONELEC. * Preparation for privatized distribution. In 2001 and 2002, the groundwork was laid for the privatization of 17 distribution companies in four groups. This process reached an advanced stage (data gathering, preparation of bid- ding documents, and valuation of the four groups of companies), but was not completed for a variety of political, institutional, and regulatory reasons, and also because of unfavorable regional conditions that limited the interest of international investors in distribution companies. In fact, even when the companies were regrouped into only two blocks, (the Highlands and the Coast), there were only three prequalified investors. This process was handled by CONAM, the authority that has led sector reform. As a result, the current state of the sector is somewhat perculiar, composed almost entirely by state-owned companies (except for the three independent power providers [IPP]), and subject to legislation inspired by principles that are essentially applicable to private companies. 202 ECUADOR: AN ECONOMIC AND SOCiLk AGENDA IN THE NEW MILLENNIUM Telecommunications STRUCTURE OF THE SECTOR AND MAIN PLAYERS. The telecommunications sector in Ecuador continues to be one of the least developed in Latin America and has been among the last to open up to competition. The liberalization and privatization of the sector have not been consolidated owing to the failure to sell part of the opera- tors on several occasions, and to Congress' unwillingness to pass new legislation that would strengthen and bring greater transparency to the sector. The local fixed telephony market is still controlled by Andinatel and Pacifictel, in the highland and the coastal areas, respectively. The exception is ETAPA, a municipal company that provides services exclusively in the city of Cuenca. Recent progress was made in the form of competitive bidding for three licenses for local wireless service (known as "WLL" (Wireless Local Loop), which connects the telephone switchboard with the subscriber via radio signals instead of wires). Although this technology will increase the coverage of local service, its short geographic reach and relatively high operating costs means it will have litde overall impact on the market. These licenses were granted to two local companies-Consorcio TV Cable and Ecuador Telecom- while the third license was not issued for lack of interested parties. The cellular tele- phone market remains under the duopoly of Otecel (Bell South Ecuador) and Cone- cel (America M6vil), and although it has grown an average of 50 percent in the past two years, it has not yet demonstrated the penetration and rate reductions seen in other countries in the region. In November 2002, both operators obtained a court order to suspend tenders for a third license, arguing that the new player would receive undue privileges. The lack of additional competitors has constrained the growth of the market. LEGAL AND REGULATORY FRAMEWORK. In general, it has not been possible to con- solidate the reform of the telecommunications sector. The lack of political support has meant that despite several attempts at legal reform over the past seven years, no new law has been passed. According to the most recent ranking of the telecommu- nications sector by the Pyramid Research consultancy firm, the regulatory frame- work and the level of competition in Ecuador is one of the poorest in the region. Of the 18 countries studied, Ecuador ranks 16th and 13th in those two categories, respectively. The main challenges now are the existence of contradictory regulations, delays in the approval of the new Telecommunications Act, and finally, the confu- sion and overlap of responsibilities among the three regulatory authorities. Although it is argued that each of these has a different function, there is in fact a great deal of confusion regarding their functions and responsibilities: the National Telecommu- nications Council (CONATEL) is responsible for setting state policy in the sector and establishing interconnection regulations and the terms for concessions; the Telecommunications Authority (SUPTEL) is by law the only independent body responsible for the control of telecommunications in the country; and the National Secretariat of Telecommunications (SENATEL) prepares the National Telecommu- nications Development Plan and signs concessions contracts in the sector. Interna- BASIC INFRASTRUCTURE 203 tional experience shows that having a single regulatory authority, independent of any operator and with sufficient power to supervise private operators in the sector, is the best way to ensure transparency, boost private investment, and support sector development. As far as tariff regulation is concerned, CONATEL has approved the adjustment of rates. However, in late 2002, the executive branch of government ordered a rate freeze for the rest of the year, which will delay the January 2003 tar- get date of the adjustment plan. Another pending issue is interconnection, which is essential in order for competition to exist in the international long-distance, cellu- lar, and WLL markets. Although interconnection regulations were only recently issued, they nonetheless contradict other regulations on several points. Transport CHARACTERISTICS OF THE SECTOR. The transport sector represents 6.2 percent of GDP, a percentage that remained relatively constant from 1995 to 2001. Like GDP at the national level, transport activity declined sharply in 1999. Seven percent of the state's general budget for 2002, prepared by the Ministry of Economy and Finance (MEF), was allocated to the transport sector. Furthermore, almost 10 per- cent of transfer payments to provincial and municipal governments (called local governments-LGs) are also earmarked for the transport sector. INSTITUTIONAL FRAMEWORK. Various government bodies, with different degrees and levels of interdependence, are responsible for the planning, construction, mainte- nance, and operation of the transport system in Ecuador. At the national govern- ment level, several ministries and therefore several councils and commissions are involved. Among the most important in terms of highways is the Ministry of Pub- lic Works (MOP), which is responsible at the national level for building and main- taining the national highway network. At the moment, certain stretches of the state highway network (the main network) are operated under concession to private com- panies working in different regions of the country. As for rural roads, provincial and municipal councils, the Ministry of Social Welfare, the FISE (the Ecuadoran Social Investment Fund), CORPECUADOR (a regional development corporation), and now, the MOP, with its Local Road Works Unit (UCV), are all involved in building and repairing rural roads in different provinces throughout the country. At the provincial level, provincial councils are responsible for highway construction, main- tenance, and rehabilitation. The Civil Aviation Office (DAC) is responsible for the construction and main- tenance of the national airports. Although the construction of private runways is very common, only the DAC can authorize this. Construction projects for new air- ports in the cities of Quito and Guayaquil are under the management and respon- sibility of CONAM and the respective bodies created by the municipal councils of these cities. DIGMER is responsible for maritime transport, administrating and controlling the largest ports, such as Esmeraldas, Manta, Guayaquil and Port Boli- var. DIGMER is also responsible for regulating river traffic on the navigable rivers 204 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM of the coast, the mountains, and the eastern regions of the country. ENFE, the National Railway Company, is responsible for the railway sector. This form of trans- port is not heavily used, and is not really significant at the national level. Its tracks and trains are obsolete, service is poor, and certain lines of service have been sus- pended. REGULATION AND CONTROL OF THE TRANSPORT SERVICES: Passenger and cargo trans- port by highway, both nationally and internationally, is handled by the National Land Transit and Transport Council (CNTTT), which regulates passenger rates. The CNTTT is attached to the Ministry of the Interior and has 14 members. At the national level, a rate was established for popular (basic) transport. Freight charges are not subject to established regulations and depend on the free market and each trans- port company. Air freight rates are established by the National Civil Aviation Coun- cil and by the Civil Aviation Authority. Rail transport rates are established by ENFE, with different fares for national and foreign passengers. At the regional level, the 20 Provincial Land Transit and Transport Councils, the Guayas Transit Commission, and the Quito Metropolitan Transport Service and Administration Company are all involved. Finally, the National Merchant Marine and Ports Council determines poli- cies and regulations for this form of transport. B3. Diagnosis of the Main IProblems and ChaIlRenges Water Supply and Sanitation Sector CHARACTERISTICS OF THE SECTOR. The water supply and sanitation sector in Ecuador is characterized by (i) low levels of coverage, especially in rural areas; (ii) low quality of services and inefficiency; (iii) low recovery of costs through tariffs and high dependence on transfer payments from the central government to cover oper- ating deficits; (iv) an incomplete legal and regulatory framework, leading to over- lapping functions and confusion within the national government and among differ- ent levels of government regarding the role of different actors; and (v) the lack of an integrated national water resource management system. COVERAGE. Despite significant improvements made over the past decades (total water and sanitation coverage rose from 48 and 43 percent in 1980 to 67 and 57 percent, respectively, in 1999), water supply and sanitation coverage in Ecuador remains relatively low compared to other South American countties, even when this coverage is adjusted to take into account differences in per capita GDP in the region. Figure 1 shows that current levels of coverage for adequate water and sanitation serv- ices are particularly low for water supply (both urban and rural) and for rural sani- tation. On the other hand, urban sanitation stands out as a subsector with relatively Figure 1. Water Supply and Sanitation Coverage in Latin America (in percentage, compared with per capita GDP) Urban Water Supply Urban Sanitation s 120.00- CR.CH l O 100.00 CO * 1 100.00- B * I A 80.00- EC* PE * *MX , 60.00 EC P? i 60.00 - V E BR - A ,, 40.00- _ 40.00 BO (K MX 20.00- 20.00 * o 0.00- 0 o 0.00 1 u 0 5,000 10,000 15,000 u 0 2,000 4,000 6,000 8,000 10,00012,00014,000 Purchasing power adjusted per capita GDP, 2000 Purchasing power adjusted per capita GDP, 2000 Rural Water Supply Rural Sanitation O 100.00- ciU.. o 120.00- 80.00 ('1 ~~CP* UY100.00 *C 0 80.0 0 .0 0 80.00- C1 , 40.00 B 0.00' ~~.o 20.00 EC *~~~~~~~ ~~. 4~0.00- D. E" 40.00 AR~~~~~~~~o2000 E 0 ~~~~~~~~~~~~~~~0 U 0 5,000 10,000 15,000 j 0 2,000 4,000 6,000 8,000 10,00012,00014,000 Purchasing power adjusted per capita GDP, 2000 Purchasing power adjusted per capita GDP, 2000 s Source: PAHO 2002 and World Bank. 206 ECUADOR: AN ECONOMIC AND SOcIAL AGENDA IN THE NEW MILLENNIUM high coverage. Water supply5 coverage is 82 percent in urban areas and 39 percent in rural areas; and sanitation6 coverage is 73 percent in urban areas and 29 percent in rural areas. INEQUALITIES IN THE PROVISION OF SERVICES. Coverage of appropriate water and sanitation services is characterized by a number of inequalities in provisions.7 • Regional inequalities: As Table 4 shows, the lowest levels of potable water and sanitation coverage are on the coast and in the east of the country. o Inequalities between urban and rural areas. In percentage terms, rates of coverage with an appropriate services are higher in urban areas than in rural ones (twice as high for water supply and 2.5 times as high for sanitation). o Inequalities in terms of income level. Both in urban and rural areas, low- income families are those with the lowest levels of access to water and sanita- tion services (see Figure 2). QUALITY OF SERVICES. At the national level, it is estimated that only half of potable water supply installations have disinfection systems and only 11 percent of urban Table 4. Coverage of Potable Water and Sewage Services, 1999 (percent) Rerion Service National Highlands Coast East Islands Potable water 67 Urban 82 90 70 73 98 Rural 39 56 22 26 48 Sanitation 57 Urban' 73 83 60 61 19 Rural 29 34 30 22 22 Note: Boldface shows coverage under national average. Source: MIDUVI; Coverage for piped water supply in urban areas, appropriate piped or point source supply in rural areas. 5. Potable water service available either via household connection or protected and easily accessible public sources (standpipes, wells, springs, rainwater collection systems). 6. Sanitation service either via sanitary sewerage system (untreated) or on-site disposal sys- tems (dry latrines or pour-flush latrines). 7. "Plan Nacional de Desarrollo del Sector de Agua Potable y Saneamiento Basico," G. Yepes, B. G6mez, and E. Carvajal, December 2002; pp. 11-14. BASIC INFRASTRUCTIURE 207 Figure 2. Access to Potable Water Supply by Income Level 90 _ _ __ Urban -~80 o70 un 60 - _ _ _ _ _ - Consolidated , 50 _ _ _ - R _ rural settlements 30 ~ _ _ r _ _ _ - Dispersed rural 10 - …… _ _ = = =settlements 1 2 3 4 5 6 7 8 9 10 Income decile Note: I = lowest; 10 = highest. Source: "Desigualdades en el acceso, uso y gasro con el agua potable en America Latina y el Caribe," Ecuador, Technical Report Series No. 5, Pan-American Health Organization (PAHO), Washington D.C., February 2001. systems have full treatment plants.' Even in big cities such as Guayaquil there are still areas with intermittent water supply (12 hours of service in residential neigh- borhoods in the center and southern parts of the city) and low pressure (less than 0.5 Bar in the south, center, and poor outskirts). In Guayaquil, however, a conces- sion contract with INTERAGUA establishes clear goals for achieving continuous service and guaranteed minimum pressure within five years.9 This is not the case in the 12 medium-size cities (with populations between 100,000 and 300,000) admin- istrated by 11 municipal utilities and 1 municipal water department. In these cities, the potable water supply is intermittent in 55 percent of urban systems and 60 per- cent of the water supply is not disinfected. The poor quality of water means extra costs for users who disinfect it at home, in addition to medical costs and lost time resulting from water-related illnesses-for lack of treatment. The poor quality of water in many systems has a particularly severe impact on the poor, since at the national level only 40 percent of families among the poorest one-tenth of the pop- 8. "Project Appraisal Document, Rural and Small Towns Water Supply and Sanitation Pro- ject (PRAGUAS)," World Bank, September 2000, p. 6. 9. "Proceso de Modernizaci6n de los Servicios P6blicos de Agua Potable y Saneamiento de Guayaquil," ECAPAG, 2001. 208 EcUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM ulation treat their water at home, compared to 90 percent of families among the richest one-tenth (see Figure 3). EFFICIENCY OF SERVICE. The available figures suggest that water supply and sanita- tion services in the large and medium-sized cities of Ecuador are very inefficient given that the number of employees in almost all utilities (except Guayaquil/ INTERAGUA) is 2 to 7 times as high per 1,000 water connections than the best levels in Latin America (see Table 5). The conclusion is that in addition to low tariffs, excessive personnel costs also deprive companies of the resources they need to extend coverage to poor, unserved population groups. In 2001, for example, personnel costs at EMAAP/Quito were equivalent to 115 percent of income. Based on the litde data available, it is difficult to reach a conclusion regarding the efficiency of service in small municipalities where employees are often shared with other services and separate accounts are not kept. However, regional experience suggests that the absence of economies of scale in these small systems (needed to maintain technically skilled personnel and spe- cialized equipment) goes hand in hand with inefficient service. Figure 3. In-home Water Treatment by Ilncome Percentage of families that treat their water 100 - 80 - 60 - 40 - 20 - 20 1 2 3 4 5 6 7 8 9 10 Income decile Note: I = poorest; 10 = richest. Source: 'Desigualdades en el acceso, uso y gasto con el agua potable en Amr&ica Latina y el Caribe," Ecuador, Technical Report Series No. 5, Pan-Arnerican Health Organization (PAHO), Washington D.C., February 2001. BASIC INFRASTRUCTURE 209 Table 5. Operational Efficiency of Water Utilities in Large and Medium-Size Cities Empleyees (N) per 1,000 Water Number of water Company connections (total) employees (N) connections Cities with more than 1 million inhabitants Quito (EMiAAP) 318,000 2,060 6.5 Guayaquil (INTERAGUA) 266,000 900 3.4 (estimate) (estimate) (estimate) Cities with 100 to 300 thousand inhabitants (examples) Santo Domingo de los Colorados 20,375 196 9.6 Machala 29,685 173 5.8 Manta 29,000 220 7.6 Portoviejo 24,051 340 14.1 Duran 27,369 195 7.1 Ambato 34,741 300 8.6 Riobamba 30,122 180 6.0 Milagro 16,351 69 4.2 Ibarra 23,866 205 8.6 Esmeraldas 22,387 167 7.5 Examples of the best water supply companies in Latin America Santiago (Chile) 1,200,000 1.2 SANEPAR-Parana (Brazil) 1,914,000 2.6 Source: MIDUVI and the World Bank. OVERALL SECrOR FINANCING. The water and sanitation sector is characterized by generally low tariffs and high dependence on transfer payments from the central government and municipalities. At the national level, cumulative income from tar- iffs (approximately $US74 million in 2001) covers only 67 percent of the costs of adequate operation and routine maintenance. This drops to 58 percent if we con- sider debt service (approximately $US18 million a year). The deficit is closed by transfers to the water and sanitation sector by the national government (approxi- mately $US1 14 million in 2001), and by the municipalities (approximately $US30 million in 2001). Of central government transfers, approximately $US64 million were made through MIDUVI in 2001 ($US6 million from the Solidarity Fund and $US58 million from its own budget), and $US50 million came from a telephone tax. These national and municipal transfers cover the deficit created by low tariff rev- enue in the companies and municipalities directly responsible for water and sanita- tion services, leaving about $US90 million a year for modest investments in 2001. These investments come to about $US40 per connection per year-which is less than is spent in other more developed Latin American countries (Brazil spends $US52 per water connection per year, and Uruguay $US59 per water connection 210 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM per year). Figure 4 breaks down aggregate income and costs for providers of water supply services at the national level. DISTRIBUTION OF SUBSIDIES. The importance of the different transfers to the sector varies according to the size of municipalities. In 2001, two cities (Quito and Guayaquil) received approximately 60 percent of all telephone tax transfer pay- ments, though they represent only 28 percent of the country's population. In its present form, the special telephone tax-which has existed for nearly 40 years-is collected by the telephone companies. The companies then pass it on to the central government, which in turn distributes it among the potable water service providers in the area where the tax was generated. This form of distributing the income gen- erated by the tax is apparently due more to tradition than to the letter of the law, which requires only that this income be used "... for the companies or local bodies that are responsible for providing potable water services, allocating this money Figure 4. Aggregate Income and Costs of Water and Sanitation Services 250 200 E0 5 v 100 50 0 Income Expenditures oAvailable for 90 investment zj Debt service 18 EiAdequate O&M 110 z Telephone tax 50 cu Transfers from 64 MIDUVI 0 Municipal 30 expenditures r Tariff revenue 74 Source: Yepes, G6mez, and Carvajal 2002. BASIC INFRAS1TRUCTURE 211 exclusively to potable water supply projects in all the cantons of the Republic."'0 To compensate for this imbalance in the distribution of the telephone tax, and given low revenue generation from tariffs, small municipal governments use a large part of their budgets to subsidize water and sanitation services, as can be seen in Table 6. CRITERIA FOR ALLOCATING SUBSIDIES. Apart from the amounts transferred to the sector by the national government and the municipalities, it is important to consider that almost all of these resources are transfered without conditions that could encourage greater efficiency or quality of service to the public. In theory, resources from the telephone tax must be used for investment projects. In practice, however, they are often used by many service providers to finance operating costs that they cannot cover with income from tariffs. Even the SAPYSB-whose role as a body governing the water and sanitation sector makes it responsible for defining financial policy to support the sector-transferred 20 times more resources to service providers in 2002 (with no conditions of any kind) than was provided via the PRAGUAS project (Water and Sanitation Project for Rural Communities and Small Municipalities-financed by the World Bank through loan 7035-EC). The PRAGUAS project requires that both municipalities and rural communities comply with conditions aimed at improving the quality, coverage, and sustainability of their water supply services to qualify for project financing. IMI'ACT OF TARIFFS AND TRANSFER PAYMENTS ON THE POOR. The poverty affecting a large part of the Ecuadoran population, as well as the fact that water is both a social and an economic good, is often involved as justification for low water tariffs. Unfor- Table 6. Distribution of the Telephone Tax and Municipal Expenditure on Water and Sanitation ($US/inhabitant in 2001) Telephone Total Municipal tax municipal W+S W+ S % City tranfers expenda expend total Quito 8.40 31.80 0 0% Guayaquil 4.69 63.80 0.18 0.2% Cities of 100,000-300,000 inhabitants 2.27 56.50 2.80 5% Cities of 30,000-100,000 inhabitants 2.52 68.40 7.90 12% Cities with fewer than 30,000 inhabitants 1.91 91.10 9.60 11% Source: Yepes, G6mez, and Carvajal 2002. 10.Law Reforming the Internal Tax Regime of May 2001, Article 38, added to Article 84 of the Tax Regime, which is partially quoted above. (Official Register number 325). 212 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM tunately, it is not the poorest who benefit from the lowest rates and transfer pay- ments to the sector. As Figure 2 shows, almost 40 percent of the urban poor (lowest 3 income deciles) does not have access to piped water supply. The situation is even worse in consolidated rural settlements, where more than 60 percent of the poorest population (lowest 3 income deciles) does not have household connections. These people, who often get their water from untreated sources far from home (in rural areas) or from tank trucks (in peri-urban areas) spend much more time and money getting water of unreliable quality than their connected neighbors. In Machala," (see Table 7), for example, it is estimated that a poor family connected to the water supply system spends only 0.4 percent of its monthly income to cover its water needs, while an unconnected family spends approximately 9 percent. The World Health Organization recommends that no more than a maximum 5 percent of household income be spent on water supply. When the figures above are compared to this standard, it must be concluded that the current low tariffs deprive water and sanitation service providers of the resources they need to extend services to uncovered areas-areas that pay much more for water of unreliable quality. This deficit is only partly compensated by national and municipal transfer payments, which cover little more than operating and maintenance costs, and become a sub- sidy for the relatively privileged population that already has piped water supply. INCOMPLETE REGULATORY AND LEGAL FRAMEWORK. Ecuador's National Water and Sanitation Policy (Executive Decree 2766 of July 30, 2002) establishes guidelines and basic principles to increase water and sanitation coverage. It also aims to Table 7. Machala: Monthly Expenditure on Water Supply and Sanitation Services-Families with and without Home Connection User With borne Supplied by Item connection tank truck Monthly consumption, poor family (m3) 15" 4 to 5b Monthly expenditure per family 1.20c 29.00 Monthly expenditure (percentage of family income) 0.4 9.0 a. World Bank estimates. b. World Bank estimates based on approximately 30 liters/person/day. c. The rate depends on the type of housing. The amount indicated is for the most inexpensive housing. Source: World Bank. 11. "National Plan for the Development of the Potable Water and Basic Sanitation Sector," G. Yepes, B. G6mez, and E. Carvajal, October 2002; p. 13. BASIC INFRASTRUCTURE 213 improve the quality of services provided and make more efficient use of water resources, all within a framework open to participation by the private sector and benefiting communities. However, the document does not take a clear position on key issues such as subsidies to the sector nor does it establish objective criteria for selecting the municipalities receiving them. Current legislation also does not establish an independent regulator of water and sanitation services-an issue that must be dealt with in the framework of a new Water and Sanitation Law, to be prepared by international consultants hired by the CONAM and monitored jointly by the CONAM and the SAPYSB. The new law should also more clearly define the responsibilities and functions of the various national bodies involved in the sector (see Table 1), and propose a clear division of sectoral responsibilities among the different levels of government. Management of Water Resources GENERAL SITUATION. Although in general Ecuador has sufficient water resources to cover its needs, there is constantly increasing competition for water use and greater conflict over its allocation. This leads to environmental degradation that affects poor and indigenous communities disproportionally. The efforts made to date by the gov- ernment to protect water quality, promote efficient water use (especially in agricul- ture), increase the availability of water resources over the course of the year, and con- trol flooding have been insufficient. The country needs a systematic long-term program to modernize the management of its water resources and to guarantee sus- tainable management both at the local and national levels. MAIN CHALLENGES. The main problems affecting the sustainable management of water resources are as follows: (i) lack of updated information on the quantity, quality, and seasonal availability of water and its use by different subsectors (human consumption, agriculture, and so on), which impedes sectoral planning (stock was last taken of water resources in 1985); (ii) lack of political consensus regarding water as a social and economic good; (iii) weakness of the institutions responsible for managing water resources and overlapping functions among the National Council on Water Resources (CNRH), the ministry of agriculture, and the min- istry of the environment, provincial councils, regional development corporations, and municipalities; (iv) degradation of water quality in several rivers (some already considered "dead") due to chemical discharges and pesticides; (v) flooding (espe- cially on the coast) and erosion (accelerated by deforestation); (vi) sedimentation of hydroelectric reservoirs (the Paute station has lost approximately 20 percent of its generating capacity in the past decade); (vii) increasing conflict among different users of the resource, which is especially harmful to poor and indigenous groups; and (viii) lack of an integrated water resource management law and limited appli- cation of existing legislation. 214 ECUADOR AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Energy Sector The main problems in this sector have been identified during previous Bank opera- tions. They include (i) inefficient, incomplete reform; (ii) institutional vulnerability; (iii) doubtful sustainability of the wholesale electricity market (MEM); (iv) tariff adjustments necessary for financial sustainability that have yet to be made; (v) uncertain availability of resources for investment; (vi) insufficient coverage; and (vii) incomplete implementation of environmental policy in the sector. INEFFICIENT, INCOMPLErE REFORM. Despite having implemented important struc- tural changes, the sector remains practically the same as before the reforms. State- owned companies dominate, both in generation and distribution, and do not respond to economic and financial incentives, but rather to local or national politi- cal interests. This leads to low efficiency, which is reflected in the figures on losses and tariff collection, mainly in the area of distribution (see Table 8). Losses came to 23 percent in 2001 at the national level, with large differences among companies. For example, EMELEC and Empresa Electrica Quito (EEQ) registered 25 percent and 16.1 percent, respectively, whereas Centro Sur, with a market that is five to six times smaller, registered only 11.4 percent. In general, the companies with high losses are characterized by high nontechnical losses, corre- sponding to unbilled energy (6 percent at EEQ, 15 percent at EMELEC, and only 2 percent at Centro Sur), which could be reduced with more concerted antifraud management. Another important indicator is collection efficiency: the percentage of energy billed and effectively paid for by customers. At the national level, collection stood at an average of 90 percent in 2001; in competently managed companies this figure should be over 95 percent. Proof that this is possible is the fact that 4 companies have collection rates between 95 and 100 percent and 6 are between 90 and 95 per- cent, while 10 have lower rates. Losses and collection efficiency are factors that have a direct impact on the financial performance of these companies, almost all of which showed net losses for 2001. The figures above indicate that of 100MWh delivered to distributors, 1OMWh are lost in the network (technical losses) and 13MWh are consumed but not billed-and that of 77MWh billed, only 69MWh are collected. Efficient manage- ment should reduce nontechnical losses to less than 3 percent and should increase collection to above 95 percent. At these levels, instead of collecting the equivalent of 69MWh per 1 OOMWh, the equivalent of 83MWh would be collected, with a cor- responding 20 percent increase in income. In the present context, there is little prospect that this inefficiency will be reduced, given the lack of an authority or agencies whose interests are directly affected by inefficient management. The current owner of the sector is the Solidar- ity Fund (FS), a body designed to administer proceeds from the sale of state-owned companies, and to allocate them to social sectors. The fund was not designed to Table 8. Main Characteristics of Distribution Companies in 2001 Technical indicators Financial indicators Cost- Liquidity Solvency efectiveness % Current Electricity Peak Average Average collected / assets Total invoiced Ekectricity demand Load annual price invoices short-term liabilities / Returns / Company (MWh) losses (%) (MW) factor (%6) customers (0/kWb) (a) liabilities total assets assets (b) Ambato 229,577 14.0 63 52 136,014 7.7 94 2.75 0.20 (0.08) Azogues 53,089 10.0 15 44 23,221 6.6 93 2.61 0.13 (0.09) Bolivar 34,662 18.9 12 42 36,926 7.5 63 3.16 0.17 (0.14) Centro Sur 443,962 11.4 102 56 210,868 6.8 101 1.73 0.12 (0.06) Cotopaxi 141,025 17.8 38 51 70,392 7.9 88 3.02 0.07 (0.03) El Oro 280,962 25.7 72 60 131,988 6.9 95 0.84 0.84 (1.66) Emelec 2,246,711 25.0 526 65 340,595 5.8 91 Esmeraldas 188,523 27.2 47 63 56,713 8.0 75 0.79 0.51 (0.26) Galapagos 14,443 11.4 4 48 4,665 6.3 85 0.08 (0.56) Guayas-Los Rios 506,945 34.0 137 64 134,595 7.8 76 0.62 0.58 (0.67) Los Rios 138,457 26.9 39 55 60,367 7.0 84 0.93 0.69 (1.01) Manabi 504,317 27.6 130 61 171,522 7.5 70 0.79 0.42 (0.32) Milagro 175,702 40.2 59 57 84,643 7.2 86 1.24 0.53 (0.56) Norte 248,397 17.3 65 53 131,326 7.2 93 3.53 0.18 (0.19) Quito 2,065,354 16.1 475 59 536,635 5.7 97 2.44 0.23 (0.12) Riobamba 144,873 18.3 40 51 107,574 6.9 94 0.07 0.02 Sta. Elena 184,958 25.8 56 51 59,414 7.7 90 2.55 0.30 (0.25) Sto. Domingo 172,496 24.8 47 55 82,253 7.2 104 1.29 0.3 (0.19) Sucumbios 38,995 32.5 16 41 21,027 8.4 61 0.13 (0.25) Sur 131,758 15.1 36 49 102,940 7.2 72 1.85 0.29 (0.11) Total 7,945,209 22.6 1980 59 2,503,676 6.5 90 (a) Amounts may be higher than 100 percent due to recovery of debts outstanding from previous years. (b) A number in parenthesis indicates a negative result. Sources: CONELEC 2001 statistics. Audited balances 2001, Solidarity Fund. 216 ECUADOR: AN ECONOMIC AND SOCLAL AGENDA IN THE NEW MILLENNIUM actually manage these companies. The FS has a budget of only $2 million a year to control the management of 19 distribution companies, five generators, and the transmission company. It is worth noting that the fundamental change introduced by private participation is the profit motive.12 The impact of this change should not be confused with the effect of restructuring. The effort already made to restructure the sector will have been in vain if incentives are not introduced that ultimately pro- duce the social benefits for which sector reform was undertaken in the first place. At present, despite its role as majority stakeholder, the hands of the FS are tied by local interests in the companies under its control. INSTITUTIONAL VULNERABILITY. One of the main goals of reform in the sector is to attract private investment in energy generation and distribution. This requires a clear legal and institutional setting, one element of which is stability, both in terms of the rules and principles governing the functioning of the sector and the institu- tions that govern it. At present, this is not the case, particularly regarding the regu- latory authority (CONELEC). While there is a consensus that CONELEC carries out rigorous technical studies, there is general distrust regarding the decisions made by its management, which is dominated by representatives of the executive branch whose disproportionate influence can block decisions of vital importance. Proof of this is the tariff freeze ordered in April 2002, which aborted a process of rate adjust- ment that would have finally raised rates to economically viable levels. Furthermore, CONELEC also manages companies placed under the care of administrators, as one of its many functions. This function entails serious problems, as it leads to conflicts of interest, since the regulatory authority has an incentive to favor companies under its care, and to help them recover. An example of this con- flict can be seen in the current intervention in EMELEC, the company with the largest market share in the country, which is not now subject to the same rules gov- erning the transfer of operating revenue as the other distribution companies. This affects the wholesale electricity market and foments a perception of discretionality and unfairness in the decisions of the regulatory authority. QUESTIONABLE SUSTAINABILITY OF THE WHOLESALE ELECTRICITY MARKET. The wholesale electricity market has been competently managed by CENACE, which projects an image of seriousness, transparency, and fairness, especially in the critical function of network operations and in market administration-its two main func- tions. Proof of this is the confidence it instills in market agents and the absence of lawsuits involving its actions, though it should be noted that until now the market has involved only public bodies, with very few exceptions. However-and perhaps in large part owing to this fact-the liquidation of transactions in the wholesale elec- 12. Robert Bacon, "Restructuring the Power Sector: The Case of Small Systems." The World Bank, FPD Note No.10, June 1994. BASIC INFRASTRUCTURE 217 tricity market has not had satisfactory results, as distributors have (to date) accu- mulated debts of $US430 million, which is equivalent to eight months' billing for the entire sector. The wholesale electricity market's deficit originates in excessively low rates (applicable to all the distributors), in delays in payments (applicable specif- ically to EMELEC, which is the biggest MEM debtor), and in great inefficiency in distribution. Part of this deficit (about $US40 million in 2001) is financed by the government and involves thermal generators' debts to PetroEcuador. Given the obviously insufficient collection of tariffs, the income of the distribu- tion companies (with the notable exception of EMELEC) is managed through a trust that pays according to the following order of priority: (a) a percentage of added distribution value (ADV) for the distribution companies, (b) payments for supplies contracted with private thermal generators, (c) payments contracted through inter- national interconnections, (d) payments for fuel used by state-owned companies, (e) remuneration of the transmission company, and (f) payments for transactions in the spot market, where most of the deficit accumulates. In the end, debt with genera- tors translates into nonpayment of obligations contracted with Petrocomercial (a subsidiary of the government-owned PetroEcuador corporation) that does not cut off fuel supplies to the electricity sector, even when it is not paid. This accumulation of debt will most likely be dealt with by ad hoc measures that do not respond to eco- nomic principles. It is not financially healthy or useful for the debt level to rise above current levels. TARIFF INCREASES NECESSARY FOR THE FINANCIAL SUSTAINABILITY OF THE SECTOR. The financial sustainability of the sector is intimately linked to the deficit in the spot market. The average rate for regulated customers in June 2002 was 8.6˘/Kwh and has been frozen there since April 2002. The efficient level of cost has been estimated at about 10.4˘/Kwh,'3 meaning that a hike of approximately 21 percent is needed to reach that goal. The difference is concentrated mosdy among residential users, who paid an average rate of 8.7˘/Kwh in June 2002. This, however, hides a crossed subsidy that favors those who consume less than the average for each electric com- pany. This subsidy covers a wide range of consumers (about 62 percent of consumers in October 2001) and is therefore not really focused on the neediest sectors of the population. In addition, the sector's financial problems are worsened by high tech- nical and nontechnical losses, which accounted for 27 percent of the energy deliv- 13. Calculations by CONELEC and from the report, "Impacto de las Variaciones de los Pre- cios de la Energfa sobre el Costo de Vida y Costos de Producci6n Industrial" (Impact on Variations in Energy Prices on Inflation and Industrial Production Costs), February 2002, appendix 2. It is worth mentioning that efficiency cost is sensitive to three main factors: hydroelec- tric production, international fuel prices, and hypothetical costs used to calculate the AVD. 218 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM ered to the wholesale electricity market in the first half of 2002. This is more than double the acceptable amount for an average, well-managed system. It is clearly pos- sible to reduce these losses, considering that several distribution companies show good results in this area (see Table 8 above). The recovery of 50 percent of the losses (which is approximately equivalent to commercial losses due to energy delivered but not billed) would mean about 130 GWh a month, which would increase income in the sector by $11 million a month. Regarding tariff increases, there are doubts regarding the calculation for added value of distribution (AVD), which can vary according to the characteristics of each company, but generally is in the 3 to 4˘/Kwh range. With a margin of 1˘/Kwh for transmission and generating costs of 5/Kwh, the reference cost comes to approxi- mately 9-10˘/Kwh, which is near the desired rate of 10.5˘/Kwh. As has been men- tioned, a significant part of the sector's problems involve inefficiency resulting in losses and a low collection rate. At present, the average wholesale electricity market price is around 5˘/Kwh; for every lOOKwh bought at a cost of $5, distributors col- lect the equivalent of only 69Kwh, which at current rates means income of about $5.9. Since their highest priority is to cover their own costs in terms of the AVD, a deficit with wholesale electricity markets is inevitable. UNCERTAIN MOBILIZATION OF INVESTMENT RESOURCES. Gas production has recently begun (by Machala Power) in the Gulf of Guayaquil, which offers potential for the development of low-cost resources in the Ecuadoran system via combined cycle plants. At the same time, the national grid has been interconnected with Colombia, thereby providing access to a market where energy moves at lower cost than is now the case in Ecuador. Interconnections with Peru are also being prepared. These developments guarantee short-term supply (2003-04) for the system, but nagging questions remain regarding medium and long term sustainability. Transmission and distribution companies also face major difficulties in mobilizing financing for investments necessary for maintaining quality service (to say nothing of expanding service), owing to their financial situation and lack of access to capital markets. These difficulties are cause for concern in the case of the transmission company that is the heart of the electric system. Reform of this sector was focused on attracting private investors, but the problems associated with legal uncertainty and regulatory stability, in addition to smaller numbers of strategic international investors and changes in their investment strategies, threaten the mobilization of private invest- ment. For example, the development of new power plants using gas from the Gulf of Guayaquil requires investment in new wells and new plants, which will not occur if doubts continue as to the stability of the legal framework and the sustainability of the wholesale electricity market. If institutional weaknesses are not dealt with, the state will likely face supply crises forcing it to take on investment risks, either through the companies in which it has a stake or as a guarantor of"PPA" contracts, which would contradict one of the goals of reform-that is, to substantially reduce the state's role in the provision of electrical services. BASIC INFRASTRUCTURE 219 INSUFFICIENT COVERAGE. Electrification is now being carried out with the resources of the Rural and Peri-Urban Electrification Fund (FERUM), provided by commer- cial and industrial users, paid into the FS to later finance electrification projects pro- posed by the distribution companies. Most of these projects consist of extending networks and attending to the needs of the population in the area covered by the interconnected system. However, new initiative and alternative approaches are needed to extend service to the most remote rural areas, including mobilizing com- munities and local private agents to develop decentralized systems. INCOMPLETE IMPLEMENTATION OF ENVIRONMENTAL POLICY IN THE SECTOR. In the framework of the Integrated Environmental Management System (SUMA), the Ministry of the Environment, in collaboration with the World Bank and the Inter- Arnerican Development Bank, prepared a draft decree regulating environmental impact studies, licensing, and environmental control and monitoring of the differ- ent sectors of the economy, including the energy sector. One of the components of the Bank's electricity and telecoms project (PROMEC) is to boost CONELEC's environmental planning and management in the electrical energy sector in order to comply with these mandates and to establish environmental regulations. Although the corresponding unit has been created, it is still not fully operational and does not have a work plan. Telecommunications Sector OVERVIEW OF THE SECTOR. During the past decade, Ecuador has practically tripled its number of fixed lines, reaching 1.35 million in September 2002, while doubling the density of telephone connections from 5 to 11 lines per 100 inhabitants. Com- pared to other countries in the region, Ecuador is below the Latin American average of 15 lines per 100 inhabitants. However, considering its per capita income, Ecuador has a higher level of penetration than other countries with the same level of develop- ment (see Figure 5). There are great differences in coverage within Ecuador: in the province of Pichincha (the capital of which is Quito), one out of five inhabitants has telephone service, while in provinces such as Orellana and Sucumbios, there is one telephone line for every 30 inhabitants. This situation is similar to that faced by many other countries in Latin America, such as Mexico, Brazil, and Bolivia. Countries with low fixed telephone line coverage, such as Paraguay, have seen a great increase in cellular telephones since this market was opened to free competi- tion, at times quickly overtaking the number of fixed lines. In September 2002, Ecuador registered nearly 1.3 million cellular telephone subscribers, equivalent to 10 percent of the population. Compared to the region as a whole, Ecuador is below the average of 14 subscribers per 100 inhabitants and is behind other countries with a similar level of economic development (see Figure 6). There are several factors that account for the poorly developed cellular market, particularly the scarce competition and late introduction of mobile phone technol- 220 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Figure 5. Percentage of the Population with Fixed Telephone Line (2001) 30 25- QQAC CR1 25 ~~~~~~BAARG 20 CC)L 15 PAN oME ECU oMEXg 10- BOL MAEX 5 TER p HON PARR 0 l 0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 Purchasing power adjusted per capita GDP Source: World Bank. Figure 6. Percentage of the Population with Cellular Phones (2001) 40 CHI 35 30 - VEN 25 ~~~~PANAR 20 PAR 15- BOL 10 B, A 9 5 tL-U 0o PER 0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 Purchasing power adjusted per capita GDP Source: World Bank. ogy to Ecuador (in 1993), making it one of the last countries in the region to acquire it, ahead only of Panama and Honduras. It is significant that in 2001 (and during the first half of 2002), the cellular market grew by an average of 50 percent per year, because of the inability of fixed line companies to respond to demand and because of the threat to incumbent mobile phone operators, a third competitor would enter the market. The government has failed in its effort to attract private capital, inter- national operators, and more competition to the fixed and mobile telephone mar- kets, mainly because of scarce political support, financially unattractive contract structures, and a lack of clarity in the regulatory framework governing the sector. BASIC INFRASTRUCTURE 221 The Chilean success story suggests that to reduce inequalities in access to telecommunications services, the most effective strategy for increasing low coverage in poor urban and rural areas is to introduce competition and private investment to the sector, and to create a development fund to which the companies themselves contribute. Although Ecuador has already created Fodetel, financing for this fund is not included in the law and it is therefore not operational for lack of resources. For this reason, the PROMEC project, which is financed by the World Bank, intends to install 160 rural telephone centers, including phone booths and computers with Internet access in order to provide government services in rural areas. Four pilot projects will also be implemented to support small and medium-sized enterprises (SMEs) and increase their production and export capacity. It must be kept in mind that as long as the basic telephone sector does not develop with private funds and does not open to competition, the viability of Fodetel will remain uncertain. QUALITY AND EFFICIENCY OF SERVICE. The quality of fixed telephone service remains below the regional average. In 2000, there were 48 failures per 100 lines per year, compared to 39 for other countries in the region with the same level of develop- ment. It must be noted that low quality service has more to do with the provider being government-owned than with the level of a country's development. There is an average of 49 failures in countries where the local operator is in government hands, whereas the figure is 26 for countries with private sector operators. To take a specific example, Bolivia has a lower per capita income than Ecuador but its opera- tor, ENTEL (privatized in 1996), registered only about 20 failures per 100 lines in 2000, while ICE in Costa Rica (with higher per capita income but a public phone company), registered an average of 65 failures in the same year. As long as the main local telephone operators do not operate with strict business discipline in a compet- itive market, there will be few incentives to improve the quality of service and avail- ability of new products. SUBSIDIES. Despite having opened the market to competition, serious distortions remain in the basic telecommunications services market. For several years, the basic telephone operator, EMETEL, and then Andinatel and Pacifictel, maintained a cross-subsidy to offer very low local service rates while maintaining artificially high international long distance charges far above the international average. This led to a large percentage of international calls being made via "by-pass" or the Internet, giv- ing rise to a boom in cyber-cafes, some operated illegally. In 2000, CONATEL agreed to a rate adjustment plan to solve this problem and balance the market before the operators were privatized. Nonetheless, this process was brought to a halt that same year when the execu- tive branch of the government ordered a rate freeze. As a result, the local Pacifictel rate for the residential sector in November 2002 was 60 percent lower than origi- nally planned in the adjustment program that should have concluded in January 2003. The cost of a local call is now one of the lowest in the region and both Andi- 222 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM natel and Pacifictel offer below-cost local service. Also, the long distance market has been opened to competition and international rates have dropped, meaning that both companies will begin to face financial difficulties if local rates are not adjusted to real costs. Adjusting rates is necessary so that both companies can operate effi- ciently and be ready to be bought or capitalized by an experienced operator. Both companies urgently need fresh capital to continue to make investments, build new networks, and install fixed lines, which are still a fundamental part of the basic struc- ture for developing information and communications technology (ICT). The nec- essary increase in local rates will undoubtedly affect some population groups with the least economic resources, making it necessary to adopt a more effective strategy to continue subsidizing them. The present system of cheap rates is ineffective because it is based on the geographic location of individuals instead of their income level. One possibility would be to create a system of prepayment cards in which each individual has complete control over his or her spending. LEVEL OF COMPETITION. In general, competition in the sector has risen continuously since it began in January 2002. The national and international long distance market is more competitive and rates have dropped sharply. A few years ago, it cost about $US1.30 a minute to phone the United States, whereas this can now be done for $USO.30. It is hoped that rates will continue dropping once the interconnection plan is clearer and the surtax on termination of traffic levied by incumbent opera- tors is eliminated. CONATEL seems to have opted for the presubscription system instead of the dial-up system for choosing a long distance operator. International experience indi- cates that markets become more competitive when consumers are more easily able to choose the operator that offers the best service and prices, which is facilitated by dial-up selection. This is particularly the case in markets such as Chile and in those recently opened to competition, for example Bolivia. Another problem that has arisen in countries that have opened up to competition but do not have an advanced and well-defined monitoring system involves illegal changes of operator, known as "slamming." The new national long distance regulations consider the possibility of implementing the dial-up system after two years, if this becomes economically viable. However, this strategy may be insufficient, given that once competition has become established and consumers have decided which service to subscribe to, a dominant operator is highly unlikely to lose its market share. This is the case of Telmex in Mexico, where after seven years of open competition, this company still controls about 70 percent of the long distance market. The presubscription system for choosing an operator tends to hold back competition, since it means that each customer has to change and consumers are generally not very proactive when it comes to taking this step. The recent postponement of the third cellular license has sent a bad signal to the international markets. Compared to the rest of the region, Ecuador continues to have one of the lowest levels of competition in the cellular market, with few BAsic INFRASTRUCTURE 223 providers amd, consequently, with high prices (see Figures 7 and 8). However, so far this year, the mobile services market has grown approximately 50 percent and it is estimated that by the end of the year there will be as many subscribers with cellular phones as those with fixed lines. This significant growth is due in part to the fact that the operators Porta and BellSouth, threatened with the entry of a third com- petitor, recently decided to intensify their market strategy to attract as many cus- tomers as possible. Competitive bidding for a third license, or else granting one to Andinatel and to Pacifictel, so that they could partner with an experienced interna- tional operator, would undoubtedly improve current market conditions, benefiting low-income Ecuadorans in particular. INTERNET ACCESS. According to the Office of the Superintendent of Telecommu- nications, only 2.47 percent of the population has direct Internet access. Statistics from the International Telecommunications Union (ITU) for 2001 show that Ecuador had 0.26 Internet servers per 1,000 inhabitants, ranking well below other Figutre 7. Competition in the Cellular Phone Market (Sept. 2002) Brazil Paraguay Mexico Chile Argentina Venezuela Peru Colombia Bolivia Ecuador Uruguay 0 2 4 6 8 Number of operators Source: EMC-Database. 224 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Figure 8. Average Cost per Minute: Cellular Prepayment Plan (Nov. 2002) 0.7 0.6 0.5 0.3- ~q0.2 0.1 0 A e) Source: National operators. countries with a similar level of development, such as Colombia, Peru, and Paraguay, which have 1.33, 0.52, and 0.48 respectively. The low level of ICT in Ecuador is attributable to the fact that the basic telecommunications system remains seriously outdated, which prevents development of the value-added serv- ices sector. In response to this need, in August 2001 the national government ordered the creation of the National Connectivity Commission, responsible for for- mulating and developing state policy and programs aimed at increasing Ecuador's communications capacity through the effective use of ICT. This initiative includes various proposals to improve access to infrastructure; among the most important is a flat rate for Internet access and the development of network access points (NAPs) for local interconnection of Internet service providers (ISPs). The cost of Internet access is the key factor that determines the speed and scope of its development, and for this reason the implementation of a flat rate for Internet access through tele- phone lines is essential to reduce costs. Although Ecuador has the lowest local tele- phone rates in the region, a microenterprise that uses 20 hours' access a month still pays about $28 a month for calls and $22 for unlimited monthly access to the Internet. In terms of infrastructure, the lack of local NAPs makes it faster to send a data package via Miami than berween two locally connected ISPs. The National Connectivity Commission needs greater decisionmaking and implementation power. Also, it must increase its dialogue with the government, Congress, and the general public to pass reforms to extend Internet access, which is considered a national priority within the National Development Plan. BASIC INFRASTRUCTURE 225 Transport Sector CHARACTERISTICS OF THE SECTOR. The transport system in Ecuador has never been systematically planned, but rather has developed in response to the specific needs, public demand, or government policy of the moment. The development of the dif- ferent transport systems has never been coordinated and each one has acted inde- pendently of the others. The problems in the sector arise from the inadequacy of the policies and strate- gies applied, and from a weak regulatory, legal, and institutional framework. These weaknesses then translate into operational, financial, and management problems. Investments and road maintenance are not adequately programmed, efficiency is low, and budget allocations to the sector remain below real investment and mainte- nance needs. Although the government dominates the sector in terms of formulat- ing policy, acting as the regulatory authority and providing infrastructure and serv- ices, poor coordination among institutions prevents government plans from achieving the desired benefits. The provinces and municipalities have very little technical, administrative, and financial capacity to take on the new responsibilities imposed by the Special Law on Decentralization and Social Participation. At these administrative levels, political influences, poor training, and shortages of resources often contribute to paralysis. Highway administration is generally a public sector function, with several insti- tutions responsible, thus preventing proper planning and a clear division of respon- sibilities. Urban and rural cargo and passenger transport service is overwhelmingly managed by individuals and small private companies without proper planning or operational efficiency. This structure results in inefficiency to the detriment of users. The following is a summary of the situation, as well as the key issues facing dif- ferent transport subsectors. ROAD TRANSPORT. All forms of transport are present in Ecuador but highway trans- port is the most important, accounting for 85 percent of domestic cargo and pas- sengers. Though extensive, the road system is poorly operated and maintained. According to an inventory carried out by the Ministry of Public Works (MOP), Ecuador has about 43,200 km of roads, of which 8,161 km are paved, 23,055 km are gravel, and 12,000 km are dirt roads. Functionally, the national highway net- work is officially broken down by jurisdiction into (i) the State Highways Network (Red Vial EstataQ, which includes roads managed by the MOP (8,682 km); (ii) the Provincial Highways Network (Red Vial Provincial, which includes the group of roads managed by each of the provincial councils; and (iii) the Cantonal Roadways Network (Red Vial Cantonal), which includes all the urban and interparochial roads managed by the provincial and cantonal councils. Approximately 51 percent of all the roadways in the country are local roads. In terms of geographical coverage of roadways, there is a relatively extensive system of roads on the coast (except in Esmeraldas) and in the highlands: 16,492 km and 226 ECUADOR: AN ECONOMIC AND SOC1AL AGENDA IN THE NEW MILLENNIUM 22,052 kin, respectively. In the Amazon (or Eastern) region, there are only 4,470 km of roads, of which 89.3 percent are gravel or dirt roads. In the Galapagos Islands there are 184 km of roads, of which 92 percent are gravel. The eastern part of the country, characterized by a low level of development, sparse population and numerous rivers, is sparsely covered by roads. (See Table 9 for more figures on the highway system.) The length of the road network, its functional distribution, and the type of sur- face applied are similar to other countries with similar levels of development. A total of 0.7 km paved and 3.6 km paved and unpaved roads per thousand inhabitants is typical of low/medium-income countries. Several factors, including the institutional environment, uncertain budgets, and the lay of the land contribute to the poor state of the highway network, resulting in long travel times and many accidents. Mainte- nance is poor throughout the network, especially the provincial and municipal rural network, only 30 percent of which is in good condition. In general, most of the primary network is paved, except in the eastern part of the country, where gravel and dirt roads predominate. Difficult topography limits the technical quality of the nerwork, and winding roads increase travel time. For example, the distance between Quito and Guayaquil is only 270 km as the crow flies, but the highway is 420 km long and travel time for Table 9. Characteristics of the Ecuadoran Road System by Regions Highway administration Unit Coast Mountains East Islands Total Total length of roads km 16,492 22,052 4,469 184 43,197 Population inhabi- tants 5,989,543 5,463,934 546,602 18,555 12,018,634 Total km km/ roads per 1,000 1,000 in- inhabi- habitants tants 2.75 4.03 8.18 9.92 3.59 Jurisdiction Primary km 1,830 2,586 1,120 72 5,608 Secondary km 1,461 1,847 534 34 3,876 Tertiary km 4,705 5,091 1,294 16 11,105 Residential km 8,354 12,239 1,499 61 22,153 Local km 141 290 21 0 452 Road surface Paved km 4,040 3,628 478 14 8,160 Gravel km 6,665 12,405 3,816 169 23,055 Dirt km 5,787 6,019 175 0 11,981 Sources: MOP, "Planning and Decentralization of the National Roadways Ad ministration," Isra and Maj6n, 1997. National Bank, Rural Roads Team, July 2002. BASIC INFRASTRUCTURE 227 a heavy vehicle is over 8 hours. These great lengths also make highways more vul- nerable to rockslides, floods, landslides, land sinkage, and earthquakes, as well as to interruptions due to other causes (public demonstrations, strikes, and so on). Road-building practices used until recently have caused environmental problems in areas such as those near the Cuenca-Molleturo-Naranjal highway or the Borb6n- Punta Pefias highway. Given the topographic and geological conditions in the Andes, action is required to mitigate environmental degradation. In summary, the length and coverage of the network is sufficient, but the road surfaces are in poor shape due to lack of maintenance and institutional weakness. An extensive program of routine and periodic maintenance of the main MOP network is now necessary; at present, the MOP has plans for a routine maintenance program to be carried out by microenterprises. It is also absolutely essential to prepare and implement a comprehensive maintenance and repair program for the secondary and rural system, the state of which is so bad that many rural communities are cut off for weeks at a time during the rainy season. VEHICLES AND TRAFFIC. The number of vehicles and the volume of vehicle traffic are also within the range to be expected in a country with Ecuador's per capita GDP. In 1999, there were a total of 624,924 registered vehicles in four groups: (i) Light: 559,691, including cars, jeeps, passenger vans, motorcycles, pick-up trucks, and cargo vans; (ii) Buses: 9,917, consisting of buses and other large passenger vehicles; (iii) Heavy: 54,233, corresponding to trucks, tank trucks, dump trucks, and truck trailers; (iv) Others: 1,083. The distribution of motorized vehicles is not uniform, with the greatest concentration in the provinces of Pichincha (34.5 percent) and Guayas (30.6 percent). 80 percent of registered cargo vehicles are of small capacity (weighing under 3 tons) and only 6,000 vehicles have a capacity of more than 15 tons. However, the number of these large trucks is increasing faster than the smaller ones, indicating a trend toward greater efficiency in cargo transport. Traffic volumes are not very high, wirh most stretches of trunk highway carrying an annual average daily traffic (AADT) of 6,500 vehides a day, but there are four stretches with 10,000 vehicles a day. Most stretches with high volumes of traffic are located near big cities and are held in concession or are in the process of being concessioned. In prac- tice, there are periodic problems of traffic congestion owing to the state of the roads, special holidays, and the presence of slow trucks on mountain highways, but the main limiting factors involve the structure and condition of the highways. The volume of gas emissions generated by the transport sector and the atmospheric conditions of cities such as Quito lead to high levels of air pollution in densely populated areas. Air qual- ity monitoring systems are being installed in some of these cities. RAIL TRANSPORT. Ecuador's rail network has a total length of 964.6 km, of which 30.61 percent is in service. The network is divided into three sectors: Southern Divi- sion (Duirn-Quito, 445.8 km); Northern Division (Quito-San Lorenzo 373.4 km); and Southern Branch (Sibambe-Cuenca, 145.4 km). The system is operated 228 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM by the Ecuadoran National Railway Company (ENFE). This means of transport is used mainly by tourists. The most recent figures available, from 1999, show a very significant drop in passenger transport, with 94,029 passengers travelling by rail that year, compared to 197,855 passengers in 1996. ENFE is now involved in the process of legalizing its new name: Empresa de Ferrocarriles Ecuatorianos (Ecuadoran Rail- ways Company). AIRPORTS AND AIR TRANSPORT: Ecuador has about 200 runways, aerodromes, and airports, five of which are international airports: the Mariscal Sucre (Quito), the Sim6n Bolfvar (Guayaquil), the Manta, the Tulcan, and the Esmeraldas airports. There are also 23 important airports for domestic flights. In 2000, 2.6 million passengers were transported-more than 1.5 million on international flights. Owing to the increase in passengers at the country's two main airports (Quito and Guayaquil), combined with increasing noise and urban pollution levels and the need to modernize and relocate the airports, a process has begun to build or grant new concessions in both cities. In the case of the Quito airport, an agreement was formalized on July 22, 2002, between the Municipality of Quito and the Cana- dian government. The Canadian Trade Consortium agreed to build a new airport (investing about 300 million dollars) and also to manage and operate the Mariscal Sucre airport for five years. Work will begin on March 15, 2003. The total con- cession period will be 35 years-5 for construction, followed by 30 years of oper- ation. PORTS AND MARITIME TRAFFIC: It is estimated that 8 million tons of cargo were moved at the country's main ports in 2001. The largest port is at Guayaquil, which handles 70 percent of the country's foreign trade. The national government has decided to grant concessions for the management of four state-owned commercial ports, through "landlord" contracts, by which the concessionaire assumes all respon- sibility and risk for the administration of existing infrastructure and for any invest- ments that may be required, depending on the activities. At present, the national port authorities are not unionized and are free of labor liabilities. Services are cur- rently provided by operators with short-term contracts, pending award of long-term concessions in the coming phase port modernization. URBAN TRANSPORT: Except in Quito, urban transport in most cities is organized, planned and controlled by the CNTTT. Specific urban transport plans for Ecuado- ran cities are rare and in most cases nonexistent. In most cases official information does not even exist. The only city government that has an official plan is the Munic- ipality of the Metropolitan District of Quito (MDMQ). This body has the author- ity to plan, regulate, and coordinate everything to do with public and private tran- sit and transport in its area of jurisdiction. In Quito, urban transport has many problems, but has undergone relative improvements in recent years, since the MDMQ has implemented projects such as the trolleybus system that has partially BASIC INFRASTRUCTURE 229 rationalized public transport on its main route. In May 2002, the Master Plan for Transport in the Metropolitan District of Quito was launched, setting out actions to be taken over the next 20 years. The MDMQ covers 4,228 km2 and has about 1.45 million inhabitants. There are about 10 inhabitants per vehicle. Public transit/transport demand is approxi- mately 1.6 million trips a day, of which the trolleybus system handles 185,000 trips a day and Ecovia handles 24,000 trips a day. These two services are managed by the MDMQ through the Trolleybus System Operating Unit (UOST). There is a high concentration of public transport on the main routes, where the services overlap and generate congestion. Service is poor, routes are poorly organized, environmental impact due to exhaust emissions is high, and regulations and standards are not prop- erly monitored. Eighty-two percent of movements on public transport are handled by private operators, representing 1.25 million urban trips. Forty-one percent of buses are less than 5 years old, 48 percent are between 5 and 10 years old, and only 11 percent have been operating for more than 10 years. This means that the fleet is relatively new, though there is a great diversity of makes and models. Transport in Quito is divided into 132 routes and includes about 55 operators. GENERAL FRAMEWORK OF THE RATES SYSTEM: The national rates system for transport is established by the CNTTT, except in the cities of Quito and Guayaquil, where this is handled, respectively, by the Municipality of Quito and by the Guayas Trans- port Commission. In general, urban passenger transport rates depend on the type of vehicle used. Prices vary between 10 and 36 cents (U.S.). As for interprovincial transport rates, because there is a great variety of companies and cooperatives with routes throughout the country, there is fierce competition and prices are too low to renovate the fleet. SUBSIDIES. In the highways sector, user charges include taxes on fuel, on vehicle imports, on tires, and on spare parts, plus charges for driving licenses and vehicle license plates. In Ecuador in July 2002, the price of gasoline ($1.12 a gallon for reg- ular and $1.42 for super) was higher than the price of diesel fuel ($0.89 a gallon). Therefore, although the total amount collected from users is greater than the cost of maintaining the network, there is clearly a cross-subsidy for heavy vehicles using diesel fuel, which cause the most damage to the road network. Highway Safety There is an adequate Traffic Code included in the Law on Land Traffic and Trans- port of 1966. However, a number of institutions share the responsibility for traffic safety, and the management of this sector is not properly coordinated. There is a high rate of traffic accidents, almost all trucks fail to obey laws on weight limits, theft of cargo en route is very common, and secondary and rural roads are practically abandoned in terms of signposting and highway safety. 230 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM C. Sectoral Pollicy Recommendations Recommendations vary depending on the maturity of existing institutional and legal arrangements and the degree to which the central government controls each sector. The electricity sector, for example, already has a modern institutional and legal framework (vertical separation of the functions of generation, transmission, and distribution and an adequate sectoral law). The main challenges include increasing operational efficiency and tariff collection through greater private sec- tor participation, the necessary increases in rates, and increased coverage in rural areas. These measures depend mostly on the central government, which controls most of the distribution, transmission, and generation companies. In the telecom- munications sector, on the other hand, the legal and regulatory framework is still incomplete, since a framework law appropriate to the sector is still lacking, as is a clear designation of regulatory responsibilities (several bodies have overlapping responsibilities). Improved coverage and quality of services also depend on greater private sector participation, for which a legal and regulatory framework must first be put in place. Since the central government controls the companies Andinatel and Pacifictel and also controls the issuing of licenses, improvements in the telecommunications sector also depend mostly on the central government. In the water/sanitation and transport sectors, a large part of the services is provided by decentralized providers that depend on provincial or municipal governments. Here too, the central government must finish an incomplete institutional, regula- tory, and legal framework and promote better provision of services, using fiscal transfers as an incentive. In both sectors, improvements in the quality and cover- age of services depend on greater private sector participation in the design, con- struction, and operation of the services (water/sanitation and transport) or the delegation of services to independent public and private operators (water/sanita- tion). Finally, regarding rural community infrastructure (construction of schools, health centers, bridges, local roads, and so on), Ecuador faces the challenge of gen- eralizing a demand-driven approach (see section 4) with communities and munic- ipalities in the driver's seat. This approach already exists in several isolated proj- ects, such as PROLOCAL and PRAGUAS, for example, but is still not widespread. CONTEXT OF DECENTRALIZATION. The recommendations summarized in the fol- lowing subsections are given in the context of the general process of political, finan- cial, and administrative decentralization that Ecuador has been carrying out since the country's return to democracy in 1978. The scope of this process is summarized in a separate document prepared by the World Bank (see chapter 17 on Decentral- ization in this volume). Only 7 percent of public spending in the country is now made by provincial councils and municipalities. However, it is significant that since 2001, agreements have been signed between the national government and 22 provinces and 140 municipalities to decentralize specific responsibilities in the envi- BASIC INFRASTRUCTURE 231 ronmental, tourism, agriculture, and public works sectors, including roads. As of this date, no agreements have been signed with the multiple autonomous bodies responsible to the central government (regional development authorities, social funds, institutes, implementation units, and agencies attached to municipalities). These independent bodies manage about $US1.5 billion a year and participate in various infrastructure sectors (including roads, water, and sanitation), implementing their own policies. These policies are not well coordinated with the sectoral policies of government ministries. This context is important, since the following subsections (especially those on the water supply/sanitation and transport sectors) recommend that the national government use financial transfers to the various sectors to encour- age improvements by service providers. This makes sense only if the autonomous bodies operate clearly in accordance with the sectoral policies established by the ministries responsible. ENVIRONMENTAL CONTEXT. There is a pressing need for an Integrated Environmen- tal Management System (SUMA), established through a government decress that regulates environmental impact studies, licensing, and the control and environmen- tal monitoring of all parts of the economy, including the infrastructure sectors. Water Supply and Sanitation Sector USING CENTRAL GOVERNMENT TRANSFERS TO PROMOTE IMPROVEMENTS. Earlier studies prepared by the World Bank have identified disperse, discretional transfer payments (made under 18 special laws) as being among the basic fiscal obstacles to the success of the decentralization process in Ecuador. The success of intergovern- mental transfers depends on at least a minimal relationship between responsibility and resources, something that is nonexistent today. As for transfers to specific sec- tors, it is particularly recommended that mathematical formulas be used to link the physical and financial performance of the service provider (or of the sector) with the size of the transfers made by the central government.'4 Since the country's water supply and sanitation services are municipal, the main instrument available to the central government to encourage improved performance by service providers is financial transfers. These transfers may be used so that munic- ipalities adopt (i) adequate tariffs, with due protection for the poor; and (ii) mod- ern structures for providing services. The following steps could be followed to turn financial transfers into development tools for the sector: * Calculate and publish the resources effectively transferred by the central gov- ernment to service providers and municipalities via either general transfers 14.The World Bank, "Decentralization Reform Agenda in Ecuador," May 11, 2001, pp. v, 42. 232 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM (the 15 percent law) or transfers linked directly to the water and sanitation sector (transfer of telephone tax, solidarity fund, and the like); o Design a model formula linking the size of transfers to the water and sanita- tion sector to a set of variables (poverty, present coverage, performance and autonomy of the service provider, and so on); o Apply this formula to a pilot group of water companies and municipalities of different sizes and characteristics, in order to refine criteria and goals and to determine their impact; o Extend the use of the final formula to all providers of water and sanitation serv- ices. During this stage, the sector's multiple, overlapping sources of financing would be unified in a single Water Fund, which would make payments on the basis of the established formula. An alternative would be to adopt a single financing formula for all of the sector's present sources of financing (or for a small number of sources that would have the right to invest in the sector). COMPLETING THE INSTITUTIONAL AND LEGAL FRAMEWORK. The development of the water supply and sanitation sector in the coming years depends to a great extent on a reform of the existing legal and institutional framework. Sectoral legislation is required to (i) clearly define and specify the functions of the different national and municipal actors in the sector; (ii) establish an independent national regulatory authority for the water supply and sanitation sector and grant it the minimum nec- essary functions to operate in a decentralized country; (iii) create conditions for the municipalities to delegate the operation of their systems to independent (public and private) operators; and (iv) promote private sector participation in the operation of water systems under clear, transparent contracts that guarantee the greatest possible benefits for the most vulnerable segments of the population. The proposed Water Supply and Sanitation Law, to be prepared by international consultants contracted by CONAM and jointly monitored by CONAM and SAPYSB, is an important opportunity to reform sectoral legislation. Along with the preparation of a new Water Supply and Sanitation Law, it will be important to establish an updated National Water Supply and Sanitation Policy that clarifies key issues such as the sec- tor's policy on subsidies, and the criteria by which service providers can receive them. IMPROVING THE QUALITY AND EFFICIENCY OF SERVICES. Along with the reform of subsidies policy and of the legal and institutional framework for the sector, a mod- ernization of service providers (SPs) will be necessary to achieve a significant improvement in the coverage and the quality of water supply and sanitation services. The best way to modernize the SPs will depend on the size of each and on the spe- cific characteristics of the municipalities involved: 0 Quito and Guayaquil. On August 9, 2001, Guayaquil transferred responsi- bility for providing its water supply and sanitation services for 30 years to a pri- BASIC INFRASTRUCTURE 233 vate company, International Water Services (Guayaquil)-known as INTER- AGUA. The Empresa Cantonal de Agua Potable y Alcantarillado de Guayaquil (ECAPAG, the previous public operator) became the regulatory authority for the contract. A year after the transfer, the operator is meeting its contractual obligations and has achieved (i) better customer service via its "telephone hot- lines"; (ii) an increase in registered users (from 230,000 to 266,000); and (iii) an increase in the collection rate from 60 percent to 70 percent. The additional income from these measures are fundamental for connecting more than 55,000 more families to the water and sewage systems in the first five years of the con- tract. In addition to investments in the water and sewage system, the presence of a new private operator has enabled new schemes to be developed for tack- ling the issue of urban rainwater drainage, a problem that affects many munic- ipalities in the country (especially on the coast) threatened by frequent flood- ing (see Box 1). In Quito, the municipality is preparing more limited private sector participation with the concession of approximately 300,000 connections to the private sector in the eastern districts. In general, both of the largest cities in the country are working to modernize their structures. * Cities with between 100,000 and 300,000 inhabitants. The 12 cities in this group, which have the fastest growing populations in the country-an annual increase of 7.8 percent-have not taken serious steps to begin the moderniza- tion process. It is essential that there be some form of private sector partici- pation (PSP)-national, regional, or international-in the operation, renova- tion, and extension of the systems. PSP should include some investment requirements in the future to attend to the great number of users who will be needing services, while improving the poor quality of existing supply. * Cities with between 30,000 and 100,000 inhabitants. Of the 37 cities that make up this group, 29 do not even have an independent water supply and sanitation service, and the great majority operate their service directly from the municipality. The priority must be to delegate services to administratively and financially independent operators, who in turn could, if they wanted, look for private sector participation. Pedro Moncayo and Caluma are inter- esting examples: Pedro Moncayo has created a municipal company headed by a manager who will administer a management contract with a small private company which will operate the system. Caluma has created a "mixed" com- pany (two municipal representatives and three users on the executive board) in order to operate its water supply system in a nonpolitical manner. * Cities with fewer than 30,000 inhabitants. The 169 municipalities that make up this group are home to 11 percent of the population of Ecuador, and are growing well above the national average (3.5 percent a year versus 2.1 per- cent nationally). All of them administer their water services (and sometimes sewage) directly. In addition to delegating to independent operators, the main challenge for this group of municipalities is to create multicantonal enterprises that allow for economies of scale in order to be able to hire skilled technical 234 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM staff and acquire proper maintenance equipment. The consolidation of small water supply services has been very successful in other countries in the region (Brazil, Chile) and in other parts of the world (England), but has not yet taken shape in Ecuador. To support all municipalities (especially the small and medium-sized ones) that wish to delegate their water supply and sanitation service to independent operators, it is essential to strengthen the capacity of the SAPYSB to provide quick, high qual- ity technical support. It is also important to involve the Association of Municipali- ties of Ecuador (AME) to boost the process of delegating services to convince the smallest municipalities (fewer than 30,000 inhabitants) to create multicantonal water supply and sanitation enterprises. IMPROVING THE MANAGEMENT OF WATER RESOURCES. The sustainability of the qual- ity and quantity of the water supply to urban and rural communities depends on Box 1. Stormwater Drainage-A User Surcharge for Improvements in the Context of a Concession Contract In August 2001, the firm International Water took responsibility for water supply and sanitation services in Guayaquil, while the former company, ECAPAG, became the regulatory authority for the service. However, the con- tract with the concessionaire did not initially include drainage service, which is to be considered in the fifth year of operations. To solve the drainage prob- lem, in part motivated by the coming rainy season and the resulting flooding, the city established a plan for building and financing drainage based on the contract with the operator and on a special surcharge for improvements. Through this plan, previously approved by the Municipal Council, the con- cessionaire is to build the requested works and recover its costs, by charging beneficiaries for the costs separately on their water bills in the form of a spe- cial surcharge for improvements, with a three-year payment period. To test this system, a $US500,000 emergency works operation was successfully car- ried out. Given the success of this operation, the city has recently approved a second surchargefor improvements program, this time worth $11.0 million dollars, to finance the construction of a priority drainage plan for the next four years. To maintain manageable cash flow, the works will be carried out at the same rate that beneficiaries make payments. In this way, Guayaquil is headed toward significant improvement in these services-and perhaps toward becoming a management and financing model for the rest of Latin America. BASIC INFRASTRUCTURE 235 integrated management of the resource at the river basin level, where all users (including rural municipalities and communities) can openly discuss the use, management, and prioritization of the resource. The management of water resources at the level of water basins is fundamental, especially in places where one municipalitys sewage (or agri- cultural effluents) has a significant impact on raw water quality in other municipali- ties downstream. Two short- and medium-term measures are recommended: • Monitoring water basins. In water basins where there are already conflicts over use or significant risks of flooding, it is important that the CNRH (sup- ported by regional development corporations, provincial councils, and munic- ipalities) monitor both the supply and the demand for surface and under- ground water and evaluate its quality to prepare more systematic management in the medium term. * Legal framework. Although Ecuador already has a National Strategy for the Management of Water Resources, it is important that the government review the country's legal fiamework in this regard, in order to establish a more efficient and fairer system for managing river basins and allocating water resources. The World Bank is now evaluating the best way to support this process, perhaps in the framework of a new Project for the Management of Water Resources. Energy Sector The priorities identified for the electrical sector include (i) reactivating private sector participation; (ii) limiting or eliminating state interference in the regulatory author- ity; (iii) reinitiating tariff adjustments; (iv) regularizing the financial situation of the wholesale electricity market; (v) facing the EMELEC problem; (vi) developing a rural energy strategy; and (vii) starting up the environmental division of CONELEC. REACTIVATING PRIVATE PARTICIPATION. This aspect of the reform could begin with the incorporation of private interests into the generation of electricity and, more importantly, into its distribution. Given the factors that prevented the sale of distri- bution companies in the past, and which will likely remain in the near future, it will be necessary to look for new ways to include private participation, such as granting concessions for state-owned assets, capitalization schemes (particularly in the case of the transmission company), or administration contracts that reward the administra- tor according to its performance and the achievement of clearly established quanti- tative goals. Such contracts would introduce the profit motive into this activity, motivating better business management through cost reductions, recovery of losses, and more efficient collection. It must be noted, however, that in the experience of the electrical sectors of other countries, such contracts generally do not lead to sig- nificant or lasting gains in corporate efficiency, owing to the difficulty in guarantee- ing the private partner sufficient control over investments and company employees. It would also be desirable to encourage private sector participation in electrical gen- 236 ECUADOR: AN ECONOMIC AND SocLAL AGENDA IN THE NEW MILLENNIUM eration, where the presence of new investors, besides increasing competition and envigorating the wholesale electricity market, would send out a positive signal for the allocation of new resources. Support should also be given to the development of projects based on renewable energies leading to the reduction of carbon gas emissions. These projects, generally promoted by private investors, could benefit from financing under the Clean Devel- opment Mechanism, in particular the Community Development Carbon Fund. REDUCING STATE INTERFERENCE. State influence in the regulatory authority com- pletely distorts the incentives perceived by existing and potential investors. An ini- tiative is therefore needed that would send a signal of legal stability to the market, whether through regulations that provide greater permanence (and thus assign greater responsibility) to directors of CONELEC, eliminating the possibility that these public employees can be freely transferred to other posts or, in the longer term, by amending the law in this regard. REINITIATING RATES ADJUSTMENTS. This is a prerequisite for realizing the benefits of the reform, guaranteeing that the companies can meet their financial obligations and enabling the wholesale electricity market to operate without accumulating deficits. This adjustment will consist of maintaining a "lifeline" subsidy aimed only at the lowest-income households, for example, for consumption of less than 150-200 kWh/month. However, a simple increase in rates without clear budget restrictions (which would be obtained with the incorporation of private manage- ment-see above) would not guarantee efficient operations, especially in the case of the distribution companies. FINANCIAL SITUATION OF THE WHOLESALE ELECTRICITY MARKET. The wholesale elec- tricity market's continuous accumulation of deficits is not sustainable and requires a solution on the part of the government. The measures to be taken are related to the rates issue (so that the distributors can cancel their debts with the wholesale elec- tricity market), the efficient operation of the trust and, most important, the nor- malization of EMELEC management, as is explained below. FACING THE EMELE,C PROBLEM. This private company has a service concession in the Guayaquil area and is the biggest distributor in Ecuador. However, its financial and legal problems with the state go back many years and it is now being adminis- trated by CONELEC. Solving its problems may involve long and complicated nego- tiations and disputes, especially regarding the company's demands in terms of the state's obligation to guarantee it a certain level of cost-effectiveness. Therefore, although deeper problems may remain latent for a long time to come-beyond the term of the new government-it would useful to develop a strategy to normalize the company's current operations. This requires strong intervention by CONELEC to impose administrative discipline regarding obligations to the wholesale electricity BASIc INFRASTRUcrURE 237 market, as well as guaranteeing short- and medium-term implementation of the investments required to maintain the quality of service in the city. DEVELOPING A RURAL ENERGY STRATEGY. The resources of the Rural and Peri-Urban Electrification Fund (FERUM) must not only be devoted to programs for extending networks, but must also support measures to take energy to isolated communities, using a broad-based approach to look for comprehensive solutions to their energy problems, either by extending networks or through decentralized systems. The first step in this direction is to develop a strategy for reaching these communities and studying the viability of different ways of implementing the strategy. The PROMEC project could be an important instrument for this endeavor. The rural energy strat- egy should include these main features: a rural electrification plan that makes the extension of the network compatible with decentralized systems (mini-networks, individual systems, and the like); determining the legal and regulatory changes and the financial mechanisms necessary to support the strategy (for example, increasing the sources for financing FERUM and their extension to decentralized systems); determining the instruments for providing rural electrification service, such as distri- bution companies, private operators, local organizations, and so forth. ENVIRONMENTAL PLANNING AND MANAGEMENT IN THE ELECTRICAL SECTOR. To guarantee that environmental planning and management systems are set up for the sector, sector authorities must be strerngthened institutionally. This includes the Ministry of Energy and Mining and CONELEC, whose environmental unit must be strengthened. Telecommunications Sector REGULATORY AND POLICYMAIING AGENCIES. To provide greater solidity to the insti- tutional and regulatory framework, the organizational structure that regulates and sets policy in the sector must be reformed. There is great confusion regarding the functions of each agency. For example, SUPTEL controls and monitors the use of the radio frequency spectrum, SENATEL administrates and manages it, and CONATEL approves the frequencies plan and uses of the spectrum. The difficulty in defining the lines of authority and responsibilities make investors hesitant and uncertain. The con- solidation of CONATEL, SUPTEL and SENATEL in two agencies with sufficient authority and functional capacity-one for regulatory functions and the other to set policy in the sector-will provide the simplicity and clarity necessary for a dynamic, competent sector. While the international trend is toward the convergence of telecommunications services, the Ecuadoran telecommunications sector is still extremely fragmented, beginning with the organization of the regulatory agencies. LEGAL FRAMEwoRK. A new legal framework must be found to replace the existing one based on regulations characterized by duplications, inconsistencies, and a lack 238 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM of clarity. For example, Article 15 of the General Regulations prohibits private net- works being connected to public ones, while Article 36 allows it. Furthermore, this same article indicates that operators of public networks must lease their infrastruc- ture to third parties, but limits this leasing to a maximum of two years; however, Article 7 of the Interconnection Regulations requires that the network and other ele- ments be broken up with no time limits. ENERGIZING THE NATIONAL CONNECTIIVTY AGENDA. It would be advisable for the new government to strengthen the National Connectivity Commission, providing it with a direct link with the executive branch of government. This could be achieved by proposing a new director of the commission with a high enough rank to be able to promote the Agenda, while remaining independent of any other government agency. Likewise, the Commission must include representatives of the private sector and of other levels of government, which are essential allies in this effort. IMPROVING QUALITY. The cellular market is a serious threat to both current local telephone operators, which need capital and efficient administration to make the large investments the sector requires. Although there have already been several attempts to attract private capital to Andinatel and Pacifictel, the strategy has not been sufficiently clear, nor have the necessary incentives been offered. A package must now be put together that is attractive enough to convince international oper- ators and investors. Unfortunately, the global telecommunications sector is now depressed and most companies are not in a position to invest in new markets, espe- cially in fixed line operators. Cellular technology has proven to be the most attrac- tive option for developing countries today, since it has the potential to attract a larger sector of the population at a lower cost. As a result, two possible strategies are recommended for Andinatel and Pacifictel: • The first alternative is offering (by public tender) the sale of new shares in both companies to a strategic investor, including a management contract for both operators. A cellular telephone license would be included as the most attractive feature of the package. Thus, as the private operator invests in the companies, its capital stock would gradually increase and service would improve as investments are made to extend services. o An alternative would be to offer (by public tender) a management contract to a well-known international operator that would manage one or both compa- nies, and would gradually sell the companies' shares on the local and interna- tional stock markets. As in the previous alternative, both companies would have a cellular license to expand services. Either of these options would solve the problem of the duopoly in the cellular market and would attract an operator with international experience and fresh capi- tal. This operator could meet the sector's investment needs in terms of improved BAsic INFRASTRUCTURE 239 quality, increased coverage, and the introduction of new technology. It is important that before another tendering process is begun, rates must be adjusted and CONA- TEL must become consolidated as the regulatory authority for the sector, since cer- tainty and transparency are generally highly valued by investors. Transport Sector Institutionally, the agencies responsible for planning, regulation, and control of transport are spread out among different ministries at different administrative levels, generally without proper coordination. Medium- and long-term sectoral and modal planning is deficient. In the short term, agencies try to solve immediate problems in an inappropriate framework, with insufficient resources. In this regard, there is a clear lack of leadership; better planning is also absent at the provincial and munici- pal levels. An exception is the metropolitan district of Quito, which has a properly functioning planning unit. Deficient planning is partially compensated for by CONAM, but this is not sustainable in the medium or long term. The greatest need is to complete institutional restructuring in the sector. This could include turning the MOP into a Ministry of Transport in charge of planning, regulating, and con- trolling the different forms of transport-functions now in the hands of different ministries. In this scheme, independent agencies would be responsible for the administration of each form of transport, with greater private sector participation in the creation of infrastructure. A Concessions Superintendency could even be estab- lished to administrate all projects of this kind in the sector, and improve the sector's institutional framework. DECENTRALIZATION. As was mentioned earlier, Ecuador is deeply immersed in a long and difficult process of decentralization with significant implications for the transport sector. At present, there is a theoretical consensus on the definition of the types of network (primary, secondary, and tertiary) but administrative responsibili- ties are not clear. This issue also involves strengthening regional councils; financing provincial highways; maintaining and improving local roads, concessions, tolls; and environmental and social management. The case of local roads merits special com- ment, since national agencies have participated in their financing and construction and now their maintenance will theoretically be turned over to the municipalities. However, provinces and municipalities have little technical, administrative, or finan- cial capacity to take on the new responsibilities imposed by the Special Law on Decentralization. At these levels of government, political pressures, insufficient training, and a critical lack of resources conspire to prevent change in the situation. Linked to decentralization is the functioning of the system for transferring 15 percent of the total government budget to the local governments. A fundamental problem is that this system of transfer payments is nearly automatic and there are no incentives to link transfers with efficient use of the funds by local governments. The other problem is that local governments claim that the system is not adequate for 240 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM managing the transferred infrastructure and, furthermore, that at the end of each year the central government typically transfers only 10 percent. The government cannot change the 15 percent transfer and should take steps to fund it. However, transfers above this level must be devoted to (i) projects focused on special issues such as the fight against poverty, and (ii) local governments that demonstrate good ability to manage resources and to plan and implement projects. This approach pro- vides double benefits: the efficient use of resources and an incentive for weak local governments to improve their performance. The transport sector will not be successfully modernized without greater private sector participation in various forms: in concessions (not only highways, but also concessions of maritime infrastructure, urban transport, and railways), the design and implementation of infrastructure works, and the provision of transport services. To do this, clear rules and appropriate project management are essential. RURAL ROADS. Unquestionably, one of the main problems faced by rural and indige- nous communities is the poor state of local roads (both for motorized and nonmo- torized vehicles), as well as poor coverage by transport services. The combination of these factors in rural areas makes economic production more expensive and threat- ens government programs aimed at poor areas. Considering the goals of the decen- tralization process, the need for social participation by the rural population and the needs of the transport sector, emphasis should be placed on satisfying the trans- portation needs of rural communities. For rural transport, Ecuador could experi- ment with small truck cooperatives created with mixed capital (municipal, commu- nity-raised, and supplied by individual companies), as well as other more traditional forms of mixed capital ventures for operating stretches of railway. MAIN NETWORK. The MOP has decided to substantially improve its highway main- tenance system by contracting maintenance services on the basis of performance, rather than bu force account. In this context, a routine maintenance pilot project has already been implemented with 14 microenterprises in the province of Loja. Results have been positive, and there are plans to use this approach for the routine maintenance of the entire main network. Community Infrastructure THE ROLE OF THE COMMUNITY IN RURAL INFRASTRUCTURE SERVICES. Rural commu- nities play an active role in the demand, planning, implementation, and adminis- tration of their own infrastructure services. Infrastructure service coverage is lower in rural areas than in urban settings, in terms of access to water supply and sanita- tion, electricity, transport, and telephone services. This lack of services affects all aspects of daily life and the general wellbeing of the rural population, making it dif- ficult to rise out of poverty and develop economic productivity. Economies of scale and administrative involvement make large independent companies more efficient BASIC INFRASTRUCTURE 241 for taking on the management of certain infrastructure services, such as telecom- munications and electric energy. However, other services such as water supply and sanitation, independent energy systems, rural roads, and computer centers are more efficient when decentralized. Whenever rural communities and small companies have been given the opportunity and proper training, they have proven themselves capable of taking on the management of decentralized services. For example, rural water supply systems are successfully managed by water boards throughout Ecuador. There are also numerous examples of small companies contracted for highway main- tenance, managing computer centers, and supplying off-grid energy. Focus ON DEMAND. A common feature of all infrastructure services is that they must be continuously paid for and maintained. In addition to the initial investment costs, all these services involve operational and maintenance costs. User tariffs are the best way to finance water supply, sanitation, energy, and telecommunications services. At the same time, community members make daily decisions by consum- ing services on the basis of their cost and their ability to pay. This information on the consumer is the starting point for determining the level of service to be provided. However, it is important to consider that in each infrastructure sector there is a range of technical options and different levels of service that can be designed to meet consumers' ability to pay. Projects must include a social intermediation program to help organize the community and inform residents about the different levels of serv- ice and their associated costs and management models, while helping the commu- nity make an informed decision about which option to choose. FINANCING. Regarding the financing of community services involving rural infra- structure, tariffs should entirely cover operating and maintenance costs. In certain situations of poverty, the government can provide an initial subsidy for financing the investment. The design of the subsidy system is quite important and the following should be considered: (a) the importance of community participation, demonstrat- ing demand and willingness to pay; (b) participation by, the municipal government as the agency responsible for providing the service, depending on its municipal development priorities; and (c) the central government's contribution to the trans- parency, fairness, and fiscal impact of the subsidy in the context of the sectoral goal of extending service at the national level. An ideal scheme for subsidizing rural infra- structure programs provides a per capita subsidy up to an established limit, which encourages additional contributions from the community and the private sector. Community participation should go beyond assessing initial demand and plan- ning services; it should enable the community to participate in all stages of the implementation of the project. Community members can reduce their financial contribution by making contributions in kind, such as labor or local materials. Fur- thermore, it is during the infrastructure construction and installation stage that the community organization can develop its capacity to administer contracts and imple- ment works. At the same time as the technical aspects of the project are imple- 242 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM mented, it is essential that a training program be developed enabling the commu- nity to establish an organization responsible for managing services and determining a tariff scheme. This organization should also have the technical capacity to operate and maintain the services, either directly or through a contracted company. SERVICE PROVIDERS AND NECESSARY TECHNICAL ASSISTANCE. Decentralized rural infrastructure services must be provided by community organizations and small companies according to the same principles as those followed by centralized serv- ices-thus constituting a viable financing system that provides quality services suf- ficiently and sustainably. Community-based service providers require long-term technical assistance and training in business management skills. The government must provide this technical assistance either direcdy or through third parties-for example, through a contract with the urban services company. Supervision of the performance of community operators is also important and must be carried out within a simple, municipally based regulatory framework, with emphasis on finan- cial concerns and quality of service. SECTORAL POLICIES. Finally, sectoral policies for infrastructure are extremely important and must include legal provisions that allow for participation by community organi- zations and small companies as a viable alternative for providing services in rural areas. At the same time, the government must consider the need to establish a sustainable business model aimed at providing services over the long term, and not simply focus on the construction of infrastructure. This approach is possible if clear rules are estab- lished regarding financial policy, the role of the community and the extent of its con- tribution, the legal framework, and the technical standards applicable to each sector. It is important that these rules be followed by all programs that channel financial resources for the supply of rural infrastructure services. The policy on subsidies must be transparent and well-focused, supporting contributions to new investments to ben- efit those who do not receive services-and not used to cover maintenance or other recurring costs. The Water and Sanitation in Rural Areas and Small Municipalities (PRAGUAS) program, implemented by SAPYSB and financed by the World Bank (through loan 7035-EC), is an example of a demand-based project that (i) gives com- munities and municipalities the leading role in choosing water supply and sanitation systems that satisfy their needs and correspond to their ability to maintain them; (ii) requires financial contributions from municipalities and communities, as well as a commitment to provide the labor necessary to guarantee the sustainability of new infrastructure; and (iii) provides long-term technical assistance to communities (through the municipalities) for operating the systems. Finally, it is important that infrastructure services be considered an integral part of a broader vision of rural devel- opment involving increased productivity and growth of the rural economy. SUPPORTING THE DECENTRALIZATION OF THE COUNTRY. According to other World Bank studies, the main problem with decentralization in Ecuador is "the many BASIC INFRASTRUCTURE 243 autonomous agencies responsible to the central government, but which do not have clear jurisdictions and responsibilities," such as the "regional development agencies, social funds, and the many institutes, implementation units, and agencies attached to ministries." These entities invest in many areas of rural infrastructure such as rural roads, potable water, and sanitation, without involving local governments (munici- palities and provinces) in the process of prioritizing, planning, and implementing the investments. In addition to preventing true decentralization in the country, this tendency reduces the sustainability of the investments made, since the most com- plex examples of community infrastructure (rural roads, water supply systems, and so on) depend on long-term technical assistance from the municipalities. This assis- tance is often not provided when municipalities do not feel associated with the proj- ect from the start. For this reason, the Bank recommends that both municipalities and communities (and provinces, if appropriate) be involved in the process of plan- ning and implementing community infrastructure. Sectoral Action Plan Policy measures Problem Short term Medium term (to June 2003) (2003-07) Progress indicators Objectives/goals WATER SUPPLYAND SANITATION The sector's dependence Publish the list of Apply the model formula Amount of transfers Have service providers with on subsidies slows resources effectively to a pilot group of water published. modern, efficient structures modernization of transferred by the supply companies and Model formula designed. and with the proper tariff- service providers. central government municipalities. Model formula applied based resources to extend 0 and municipalities Extend the use of the to a group of water supply coverage and improve the to service providers. final formula to all companies and quality of the service provided. m Design a model providers of water municipalities. o formula linking the supply and sanitation Formula extended to all z size of transfers to services. providers of water supply 0 the sector to a set and sanitation services. of variables (poverty, existing coverage, performance and autonomy of the service provider, and so on). Incomplete regulatory Prepare and pass a Establish an independent Draft law prepared. Clear regulatory framework and legal framework. new Water Supply regulatory authority for Law passed. that encourages modernization and Sanitation Law. water supply and Regulatory authority of services and private z sanitation. operating. investment. k Update Sectoral Policy Policy published. Document. Lack of transparency, Develop a sectoral Gather data on service Information system z in terms of performance, information system. providers. designed and operating. c of companies in Performance indictors the sector. of providers published ("benchmarking"). z Mismanagement of Unify and modernize Improve and modernize Implementation of the Implement an integrated water water resources. the legal and instiru- the administration and new legal and institutional resources management system tional framework for management of available framework underway at that includes a legal / q water resources water resources (and the national level and in institutional framework that is management. related water infras- at least one priority river coherent at the national level, tructure) in priority basin. and has sufficiently decentral- river basins. ized administration and man- agement. ELECTRICITY Incomplete reform. Develop alternative Implement the identi- Production and discussion Increase the efficiency of strategies for private fied strategy (concession, of the strategy; companies by introducing participation. capitalization, administra- Companies with private economic and financial tion contracts, or others). participation. incentives. Institutional Provide stability and Amend the law to reduce Decrees passed regarding Make the regulatory authority vulnerability. independence to the state interference in the CONELEC Board transparent and credible posts of regulators regulation. of Directors; Make investors feel secure. using short-term ad- Amendments to the Law ministrative measures. Confidence of regulated entities, allocation of investment resources. Unsustainable nature Restart tariff adjust- Implement deficit Reduction of wholesale Guarantee the financial of the wholesale ments; include reduction strategy electricity market viability of the wholesale electricity market "lifeline" rate. Implement corporate. deficit. electricity market. ($430 million deficit). (Sectoral Action P/an continues on the following page.) , Sectoral Action Plan (continued) Problem Short term Medium term (to june 2003) (2003-07) Progress indicators Objectives/goals Normalize EMELEC payment plan. Reduce impact on low-income payments. Improve EMELEC households. Develop strategy for management. reducing accumulated deficit. x Unsustainable 1. Adjust rates. Implement private 1. Rates set at objective Implement financial financial nature 2. Develop strategy sector participation. levels. restructuring of the sector. of the sector. for private sector 2. Losses reduced to z 0 participation. reference levels. 3. Private sector n participation. Achieve greater efficiency. z 0 Poor allocation of 1. Adjust rates. Implement legal reform Private investors Meet future demand. 0 investment resources. 2. Effect juridical regarding CONELEC. developing new n stability (via reform generation plants. of CONELEC). Insufficient coverage Develop a rural Implement the rural 1. Strategy defined. Service isolated areas. of the service. energy strategy. energy strategy. 2. Pilot projects in ; implementation stage. 3. Legal and regulatory z changes made. Flawed environmental Begin operation of Implement environ- 1. Environmental and g policy. CONELEC environ- mental policy. social impact studies mental unit. developed. Z 2. Implementation of Ensure environmental measures to limit protection and attenuation of environmental and social consequences in electrical z social impact of energy projects. future projects. TELECOAMMUNICATIONS Lack of competition Establish the bases for Choose a bid for 1. Increased percentage 1. Foment competition in the and private invest- new tendering for private participation in of private participation market. ment in the sector. private participation Andinatel and Pacifictel, in operators. 2. Promote investment and in Andinatel and including bid(s) for 2. Increased number of increase number of Pacifictel, including cellular telephone operators in each operators in the market. new tendering for service. market. mobile telephone service. Overlapping respon- Create a structural Implement institutional 1. Reduction in number Establish a single regulatory sibilities and confusion plan for the new reorganization according of regulatory agencies. authority that is separate from regarding the role of organization of to the plan. 2. Consolidation of the agency that dictates policy each institution. regulatory institutions authority and functions in the telecommunications in the sector. in a single regulatory sector. authority. Contradictions between Prepare a new draft of Carry out negotiations Approval of a new law Establish transparent regulatory regulations and a general law on and make agreements on telecommunications framework that encourages confusing legal telecommunications necessary for the draft that is comprehensive, private investment. framework. to eliminate legal law to be passed by clear and effective. inconsistencies in the Congress. existing regulatory framework. (SectoralAction Plan continues on the following page.) > Sectoral Action Plan (continued) Policy measures Problem Short term Medium term (to June 2003) (2003-07) Progress indicators Objectives/goals Rates not fixed Continue adjusting Rates established Eliminate distortions in the according to real costs. rates; complete this according to costs. market that discourage private before opening bidding investment. for private participation in the companies. Low coverage in rural Receive bids to extend Private companies Increase penetration of and peri-urban areas. telecommunications implementing telecommunications services in , services in rural areas investment contracts rural and peri-urban areas. 0 z through a minimum in rural areas. 0 subsidy financed by Fodetel. z Little use of ICT Appoint a director Implement the National Increased use of ICT in Increase the use of ICT in 0 for development of the National Con- Connectivity Agenda in schools, health centers, business and education in Ecuador. nectivity Commission accordance with its agencies and national and extend government with ministerial rank. design. government ministries, services through use of ICT. mtnicipalities, and so on. z > TRANSPORT Poor Establish micro- Prepare and implement 50 companies, formed, Improve the state of the m highway maintenance. enterprises to maintain a project for maintaining trained, and working network. Z the main network. and improving the main throughout the main Increase the network's useful network. network. economic life. Increase highway safety Generate employment for z unskilled workers. Necessity of Form a committee to Rationalize and clarify Completion of the Improve service. institutional reform. carry our sectoral reform. the role of management strategic plan for the Reduce costs to users. agencies in the highway sector. Guarantee more efficient use sector. of resources. High rate of rural Prepare a rural roads Implement the rural Preparation of highway Eliminate bottlenecks poverty. project with the World roads project. plans at the provincial impeding economic growth. Bank and Inter- level. Provide isolated areas with American Development Guaranteed budget for social services. Bank. national participation. Provide employment. Stimulate agricultural production. 8 Urban Development' Alexandra Ortiz The urban population of Ecuador is growing at an increasing rate, not only in Guayaquil and Quito, but also in some smaller cities. In addition to natural urban growth and rural migration to urban zones, this process is being spurred by the internationalflow ofpersons displaced by the civil conflict in Colombia. The general deterioration of the macroeconomic situation in the country in combination with this heavy population increase in urban areas has resulted in a dramatic increase in urban poverty. The "urbanization" of poverty has caused the multiplication of squatter settlements that house over half ofthe population. In these marginal barrios, living conditions are precarious and residents are totally exposed to the elements. Often severalfamilies and a great number of individuals live in one dwelling, they lack basic sanitation and water connections, and access to servicesis very difficult. Part of the problem is that the price ofhousingsolutions in theformal market is beyond the reach of the majority. While the price ofpartially urbanized land in established neighborhoods varies between $US50 and $ 60 per m2, the price of land that has not been urbanized in illegal subdivisions is only $US4 per m2, the only affordable option for the poor. The Sys- tem of Incentives for Housing (SIV), introduced in 2000, is a direct subsidy system based on demand. Through the SfV; low-income families receive cash payments for housing based on transparent and established criteria. Unfortunately, however, families that are benefici- aries of the SIVdo not have thepurchasingpower to acquireprivate sector housing. In order to confront this problem, a program ofglobal urban improvement should be implemented to decrease the economic, social, andphysical vulnerability of the poorest ofEcuadors urban poor. This program should also include preventive policies, particularly for the functioning of land markets and management of natural disasters. 1. Alexandra Ortiz is the World Bank's main urban economist. Valuable input and collabo- ration were provided by Marianne Fay and Thakoor Persaud, also with the World Bank. 251 252 ECUADOR: AN ECONOMIC AND SOCLAL AGENDA IN THE NEW MILLENNIUM A. Diagnostic Study Urban development is of crucial importance to global economic development in Ecuador. Owing to the high percentage of residents living in urban areas and the fact that the population growth rate is greater than the regional average, the urbaniza- tion process is very dynamic in the country. Since industry and services, both typi- cally urban activities, represent the largest share of GDP (34 percent and 59 percent, respectively) cities are the best places to implement effective development interven- tions. This chapter contains a summary of the main aspects involved in Ecuador's urban development. The first subsection presents statistical data to provide a typol- ogy of the population's urban nature, while the second offers a concise analysis of housing and land. The third subsection focuses on access, quality, and cost of basic urban services. The fourth briefly summarizes an analysis of the vulnerability of the poor in the face of an economic crisis and natural disasters. The document con- cludes with a second section containing specific recommendations. Urbanization Ecuador is one of the least urbanized countries of South America (see Figure 1). In 2001, 63 percent of the population lived in urban areas, compared to 76 percent in Latin America overall, and 80 percent in South America. However, this relatively lower level of urbanization is coupled with a population growth rate above the regional average: while South America's urban population increased an average of 2.1 percent annually between 1995 and 2000, the rate for Ecuador was 3.6 percent. During the next five years the rate is projected at 1.9 and 3 percent percent, respec- tively. Even more compelling is the fact that the increase in urban population accounts for 91 percent of total demographic growth in Ecuador between 1990 and 2000 (World Bank [several years]; United Nations [2000]). Figure 1. Urbanization in Ecuador in Comparison with Latin America 0 'o 280 : 70 a i i c e 40 m d 30 F -H-- 92 1960 1965 1970 1975 1980 1985 1990 1995 2000 2001 r_ oEcuador oLarin America and the Caribbean Source: World Bank, several years. URBAN DEVELOPMENT 253 Another important characteristic of urbanization in Ecuador is that the popula- tion is concentrated in two cities, rather than in just one as is common in many countries of Latin America: Guayaquil, with an estimated population of 1.7 million in 1998, and Quito, the capital with approximately 1.6 million (Global Urban Observatory of the United Nations-GUO). Nearly half of the urban population- and a third of the entire population-is concentrated in these two cities. Guayaquil, in the coastal region, continues to be the country's most important commercial cen- ter, while Quito, in the Sierra region, is the center of political and administrative power. While Guayaquil and Quito continue to grow at elevated rates,2 some smaller cities (100,000 to 300,000 residents) and third-tier (30,000 to 100,000 residents), are growing even faster. In addition to natural urban growth and rural migration to urban areas, both important phenomena in Ecuador, foreigners are also arriving. The cities located in the north are the recipients of important waves of international immigrants, particularly people displaced by the civil conflict in Colombia. When combined with the general economic deterioration, this heavy migration to urban areas has resulted in a dramatic increase in urban poverty. In 1995, 19 per- cent of the urban population was poor. By 1999, this percentage had jumped over 100 percent, reaching 42 percent. The high figures show that the urban proportion of poverty is growing rapidly, with an increase from 33 percent in 1995 to 48 per- cent in 1999 (SIISE). As showvn in Figure 2,3 other indicators that measure poverty levels also have worsened such as the poverty gap (the amount needed to lift the poor above the poverty line, as a percentage of the line), and the poverty severity index (which measures level of inequality between the population below the poverty line). One of the consequences of the urbanization of poverty is the appearance of squatter settlements in the large and medium-sized cities. According to data from the Ministry of Urban Development and Housing (Ministerio de Desarrollo Urbano y Vivienda-MIDUVI), the percentage of households in these settlements rose to 64 percent in Guayaquil in 1994, of which 45 percent did not have property titles. These percentages are lower in Quito, but still high: 30 percent and 18 percent, respectively. In intermediate-size cities of the Sierra region, these percentages are also high, although they fluctuate widely between 25 and 13 percent. The worst condi- tions are in the medium-sized cities of the coastal region, where 70 percent of the population is concentrated in marginal barrios and where 56 percent of this popu- 2. The annual combined rate for the two cities was 2.3 percent during 1990-2001. How- ever, other data from the United Nations and the Inter-American Development Bank indicates that during,the five-year period 1993-98, Guayaquil grew 4.6 percent and Quito grew 2.8 percent annually. 3. The tern recount in Figure 2 is equivalent to the incidence of poverty in Figure 2: per- centage of inhabitants below the poverty line. 254 ECUADOR: AN ECONOMIC AND SOCLAL AGENDA IN THE NEW MILLENNIUM Figure 2. Urban Poverty in Ecuador, 1995-99 50 40 30 u. 20 10 0 Recount Poverty gap Degree of intensity o 1995 01998 011999 Source: SIISE. lation lacks property titles. These numbers are very high and although the definition of "illegal occupants of barrios" differs greatly from one country to another, the data provided by the GUO demonstrates marked differences between Guayaquil and other cities similar in size within the region (see Table 1).4 Land and Housing in Urban Areas Ecuador is characterized by a low rate of urban homeowners compared with other countries in the region (see Table 2), particularly among the poor. However, the Table 1. Percentage of the Population without Formal Property Titles (1998) Percentage without City Population fornal property rights Asunci6n (Paraguay) 1,080,000 9.8% C6rdoba (Argentina) 1,198,000 15% Guayaquil (Ecuador) 2,166,000 54% Recife (Brasil) 1,346,000 16.2% Rosario (Argentina) 987,800 7.9% Santa Cruz de la Sierra (Bolivia) 904,376 13% Source: GUO. 4. Worldwide information is only available for a sample of 232 cities, including 53 cities in Latin America and the Caribbean. Of these cities, only a few have a population close to one million inhabitants, and complete information on the property regime is available for even fewer. URBAN DEVELOPMENT 255 Table 2. Housing Ownership Rates in Ecuador and in Other Countries Ecuador Argentina Peru Mexico Chile Colombia All of the urban population 0.55 0.77 0.73 0.71 0.67 0.49 Income 1999 1998 1999 1999 2000 1999 l 0.53 0.78 0.65 0.63 0.62 0.30 2 0.48 0.72 0.72 0.65 0.64 0.44 3 0.53 0.73 0.71 0.69 0.68 0.54 4 0.58 0.79 0.77 0.77 0.72 0.58 5 0.63 0.83 0.82 0.81 0.68 0.58 Note: Sample only includes the urban population. Source: World Bank estimates. data presented in the table could also be overstated, since the poor tend to declare themselves as owners even when this is not the case on paper (legally), because of the fear of public measures to crack down on squatting. Since security of tenure is the main form of access to patrimony for the urban poor, this situation is cause for great concern. The root of the problem is the inability to make payments and lack of financing. According to MIDUVI's analyses, urbanized and partially urbanized lots should only cost between $US660 and $1,330 (or $US6 and $ 11 per m2 for lots of 120m2), so that the lowest income group can have access to them. Land for dwellings for medium-income households costs between $US50 and $ 60 per m2, while partially urbanized lots in informal settlements cost between $US15 and $ 25 per m2. On the other hand, lands that have not been urbanized cost $US4 per M2 in illegal subdivisions. This has generated a progressive supply of informal housing: of total annual housing demand of approximately 54,000 units, the informal sector provides close to 31,000 each year, covering over 50 percent of the demand. To improve this situation, in 2000, a direct subsidy system was introduced based on demand (the Housing Incentives System-SIV), one of the main programs administered by MIDUVI. The Ministry stopped participating in the direct exe- cution of housing projects years ago, promoting private sector participation instead with the help of subsidies. The SIV system awards cash payments to low-income families through transparent and established criteria, and payments can be used to purchase new homes or improve old dwellings As of this date, 43 percent of the new homes built each year receive SIV support. Although during the 1 990s the pri- vate sector only built houses for the highest income groups, the new system pro- duced a change and the private sector now reaches the third income group with housing units that fluctuate between $US4,500 and $8,000. However, as shown in Table 3, these prices continue to be outside the range of the poorest urban Ecuado- rans. 256 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Table 3. Effects of the Subsidy on Purchasing Power for Housing Average monthly Purchasing power Purchase power with Group income (doUlars) in U.S. dollars subsidy (dolars) 1 104 1,294 3,094 2 184 2,289 4,089 3 281 3,992 5,792 4 439 7,982 N/D 5 922 18,937 N/D Source: IDB (2002). The situation is even worse for the poorest households regarding the private financial sector. In the past, commercial banks performed an important role in financing housing for medium- and high-income groups, in particular during the oil boom period. But the economic crises, particularly the banking crisis of 1999, caused a sharp drop in the mortgage portfolios of banks. Even the Ecuadoran Hous- ing Bank (Banco Ecuatoriano de la Vivienda, BEV) has suffered a reduction in its mortgage portfolio, despite a recent restructuring which has progressively trans- formed it from direct lender to second-tier financial institution. In light of this sit- uation, the banking sector is not very interested in extending credit to low-income borrowers, since small loans are considered to carry a high risk as well as higher costs in relation to capital. The municipalities also play an important role in this process, at least potentially. The decentralization laws establish that municipalities are responsible for urban planning functions and also must establish zoning prerequisites and approval processes for building. While municipalities can undertake local housing programs, they are not obligated to do so. Larger municipalities (Guayaquil and Quito) have joined forces with the private sector to turn over lots with basic services to low- income families, and they have also created programs to regularize property rights for those living in illegal settlements. The accumulated housinghousing deficit is close to 850,000 homes, while the qualitative deficit is 350,000 (IDB 2002) if overcrowded shelters built with tempo- rary materials, and without adequate sanitation and other characteristics are included. Table 4 shows that urban housinghousing conditions are worst in the coastal region. Urban Services In 1999, access to potable water inside houses in urban areas was 58 percent, five percentage points higher than in 1995. On the other hand, the statistic for sanitary services was calculated at 65% (Integrated System of Social Indicators of Ecuador- SIISE). Both percentages are low compared to standards in South America, and it is URBAN DEVELOPMENT 257 Table 4. Housing Conditions in Urban Areas of Ecuador (1998) (percent) Housing conditions Coast Sierra East Percentage with deficient housing conditions 29 22 19 Percentage with overcrowded conditions 44 24 26 Percentage of dwellings with walls built from remporary materials 19 0.7 0.2 Percentage without sanitation inside the dwelling 61 13.3 19.1 Notes: 1. Deficient dwellings include "renter's room," "mediaguas," "rancho, hut, or shack" 2. "Overcrowded conditions" refers to dwellings with more than three people per room. Source: PHO (2001), based on surveys on living conditions. estimated that they are dropping rapidly due to the crisis. However, these statistics conceal important differences between large and small cities in different regions. Table 5 shows that this situation is extremely serious in the coastal region, where less than half of the population has water connections in their dwelling, and less than 40 percent has sewage. The collection of solid wastes by municipal services is very spotty, particularly in the coastal region. In Guayaquil, the largest city in the region, an estimated 70 percent of the dwellings had water connections and 42 percent of homes had toilets inside in 1998, according to the Global Urban Observatory of the United Nations. These statistics indicate that 600,000 people in Guayaquil, a con- siderable number, had to find access to water through alternative means, which takes more time-and frequently this water is lower in quality and more expensive. More than one million people living in the city utilize latrines, septic pits, or simply dump sewage water into their back yard, on side streets or rivers nearby. Table 5. Access to Water, Sanitation, and Trash Collection in Urban Areas of Ecuador (1998) (percent) Indicator Coast Sierra East Water connection inside dwelling 42.1 69 66.1 Sanitation inside dwelling 39.2 86.8 81 Collection of solid wastes by municipal services 68.2 87.6 81 Access to electricity 99.6 99.6 98.6 Source: PHO (2001). 258 ECUADOR: AN ECONOMIC AND SocIAL AGENDA IN THE NEW MILLENNIUM In addition to low coverage levels, the quality of services is deficient. In the case of water, residents without connections inside their dwellings spend an average of eight minutes in all urban areas (PHO 2001) trying to find this vital liquid, but it can increase to 12 minutes for those who utilize public faucets and up to 14 min- utes when the water is taken from a river nearby. The water for all of these sources is of dubious quality, and up to 70 percent of urban Ecuadorans have to treat their water through various methods. Of this 70 percent, 26 percent have a home con- nection. The same source informs us that up to 25 percent of children five years old and under suffer from diarrhea during any given month. This statistic comprises 23 percent of the children without home connections, and 28 percent of the children in the opposite situation, which is not much of a difference. Other complaints refer to interruptions in service, inefficient services for the customer, and high water rates without accountability. The problems with sanitation services are even more serious: in Quito the same pipes are used to evacuate rain water and sewage, creating serious health risks during flooding. Another problem in Quito is the lack of treatment for sewage water. Flooding is the main problem in Guayaquil, particularly the poorest families living near the Guayas River. The tariff and subsidy situation in Ecuador is similar to other Latin American countries-that is, (i) tariffs tend to be very low and they do not cover operational costs or investment costs (see Table 6); (ii) although tariffs are not regulated by the national government, they very rarely increase because of the fear that this would be an extremely unpopular measure; and (iii) subsidies are awarded based on con- sumption and not on purchasing power (IDB 2002; Yepes and G6mez 2002). This situation has had a negative impact on the finances of municipal water and sewage companies that have been charged with providing these services since decentraliza- tion was initiated. In order to relieve this problem, the companies in Guayaquil and Quito have begun to solicit private sector participation. In the case of Quito, Empresa Municipal de Alcantanillado y Agua Potable de Quita (EMAAP-Q) has delegated the updating and maintenance of the cadastral study to the private sector, as well as meter reading, billing, collection, and client services for certain contracts. The next step for EMAAP-Q will be the concession of the eastern area of Quito (Parroquias Orientales), an area with 100,000 medium- and high-income residents Table 6. Tariff and Operation Costs for Water Companies in Ecuador, 2001 (millions of dollars) Indicator Guayaquil Quito Otras ciudades Tariff revenue 21 34 19 Cost O&M 29 47 34 Debt service 13 13 5 Source: Yepes and G6mez, 2002. URBAN DEVELOPMENT 259 and 16,000 connections. In Guayaquil, Empresa Cantonal de Agua Potable y Alcantanliado de Guayaquil (ECAPAG), with the help of the World Bank, has also increased private sector participation. The institutional framework, however, is still not clear because of duplication of management and regulatory functions between municipal enterprises and MIDUVI subsecretariats of water and sanitation. Economic Vulnerability and Vulnerability to Natural Disasters The urban poor in Ecuador face difficult conditions. The serious deficiencies in housing and basic services described in this chapter become problems of hygiene, health and sanitation, low educational levels, complex family relationships, and even violence and criminal activity. The problems are complicated further by the great vulnerability to any economic crisis or physical disaster. Perhaps most depressing, these circumstances constitute a vicious circle from which it is very difficult to escape. In terms of economic vulnerability, the most serious problem is the high per- centage of urban poor in need of employment. Among those who do have jobs, a large majority work in the informal sector without security or benefits. This situa- tion forces them to adopt a series of survival strategies that affect individuals, par- ticularly women and children, the family structure and budget, as well as interfa- milial relationships. A study done by Moser (1997) for the Urban Development Program describes the situation of an extremely poor community of Guayaquil called Cisnes Dos. This study was done at the beginning of the 1990s, but its find- ings are still valid. Some of the most important results are: (i) mothers are forced to increase their participation in the working world and decrease the amount of time they spend taking care of their children; (ii) children of both sexes (12-14 years) also must work an average of 15 hours weekly in family businesses or taking care of their younger siblings; (iii) family nuclei are diminishing and being replaced by extended families with "nests" of relatives who live on the same land and help to take care of the children, and help with cooking and other reciprocal chores; (iv) there is a decrease in family spending and changes in composition, with greater priority given to education in the face of nutritional and health needs, or housing repairs; (v) increased sharing of assets between households, on exchange or credit; and (vi) there is greater participation at the community level in formal protection networks and greater dependency on these networks. A second aspect of urban vulnerability is the high risk of natural disasters that characterizes the country. Quito, for example, is located in a valley surrounded by high mountains, both on the east as well as the west, several of which are active vol- canoes. A number of creeks that feed the Machangara and Monjas rivers cross the city. There is the serious risk of flooding, landslide, and volcanic activity. And the poor, who normally live on the outskirts of the city and close to the creeks, are more exposed to thesedangers. The situation is particularly critical because rainwater and sewage are all carried by the same pipes. In Guayaquil, seismic activity poses the 260 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM greatest risk, and the city has been affected by several earthquakes in the past which have destroyed the dwellings of the poorest inhabitants and cut off basic services. At the end of the 1990s, Ecuador was hit by ocean swells that affected the coast. In addition to injuries and loss of human life, El Nifno destroyed many dwellings and seriously damaged productive infrastructure, roads, and services. B. Recommendations The situation of the poorest Ecuadorans living in urban areas is harsh, and threat- ens to become worse because of the rapid increase in poverty in all cities. We pro- pose that this serious problem be treated through an urban improvement program in various cities, particularly in the coastal region. This would help to support and optimize actions undertaken by various municipalities, where property tides have been awarded, and it would also take advantage of the high level of social participa- tion that exists in poor neighborhoods.5 However, in order to go beyond the classic urban improvement program that is by nature corrective, it is necessary to under- stand the dynamics of the housing and real estate market, both for land as well as dwellings, and find a way to bring housing within reach of the poorest of the poor. In addition, since urban improvement means building or improving basic infra- structure, it is important to keep in mind the aspect of disaster prevention. Because of this, the program of recommendations is two-fold, one part preven- tive and the other corrective. The preventative part has two main objectives: (i) understand completely how land markets work, and (ii) decrease vulnerability to natural disasters. Regarding land markets, there are techniques-such as price gra- dients and density, indexes of unplanned urban growth, prices and uses of land, impact of regularization of soil, spatial and temporal price analysis, densities, land use and building permits-that would all help to characterize formal and informal land markets. This analysis should result in the formulation of specific reforms that allow the poorest urban families to get access to formal land markets Regarding dis- aster vulnerability, the program should lend technical assistance to municipalities and communities in the form of geo-referenced information systems (such as vul- nerability maps), institutional dispositions to prevent and mitigate disasters, pro- grams to raise community awareness, and specific civic works. The corrective part of the program should deal with housing and infrastructure deficiencies at the neighborhood level, such as the organization of land lots, invest- 5. The Bank has considerable experience with urban improvement programs all over the world, and can offer specialized knowledge to the Government of Ecuador. In Latin America, projects such as El Mezquital in Guatemala City and the CAMEBA project underway in Caracas, are good examples of direct intervention to improve living condi- tions for thousands of families. URBAN DEVELOPMENT 261 ment in infrastructure, social development programs, and a pilot project to generate income. The territorial organization of land lots includes registering and turning over property titles, improving cadastral studies and municipal registries, and the process of awarding property titles, in addition to technical assistance to improve household conditions. One phenomenon that is well documented by studies is that the awarding of property titles increases property value and thus represents a trans- fer of patrimony to the poor, increasing private investment in housing and strength- ening the possibility of obtaining credit. The improvement of related information systems, particularly cadastral studies and registries, should translate into greater transparency in real estate transactions, and an increase in the municipal tax base. Investments in infrastructure should include water connections and sewage; improvement of roads and pedestrian access, ditches, and public lighting; as well as the construction of social centers and social infrastructure of other types. General support for community organization and extension, as well as education and train- ing of communities in environmental matters will be decisive in order to ensure active participation in the design, implementation, and evaluation of programs. Finally, a pilot project to generate income through small businesses, better market information systems, and the formation of local capabilities is needed to complete an integral intervention program to combat urban poverty. Ecuadoran municipalities have been in charge of water, sanitation, sewage, drainage, trash collection, roads, and urban transport since 1997. They are ready to directly implement these types of programs. The Special Law for State Decentral- ization and Social Participation also allows municipal governments to assume responsibility for social services, particularly health and education. Despite the incipient nature of the decentralization process, municipalities have progressed in this area during the last five years, especially in terms of diversifying their income sources and decreasing dependency on transferences from the national government. Important efforts are underway to boost local tax collection, and in the case of the most advanced municipalities, to improve access to credit. Policy Matrix C Recommendations Short term Medium term Progress acbievement Problems (to June 2003) (2003-07) indicators Objectives/goal Increase in the quantity Analysis of urban Implementation of Prices of un-urbanized lands Deal with land market of urban squatter land markets to specific measures that and urbanized lots in failures that are the settlements. determine reasons result from analysis. different areas of each city. fundamental cause of for failure. formation of squatter settlements. ° Decrease in the quality Pilot project for Extending scale of Water and sewage Improve quality of life and of life in existing urban improvement. pilot project to turn connections, kilometers productivity of poor urban , settlements. it into an urban of pedestrian and residents and their integration ° improvement project. vehicular access. into the formal city. 0 High vulnerability Vulnerability analysis. Technical assistance Number and type of risk Achieve greater awareness and of urban poor to and infrastructure to maps produced and preparation for natural economic crisis and decrease vulnerability. interpreted, awareness disasters. 0 natural disasters. campaigns, institutional n framework to prevent and mitigate disasters. c z a z r Part II Boosting Sustainable and Equitable Social Development 9 Education' Carlos Rojas The principal challenges facing education in Ecuador are extending the coverage of qual- ity education, so that allboys and girls can receive 10 years of basic schooling, andfinanc- ing the sector and improving its administration. Although the country has made signif- icant progress in expanding the systems coverage, there are signs of inequity between urban and rural areas, and between the indigenous and nonindigenous populations. Coverage at the secondary level is limited, with a net school enrollment rate of 51 per- cent. In terms of quality, the results of the academic achievement tests known as APRENDO, indicate that third-, fifth-, and seventh-grade students have deficiencies in achievement and aptitude for language and mathematics. These deficiencies are espe- cially pronounced among students who live in rural areas, who attend public schools, or who live in the coastal region. As forfinancing, spending on education was cut in half in the past decade. This has affected the provision of teaching materials, maintenance of school infrastructure, and teacher training and salaries. In terms of administration, it is still centralized. Thus, increasedpublic andprivate investment in the sector will not have the desired impact unless the sector is decentralized. Clearly, in order to achieve the estab- lished coverage and quality goals, spending on education must be raised to at least 5 per- cent of the GDP! Furtherrmore, quality must be improved based on high-performance programs monitored through institutionalizing the APRENDO testing. Finally, it is imperative to review the structure andfunctions of the Ministry of Education, analyzing personnel selection processes, andfurther decentralizing education, so as to grant greater autonomy to the local level and increase parent participation. 1. Carlos Rojas is a specialist in education for the World Bank. 265 266 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM A. lintroductioin Ecuador is one of 189 countries that have pledged to meet the eight "Millennium Development Goals" aimed at eradicating extreme poverty and at improving the liv- ing conditions of its people by the year 2015. One of these goals is universal ele- mentary school education, which means that all boys and girls would complete ele- mentary school. Given that investment in education has diminished in recent years to levels below 3 percent of the GDP, the attainment of this goal is in great jeopardy. Access for children and young people to education in EcLador has increased with each generation, resulting in higher average years of schooling. Persons born in 1933 were, on an average, functionally illiterate, with less than four years of schooling, while persons born in 1973 have an average of nine years of schooling. Estimates by the Inte- grated System of Social Indicators of Ecuador (Sistema Integrado de Indicadores Sociales de Ecuador-SIISE) indicate that the present generation of boys and girls will attain 11.5 years of schooling. In elementary school education, Ecuador, like the rest of the countries in the region, has made significant progress, steadily extending coverage. Despite these efforts, however, there are still large sectors of the population without access to education or that are prematurely forced out of the system. In 1999, the net enrollment rate for elementary schools was 90 percent. For secondary schools, cover- age is still very limited, with a net school enrollment rate of 51 percent, and at the level of higher education, the net enrollment rate is just 14 percent. Only one out of every three children between ages four and five is enrolled in preschool. Progress in coverage for the sector, particularly in elementary school education, is due, in great measure, to the Ecuadoran government's investments in education during the 1970s and 1980s. In the 1970s, spending on education averaged 4.4 per- cent of GDP. This percentage rose in the 1980s, to as much as 5.8 percent of GDP in 1988. Spending on education has gradually diminished since that time, reaching levels as low as 2.7 percent in 2000. Education spending is currently estimated at close to 3 percent of GDP. Unless investment in education is restored to the levels of the past decade, it will be difficult for Ecuador to meet the goal of universal ele- mentary school education by the year 2015. This chapter first presents the principal problems facing the educational system in Ecuador. It then summarizes some of the Ministry of Education's initiatives, actions, and measures to promote decentralization of the system. Also included is a summary of the 10-year plan adopted in 2000.Lastly, conclusions and policy rec- ommendations are given, summarized in a policy matrix, which includes progress indicators. B. The Educational System: Principal Problems Ecuador has a complex institutional system (see Box 1). Several plans and initiatives have been developed during the 1990s and in the past few years (see Box 2). Yet EDUCATION 267 many challenges still face the educational sector. The principal challenges are described below: (Text continues on page 271.) Box 1. Ecuador's Institutional Framework for the Education Sector The Ministry of Education and Culture is responsible for formulating policies in the sector, administering the national education system, and managing and administering certain aspects of cultural and sports affairs. The Ministry of Education and Culture is also responsible for disseminating scientific and technological knowledge. Ecuador has a National Education Council com- prising the Minister of Education or his/her representative, the president of an institution of higher education representing the National Council of Univer- sities and Polytechnic Institutes, two members of the teachers' union, one rep- resentative for public schools and another for private schools, and a represen- tative from the National Council on Development. The Ministry of Social Welfare and the Children's and Family Institute are responsible for early child- hood education (zero to six years). These two institutions provide coverage to approximately 250,000 at-risk children. The National Council of Universities and Polytechnic Institutes, as an autonomous entity, regulates, coordinates, and administers higher education. THE ORGANIZATIONAL STRUCTURE of the Ministry of Education and Cul- ture includes four technical/administrative levels: executive, advisory, sup- port, and operational. The system has four territorial levels: central, regional, provincial, and local (educational establishments and networks). There are also subsystems for "Spanish" education and "Intercultural Bilin- gual Education.2 CENT'RAL ADMINISTRATION. The executive level is responsible for setting policies, and for general administration and control of the educational and cultural system on the national, regional, provincial, and educational insti- tution levels. The advisory level is responsible for overall planning in the educational system. The support level is in charge of the administration and provision of human, financial, material, and technological resources, and for providing services for carrying out the activities of the Ministry of Education and Culture. The operational level is responsible for educational and cultural development, and in said capacity administers, controls, supervises, and carries out activities aimed at meeting the objectives of the (Box continues on thefollowing page.) 268 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Box 1. (continued) Ministry of Education and Culture. There are three deconcentrated enti- ties: The National Service for Books and Teaching Materials; the National Directorate on Physical Education, Sports, and Recreation; and the National Directorate on School Structures. There are also five decentral- ized entities: the National Directorate on Intercultural, Bilingual Educa- tion; the Ecuadoran Institute on Educational Loans and Scholarships; the National Institute on Cultural Heritage; the Ecuadoran Cultural Associa- tion (Casa de la Cultura Ecuadoriana); and the National Sports Forecasting Company. PROVINCIAL ADMINISTRATION. The subsystem for "Spanish" education includes 22 Provincial Directorates of Education and Culture, 1 0 of which are under the technical and administrative control of the Office of the Assistant Secretary for Education, 6 of which are under the Regional Undersecretariat of the Coastline, and 6 of which of are under the control of the Undersecretariat for the Southern Region. These two regional under- secretariats have an organizational structure that replicates the structure of the central administration. The subsystem for intercultural, bilingual edu- cation, has Provincial Directorates in the 16 provinces with indigenous population. FORMAL EDUCATION AND NONFORMAL EDUCATION. Intercultural Bilingual Education is also divided into formal education and nonformal education. Formal education includes 10 years of basic education (one year of pre- school, six years of elementary school, and three years of basic middle school education); three years of specialized secondary education; technical institutes; and university education. Formal education contains three spe- cific programs: (i) the regular program, which requires attendance in accor- dance with age groups, with a sequence of grades and a specific duration of courses; (ii) alternative programs for boys and girls who are not enrolled in regular programs, or who, for a variety of reasons, have not completed their programs (basic literacy and postbasic literacy is included in these pro- grams); and (iii) special education programs. Nonformal education includes early childhood education (zero to six-year-olds) and educational, cultural, and technical instruction programs for boys and girls, youth, and adults. These programs are offered through both public and private insti- tutions. EDUCATION 269 Box 2. Government Strategies and Initiatives PROGRESS IN THE DECENTRALIZATION OF THE SYSTEM. In Ecuador, the legal framework for decentralization and deconcentration is found in the Consti- tution of the Republic and in a series of legal provisions. Despite the good intentions toward establishing a decentralized system, the efforts made in that direction are quite timid and incomplete. Current decentralization efforts are based in part on prior experiences, especially those of the 1990s, which were partially successful. Examples of these experiences include the Program for Better Quality Basic Education, which created 120 Educational Matrix Cen- ters (Centros Educativos Matrices-CEM), with each CEM constituted by approximately 20 schools comprising a network; and the Autonomous Rural School Networks Program, known as RedesAmigas. The latter has as its objec- tives the following: (i) to grant autonomy to approximately 20 percent of the rural schools (close to 2,400 schools) for the management of their resources, with greater participation from parents and members of the community in school administration; and (ii) to improve teaching conditions in basic rural education (elementary school and middle school) in the beneficiary schools' zones of influence. A third example is the decentralization of approximately 1,800 secondary schools, which are managed as decentralized units and receive funds (cash transfers) directly from the Ministry of Economy and Finance. With the funds received, the school pays its teachers directly and cov- ers campus utility bills and maintenance expenses. In the municipality of Quito, decentralized education currently covers 42 Municipal Educational Centers, more than 12,000 students, and 900 teachers. The Quito experience is a further example of actions that are conducive to providing autonomy and delegating functions to the various levels. The annex includes a summary of the progress mentioned above, which plays a fundamental role in future edu- cational policy decisions. PROGRESS IN PLANNING. Various plans have been delineated by past adminis- trations to continue the process of extending coverage, improving the quality of services, and, in general, making services more efficient. In 2000, the Min- istry of Education and Culture prepared and published a 10-year plan cover- ing the various levels of the education sector. The plan sets forth policies to be followed, priorities for the sector, and strategies to be implemented. The fun- damental objective of this plan is to ensure universal access to general educa- tion (that is, basic education, high school, and adult education), in accordance with the principle of equity. This plan contemplates a Ministry "converted (Box continues on the following page.) 270 ECUADOR: AN ECONOMIC AND SOciAL AGENDA IN THE NEW MILLENNIUM Box 2. (continued) into an organization that functions as a leader; that is decentralized, efficient, and flexible; and whose management contributes to reducing inequities in access to educational services and in the distribution of knowledge..." (Min- istry of Education and Culture 2001). The plan in question established the following policies and strategies to be implemented: (i) universal access to early childhood and basic education, while ensuring that students stay in school at those levels of education; (ii) improved quality of education, to ensure significant learning and the integral development of the students; (iii) strengthening of intercultural, bilingual education; and (iv) better conditions for teachers, along with regulation of the teacher training system for intercul- tural, bilingual education. In order to implement these actions, the Ministry of Education and Culture has considered the following measures: (i) decen- tralization and devolve authority, with specific strategies for each level of administration-central, provincial, and local; and (ii) changes in financial and budgetary administration that involve strengthening and integrating the planning and financing functions; (iii) monitoring and evaluating the use of financial resources; and (iv) a decentralized allocation of budgetary funds in order to generate autonomous school networks and schools. THE "SOCIAL CONTRACT FOR EDUCATION." More recently (September 2002), the agencies of the United Nations system proposed what has been called the "Social Contract for Education," which sets forth the following goals: "...ensure that Ecuadoran girls and boys have access to and remain in school for 10 years of quality basic education; and adopt standards of quality in edu- cation, taking into consideration the ethnic and cultural diversity of the coun- try, which would include training in ethical, moral, and civic values, so that Ecuador would become one of the countries with the best indicators in basic education within the region." The declaration also includes strategies that need to be followed to meet these goals, which can be summarized as follows: (i) training and continuing professional development for the teachers, and decent pay; (ii) an equitable distribution of human resources in accordance with the needs of the schools; (iii) compliance with curricula; (iv) establish- ments with adequate infrastructure and equipment; (v) an incentive policy based on the implementation of a national evaluation system; (vi) support to needy families (through scholarships and school meals, for instance); and (vii) ensuring that appropriate financial resources to meet the goals that have been established. EDUCATION 271 Limited and Unequal Access to Education Considerable discrepancies and inequities are seen in the provision of services when comparing income quintiles or urban, rural or indigenous/non-indigenous popula- tions. While the population of the poorest quintile in rural areas has less than 4 years of schooling, the population of the wealthiest quintile in urban areas has more than 12 years of schooling (World Bank World Development Report 2000). The results of the Living Conditions Survey of 1999 indicate that the indigenous population over the age of 24 living in the rural highland areas has an average of 2.4 years of schooling, compared to 5 years of schooling for the rural nonindigenous population in the same areas and 7.6 years of schooling on a national level. In 1999 the net school enrollment rate for basic middle school education among the poorest quin- tile of the population was 19 percent, while for specialized high school this figure was 11 percent. Among the wealthiest quintile of the population, these rates were 80 percent and 62 percent, respectively. Inequities are also reflected in higher edu- cation, as only 2 percent of the population among the poorest quintile has access to higher education, as compared to 38 percent among the wealthiest quintile. A sum- mary is presented below of this situation as seen in early childhood education, pre- school, elementary, secondary, and higher education. EARLY CHILDHOOD EDUCATION. The supply of early childhood education is very limited. Only 7.3 percent of children up to four years of age in the three poorest quintiles of the population have access to these services. It is estimated that out of a target population of close to 1.2 million children, only 97,000 are serviced by the two national programs. There is no national policy or strategy that addresses this group of children. PRESCHOOL EDUCATION. This level, which is considered to be the first year of the mandatory 10-year cycle (basic education), covers only half of children who are age five. Only 42 percent of children among the poorest quintile have access to pre- school education, as compared to 86 percent among the wealthiest quintile. Rural enrollments at this level account for only 22 percent of the total, even though the number of children in rural areas represents 44 percent of all children between four and five years of age. Net enrollment at this level (33 percent) for children between four and five is similar to that of other countries of the region with similar income. ELEMENTARY SCHOOL EDUCATION. The majority of children in urban and rural areas have access to elementary school education. In 1999, net enrollment was 90 percent and gross enrollment was 109 percent, demonstrating high coverage. Yet a signifi- cant number of students were either younger, or, as happens more often, older than what was expected for this cycle. According to a study conducted by the World Bank (2000), at age six, only 65 percent and 78.6 percent of children from the two low- est income quintiles, respectively, were enrolled in school, while 98.8 percent of chil- 272 ECUADOR: AN ECONOMIC AND SoC1AL AGENDA IN THE NEW MILLENNIUM dren from the wealthiest quintile were enrolled. At age seven, children from the poorest quintile were the only ones with late-enrollment problems (82.9 percent enrolled), and at age eight, the enrollment rate was 92.5 percent. The study also indicated that delayed enrollment age was principally a problem in rural areas, where, at age six, slightly more than 70 percent of children were enrolled, while in urban areas this figure was 90 percent. (See Figure 1). At the elementary school level, the enrollment rate nationwide grew by 7 percent between the 1994-95 school year and the 1999-2000 school year-that is, by two million students. In this estimate, bilingual schools are included. Yet enrollments only grew by 3.9 percent during that same period in the rural areas. The annual enrollment growth rate was lower than the estimated growth of the population (2 percent). Over a five-year period, the number of teachers grew by 25 percent in Figure 1: Net Enrollment Rates, by Consumption Quintiles and by Educational Levels 120 100 80 QL Q2 Q3 Q4 Q5 Total oElementary oSecondary nUniversity (6-11) (12-17) (18-24) 120 100 60_ _ 40 - 20 _, 0 Men Women Rural Urban oElementary oSecondary -University Source: Living Standards Measurement Study (LSMS ) 1999), in Social Indicators System of Ecuador-SIISE) (Sistema Integrado de Indicadores Sociales de Ecuador-SIISE) (2000), and the author's calculations (using information based on consumption quintiles). EDUCATION 273 urban areas and 20 percent in rural areas, which reduced the student/teacher ratio from 26 to 23 during this period. The Intercultural Bilingual Education subsystem, created in 1998, had slightly more than 85,000 students in 2000, which corresponds to 4.4-percent of the total enrollments in that year. This percentage is relatively small when one considers that between 12 and 25 percent2 of the rural population is indigenous. Enrollments in bilingual schools increased by more than 100 percent in a decade. It is worth not- ing that the enrollment of males grew twice as much as the enrollment of females. Close to one-third of elementary schools nationally (approximately 6,000) have only one teacher for the school. In the Amazon region the percentage of schools with one teacher is higher (53.5 percent). One-teacher schools cover an estimated 170,000 students or 9 percent of total elementary school enrollments. Since these schools are principally found in the country's poorest rural, isolated areas, they are at a disadvantage with respect to the rest of the public schools in the rural areas. Despite significant reductions in grade repetition rates, these rates are still alarm- ing, particularly in rural areas, where grade repetition rate is 13 percent during the first two grades, compared to 6 percent in urban areas. As well, the percentage of students in bilingual schools who are not promoted to the next grade has been shown to be almost double the number of students who are not promoted in "Span- ish" schools. BASIC MIDDLE SCHOOL AND SPECIALIZED HIGH SCHOOL EDUCATION. The nationwide enrollment rate at this educational level grew by 19 percent between school years 1994-95 and 1999-2000. During school year 1999-2000, the country had close to one million students enrolled in 3,473 schools. One out of every four students attended a private school, while educational institutions in rural areas accounted for only 14 percent of the students. This demonstrates that access to middle and high school is limited for poor and indigenous peoples. Enrollment in intercultural, bilin- gual education establishments amounts to less than 1 percent of total enrollments in middle and high school education. The net school enrollment rate is calculated at 50 percent. The student/teacher ratio is very low when compared to the average in Latin America. Data from the Living Conditions Survey for the year 1995 indicate that the older the age-group, the less likely it is that youth will be enrolled in school. For example, 91 percent of youth who are 12 years of age were attending school, while in the same year, only 76 percent of 13-year-olds, 68 percent of 14-year-olds, 62 percent of 15- year-olds, 58 percent of 16-year-olds, and 55 percent of 17-year-olds were attending school. The gap between rich and poor is wider at this level than in the elementary grades. A study conducted by the World Bank, Ecuador. Crisis, Poverty, and Social Conditions, (2000) using data from the Living Conditions Survey of 1998 found 2. The percentage depends upon the source of information. 274 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM that the principal reason why 34 percent of children between 11 and 15 years of age were not attending an educational institution was the cost; 19 percent were not attending owing to a lack of interest, 16 percent because they had to work, 10 per- cent owing to lack of access, 4 percent because of sickness, and 3 percent because they had to do chores at home. During school year 1998-99 almost 235,000 students, 14 percent of the popula- tion between 18 and 24 years of age, were enrolled in institutions of higher education. The percentage is very low when compared to Chile, which has a university enroll- ment of 21 percent, or Argentina which has a university enrollment of 27 percent. Eighty percent of the students enrolled attend public universities and the remaining 20 percent attend private universities. The Universidad Central del Ecuador and the Universidad de Quito account for almost 50 percent of university enrollments. Higher education is not equitable: Net enrollments are 4 percent in the country's rural areas and 22 percent in urban areas. Less than 1 percent of the population over 24 years of age has a university degree in the rural areas of the coastal region, compared to 8 per- cent in the cities. In the highlands region these percentages are 1.1 percent and 11.8 percent, respectively. By income quintiles, the percentages are 2 percent and 5 percent for the poorest quintiles and 38 percent for the wealthiest quintile of the population. In the highlands region, significant differences between genders are found: male pop- ulation rates in institutions of higher learning are twice higher than female rates. Higher education is inefficient as it takes an average of 13.4 years of study for a per- son to graduate (including primary school years) at a cost of $US22,460. The rate of graduation at public universities is rarely more than 10 to 15 percent of the original freshman class (Ecuador: Crisis, Poverty, and Social Conditions, World Bank 2000). In summary, inequities are seen at all levels of the system. It is clear that there are significant discrepancies among rural, indigenous, and urban populations and within income groups (See Figure 2). The school-age population of a poor, indige- nous rural area is at a great disadvantage compared to non-poor, non-indigenous urban school-age children. Middle school, high school, and university education are principally aimed at the urban school population from the wealthiest quintiles, as the poor in rural areas have no possibility of enrolling in middle school. It is inter- esting to note that the analysis found no differences that could indicate problems of inequity between men and women in basic education. Efforts to expand coverage have had positive results. It is important to note that illiteracy rates in the country have been significantly reduced. Currendy it is esti- mated that 10.5 percent of the population over the age of 15 is illiterate. This illit- eracy rate is only 3.2 percent among persons between 15 and 24, and 6.2 percent among 25- to 39-year-olds. As is to be expected, the greatest percentage of illiteracy is found among persons over the age of 65, among whom the illiteracy rate is 34.5 percent. It can also be noted that illiteracy is chiefly found in rural areas, and espe- cially in indigenous regions. Within the Ministry of Education, the National Directorate of Continuing Pop- ular Education (Direccidn Nacional de Educacion Popular Permanente-DINEPP) is EDUCATION 275 Figure 2. Public Spending on Education by Consumption Quintile 60 50 40 _ 30 20 X ;i Elementary Secondary Universiry All oQuintile 1 oQuintile 2 uQuintile 3 .QLiintile 4 .Quintile 5 Source: National Educational Statistics System of Ecuador - SINEC (Sistema Nacional de Estadisticas Educativas del Fcuador-SINEC);, Living Conditions Survey, 1998,. iln World Bank, (2000). in charge of adult education. Currently it coordinates a plan aimed at improving the supply of formal and nonformal education for groups that for one reason or another have been excluded from the system. The progress report indicates that the plan lacks the political support and economic resources needed to put it into action. Low Quality of the Education Imparted Results from academic achievement tests (APRENDO) indicate deficiencies in the quality of teaching at the basic level. It is clear that the low quality of education is related to factors involving school campuses, the teaching staff, the family, and in general, to the socioeconomic conditions surrounding the students. In 1996 the Ministry of Education and Culture implemented a system to measure the quality of education and ascertain student achievement in the areas of language and mathematics. This system was applied to students in second, sixth and ninth grades in public and private schools in the coastal region and the highlands. To date, the system has been applied four times (in 1996, 1997, 1998, and 2000). In general, results indicate deficiencies among the students in achievement and aptitude for lan- guage and mathematics, especially in the rural areas and among public school students. Similarly, the deficient quality of education was noted in a survey conducted in Ecuador in 1998, known as "Barometro Latino" ("Latin Barometer"). The survey's participants indicated that they considered the educational system in Ecuador to be one of the most deficient educational systems of the Americas. Researchers who con- ducted a survey of employers in 2001 for the World Economic Forum and Harvard University's Center for International Development (CID) reached the same conclu- sion. As is seen in Figure 3, the results for quality of education in Ecuador are the lowest from among 19 Latin American countries (Arellano 2002, pp. 75-76). Figure 3. Quality of Schools, Based on the Opinion of the Business Sector 6 ~~~~~~~~~~~~~~~~~~~~~~~Trinidad and Tobago OOECD* ° high-income . ELs Asia and the Pacific n MexiJamaicao 4 El Salvador Brzi ° Argentina° osaRc... -r a ~ Mexico Colombia Venezuela Peru LAC** 3 _ Bolivia C Paraguayo z .,> Guatemala 0< Honduras n ._ z z 0~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 0 1 2 3 4 5 6 7 Quality of public schools z Notes: 'OECD = Organisation for Economic Co-operation and Development; '* LAC = Latin America and the Caribbean; I = Worse than most other countries; 7 = Among the best in the world. Source: Global Competitiveness Report 2001-2002, Harvard University. EDUCATION 277 Among the principal causes that directly affect the quality of education, the fol- lowing could be considered: * Poor teacher training, particularly in the country's rural areas. Despite the efforts of the Ministry of Education to improve the quality of the teaching staff, teach- ers need more training, both in content and in teaching techniques. The major- ity of teachers in rural areas who have to work simultaneously with more than one grade or on more than one course (that is, in multigrade classrooms), have not been trained to handle such a situation. Similarly, there is still a long way to go in terms of teacher training for contexts of intercultural, bilingual education. A further problem is that teachers are using obsolete methodologies that are not conducive to furthering an effective teaching/learning process. * Because of the economic crisis of the past few years, investment in teaching materials for students and the teaching staff is very limited or almost nil. It is common in rural areas to find students who do not have access to the most minimal school supplies (such as notebooks or pencils). It is also common, in both rural and urban areas, for school campuses to be in physically deplorable conditions that are not conducive to learning. * Other factors affect the quality of education, related to child labor, absen- teeism among children who work to help their parents, and other socioeco- nomic realities. It is important that future measurements under the APRENDO system include instruments to detect the influence of associated factors (family, school, teachers) in the students' academic achievement. Serious Difficulties for Financing Education Serious financial difficulties resulted in the funding cuts that made an impact on the educational sector. Teachers' salaries have been affected and families had to con- tribute more than they used to in the past to educational expenses. Some indicators are presented below: Since the late 1980s, investments in education have been cut sharply as a result of the economic crisis. Available information suggests that spending on education dropped, on an average from 4.7 percent of GDP in the 1980s to 3.1 percent in 1998 and 2.7 percent in 2000. (See Figure 4). As a result of the spending cuts, needed investments in education are not being made. Infrastructure maintenance is minimal and teachers' salaries have been reduced. This has contributed to a higher turnover rate, moonlighting, and absen- teeism among teachers. Similarly, these pay cuts have probably reduced the interest taken in the profession by young people who would have wanted to be teachers. This situation could have serious consequences for the availability of well-trained teachers in the future. Parents have had to increase their contribution to finance their children's educa- tion. For example, they have had to hire teachers to replace those who have aban- Figure 4. Spending on Education as a Percentage of the GDP in Ecuador and in Latin America and the Caribbean, t 1980 to 2001 6.0% 6.0% 5.0% 5.0% 4.0% 4.0% 3.0% ~~~~~~~~~~~~~~~~~~~3.0%z 0 2.0% 2.0% 1.0% 1.0% C, z 0.0% 0.0% z 1980 1985 1990 1995 2000 -i E; Ecuador LLAC 5 Sources: Data on Ecuador from 1980 to 1995 based on Social Indicators System of Ecuador (SIISE), 2000). Data, and from 1996 to 2001 from the Ministry of r z EDUCATION 279 doned schools in isolated rural areas, or hire teachers for certain subject matters in secondary schools. The home survey conducted in 1998 indicates that 40 percent of parents from the poorest percentile contributed a monthly amount in fees and uni- forms, both in elementary and secondary schools (excluding transportation, text- books, and school supplies), that was almost equal to the monthly payment made by parents of private school students (Ecuador: Crisis, Poverty, and Social Conditions, World Bank 2000). Data from the most recent teacher census indicate that more than 1,000 public school teachers are paid with community funds (World Bank 2000). During the years 2000 to 2001, higher education received 26 percent of the funds allocated to the educational sector, compared with 22 percent in 1995. In 2001, the budget for elementary and secondary education was the same as the amount allocated for these levels of education in 1995, while higher education received an increase in its budgetary allocation of almost 33 percent over that same period. From an equity point of view, these budgetary allocations are not advisable. Aggregate spending in education at all levels indicates that the lowest-income pop- ulation quintile is allocated 12 percent of public spending on education, while the highest-income quintile is allocated 25 percent. The percentage of public spending on education that reaches the poorest sectors of the population is lower in Ecuador than in neighboring countries such as Peru, where 21 percent is channeled to the poorest population quintile, Bolivia (32 percent), or Chile (34 percent). Problems in Sector Administration Despite the magnitude of the educational sector's financial problems, one of the greatest challenges is the sector's administration. Greater public and private invest- ment in education will not have a significant impact unless measures are taken to address administrative deficiencies. The principal issues are mentioned below, along with certain points that serve as indicators to illustrate the severity of the problem: The Ministry of Education and Culture has an elevated turnover rate in its high- level authorities (ministers, assistant-ministers, provincial directors, and advisors). This situation impedes continuity in educational policies, makes it difficult to apply a long-term outlook for resolving problems in the sector, and also creates obstacles for teamwork within the Ministry. In its 118 years of existence, the Ministry of Edu- cation and Culture has had 113 ministers, 11 in the last 10 years alone. In a recent analysis of the ministry's structure and functions (Moore and Rosales 2001), the administration was found to be excessively centralized, that there are too many administrative units with parallel functions and lacking coordination, that participation in decisionmaking at the local levels is almost inexistent, and that serv- ice to clients is deficient. Within the Ministry of Education and Culture, intercul- tural, bilingual education has been incorporated through the creation of a parallel system, meaning it and the "Spanish" system are nearly independent of one another. Coordination is lacking throughout the sector. The Ministry and the Provincial Directorates have limited communication with the elementary and secondary 280 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM schools. As a result, follow-up and control of activities at the school level are not effective. In addition, there is almost no follow-up or support from the Ministry for teachers, who are the most important resource in the educational process. Finally, early-childhood education is beyond the control and coordination of the Ministry of Education and Culture, since it is administered by the National Children's and Family Institute and by the Ministry of Social Welfare. The administration of human resources, mainly teachers and principals, is defi- cient and must be improved. The screening, appointment, and promotion of teach- ers within the institution is a process that lacks transparency. Principals of elemen- tary and secondary schools lack authority to select their personnel, or to take corrective measures when teachers engage in serious misconduct. Frequently, appointments depend on subjective criteria and not necessarily on the experience and qualifications of the teachers being considered for the position. The system for assigning teachers contributes to the difficult situation, princi- pally in rural schools. When there is a vacancy in a rural school, a teacher can be appointed to work in the school, but a few months later, can obtain a position in an urban school or in a Provincial Directorate, taking the appointment along with him or her, and leaving the school without an available position to fill with a replacement teacher. Teachers and principals of elementary and secondary schools are appointed for an indefinite period. No mechanisms exist to ensure that they will retire when they reach a certain age. Because retirement income is significantly lower than salaries, very few persons opt for a voluntary retirement. The rate of teacher absenteeism in schools is high, as teachers must visit the Provincial Directorates or the offices of their supervisors frequently regarding administrative matters. Moreover, during the past 15 years an estimated one month per year on average has been lost because of teacher strikes. At schools servicing the poorest populations, an average of nine days of work per month is lost. The distribution of teachers is not adequate. There is a glut of teachers in some areas and a deficit in others. During the 1990s the student/teacher ratio declined and the inadequate distribution worsened. Finally, the salary structure of the teachers has no correlation to the objective of improving the quality and equity of the system. For example, the "frontier bonus" received by teachers in isolated rural areas, which represents an amount equivalent to up to 25 percent of their salary, continues to be included in a teacher's salary even when the teacher stops working in the rural area and is trans- ferred to an urban school. The management of the budget as a tool to promote progress in the implemen- tation of educational policy is inexistent. The budget of the Ministry of Education and Culture is administered by the Ministry of Finance, with limited participation from the former. There are delays in the transfer of funds and the educational authorities are not incorporating economic and financial variables into their policy decisions. EDUCATION 281 C. Recommendations The new administration needs to find solutions to the problems detected in the areas of coverage, quality, financing, and administration of the sector. The principal challenge is attaining the goal of providing 10 years of basic quality schooling. This challenge is encompassed within the framework of the Millennium Development Goals. Programs aimed at extending coverage must be clearly focused on groups that have not been attended to, such as low-income persons and those in rural areas, par- ticularly the indigenous areas. The Ministry of Education and Culture has had suc- cessful programs during recent years, and its coverage must be expanded. Particular attention must be paid to the schools known as one-teacher or multigrade classroom schools, so that in places where there are only one or two teachers, at least all ele- mentary school grades would be offered. Ecuador should consider other educational options such as the "Telesecondary" education model developed by Mexico, which is being successfully implemented in countries of the region such as Guatemala, Panama, Colombia, and Brazil, among others. Similarly, innovative strategies should be developed to offer the complete basic education cycle in areas that are far from major population centers, where there are no schools offering secondary education. Given that the economic situation of families is a factor influencing whether stu- dents enroll and stay in school, the Ministry of Education and Culture should con- sider financing the most needy students through scholarships. Regarding education quality, Ecuador has already made significant efforts to design and implement a quality measurement system, which can be improved and institutionalized. APRENDO can play a fundamental role as a measuring tool that makes it possible to: (i) identify schools with serious difficulties in attaining given standards; and (ii) provide follow-up to policies focused on solving certain identified problems. As for training (continuing education) of the teaching staff, various options or strategies should be evaluated. The Ministry of Education, public and private uni- versities, as well as teacher schools should all be involved in the training process. The most ideal institutions would be those devoted to teacher training. This process will be highly effective if the instruction, as well as the teacher training, are closely cor- related to teacher promotions and thus increase remuneration. The financing of the sector should be closely analyzed from an efficiency stand- point (size of the system at the central, provincial, and local levels), as well as that of resources needed to expand coverage and guarantee at least 10 years of basic educa- tion. Consideration should be given to financing demand for the service, through scholarships for students of the poorest families. An investment in infrastructure, textbooks, libraries, and teaching materials is fundamental to ensure, at least in part, the quality of the service being offered. If the Ministry of Education and Culture fails to improve sector administration, it is quite possible that the funds allocated will not achieve the desired results. The 282 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM structure of the Ministry should be reviewed, carefully analyzing processes for screening, appointing, and promoting personnel both in teaching and administra- tive positions. It is equally important to review experiences with decentralization and devolving authority, so as to give autonomy to individual schools and greater participation to parents. Policy Matrix Short-term policy measures Mid-term policy measures Problems/chalenges (to June 2003) (2003-07) Progress indicators Z Access and equity: *Define the strategy to be followed *Target investments at all levels toward *As is set forth in the Social to ensure universalization of basic the poorest (rural and indigenous Contract for Education: "Access education and include the populations) to increase coverage at for all Ecuadoran girls and boys educational models. all levels. ro 10 years of basic education." Elementary and basic *Evaluate different approaches to *Make sure that real decentralization has *CEM networks and Redes middle school decentralization so as to detcrmine brought decisionmaking to local levels Amigas Networks are strength- whar is working well and what and promote rational, equitable manage- ened and imptoved. aspects rcquire adjustments. ment of resources at local levels. *Evaluation system is being *Increase coverage in the rural and *Strengthen the evaluation system. implcmented. indigenous areas through various *Take measures at the cenrral, provincial, *Poorest students are receiving administrative and teaching options. and local level to make sure that all boys scholarships. and girls enter school at the *Net coverage has increased appropriate age. from 90 to 95 percent in *Grant scholarships to the most needy elementary education. students in the rural areas. *Consider other educational options to extend coverage such as telesecondary education and postelementary education, among others. High school 'Evaluate the current system of Create distance-learning programs (for *Net coverage increases from 51 decentralized management in the example, telesecondary programs), to 65 percent in five ycars. secondary schools to determine especially in rural and indigenous areas, *Secondary schools are fully which aspects need to be improved. to increase access to services. autonomous and receiving *Develop and commence imple- *Transfer responsibility for decision- transfer of funds from the mentation of the plan to transfer making, as well as resourccs for provision central level. 9 decisionmaking and responsibility. of services to the majority of secondary *oorest students are receiving x schools and to the community. scholarships. ( (Matrix continues on the following page) Policy Matrix (continued) 0 Short-term policy measures Mid-term policy measures Problems/ehallenges (to June 2003) (2003-07) Progress indicators *Grant scholarships and subsidies to the best students from the poorest areas so that they can continue their education. Quality and relevance: *Institutionalize the APRENDO 'Improve the academic achievement *Achievement tests have been academic achievement measurement measurement system, making sure that applied and results returned to system as a tool for monitoring the all levels receive feedback so that they the individual schools. system's success at the various levels. may take corrective measures rhat impact learning in the classroom. m (At least two measurements should be 0 a conducted in grades 3, 5, 7, and 9.) 0 Elementary and basic 'Train all teachers of multigrade *Train bilingual teachers of all ethnic *AII rural teachers are trained in > middle sehool classroom schools in the use of groups, so that they specializc in intercultural, bilingual educa- r APRENDO. teaching at multigrade classroom tion and education in multi- 0 *Revise teacher training programs. schools. grade classrooms. 0 *Develop a continuing education *Train teachers, utilizing new methods plan for teachers that is correlated and technologies. to their pay scale. *Promote teacher training at the level Z of the educational network or CEM. > Secondary school *Revise the policy on specialized Reform education at this level to meet Concerted proposal for secon- secondary education. the needs of the labor market. dary education. r Financing of the sector: 'Determine financing requirements *Provide financing to the sector *Coverage and quality goals are to rcspond to the demands for consistent with identified needs. met. coverage and quality. *Implement the new promotion *N basic elementary students *Design the model for a teachers' model, in which teacher remuneration from the poorest stratums are z pay scale based on training and is correlated with training and receiving scholarships. continuing education. continuing education. Administration of *Define educational policies that *Implement the decentralization plan, *Ministry of Education has r ) the sector: improve the system's equity, quality, making sure that the monitoring system been restructured. , and efficiency, taking into account for the process is functioning properly. *Provincial and local level has m the resources available for doing so. *Utilize the budget as a tool to support greater autonomy. 0 z *Develop a plan to implement an educational policy. efficient administrative and *Implement the restructuring of the financial decentralization process. system at all levels to make it more *Initiate the process of reorganizing efficient and equitable. the Ministry of Education and Culture at all levels. *Initiate gradual transfer of budget management to the decon- centrated entities of the Ministry of Education and Culture. t.'J oo vlA 286 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Annex Progress in the Decentralization of the Ministry of Education and Culture In Ecuador, the legal framework for decentralization is found in the Constitution and a series of legal provisions that apply those constitutional principles. In addition, it should be noted as advantageous that the government has seriously embarked upon the process of decentralization, through the creation of the National Com- mission on Decentralization, Autonomy, and Territorial Limits. This body has for- mulated a Decentralization Plan based on the legal framework in effect, in which the scope and phases of decentralization are delineated. Current efforts toward decen- tralization are based in part on prior experiences, especially those of the 1990s, which were not always successful. Program for Better Quality Basic Education (PROMECEB) The Program for Better Quality Basic Education (Programa de Mejoramiento de la Cal- idad de la Educacidn Bdsica-PROMECEB) was created to provide an integral, long- term response to problems in basic education in the country. In its original design, the programs objective was to contribute to improving the efficiency and effectiveness of basic education, particularly in rural areas. In order to attain this objective, the pro- gram promotes administrative and teaching academic decentralization coupled with increased parental and community participation and control over the quality of edu- cation. Over time, however, the program has defined its objective as the creation of a quality educational environment so that children in the rural sector will learn effec- tively. To that end, the program has proposed a strategy to transform basic rural edu- cation. Three years of middle school have been added to the traditional six years of ele- mentary school. Thus, basic education now comprises nine years of compulsory education, plus one year of preschool. Furthermore, based on the methodology and knowledge gained through school mapping, the plan proposes a clustering strategy, organizing intermediary institutional networks for administrative management and teaching collaboration among establishments. These are the Educational Matrix Cen- ters (Centros Educativos Matrices-CEMs) located in selected rural areas. In accordance with the program and its operating regulations, the CEMs are teaching academically and administratively decentralized, aimed at bettering the quality of basic education. These networks have been authorized to appoint their personnel, administer the financial resources allocated to them, and administer insti- tutional educational plans. The CEMs are an institutional network formed by a cen- tral campus plus the public schools of a homogeneous or geographic area. The cen- tral campus is the educational unit for offering the 10 years of basic education, and is the headquarters that encourages the rest of the educational units of the CEM. In the year 2001 there were 119 CEMs (36 urban and 83 rural), with a total of 2,380 schools in the networks. EDUCATION 287 The objectives of the Educational Matrix Centers are as follows: (i) apply the policies formulated by the Ministry of Education and Culture for improving educational quality; (ii) decentralize budgetary, administrative, and technical teaching aspects of educational administration; (iii) expand opportunities for the population to obtain access to and remain in the educational system; (iv) organize and consolidate the supply of 10 years of education, conceived as basic education; (v) facilitate the educational supervision system's function as a resource that drives educational innovations and provides technical support to teachers; (vi) create conditions for the development and implementation of education based on school/community interaction; (vii) promote interaction among the communities comprising the CEMs and participate in the design and implementation of community development projects; (viii) improve the capacity of the network's teaching and administrative person- nel through continuing education; (ix) promote the production of teaching resources and auxiliary materials, by incorporating new educational technologies and using materials from the media; (x) collect useful information from the network for evaluation and research; and (xi) conduct teaching research that generates curriculum innovations. Results of the Evaluation of PROMECEB3 The CEMs' experience with decentralization should be carefully reviewed to ensure that whatever model is implemented under the current circumstances will not repeat the same mistakes. Certain evidence indicates that a lack of clear strategies for the participation of parents and for the various players within the different levels of the Ministry of Education and Culture could limit possibilities for success in the decen- tralized management models. One of the most serious problems in the implementation of the CEM networks has been a lack of administration and continuity, delays in the implementation of components, changes in priorities and in orientations for spending, lack of follow- 3. Juan Samaniego offers a model for strengthening the Model CEMs in "Diseno de un Cen- tro Educativo Matriz Demostrativoy Estrategia de Reingenieria de Siete Existentes (Design of a Model Educational Matrix Center and Strategy for Reengineering Seven Existing Ones), December 2000. Processed. 288 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM up and monitoring, and conflicts with several of the country's sectors and institu- tions. Another problem that existed from the start was the creation of an autonomous executive entity that was totally separate from the Ministry of Education and Cul- ture, displacing traditional players. The agency within the Ministry of Education and Culture that was traditionally in charge of the administration and management of education felt excluded, marginalized, and relegated to performing insignificant functions. The original design of PROMECEB failed to incorporate an adequate feasibility analysis. It also failed to consider the conflicts that a proposal of such a nature would generate among the various interest groups-regarding the degree of influence to be exerted by the educational system's centralized administrative organization; the technical capacity and openness to change of the Provincial Directorates and of the supervisors for implementing the program with autonomy; the lack of interest of the Teaching schools themselves for participating in a strategy of teaching change; and the legal and administrative complexity involved in operating the programmed activities, organizing bidding competitions, and engaging in adequate follow-up. The majority of the investment was made in infrastructure and civil works, while the importance and visibility of the teaching dimension was lost. This investment was principally made in the matrix schools and not in the network schools, which had a negative impact on the possibility of constructing true networks and a good flow of communication and interchange with the schools. The importance of the teaching dimension was revived when the program was reformulated in 1997. A movement was clearly directed toward teaching aspects of the program and the strengthening of the CEMs' decentralization and autonomy. Similarly, the implementation of a decentralized teacher-training system through nongovernmental organizations was a good response to the deficiencies seen in the program's prior phases. Yet the impact of these achievements in the model have been minor. One flaw of the program is the lack of ongoing intermediary monitoring and evaluation activities nor progress balance sheets or reports that allow one to become rapidly familiar with each program component. Serious problems exist regarding the personnel chosen to implement the project, principally with regard to their quality and motivation. There is also no performance incentive-based personnel policy, which would have contributed to obtaining bet- ter results. The lessons learned lead to the conclusion, as set forth in the decentralization objectives, that the administration of resources and decisionmaking are supposed to be transferred to the local level. In that light, such a transfer should indeed be made and community interests and demands should be prioritized. Otherwise, the pro- gram will end up being an experiment administered centrally, which would further drain the educational system, erode the faith of local players, and waste resources. EDUCATION 289 Autonomous Rural School Networks (Redes Amigas) This program is being conducted through a loan agreement signed by the Govern- ment of the Republic of Ecuador and the Inter-American Development Bank. The Ministry of Education and Culture is in charge of the program's implementation through the program's coordinating unit. The Autonomous Rural School Networks, known as Redes Amigas, have as their objectives the following: (i) grant autonomy to approximately 20 percent of rural schools (close to 2,400 schools) for the management of their resources, with greater participation from parents and members of the communiry in school administra- tion; and (ii) improve teaching conditions in rural basic education (elementary and middle school) in the beneficiary schools' zones of influence. A series of actions are contemplated, targeting approximately 120 school networks. It is characteristic of the program that the networks participate voluntarily. The program seeks to strengthen the network's organizational capacity for exer- cising autonomy and participatory management, and will also finance projects to improve teaching. Based on its objectives, the program has three components: (i) support for the school autonomy process; (ii) betterment of teaching conditions in the networks; and (iii) follow-up and evaluation. The school networks may directly contract approximately 30 of the technical support institutions called "Educational Support Units" (Unidades deApoyo Educa- tivo-UAE) out of the 60 certified UAEs. The contracted UAEs would primarily engage in activities related to (i) training for parents and communities to promote participation; (ii) training for the networkes board members, administrators, and teaching staff; and (iii) advice and accompaniment to the networks to strengthen management capacity and to design and implement projects for their betterment. These actions will be combined with equipment purchases (computers, photo- copiers; and so on) necessary to facilitate the networks' autonomous administration. This component also carries out activities for the adjustment and institutional strengthening of the central agencies of the Ministry of Education and Culture and of the Provincial Directorates. This reinforcement of capacity is oriented toward improving the educational planning system, strengthening management evaluations and impact evaluations, updating the sector's statistical and financial information system, and training the respective agencies' personnel. The Provincial Directorates should be strengthened so that they will efficiently take on the role of providing academic advice and verifying learning results. To do so, the program would contract consulting firms to reach agreements with the vari- ous sectors involved in the educational process and to promote active parent and community participation. For the component of Improved Teaching Conditions in the Networks, the program will finance approximately 120 network projects to resolve problems involving physical infrastructure, the supply of teaching materials, and training for 290 ECUADOR: AN ECONOMIC AND SOCLkL AGENDA IN THE NEW MILLENNIUM the teaching staff, among others. For that purpose, the needs diagnostic and design of the projects should involve the collaboration of parents, local communities, teach- ers, and board members, and should consider project options that the program offers. It is worth noting that the program calls for at least one-fourth of the proj- ects financed as benefiting school networks that serve indigenous communities, given the high proportion of indigenous communities in rural areas. A further component aims to provide lIncentives to Teachers through two forms of monetary awards: (i) $US25.00 per month to teachers who have been at school every working day of the month, which would increase teachers' salaries, reduce teacher absenteeism, and improve the quality of the teaching; and (ii) an annual US $1,200 prize to one teacher in each network, which would stimulate the behavior of the teaching staff in a manner that benefits the academic life of the networws schools. The Follow-up and Evaluation component is aimed at establishing and apply- ing the mechanisms needed for ongoing follow-up and evaluation of the effective transfer of competencies and resources to the school networks, the resulting trans- formations, and their impact on administrative and academic improvements in the schools. Decentralization of the Academies ("Colegios') The approximately 1,800 primary and middle school academies in Ecuador known as "colegios" are currently managed as decentralized units. They are "implementation units." That is to say, they receive cash transfers directly from the Ministry of Econ- omy and Finance. The academies directly pay teachers, utilities, and maintenance expenses. Given that the transferred funds are generally insufficient, schools typi- cally request contributions from parents. In cases in which financing is required for investment in infrastructure or equipment, the academy's headmaster is in charge of directly negotiating with the Ministry of Economy and Finance to obtain the nec- essary funds. Nonetheless, financial autonomy does not imply that the headmaster has auton- omy for the management of the school. Transfers and contracting of the teaching staff are decided by the Provincial Administration. Likewise, the academy is subject to the directives issued by the Ministry of Education and Culture as regards cur- riculum and the school calendar. There is no evidence that the academies actually have greater participation from parents or have an accountability system. Decentralization to the Municipalities: The Case of Quito The municipality of Quito currently has 42 municipal educational centers, of which 8 cover early childhood education, 11 are basic education elementary and middle schools, 2 are high schools, and 21 are trade schools, with a total coverage of more than 12,000 students and 900 teachers. The municipal educational centers are the EDUCATION 291 responsibility of the municipality's Directorate of Education and are financed through tax revenues. The teaching staff receives a significantly higher salary. On the other hand, promotions and supervision are still determined by the Provincial Directorate of Education. One-hundred and sixteen schools have requested to be transferred to the municipal system. Although no evaluation has been made of children's performance in these munic- ipal schools as compared to those in state schools, there are certain indications that the municipal schools are providing higher quality education, among them the number of actual days of classes imparted (198 versus 140 in school year 2000-01), the high rate of enrollment in higher education, the high demand for enrollment, and the award of the national mathematics and physics prizes. The Municipality of Quito, in response to the national decentralization policy, is developing a Metropolitan Education Subsystem, for which it already has a model and a strategic development plan. Furthermore, a Municipal Education Commis- sion exists, with prominent members of the local community meeting each week to approve and follow up on the actions of the Directorate of Education. The Ministry of Education and Culture, through a Ministerial Decree, has transferred authority and responsibilities over personnel status (including the hiring, continued employ- ment, and promotion of teachers) and professional registration, the school calendar, the granting of degrees, training and continuing education of teachers, curriculum, and creation of educational establishments and educational supervision to the Directorate of Education of the Metropolitan Municipality of Quito. On the other hand, the municipality has issued a Municipal Ordinance, which limits the time in office of headmasters and principals to four years, although they can be reelected for one additional term. The Municipality of Quito hopes to see the approximately 800 educational establishments located in its jurisdiction transferred to the municipality. Nonetheless, it is felt that the transfer should be gradual, at a projected rate of approximately 100 establishments per year. The basic criteria for the transfers is that they be made voluntarily and that the schools be eligible for accreditation by the municipality (in other words, the municipality should determine that it has the capacity to receive the establishment). The municipaliry will have to face a number of significant challenges to be able to receive the transferred schools while also ensuring that quality education is being provided. The principal challenge is financing. The municipality's own resources do not allow it to finance additional spending on education. Furthermore, the munic- ipality will have to strengthen its capacity to manage and supervise the schools in its jurisdiction. 10 Health' Marcelo Bortman Despite recent efforts to encourage investment and decentralization, the health sector has not resolved its fundamentalproblems. These efforts were modest, and low popu- lation coverage, lack of access, and low quality of health services prevail. In addition, public spending on health continues to be insufficient, while private spending is inequitable. Approximately 30 percent of the population still has no access to basic health services. More than twvo-thirds of Ecuador's inhabitants have no formal health insurance, and the Ministry of Public Health (Ministerio de Salud PTblica-MSP) and other public institutions are incapable of providing healthcare services to nearly half of them. Those who are left without service are precisely the persons with the worst health indicators. Childbirths without proper medical care and lack of access to basic healthcare are the principalfactors responsiblefor an epidemiologicalprofile marked by inequities. A direct consequence of the low levels ofpopulation coverage is seen in the high rates of infant, maternal, and premature mortality. Mortality rates due to infectious disease and cancer are also very high, with great disparitiesfrom one region to another. The reform of the health sector should include several measures: The Free Healthcare Maternity Act (Ley de Maternidad Gratuita-LMG) should include a targeting model to avoid double coverage, while also taking into consideration social and cultural issues that tend to limit the demandfor basic services. The coverage of the Rural Peoples Social Security Program (Seguro Social Campesino-SSC) should be expanded and coordinated with coverage under the Free Healthcare Maternity Act. Basic health benefits should be incorporated into the Bono Solidario Cash Subsidy Program for retired persons and the disabled. The essential functions of the Ministry 1. Marcelo Bortman is a health specialist for the World Bank. The author thanks Daniel Dulitzky, Patricia Bernedo, Daniel Cotlear, and Pablo Gottret. 293 294 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM of Public Health should be redesigned, with a new Organic Law for the national health system that modifies the systems role from that of a service provider to that of a regulating body. In said role, the Ministry of Public Health would take charge of mech- anisms to accredit establishments, monitor the quality of services, create a health sur- veillance system, and provide training for situations of epidemiological risk, among other functions. As part of the redefinition of the Ministry of Public Healths functions, it should once again be coordinated with the Ecuadoran Social Security Institute (Instituto Ecuatoriano de Seguridad Social-IESS). Finally, a regulatory frame- work should be created to develop a system of regional health service networks, expand- ing the coverage of the SSC and possibly creating a new insurance for the low-income population to consolidate and gradually replace the benefits of the Free Healthcare Maternity Act and the Bono Solidario Cash Subsidy Program. A. Introduction Despite the difficult economic and political conditions that Ecuador has confronted in recent years, the country's Human Development Index (HDI) has shown sus- tained improvement, increasing by 9 percent between 1980 and 2000. Nonetheless, even though new countries have been incorporated into the analysis, Ecuador's rank- ing has dropped, from 49th place in 1975 to 93rd place in 2000.2 During this period, Ecuador's health indicators have improved significantly. Life expectancy at birth, (one of the three components of the HDI), increased from 58.8 years in 1975 to 70 years in 2000-67.3 years in males and 73.5 in females. This represents an increase of 19 percent and an average of 11.2 additional years of life for each member of the population. Infant mortality was reduced by two-thirds, from 87 per thousand in 1970 to 30 per thousand in 2000, and mortality in children under five was reduced by three- fourths, from 140 per thousand to 39 per thousand over that same period. Nonethe- less, the changes seen at an overall national level were not evenly distributed in the country's interior. This trend toward better health was seen in the majority of the countries in the region. Social, cultural, technological, economic, and environmental factors have all contributed to these changes, along with increased accessibility to and improved quality of health services. The relationship between a country's per capita income and its life expectancies follows a curve, with Ecuador located at the curve's mid-point (Figure 1). Some countries with income similar to that of Ecuador show greater life expectancies, such as Armenia, Syria, Sri Lanka, Suri- name, and Jamaica, among others. Certain countries, however, such as Egypt, 2. UNDP, Human Development Index-, statistics available at http://hdrundp.org/sratistics/ default.cfm. Figure 1. Relationship between Income and Life Expectancy, 2000 Japan 80 Barbados .- . * t Ja aica C b * 0 Arme*; uuLek t of the SSC. Z Poor performance of Elaboration of a Implemenitation of a Development plan for The Ministry of Public Health 0 Essential Public Health program for carrying program for the develop- the Ministry of Public is properly fulfilling its admin- Functions (EPHF) by out the Essential ment of the Ministry Health and the National istrative, regulation and the Ministry of Public Public Health of Plublic Health. Hygiene Institute. control, and health surveillance Health. Functions (EPHF) of functions, and so on. the Ministry of Public ° Health. Limitations of the Preparation of a Program Development plan The health area of the IESS has IESS health area. program for developing implementation. designed. the capacity to manage the the health area of the health insurance of 50 percent IESS. of Ecuador's population. rn 11 The Social Assistance System1 Daniel Dulitzky This chapter presents a synthesis of the current state of Ecuadors social assistance system. With $US264 million spent in 2001, Ecuadors spending on social assistance, as a per- centage of GDP is average among the countries of the region. Despite the crisis, Ecuador has maintained a system with programs that assist a large number ofpersons. Some of these programs have clear objectives and a certain degree oftargeting, yet with more than 22 programs, the system is extremely fragmented. The are administered by several differ- ent entities and their objectives and beneficiary population overlap one another. Three principalproblems are present. First, the system is very inflexible, in terms of its budget, design, and coverage, as it has no mechanisms to increase the number of beneficiaries in times of crisis. Second, the social programs, in general, lack consistent targeting criteria. The universal programs, such as subsidies to public utilities, tend to be regressive, while the targeted programs fail to address particularly vulnerable groups, such as children between zero andfiveyears of age at risk of malnutrition or pregnant women. Third, the Bono Solidario Cash Subsidy Program, which currently has the largest budget and is one of the most sign ificant programs in terms of coverage, is plagued by numerous problems. The program fails to update its beneficiary base, lacks clear objectives, has inadequate targeting mechanisms, and grants a low level of benefits. Through restructuring, the social assistance system should become more flexible, using budgetary contingency funds to provide specialfunding increases to specific socialprograms in times of crisis. A mech- anism should also be designed that will allow a programs beneficiary base to be updated. 1. Daniel Dulitzky is a social protection specialist for the World Bank. The author thanks Carolina Sinchez-Paramo and Norbert Schady for their valuable participation in defining the chapter's content and structure, and also thanks Marcelo Bortman and Jose Roberto L6pez Calix for their excellent comments on the preliminary versions. 319 320 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Furthermore, iffunds are available, an anticyclic program should be created-for exam- ple, a public works program targeted to principally assist individuals in temporary situ- ations ofpoverty. There is also a need to improve coordination, protect the budget, and better target existing priority programs, applying a single targeting instrument to each of them. The objectives and beneficiary population ofthe programs should be reviewed, and consideration should be given to eliminating programs that are outright regressive. Finally, the Bono Solidario Cash Subsidy Program should be transformed into a pro- gram of conditioned subsidies, oriented toward protecting the health and nutrition of children and pregnant women who live in poverty. The benefit to the elderly and to expectant mothers should be recalculated as afunction of some criterion that reflects the beneficiary population and the programs objective. A. Introduction The Ecuadoran economy has recently undergone a major economic crisis. It is there- fore imperative that the performance of the country's social assistance system be evaluated. In fact, the economic crisis of the late 1990s was the worst such crisis over the past one hundred years, if measured in terms of reductions in GDP. Between 1997 and 1999, Ecuador's GDP fell by 10.4 percent (Frente Social 2002). Though the economy has since recuperated, exhibiting positive growth rates, the country's GDP has yet to attain precrisis levels. This crisis resulted from a combination of economic problems and natural disas- ters. The damage caused by the El Niflo phenomenon in 1997 and 1998 is esti- mated between 2.7 and 13.6 percent of GDP, depending on the source one consults. The situation was further aggravated by a series of exogenous impacts, such as the drop in oil prices, increases in the fiscal deficit, instability of the exchange rate, and unsustainable growth of the external debt, which unleashed an economic crisis of unprecedented impact. The economic crisis of the late 1990s has increased the pressure felt by social pro- tection programs. The poverty rate jumped in a period of only three years (1995 to 1998) from 34 to 56 percent of the population (World Bank 2000). The poverty rate is higher in rural zones, but its relative change has been greater in urban zones: in the latter, the poverty rate rose from 19 to 42 percent, while in the former, 77 percent of the population was considered poor in 1998, up from 56 percent in 1995. Extreme poverty, nonetheless, continues to be a principally rural phenomenon. Increased inflation rates, the decline in real wages, and the rise in unemployment have had a cumulative effect, creating a new group of families in need of temporary social assistance. In addition, some groups, with even fewer protections, face chronic problems of poverty. The system must therefore be reviewed in light of this new demand for social assistance, contemplating the need to have certain flexible pro- grams that can provide protection not only in a permanent manner, but also on a temporary basis to those in need during times of crisis. TIDE SOCIAIL ASSISTANCE SYSTEM 321 Recovery from the crisis, dollarization, and political changes on the country's horizon are creating a favorable climate to redefine the features of the social assis- tance system in light of the needs of the population. With approximately 1.5 per- cent of GDP allocated to social assistance-without including insurance programs aimed at helping the poorest of the poor, such as the Rural People's Social Security Program (SSC)-Ecuador has succeeded in maintaining a system that aids a large number of persons in vulnerable population groups. Some of its programs have clear objectives and a certain degree of targeting, and the country has managed to protect a good part of social assistance budgets over recent years. Nonetheless, the system is still very fragmented, and in several programs, targeting and coordination could be improved. This chapter describes the most prominent aspects of the social assistance system. Problems and risks faced by different population groups-those that will potentially be in demand of social assistance-are indicated, and the most severe problems in the system's current structure are identified. Based on this analysis, the chapter cul- minates with a series of recommendations for the short and medium terms, aimed at improving the system's functionality. An analysis of the social security healthcare system and programs such as the SSC goes beyond the scope of this report (see Chapters 10 and 12, on Health and on the Pension System, respectively). Such pro- grams have a social assistance component, but since they are insurance, they do not constitute social assistance per se. B. Principal Features of the Social Assistance System A social assistance system can be defined as a set of programs designed to protect vul- nerable population groups (whose vulnerability may be chronic or temporary) against specific risks that threaten their well-being. Such a system should be comprise struc- tural elements as well as anticyclic elements. Programs of the structural type attempt to raise the standard of living and well-being of persons in situations of chronic poverty, that is, persons who face a prolonged impossibility of subsisting or generat- ing an adequate level of income on their own. Anticyclic programs aim to protect individuals against temporary reductions in their income or well-being, and are fun- damental in times of crisis, when the number of poor increases as a consequence of temporary impacts on major sectors of the population. A typical example of a classi- cally anticyclic program-although it is actually insurance-is unemployment insur- ance. In times of crisis, when the number of unemployed increases, the base of the insurance also expands; once the crisis is over, the base of the insurance contracts. A system can be composed of a great variety of programs. There are programs for the supply of goods and services, such as in-kind transfers and subsidies on the con- sumption of certain goods; demand-based programs, such as money transfers; and programs that help generate income in families by providing temporary employ- ment. Many of these programs are represented in the Ecuador's social assistance sys- 322 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM tem. In fact, the country has 22 social assistance programs designated as Priority Programs by the Frente Social (the "Social Front")-an entity that attempts to coor- dinate the social assistance activities of the ministries of Education, Health, Social Welfare, and Urban Development and Housing, which administer these priority programs.2 The Priority Programs came into being in 2000 with the design of the Emergency Social Plan in an attempt to confront the crisis. Table 1 summarizes the principal features of the Priority Programs. In 2001, Ecuador spent close to $US264 million on its Priority Programs, or approximately 1.5 percent of its GDP Out of that sum, approximately 60 percent is represented by two money-transfer programs, the Bono Solidario Cash Subsidy Program and the Scholar- ship Program ("Beca Escolar"), the latter of which has a minimal budget as it is at an experimental stage. The rest involve food and nutrition, education, childcare for chil- dren between zero and six years of age, healthcare, and construction of housing. This list does not include subsidies on gas and gasoline consumption, which, according to Gutierrez Santos, etal., cited in Perez (2002), represented approximately $US350 mil- lion in transfers to households in 2000, and almost $US500 million in total. Table 2 summarizes the outstanding features of the most significant social assis- tance programs. In terms of coverage and budget, the two foremost programs are the School Breakfast and Lunch program, with an implemented budget of $US25.4 mil- lion in 2001, and the Bono Solidario Cash Subsidy Program, with a budget of $US154.5 million in 2001. In general, the system is made up of a great number of programs-some of which overlap one another in terms of their objectives and the population they cover. In addition, the programs are administered by many different players. Some recent programs, such as the Scholarship Program, represent a ftnda- mental change. Indeed, this program pioneered the use of a clear targeting tool, a sys- tem known as SELBEN, the Ecuadorian Beneficiary Identification and Selection Sys- tem (Sistema de Identificacidn y Seleccidn de Beneficiarios), and it also provides money transfers in an attempt to influence the behavior of the beneficiaries. C. Supply and Demand for Socia Assistance Vulnerable Groups One methodological framework for evaluating social protection programs is known as the Social Risk Management Framework.3 The concept of Social Risk Manage- 2. The 22 programs designated as Priority Programs are not an exhaustive list of social assis- tance programs. In addition, there are the programs administered by the National Chil- dren and Family Institute (Instituto Nacional del Nifno y la Familia-INNFA), an autonomous entity historically directed by the First Lady. Several NGOs also provide decentralized social assistance. 3. "Social Risk Management Framework," in World Bank (2001). THE SOCIAL ASSISTANCE SYSTENM 323 Table 1. Selected Features of the Social Assistance Systems Priority Programsa for 2000-01 Number of programs 22 Approved budget for 2001 $US295.7 million Implemented budget for 2001 $US263.8 million Money transfer programs 2 Percentage of the budget for money transfers 58% Programs that provide food 5 Percentage of the budget 20.9% Energy subsidy for households, 2000 $US341 million a. Social Assistance Programs created in April 2000 as a part of the Emergency Social Plan. These include Redes Amigas ("Girls' Networks of Friends"); Mochila Esco/ar ("Backpack for School"); Improvement of Intercultural Bilingual Schools; School Meals; Nuestros Niiios ("Our Children"); Operacidn Rescate Infantil ("Children's Rescue Operation"); "Beca Escolar" ("Tise Scholarship Program"); Credito Productivo ("Productive Credit"); the Bono Solidario Cash Subsidy Program; Community Kitchens; Generic Medications; Mobile Health Units; Free Maternity Healthcare; National Food and Nutrition Program (PANN) 2000; Extended Immunizations Plan; Epidemiological Control: Tuberculosis; Epidemiological Control: Malaria and Dengue; Peasant Housing; Urban Low-Income Housinig; Housing for Beneficiaries of the Bono Solidario Cash Subsidy Program; and Potable Water and Environmenral Saniitation. Source: Frenre Social (2002). ment is based on the idea that individuals are subject to unexpected shocks that affect their capacity to generate income. In some cases, the shock is permanent in nature, while in others it is purely temporary. Optimal risk management consists of a series of mechanisms to prevent and mitigate the risk in question, and, as a last resort, activities to aid those affected, so that they can minimize the adverse effects of the shocks. The mechanisms so utilized include social security health systems and social assistance systems. This framework for evaluating the social assistance system involves the following steps: First, a determination is made of the potential demand for social assistance, as a function of the risks associated with the various population groups. Second, an eval- uation is made of the mechanisms that these groups employ in order to cope with those risks, and how such mechanisms could affect the well-being of the respective groups. Third, a survey is conducted among the groups that face a high-risk of tem- porary impacts as a consequence of a crisis, or of permanent impacts due to a chronic impossibility of generating income. Fourth, an evaluation is made of the features of the current social assistance programs in light of the needs of the population, espe- cially the needs of vulnerable groups as determined above. Finally, a decision is made regarding measures to be implemented, aimed at improving the contribution of pro- grams to the well-being of groups who are in need of social assistance. (Text continues on page 328.) Table 2. Outstanding Features of the Most Significant Social Assistance Prograrns w Implemented budget in 2001 Program Type of assistance Risks addressed Administration Coverage Targeting (million $US) Bono Solidario Money transfer Low income, Autonomous entity 1,216,222 direct Self-screening, Cash Subsidy poverty associated with the beneficiaries validated by Program Ministry of Social 4,500,000 total churches Welfare beneficiaries Error of exclusion: 21.2% ° Error of > inclusion: 18.3% 154.5 Z n Free Maternity Provision of healthcare Maternal and Ministry of Health 743,000 women Universal - 0 Healrhcare to pregnant women infantile receiving prenatal 0 at units of the mortality care Ministry of Health 93,000 normal childbirths National Provision of iron - Ministry of Health - - n Micronutrients and Vitamin A Program supplements to children under five z years of age, pregnant and nursing women i Children's Day care, nutrition Early National Children's 47,000 children 65% bene- - Development for children from childhood and Family Institute ages zero to six ficiaries in Z Program six months to six development (Instituto Nacional quintiles years of age, whose de la Niniezy la l and 2 - parents are working Familia-INNFA) outside the home Z c Operation Day care, nutrition, Early Ministry of 50,296 41% bene- 14.1 Children's healthcare for poor childhood Social Welfare ficiaries in Rescue children under six development quinriles C (Operacidn de years of age I and 2 Rescate Infantil-ORI) National Pre- Day care for children Early Ministry of 18,027 - - school Educa- from four to six years childhood Education M tion Program of age who have no development < (Programa access to preschool Nacional de education Educacidn Preescolar- PRONEPE) Supplementary Nutritional supplements Early Ministry of 14,930 (5% of 73% bene- Food Program for children and under- childhood Health the group ficiaries in for Mothers and nourished pregnant development objective) quintiles Infants (Programa women I and 2 de Alimentaci6n Complementaria Materna-Infantil- PACMI) Nuestros Ninzos Complement to Early Ministry of 82,300 - 7.9 ("Our Children") INNFA, ORI, and childhood Social Welfare other programs for development children from zero to six years of age (Table continues on the flowing page.) Table 2. (continued) Implemented budget in 2001 Program Type of assistance Risks addressed Administration Coverage Targeting (million $US) School Snacks Food supplement for School dropout Ministry of 1,251,000 (76% Poorest 40% 25.4 and Lunches poor children in rate, accumu- Education of the total chil- receive 53% of public schools lation of human dren enrolled in the benefit c capital elementary schools) Almost universal RedesAmigas Teacher training, - Ministry of 128,469 (16% of 58% of bene- 7.9 (Girls' Networks school books, creation Education students in rural ficiaries in the of Friends") of school networks zones) poorest munici- g palities o Child Workers' Scholarships, tutors, Accumulation INNFA 12,335 (In Ecuador - 32.8 n Program familiar education of human capital there are 330,000 z children berween the ages of five to nine ° who are working) Community Supplemental food Chronic poverty Ministry of 238,000 persons - 4.7 Kitchens to the population Social Welfare National Food Education and Malnutrition Ministry of 102,000 pregnant Poorest townships 2.4 Z and Nutrition supplemental nutrition Health women and Program to pregnant women 117,000 children z (PANN) 2000 and to children ages 6 to 24 months z a: c Subsidies on Subsidy for gas and Low income - Universal The poorest 20% 341.0 gas and fuel gasoline consumption receives 8% of the w CA, subsidy 0 Scholarship Subsidy in money School Ministry of 35,000 children Use of SELBEN 1.0 Program conditioned upon dropout rate Social Welfare for targeting school attendance Credito Financing of Low family Ministry of 3,000 persons - 3.5 Productivo microbusiness income Social Welfare (Productive projects Credit) Sources: Frente Social (2002), Cely (2002), UNICEF (2002). t'J 328 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM A study of poverty in Ecuador (Le6n 2002) maintains that "recent" poverty in Ecuador doubled between 1998 and 1999. "Recent" poverty refers to households that are below the poverty line, but whose basic needs are satisfied. This means that the households in question are confronting a situation of temporary poverty, in which their standard of living has been reduced, but not for so long that their basic needs are affected. When households live in poverty over a long period of time, their basic needs go unsatisfied. The population of Ecuador living in conditions of poverty qualified as "chronic" increased from 28 to 36 percent between 1995 and 1999. Interestingly, the increase in temporary or recent poverty was principally seen in urban zones, while the increase in chronic poverty is both an urban and a rural phenomenon. The unemployment rate also increased notably during the period of crisis. While for the 15- to 28-year-old age group, unemployment rose from 15.3 to 27.8 percent between 1998 to 1999, unemployment for the 29- to 44-year-old age group rose from 5.4 to 11 percent. In total, the unemployment rate doubled, from 8.5 percent in May 1998 to 16.9 percent in August 1999. Underemployment also increased sig- nificantly. The increase in the inflation rate, the depreciation of the sucre, and the subse- quent dollarization of the economy may have increased the number of recent poor. The inflation rate was 52 percent in 1999 and 96.1 percent in 2000. Many families who were not poor at the beginning of the period may have been affected by the depreciation of the sucre if they had debts in dollars. At the same time, those with savings in sucres suffered from the freeze on deposits ordered by the government in March 1999 and the high inflation and depreciation rates that eroded the value of their savings. According to the survey of households of 1998, approximately 25 per- cent of the families in the third quintile of consumption had savings accounts. The most vulnerable age groups in Ecuadoran society are poor children and pre- teens, pregnant women in conditions of poverty, and elderly persons with no formal income. In fact, families with children under two years of age, and to a lesser extent families that include older children or elderly persons, have a higher probability of being poor. Indigent families include, on average, a higher number of elderly per- sons and children between zero and two years of age (World Bank 2000). According to the Living Conditions Survey of 1998, the percentage of chronic malnutrition among children between zero and two years of age in the first income quintile was 32.5 percent, while the percentage of low weight-for-age was 24.3 per- cent. Both these figures are far above average for that age group. This situation was also seen, to an even worse extent, in the group of children between three and five years of age, where the percentage of chronic malnutrition was 44 percent in the lowest quintile, as compared to an average of 29 percent in the general population. Among this group, the percentage of low weight-for-age was 23.3 percent as com- pared to 14 percent overall. The National Children's and Family Institute (INNFA) reports that approximately 660,000 children between zero and five years of age show signs of acute, chronic malnutrition. THE SOCIAL ASSISTANCE SYSTEM 329 The group of school-age children in the poorest quintile is also subject to numer- ous risks, especially malnutrition and limited formation of human capital. Preschool education for this group is very low, with levels of attendance at 10 percent (com- pared to 30 percent for the highest quintile). The disparity between levels of income is particularly notable for secondary schools, with net attendance rates of 44 percent for the country as a whole, but only 19 percent for the lowest quintile. A parallel phenomenon to low school attendance is that of children who work, with 21 per- cent of children between the ages of 10 and 15 working and not attending school in 1998. According to data from the Integrated Social Indicators System of Ecuador (Sistema Integrado de Indicadores Sociales de Ecuador-SIISE), there are 1,050,802 Ecuadoran children who work, 32.5 percent of whom are between five and nine years of age, and the rest of whom are between 10 and 17. According to the Demographic Survey and the Survey on Maternal and Infantile Health, there were no significant changes in the percentage of children who received healthcare and follow-up during the first five years of life between 1994 and 1999. Though the prevalence of diseases such as diarrhea and acute respiratory infections went down for the country as a whole, an a increase was seen in the incidence of both these ailments for the group of mothers without schooling, which is an approx- imate indicator of low levels of income. A similar trend was seen for vaccination rates. When observing the percentages of children under one year of age who received complete vaccinations, a significant deterioration was seen between 1994 and 1999, especially in rural zones and in families in which the mother has no schooling. In these families, the percentage who received complete vaccinations declined from 26 to 16 percent. This might reflect a deterioration of healthcare con- ditions as a consequence of the crisis. The elderly without coverage are an especially vulnerable group. Poverty statistics indicate that families with elderly persons in their nuclear family unit have a 13 per- cent greater probability than the average population of being poor (World Bank 2002). From 1990 to 2001, the proportion of persons older than 60 rose from 6 to 9 percent, and in 1999, illiteracy was seen in 34 percent of the elderly. Five out of every 100 poor persons were elderly (SIISE 2002). The coverage of the social secu- rity health system is minimal, as only 23 percent of Ecuadorans over 60 are affili- ated with the IESS. In this context, many elderly persons belong to multigenera- tional households (54 percent of the elderly live in this type of household). A social assistance program does target this population group, as according to the Living Conditions Survey of 1999, 30 percent of Ecuadorans over 65 were receiving the Bono Solidario Cash Subsidy. Currently the subsidy is approximately $US7 per month, representing between 15 and 30 percent of the value of the average pension. Social Risk Management Strategies The Living Conditions Survey and information from a qualitative study aimed at determining the effects of the crisis in Ecuador reveal a series of behaviors that could 330 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM be considered to constitute social risk management (World Bank 2000). Many of the behaviors that households are employing to manage risk could have a negative impact on the future well-being of their members, and the social assistance system aims in part to prevent these behaviors from being maintained for prolonged peri- ods of time: • Child labor: According to a 2001 UNICEF study (based on the Living Con- ditions Survey of 1999), there were 136,700 children in Ecuador between five and nine years of age and 914,000 between 10 and 17 years of age who were working.4 This is not necessarily due to the crisis, and may have already existed, but some households have indeed coped with the crisis by incorpo- rating more members of the family into the labor market to generate income. The percentage of children between 10 and 15 who were working and not studying remained more or less constant between 1998 and 1999, and the same constancy was seen in the gross attendance rate. Nonetheless, the num- ber of days absent from school almost doubled, from 5.4 to 10.5 days per month. This may reflect a deterioration in the supply of education or prob- lems with transportation and other social services, on account of which it has become more difficult to attend school, but it may also be due to the alterna- tive use of time by children on temporary jobs. In many cases, even where no drop has been seen in school attendance, the quality of the education received, which is much more difficult to measure, could have been affected as a result of the crisis. O Reduction in consumption: A recent IDB study (2002) cites data from 1999, which indicates that 95 percent of the beneficiary households of the Bono Sol- idario Cash Subsidy Program have reduced their consumption of food, and 58 percent have reduced their number of meals per day. Information is also found in interviews with focus groups conducted in July 1999 (World Bank 2000), which reported a drop in the consumption of proteins and minerals, and an increase in the consumption of carbohydrates and cheaper foods of poorer quality. In small local markets, a decline was reported in the sale of fruits and vegetables, cheese, eggs, and meat. o Debt: This strategy is more common in-but not exclusive to-households that face a situation of temporary poverty. One out of every two beneficiaries of the Bono Solidario Cash Subsidy Program applied for a loan in 1998; one in four beneficiaries fell behind in rent payments, and one in five had to buy on credit in neighborhood stores or sell belongings (Carrera 1999, cited in Perez 2002). o Deferred healthcare: According to a World Bank report (2000), the percent- age of households that report that they deferred healthcare for some member of the family because they could not afford it rose from 51.5 to 72 percent. 4. INNFA reports significantly higher numbers, based on information from the SIISE. THE SOCIAL ASSISTANCE SYSTEM 331 * Migration: Several newspaper articles have reported an increase in the num- ber of persons who have left the country and not returned. While in 1997 the total number of migrants was 18,000, in 2001 160,000 persons left the coun- try without returning. Moreover, during the past five years 451,143 Ecuado- rans have migrated (Perez 2002). Money sent from abroad is becoming an important source of income for many Ecuadorans. D. Problems of the Social Assistance System LACK OF FLEXIBILITY. With a budget of between 1 and 1.5 percent of GDP ear- marked for social assistance, spending on social assistance in Ecuador is average for the region.5 Nonetheless, the system does not seem to have the capacity to adapt to the needs of the population, that is to say, to expand in times of crisis and contract under normal circumstances. The system's lack of flexibility is a result of the nature of its budget, problems related to coverage, and the design of its programs. FLEXIBILITY IN THE BUDGET. In a recent analysis of trends in social spending between 1970 and 2002, Vos and others (2002) argue that social spending as a whole has been procyclic, although volatility varies according to the category of the expendi- ture-education, health, social security healthcare, and social assistance. In the case of social assistance, the trend is principally noncyclical, as it is characterized by a rel- atively inflexible budget that is not correlated to the needs of social protection of vulnerable groups during times of crisis. Over the past two years, social assistance spending has increased, to the detriment of spending on health and education. This is primarily a consequence of the creation of money transfer programs such as the Bono Solidario Cash Subsidy Program. Nonetheless, the trend over the past two decades has been a decline in social spending as a whole. It is not only necessary to keep the social assistance budget flexible-and wher- ever possible anticyclic-but also to protect the budgets of certain priority programs in order to guarantee their long-term sustainability. If minimum floors were estab- lished-in terms of absolute value-for the budgets of some programs, this in fact would add an anticyclic component to the social assistance system. Currently there are no guarantees regarding the continuity of several social programs, as the budgets are not protected in the future. Although the World Bank Structural Adjustment Loan for the year 2000 included a commitment from the government to maintain minimum floors for social programs in terms of absolute value for 2000 and 2001, there are no similar figures for 2002 and the following years. 5. For example, in 1999 Argentina spent approximately 0.9 percent, Mexico 1.1 percent, Nicaragua 1.1 percent, Peru 1.4 percent, and Venezuela I percent (Dulitzky, Gragnolati, and Lindert 2001). 332 ECUADOR: AN ECONOMIC AND SOCLAL AGENDA IN T HE NEW MILLENNIUM FLEXIBILITY IN COVERAGE. The programs do not have an automatic mechanism that allows them to be rapidly updated. This is especially necessary for anticyclic pro- grams aimed at providing temporary social assistance in times of crisis. In these cases, it is necessary to be able to enroll beneficiaries at various times during the life of the program, and, in the same manner, remove beneficiaries from the system when they no longer require assistance. For example, the Bono Solidario Cash Sub- sidy Program enrolled beneficiaries only at the time of its launch in 1998. In suc- cessive years the beneficiary base was screened and noneligible households were eliminated, yet no mechanism was ever designed to enroll new beneficiaries. Some supply-based programs are updated, which allows for the enrollment of new benefi- ciaries, but no systematic mechanism exists. Rather, the review of the beneficiary base is made on an ad hoc basis. FLEXIBILITY IN DESIGN. At this time there is no program that is classically anticyclic. Anticyclic programs contain automatic adjustment mechanisms that allow the ben- eficiary base to be increased in times of crisis. For example, programs that provide temporary employment with a self-targeting criterion and sufficiendy low wages are clearly anticyclic, as only during a crisis is the opportunity cost of taking such employment sufficiently low, and therefore the beneficiary base increases. ABSENCE OF CONSISTENT TARGETING CRITERIA AND REGRESSIVITY IN THE SYSTEM'S PROGRAMS. The social assistance system in Ecuador includes both universal and targeted programs. In general, it is observed that many of the universal programs tend to be regressive, as a high percentage of the expenditure on those programs ends up benefiting the higher-level income quintiles. The targeted programs vary in their effective outreach to the lower quintiles, and furthermore, do not utilize consistent targeting criteria. This generates duplications and dilutes their effective- ness even further. Several programs-for instance, those in place to protect children from zero to two years of age against the risk of malnutrition-also have insuffi- cient coverage, and in many cases fail to address important risks for certain vul- nerable groups. TARGETING AND REGRESSIvI-rY. The social assistance system includes certain highly regressive programs. For example, subsidies for electricity, gas, and gasoline amounted to $US541 million in 2000, almost 4 percent of GDP, of which house- holds received 63.5 percent (Gutierrez Santos 2002, cited in Perez 2002). These subsidies are highly regressive, as they are correlated to the consumption of fuel, which increases with income. It is estimated that the total subsidy per capita-on electricity, gas, and gasoline-is five times as large among the wealthiest quintile as among the poorest (Gutierrez Santos 2002, cited in Perez 2002). Nonetheless, the subsidy represents a fundamental source of aid for the poorest of the poor. The study in question argues that without the subsidies, the poorest sectors would see their income reduced by 7 percent annually. THE SOCIAL ASSISTANCE SYSTEM 333 Vos and others (2002) estimate the percentage of benefit of various social assis- tance programs in terms of the population quintiles benefited. This can be repre- sented graphically through concentration curves, such those in Figure 1. A progres- sive program would have a concentration curve higher than the 45 degree curve, indicating that the poorest quintiles receive a more than proportional benefit. Fig- ure 1 illustrates that some social assistance programs are progressive, but even in those programs, a high percentage of the benefit reaches the wealthiest population quintiles. For example, 45 percent of the benefits of the Bono Solidario Cash Sub- sidy Program is received by families in the three highest quintiles (The annex con- tains the exact percentages of benefits reaching the various population quintiles). INSUFFICIENT COVERAGE. The coverage of the social assistance system is inadequate. This is not necessarily due to a lack of budget, for, as was mentioned above, Ecuador's spending on social assistance is average among the countries of Latin America for which information is available. Yet due to the lack of a consistent tar- geting criterion and the overlapping of programs, in many cases funds are diverted coward groups that do not need them. The group of children under the age of six offers a clear example. There are at least five programs that target this population Figure 1. Concentration Curves for Some Social Assistance Programs 0.9. -~0.7 --.. 0.6- 0 ~0.5 / 0 0.4 0 0 ~ L 0.3 /* ~0.2 /- .u 0. 1- - - 0 0.2 0.4 0.6 0.8 1 Accrued proportion of households -- School breakf'ast -- Gasoline subsidy - Childcare Gas subsidy - 4 - Bono solidario cash subsidy - Equitable distribution Source: Vos, Ponce, Le6n, er al. (2002). 334 ECUADOR: AN ECONOMIC AND SocLAl AGENDA IN THE NEW MILLENNIUM group, and according to INNFA (2000), the programs administered by the Ministry of Education, of Social Welfare, and INNFA itself cover approximately 139,000 children-that is, approximately 7 percent of all children, and 11 percent of chil- dren in poverty, in that age group. According to INNFA 1999, 40.3 percent of the population was undernourished in Ecuador in 1999-comprehensively and chron- ically. In other words, out of 1,304,920 children under five, approximately 525,800 showed some sign of malnutrition. This illustrates that the programs for this age and risk group are far from ideal. Other vulnerable groups, such as the elderly, are cov- ered by social assistance programs, but the benefit received is insufficient to meet their needs. The near universality of certain programs limits the field of action of the social assistance system. The Free Maternity Healthcare program provides free medical assistance to pregnant women through childbirth, even for women covered by IESS health insurance. It is imperative to review the targeting criteria, coverage, and ben- efits of the system's most significant programs. SHORTCOMINGS OF THE BONO SOLIDARIO CASH SUBSIDY PROGRAM. The Bono Soli- dario Cash Subsidy Program is the most significant endeavor in the social assistance system. If Ecuador could only administer a single assistance program, this would be a natural candidate, given its broad beneficiary base, its high budget within the sys- tem, its scope, and the possibilities it offers. Nonetheless, the program has numer- ous organizational and implementation problems that must be addressed. ENROLLMENT OF BENEFICIARIES. To date there is no mechanism that allows for the enrollment of new beneficiaries. The beneficiary base is being screened, and the number of beneficiaries has been reduced from approximately 1.7 to 1.2 million through this mechanism. Yet new beneficiaries have not been allowed to enroll since the commencement of the program. This is particularly serious if one bears in mind that the program's initial targeting did not utilize any consistent instrument beyond an enrollment form verified by local churches and parishes. QUESTIONABLE VALIDATION CRITERIA. The original beneficiary base has been gradu- ally screened, using a series of criteria. For example, the elimination from the bene- ficiary base of all individuals affiliated with Social Security Insurance creates disin- centives to affiliating with this program. Although the idea of approximating beneficiaries' income levels through closely-correlated indicators is adequate, such indicators must be selected with care in order to minimize disincentives. INADEQUATE TARGETING. At present, the Bono Solidario Cash Subsidy Program is a self-targeted program, given that, as mentioned above, enrollments were made through an enrollment slip validated by local parishes and churches. A World Bank analysis conducted in 2000 demonstrated that the coverage rate of the program was 88 percent of the poor. Yet according to that same study, many individuals who met THE SoCAL ASSISTANCE SYSTEM 335 the requirements for the subsidy were not actually receiving it, while many who were receiving it failed to meet all the requirements. Table 3 shows the number of moth- ers and the elderly who were receiving the Bono Solidario Cash Subsidy in 1999 according to the Living Conditions Survey, as compared to the potential number of beneficiaries. It is seen that the number of persons who are not receiving the subsidy despite meeting all its requirements is high-59 percent of those eligible-while ineligible persons who nonetheless receive the subsidy represent 54 percent of the total number of beneficiaries. INADEQUATE BENEFIT LEVELS. Currently mothers with children under 18 years of age receive $US11.50 per month, the elderly $US7 and the disabled $US7. These lev- els of benefits were determined in keeping with the initial purpose of the Bono Sol- idario Cash Subsidy Program: to aid families with the costs of gas and electricity, given the elimination of energy subsidies. Nonetheless, the energy subsidies were later reinstated, and the program, which was supposedly a replacement for them, was never eliminated. The calculation of the benefit is based on a historical criterion, and does not accurately correlate to the way beneficiaries use it. Factors such as the poverty line, the opportunity cost of accumulating human capital, the cost of basic healthcare, and the effects of dollarization and inflation on the income of the bene- ficiaries were not borne in mind for the calculation. INSTITUTIONAL PROBLEMS. Currently, the Bono Solidario Cash Subsidy Program is an entity with financial autonomy, associated with the Ministry of Social Welfare. Nonetheless, the payments are made by the Ministry of Economy and Finance. This means that there is no single responsible entity. Rather, different administrative aspects of the program are under the dominion of different administrative bodies. Such a state of affairs creates confusion and problems of coordination. Other insti- tutional aspects should also be reviewed. For example, the system uses the private banking system, intensely clustered in urban zones, to effect payment of the bene- fit. The banks verify the identity of the payment recipients, but are not obligated to convey that information to the government. There are also problems with the man- ner in which payments are made (such as times of service and long waits at private banks). Table 3. Targeting of the Bono Solidario Cash Subsidy Program (Individual Beneficiaries) Eligible Ineligible Total Receive the subsidy 590,955 692,985 1,283,940 Do not receive the subsidy 856,442 1,417,795 2,274,237 Total 1,447,397 2,110,780 3,558,177 Source: World Bank (2000). 336 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM FAILURE TO EVALUATE THE PROGRAM'S IMPACT. No evaluation is made of the impact of the Bono Solidario Cash Subsidy Program in terms of its effectiveness. The clos- est approximation to such an evaluation was a baseline survey of the program, con- ducted in August 2002, which attempted to determine how the beneficiaries were using the money. Yet, just as occurs with the rest of the programs in the social assis- tance system, no serious evaluation is being made of the subsidy's effects. LACK OF CLEAR OBJECTIVES. As was mentioned above, the historical reason for which the Bono Solidario Cash Subsidy Program was created-that subsidies on energy consumption were being eliminated-is no longer valid, as the energy subsidies have since been reinstated. The Bono Solidario is currently a money transfer program with no stated purpose. This compromises other dimensions of the program, such as tar- geting and determination of the level of benefits. LACK OF AIM TO INFLUENCE BEHAVIOR. In many cases, the most effective social assis- tance programs are those that attempt to influence changes in the behavior of their beneficiaries. A good example would be the education of mothers on aspects of nutrition, which is considered more effective and longer lasting than food distribu- tion programs. The Bono Solidario Cash Subsidy Program is nothing more than a money transfer. It does not seek to influence behavior, and thus entails a risk of gen- erating dependency among its beneficiaries. E. Recommendations Ecuador's social assistance system is plagued with numerous faults that the new administration needs to address. The principal problem is not a lack of funds for social assistance-rather, it is that social assistance is not well targeted, and that sev- eral programs are regressive, and therefore do not reach the population most in need. The recommendations of this chapter can be grouped into three categories. In the first place, the flexibility of the social assistance system needs to be increased, using some mechanism to ensure that the system can adapt in times of crisis, when the number of persons demanding social assistance grows. In second place, a series of distortions in the current social assistance system must be corrected. This will require a review of the benefits, targeting criteria, objectives, and administration of certain programs. Changes such as these demand a major political commitment and are not easy to implement. An evaluation of the impact of the measures adopted is therefore imperative. The third recommendation involves Ecuador's largest assistance program, the Bono Solidario Cash Subsidy Program. The new administration should focus its efforts on ways to take advantage of the program's structure, which has a broad outreach and could serve as the backbone of the social assistance system. In this sense, numerous changes are needed, which are described below. THE SOCIAL ASSISTANCE SYSTEM 337 Increase the Flexibility of the Social Assistance System As was stated above, creating flexibility in the social assistance system entails the cre- ation of mechanisms so that it can expand in times of crisis and contract under nor- mal circumstances, when the demand for social assistance goes down. For said pur- pose, the following is recommended: PROTECT THE BUDGET OF PRIORITY SOCIAL ASSISTANCE PROGRAMS. It is recom- mended that minimum statutory budgets be created for certain social assistance pro- grams. The social assistance system should have a basic budget that is protected, at least in the case of certain programs. In this sense, the inclusion of clauses in the agreements made with multilateral entities to guarantee the protection of these funds is an option that has been utilized in the past, which has allowed certain pri- ority programs to stay in operation. DESIGN A SYSTEM THAT ALLOWS FOR AN UPDATING OF PROGRAM BENEFICIARIES. To date, the most significant targeted programs are not allowing new beneficiaries to enroll. This means that during a crisis, those who require temporary social assistance have no access to it. A mechanism must be conceived that will allow new benefici- aries to enroll at various times of the year. One way to accomplish this is to period- ically verify the eligibility of potential beneficiaries, particularly during a crisis. Another possibility is to consider a functional decentralization of certain programs. If their administration were in the hands of provinces or municipalities, which would be closer to the potential beneficiaries, it would be easier to evaluate the needs of the population. CONSIDER THE CREATION OF A PUBLIC WORKS PROGRAM OR OTHER ANTICYCLIC PRO- GRAM. Public works programs provide income to unemployed persons who are unable to obtain work during a crisis, while simultaneously contributing to the cre- ation of infrastructure. The advantage offered by these programs is that they are purely anticyclic and temporary. Indeed, it is only during a crisis that a major group of individuals will exist who will be looking for work and unable to find it. In gen- eral, these programs are self-targeted, as they offer low wages that only attract very poor persons who are truly in need. Furthermore, the benefit granted is usually short in duration. The programs tend to be expensive, but part of the financing for a pro- gram of this type could be made available through rationalizing or adapting many other existing programs, such as the energy subsidies. Improve Coordination and Targeting in Existing Programs Ideally, a social assistance system should focus on a few programs with specific objec- tives and consistent targeting instruments. In the case of Ecuador, the system could cover vulnerable groups and the most immediate risks to which these groups are 338 ECUADOR: AN ECONOMIC AND SOCILA. AGENDA IN THE NEW MILLENNIUM subjected through the Bono Solidario Cash Subsidy Program, the Scholarship Pro- gram, and an anticyclic program such as public works employment. This would entail a reform of the Bono Solidario Cash Subsidy Program (the recommendations for which are included in the next point). This program should be reoriented toward protecting very young children and pregnant women against the risks of malnutri- tion. At the same time, the influence of other programs that offer in-kind transfers should be reduced. Given that the elimination of programs can be very costly from a political point of view, an attempt should at least be made to improve coordina- tion among the programs already in existence, so as to avoid the temptation of cre- ating more programs than are recommended. It is recommended that the following measures be studied: ADOPT CONSISTENT TARGETING CRITERIA. As was explained in the preceding section, there is evidence that the present social assistance programs do not always reach those most in need. It is suggested that a single criterion be adopted for targeting the most significant social assistance programs. There are at least two possibilities. On the one hand, surveys of households can be used to determine which ones are the most needy, in order to entitle those households to a series of benefits. That system would be periodically reviewed to allow the enrollment of new households and to validate the information obtained on households that are already receiving benefits, thus minimizing errors of inclusion or exclusion. There are numerous examples of this type of targeting criterion, such as Colombia's Beneficiary Selection System (Sis- tema de Selecci6n de Beneficiarios-SISBEN), and the Ecuadorian Beneficiary Iden- tification and Selection System (Sistema de Identificacidn y Seleccidn de Beneficiarios-SELBEN), which is now being developed. This system tends to be very onerous and difficult to administer. Thus, in several cases, it has been decided to utilize poverty maps to grant benefits. The benefits are granted to all the inhabi- tants of a given community considered to be very poor. Such a system is easier to administer, but in principle can generate errors of exclusion if the mapping is not sufficiently precise, that is to say, concerning the lowest geopolitical division of the population (in the case of Ecuador, that would be the sub-township level). IMPROVE THE COORDINATION OF EXSTING PROGRAMS. The objective of the pro- grams on which the most emphasis is placed must be clearly defined. This means that their targeted population must be identified, as well as the eligibility criteria and the risks against which the beneficiaries would be protected, in order to prevent an overlapping of programs that benefit one and the same household and address one and the same problem. In this sense, it will be necessary, for example, to reconsider the role of the School Meals Program, as it addresses risks that are similar to those covered by other programs. The School Meals Program has an approved budget for 2002 of $US46 million, and provides nutritional supplements to school-age chil- dren, both elementary and secondary. The program uses an approximate poverty map determined by the Social Vulnerability Index. Yet this program's benefit clearly THE SOCIAL ASSISTANCE SYSTEM 339 reaches beyond those who are the poorest. Indeed, in 2001 supplements were granted to approximately 1.4 million school-age children, yet in 1999 Ecuador had 1,629,065 children enrolled in elementary schools. Furthermore, like all programs that grant in-kind transfers through schools, those who are the poorest do not receive the benefit, because they are outside the formal educational system. As for the objective of programs such as these, it is clear that they do not solve the prob- lems of infant malnutrition, as such a goal would require interventions at a very early age. Although the School Meals Program does act as an incentive to school attendance, it also competes with the Bono Solidario Cash Subsidy Program. In fact, recent surveys have determined that 60 percent of the beneficiaries of the Bono Sol- idario Cash Subsidy use all or a significant portion of that money to buy food. The School Meals Program also competes with the Scholarship Program, whose objec- tive is to promote school attendance through a cash subsidy to families that send their children to school. CONSIDER THE ELIMINATION OF SUBSIDIES ON ENERGY CONSUMPTION. It has been demonstrated that this program is highly regressive and costly for the government. EVALUATE THE IMI'ACT OF TlIE MOST SIGNIFICANT PROGRAMS. All decisions to make changes in current programs should be founded on a cost/benefit study and on a measure of their impact. PRIORITIZE DEMAND-BASED PROGRAMS SUCH AS CONDITIONED SUBSIDIES. This will also require the improvement of the supply of related health and education services to make it easier for beneficiaries to meet the requirements. Reorient the Bono Solidario Cash Subsidy Program toward Becoming a Program of Conditioned Subsidies The Bono Solidario Cash Subsidy Program, which represents approximately half of the government's social assistance budget, has the tools it needs to become the cen- tral program of the social assistance system. Nonetheless, a series of changes need to be made to it, including a review of its objectives, a recalculation of its benefits based on clear criteria, and an improvement in its targeting. Specifically, the following measures are recommended: TRANSFORM THE BONO SOLIDARIO CASH SUBSIDY PROGRAM INTO A CONDITIONED SUBSIDY PROGRAM, ORIENTED TOWARD PROTECTING THE HEALTH OF CHILDREN AND PREGNANT WOMEN WHO LIVIE IN POVERTY. Children's nutrition programs have very limited coverage. It is estimated that there are 1.3 million boys and girls in Ecuador between zero and five years of age. Programs targeting this vulnerable group only provide services to approximately 200,000 children, even though, according to SIISE data, approximately 600,000 children are suffering from chronic malnutri- 340 EcUADOR: AN ECONOMIC AND SOcIAL AGENDA IN THE NEW MILLENNIUM tion. Clearly the coverage of the programs aiming to alleviate this problem is insuf- ficient and inadequate. The Bono Solidario Cash Subsidy Program is a good poten- tial channel for promoting control of children's nutrition and health in exchange for a transfer in money. This approach is already functioning in other countries, such as Colombia and Mexico. The conversion of the Bono Solidario Cash Subsidy Program would entail an analysis, among other things, of the possibility of including preg- nant women in the system; the type of control that would be required of mothers; and the exclusion of persons who are receiving benefits from other programs such as the ORI, PDI, or the PANN.6 An approach must also be developed for mothers with children over the age of five, for whom the type of control and the objective of the program would be different. MAINTAIN BENEFITS FOR THE ELDERLY, OR PROGRESSIVELY REPLACE THEM WITH A NONCONTRIBUTIVE PENSION FOR THE ELDERLY POOR. As explained in section C, the elderly are a vulnerable group, especially those elderly persons who do not receive pensions from the social security system (in other words, the majority). The Bono Solidario Cash Subsidy Program is thus the only program that mitigates the lack of income in this demographic group. Nonetheless, there needs to be coordination with the Social Security System, so that this program does not compete with a pos- sible noncontributive pension under the IESS reform plans (see Chapter on the Social Security System). Also, elderly persons who live with beneficiary families of the Bono Solidario Cash Subsidy Program should not receive a separate benefit under that same subsidy amounting to a double benefit for those families. One possibility in such a case is to consider a reduction in the benefit, rather than its complete elim- ination. IMPROVE TARGETING CRITERIA. In the first place, the beneficiary base should be screened, using a criterion consistent with those of the other most significant social assistance programs. In the second place, new beneficiaries should eventually be allowed to enroll, provided that they meet the respective eligibility criteria. In the third place, clear targeting criteria should be chosen. For said purpose, the advan- tages and disadvantages of systems such as surveys or poverty maps should be stud- ied. A possible combination of these methods with self-targeting criteria should also be considered. REVIEW THE AMOUNT OF BENEFIT GRANTED. In good measure, the amount would depend on the program's objective and beneficiary population. For example, the benefit amount to protect children against problems of malnutrition would be very 6. Children's Rescue Operation (Operacidn Rescate Infantil), Children's Development Pro- gramn (Programa de Desarrollo Infantil), and the National Food and Nutrition Program (Programa Nacional de Alimentacidn y Nutricidn), respectively. THE SociAL ASSISTANCE SYSTEM 341 different from the amount granted to protect families from temporary reductions in their levels of income or to protect children from possible losses in the development of their human capital. Benefits must be based on clear criteria and must respect budgetary limitations. For example, increasing the benefit to mothers so that their income would reach 50 percent of the poverty line would require a doubling of the budget. Considering the budgetary limitations, these funds could be made available through a reorganization of existing programs or an elimination of certain benefici- aries based on such targeting criteria as may be adopted. Rofman (2002) estimates the additional costs of increasing benefits and enrolling additional beneficiaries under various scenarios. REVIEW ADMINISTRATIVE ASPECTS OF THE PROGRAM. This includes reevaluating the contracts with private banks for handling benefit payments, confirming the benefi- ciaries' identity, and studying possible delays in project budget implementation. EvALuATE THE IMPACT OF THE PROGRAM. An impact evaluation plan should be included in the design of the new program. F. Conclusions The political changes on the horizon in Ecuador create an opportunity to lay the groundwork for a more efficient and equitable social assistance system. The econ- omy has been recuperating in recent years, but the effects of dollarization and a pos- sible repeat of the El Nifio phenomenon necessitate a profound analysis of the social assistance programs. It has been emphasized in this chapter that many of the changes do not require budget increases, but simply a firm political commitment to improve the well-being of Ecuador's vulnerable population groups. Policy Matrix Policy measures Short term Medium term Problems (to June 2003) (2003-07) Progress indicators Objectives/goals 1. The social assistance system is inflexible The social assistance Propose new minimum Protect the social assis- Budgets of social assistance Provide the social assistance tt budget is inflexible, and floors for certain social tance budget of the most programs. system with greater flexibility, is not dependent on the assistance programs. significant programs. Agreements with multi- so that it can respond to G social protection needs lateral entities, specifying sitmations of crisis through of vulnerable groups. minimum floors for social anticyclic changes in its budget. z assistance. Stabilization Fund in 0 operation. 0 The social assistance Evaluate possible Implement the plan to Beneficiary database. Allow individuals in temporary n programs do not mechanisms for update the beneficiary situations of vulnerability to a contain mechanisms updating at least database in at least three benefit from social assistance to update the three of the most of the most significant programs. beneficiary base. significant social programs. assistance programs. z There are no Evaluate the costs of Reorient funds from Report that simulates Improve the social assistance anticyclic programs. implementing various the most regressive various anticyclic system's response capacity to anticyclic programns. social assistance pro- programs. emergency situations. grams toward the creation of an anticyclic program. 2: Absence of consistent targeting criteria and problems of regressivity r, z Various social Redefine objectives and Evaluate various Reports on social Improve the targeting of the assistance programs the beneficiary popu- targeting mechanisms. assistance programs' social assistance programs. are regressive or lation in the most Adopt a unified objectives and H inadequately targeted. significant programs. targeting mechanism beneficiary population. - Evaluate the impact of for the most signifi- Reports with impact 0 the social assistance cant programs, in a evaluations. n system's most coordinated manner. Report on targeting significant programs. mechanisms. Executive order, law, or M regulations that adopt n unified targeting criteria. There is little Analyze gaps in the Coordinate existing Plan that addresses the Improve the scope and coverage for certain social assistance system programs to minimize coordination of the most effectiveness of the social key risks. in terms of vulnerable overlapping and to significant programs. assistance system. groups and risks that ensure that benefits are Plan aimed at reorienting are not being correctly granted to the groups programs in order to cover addressed. that need them. risks that are not currently addressed. 3. Faults in the Bono Solidario Cash Subsidy Program The targeting of the Examine the possibility Reorient the Bono Changes in the operating Improve the effectiveness of the subsidy is inadequate. of enrolling new bene- Solidario Cash Subsidy regulations of the Bono Bono Solidario Cash Subsidy Self-targeting was used ficiaries while continu- Program toward the Solidario Cash Subsidy Program. when the program ing to screen the bene- objective of combating Program. was launched, and new ficiary database. malnutrition, trans- beneficiaries have not forming the benefit been incorporated. into a conditioned subsidy. The level of benefits Establish clear Update the benefits Changes in the operating Improve the beneficiaries' level is not based on clear eligibility criteria for based on the criteria manual of the Bono of income as a function of the criteria, and is the benefit. If the established. Solidario Cash Subsidy program's objective. very low. Bono Solidario becomes Program. (Matrix continues on thefollowing page.) Policy Matrix (continued) t Policy measures Short term Medium term Problems (to June 2003) (2003-07) Progress indicators Objectives/goals a conditioned subsidy, the benefit should be related to the poverty m line or the cost of a basic family food budget. There is no evaluation Conduct periodic Report that includes Allow for corrections in the of impacts and the impact evaluations. impact evaluations. Bono Solidario Cash Subsidy O a program's objective Program as a function of their Z a is not clear. impact on the beneficiaries. x n 0 r z C THE SocIAL ASSISTANCE SYSTEM 345 Annex: Incidence of Social Assistance Programs (Selected) Bono Solidario Consumption Free Cash per School food Childeare Subsidy Gasoline Gas Quintiles capita breakfast programs programs Program subsidy subsidies Poorest 5 38 17 16 27 0 8 Second 9 15 18 37 28 1 14 Third 13 12 46 20 25 4 20 Fourth 20 33 19 19 16 10 24 Wealthiest 53 2 0 7 4 85 33 Source: Vos and others (2002). 12 The Pension System1 Rafael Rofinan The Ecuadoran pension system has three types ofproblem in its design, management, and institutional makeup, which need to he resolved in the short and medium terms. The first problem involves the programs effective coverage. The proportion of the economi- cally active population and the elderly who are protected by the Obligatory Insurance of the Ecuadoran Social Security Institute (IESS) is one of the lowest in the region. Non- contributive programs, such as Rural Peoples Social Security (SSC) or the Bono Soli- dario Cash Subsidy, extend coverage, but with benefits that are too low to provide effec- tive protection for old age. A second problem is in the financial management of the IESS. On the one hand, the state has failed to pay certain contributions to the IESS for more than a decade. Yet according to the Institutes accounting, this debt is listed as an asset. The amount of the debt differs significantly, depending on whether it is calculated by the IESS or by the Ministry ofEconomy and Finance. The discrepancy in question has a major impact on the actual size of the reserves. Furthermore, reserves are not clearly separated in accordance with the uses for which they are earmarked. Thus, undetected cross-subsidies may exist. Finally, the state is mandated by law to contribute 40 percent of the benefits of retired persons each year, even though the pension program of the IESS clearly has a surplus. As such, unnecessary pressure is placed on government revenues. A third type ofproblem is in the systems legal situation. With the enactment of the Reform Act in November 2001, a new organizational design was to have been implemented within the institution. However, the lawsfull application was blocked by a decision of 1. Rafael Rofmnan is a senior economist and specialist in pension systems at the World Bank. The author thanks McDonald Benjamin, Christopher Chamberlin, Daniel Dulitzky, Jose R. L6pez Caliz, and Anita Schwarz for their comments, and also thanks the officials of the government of Ecuador and of the World Bank's Quito office for their kind support. 347 348 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM the Constitutional Court, which in turn is being challenged in the court system. As a con- sequence, the new laws validity is debatable. The IESS has opted to apply some aspects of the law while ignoring others, at its own discretion. Even if the law were eventually implemented, there are serious problems in its language, particularly with respect to the role of the Technical Commission on Investments in relation to pri'vate pension funds. The law also contains certain inappropriate rules for handling thosefinds. All this must be corrected before the law goes into effect. This chapter proposes measures for broaden- ing the scope of coverage of the insured, in a manner that is fiscally and socially respon- sible, while improving the financial management of the IESS and strengthening the sys- tems institutional stability. A System Diagnostic The Institutional Organization of Ecuadors Pension System Ecuador's system for the protection of the elderly's income comprises three con- tributive type programs; a fourth program that, though nominally contributive, has a major subsidy component; and a fifth, noncontributive program. The principal contributive program is Obligatory Social Security (Seguro Social Obligatorio- SGO), which covers workers from the formal sector of the economy. The other two are the pension systems of the Armed Forces and of the police. The Rural People's Social Security Program (Seguro Social Campesino-SSC), which covers peasants who work independently or are members of communes, cooperatives, or other com- munity organizations, is nominally contributive, but the contributions made by the beneficiaries cover only a minimal part of expenses. Finally, the fifth program, which was not created as part of the pension system but in practice plays an important role in the economic safety net for old age, is the Bono Solidario Cash Subsidy Program. Obligatory Social Security began in the first two decades of the 20th century, when certain government workers obtained the right to receive pensions upon retirement. This program expanded to further sectors of public servants and private employees in the following decade, and other coverage was added, including sick pay, maternity benefits, disability insurance, death benefits, workman's compensa- tion, and severance pay. Obligatory Social Security has been administered by the IESS since the early 1970s. The IESS also administers the SSC, which was created a little more than 20 years ago with the goal of extending social security coverage to families belonging to communes or other social peasant organizations. This program has been financed through contributions from workers and employers enrolled in Obligatory Social Security, as well as contributions from the state and minimal con- tributions from the participants themselves. Benefits under the SSC are lower than benefits to persons covered by Obligatory Social Security. Members of the Armed Forces and the police force enjoy a protection similar to that of Obligatory Social Security, through programs administered by independent THE PENSION SYSTEM 349 institutions-the Social Security Institute of the Armed Forces (ISSFA) and the Social Security Institute of the Police (ISSPOL). Finally, the Bono Solidario Cash Subsidy Program, which grants a noncontributive monetary subsidy to low-income elderly persons, is administered through the Ministry of Social Welfare. Structure of the Pension System Prior to the Reform Prior to the reform of late 2001, Obligatory Social Security protected its affiliates against the risks of disability, old age, and death, as well as risks related to health, maternity, workman's compensation, and job loss. Participation in the program was obligatory for all public and private sector employees. Its financing was accom- plished through personal contributions from workers and employers. In addition, the state contributed the equivalent of 40 percent of the pensions paid by the IESS. Total contributions from workers and employers were made at the rate of 20.5 per- cent of the wage base, out of which approximately 8.4 percent was earmarked to cover disability, old age, and death benefits. Finally, pursuant to the Labor Code, the IESS administered a reserve fund generated through a monthly contribution from employers equivalent to one-twelfth of monthly wages. The contribution was cred- ited to an individual account of the worker, and could be recovered upon termina- tion of the labor relationship with the employer or after three years. Workers of both sexes could retire at age 55, provided they had 30 years of con- tributions credited. The two limits (age and years of contributions) were flexible. For example, a person with 40 years of contributions could retire regardless of the age limit, while persons who had less than 30 years of contributions could retire with a minimum of 10 years of contributions at age 70. The monthly old-age retirement benefit was proportional to the average of the five best years of the worker's contributions, and was further determined based on the number of years of contributions. Thus, a person with 10 years of contributions at the time of retirement (regardless of age), would receive 50 percent of his or her former wages. That percentage would increase by 1.25 points for each additional year, up to 81.25 percent with 35 years of contributions, and up to a maximum of 100 percent with 40 years of contributions. Although one's employment had to terminate in order to receive retirement ben- efits, there was no restriction against obtaining employment after retirement. This means that a worker could simultaneously receive a pension and a salary or wages. Furthermore, the corresponding additional contributions subsequent to retirement increased one's benefit by 0.8 to 3 percent per year of additional contribution, depending on one's age. Finally, a special reduced retirement allowed benefits to be received at 45 years of age with 25 years of contributions, and with a proportional reduction in the benefit amount. Disability and death benefits had their own structure. The amounts of these ben- efits were not established as an automatic percentage of prior wages, they increased as a function of the age of the disabled or deceased person. In the case of disability, 350 ECUADOR: AN ECONOMIC AND SociAL AGENDA IN THE NEW MILLENNIUM workers with a minimum of 60 monthly contributions had a right to a pension once they were declared disabled by the IESS. The corresponding pension was calculated using the same criterion as retirement, with a minimum of 43.75 percent of wages for beneficiaries who had made a minimum of five years of contributions. Death benefits were made to a widow or female cohabitant, and to a widower or male cohabitant if he were disabled and a dependent of the decedent, as well as to chil- dren who were under 18 years of age or disabled. Death benefits for widows, wid- owers, or cohabitants were 40 percent of the pension that the deceased had been receiving or would have been entitled to collect, and 20 percent of that amount for each child. The rules and regulations also provided for benefits to other family mem- bers under exceptional circumstances. Contribution rates and benefits were both determined on the basis of "taxable wages." This only reflected a part of the workers' actual income-as, in recent decades, workers' wages have tended to be adjusted not through direct increases to their pay, but through the creation of new forms of remuneration that formed a part of the worker's total income but were not considered taxable wages. This practice was especially pronounced in the public sector, in which there were 28 items for which compensation was received, but contributions were only made on base wages. The complementary remunerations, which represented 36.5 percent of total remu- nerations in 1990, grew to the point at which they reached up to 92.5 percent in 1999 (IESS 2001). The trend started to reverse in 2000, and private estimates indi- cate that taxable income now represents 82.5 percent of total remuneration in the private sector and 25 percent of total remuneration in the public sector. The distor- tion that this phenomenon introduced into the system is twofold. On the one hand, it severely reduced the resources available to the IESS for financing benefits. At the same time, it affected (though to a lesser degree) the future benefits of those mak- ing contributions during those years. The Rural People's Social Security Program, in contrast to Obligatory Social Secu- rity, required minimal contributions for benefit entitlement. Heads of households contributed 1 percent of the basic minimum wage to finance worker benefits. Work- ers and employers enrolled in Obligatory Social Security were required to contribute 0.35 percent of wages. In addition, 0.30 percent of that same wage base was provided as a contribution from the state, and the state also made another direct contribution. Enrollment in the SSC entitled the beneficiary to health services for his or her fam- ily unit. The head of the household was also entitled to disability or old-age benefits, equivalent to 75 percent of the basic minimum wage. The right to an old age pen- sion was acquired at age 65, provided that the beneficiary had made at least 10 years of contributions. This requirement was gradually phased out starting at 71 years of age, and at age 75 or above, only five years of contributions were required. Finally, the Bono Solidario Cash Subsidy Program offered a benefit in the form of assistance granted through the Ministry of Social Welfare. The subsidy was created in 1998 to replace subsidies on consumption energy, which were eliminated that same year (although the energy subsidies were reestablished shortly afterwards). This THE PENSION SYSTEM 351 program targeted mothers of minor children, the disabled, and low-income persons over 65 years of age. In the case of the elderly, eligibility to obtain the benefit was determined through meeting the requirements of reaching the established minimum age and having a family income of less than $US20 per month and no job. This pro- gram is closed-to be precise, at the time it was created a mass enrollment took place, but since then no new beneficiaries have been admitted. Financial Situation The financial situation of the pension system in Ecuador is difficult to evaluate, owing to various factors. For one, the IESS has not maintained a separate adminis- tration or accounting of the various types of insurance. One therefore has to make a series of estimates to obtain an approximation of trends in insurance for old age, disability, and death over the past decade. Furthermore, the flow of revenues has var- ied considerably, as the result of the fluctuations in taxable wages described in the previous section, the state's failure to perform its obligations as an employer and as a direct contributor, and the acute fluctuations in variables provoked by inflation and dollarization in 2000. The IESS, in recent years, has had a surplus. The surplus was smallest in 1999, when it amounted to only 0.2 percent of the GDP, and largest in 2001, when it amounted to 1.7 percent. The surplus for 2002 is projected at 2 percent (Figure 1). These results reflect the combined effect of the various insurances, foremost among which are health insurance and old age insurance. The recent growth in revenues is because the state has now commenced to pay its obligations. An analysis of trends in insurance for old age, disability, and death is more com- plex because, as mentioned above, the IESS did not keep a separate accounting of the various funds. Nonetheless, estimated values indicate a surplus since 1993, with balances ranging from 0.16 percent of GDP in 1999 to 0.74 percent in 2001. It is interesting to note that the trend in 2002 indicates a leveling of revenues (in terms of GDP), while expenditures continue to grow. Thus, the surplus is expected to decline by 0.25 percent of GDP (Figure 2). Figure 2 shows the estimated results for the Obligatory Social Security pension system, without considering transfers from the government. If the total results of policies aimed at generating income for the elderly were included, the estimated sur- plus would be smaller, as disbursements are also made from the military and police retirement systems (with expenditures of $US60 million and a deficit of 50 percent of that amount), pensions granted through Rural Social Security (less than $USI million annually), and the Bono Solidario Cash Subsidy Program for the elderly ($US20 million). Thus, the total disbursements of programs that transfer revenues to the elderly in 2002 would be in the neighborhood of 1I.1 percent of GDP and the aggregate financial surplus would only be 0.15 percent of GDP Also, it should be noted that at the end of 2002, the state reportedly transferred some $US80 million in additional funds, or 0.4 percent of GDP, to the system. 352 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN fHE NEW MILLENNIUM Figure 1. Financial Trends in the IESS (as a percentage of GDlP, 1993-2002) 4.5; 3.0 C) 2.5 0.0 1.0 0.5l 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 (projected) Q Reventues a Disbursements Source; Generated by the author, based on IESS data for 2001 to 2002 and on IMF data for 2002. Figure 2. Financial Trends: Insurance for Disability, Old Age, and Death (as a percentage of GDP?, 1993-2002) 1.20 1.00 0.80-, 0.60 5 0 B 0.40. 0.20I 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 (projected) U Revenues Li Disbursements Source: Generated by the author, based on IESS data for 2001 to 2002 and on IMF data for 2002. THE PENSION SYSTEM 353 The improvement in capturing revenues as of 2000 is due to two reasons. First, since March 2000, a wage standardization process has begun, which tends to sim- plify the structure of remunerations and to classify the majority of wages as taxable income for purposes of social security contributions. Second, since 2001 the gov- ernment has started paying the contributions it owes as an employer and as a third party, thus collected revenues have rapidly increased. The positive results obtained by the IESS have led to an accumulation of reserves. In late 2001 the General Insurance reserve (which includes disability, old age, death, and health), according to the Institute's own accounting, was $US 1.092 billion, and the reserve grew during the first nine months of 2002 by approximately $US300 million. It is also important to point out that the IESS, in its accounting statements as of December 2001, has included a debt owed by the national gov- ernment in the amount of $US2.085 billion among the assets supporting these reserves. The government has not acknowledged that amount, and estimates the debt at approximately $US400 million. As a result, the actual size of the reserves is unknown. The Level of the Benefits One of the reasons why the IESS has been able to maintain a certain degree of finan- cial stability despite the problems discussed in the previous section is that benefit amounts were severely affected by macroeconomic dynamics. The average benefit, which in the mid 1990s was approximately $US 100 per month (after accounting for special payments), fell rapidly between 1998 and 2000, to less than $US30. As of 2001 the IESS has been restoring benefit levels. Thus in the third quarter of 2002, the average was approximately 70 dollars per month (Figure 3). Although the average benefit payment has increased in the past year, it is still sig- nificantly less than as promised under the law. In fact, in accordance with the legis- lation, workers who retire because of old age should receive benefits equivalent to approximately 75 percent of the average of their best five years of wages. Nonethe- less, the average salary of an IESS affiliate in mid-2002 was $US171, and the aver- age retirement was approximately 30 percent of that amount. There are several rea- sons for this great disparity, including the absence of automatic mechanisms to adjust benefit payments, as well as the methodology of calculating the initial bene- fit, which fails to consider the current value of the wages when calculating the aver- age of the best five years. Retirees eligible for the SSC, in accordance with the law, receive a benefit pay- ment equivalent to 75 percent of the basic minimum wage, but the amount has not been adjusted since the dollarization. The average pensions under this program in the mid 1990s were slightly greater than $US20 monthly, but then the amounts fell, in a similar manner to what occurred with benefits under Obligatory Social Secu- rity, reaching levels of less than $US3 monthly in 2000. The amount has yet to be corrected. 354 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Figure 3. Average Benefit per Month per Person, in Dollars, lInsurance for Disability, Old Age, and Death: Rural People's Social Security Program; and the Bono Solidario Cash Subsidy 1995-2002 $120 $10( $806 $60 \()bliga-e Sncial_&Panriru / $4C Rural People's Social Securiry $2C m Subsidy $0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Source: Generated by the author, based on IESS data for 2001 and 2002, data from the Social Protection Program (Programa de Plroteccidn Social-PPS) for 2002, and IMF dara for 2002. Finally, beneficiaries of the Bono Solidario Cash Subsidy Program have been receiving $US7 per month since December 2000. This represents an increase as compared to the $US3 benefit paid at the time of the dollarization, and is approxi- mately equal to the amount originally granted in 1998. Coverage The core objective of a pension system is to provide income for persons who, by rea- sons of age (or disability or death), are unable to generate the income they need for their subsistence and the subsistence of their family group. Therefore, a system's cov- erage is a central issue. A pension system that fails to protect a significant propor- tion of the population has failed to meet its principal objective. The coverage of Ecuador's pension system is one of the lowest in South America. The coverage indicators customarily utilized (such as the proportion of the eco- nomically active population that pays into the contributive system, or the propor- tion of persons of age 60 or above with benefits) indicate values that are much lower than those of other countries in the region. Indeed, only Bolivia has a lower per- centage of contributors (Figure 4). The problem of low coverage in Ecuador has worsened in recent years, given that macroeconomic difficulties affected the degree to which workers had formal employment. This provoked a stagnation in the number of contributors to Obliga- tory Social Security in the mid-1990s, at a time when the economically active pop- THE PENSION SYSTEM 355 Figure 4. Percentage of the Labor Force Participating in Contributive Pension Programs in South America in and about the Year 2000 100 2 80 0 60-6 U ___3___ DD QO40- so 20 -F 0~ 45. I- 00 -~~~I 7- so > C- '5 Source: Palacios and Pallares (2000), anid the author, based on information from IESS Social Protection Program (PPS). ulation was growing steadily. As a consequence, the proportion of the economically active population covered by Obligatory Social Security declined between 1995 and 2002 from 34 percent to 26 percent. This fall reflects the incapacity of the formal labor market to expand at the same rate of growth as the population (Figure 5). Trends in the Rural People's Social Security Program during this same period were similar. The SSC grew rapidly during the first decade of its existence. In 1995, however, the number of heads of households registered in the program started to sta- bilize, and the program's impact diminished in terms of the benefited percentage of the economically active population. The low coverage of Obligatory Social Security among active workers is also reflected among elder workers. Indeed, the coverage of this program among persons over 55 years of age (the minimum required age for retirement) is 13 percent. Cov- erage for the Bono Solidario Cash Subsidy Program, by contrast, is 30 percent. Other programs have little effect, either because they are relatively new (in the case of the SSC) or because they are small and/or cover a younger population, given the charac- teristics of the programs themselves (for example, the retirement systems of the police force and the Armed Forces). An analysis of coverage by age group shows that even though the minimum retirement age is 55, relatively few persons actually retire at that age. Coverage, as would be expected, grows with age, reaching 70 percent for the 70-74 age group. The coverage indicated for the 80-and-above age group is strikingly high-but that value may have been affected by errors in the data (Figure 6). 356 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Figure 5. Participation of Active Workers in Ecuador's Pension Systems (as a percentage of the economically active population in each program and in the system as a whole, 1965-2002) 45% 40% TOTAL 1 35% /T A 30% /Obit t 30/ Social Security 25% 20% / 15% 10% 5% t::Rural People's Social Secuio ice an i 0% A 1965 1970 1975 1980 1985 1990 1995 2000 2005 Source: Author, based on IESS data for 2002 and 2002 and on IMF data for 2002. Figure 6. Coverage of Pension Systems with Respect to the Population Age 55 and Older (by age group and in total, 2002) 100% o Rural People's Social Security 8 - o Bono Solidario Cash Subsidy 80%- Obligatory Social Security 60%- 40%-l 20% 0%1 ,-,-. 55-59 60-64 65-69 70-74 75-79 80 + TOTAL Source: Generated by the author, based on data from the IESS, PPS, and the Larin American Demography Center (Centro Latinoamericano de Demografla-CELADE). THE PENSION SYSTEM 357 The Reform After a prolonged debate, the National Congress passed a new Social Security Act in November 2001. Application of this law is being legally challenged, as we shall dis- cuss below. The new Social Security Act fully supersedes the old law, created 60 years earlier, and modifies the system's basic structure, through changes in parameters, in the system's structure, and in the system's institutional organization. Some of the principal reforms introduced are summarized below. Reforms to Parameters The new law changes several parameters of the Obligatory Social Security system, in order to adapt them to the current situation. These changes include the following: * The minimum retirement age is raised to 60, and (as of 2006) the possibility of retiring with 40 years of contributions regardless of age is eliminated. In addition, in an innovation that is unprecedented in the world, the law pro- vides that in the future, the minimum age shall be corrected as a function of life expectancy at the time of retirement. * Formal coverage is expanded to encompass all workers, including the self- employed and employers. * The method of calculating pensions in cases of disability or death is changed. They are now set as a percentage of the base calculation, and are no longer proportional to the number of years of previous contributions. * The rate of contributions to the pension system has been indirectly increased, since contributions to the reserve fund (8.33 percent of the wages) shall now be capitalized in individual accounts and may only be recovered upon retire- ment, disability, or death (although affiliates may use this fund to secure debt and may withdraw it in its totality upon retirement). Structural Reforms * A multitier approach is taken, with a structure similar to that of the reform carried out in Uruguay. As such, all workers must participate in a first "Oblig- atory Solidarity Regimen," for which they must make contributions based on their income up to the sum of $US 165 per month. At the same time, the totality of employer contributions and personal contributions corresponding to wages in excess of $US500 are earmarked to finance this regimen. * The second tier, or "Obligatory Savings Regimen," consists of capitalizing per- sonal contributions on wages between $US165 and $US500, in individual accounts. These contributions shall be administered by Pension Savings Deposit Institutions (Entidades Depositarias del Ahorro Previsional-EDAP), for which purpose a bidding competition shall be conducted by the IESS Tech- nical Commission on Investments (Comision Tecnica de Inversiones-CTI). 358 ECUADOR: AN ECONOMIC AND SOCiAL AGENDA IN THE NEw MILLENNIUM 0 A new noncontributive assistance benefit is created for individuals over the age of 70 who have no other funds, and it is financed by the General Budget of the state. The features of this benefit are similar to those of the Bono Soli- dario Cash Subsidy Program, but the two programs are kept separate. lInstitutional Reforms o The new law requires a separate reserve for each fund administered by the IESS, and prohibits the use of funds from one program to finance another. • A dual control system is created for companies administering pension funds. The Technical Commission is assigned the ultimate responsibility for manag- ing the funds. At the same time, supervisory authority is delegated to the Superintendency of Banks. The new law also grants the CTI an imprecise degree of autonomy, as it sets forth that the Commission's members shall be designated by the state, the insured, and the employers, in a tripartite fashion. Predicting the fiscal effects of the reform is a complex task, as this depends, in good measure, on variables that could be (and have been) discretionally altered. Informal estimates based on data available as of December 2000 indicate that only 9.5 percent of the contributors to the IESS (that is, slightly more than 2 percent of the workforce) will be making contributions to the pension funds. This estimate needs to be corrected to account for the effect of wage standardization in the private sector, but even so, it clearly seems that at least in the first few years, the magnitude of the private system, and therefore the fiscal cost of the reform, will be minor. The validity of the new law was challenged in the Constitutional Court. The court ruled that several of the law's articles were unconstitutional, among them Arti- cle 176, which sets income ranges for participation in the various tiers of the new system. As a consequence, the court prohibited application of the individual accounts mechanism provided for in the law. Nonetheless, a further court action blocked the official publication of the Constitutional Court's decision. Thus, the decision currently has no formal effect. This dispute remains unresolved to date, which increases confusion as to what constitutes applicable law. The national gov- ernment has not issued the necessary regulations for the law's application, although the IESS and the Superintendency of Banks have started to set their own rules and selectively apply certain aspects of the law. 13. Proposed Solintions The current state of the pension system raises several issues that require attention. A general problem is the institutional weakness of the sector, which is attributable, in part, to the fact that there is no high-ranking entity within the national government that is politically responsible for designing strategies, coordinating their implemen- THE PENSION SYSTEM 359 tation, and evaluating their execution. Such an entity must have the budgetary and technical resources it needs and should mainrain an active policy of coordinating the various programs aimed at economically protecting the elderly. Furthermore, there are various specific issues on which action should be taken. These include but are not limited to the following. Problems of Coverage, in Terms of Broadness and Depth If we include the Bono Solidario Cash Subsidy Program for the elderly in our analy- sis of the system to protect the elderly, it is clear that the current system still provides a low level of coverage among the age groups that actively participate in the econ- omy. Nonetheless, the coverage increases considerably among the elderly, especially among those over the age of 70, for whom coverage surpasses 60 percent and approaches levels that could be considered satisfactory. There are various problems of magnitude, however, that ought to be consid- ered. On the one hand, the limited coverage of Obligatory Social Security makes coverage among persons under 70 very low. Furthermore, the Bono Solidario Cash Subsidy Program for the elderly, created in 1998, has not permitted new enroll- ments since that time. As a result, the number of beneficiaries of that program has slowly but surely diminished since its creation. Even more important is the prob- lem of "depth" of coverage. The fact that people are formally enrolled as benefici- aries is positive, but if the benefits received are minimal, the practical effect is also minimal. The current monthly benefit payment of the Bono Solidario Cash Sub- sidy Program for the elderly is $US7, while, under the Rural People's Social Secu- rity Program, the retirement benefit is only $US3 per month. The benefits of Obligatory Social Security are greater, and have been increasing considerably since 2001, but even so, the average benefit of the old-age pension, as of June 2002, was only around $US70 per month, with 30 percent of the beneficiaries receiving $US20 or less. The poverty line for the country's population is estimated at $US47 per person. This means that close to 57 percent of the beneficiaries are receiving pensions at less than 15 percent of the poverty line (recipients of the Bono Solidario Cash Subsidy Program and of pensions through the SSC), while another 13 percent are receiving pensions at less than 50 percent of the poverty line. The Ecuadoran government should make efforts to extend nominal and effective coverage to the majority of the population. Five actions in particular could be rec- ommended: DEVELOPING A RIGOROUS METHODOLOGY FOR ANALYZING PENSION POLICIES. This first action is relevant in terms of applying the other recommended actions. It con- sists of preparing a methodological framework and delineating a critical path along which to implement measures aimed at broadening the coverage proposed below. For that purpose, the fiscal cost (as well as the savings) generated by the reform and 360 ECUADOR: AN ECONOMIC AND SocIAL AGENDA IN THE NEW MILLENNIUM by the proposed measures in the short term need to be evaluated, to plan for their gradual implementation .2 BROADENING THE SCOPE OF COVERAGE OF OBLIGATORY SOCIAL SECURITY. The new Social Security Act calls for mandatory participation of all workers in Obligatory Social Security, including the self-employed and employers. In order for this provi- sion to be effective, regulations need to be drawn up that establish enrollment pro- cedures, the method for paying contributions, and so on. This action must be taken in the short term, in order to enroll new beneficiaries as soon as possible. Further- more, in order to ensure effectiveness, contribution payment mechanisms and pro- cedures for control of evasion among new affiliates need to be designed and imple- mented. This measure has no fiscal cost whatsoever in the short term. Rather, it will immediately increase revenue collections. BROADENING THE SCOPE OF COVERAGE OF THE SSC. The Rural People's Social Secu- rity Program currently covers close to 25 percent of its target population, estimated at one million families. The IESS should develop a mechanism to broaden coverage, bringing in new families, individuals, and communities. lo do so, an expansion plan must be designed, defining a geographical targeting mechanism that identifies the zones with the greatest need so as to commence the expansion effort in a targeted man- ner. Although this action does entail a fiscal cost, it would be limited, considering the low cost of the system at present. A 20 percent increase in the current coverage per year would result in an additional cost of approximately $US2 million per year. REGULATION AND GRANTING OF NONCONTRIBUTIVE AID. The new law also provides for the granting of noncontributive benefits to persons over the age of 70 who lack adequate resources of their own. These pensions should gradually replace the Bono Sol- idario Cash Subsidy, by bringing the informal sector into the social protection system. For this purpose, the government needs to issue the respective regulations and start granting the benefits. Given the potential fiscal cost of this program, the government should consider a phased-in implementation of the program, targeting access based on minimum age criteria until the totality of the target population is included. CORRECTION OF BENEFIT PAYMENTS FOR RETIREES UNDER THE SSC AND FOR BENEFI- CIARIES OF THE BONO SOLIDARIO CASH SUBSIDY PROGRAM. As mentioned above, the benefit payments received by these two groups are very low. It is positive that a min- 2. The World Bank has offered to provide support using a methodological simulation tool called Pension Reform Options Simulation Toolkit (PROST). This software evaluates the effects of various policies, based on the system's relevant variables. With this objective, the new administration of government may be requested to provide a training course regard- ing its use of technical administration personnel. THE PENSION SYSTEM 361 imum coverage is being offered to them, and indeed, in order to preserve a reason- able incentive, benefits under these programs ought to be lower than Obligatory Social Security benefits. Nonetheless, the current amount seems to be insufficient. The problem is particularly serious for the SSC, which provides a retirement benefit of only $US3 per month. The amount of the benefit under both programs should be established using a rigorous criterion, such as a percentage of the poverty line, con- sidering the capacity of the state to finance the assistance. In this sense, it is worth noting that raising the benefits of the SSC up to the level of the Bono Solidario Cash Subsidy Program would entail an increase in spending of $US850,000 per year, and as a result, the cost of increasing benefits under the SSC and the Bono Solidario Cash Subsidy Program by one dollar per beneficiary would be $US3 million per year. Table 1 provides an estimate of implicit costs considering different scenarios of modifying benefit payments and coverage under the SSC and the Bono Solidario Cash Subsidy Program. It should be mentioned that the figures indicated refer exclusively to retirement benefits under the SSC and to subsidies for the elderly in the case of the Bono Solidario, as other benefits under those programs are addressed in chapters 10 and 11 on Health and Social Assistance, respectively. In this context, it is worth noting that the $US85 million earmarked by the state as an additional contribution for the IESS during 2002 would be sufficient, for example, to raise benefits in this entire category to 50 percent of the poverty line, and at the same time, broaden the scope of coverage by 20 percent. Table 1. Cost of Increasing Coverage or Benefits under Rural Social Security and under the Bono Solidatio Cash Subsidy Program for the Elderly (absolute values and as percentage of GDP) Number of beneficiaries Current 20% increase 50% increase Amount Current $US20,023,200 $US24,027,840 $US30,034,800 of benefit 0.10% 0.11% 0.14% Raising the SSC to $US20,848,800 $US5,018,560 $US31,273,200 the level of the Bono 0.10% 0.12% 0.15% Solidario for the elderly ($US7/month) Raising all benefits to $US34,251,600 $US41,101,920 $US51,377,400 the level of the Bono 0.16% 0.20% 0.24% Solidario for mothers ($USI 1.50/month) Raising all benefits to $US69,992,400 $US83,990,880 $US14,988,600 50% of the poverty 0.33% 0.40% 0.50% line ($US23.50/month) Source: Generated by the author, based on IESS, PPS, and IMF data, all for 2002. 362 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM The Financial Management of the IESS The IESS administers reserves for the various insurance programs it offers its affili- ates. The management of these reserves is critical for the smooth functioning of the system, as they guarantee the payment of future benefits. Certain problems exist with respect to these reserves that should be carefully considered, as they could have adverse effects. They include the following: THE DEBT OWED BY THE STATE TO THE IESS. Between 1984 and 2000, the state stopped paying its two obligations with respect to Obligatory Social Security: the contributions corresponding to its role as an employer and the contribution for 40 percent of the pensions, as required by law. The amount accrued is significant. The IESS estimates it at $US2.085 billion (as of December 2001), while the Ministry of Economy and Finance estimates it at less than $US400 million. The discrepancy results from applying different criteria to adjust the amount to current money val- ues. The IESS has included the $US2.085 billion as part of its assets in its account- ing-therefore at least a portion of its reserves is based on assets whose collectabil- ity is doubtful. The IESS should correct its accounting to bring its estimate of the debt in line with that of the Ministry of Economy and Finance. For its part, the Ministry should document the debt through the issuance and delivery of a specific certificate of debt to the IESS, with interest and dates certain of payment. ADMINISTRATIVE SEPARATION OF THE INSURANCE PROGRAMS. The Obligatory Social Security reserves, which include the health and pension programs, are not differen- tiated, nor are the Institute's administrative expenses. This situation diminishes the transparency of the programs' financial management, since one cannot establish each program's situation with precision. The IESS should immediately differentiate the various programs, both in accounting and in administrative terms, identifying each program's revenue sources, disbursements for benefits, administrative expenses, assets, and equity. THE CONTRIBUTION FROM THE STATE. Laws regarding the social security system indicate that the state has an obligation to contribute 40 percent of the Institute's pension-payment expenditures, so as to stabilize the Institute's actuarial balance. This percentage is required under the previous legislation as well as the legislation passed in 2001, since it was believed that the IESS lacked sufficient funds to meet its obligations in the long term. Nonetheless, it is important to note that this con- tribution is not needed at present, given the IESS's current financial situation. In practice, during the first nine months of 2002, revenue collections from contribu- tions to the pension program surpassed benefit payments and administrative expen- ditures by approximately $US1 0 million. The state made additional contributions as well, for a total of $US65 million so far in 2002, which are expected to total $US85 million by the close of the year. Thus, IESS reserves have increased signifi- THE PENSION SYSTEM 363 cantly. The state's obligation to contribute 40 percent of benefit disbursements should be reviewed, as that practice has several negative implications. For one, this contribution is a major fiscal burden, in a context in which the state is facing finanl- cial difficulties. Furthermore, the transfer is clearly regressive in nature, as it consists of a subsidy from the general revenues to the affiliates of the IESS, who comprise 25 percent of the labor force and whose features clearly identify them as middle-income level, since they are public servants or employees in the formal urban sector. If the flow of revenues and disbursements of the IESS shows a deficit in the future, the proper policy should be to correct the system's parameters in order to reverse that trend, or, if it is considered justified within the priorities of the state's social policy, the IESS could be subsidized by the rest of society. It is not clear that such a discus- sion has taken place (and indeed, it appears more reasonable to allocate this subsidy to more vulnerable sectors of society). Yet even if a social consensus and political agreement existed, rhe mechanism of "presubsidizing" the pension system would be considered inefficient. If the state wishes to grant a subsidy to workers in the formal sector of the economy through a pension system, that subsidy should be transferred when needed, and not accumulated in the reserves of the IESS. Of course, elimi- nating this transfer requires amendments to the law and would generate a major political debate, but the policy must be immediately reviewed, given the pressure it exerts on the fiscal balance. Partial Implementation of the Reform of the Social Security System The law enacted in November 2001 included certain significant improvements in the system, in particular regarding changes in eligibility requirements for retirement, the administration of the funds accrued, and the management of the IESS. At the same time, some aspects of the law are confusing or inapplicable (especially those involving the operating rules of the Pension Savings Deposit Institutions-EDAP), and should be reviewed to ensure the smooth operation of the system. THE COURT CONFLICT. The new law was challenged before the Constitutional Court, yet institutional problems have prevented the court from issuing a clear, applicable ruling. This situation has created a particularly distressing legal void, con- sidering that a pension system's efficiency is affected by its mid- and long-term sta- bility. The resulting institutional confusion must be overcome, as various entities have adopted their own interpretations of the legal situation. For example, the Superintendency of Banks has started issuing resolutions regarding the management of the IESS reserves (which the IESS does not apply). It has even issued resolutions as to whether the IESS executive officers are fit for their jobs, along with resolutions regarding the creation of the EDAP. For its part, the IESS has modified criteria regarding the application of the reserve funds, as it no longer returns them to work- ers after three years. Yet it has not applied other changes embodied in the law, some of which were not even ruled against by the Constitutional Court, such as the 364 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM requirement to separate reserves by type of insurance or extend the formal coverage of Obligatory Social Security. LACK OF A WELL-DEFINED ROLE FOR THE TECHNICAL COMMISSION ON INVESTMENTS. The new law grants a central role to the Technical Commission, giving it political autonomy and the ability to significandy influence the investment strategies of the EDAP. Furthermore, certain of its functions would seem to contradict those of the Superintendency of Banks. PROBLEMS IN REGULATING THE EDAP. The new law makes several references to oper- ating rules for the pension savings institutions. These rules should be reviewed, as the current language is confusing or inapplicable. One example is the requirement to guarantee minimum profitability, while leaving the definition of this concept in the hands of each institution. Thus, unless the possibilities are restricted through regulations, the lack of standardization could make comparisons impossible, and the guarantees, in practice, might not offer any protection whatsoever. Similarly, the requirement that the EDAP maintain an equity stake in the amount of 10 percent of the administered fund is impractical and unnecessary. Minimum equity require- ments in other countries are much lower, and generally correlated in some way to the minimum profitability guaranty. In contrast, such equity requirements are pointless if their objective is simply to make participation more costly and create obstacles for the entry of new participants in the market. Policy Matrix H Policy measures z Short term Medium term z Problems (to June 2003) (2003-07) Progress indicators Objectives/goals Z 1. The institutional structure of the Social Security System % There is no hierarchical Creation of a hierarchical Full functionality of Issuance of the formal To improve the institutional entity within the entity responsible for the entity, with responsi- regulations created by this and technical capacity of the national government planning, designing, bility for drafting regu- entity, which define its state in proposing and develop- that is responsible for coordinating, and lations and for the organizational structure ing pensions policies. designing policies and evaluating the income systematic dissemination and budget. Drafting of evaluating the pension protection system for of evaluations. proposed legislation and system. the elderly. regular publication of reports. 2. The effective coverage of the system No rigorous method- Evaluation of the costs Follow-up on the imple- Preparation of a short-term To develop the capacity for ology exists for and savings entailed by mentation process, with progress report. designing policies that seek to evaluating the fiscal the reform. This evalu- periodic cost evaluations. Issuance of a periodic report improve the level and depth of effect of the measures ation would include the indicating the fiscal results the coverage, without placing to be implemented defining of a critical path of the various measures excessive pressure on govern- under the Social for the implementation and possible future trends. ment revenues in the short Security System of coverage-expansion term. reforms, in particular efforts. in the short term. Obligatory Social Regulations for the Implementation of Increase in the rate of To increase the participation of Security has low new Social Security Act captation and control coverage among the groups who are in an economic coverage within the that make participation compliance mecha- economically active condition to do so. economically active obligatory for new nisms among the new population. population. types of workers. workers who have c,> compulsory coverage. (Matrix continues on thefollowing page.) Policy Matrix (continued) cb Policy measures Short term Medium term Problems (to June 2003) (2003-07) Progress indicators Objectives/goals Rural People's Social Definition of a Expansion of coverage. Increase in the percentage To improve the protection of Security covers 25 program to expand of coverage among the the sectors that do not partici- tm percent of the the Rural People's peasants. pate in the formal labor potential economically Social Security market. a active population. Program, with explicit quantitative goals. 0 Access to the non- Regulation and Enrolling elderly Increase in the rate of To offer effective protection to O contributive pensions implementation of workers from the coverage of elderly those who have been unable to or the Bono Solidario the noncontributive informal sector as workers from the participate in the formal labor Cash Subsidy Program benefits provided for beneficiaries. informal sector. market. a for the elderly is in the new Social cv, blocked. Security Act. The amounts that Immediate corrective Gradual increase in Increase in the buying To offer effective protection, retirees receive from adjustment of retire- these benefits until they power of the with income that brings z Rural People's Social ment benefits under reach the level of the beneficiaries. improvements to the quality of F Security and the Bono the SSC and the noncontributive life. z Solidario are very low. Bono Solidario Cash assistance. Subsidy Program. z 3. Financial Management of the IESS IESS accounting, as Development of Application of the new Publication of the To increase transparency in the of December 2001, suitable accounting accounting criteria and corrected accounting management of the IESS z has included a debt criteria, so that the issuance of the debt statements of the lESS. funds. owed by the state in estimates of the debt instrument to the IESS. the amount of calculated by the IESS $US2.085 billion, and by the Ministry while the Ministry of of Economy and 5 Economy and Finance Finance will be con- estimates said debt at sistent with one -< less than $US400 another; designing of million. a debt instrument for the payment thereof. The Health Insurance Immediate separation Continual publication of To increasc transparency in the reserve is nor differen- of the reserves, both the equity statement for management of the IESS tiated from the pension in terms of their each insurance, itemizing funds. reserve. accounting and their assets. effective assets. The state has an obliga- Drafting and passage of Application of the Enactment and application To free funds that are being tion to contribute 40 a proposed legislative new law. of the legal reform. unnecessarily allocated to the percent of the pension reform to eliminate IESS, so that they may be used disbursements, which the 40 percent for other purposes. amounted to approxi- contribution. mately $US85 million in 2002, when the system had a surplus even without that contribution. 4. Institutional instability of the system Application of the new Drafting and passage of Application of the Enactment and appli- Generate a climate of legal Social Security Act is a legislative bill that new law. cation of the legal security, which is needed for partial owing to a allows for resolution of reform, without the system to run smoothly. court conflict. the court conflict, while court restrictions. t (Matrix continues on the following page.) Policy Matrix (continued) Policy measures X Short term Medium term Problems (to June 2003) (2003-07) Progress indicators Objectives/goals also correcting several technical problems in the law. toi The new law has several Allow the Pension Savings ambiguities and contra- Deposit Institutions to design dictions in its language their own investment policy; with respect to the role place restrictions on discretion- of the Technical Com- ality in the management of m mission on Investments IESS assets. o z and the autonomy of that Commission. Several articles Reducing the equity require > z regarding the Pension ment will make the Pension Savings Deposit Insti- Savings Deposit Institutions 0 tutions are vague or viable. Likewise, if the mini- inapplicable, such as mum profitability requirements the absence of a in the law are specified, that definition regarding would increase transparency the minimum and legal security. profitability guaranty _ or the requirement to maintain an equity in Z the amount of 10 percent of the administered funds. z z 13 Rural Development' Maria Donoso-Clark Three fundamentalfactors highlight the importance of rural development for Ecuador: the high dependence of the economy on natural resources, particularly from agriculture, hydrocarbons, forestry and mining; the concentration ofpoverty in predominantly rural areas; and the great natural, social, and cultural wealth and diversity in rural Ecuador. Despite this importance, rural development in this country has sufferedfrom poor coor- dination and excessive centralization, resulting in inefficient public and private invest- ment. Many ruralpolicies have concentrated on the agricultural sector, with little atten- tion to other activities. A set ofpolicies must be established to guarantee natural resource sustainability, reduce rural poverty, and take into account the cultural and natural wealth of the rural sector. 7he emphasis on agriculturalproduction as the engine for rural development has been changing in favor of also recognizing the importance of occupa- tional diversification, of the links between rural regions and cities, of access to markets as an enginefor growth, and of developing local capabilities. However, the agricultural sec- tor will continue to play a key role in rural development, requiring major adjustments in order to meet challenges involving a demand for greater productivity, the consolida- tion of lands, a reduction in the labor force due to migration, and the transition toward products of greater value. Furthermore, centralized administration must be replaced by processes guided by demand and local-level decisionmaking, so that the beneficiaries of antipoverty strategies can themselves discover and implement these strategies in their own surroundings. In this context-with an eye on decentralized economic growth and relief 1. Maria Donoso-Clark is regional sector leader for Environment and Sustainable Social Development at the World Bank. Jorge Caballero (FAO), Matthew A. Mcmahon, Fran- cisco Pichon, Jorge Uquillas, and Pierre Werbrouck, World Bank specialists in rural devel- opment, helped the author in the preparation of this chapter. 369 370 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM of rural poverty- it will be necessary to prepare a strategy for multisectoral, diversified, and spatially-focused rural development. This strategy should have three main objectives: economic and social cohesion through the development of local space; changes in agricul- ture and rural economic diversification; and environmental protection. Ecuadors geo- graphic, economic, and sociocultural diversity require that this strategy be based on poli- cies that support a participative approach to development based on jurisdiction or rural spaces; the diversifcation of the rural economy; agricultural adjustments aimed at increasing competitiveness in the agricultural sector through new technology and research; and the promotion of environmental conservation through better land zoning and use ofnatural resources. This strategy will also require an institutional structure that facilitates complementarity among the roles of the different actors. International rules guiding this effort must promote the convergence of key objectives of the national public sector, the private sector, civil society, municipalities, provincial governments and parochial boards; stimulate coherence among the regulations and activities of the various institutions that are involved; and define a program based on the strategic plans of each jurisdiction and establish financial allocations, based on the concept of 'additionality" to encourage the implementation of strategic plans. This chapter is limited to a proposalfor a conceptual framework and some policy points for the preparation of a rural develop- ment strategy that recognizes the great potential of Ecuadors geographic, social, and cul- tural diversity.2 A. ]introduction Three fundamental factors highlight the importance of rural development for Ecuador: the high dependence of the economy on natural resources, particularly from agriculture, hydrocarbons, forestry, and mining; the concentration of poverty in predominantly rural areas; and the great natural, social, and cultural wealth and diversity of rural Ecuador. Four sectors-agriculture, mining, forestry, and hydrocarbons-contribute about 40 percent of the country's GDP.3 However, these resources are not exploited with enough care for the environment, and the resulting profits are not fairly dis- tributed. The result is an accelerating degradation of land, rivers, and coasts, and great economic inequality between rural and urban areas. Rural poverty in Ecuador was estimated at 56 percent of the population in 1995 and 77 percent in 1998, versus 34 percent and 46 percent, respectively, in the coun- 2. The World Bank, in collaboration with the government of Ecuador and other national organisms, is preparing a rural development study in which the proposals presented here will be dealt with in greater detail. 3. These sectors cover agriculture, livestock breeding, silviculture, fishing, mining, hydrocar- bons, food products, and leather and wood goods. RURAL DEVELOPMENT 371 try as a whole, with the rural population representing 40 percent of the country's population. Extreme poverty at the end of the 1990s was four times as high in rural areas as in the cities and according to data from the Survey on Employment, Unem- ployment, and Underemployment (INEC), rural dwellers and indigenous people are more exposed to social exclusion than people living in the cities. Rural poverty in Ecuador is diverse and varies by region, but is generally linked to five factors: (i) lack of work in activities off the land or in the formal sector, (ii) a low school attendance rate, (iii) little available land, (iv) limited access to markets, and (v) the fact that many heads of households speak only an indigenous language. All of these are the results of social exclusion related to centralist, narrow policies that prevent inte- grated development at the community level, efficient markets, and the development of local potential. At the same time, rural areas where poverty is concentrated are very often also areas with community and cultural practices that offer potential for development and economic diversification. Ecuador has great ethnic and natural diversity with equally diverse cultural and social practices that have very often served as starting points for decentralized economic development, for example in the province of Imbabura, where crafts made by the Otavalefio indigenous people; the natural land- scape, with the lakes of San Pablo and Cuicocha; flower plantations; and local cus- toms have all served to support the development of a diversified and complemen- tary economy. This diversity stems from the country's geographic diversity, and therefore requires diverse development strategies. The rural sector in Ecuador has undergone several transformations since the decline of the feudal and semifeudal haciendas in the mountains and the plantations on the coast before the 1970s. First came the subdivision and fragmentation result- ing from the reform of the agrarian and inheritance systems Uokisch 2002), and more recently, the move toward more intensive agriculture-the result of rural poli- cies contained in the Law on Agricultural Development of 1994. The policies con- tained in this 1994 law are aimed at favoring intensive modern agriculture and have had a positive impact on export-oriented coastal agriculture and on some subsectors in the highlands, such as fiuit growing, horticulture, and floriculture. Export-ori- ented agriculture reveals acceptable levels of productivity in some categories, com- pared to industrial and service sectors, according to a Central Bank report (2002a). Even so, agriculture dropped from 12 percent of total GDP in 1994 to 10.5 percent in 2002 and the productivity and cost-effectiveness of small and medium-sized agri- cultural operations has been dropping continuously (Figures I and 2). Meanwhile, the agricultural sector continues to be subject to various exogenous factors that increase its vulnerability, including natural disasters, the El Nifio phe- nomenon, the recent Reventador volcano eruption that destroyed hundreds of hectares of flower plantations and hit livestock hard, and low world market prices- such as the case of coffee. (See Figure 3). Being highly market-dependent and subject to macroeconomic and trade policies and international agreements, the agricultural sector is vulnerable and requires great 372 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Figure 1. Yield per Hectare in 2002 (tons) Peru | ; El Salvador Venezuela - s I- I Colombia , _ Costa Rica -- : - Ecuador - 0.00 2.00 4.00 6.00 8.00 Source: Banco Central del Ecuador (BCE). Figure 2. Agricultural GDP/Total GDP 13 13 y 12_ c 12\ U, Q 11\ 10 10 9 1994 1995 1996 1997 1998 1999 2000 2001 2002 Source: Banco Central del Ecuador (BCE). dynamism. Lower prices for domestically marketed agricultural products and depressed international prices mean that national production loses cost-effectiveness (through prices-see Figure 3 and Table 1). The rural poor, who produce for exam- ple potatoes, corn, rice and nonexportable vegetables, are facing especially unfavor- able terms of exchange with neighboring countries. Competition with imported (and subsidized) products is very strong and production costs tend to rise. Com- pared to other countries, dollarization has had a significant impact on the market- ing of products in Ecuador. Migration from the countryside to the cities and abroad has been an important strategy for escaping poverty. Remittances from abroad (principally from Spain) are RURAL DEVELOPMENI 373 Figure 3. Producer Price Index 1,400 - 1,300 - ii 1,200 - 1,100 1,000 \ 900 \ 800 - I l General total Agriculture, silvicultttre, and fishing Source: Banco Central del Ecuador (BCE). Table 1. Ecuador's Agricultural Trade Balance with Colombia and Peru Year Columbia Peru 1997 59,742.86 6,795.87 1998 -41,597.92 -10,128.14 1999 52,826.07 15,030.13 2000 61,879.82 6,950.05 2001 93,851.06 6,101.18 2002 18,022.27 -15,639.15 Source: Banco Central del Ecuador (BCE). now estimated at $US 1.4 billion a year, a clearly significant amount if compared with total exports in 2001 ($US4.474 billion) or petroleum and banana exports ($US1.722 and $US827 million, respectively), which are the country's two largest exports. As a result, the emphasis on agricultural production as the engine for rural devel- opment has been changing in favor of also recognizing the importance of occupa- tional diversification, of the links between rural regions and the cities, of access to markets as an engine for growth, and of developing local capabilities. Nonagricul- tural income continues to gain importance, especially in highland areas populated by poor indigenous communities, where agriculture is no longer the main source of 374 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM income but is supplemented by a mix of crafts, wood products, services, and other occupations. Likewise, centralized approaches are being replaced by processes focused on demand and local decisionmaking, in which the beneficiaries of antipoverty strate- gies can themselves discover and implement these strategies in their own surround- ings. The importance of "social and institutional capital" and the role of women in development are also both increasingly recognized. The PROLOCAL and PRODE- PINE projects, financed by the World Bank, have a decentralized, multisectoral approach with local participation in development and are providing important les- sons for a national rural development strategy. 13, Three Strategic Goags for Rural Development In this context, the first step toward decentralized economic growth and relieving rural poverty must be to prepare a diversified, multisectoral rural development strat- egy with a territorial focus. This strategy should focus on three main goals: (i) eco- nomic and social cohesion through development of the local space; (ii) adjustments to agriculture and rural economic diversification; and (iii) environmental protection.4 ECONOMIC AND SOCIAL COHESION. Ecuador's topographic, climatic, and sociocul- tural diversity require different development strategies, each of which take advantage of social capital and the various organizational forms that characterize the country. To do so, the goal is foment the local development based on territorial units such as municipalities and micro-regions through local participative planning, strengthen- ing local institutions, identifying shortcomings in physical and social infrastructure, nurturing economic opportunities specific to each local area and their competitive advantages, and reducing local obstacles to making use of them. Convergence among national and provincial agencies, municipalities, and economic and social actors toward common development priorities is important in order to create eco- nomic corridors for rural-urban development, maximize the use of resources and other local or regional development instruments, reduce the cost of public invest- ment, and promote national economic growth. To accomplish this, policies must be established to set the conditions for convergence. For example, the allocation of resources for rural infrastructure projects should depend on an agreement between municipalities, communities, and the private sector-and based on operative crite- ria that define the rural space, the priority action for that space and the role of each of the actors. The PRODEPINE project offers a successful experience that can be 4. This strategic model has been highly effective in disadvantaged areas in the south of Italy and Spain as part of the European Union's rural development policy. See "Estrategias, Instituciones y Politicas de Desarrollo Rural en la Uni6n Europea" by Jose M. Sumpsi. RuRAL DEVELOI'MENT 375 extended. In its four years, the project supported 210 local development plans pre- pared by 194 organizations involved in a population of more than 1.4 million peo- ple. Ninety-eight percent of the subprojects financed by PRODEPINE responded to goals and priorities detailed in the strategic plans and were cofinanced by the communities, with municipal collaboration in some cases. Second- and third-degree organizations acquired the capacity to prepare local development plans through par- ticipation with the communities, thus institutionalizing the planning, monitoring, evaluation, and systematization of their experiences as management-oriented prac- tice. The project has fomented intercultural cooperation, establishing strategic alliances for promoting local development.5 AGRICULTURAL REFORM AND THE ECONOMIC DIVERSIFICATION OF RURAL AREAS. The agricultural sector will continue to play a key role in rural development, requiring major reform to respond to challenges such as the demand for greater productivity, land consolidation, the reduction of the labor force due to migration, and the tran- sition toward products of greater value. At the same time, rural economic activity will have to extend beyond agriculture. This will require two main types of inter- vention: (i) increasing the competitiveness of the agricultural sector by increasing access to new technology, training, and other inputs such as land, credit, more attractive markets, remote education, and new information sources; (ii) promoting economic diversification through systems for extension and innovation, and build- ing on nonagricultural potential in each territorial unit, including cultural capital, biodiversity, and development of services or industries derived from agriculture or livestock breeding. Successful development of the agricultural sector depends on a macroeconomic framework favorable to investment, bur its competitiveness will also depend on its capacity for technological adaptation and on the availability of-and access ro-this technology. Many poor rural people could become successful pro- ducers if they had access to the most efficient technological options, training oppor- tunities, and other input such as land, credit, and more attractive markets. These inputs can be provided through favorable institutional arrangements such as strate- gic alliances, remote education, and other information sources. We predict, however, that agricultural activity will continue to decline. Rural inhabitants will therefore need economic alternatives preferably derived from their cultural and natural resources-for example, crafts, cultural tourism, and environmental services. ENVIRONMENTAL PROTECTION. The sustainability of Ecuador's economic founda- tions depends entirely on its ability to conserve its soils and its rich biodiversity and natural wealth. The expansion of the commercial agricultural sector and the eco- nomic future of rural areas also requires the correct use of land and water, and the 5. Final Report on the Development Project for Indigenous and Black Peoples of Ecuador (PRODEPINE). 376 ECUADOR: AN ECONOMIC AND SociAL AGENDA IN THE NEW MILLENNIUM protection of forests and other important ecosystems. The development approach for rural areas where commercial agriculture predominates must focus mainly on the use of conservation measures and appropriate management of soil, water, forests, mangrove swamps, and other ecosystems. In areas with less agricultural activity, environmental policy must focus on recovering degraded soil through conservation- ist activity and small-scale value-added production associated with other activities such as tourism. Within the proposed strategic framework, an initial plan for rural development policy should include recognition of Ecuador's natural and socioeconomic diversity. This first requires that rural areas be classified according to their different features- for example, as modern rural areas, changing rural areas, or marginal rural areas. With this spatial and community focus, the application of a combination of policies will vary depending on the features of each territory. For example, in areas with pre- dominandy modern and export-oriented agricultural activities, such as the Ecuado- ran coast and some highland areas, land zoning and environmental protection poli- cies would be implemented; in changing areas with high rates of migration, such as certain areas of the provinces of Azuay and Azoguez, economic diversification poli- cies would be implemented; and in marginal, relatively depopulated areas, strategies would be implemented to conserve activities such as agriculture, forestry, the envi- ronment, and cultural heritage. All this would be based on strategic plans developed at the territorial level with the participation of local social and economic actors. The wealth of information and data available from the Ecuadorian Agricultural Census will facilitate the classification of rural areas through operative criteria. C. Key Issues in Rural ]Developmenmt in Ecuador Although interventions in the different territorial areas will vary according to their natural, economic, and social features and potential, certain key issues will appear in one way or another as implementational challenges to any community rural devel- opment strategy, and thus demand immediate attention. It should be noted, how- ever, that rural development will be effective only through an integrated, multisec- toral strategy, developed with active participation by local actors and supported by a well-organized system of incentives and state services. The problem areas considered most relevant for rural development in all of Ecuador are (i) rural education and technological progress, (ii) land ownership and administration, (iii) water resources and water basins, (iv) rural financing, (v) syner- gies with rural infrastructure initiatives, (vi) commodities markets, (vii) diversifica- tion strategies involving nonagricultural rural activities, and (viii) regional develop- ment and rural-urban development corridors. RuRAL EDUCATION AND TECHNOLOGICAL PROGRESS. The rural labor market is char- acterized by a poorly qualified labor force with low productivity. Specifically regard- RURAL DEVELOPMENT 377 ing education, at the end of the past decade the rural population received two-thirds as much formal schooling as the urban population, and its illiteracy rate was three times as high on average (6 percent urban and 19 percent rural). The agricultural census of 2001 indicates that the percentage of people without any kind of educa- tion among small producers is between 23 and 27 percent, dropping proportionally as the size of their agricultural production units rises (up to 6 percent). The national illiteracy rate for rural women is 23 percent. (See Table 2) Raising rural educational levels in accordance with local customs and socioeco- nomic features is a key to any rural development model. Educational policy must give priority to raising educational levels in rural areas through a varied combination of educational methodologies and tools, with a curriculum relevant to the real expe- rience of rural inhabitants and built on their cultural wealth. Experiences in several developing countries show that rural education programs are successful when their content corresponds to the reality of the rural world. Formal technical agricultural training is lacking in the area of research and devel- opment. Agricultural technology exists only in specific areas, for specific export crops or subject to contracts. It is generally deficient at all levels, especially on small land holdings. Producers with more than 100 hectares report technical training rates of berween 7 and 12 percent, while only 1 percent of those with fewer than 10 hectares have any technical training. Technical training and business management skills are essential for rural inhabitants to boost rural development. Higher educa- tional levels also enable the poor to look for better opportunities in the urban and rural labor markets, diversify their sources of income, and create conditions to raise productivity in agriculture and microenterprises. In recent years, the PROMSA and SICA programs have provided the country with important experiences in technological innovation and information. These experiences have given the country the opportunity to modernize these services. It is important to use this beginning to build a new institutional framework consisting of a competitive system for offering agricultural services. This would imply chang- ing the public sector monopoly on the provision of services to a pluralist model that includes the private sector, NGOs, public and private institutes, public agencies, producers' organizations, and universities. In this framework, the role of the public Table 2. Illiteracy Rates, 1999 (percentage of population over age 15) Sector Women Men Total National 13 9 11 Urban 7 4 6 Rural 23 15 19 Indigenous 53 31 43 Source: SIISE. 378 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN TiiE NEW MILLENNIUM sector would be to finance public assets, strengthen institutions, and control the quality of services. The challenges of establishing a new institutional framework will include (i) improving the ministry's management capacity, (ii) achieving more effec- tive participation by small producers, (iii) establishing efficient institutions, (iv) establishing a mechanism for more sustainable financing, and (v) increasing the capacity of producers' organizations (that is, corporate capital). LAND OWNERSHIP AND ADMINISTRATION. The high concentration of land ownership (in the highlands 2.6 percent of landholders own 50 percent of the lanid, while on the coast, where there are more medium-sized operations than in the highlands, 4 percent own 55 percent of the land) is associated with the development of a dynamic exporting sector, especially on the coast, and with a sector of small and medium- sized commercial producers focused mainly on the domestic market in the highlands (dairy farmers, flower growers, vegetable growers, and so on) and to a lesser extent on the coast. There is also an enormous number of families with very small produc- tion units, including the traditional indigenous communities, which under present conditions are hardly economically viable. For example, 30 percent of agricultural production units are under a hectare in size and occupy only 0.8 percent of the nation's land. In some cases, agriculture is not the most recommendable activity; however, there are dynamic groups of small farmers who need better access to land. There have been several unsuccessful land ownership reform initiatives. In recent years access to land has improved in several Latin American countries through agri- cultural reform programs based on market mechanisms, land purchases, and the recognition of forms of traditional community land ownership. Some programs require major financing by the state. In this framework of land ownership and eco- nomic activity, the combination of measures to be adopted will depend on the ter- ritorial area in question. In addition to the concentration and fragmentation of land ownership, the main causes for concern in the land market are the lack of a rural land register, problems involving titles and registry, and the nonfulfillment of ownership contracts. When the agricultural census was carried out, only 8 percent of producers (56,000) said they held ownership deeds. Fifty-nine percent of occupied deedless land is concen- trated among 6,000 producers with more than 50 hectares, while the 50,000 remaining producers have less than 3 hectares. To face these problems, the World Bank's 1998 Policy Notes recommended investing in a rural land register, as well as rationalizing and strengthening the legal framework. Currently the problems of legal and administrative irregularities involv- ing land ownership are being dealt with under the pilot PRAT project, which includes improvements to the rural land register in nine cantons and 20,000 titles granted by the INDA. Also, the PRODEPINE I project has managed to title 252,000 hectares of ancestral land. It is hoped that this process will continue under the PRODEPINE II project, which is now under consideration. RuRAL DEVELOI'MENT 379 WATER RESOURCES AND WATER BASINS. The distribution of water and the rights to its use (for human consumption and industrial and agricultural uses) are a source of conflict in Ecuador. The biggest users are urban municipalities, large producers on the coast, and flower producers in the highlands, while small rural producers and indigenous groups claim that they do not receive their fair share of available water. Policies on water use in urban areas are dealt with as separate water supply and san- itation policies. In terms of rural development, the approach to water management is based on water basins and on the rights to the use of water resources, including irrigation systems. There is no updated information on the availability of water in each basin or on water quality. The latest study of the water situation was in 1985. Integrated management of water basins is important for environmental conservation and economic diversification through the provision of environmental services (refor- estation, ecotourism, and others deserve urgent attention). Also, completing the transfer of irrigation systems to groups of users must continue to be a water man- agement priority. Of the 8.1 million hectares of permanently or periodically culti- vated land, 853,332 (or 10.6 percent) are irrigated. However, Ecuador potentially has an estimated 3.1 million hectares of land appropriate for irrigation, meaning that the area now irrigated represents barely 27.3 percent of the country's potential. Of the total irrigated area, nearly 170,000 hectares are on government land and the rest are collectively (communally) owned. Irrigated agriculture represents an esti- mated 70 percent of the cotntry's agricultural production, and is five times as pro- ductive as feeding crops with rainwater. In addition, the legal framework for water resources needs to be examined in order to establish a more efficient and fair system for managing water basins and allocating water resources. These initiatives are part of a much broader program for the integrated management of all resources in water basins. Several studies and pro- posals for pilot projects have already been presented. RuRAL FINANCING. Rural credit is restricted by the difficulties many producers have meeting the administrative and guarantee requirements of financial institutions. The Banco Nacional de Fomento's practice of writing off debts has created a widespread habit among the rural population of not repaying debts, as well as hesitation among formal financial agents to grant loans in rural areas. According to the agricultural census, only 7 percent of agricultural producers have access to any kind of credit (including commercial credit; bank loans; and credit from savings and loan cooperatives, from NGOs, or from informal agents such as inter- mediaries and family members who can provide loans). Informal credit is most com- mon: 41 percent of producers who receive credit, especially owners of small and medium-small operations, receive it from informal sources. Bank loans are concen- trated among producers with more than 50 hectares. Savings and loan co-ops are an important source of financing for small producers: 25 percent of producers with fewer than 3 hectares who receive credit are assisted by savings and loan cooperatives. 380 EcuADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM More than 600 rural savings and loan cooperatives and other institutions have been formed in rural areas and operate on the basis of direct intermediation with community associations, families, and the like. These institutions have existed for years, but more recently have evolved into centers of financial activity in rural areas. They are becoming the embryo of an alternative market for rural capital. After the recent conflict over the government's intention to abolish cooperatives that did not qualify to be regulated by the Bank Superintendence for lack of suffi- cient capital (a conflict resolved by placing all these small institutions under the umbrella of the Cooperatives Office of the Ministry of Social Welfare), there is now a renewed interest in setting up a national microfinancing system. In order to respond to this demand, several alternatives should be considered: (a) promoting greater competition within the national financial sector; (b) strengthening the cooperative movement by establishing (from the grassroots, not from the top) a network of cooperatives and credit institutions; (c) establishing connections among women's credit groups (cajas solidarias) and formal financial institutions; (d) estab- lishing laws and new regulations to permit the easy use of rural family assets such as land or livestock as guarantees for loans; e) allowing agricultural middlemen to use the input they acquire as guarantees for bank loans; and (f) offering a legal guaran- tee-in the Brazilian fashion-for a "rural protection certificate" for future sales, in order to reduce the risk of price drops and to enable farmers to take out loans with their future crops as a guarantee. This instrument could have a secondary market (stock market); instead of a public system of loan guarantees-which has not worked anywhere-a lottery would be established for private insurance: those who buy the ticket would be eligible to receive a prize upon independent confirmation that more or less than the prespecified amount of rain fell in a specified period of time. This sys- tem would be open to everyone who buys a ticket-the price and conditions of which would have been established beforehand. No verification would be required by an insurance agent, since payment would be based on an objective and verifiable indi- cator. This scheme covers an important aspect of production risks and when com- bined with a system of insurance against low future sales prices through the "rural protection certificate," a large part of the producer's risk is eliminated. Although these mechanisms take some time to become established, they are sustainable interventions and would be available to a much larger group of producers. SYNERGIES WITH RURAL INFRASTRUCTURE INITIATIVES. The poor state of infrastruc- ture (rural roads and marketing) and of public services (communications and elec- tricity) creates a dependency on traditional intermediation, which increases transac- tion costs. The availability of rural roads, by contrast, helps prevent the prices of locally transported goods from rising too much in situations of increasing aggregate demand, by promoting external competition and reducing transaction costs between urban and rural areas. Furthermore, improving rural infrastructure and communi- cations would help stabilize prices during times of economic expansion and would reduce the privileges of certain local agents that prevent a more equitable distribu- RURAL DEVELOPMENT 381 tion of agricultural income. Investments in infrastructure, particularly roads, also contribute to generating external economies to attract companies that transform or market agricultural products, as do many other related services in rural areas, thus aiding economic diversification. Rural infrastructure initiatives must be based on local strategic plans, with active participation by the local population through microenterprises that generate employment and financing shared by the central gov- ernment, municipalities, the private sector, and communities. Chapter 7 on Basic Infrastructure describes the policy options for rural infrastructure that may be con- sidered as part of a rural development strategy. COMMODITIES MARKETS. Commodities markets have structures that are unfavorable to the rural poor. Some have a very dense intermediary structure with high mark- ups (corn, potatoes, and similar), while others fix prices under oligopolistic condi- tions (the banana market). Production and marketing contracts are commonly bro- ken and it is not easy to have them legally enforced. Those most affected are small producers who must continually accept unfavorable transactions. The markets could be more efficient with a better legal framework, and if the Law on Competition were passed, provide penalties for anticompetitive practices-which would be unprece- dented. In addition are the transaction costs and the traditional intermediation associated with poor infrastructure. However, as soon as these traditional systems are integrated in commercial circuits dominated by cities and other populated centers, opportuni- ties arise for small producers to penetrate attractive markets and capture a large share of the added value of their products. In the highlands, COSUDE is successfully applying (with producers of vegetables, dairy products, and legumes) a model for providing aid aimed at strengthening the link between production and marketing and increasing the share of added value captured by producers. Another important factor allowing continued high mark-ups by middlemen is the imbalance in access to information on local and world prices. Wide publication and broadcasting of the information collected by SICA would provide an opportunity to inform producers about opportunities for their products. This marketing strategy contributes to improved risk management by maintain- ing a portfolio of products and diversifying buyers; appropriately managing market information in order to anticipate events, both favorable and unfavorable; and facil- itating the contracting of collective crop insurance with private insurance companies (this has been done in the case of broccoli). This latter mechanism has barely been developed in Ecuador at present. DIVERSIFICATION STRATEGIES. The agricultural census indicates that at the national level agricultural producers obtain 33 percent of their income from nonagricultural sources. Small producers obtain 60-70 percent from other sources. A study carried out in 12 Integrated Regional Development areas in 1993 (Martinez 1995) showed that "...areas with a predominance of non-agricultural income are located in the 382 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM highlands populated by poor indigenous communities with few resources, where agriculture is no longer the main source of income and occupational diversification crosses families longitudinally. At the other extreme, the only areas where agricul- tural income clearly predominates are on the humid coast of the Guayas basin. Rural people here continue with agriculture to the extent that good quality land is avail- able to them." REGIONAL-LOCAL DEVELOPMENT AND RURAL-URBAN DEVELOPMENT CORRIDORS. The diversity of rural spaces in Ecuador requires a variety of interventions that sup- port the potential of each local jurisdiction through participative plans and strategic alliances. There are already some experiences that can serve as a starting point. The PROLOCAL program, financed by the World Bank, sets out to relieve poverty by increasing local development management capacity in the cantons and provinces and by supplying financial resources, training services, and technical assistance. The following institutional strategy has been proposed: strengthening local capacity for planning (participative preparation of local development plans) and implementing projects; further advances toward decentralization of public administration; strengthening the institutional capacity of local actors; organizing action by public and private institutions; and broad participation by grassroots communities. The PRODEPINE project pursues goals similar to those of PROLOCAL, but unlike the latter, which works with nonindigenous rural communities, PRODEPINE deals exclusively with ethnic and Afro-Peruvian groups. Local planning involves all actors (communities, parishes, municipalities, the pri- vate sector, and the public sector) and the implementation of plans is a very powerful instrument for achieving rural development goals. The implementation of local plans Martfnez (2002) reports that in the province of Tungurahua, where the com- mercial dynamics of the city of Ambato and its privileged location in the cen- ter of the country have coincided with rural conditions such as a less concen- trated agricultural structure and better access to basic education, "a dense network of productive movements has been created, the focal point of which is the internal market" (clothing industries, small agricultural industries, and so on), which has benefited the poor population, including indigenous peo- ple. Also, the existence of rural infrastructure and public services (electric energy, roads, and the like) has enabled other rural communities to take advantage of this dynamic, "which in turn extends into the deepest rural areas." The author adds that this process has been boosted by the presence of Integrated Rural Development projects. This experience demonstrates the possibilities of regional-local development and the potential of urban-rural links through medium-sized cities, as well as the relevance of investment in education, rural infrastructure, and basic public services. RURAL DEVELOPMENT 383 created by local agents allows a growth dynamic to develop, based on the comparative advantages of each area, during the attempt to diversify the local economy through small and microenterprises. The conditions for attracting and keeping private invest- ment can be attained only if an investment program is also put in place for public serv- ices such as commumications, electricity, transport, and market infrastructure. On the basis of concerted local planning, "economic corridors" can be created, linking rural areas with other rural areas and with urban areas through local high- way infrastructure projects, developing comparative advantages (niches for products and know-how) and entrepreneurial and business training programs. D. The Institutional Framework of Rural Development The system for promoting rural development is institutionally complex in the sense that it includes a great number of public and nongovernmental organizations work- ing in an uncoordinated fashion and channeling resources according to objectives that are not always in line with the needs of the beneficiaries. At the central government level, we find the Ministry of Social Welfare, the Rural Development division of which presides over the PROLOCAL council; the Min- istry of Agriculture, which has agricultural and rural planning functions, and the autonomous institutions responsible for technology, training and agricultural devel- opment; the Planning Office (ODEPLAN) responsible to the President's Office, which promotes a national system of decentralized participative planning; and the Ministry of Education and Culmtre, with responsibilities in its respective sector. There is also the Council for the Development of the Indigenous Nations and Peo- ples of Ecuador (CODENPE), which is responsible for implementing the PRODE- PINE project, for which purpose it makes agreements with institutions such as INDA on the regularization of land rights and with financial intermediaries for the implementation of sub-projects. The National Council on Hydraulic Resources (CNRH) governs the use of water for irrigation, drinking, and hydroelectric energy generation. Since INERHI was eliminated, there is no central body involved in irrigation policy. Irrigation is man- aged by a set of actors with different functions, including regional development cor- porations, provincial councils, and users' boards. The Agricultural Census (SICA) project is another important actor working to improve the availability, consistency, validity, and usefulness of information in the agricultural sector in order to facilitate decisionmaking in the private and public sectors. Provincial councils, municipalities, and parochial boards share responsibilities for rural development in their respective jurisdictions, as established by each autonomous sectional government system. Parishes are the basic geographic and social unit in the local development process and the parochial boards can play a lead- ing role in guaranteeing popular participation and initiative in the management of official development policy. At the provincial, municipal, and parochial levels are 384 ECUADOR: AN ECONOMIC AND SocIAL AGENDA IN THE NEW MILLENNIUM sufficient mechanisms for discussion and agreement among state institutions and civil society, though membership in these bodies could in some cases be adjusted to reflect the importance of the social actors involved. As is enshrined in the constitu- tion, resources destined to operating local entities consist of income generated by the entities themselves plus the transfer of at least 15 percent of the total current income of the central government budget. Finally, the nine regional development corpora- tions also carry out development activities, mostly involving irrigation, rural road infrastructure, and other infrastructure. Given the limited public resources at the central and local levels, civil organiza- tions and NGOs have occupied part of the space for cooperation not covered by the state. Complete information on their activities is not available, though it is quite clear that there is no coordination among so many institutions working in rural development. An effective rural development policy that favors a spatial, multisectoral, partic- ipative approach and supports economic diversification will also require institutional architecture that facilitates complementarity among the roles of the different actors. The institutional rules that guide this effort must be based on (i) cooperation among the central public sector, the private sector, civil society, municipalities and provin- cial governments, parochial boards, savings and loan banks, and so on; (ii) coher- ence among the regulations and activities of the different institutions; (iii) pro- gramming based on the strategic plans of each jurisdiction; and (iv) financial allocations based on the concept of "additionality" as incentives for guaranteeing the implementation of the strategic plans. This means that state contributions will com- plement contributions made by other actors with similar goals. E. Conmciusions amnd Recommendationis Rural development in Ecuador suffers from a lack of coordination and excessive cen- tralization, resulting in inefficient public and private investment. Many rural poli- cies concentrate on the agricultural sector and little attention is given to nonagri- cultural activities. Community development experiences such as PRODEPINE offer a good starting point for strengthening the rural sector but require concerted action on a larger scale. Ecuador's geographic, economic, and sociocultural diversity requires a varied rural development based on policies that support (i) a participative approach to development focused on jurisdictions or rural spaces, in order to foment economic and social cohesion; (ii) diversification of the rural economy, the creation of nona- gricultural employment through investment in rural and social infrastructure, and greater competitiveness in the agricultural sector through new technology and research; and (iii) the promotion of environmental conservation through better land zoning, the recovery of soil conservation methods, and other uses of natural resources. RuRAL DEVELOPMENT 385 Creating a rural development strategy using this new approach could take a new government the better part of its first year. Rural needs demand immediate action; therefore, these recommendations are of two kinds: (i) actions leading to the prepa- ration of an integrated strategy for social development; and (ii) actions that must continue or begin immediately in order to deal with the problems identified above. Recommendations BEGIN PREPARING A RURAL DEVELOPMENT STRATEGY that supports the decentraliza- tion process and is based on participative processes and strategic alliances within each territorial jurisdiction; promotes economic diversification in the agricultural sector; and strengthens environmental protection. This will require classifying terri- torial jurisdictions on the basis of operative criteria; identifying participative process for the preparation of integrated local development plans; identifying the different actors at the national, provincial, municipal, and community levels; developing cri- teria for eligibility for the development funds supporting the strategic plans; clarify- ing the roles and responsibilities of the different actors, especially in the various sec- tors that already operate in rural areas; and creating a program of incentives for preparing strategic alliances, chains of production, and innovative local proposals. In the meantime, the following priority actions will facilitate the move toward rural development with the features mentioned above. PRIORITIZE INVESTMENT IN EDUCATION IN RURAL AREAS. This requires immediate acrion since the potential of rural Ecuador depends to a great extent on the educa- tional level of its people. Basic rural education must be in keeping with rural reality and the cultural characteristics of its people (see chapter 9 on Education). IMPROVE RESEARCH AND TECHNICAL TRAINING, not only in the agricultural sector, but also in nonagricultural sectors such as crafts and tourism. This requires contin- uing and expanding existing research and development programs and developing alternatives for spreading technology in a broad and decentralized way in areas with agricultural potential, based on an evaluation of the state of the institutions in charge of these activities. Immediate action that could be taken includes supporting (i) the National Professional Training Service in collaboration with agricultural col- leges; (ii) the National Institute for the Training of Rural Farm Workers (Capac- itacidn Campesina), which the Ministry of Agriculture and Livestock operates on a decentralized basis; and (iii) the institutionalization of a modern research and devel- opment system based on the principles of diversity, cofinancing, and competitive- ness, such as the one being developed by PROMSA. This kind of system requires the creation of real demand through the participation of the beneficiaries and a rede- finition of the role of the INIAP The Consulting Councils of the SICA project could serve as key points of contact to develop an effective research and develop- ment project. 386 ECUADOR: AN ECONOMIC AND SOCIAI. AGENDA IN THE NEW MILLENNIUM CONTINUE LAND TITLING AND ZONING. Any rural development strategy will require that private and community land ownership and their respective legal guarantees be clearly determined. When the PRAT pilot project has been completed and evaluated, it will be necessary to look for options to extend the experience and coverage of rural land registry and titling. Also, it is hoped that the PRODEPINE II project will continue advancing with the land tiding process begun during PRODEPINE I. It will also be necessary to examine alternatives for improving access for the rural poor through mar- ket mechanisms. If it is feasible and if the cost is acceptable, pilot programs should be initiated in certain key areas, aimed at implementing land zoning schemes, regulations for land use, and support for economic diversification outside the agricultural sector. MONITOR WATER BASINS AND TRANSFER IRRIGATION SYSTEMS TO USERS BOARDS. Begin monitoring water basins where the greatest conflicts have occurred and those with the greatest risk of flooding in order to determine the supply and demand for surface and underground water, to evaluate water quality, and to determine alterna- tive action. The CNRH would be responsible for such monitoring, in collaboration with development corporations and provincial councils. Future action related to water basin management must be determined as part of the strategic plan of each territorial jurisdiction. The Ministry of Agriculture should also continue with the transfer of irrigation systems to users' boards. RURAL FINANCING. Strengthen the national network of savings and loan coopera- tives for the rural sector, as well as other options that could be applied during a pilot stage of projects aimed at extending access to financial services in rural areas if these pilot stages are successful. Explore innovative risk protection mechanisms such as the "rural production certificate" and the lottery system for insurance against low prices. Links should also be established between informal credit models (such as women's credit groups) and the formal financial system. IMPROVE RURAL PUBLIC INFRASTRUCTURE (see chapter 7 on Basic Infrastructure). Increase public investment in rural areas that have the greatest potential for eco- nomic diversification or economic corridors; the highest transaction costs for mar- keting their products; and the best opportunities to form alliances with communi- ties and the private sector for financing, building, and maintaining infrastructure. REVISE THE REGULATIONS THAT REGULATE COMMERCIAL RELATIONS IN RURAL MAR- KETS. This will require wide-reaching measures such as revising and updating cur- rent legislation (the current commercial code dates back to 1904). As a start, a tech- nical commission could be established to carry out an inventory and evaluation of existing regulations that have an effect on juridical security in the rural markets. BOOST A MARKETING ASSISTANCE PLAN as a pilot project based on the following serv- ices for supporting associated producers: business management, organization, credit, RuRAL DEVELOPMENT 387 market research, chains of production, and alliances with the agroindustrial sector. The goal is to attract producers toward an expansive dynamic and support improve- ments to the productive base in order to increase productivity and diversification. In principle, this would be implemented in one or two areas with good potential for gaining access to urban or export markets, in conjunction with investment in rural infrastructure. INVESTIGATE EXISTING AND POTENTIAL DIVERSIFICATION STRATEGIES for communi- ties in order to provide them with the appropriate investment and support. This is especially true of indigenous people, many of whom have proven themselves to be successful business and craftspeople. EXPERIMENT WITH PILOT PROJECTS TO DEVELOP RURAL SPACES AND PRODUCTION CHAINS (jurisdictions) based on the principles of (i) participative local planning, (ii) implementation of locally concerted public investment, (iii) support for private investment, (iv) strategic alliances, and (v) the establishment of economic corridors aimed at diversifying the local economy. Policy Matrix 0 Problem Policy meamures Progress indicators (imnclding annmslfiscal Short term Medium term cost, if any) (to June 2003) (2003-07) Objectives/goals Lack of a comprehensive Develop a strategic framework for Implement the strategy in areas Applying the new rural develop- rural development strategy rural development Establish operative marked for priority inter- ment policy in five pilot areas with that recognizes the criteria for classifying rural spaces as vention, based on compliance different geographic, economic, geographic, economic, and modern rural areas, less favored areas, with basic requirements such and sociocultural characteristics. 0 sociocultural diversity of and marginal areas, also using as the strategic plans and Reducing poverty, strengthening of the rural sector and Agricultural Census data and other territorial agreements among the decentralization process, and its need for economic sources of information. Develop the various actors in the areas promoting diversified rural devel- diversification. participative strategic plans at the and innovative local action opment, while strengthening local 0 level of territorial jurisdictions plans. institutions and strategic alliances. 0 (municipalities, micro-regions). Establish policies that encourage the convergence of the objectives of the different actors toward a common goal-for example, additional budget allocations for projects, based on transparent and inclusive strategic alliances. Low level of education and Prioritize investment in education (Based on chapter 9, Increasing school attendance rate H training among the rural toward rural areas and adjust Education Policy) and the percentage of the popula- population. education to the local cultural Evaluate the state of rural tion with technical training. Z Low productivity of small context. research and training. Increasing technical and manage- and medium-sized agricul- Increase support of National Adopt and implement ment levels not only in the agricul- tural production units. Professional Training Service in measures to strengthen tural sector but also in other rural an alliance with agricultural training institutions. economic sectors. z colleges, and National Institute Establish a minimum of Increasing research capacity in for the Training of Rural Farm five strategic alliances biology, genetics, and other areas of Workers (Capacitaci6n Campesina) nationally and importance to agriculture. Initiate strategic alliances with internationally. Increasing dhe number of farmers national and international research INIAP either functioning in participating in development activ- institutions accordance with the pro- ities. Demand reasonable performance visions of the PROMSA Raising rural productivity and real by the INIAP under an accounta- project or else restructured. wages, increasing rural added value bility system that guarantees its Develop and implement captured by the poor, and increas- H effectiveness appropriate alternatives; ing the competitiveness of the Involve the Consulting Councils undertake massive, decen- agricultural sector. of the SICA project in the tralized distribution of development of an effective technology. research and development program. Lack of rural land register Continue with the PRAT pilot Extend the reach and coverage Establishing rural land registers in and problems with land program and begin the second stage of the PRAT project and con- municipalities, issuing deeds, tiding and registration. of the PRODEPINE project. tinue with the PRODEPINE updating registers, and so on. land titling program. Making land ownership more secure and facilitating the capital- ization of land holdings. Difficulty experienced by Evaluate the possibility of improving Develop the appropriate market Facilitating agricultural expansion small farmers in gaining access to land through market mechanism and launch pilot in areas with productive potential access to land. mechanisms. projects. and facilitating the consolidation of small land holdings with low productive value. Increasing opportunities for access to land for small producers. Inappropriate and Identify the water basins with the Identify basins and bring action Reducing conflict over water; inequitable management most conflictive situations or risk of plan to implementation stage. rationalizing its use (see water of water resources. flooding, to determine the supply Revise and approve the necessary policy) (Matrix continues on the following page.) 00 Policy Matrix (continued) Problem Policy measures Progress indicators (including annualfiscal Short term Medium term cost, if any) (to June 2003) (2003-07) Objectives/goals Social conflict involving and demand for surface and under- changes to the Water Act. Completing the process of trans- water use for industry, ground water, evaluate water quality Transfer all irrigation systems ferring irrigation systems. irrigation, and human and determine alternative action. to users' boards. Protection of natural resources and m consumption. Revise the current legal framework increase in the productive capacity e (Water Act). of small farmers. Continue with the program for transferring irrigation systems to users' boards. m G Questionable viability of Investigate strategies and potential Implement an economic Building the economic base on z 0 many agricultural production for economic diversification based diversification program based local potential outside the agricul- units. on the cultural and natural on local innovation or alliances tural sector. Insufficient agricultural potential of the different rural among actors in three pilot Increasing the efficiency of existing Z activity to employ the areas in the country: the coast, areas. programs for supporting rural rural poor. the highlands, and the east. Aim rural programs toward areas. n the goal of diversification. Increasing occupational diversifica- tion and generating employment. C z Lack of capital for the Strengthen the cooperative move- Begin establishing the network Reaching a point at which the g development of rural micro- ment through a network of in three provinces. network is structured and z enterprises and for rural grassroots cooperatives supported Link 50 percent of cajas operating. diversification. by credit institutions. solidarias (savings banks) to Achieving 50 percent increase in Establish formal conlections among formal financial institutions. access to credit among small Z women's credit groups (cajas solidarias) Implement pilot projects with producers. and formal financial institutions. new mechanisms for supporting Increasing productive investment r Explore innovative mechanisms for micro-credit, rural financing, and diversification in rural areas. financially supporting the rural and risk management. e sector such as rural production Increase income among small certificates and private insurance farmers in selected areas lottery. through risk reduction. 0 Establish laws and regulations on , the use of family assets (land, 0 livestock) as a guarantee for loans. Production and marketing Establish a commission to evaluate Implement the most urgent Increasing juridical stability in con- z contracts frequently broken; regulations on rural markets; measures among the recommen- tractual and commercial relations inefficient mechanisms for begin work. dations of the mixed technical among rural producers and enforcing them. commission. entrepreneurs. Stabilizing the income of producers. High mark-ups by middle- Design a pilot program for supporting Implement the program in Achieving goals with regard to: men and low competitiveness. rural marketing, based on business two areas with potential for functioning structures for coopera- management, organization, credit, gaining access to urban or tion with producers' groups, chains of production, and alliances export markets, in conjunction number of people trained, alliances with the agroindustrial sector. with investment in rural established with the private sector. Prioritize rural public investment for infrastructure. Increasing the competitiveness of areas that have the greatest potential the rural economy for economic diversification or eco- nomic corridors; the highest transac- tional costs; and the best opportunities to form alliances with communities and the private sector for financing, buil- ding, and maintaining infrastructure. Economic marginalization of Using operative criteria, identify areas Implement a pilot program for Developing alternative economic rural areas and weak with potential for developing local integrated development in three activities linked with rural areas. rural-urban links. and regional development programs; areas, with links to the urban Creation of virtuous circles of engage in participative planning in sector. development among the rural poor. collaboration with all actors in the area; and create economic corridors. 14 The Environment and Sustainable Development' Ernesto Sdnchez- Triana andJuan Quintero The poverty endured by more than 60percent of the population is the most criticalprob- lem confronting Ecuador. Poverty is caused and exacerbated by two priority environ- mentalproblems: environmentalpollution and natural disasters. In 2000, the major dis- eases associated with environmental pollution were (i) acute respiratory infections (697,254 cases); (ii) diseases associated with water pollution (225,734 cases), particu- larly diarrheal diseases; and (iii) vector-borne diseases (97,007 cases), such as malaria and denguefever, that are associated with sanitary deficiencies. In addition, natural dis- asters (floods in coastal areas, seismic and volcanic phenomena, landslides and erosion in the Andean area, and blights), primarily the El Nino phenomenon and other climatic changes represent one of the major limitations on reducing poverty in Ecuador. For exam- ple, the 1997-98 El Nifio producedfloods in coastal areas leading to economic losses in excess of $US2 billion. On that occasion, floods affected 2,500 kilometers of major high- ways and 40,000 kilometers of secondary roads throughout the country. Floods also destroyed 1,600 homes and affected another 7,500. Storms in recent years, including 2002, have increased in frequency and intensity, leaving unparalleled devastation in their wake. Environmentalpolicy must confront thesepriority problems associated with poverty- that is, controlpollution andprevent the effects of natural disasters on the population. To develop an environmental policy, the state has two basic forms of intervention at its dis- 1. This chapter was prepared by Ernesto Sanchez-Triana (senior environmental engineer, LCSES) and Juan David Quintero (lead environmental specialist, LCSES). The authors appreciate the comments, suggestions, and information provided by Minister of the Envi- ronment, Edgar Isch, and by Maria Donoso-Clark, Gabriela Arcos, Kulsum Ahmed, George Ledec, and Peter Brandiss. 393 394 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN T HE NEW MILLENNIUM posal: environmental regulation and investment in the environment. To control envi- ronmental pollution, the government issued Executive Decrees 3399 and 3516 in December 2002, plus secondary environmental legislation that includes environmental regulations providing for different instruments, notably economic and administrative procedures and direct regulation. The short-term challenge in this area is to ensure the implementation, supervision, and monitoring of these regulations. To reduce rural vul- nerability to natural disasters, investments are urgently needed in structural and non- structural risk prevention measures. Structural measures include the resettlement ofpop- ulations living onfloodplains, flood control projects, the use of wetlands to alleviate rising waters, and erosion control and bank stabilization projects. Nonstructural measures include establishing soil use zones, designing emergency response and assistance programs, and equipping andpreparing citizens for such events. Investments in road infrastructure; potable water; and in the agricultural, health, or energy sectors necessitate incorporating environmental considerations in order to ensure the efficiency, equity, and effectiveness of such investments. Finally, investments in conservation and protected areas should target areas that have the greatest potentialfor nature tourism. A. lntroduction This chapter starts with the premise that any strategy for economic growth and social development in the country will be contingent upon the control of degrada- tion in the biophysical environment and the sustainable management of natural resources. In this respect, we discuss the principal environmental issues associated with economic growth and the fight against poverty, and propose a series of institu- tional options intended to consolidate the government's efforts on the path to sus- tainable development. The chapter is divided into five sections. The second section identifies the most important environmental problems faced by Ecuador, including those associated with the population's morbidity and mortality rates. It also discusses the limitations that natural disasters place on growth. The third section analyzes environmental management activities currently underway in the country and examines the oppor- tunities for converting the management of natural resources into a variable that con- solidates Ecuador's competitive advantages. Finally, the fourth section presents a series of conclusions and suggests policy options designed to institutionalize the path of sustainable development. B. IPoverty and the Environment Between 1995 and 1999, the incidence of poverty in Ecuador increased from 34 to 56 percent-making the poverty endured by the highest percentage of the popula- tion the critical problem facing the country. Poverty exists and is exacerbated as a THE ENVIRONMENT AND SUSTAINABLE DEVELOPMENT 395 Figure 1. Poverty Deciles in Ecuador's Cantons ^::.~~C\-- ..... C ' ~ .............. ,, 23.8.60. 1 % - ~~~~61.4l-66.3% . .,.A66.4-68.1% - l] ..S 2-74.8% 74.9-75.6% :75.7-77.8% ___77.9-79.8% 80.0-82.5% 82.6-86.6% 86.7-95.9% Source: Henninger and Hammond (2002). result of two predominant environmental variables: environmental pollution and natural disasters. Controlling pollution and preventing the effects of natural disas- ters on the population must both be given the highest priority and attention by envi- ronmental authorities. 396 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Environmental Pollution One of the principal factors exacerbating poverty in Ecuador is the drastic increase in the rates of morbidity and mortality from diseases directly related to environ- mental pollution. In 2000, the major reportable diseases were (i) acute respiratory infections (697,254 cases); (ii) diseases associated with water pollution (225,734 cases); particularly diarrheal diseases; and (iii) vector-borne diseases (97,007 cases), such as malaria and dengue fever, that are associated with sanitary deficiencies (PAHO 2002). The economic cost of these diseases is hundreds of millions of dol- lars and the social and individual cost is even higher. Air pollution, particularly pollution created indoors, is associated with acute res- piratory infections (Harding and Staton 2002). This type of pollution is caused by incomplete combustion of firewood and other fossil fuels inside both rural and urban homes (Smith 1986). In 2001, approximately 18 percent of the energy con- sumed in the country carme from firewood and other traditional fossil fuels. This is 2 percentage points higher than the average consumption in Latin America and the Caribbean (IBRD 2001). Air pollution is one of the principal causes of respiratory diseases in Ecuador. Children under the age of five are those who are most at risk, owing both to air pol- lution inside buildings and atmospheric contamination in urban areas near road- ways or industrial corridors. Air pollution is particularly critical in cities more than 2000 meters above sea level such as Quito, Cuenca, and Ambato (jurado and Southgate 1999). The rates of atmospheric contamination in urban environments such as the historic center of Quito are made worse by high altitude conditions and weather conditions associated with thermal inversion. The effects of atmospheric pollutants are significant in areas where populations with the lowest incomes live. In these areas, high population densities, incomplete combustion of fossil fuels, motor emissions, and the topography itself synergetically increase the concentra- tions of pollutants with the resulting effects on human health. A study of school- aged children in Quito identified four times more episodes of asthma per year in children of the same age as in cities in the United States that had a higher number of automobiles Uohn Boldt 1998, cited by Fundaci6n Natura and Universidad Central del Ecuador 2000). Air pollution inhibits lung development, aggravates asthma, and contributes to chronic lung diseases. It also reduces worker productivity. A study conducted in 1996 estimated annual losses of approximately $28 million dollars owing to absence from work and the treatment of respiratory diseases associated with the elevated presence of particles in the air. Vehicles are the major generators of atmospheric pol- lution due to suspended particles, carbon monoxide, and ozone precursors, particu- larly in urban centers. Sulfur oxide and nitrogen oxide emissions come primarily from fixed sources. In cities such as Quito, fixed sources include textile factories, leather-tanning operations, and industries involved in the processing of food and beverages (Southgate and others 1996). THE ENVIRONMENT AND SUSTAINABLE DEVELOPMENT 397 Public health problems due to water-borne diseases are associated with deficien- cies in the coverage and quality of potable water services and with inadequate hygiene. The incidence of diarrhea in the infant population is estimated at more than six million per year and the country has an infant mortality rate in children under the age of five higher than the average for Latin America (UNDP 1999). For example, in the coastal cities barely 21.9 percent of the population has access to res- idential drinking water. (INFOPLAN 1999). Morbidity and mortality rates due to poisonings or diseases caused by carcinogenic and teratogenic agents correlate with the improper handling and disposal of hazardous wastes. Some existing data show the intensive use of substances that are precursors of hazardous wastes (Ministry of the Environment, IDB, and PAHO 2002). The use of agrochemicals in Ecuador is higher than the average for Latin America. According to data from the World Resources Institute (2000), during the period 1996-98 Ecuador held fourth place in the consumption of pesticides among 12 South American coun- tries. In a study of exposure risks, Britton (2000) found concentrations of 44.3 g/day of heptachloride and 11.0 g/day of aldrin. The health effects of high concentrations of these organic compounds in food are associated with cancer risks of 0.3 to 9.1 x 10-3, which means an additional 150 cases of cancer each year. Deficiencies in the handling and disposal of waste and deficiencies in sanitation in general are also associated with morbidity and mortality owing to diseases spread by vectors such as insects and rodents. The production of waste in Ecuador is esti- mated at 8,000 tons per day (PAHO 1998). Eighty percent of this waste is disposed in open-air dumps. Garbage collectors live with their families in all of these dumps. Industrial wastes containing hazardous wastes are handled along with household waste. The daily production of industrial waste in 1996 was estimated at close to 400 tons, 75 percent of which was produced in Guayaquil and Quito (Southgate and others 1996). Waste disposal problems have worsened in cities such as Quito, where in late 2002 the waste disposal site was filled to capacity and alternatives are being sought for temporary and subsequent permanent waste disposal. Natural Disasters Natural disasters (floods in coastal areas, seismic and volcanic phenomena, land- slides and erosion in the Andean area, and blights), primarily El Nifno and other cli- matic changes have caused the reappearance of diseases such as dengue fever and malaria. As mentioned earlier, natural disasters are one of the major limitations on reducing the conditions of poverty in Ecuador. The population's vulnerability to natural disasters has increased owing to the accelerated process of urbanization in recent decades. A characteristic of this process is the occupation, particularly by the poorest populations, of areas that are most susceptible to floods, erosion, landslides, and seismic movements. Natural disasters are associated with significant reductions in GNP growth. Eco- nomic growth has been significantly affected in proportion to the magnitude and Figure 2. GDP and Natural Disasters 12 10.5 6 39 4.2 4.3 4_.3 l 4- - - __ 3 Qio 3.4 1980 098 0 -S 0__3.020 0 -4 ~ ~ ~ Earthquake' >~~~Yea 0.3rce: W l B ; -8-28 _ ~~~~Yerz Source: World Ban-6.k-7. THE ENVIRONMENT AND SUSTAINABLE DEVELOPMENT 399 intensity of natural disasters. Some of these disasters have been particularly destruc- tive. For example, in 1987 an earthquake affected the area of Quijos in Napo Province, interrupting the transport of hydrocarbons from the east to Esmeralda; in 1997 and 1998, the El Nifso phenomenon had a significant impact on the country (Benavides and Solberg 2003). The El Niino phenomenon of 1997-98 produced floods in the coastal areas with economic losses in excess of $US2.869 million or close to 15 percent of GDP in 1999. On that occasion, floods affected 2,500 kilometers of major highways and 40,000 kilometers of secondary roads throughout the country. Floods also destroyed 1,600 homes and affected another 7,500. Recent storms have increased in frequency and intensity, leaving unparalleled devastation in their wake. With the El Nifio phe- nomenon and other climatic changes there has also been a reemergence of diseases such as dengue fever and malaria. Earthquakes and ash storms due to the eruption of volcanoes such as Pichincha or Revolc6n have caused significant interruptions in the country's economic activities. Landslides, floods, and mudflows that occur on the hillsides of Quito and other cities in the Andean area have also caused great dam- age to local economies. The high costs of natural disasters are associated with the great vulnerability of human settlements, particularly low-income populations, located on floodplains, areas with high seismic activity, and hillsides with geotechnical problems. Various governmental and nongovernmental organizations are engaged in disaster response and reconstruction activities. National legislation assigns the responsibility for coor- dinating emergency assistance and response to Civil Defense. In addition, organiza- tions such as the Coordinator of the Emergency Program to Cope with the El Ninio Phenomenon (COPEFEN), established in 1997, are responsible for coordinating reconstruction activities in conjunction with Ministries such as Housing (MIVI) or Public Works (MOP). In 2002, the government expanded the scope of COPEFEN so that it would act as the Coordinating Unit of the Emergency Program to Cope with Natural Phenomena. In addition, CORPECUADOR was given the responsi- bility of supervising the rehabilitation of infrastructures affected by natural disasters. However, to date Ecuador has no organizations for coordinating disaster prevention through actions to reduce vulnerability by means of economic instruments or land management schemes. C. Sustainable Development Environmental issues cut across the various sectors of Ecuadot's economy and soci- ety. Responsibility for sustainable development lies not only with the Ministry of the Environment and the environmental authorities but also with the various public and private agents. Both the public and private sectors are responsible for establishing comprehensive environmental management schemes. The incorporation of environ- mental considerations in the economic sectors and the efficient management of nat- 400 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM ural resources are essential for ensuring sustainable development in the country. Comprehensive resource planning and management ensures both equity in invest- ment projects and the effectiveness of the solutions planned-and is the basis for sustainable development in that it incorporates environmental considerations in policies, plans, and programs. In addition, natural resource management and con- servation in Ecuador are basic elements for ensuring the development of sectors such as nature tourism that offer competitive advantages in the international market. Comprehensive Resource Planning and Management Ecuador's economic growth and social development depend on variables such as sec- toral investments, increased productivity, governance, and macroeconomic stability. These variables become operational when environmental considerations are incor- porated in comprehensive resource planning. Investments in sectors such as road infrastructure, potable water and sanitation, agriculture, health, and energy require that environmental considerations be incorporated in order to ensure the efficiency, equity, and effectiveness of such investments. Increased productivity in sectors such as industry and agriculture correlates with the adoption of clean production prac- tices. Governance, as a mechanism for obtaining consensus and unifying efforts behind a common vision, is strengthened when decisionmaking processes are opened up to public scrutiny through procedures such as public hearings and envi- ronmental assessments. In addition, macroeconomic stability is guaranteed when there are clear and unchanging rules of the game that avoid distortions in pricing systems, internalize externalities, and promote efficiency in the use of resources. Investments in key sectors of Ecuador's economy, such as transportation, tourism, energy, mining, health, and agriculture, require the incorporation of envi- ronmental considerations to ensure their efficiency, equity, effectiveness, and sus- tainability. The road transportation sector demonstrates how the problems of the majority of the rural population can be resolved through environmentally sound investments such as adapting lanes and paths for nonmotorized traffic. Options for defining these projects require including communities in the processes of design, construction, operation, and maintenance. When environmental considerations have not been incorporated in the definition or implementation of such solutions, significant problems have been created for the population and the natural environ- ment. Experience in road projects such as La Virgen-Papallacta, Cuenca-Molleturo- Naranjal, and northeastern Esmeraldas make clear the need to incorporate environ- mental considerations from the outset when sectoral investments are conceived. Economically important roadways such as La Virgen-Papallacta and Cuenca-Mol- leturo-Naranjal were constructed in areas with geotechnical problems as well as without technical environmental specifications. Problems with landslides and blocked roads have meant spending considerable amounts on maintenance and rehabilitation, as well as on mitigating the environmental impacts on neighboring communities. THE ENVIRONMENT AND SUSTAINABLE DEVELOPMENT 401 The hydrocarbons sector also illustrates the need to have a precise environmen- tal regulatory framework to ensure that citizens are included in decisionmaking processes. In the design and implementation of large hydrocarbon exploration and transport projects, the lack of a precise regulatory framework has required those car- rying them out to adopt international environmental technical specifications whose monitoring and control go beyond the scope of existing national standards. In this case, and as in other hydrocarbons projects, it is necessary to ensure that environ- mental considerations are fully incorporated from the moment such investments are conceptualized. In the agriculture and fishing sectors, the destruction of natural capital and the use of deficient phytosanitary practices have also contributed to significant produc- tivity reductions. For example, the destruction of the mangrove forest and the spread of blights have created environmental and economic problems for productive sectors such as the shrimping industry. In 1999, this industry was devastated by the white spot virus; 90,000 jobs were lost and the total losses exceeded $US600 million in 2000. Natural Resource Management and Economic Growth Ecuador is one of 17 "megadiverse" countries in the world thanks to its great bio- logical and cultural wealth and diversity. The country has high species density (9.2 species/1,000 km) and high flora density, with 25,000 species of vascular plants, which is equal to 10 percent of the world's species. There are nearly 1,600 species of birds, and 12 of them are endemic. There are 301 known mammal species. In order to protect this great biological wealth, protected areas have been established in 43.6 percent of national territory. This figure is significantly higher than the average in Latin America and the Caribbean (7.4 percent). Unfortunately, the rate of defor- estation is one of the highest in South America, amounting to 1.2 percent of a for- est cover area of 106,000 square kilometers. The sustainable management of natu- ral resources is essential to ensure economic growth in Ecuador. In this respect, the results of the study conducted by the Native Andean Forests Program (PROBONA) point to promoting the management of conflicts in soil usage through systematic efforts to guarantee the sustainable use of resources (Henninger and Hammond 2002). The national biodiversity strategy prepared by.the Ministry of the Environ- ment indicates that national agriculture and ecotourism are based on the existence of a high level of biodiversity. Population groups, including many indigenous peoples and nationalities, base their livelihood on the use of natural biological riches. Biodiversity can be the basis of food security, particularly for the rural population. Deforestation and the destruc- tion of products associated with the forest help to exacerbate the conditions of poverty in which such groups live. The high rate at which the forest cover is being destroyed limits opportunities for reducing poverty and for raising the living stan- dards of population groups with ancestral cultures. It would be advisable to ensure 402 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN TIHE NEW MILLENNIUM that efforts to consolidate the system of protected areas are directed toward ensuring the livelihood and raising the living standard of these groups as well as of the major- ity of the rural population. Ecuador's economy has been strengthened, among other things, by the genera- tion of foreign exchange from tourism in natural areas. For example, the Galapagos Islands contribute about $US 100 million per year to the Ecuadoran economy. The potential for increasing employment and generating greater opportunities for growth based on tourism in natural areas is yet to be developed in areas such as the Andean plateaus and the Amazon area in eastern Ecuador. In areas with high tourism potential such as the Galapagos and protected areas in the Amazon, deforestation and over-utilization of natural capital can affect the incomes of the poor. In such cases, it is essential to guarantee investments in con- servation or in the eradication of foreign species, so that natural capital is preserved. In addition, a series of actions must be taken to confront global environmental issues such as climate change, the destruction of the ozone layer, and the preserva- tion of biodiversity. The international community's high level of interest in resolv- ing these problems justifies fully using the financial resources and assistance of the international community while following the guidelines of national authorities. The limited resources available locally should be allocated to dealing with the priority environmental problems identified earlier. With regard to the preservation of biodi- versity, international funds should supplement local efforts to manage protected areas for the sustainable management of watersheds, flood protection, and promo- tion of ecotourism. In terms of environmental management policy (see Box 1), the preference for actions and investments to preserve protected areas and biodiversity is clear in the actions financed by international bodies and multilateral financing agencies.2 2. To support the preservation of biodiversity in Ecuador, the Global Environmental Facil- ity (GEF) is financing the Comprehensive Program for the Control of Species Introduced in the Galapagos as well as the formulation of the National Biodiversiry Strategy, while the United Nations Fund is providing cooperation for the preservation of biodiversity in the Galapagos. The European Union financed the PETRAMAZ project with emphasis on the utilization and conservation of the Amazon region, as well as the identification of eco- nomic potential in the sustainable use of natural resources in the Amazon. The United' States Agency for International Development (USAID) is providing support for the Sus- tainable Management of Biological Resources project in Esmeraldas. Other bilateral part- ners, principally the Netherlands, Switzerland, Germany, and Spain, have allocated resources for projects for the conservation of native forests, management of protected areas, management of watersheds, and pilot sustainable development programs. The IDB has granted loans to the government for the conservation and utilization of biodiversity in THE ENwRONMENT AND SUSTAINABLE DEVELOPMENT 403 Box 1. Environmental Policy and Management The National Constitution enacted in 1998 establishes that the state must recognize and guarantee the people's right to live in a healthy, ecologically bal- anced, and pollution-free environment. The Constitution also establishes that the state must defend the country's natural and cultural heritage and protect the environment. The mandate to defend the natural heritage has taken prece- dence over other mandates. Since 2000, the Ministry of the Environment has had an Environmental Strategy for the Sustainable Development of Ecuador. This strategy emphasizes the preservation of fragile ecosystems, the consoli- dation of a system of protected areas, and the conservation of biodiversity. Regarding this last subject, the Ministry of the Environment developed and established the National Biodiversity Strategy in 2001. The environmental policy that Ecuador has designed and implemented in the last two decades has given preference to natural resource conservation and management programs because specialized governmental agencies, particu- larly the Ministry of the Environment, are dependent on the financial and technical support of the international community. In recent years, govern- mental efforts to formulate policy have been directed to preparing the Draft Biodiversity Law and the Draft Forest Development Law. To balance actions relating to poverty and environmental management with actions to preserve protected areas and biodiversity, a policy must be developed that revolves around two basic elements: environmental regulation and investment. Environmental regulation includes developing command and control standards, economic instruments, land management and soil use zoning, administrative procedures, and legal mechanisms. The priority for investment programs would be to strengthen the government's regulatory ability and to prevent disasters. Financing of investment in activities such as consolidating the system of protected areas, research on and protection of biodiversity, emissions control, climate change, and other global problems must be based on international support and assistance. the Galapagos and the Amazon, as well as for the conservation and management of coastal resources. The World Bank (through the PATRA project) granted a loan to the govern- ment in 1996 to support institutional strengthening and environmental management in the Amazon and in the coastal region. The Bank is also the executing agency for the "National System of Protected Areas in Ecuador" Project, financed by the GEE The prin- cipal objective of this project is to ensure the preservation of the country's biodiversity for sustainable development by strengthening the National System of Protected Areas. 404 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM D. Recommendations The increase in poverty among the Ecuadoran population associated with the grow- ing environmental deterioration requires active and effective state intervention, sup- ported by efficient environmental action by civil society and the private sector. The conditions causing poverty in Ecuador, as noted above, are rooted in the environ- mental problems of pollution and natural disasters. In this sense, the intervention priorities of environmental policy should be directed to coping with critical prob- lems. By way of conclusion, this section presents intervention priorities and recom- mends environmental regulation and intervention actions designed to deal with the critical problems that have been identified. In developing its environmental policy, the state can basically intervene in two ways-environmental regulation and environmental management and investment. Environmental regulation includes various tools, notably economic instruments, direct regulation, and administrative procedures. Environmental management and investment include the management of state assets on the one hand, and on the other, environmental investment in sectors that are facing the environmental condi- tions associated with poverty in Ecuador. As discussed earlier, Ecuador's poverty is directly related to critical environmental problems, particularly the problems of pollution, which are associated with morbid- ity and mortality among the population, and the effects of natural disasters. These problems must be given the highest priority and attention in the short and medium terms. The incorporation of environmental considerations in the private sector also merits special attention. Local investment in the preservation of natural resources is justified to the extent that such resources generate conditions for growth in economic sectors such as ecotourism in which Ecuador has clear competitive advantages. The allocation of scarce resources to environmental objectives not directly related to the eradication of poverty in Ecuador should be relegated to a secondary level. In this sense, investments in activities that aim to minimize the creation of global envi- ronmental problems should be financed exclusively through the use of international donations, nonreimbursable transfers, support, and assistance. Environmental Regulation The options for environmental regulation tools include command and control stan- dards, economic instruments, administrative procedures, reconciliation and arbitra- tion systems, and legal instruments. Among these options, the development and strengthening of command and control regulations merit special attention, particu- larly regulations on land management and land use zoning. The application, con- trol, and monitoring of these regulations is an urgent matter. Priority must be given to developing regulations to ensure land management planning in areas that are vul- nerable to natural disasters, particularly landslides, floods, or earthquakes. The basic variable for land management, particularly in the coastal provinces, is drainage. The THE ENVIRONMENT AND SUSTAINABLE DEVELOPMENT 405 definition of high water levels with periods of return beyond two years requires spe- cial emphasis. It is essential to establish resettlement programs for all settlements located on the floodplains. This resettlement should be voluntary, as involuntary resetdement are generally more costly and lead to conflict. Similarly, land manage- ment plans must ensure the relocation of settlements that are located in areas close to geological faults or areas subject to landslides. In December 2002, the national government issued Executive Decrees 3399 and 3516, with secondary environmental legislation. These Executive Decrees estab- lished the provisions for the Single Environmental Management System (SUMA), pollution rates, water and air quality control, hazardous waste management, and final disposal of solid wastes. The instrument par excellence among the administra- tive procedures is the Environmental Impact Assessment. Priority must be given to implementing the recent executive decrees that provide regulations for these envi- ronmental assessments. In the context of the SUMA, the Ministry of the Environ- ment, pursuant to the regulations issued, has the central role in certifying environ- mental impact assessments, licensing, supervision, and monitoring of the economy's various sectors. Among environmental regulation options, the new regulations develop the use of economic instruments, particularly the imposition of taxes for the use of natural resources or the degradation of the environment. These taxes are established as incentives for the placement of buildings, the efficient use of resources, and clean production. In addition, the use of economic instruments may become a source of significant tax revenues. It is advisable to take advantage of Quito's recent experience with the collection of taxes for water management and conservation programs and the establishment of funds to finance sanitation projects. The use of levies or taxes for the use or licensing of water is a mechanism that guarantees the resolution of conflicts over the use of water resources. Setting up and imposing these taxes is par- ticularly important in the country's Andean area and in the agricultural area of the coastal provinces. It is similarly advisable to apply pollution taxes on pathogenic, toxic, inflammable, reactive, corrosive, and radioactive products and wastes. With respect to legal instruments and arbitration and conciliation instruments, Executive Decrees 3399 and 3516 should be used to strengthen social control mech- anisms such as public hearings, the right to request and access public information, and public action. Strategic environmental assessment instruments are used internationally to define the priorities for sectoral or regional environmental regulations. It would be advisable to develop assessments of this type for the most important sectors of the Ecuadoran economy-hydrocarbons and energy, agriculture, potable water and san- itation, and transportation. The implementation of these sectoral environmental assessments could be consolidated as a regular policy for all basic sectors of the national economy. At the institutional level, it is essential to define mechanisms for coordinating actions to prevent disasters and minimize vulnerability to them. The Ministry of the 406 ECUADOR: AN ECONOMIC AND SOCIAI AGENDA IN THE NEW MILLENNIUM Environment and the MDIV could take a more active role in these measures. The supervision and monitoring of compliance with soil use regulations and building codes such as those that relate to earthquake tolerances should be given greater importance. In addition, based on the recommendation of Benavides and Solberg (2003), it would be advisable to establish incentives in public works design, con- struction, concession, operation, and/or maintenance contracts in order to ensure high quality and to incorporate technical environmental specifications that mini- mize the vulnerability of public infrastructure. Figure 3. Soil Use Conflicts , - vmr h1h ri~k - t d.Cndition l-prp id proplzr u..c ,iombired \ ; ' , , u,1j_jc)r md ,..,, - e Source: Henninger and Hammond (2002). THE ENVIRONMENT AND SUSTAINABLE DEVELOPMENT 407 Environmental Investment Strategic environmental assessment instruments are also used internationally to determine the priorities for environmental investment in different sectors. Develop- ing these analyses will make it possible to establish environmental investment prior- ities in sectors such as drinking water and sanitation, transportation, health, agri- culture, industry, urban development, and tourism. To ensure that the analyses use reliable information, investments must be made in setting up an environmental information system that includes environmental quality monitoring systems as well as soil use monitoring systems. The air quality monitoring systems in Quito should be completed and started up, as should air and water quality monitoring systems around the country's most important urban and industrial centers. Investment is urgently need in structural and nonstructural damage prevention measures in order to reduce rural vulnerability to natural disasters. Structural meas- ures include the resettlement of populations located on the floodplains, flood con- trol projects, the use of wetlands to alleviate rising waters, and erosion control and bank stabilization projects. Nonstructural measures include soil use zoning, design- ing programs to respond to and deal with emergencies, and equipping and prepar- ing citizens for such events. Action is needed in the short term to strengthen and consolidate the ability of the state and communities to reduce vulnerability. Pre- investment activities in the coastal provinces involve the measurement and model- ing of hydrometeorological and seismic phenomena and the design of structural and nonstructural methods in areas such as flood control. Investment in some sectors is given priority in dealing with environmental prob- lems that cause poverty in Ecuador. For example, the increased coverage and qual- ity of potable water services represent priorities for action in the short term. The situation is similar in the case of the management and final disposal of solid wastes in the country's principal urban centers, including Quito. In sectors such as man- ufacturing and health, there is an urgent need to promote clean production pro- grams that reduce the production of waste, particularly hazardous wastes that are pathogenic, toxic, or radioactive. Along these lines, efforts of this type that are being started up in the Clean Production Center must be given continuity and strengthened. It is also important in other sectors to promote environmental investments, par- ticularly those coming from the private sector. For example, environmental prac- tices, processes, and agricultural technologies can be improved in the agricultural sector, particularly through the promotion of organic farming, integrated manage- ment of soils and pests, and sustainable harvesting technologies for crops such as coffee and cacao. In the case of such crops, the export markets favor (with better prices) products certified as "biodiversity friendly," organic, and/or fair trade. In addition, the establishment of peasant and indigenous community management areas can be promoted in buffer areas for fragile ecosystems (such as the plateaus) in order to redirect the lines of settlement that are moving toward areas of high eco- 408 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM logical fragility. This is particularly applicable in all the plateau ecosystems in the Andean area and around the protected areas in the east. In the electrical energy sector, it is advisable to continue promoting unconven- tional sources for generating electricity and managing the final demand through increased energy efficiency as is being done through PROMEC. In the transporta- tion sector, it is advisable to extend the mass transit systems that are being used suc- cessfully in Quito to the major urban centers such as Cuenca and Guayaquil and to improve the quality of fuels. In addition, the sustainability of investments in rural roads should be supported through community participation in the maintenance of rural roads, extending the investment program being carried out in this area by the Ministry of Public Works. In the urban development sector, actions should be car- ried out to recover public space and promote nonmotorized transportation (using bike paths and pedestrian lanes) in urban centers such as Cuenca, Guayaquil, Cum- bayi, Esmeraldas, and Quito. The tourism sector can receive direct benefits from investments in the preserva- tion of natural resources and ecosystems. The areas where investment in tourism seems most favorable are the Amazon piedmont, the southeast Amazon, and the protected areas in the Andean area. Investment in ecotourism in the Galapagos could focus on ensuring that tourism in the archipelago targets specialized groups that maximize the generation of foreign exchange and the sustainability and conser- vation of the ecosystem. Interventions in nature tourism include stimulating tourism investment in protected areas, particularly in improving services and strengthening the participation of local populations in the provision of those serv- ices; identifying the tourism potential of protected areas and other scenic resources; and establishing systems for certifying sustainable tourism activities. Part III Building a Quality Government That Serves All Ecuadorans and Fights against Corruption 15 The Environment and Governance and Corruption1 Mitchell A. Seligson and Francesca Recanatini Ecuadors problems with poorgovernance and high corruption are legendary and lead to the deficient delivery of public services. In comparison with the rest of Latin America, most ofEcuadors recent indicators reflect deterioration, particuzrly in terms of the qual- ity of its regulations, participation, the rule of law, and the responsibility and effective- ness of government. Specifically, Ecuador rates as the country with the least control over corruption in Latin America. Corruption is a very serious problem in Ecuador, as clearly reported by most citizens, and it is particularly frequent in obtaining government con- tracts and receiving public services. The frequency of bribery varies from one service to the next, but occurs less frequently at the subnational level of government. Corruption exacerbates poverty and inequality, discourages tax collection, and reduces the resources available to society. An estimated one-third of available public funds are improperly divertedfor political reasons. A program of reforms must focus on the public sector and on civil service. In general terms, a multifaceted plan of reforms focusing on three pillars is needed: strengthening existing regulations and institutions in the fight against corrup- tion; promoting education for the population on its oversight rights regarding the work of government, with the development of mechanisms to monitor and control public spending; and improving governance in order to prevent the various forms of corruption, whether administrative or associated with specific areas such as governmentprocurement and contracting. Three measures are suggestedfor the short term: the creation of a Gov- ernance Pact between the state and civil society, civil service reform, and immediate transparency in the publication ofgovernmentprocurement bidding and contracts via the 1. Mitchell A. Seligson is the Daniel H. Wallace professor of Political Science at the Univer- sity of Pittsburgh and a World Bank consultant. Francesca Recanatini is an economist with the World Bank. 411 412 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Internet. Supplemental measures in the medium term would be modernizing budgetary information to provide access for citizens, the media, and Congress; regulatingfinances and contributions to political parties in political campaigns, strictly prohibiting the use of state funds for political campaigns; and strengthening the mechanisms for the admin- istration, control, and social auditing of sectional governments. Finally, a National Transparency Campaign, carried out at the provincial, municipal, and local levels, would be part of a new culture ofgovernance in the country. A. Governance im Ecuador from a Comparative International Perspective Although the growth of democracy in Latin America is a welcome trend ,the path followed has been neither smooth nor easy. Ecuador finds itself among the countries in the region for which democratization has been a particularly formidable chal- lenge. In recent years, Ecuador has faced political instability, with serious conse- quences for its economic and social development. However, the government assum- ing power in 2003 has numerous opportunities to make rapid progress. For various years, the World Bank Institute has gathered indicators to measure the quality of governance.2 The set of current international data is from the year 2000 and covers some 170 countries (see Figure 1).3 A key component of the indicators is "Government Effectiveness." This measures the quality of public service provided and of the bureaucracy; the fitness of public employees; the independence of public administration from political pressures; and, finally, the credibility of the government's commitment to policies (Kaufmann, Kraay, and Zoido-Lobat6n 1999a. Ecuador should be compared with other South American countries through analysis of the data seen in Figure 1. Within the con- text of Latin America, it is clear that the quality of governmental efficacy in Ecuador does not earn a good rating. In the international context, the country falls slightly below the 28th percentile, unlike Chile, which has a rating higher than 90. In effect, only two other countries in Latin America are in the "low" range in this regard: Venezuela and Paraguay. 2. The aggregate indicators constructed included data from 1997 and 1998. Assuming that institutional indicators do not change too much from year to year, these indicators pro- vide a good measure of the 1990s. However, these indicators may not capture a true insti- tutional improvement (or unfavorable evolution) in the same decade. Kaufmann, Kraay, and Zoido-Lobat6n (1999a and b). 3. The thin lines associated with each bar in Figure 1 represent the margin of error in the cal- culations for a confidence interval of 95 percent. For more data on measurement proce- dures, see Kaufmann, Kraay, and Zoido-Lobat6n (1999b). THE ENVIRONMENT AND GOvERNANCE AND CORRUPTION 413 Figure 1. Government Effectiveness (Latin America and the Caribbean Region, 2000-01) Chile l__ _ __ll _____ Costa Rica __1_T_,__ Uruguay l Belize Mexico 3 Argentina _ _l Panama r El Salvador Brazil Peru Colombia _ Bolivia _ - - Honduras Guatemala __ Nicaragua - Venezuela _ Ecuador _ _ Paraguay 0% 20% 40% 60% 80% 100% Country rating in percentile (0/100%) Source: Kaufmann, Kraay, and Zoido-Lobar6n, 1999. Why is governance so problematic in Ecuador? One reason is that the rule of law is very weak. Although its ranking is not as low as in the case of six other countries in the region, World Bank data indicate that Ecuador is in the lowest quartile in the world distribution of the rule of law. This can be seen in Figure 2. The impact of limitations on the rule of law is, in turn, manifested quite con- cretely in high levels of corruption. As can be seen in Figure 3, the World Bank Insti- tute's comparative data indicate that controlling corruption is a significant problem in Ecuador. In summary, Ecuador finds itself in a vicious circle of low government effectiveness and limited rule of law, both of which limit efforts to control corrup- tion. As we will see below, all this in turn leads to a decline in investment and eco- nomic growth. The fact that the trend of the indicators seen above has been negative is a cause for concern. As can be seen in Figure 4, which compares the measures of governance for 1997-98 with those for 2000-01, the significant challenges that Ecuador's eco- nomic and political system faced during the 1990s affected all measures of gover- 414 ECUADOR: AN ECONOMIC AND SocIAL AGENDA IN THE NEW MILLENNIUM Figgure 2. The Rule of Law (Latin America and the Caribbean Region, 2000-01) Chile Belize t Uruguay _ Costa Rica Argentina ]_ _ Panama _______ Brazil r _ Bolivia I____i_l Mexico Peru -- El Salvador Ecuador = Colombia Nicaragua ,_ l Venezuela Paraguay _ - Guaremala Honduras 0% 20% 40% 60% 80% 100% Country rating in percentile (0/100%) Source: Kaufmain, Kraay, and Zoido-Lobat6n, 1999. nance. In all cases, the most recent level is lower than the preceding one. It is possi- ble that some stability may have been created in 2002, but there are still no data to corroborate this. However, the presidential campaign seems to have shown that both party elites and the general public have generally rejected the politicians of the past-whom they blame, perhaps with good reason, for the political and economic crisis of the late 1990s. It would seem that Ecuadorans want to begin from scratch. IB. Corruption and [ts Imnpact As noted above, the problem of corruption is very serious in Ecuador. Good gover- nance is intimately associated with limitations on corruption. Corrupt undermine citizens' confidence in the political system. This section provides information that measures the cost of corruption and poor governance. According to a survey conducted by the World Bank Institute in 2000, Ecuado- ran households consider corruption to be a serious problem. When evaluating the THE ENVIRONMENT AND GOVERNANCE AND CORRUrl ION 415 Figure 3. Control of Corruption (Latin America and the Caribbean Region, 2000-01) Chile = Costa Rica Uruguay Belize l l Brazil Peru Mexico 5 'J T 7 El Salvador > -. _ -. Argentina EE5 Colombia s3 Panama P :- Venezuela . -.a . Honduras _ Guatemala Bolivia Nicaragua :i 0 Paraguay 3 1_ Ecuador 0% 20% 40% 60% 80% 100% Country rating in percentile (0/100%) Source: Kaufmanni, Kraay, and Zoido-Lobar6n, 1999. seriousness of the country's problems, approximately 70 percent of those surveyed gave "corruption in the public sector" the worst rating possible. Companies also consider corruption to be the greatest obstacle to business development (see Figure 5). When rating the seriousness of a series of obstacles to business development, more than 50 percent of the companies surveyed gave the worst possible rating to corruption (as well as to the high cost of unofficial payments, inflation, crime, rob- bery, and unstable policies). The Cost of Corruption The increasing amount of data from empirical research emphasizes that poor gover- nance and corruption reduce the standard of living and make the distribution of wealth among citizens more uneven. The channels through which corruption affects development are its prejudicial effects on the poor, negative impact on investment and growth, and negative effect on quality in and access to public services such as health and education. In this way, corruption hits companies and households hard. 416 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Figure 4. Changes 1997-98 and 2000-01 Accountability Political stability/Lack of violence Governance Regulatory quality _ _ Rule of law Control of corruption 0% 20% 40% 0% 80% 100% Comparison with 97/98 Country rating in percentile (0/100%) Source: Kaufmann, Kraay, and Zoido-Lobat6n, 1999. The data indicate that corruption perpetuates poverty, given that it acts as a regressive tax (see Figure 6). Households indicate that they allocate an average of 2 to 3 percent of their incomes to paying bribes in order to obtain access to public services. In the case of low-income households, the burden of corruption is heav- ier. On average, they spend up to 4 percent of their annual income on bribes, whereas the richest households spend less than 1.5 percent. However, Ecuador is not the only country that faces this problem. Data from surveys conducted in var- ious countries suggest a similar scenario: corruption punishes the poorest and thus most vulnerable groups excessively, given that it acts as a regressive tax on users of public services. There are other mechanisms through which corruption affects the well-being of poor citizens. Corruption contributes to discrimination in terms of access to public services. The survey indicates that the cost of corruption, in addition to the cost of illegal payments, is that numerous users stop asking for a service because they are unable to pay bribes. However, individual citizens are not the only ones who are penalized by defi- ciencies in governance: companies also pay a high cost because of corruption. The data indicate that companies spend more in bribes and bureaucratic red tape than on security. Companies indicate that unofficial payments to public servants repre- sent an average of 8 percent of their gross incomes. In contrast, companies indicate that they spend "only" 5 percent on bureaucratic red tape and 4 percent on security. Figure 5. Opinion of Companies on Obstacles to the Development of Their Business X z 0 10 20 30 40 50 60 Public sector corruption U Cost of corruption/bribes I Inflation > Crime, theft- Unstable policies I 0 Bureaucracy Uncertainty due tO corruption _ii Legal uncertainty > m_ Bu reaucratic discretionality m Financing _ _ _ Monopolies _ Wl Taxes m i m Poor infrastructure Regulatory uncertainty_ Tax regulations Tax laws and codes _ I Regulatory costs Exchange rate regulations Trade regulations Technological problems Rules for new businesses I l _ Source: World Bank Institute, 2001. N 418 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Figure 6. Corruption as a Regressive Tax on Users 12% 2 0 8% Q) 0%* Peru Ecuador Romania I D Low 0 Medium High Souirce: World Bank Institute, 2000, 2001. Small companies must spend more on bribes in terms of their monthly income than large companies. Microenterprises (with fewer than 10 employees) pay an average of 8 percent of their monthly income, while large companies (with more than 100 employees) pay less than 2 percent. Nearly all companies (97 percent) that work with the public sector indicate that they must pay bribes to obtain purchase contracts. To bid successfully, they must pay an average of 15 percent of the total value of the contract. The data indicate that corruption discourages private (particularly foreign) investment. Companies were asked whether they had ever decided not to make an investment they had already planned. The data show that companies for which the burden of bribes is highest are those that decide not to invest. In this sense, bribery frightens away investment. In particular, when the difference between local and for- eign companies is analyzed, we see that foreign companies that decided not to invest in Ecuador are also those most affected by corruption. The consequences of this are particularly negative. Corruption is widespread in public services, but some are more corrupt than oth- ers. For both households and companies, the likelihood of having to pay a bribe varies depending on the service. The data from the World Bank survey show that, of the services studied, those for which households will most likely have to pay bribes are public registry, running water, electricity, public hospitals, and public edu- cation. In the case of companies, the public services for which they will most likely THE ENVIRONMENT AND GOVERNANCE AND CORRUTrION 419 have to pay bribes are customs, automobile registration, tax inspections, the traffic police, and the technical vehicle inspection agencies.4 The amount of the bribe varies considerably depending on the service. On aver- age, households tend to pay relatively higher bribes to the traffic police, customs, the license department, and the national police. Each time they received a service from these institutions, they paid more than $US4. (Table 1). The average amount of bribes in public schools is $US 11. Companies, on the other hand, usually pay rela- tively higher bribes to customs, for tax inspections, for import/export permits, and for construction permits. On each occasion, they paid more than $US40 (Table 2). It is possible to analyze what service receives the major part of the "booty" if the frequency and amount of the bribes are taken into account. More than 80 percent of the bribes paid by households are for the traffic police, the telephone company, running water, public registry, customs, and the electrical company.5 More than 80 percent of the bribes paid by companies are for customs, construction permits, tax inspections, the traffic police, and the national police. This means that the burden of bribes can be considerably reduced if efforts to combat corruption focus on these services from the outset. The data from the survey conducted by the World Bank Institute in the year 2000 indicate that corruption reduces public resources considerably owing to uncol- lected taxes and tariffs and misappropriated public funds. On the other hand, both companies and households are willing to contribute money to eliminate corruption. More than 85 percent of the companies surveyed indicate that they would be will- ing to pay an additional share of their income if this would eliminate corruption. On average, they agreed to pay an additional amount equal to 9 percent of their income. Nearly 70 percent: of households stated that they would be willing to pay an additional share of their income if this would eliminate corruption. They indi- cated that they would agree to pay an average additional amount equal to 12 per- cent of their income. Corruption reduces the resources available to public institutions owing to the diversion of funds for political reasons. More than one-fourth of those who work in PetroEcuador (the national petroleum company) and in the National Land Traffic and Transportation Council indicate that public funds are misspent in these institu- tions. They estimated that between 40 and 50 percent of the funds available are diverted for political reasons. Overall, about 6 percent of public employees inter- viewed indicated that public funds are misspent in their institutions. They estimated that one-third of the available funds are diverted for political reasons. 4. In calculating the probability of paying bribes, the difference in the number of contacts with each public service is taken into account. For example, it is much more likely that a household will deal with a public hospital than with customs. 5. The expected amount of the bribe for each public service is calculated based on the fre- quency of contact, the frequency of the payment of bribes, and the amount. 420 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Table 1. Frequency and Amount of Bribes (According to Citizens) Frequency of Amount of payment of bribe paid in bribes each contact, contingent on Probability contingent contact Percentage of ofpaying on payment (percentage households a bribe (as of the bribe that reports with some Public services a percentage) (in $US) bribe) contact Public registry (identity document, passport) 10.5 2.72 11 (25) 42.4 Installation of running water 7.8 2.42 6 (14) 54.1 Electrical company 6.6 1.90 5 (12) 100.0 Public hospitals 5.1 2.32 11(19) 99.7 Public educational institutions 4.9 1.74 5 (15) 32.6 National police 4.7 4.37 18 (39) 12.5 Telephone company 4.2 3.72 3 (12) 99.5 Traffic police 3.0 11.50 26 (36) 8.3 Customs 2.4 5.14 30 (50) 4.7 Tax collection offices 2.0 2.31 5 (10) 19.6 Department of drivers' licenses, permits, and so on 1.9 4.48 8 (19) 9.6 Trash collection 1.2 1.03 2 (5) 99.3 Offices that grant construction permits 0.7 3.68 6 (17) 3.9 Post offices 0.3 0.34 2 (4) 99.8 Social Securiry 0.3 2.87 1 (4) 99.5 Source: World Bank Institute survey conducted in 2000. The data also reveal the close relationship between bribes and poor service qual- ity. Poor service quality (according to the users' evaluation) is associated with the highest bribes (according to households and companies). The usual argument is that bribes help to speed up the delivery of public services or even increase the quality of the services provided. The data from Ecuador prove that, on average, the higher number of bribes does not result in better quality service provision. The opposite is very much the case: poor service quality and bribery go hand in hand. Households rate customs, the traffic police, the national police, and public registry as being extremely deficient in terms of both service quality and bribes. Similarly, companies give poor ratings to the traffic police, the national police, running water installation, border crossings, and construction authorities both in terms of service quality and corruption. In contrast, they gave good grades to fire inspection, property registry, and company registry. THE ENVIRONMENT AND GOVERNANCE AND CORRUPTION 421 Table 2. Frequency and Amount of Bribes (According to Companies) Frequency of Amount of payment of bribe paid in bribes eacb contact, contingent on Probability contingent contact Percentage of ofpaying on payment (percentage households a bribe (as of the bribe that reports with some Public services a percentage) (in $US) bribe) contact Customs crossing 11.3 83.06 19 (44) 34.3 Automobile registration 11.3 31.69 24 (42) 30.8 Tax inspections 10.0 66.08 16 (36) 42.2 Traffic police 6.1 22.88 46 (61) 11.3 Technical vehicle inspection 5.8 13.95 19 (35) 18.9 Registry of companies 4.8 29.90 8 (22) 26.4 Import/export permits 3.9 58.61 11(31) 15.9 National police 3.9 24.74 33 (55) 8.6 Construction permits 3.7 49.67 22 (52) 9.2 Installation of electricity 3.7 14.91 18 (33) 12.3 Installation of running water 3.6 18.57 20 (45) 11.9 Health inspections 3.1 26.11 16 (31) 16.9 Property registry 2.8 31.99 6 (16) 17.8 Construction licenses 1.2 32.81 12 (27) 4.9 Fire inspections 1.0 17.89 11(21) 7.7 Public credit 0.9 9.11 8 (35) 3.9 Source: World Bank Institute survey conducted in 2000. It is no surprise that Ecuadorans perceive public corruption to be widespread. Tak- ing the country as a whole as the basis, three-quarters of the population believe that corruption is very common or somewhat common (see Figure 7). The answer to this question varies considerably depending on the region. As perception moves on a scale from 0 to 100, we see that in Quito, the seat of the national government, the per- ception is significantly higher than in other areas of the country (see Figure 8). By way of comparison, Ecuador's indicator is higher than that of any other coun- try for which there are directly comparable data, with the exception of Paraguay. This means that national perception of the magnitude of corruption is higher in Ecuador than in the other Latin American countries, except for Paraguay. In the survey, Ecuadorans had to rate a large variety of institutions based on a scale ranging from extremely corrupt (rating: 1) to extremely honest (rating: 10). Figure 9 shows the results. Although it may not be surprising, it is disturbing that members of Congress, ministers, and party leaders receive the lowest ratings. Nonetheless, it is to be noted that mayors obtain a considerably better grade. These findings have direct effects on any effort carried out in the fight against corruption. 422 EcuADOR: AN ECONON11C AND SOCIAL AGENDA IN THE NEW MILLENNIUM Figure 7. How Common Is Payment of Bribes to Public Employees? Rare Don't know 4.8% - - 2.7% Infrequent 17.5% o Somewhat Verycommon Somewhatr _ 509 common. 24. i%/i' Source: Seligson, 2001. Figure 8. How Common Is Corruption? (by region) 86.0 o 84.0 2 82.0 = 80.0 C ' 78.0 76.0___§ 74.0 73 7 72.0 70.0 - 715 Quito Guayaquil Large Medium Small Rural cities cities cities areas Source: Seligson, 2001. THE ENVIRONMENT AND GOVERNANCE AND CORRUPTION 423 Figure 9. Perception of Honesty 10.0 9.0 8.0 7.0 6.0 _ 6.4 4.0 3.0 2.0 L Source. Seligson, 2001. Focusing the analysis directly on the level of corruption as such, rather than on perceived corruption, the surveyors asked the respondents about their experiences with corruption in the 12 months prior to the interview (see Figure 10). The survey covered a wide range of situations, including direct and personal experience and indirect experience, that is, seeing or hearing about corrupt acts. The most com- monly experienced corrupt act is seeing a policeman ask for a bribe. More than one- third had this experience in the 12 months prior to the survey. Having seen a bribe paid to a civil servant ranks second. Sadly, the level is also high for some type of improper payment in the country's public education system: Nearly half of all those surveyed had a child in school in the year prior to the survey and 41.1 percent of these had experienced bribery. As seen in the figure, excluding those who had no children in school, 19 percent of Ecuadorans encountered corruption in this set- ting.6 According to the survey, the fourth most frequent form of corruption occurs in hospitals or health clinics. Of those surveyed, 17 percent had an experience with 6. However, this figure should be interpreted carefuilly. As indicated above, the question asked about "payments exceeding those required by law." Schools may ask parents for 424 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Figure 10. Forms of Corruption LDoes not apply E]No Pyes 25% 0% 'c, .e 04 %,OP 0" d%/. 'q, ~ CQ Ae6c /0r Source: Seligson, 2001. bribery in these settings. Once again, not everyone used the health services. In effect, only 45 percent of those surveyed used the health services in the year before the sur- vey, but 35 percent of these had to make some kind of improper payment. The remaining types of corruption are shown in the figure. How do these levels of experience with corruption compare with those in other countries? The results of the World Bank indicators on controlling corruption noted at the beginning of this report put Ecuador almost at the end of the list for Latin America. Figure I1 shows survey results on experience with corruption, and we see that they are broadly consistent with the World Bank's results. money to pay for books or other educational materials and actually use the money for that purpose. Thus, although these payments may not be required by law, they are not neces- sarily a clear case of corruption either. THE ENVIRONMENT AND GOVERNANCE AND CORRUPTION 425 Figure 11. Experience with Corruption 50% - 40% ] 42 30% 20%~~~~~~~~~~~2 2~~~~~~~~~~~~~2 10% - 4 '1i 0%6 Accused by Police asked Witnessed Witnessed Public police for bribe police bribed public employee employee asked bribed for bribe = El Salvador 1999 U Nicaragua 1998 M Bolivia 1998 * Honduras 2001 JParaguay 1998 M Ecuador 2001 Source: Seligson, 2001. A general index of victimization by corruption has been created by recording direct and personal experiences with corruption, setting aside observed or second- hand accounts. The index includes bribes paid to the police, to public and munici- pal employees, bribes at work, in the courts, in the public health services, in the schools, and bribes paid to obtain electrical service. The results show that 50 percent of Ecuadorans have had at least one experience of corruption in the 12 months pre- ceding the survey. In addition, we see that one out of every four Ecuadorans has been the victim of a corrupt act, and that 25 percent have been the victim of more than one. In other words, on average Ecuadorans experienced about one act of cor- ruption in the year prior to the survey. Perhaps the most important reason for studying corruption is its potential influ- ence on long-term democratic stability. Recent studies conducted in various Latin American countries have shown empirically that citizens who have been victims of 426 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM corruption support their political systems less than those who have not (Seligson 2001, 2002). These findings come from studies conducted in Bolivia, El Salvador, Honduras, Nicaragua, and Paraguay. When the measure of support for the system (presented earlier in this work) is used as the dependent variable, the impact of cor- ruption is very clear, as can be seen in Figure 12. The national survey showed that citizens who had not been the victim of corrupt acts during the preceding year were above average in support for the system, but the higher the number of corrupt acts experienced by the person surveyed, the more his or her support for the system was reduced.7 The results do not vary when controls for gender, age, education, income, marital status, and city size are introduced. In addition, the effects of political par- ties were analyzed to check whether official party voters were less likely to report being victimized by corruption. No such effect was found. Corruption in Ecuador is clearly a matter of importance, as in other countries in the region. Figure 12. The Impact of Being Victimized by Corruption (on support for the system) 42 40 U 38 36 34 Q 32 30 .00 1.00 2.00 3.00 4.00 5.00 & 1 Total number of corrupt acts Source: Seligsoni, 2001. 7. The slight increase at the highest levels is statistically insignificant but could reflect the political power of the countrys wealthiest groups and their ability to avoid the usual forms of bribery. THE ENVIRONMENT AND GOVIERNANCE AND CORRUPTION 427 C. Local Government and Decentralization During most of its history, Ecuador has been a highly centralized country. Local gov- ernments have been, and continue to be, highly dependent on transfers from the national government because of their limited ability to generate their own revenues. In recent years, the government decided to increase decentralization. As the National Modernization Council (CONAM) has declared, the Political Constitu- tion of the Republic of Ecuador provides that public administration be organized and developed in a decentralized way, and that the central government will gradu- ally transfer its functions, powers, jurisdiction, responsibilities, and resources to independent organizations or other regional organizations. The data from the University of Pittsburgh/Cedatos-Gallup survey show what citizens consider to be the most serious problems of municipal governments at pres- ent. The results shown in Table 3 reveal some variation between regions. Road main- tenance is an important problem throughout the country, but it seems much more serious in the rural highlands region. In contrast, problems relating to security and crime are common in urban areas but not in rural areas. We also see that deficient municipal administration is mentioned more frequently by citizens in the urban highlands area. In no region of the country are local corruption, the environment, or taxes considered important municipal problems. This does not mean that Ecuadorans are unconcerned about these problems (in the national context, for example, corruption is mentioned frequently), but rather that those surveyed do not consider these problems to be the most serious in the context of local government. Problems require solutions. To what extent are Ecuadorans satisfied with the solutions provided by their local governments? Figure 13 shows the results of this question for the entire country. Figure 14 shows the regional variation within Ecuador. We note that satisfaction is much higher in Guayaquil than in other regions of the country. Participation is the essence of democracy, and nearly all programs that seek to strengthen local governments include citizen participation as a key mechanism for achieving their objective. As shown in Figure 15, Ecuador is at the very bottom of the list of Latin American countries in this regard. Within Ecuador, urbanization and geographic location affect participation in municipal meetings. The results reveal a notable variation: participation is three times as high in small cities and rural areas than in Quito. Ecuadorans recognize different levels of government, including local and national. Do they look at all levels the same way, as "just government"? It is clear they do not. Those surveyed were asked what level of government they considered more effective in resolving local problems. The question was, "In your opinion, which has provided the best response to help resolve problems in your community or neighborhood-the national government, Congress, or the municipality?" Figure 16 shows the results. Citizens responded overwhelmingly that the municipal gov- ernment did best at resolving local problems. 428 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Table 3. The Most Serious Problem Faced by the Municipality (by Region) STRATUM Region Urban Rural Urban Rural North- South- coast coast highlands highlands east east Total In your opinion, what is the problem in your municipality? Lack of water 10.5% 14.9% 7.2% 17.8% 11.9% 10.6% 10.8% Road maintenance 14.0% 13.7% 13.1% 20.2% 7.1% 10.6% 14.3% Lack of security, crime 12.0% 8.1% 20.8% 5.5% 4.8% 2.1% 13.4% Cleaning of public spaces 7.1% 2.0% 2.1% .3% 2.1% 3.8% Lack of services 12.5% 14.1% 7.4% 14.7% 11.9% 10.6% 11.2% The economic situation 11.2% 8.1% 8.6% 11.7% 19.0% 23.4% 10.5% Lack of funds 8.0% 18.1% 8.9% 9.8% 16.7% 19.1% 9.9% Poor administration 11.3% 12.1% 21.1% 13.5% 14.3% 12.8% 15.0% Corruption 1.4% 1.6% 2.4% 1.8% 2.4% 4.3% 1.9% Lack of machinery and equipment 1.8% .6% 2.8% 2.4% 1.3% High taxes .0% .4% .3% 2.4% .2% Abuse of mayor's power .7% .7% .5% Others .4% .1% .3% .2% Total 1.7% .8% 2.4% .9% 2.4% 2.1% 1.8% Total 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% Source: University of Pittsburgh/Cedatos-Gallup. Figure 13. Evaluation of Municipal Services Very bad Don't know Bad 8% 140 Very good 6% Neither Good good - -- 28% nor bad -^ 40% . , Source: University of Pittsburgh/Cedatos-Gallup. THE ENVIRONMENT AND GOVERNANCE AND CORRUPTION 429 Figure 14. Satisfaction with Municipal Services and Locality 70 - x60 0 * 50 v40 _11 g1 l l|1|5 3.0 2- .0 1.0 - _ _ __ _ _1 Community Electoral Street Over- Invading Takeover meetings campaigns protests throwing property of government buildings Source: Seligson, 2001. THE ENVIRONMENT AND GOVERNANCE AND CORRUPTION 443 Figure A5. Professional Participation and Fear of Crime 9.0 8.5 = 8.0 .u 7.5 a 7.0 6.5 6.0 5.5 Very safe More or less Somewhat Very unsafe safe unsafe Level of fear Source: Seligson, 2001. Figure A6. Participation in a Parents' Committee and Support for the System 44 E 43 42- \ 2 41 Q. eo 40 39- 38 Weekly Monthly Yearly Never Source: Seligson, 2001. 16 The Labor Market and Civil Service in Ecuador' Jeffrey Rinne and Carolina Sdnchez-Pdramo Ecuador's dollarization carries with it a complete transformation of the role of labor markets-in that external and internal competitiveness no longer depend on devaluations. This has madeflexibility and labor productivity central elements in economic growth. In addition, an efficient civil service is key to combating cor- ruption and gaining noticeable improvements in the delivery ofpublic services. Labor indicators show a partial recoveryfrom the impact of the crisis at the end of the last century. Formal employmentfell until 2000, and later showed a tepid recovery to levels close to those of 1998. This partial recovery conceals deeper shocks such as high migration, with half a million Ecuadorans moving out of the coun- try; continued migration from the country to the cities; and the fact that the rate of underemployment remains three times as high as the 1998 level, reflecting a growing number of workers who work ftwer than 40 hours per week (visible underemployment) or are paid less than their stipulated salary (invisible under- employment). The evolution of real incomes and salaries has followed a similar trend. Although the Economic Transformation Law simplified private sector salary pol- icy and introduced new and moreflexible hiring methods through hourly and tem- porary contracts, the system still contains excessive rigidities in its sectoral tables, the adjustments to which bear no relationship at all to productivity. The mechanism for indexing to projected inflation, which is logically desirable in the case of rapidly falling inflation, becomes a serious obstacle to competitiveness once inflation stabi- lizes close to international levels. In addition, the proliferation of temporary 1. Jeffrey Rinne is civil service specialist and Carolina Sinchez-Paramo is a labor markets spe- cialist at the World Bank. 445 446 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM employment agencies means that they are not adequately monitored- the labor rela- tionship deteriorates, and it is difficult to ensure compliance with minimum labor requirements when the task falls on the firms doing the hiring. Civil service also shows serious deficiencies: the proliferation of salary benefits and hiring methods makes it impossible to assess the exact number of workers andpayrolls, significantly multiplies the cost of "base" salary increases granted by the government, and does not allow for control of the government payroll. Given that one of the central objectives of the government is to promote job cre- ation, particularly in the formal sector, special attention must be given to salary levels and the degree of labor flexibility. In the private sector, it is suggested that future salary increases be consistent with increases in labor productivity; that the current negotiation process be simplified by abandoning salary reviews based on projected inflation; that the requirement of increases decreed based on "sectoral tables" be eliminated; that a single minimum reference salary be established; that collective agreements as a mechanism for salary negotiation, rather than govern- mental dictates, be strengthened; that the use of temporary employment agencies be regulated and limited; and that the rule requiring that 15 percent of profits be redistributed to the workers be eliminated. In civil service, the basic objective of the government should be to continue streamlining the public sector; to approve an improved draft law on salary unifica- tion; to maintain incentives based on geographic location for physicians and teach- ers so that minimum health and education services are guaranteed in remote areas; to combine salary unification with a process to restructure public employment, reducing staffing levels as much as possible; and to strengthen the system for control- ling public contracting through a centralized registry within the Integrated Finan- cial Management System (SIGEF) of the Ministry of Economy and Finance (and ensuring that this system is set up in the near future). A. Xntroduction The 1998 crisis and dollarization in 2000 have had profound and lasting repercussions for Ecuador's economy. Since dollarization, the country has been operating in an environment in which external and internal competi- tiveness can no longer be achieved through devaluations. In this context, labor flexibility and labor productivity have become key elements for maintaining economic growth. This chapter examines how labor markets in general and civil service employment in particular have been affected by these changes, and identifies what challenges are on the horizon in both areas. Given that the problems of each environment are different and thus the policy recommenda- tions are different as well, we have decided to discuss each segment in a dif- ferent section. THE LABOR MARKET AND CIVIL SERVICE IN ECUADOR 447 B. The Labor Market in Ecuador2 Employment and Unemployment Macroeconomic developments in Ecuador, specifically the 1998 crisis and dollariza- tion in 2000, have had profound repercussions for the labor market. The activity rate rose slightly in 1999, fell in 2000 in response to the economic crisis, and rose again in 2001 when it reached its highest level in the last four years. These changes applied to both men and women. The employment and unemployment rates fol- lowed a similar cyclical pattern. Employment fell and unemployment rose as a result of the crisis. Then the employment rate recovered in 2000 and suffered a small decline in 2001, while the unemployment rate fell and then rose to 11 percent, a figure similar to that for 1998 (Table 1). Although according to this general trend the labor market situation in 2001 was slightly better than in 1998, suggesting that the negative effects of the crisis and dol- larization may have only been temporary, other changes emerged during the same period that call that optimistic view into question. First, a large number of working- age Ecuadorans emigrated from the country and in this way relieved the pressure on the labor market. A clear reflection of this is that unemployment is below the national urban average in Cuenca and other cities that have had high outmigration rates. Second, the rate of underemployment rose noticeably in 1999 and, while falling somewhat in 2001, it remained at a level three times as high as that of 1998. This increase indicates that a growing number of workers are involuntarily working fewer Table 1. Active Work Force, Employment and Unemployment in Urban Areas, 1998-2001 Active labor force Employment Unemployment AlU Women rate 1998 58.4 46.1 88.5 11.5 1999 60.0 47.8 85.6 14.4 2000 57.3 45.0 91.0 9.0 2001 63.1 52.5 89.1 10.9 Source: Survey of Employment, Unemployment, and Underemployment (INEC). 2. All figures on activity, employment, and unemployment discussed in this section are based on the Survey on Employment, Unemployment, and Underemployment (INEC). Inde- pendent experts and other users in Ecuador have expressed concern regarding the survey's sampling method and the comparability of its data over time. It would be useful to recal- culate some of the data on the basis of the Central Bank of Ecuador's (BCE's) employment survey. 448 ECUADOR: AN ECONOMIC AND SOcIAL AGENDA IN THE NEW MILLENNIUM than 40 hours per week (visible underemployment) or, while still working 40 hours or more, are receiving less than the stipulated salary (invisible underemployment). Further, there was an increase in informal employment that coincided with the cri- sis and this did not later reverse itself (Table 2). These changes generally suggest that to a large extent the recovery of the rate of employment described above was somewhat precarious. In fact, although total employment rose 17 percent between 1998 and 2001, formal employment rose only 11 percent while informal employment rose 24 percent (Table 3). It is striking that most of this growth was concentrated in the manufacturing (or marketable) sector and in construction, where employment grew more than 25 percent compared to 11 percent in the service (or nonmarketable) sector. Table 2. Underemployment and Informal Employment in Urban Areas, 1998-2001 (as percentages of employed people) Rate of Vsuible Invisible Informal underemplonment undremployment underemployment employment 1998 5.5 2.5 3.0 42.2 1999 21.9 7.5 14.4 45.0 2000 22.1 6.4 15.7 44.4 2001 17.7 7.1 10.6 45.0 Notes: Rate of underemployment: percentage of employed persons who involuntarily work fewer than 40 hours per week-that is, the legal work week-(visible underemployment) or who work 40 hours or more per week but receive wages below the legal minimum (invisible underemployment). Informal employment: percentage of the work force classified as employers, independent workers, unsalaried workers, and salaried employees in companies with five employees or fewer, with the exception of those who engage in professional, intellectual, or scientific activities. Source: Survey of Employment, Unemployment, and Underemployment (INEC). Table 3. Growth of Urban Employment by Sector, 1998-2001 (percentage changes) Al sectors Manufacturing Constrction Services Total 16.6 31.9 26.4 11.0 Formal 11.6 28.4 12.1 5.8 Informal 24.1 35.0 38.6 19.7 Source: Survey of Employment, Unemployment, and Underemployment (INEC). THE LABOR MARKEr AND CIVIL SERVICE IN ECUADOR 449 Labor Income and Salaries The crisis and dollarization also had a profound effect on compensation in the work force in terms of both labor income and salaries. According to the most up-to-date data available, real labor income and salaries fell significantly (35 percent) as a result of the crisis, recovered in 2000 thanks in large part to the price stabilization achieved through dollarization, and fell slightly in 2001 because of inflation. The result of all these changes was a 20 percent increase in real labor income during the period 1998-2001 (Table 4). However, these changes must be viewed with caution because the period between 1998 and 2001 in Ecuador was one of significant macroeconomic unrest, and these trends are the result of simultaneous changes in labor income and nominal salaries and changes in prices and the sucre-to-dollar exchange rate. In particular, alternative assumptions regarding the evolution of prices between 1998 and 2001 can create entirely different scenarios. 'The technical annex that appears at the end of this chap- ter discusses this subject in detail and presents alternative calculations for real labor income and salaries based on a different price deflator.3 It is striking that real labor income increased markedly more in the informal than in the formal sector, although the informal sector continued to pay less than the for- Table 4. Real Monthly Labor Income in Urban Areas, 1998-2001 (at constant 1998 $US values) Total Formal Informal 1998 146.5 209.4 103.6 1999 96.0 138.6 70.6 2000 186.0 258.5 143.6 2001 177.2 240.2 135.9 Notes: Labor income includes salaried income and the income of independent workers (INEC). The calculations for 1998 and 1999 use the sucre/dollar exchange rate provided by BCE: 6,780 and 20,100, respectively. Source: Calculations by the authors using BCE data. 3. Ecuador has just returned to calculating its National Accounts for the period 1993-2002 in dollar terms with technical assistance from the IME Thus, the data that appear in this chapter use the deflator created for this review, while the data presented in the annex uses the deflator published by BCE in October 2002. Given that the data in each of the series yield very different panoramas, we feel it is necessary to continue the discussion on the development of these price indexes. This is particularly important not only for the descrip- tion of real salaries and their evolution but also for the poverty calculations. 450 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM mal sector. Real monthly labor income in urban areas increased by 30 percent in the informal sector compared to some 14 percent in the formal sector (Table 5). Appar- ently, the rounding up of prices was more common and widespread in the informal sector than in the formal sector after dollarization. This, added to the fact that self- employment occurs more frequently in the informal sector, could explain the dif- ference. This is confirmed by looking at changes in real earnings according to the employ- ment situation. Although there is no information for the year 1998 and we thus cannot calculate the decline in real earnings associated with the crisis for the various groups, it is possible to see up to what point real income increased between 1999 Table 5. Monthly Labor Income in Urban Areas According to Employment Situation, 1998-2001 (in constant 1998 $US values) Total employees Salaried Salaried Independent employees in the employees in the Employers workers public sector private sector Others 1998 - - - - - 1999 241.4 72.2 134.9 93.5 30.2 2000 583.6 172.3 251.0 176.9 59.0 2001 487.0 153.3 244.6 173.9 69.6 Formal sector Salaried Salaried Independent employees in the employees in the Employers workers public sector private sector Others 1998 - - - - 1999 405.3 198.3 134.9 115.3 2000 774.1 391.6 251.0 220.7 2001 728.3 275.0 244.6 205.4 Informal sector Salaried Salaried Independent employees in the employees in the Employers workers public sector private sector Others 1998 - 1999 170.0 71.0 55.7 2000 455.1 167.8 99.8 2001 337.0 147.8 122.8 -. No data available. Note: The calculations for 1998 and 1999 use the sucre/dollar exchange rate provided by BCE: 6,780 and 20,100, respectively. Source: Calculations by authors using BCE data. THE LABOR MARKET AND CML SERVICE IN ECUADOR 451 and 2001. On average, real labor income more than doubled for employers and self- employed workers, while it rose 80 percent for salaried workers in both the public and private sectors. However, this average conceals significant differences between the formal and informal sectors. Employers and self-employed workers in the formal sector enjoyed an increase of their real incomes of 79 and 40 percent respectively, compared to 98 and 100 percent in the informal sector. Similarly, salaried private- sector workers in the formal sector enjoyed an increase in their real salaries of 78 per- cent compared to 120 percent in the informal sector. The real minimum salary increased 62 percent between 1998 and 2001: first it fell to half its value between 1998 and 1999 and then increased 200 percent between 1999 and 2001 (Table 6). This means that although the real minimum salary actu- ally increased more than real labor income or than real salaries, it was also more volatile (that is, it fell more drastically after the crisis and recovered more between 2000 and 2001). This could affect the changes seen in poverty during this period, in that the minimum salary generally covers those workers who find themselves at the bottom of the salary distribution. In summary, Ecuador's labor market was characterized by a tenuous creation of employment in the formal sector as a result of a notable deterioration in most of the indicators during the 1998 crisis, followed by a very timid recovery after 1999. This is particularly disturbing given that emigration increased noticeably after 1998 (approximately 200,000 people have emigrated during the last 3 years, dou- bling the number of Ecuadorans who live and work outside the country). This probably relieved the pressure on the labor market. In fact, calculations submitted by the SIISE indicate that the rate of unemployment might be between 0.5 and 2 percentage points higher than the current rate if all these people had not emigrated (SIISE. 2002). Table 6. Labor Income, Average and Minimum Salary in the Private Sector in Urban Areas, 1998-2001 Minimum salary and basic Labor income Average salary sutppkments Nominal Real Nominal Real Nominal Real ($) ($1998) ($) ($1998) ($) ($1998) 1998 146.5 146.5 - - 84.5 84.5 1999 68.9 96.0 67.1 93.5 29.7 41.4 2000 123.0 186.0 117.0 176.9 91.9 138.9 2001 163.0 177.2 160.0 173.9 125.3 136.2 -. No data available. Note: The calculations for 1998 and 1999 use the sucre/dollar exchange rate provided by BCE: 6,780 and 20,100, respectively. Source: Calculations by authors using BCE data. 452 EcUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM The data on real earnings are more confusing in that they depend on assump- tions regarding inflation. If we do the calculations according to the latest revision submitted by BCE we see that real labor income increased an average of 20 percent during the period. The increases were higher than average for the informal sector and among employers and independent workers, and lower than average for the for- mal sector and for salaried workers. Generally we can see deficient performance in terms of employment and a sig- nificant recovery in terms of real earnings during the 1998 crisis, with potential effects on competitiveness to the point that true changes in the productivity of the labor force would not be reflected. We will discuss these questions as well as the pol- icy recommendations below. We will discuss employment and salaries first in the private sector and then in the civil service sector. C. Probtlems in the lPrivate Market In this context of limited creation of employment in the formal sector and positive growth in real earnings, two aspects stand out that merit greater attention. First, salary negotiation is a complex process for Ecuador, both because it involves many agents who negotiate at different levels and times and because, until recently, salaries represented only a part, and sometimes a very small part, of what workers received, the rest consisting of supplements and allowances. Second, formal employment has over the last 10 years been subject to what is commonly called "outsourcing" or the growing use of so-called temporary employment agencies through which temporary employees are hired to do permanent work, thus avoiding the payment of the con- tractual obligations that a permanent employee entails. Congressional ratification of Ecuador's Economic Transformation Law (also known as TROLE I) in 2000 sought to deal with these matters by simplifying pay policy in the private sector ("salary unification") and introducing more flexible and modern hiring methods, such as hourly and temporary contracts. The new Social Security Law also provides that all workers, regardless of the nature of their con- tracts, must contribute to Social Security, thus equalizing to some extent the con- tractual obligations of "regular" workers and those hired through temporary agen- cies. However, these measures may not have been enough. Setting Salaries, Salary Unification, and Incentives for Creating FormalJobs Salaries are set at three different levels: The National Wages Council (CONADES) regulates the base salary and annual increases to it. When no agreement is reached between employers and workers' representatives within the CONADES framework, the Ministry of THE LABOR MARKET AND CIVIL SERVICE IN ECUADOR 453 Labor establishes an annual increase in the base salary equal to expected infla- tion in the upcoming year. * Minimum salaries specific to each occupation (and thus the relative minimum salaries for each occupation) are established in each sector though fixed salary programs called "sectoral tables" that employers and workers' representatives renegotiate periodically. In the past, the tables had to be updated once a year, but this is no longer the case. Except in the petroleum, electricity, and telecommunications industries, the tables seem to be binding, that is, workers receive salaries according to the levels specified by the tables. * Employers and workers' representatives can agree on additional salary increases through "collective agreements" by sector or by company. The interaction between the tables and decisions made through CONADES and the agreements has multiple effects: * The tables, by setting relative salaries, have the ability to automatically trans- mit the increase in the minimum salary to the entire salary distribution. This situation may or may not be desirable. Although it may be considered rea- sonable to index the minimum salary according to inflation in order to pre- serve the buying power of those less favored by the distribution, it is not clear that this is the best method for all salary levels. * The tables do not reflect differences in productivity between companies in a single sector and thus create considerable salary rigidity at a time when dol- larization has diminished the competitiveness of Ecuadoran companies. In addition, renegotiation could create a tool for unfair competition between large and small companies in the same sector given that the former are more productive than the latter, and have more negotiating power in the renegoti- ation process. * Increases in the minimum salary that are indexed to projected inflation are desirable in a period of rapidly declining inflation, but once prices stabilize they can cause inflationary pressures. This situation could be exacerbated by the fact that the agreement can propose additional salary increases and at the same time follow what is stipulated by CONADES if the economic condi- tions of the sector and of the company so require. In summary, the system is too rigid, leaves little room for differences in produc- tivity to be reflected in salary differences, and makes it difficult to modify relative salaries between employees and companies. In this context, Congress approved salary unification in the year 2000 (TROLE I). The law establishes that, with the exception of the 13th and 14th salaries, all existing allowances should be incorpo- rated in the minimum salary-an attempt to expand the tax base for Social Security and other employment-related taxes that are traditionally paid exclusively on the 454 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THIE NEW MILLENNIUM basis of salaries. Given that in practice these changes will increase the cost of employment for employers, they will be implemented over five years, so that in each year during that period the base salary will incorporate 20 percent of all nonsalary components of the workers' pay. The effective increase in labor costs, combined with a somewhat rigid salary-set- ting system (which will be still more rigid once the discretionary element involved in the special allowances disappears), may partially explain why the creation of for- mal employment has been limited since 2000 in comparison with the creation of informal employment. Outsourcing and Flexibility in the Labor Market Since the emergence of temporary employment agencies, employers have made extensive use of them, far beyond their cyclical needs, to the point that some com- panies are now operating exclusively with "temporary workers." The result is that the country now has some 2,000 temporary employment agencies employing approxi- mately 10,000 workers-that is, between 5 and 10 percent of formally employed workers.4 Termination costs in Ecuador are similar to those in Peru, Bolivia, and Colom- bia (approximately equal to 3.5-4 months of average monthly salary-see Pages and Heckman 2000), but much higher than termination costs in other countries in the region such as Argentina, Paraguay, and Uruguay (2-2.5 months of average monthly salary), most European countries, and the United States. Avoiding these costs may be part of the reason why temporary employments agencies are popular. Another reason why companies use temporary employment agencies seems to be to avoid paying employees the profit sharing that is due to them by law (up to 15 percent of all company profits). Although all workers are entitled to this, regardless of whether they are temporary or permanent, the threat of losing work is enough to keep the demands of temporary workers to a minimum. This in turn explains why outsourcing did not decrease despite the introduction of hourly and temporary con- tracts in 2000 (although companies are allowed to hire temporary employees for up to 40 percent of their total work force, regardless of the company's type of activity). In addition, temporary employees often receive salaries below the legal minimum and are completely denied special allowances. This could partially explain the increase noted in invisible underemployment. Finally, the fear is that outsourcing has contributed to a general deterioration of relations between employers and employees, as well as to the decrease training and 4. Preliminary data obtained from Ecuador's representative to the International Labor Orga- nization. To date, Ecuador has no reliable and systematic sources on information on our- sourcing. THE LABOR MARKET AND CIVIL SERVICE IN ECUADOR 455 other types of company investments in human capital, although once again the quantitative data are limited. The second outcome could have serious consequences in an era when technology and skills complement each other and when growth in productivity seems to depend more on the simultaneous accumulation of both fac- tors rather than the replacement of one by the other. In summary, although outsourcing prevented later increases in informal employ- ment, it does not have the principal characteristics of formal employment-namely, the right of workers to a minimum salary and some type of job protection, as well as the right to join unions and receive appropriate training. D. Recommendations for the Private Labor Market Recommendations for Setting Salaries The process used to set salaries must be simplified so that salaries by sector and by company are more sensitive to the labor productivity changes. This would minimize potential negative effects on competitiveness. The three measures suggested below could make a contribution in this respect: * Suspend the indexing of annual salary increases to projected inflation in order to prevent the emergence of inflationary pressures and greater deterioration in competitiveness. * Make the recommendations of the sectoral tables optional. Specific values rec- ommended should be used as a reference but should not be compulsory, par- ticularly for the private sector. Although after dollarization the spread between the lowest and highest levels has diminished considerably in almost all of the tables, the tables still have the adverse effect of transmitting any increase in the minimum salary to the entire salary distribution. The Ministry of Labor has already taken some steps toward transforming the tables into a specific mini- mum salary for each sector, indicating the corrections in the tables in dollars and not in percentages (that is, all salaries in the table increase based on a $US multiple and not by a percentage). This compresses the distribution of the table by increasing the lowest salaries proportionally more than the highest salaries, and thus makes the table less relevant for workers at higher levels in the distribution. The new minimum salary should be a reference point but should not be compulsory. * Follow the regulations on the basic salary and collective agreements in setting salaries. The collective agreements by sector and particularly the agreements by company should be the principal instruments for setting salaries that exceed base salary, so as to leave room for greater sensitivity to economic con- ditions. 456 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Recommendations on Labor Market Flexibility It is necessary to control the frequency of outsourcing and promote the replacement of temporary workers from agencies with formal workers governed by a flexible sys- tem that allows for temporary and hourly contracts. It is hoped that this change will have a favorable impact on income, labor relations, and training-without compro- mising labor market flexibility. Four types of measures should be implemented: o Control the use of temporary employment agencies and monitor the work and pay conditions of temporary employees in order to ensure that they reflect the provisions of the law. This subject has already been discussed with the Minister of Labor and various employer representatives, but not much progress has been made. It would be interesting to review the proposals raised during their discussions. o Reduce the costs to terminate formal permanent employees under new contracts. o Eliminate rules on profit sharing. Given that this seems to be the principal cause of outsourcing and possibly also for reliance on the informal sector, it would be desirable to eliminate this clause in all new contracts. For economic policy reasons, it would be extremely difficult to take this step with existing contracts. o Promote the use of temporary and hourly contracts when labor flexibility is needed. These contracts give the employer flexible arrangements and give workers formal employment and the benefits that go with it. E. Civil Service in Ecuador Number of Personnel Since 1998, the number of central government positions, without counting autonomous and decentralized agencies, has remained stable at about 276,000 employ- ees.5 The number of employees in the police, health, and education departments has increased during the last five years by a total of more than 13,000. However, there has been a reduction of about the same amount in other areas of the central government.6 5. The data on employees in autonomous and decentralized agencies prior to the year 2001 are very difficult to obtain. However, it seems that employment rose a little, from approx- imately 32,500 in 2001 to 33,500 in 2002. 6. After the decline in 2000, the total number of central government employees (including autonomous and decentralized agencies) rose by several thousand in recent years. The increase was 2.4 percent during 2001-02. In 2002, the total number of central govern- ment employees plus the Armed Forces was approximately 328,700. Policy Matrix for the Private Labor Market H Policy measures Short term Medium term Problems (to June 2003) (2003-07) Progress indicators Objectives/goals Salary setting Go from revisions in per- Change the sectoral Reduction of salary spread Establish salary-setting system H mechanism that is centages to revisions tables into noncom- in sectoral tables. that is more sensitive to labor z too complex and rigid. in dollars for the sectoral pulsory minimum productivity. sectoral tables and make reference salaries by adlierence to the tables sector. optional (recommended) rather than compulsory. c) Strengthen the role of the minimum salary as a reference only-that is, ,not compulsory-and of nego- tiations by company as tools for setting salaries. Amend TROLE I to eliminate salary indexing tied to projected inflation. High termination Control the use of Reduce termination Percentage of temporary Promote the creation of formal costs. temporary workers. costs in all new workers hired by a single employment. Need to go from Improve the super- contracts for perma- company. Increase labor flexibility precarious hiring vision of work and pay nent formal workers. General incidence of without reducing workers' methods (temporary conditions for tem- Eliminate in all new outsourcing. access to social securiry and employment agencies) porary workers. (temporary) contracts other benefits. to formal methods Promote the use of the rule that provides (temporary and formal temporary for paying workers hourly) in order to contracts and hourly 15 percent of profits. achieve labor flexibility. contracts instead of temporary workers. 458 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NFW MILLENNIUM As for the subnational governments, the officials in Quito calculate that Ecuador currently has 34,000 municipal and provincial council employees. The data on state companies are not easy to obtain but we have been told that they can be extracted from files in the hands of the Ministry of Labor and Human Resources. These data have not been given to us at this writing.7 Table 7 shows the annual figures on public employees in Ecuador and in other countries presented for purposes of comparison. Table 7. Public Employees of Ecuador and Other Selected Countries Ecuador' Bolivia2 Chile3 Honduras4 Nicaragua' (2002) (1999) (2001) No. % pop. % pop. % pop. %pop. %pop. Total public employees - 2.8 3.1 1.9 - State companies - 0.1 0.2 0.3 - Armed Forces 56,200 0.4 0.3 0.6 0.1 0.3 Central civil government 269,600 2.2 2.3 ... 1.4 1.3 Education 112,600 0.9 1.3 0.8 0.7 0.3 Health 16,900 0.1 0.2 0.2 0.16 0.2 Police 26,000 0.2 - 0.23 - - Subnational government 34,000 0.3 0.2 ... 0.1 0.1 -. No data available. Note: A definition of the categories can be found in http://wwwI.worldbank.org/publicseccor/civilservice/cross.htm. Sources: 1. Calculated based on data from the Ministry of Economy and Finance. The figure for subnational government is a calculation of actual employment. The remaining categories represent authorized positions, which quite probably exceed the actual number of public employees. In order to determine the number of employees in the health sector, the percentage of health professionals employed by the Ministry of Public Health was calculated in three provinces and this ratio was then applied to the country as a whole. 2. World Bank 2002. 3. World Bank data series on government employees and salaries, available at http://wwwI.worldbank.org/publicsector/civilservice/cross.htm. 4. Data gathered by the author and the World Bank on government employees and salaries. 7. In 2000, some of the largest state companies in Ecuador (for example, PetroEcuador) did not respond to a request from the Ministry of Labor and Human Resources for data on their employees. Up to this point, it is not clear how accurately the Ministry can record data on employment in state companies. THE LABOR MARKET AND CIVIL SERVICE IN ECUADOR 459 Public Employee Systems in Ecuador Civil service in Ecuador belongs to the largest framework in the public sector. The legal code for government employees (approximately 53,000) is the Civil Service and Administrative Career Law. The National Teaching Corps, regulated by the Teaching Career and Teaching Salary Scale Law, has approximately twice as many employees. Another 20,000 state employees are governed by the same law that applies to private company employees-the Labor Code (see Table 8). Physicians are in the category of "Scheduled Professionals" but have their own salary schedule, while the other eight professions also in this category receive a sin- gle salary and have the sarne grade system. Although the total number of physicians employed is fewer than 7,000, the remaining professions together amount to less than 2,800.' The Police and Armed Forces of Ecuador have their own salary schedules, as do the Judiciary, the Legislature, and Foreign Service personnel. Contract employees, amounting to 2,500 last year, are governed by the Law on Contracted Professionals Services. Table 8. Number of Government Jobs under the Public Employees System, 2002 Employment system No. % total Civil Service and Admin. Career Law 53,330 16.3% Labor Code 23,865 7.3% National Teaching Corps 112,790 34.5% Armed Forces Personnel Law 57,440 17.6% National Police 26,000 8.0% Scheduled Professionals (excl. physicians) 3,075 0.9% Physicians 6,940 2.1 % Judiciary 4,900 1.5% Legislature 320 0.1% Foreign Service Law 610 0.2% Law on Contracted Professional Services 2,540 0.8% Others 35,120 10.7% TOTAL 326,930 100% Source: Gathered using data from the Ministry of Economy and Finance. 8. The eight professions are attorney, administrator, architect, economist, civil engineer, chemical engineer, geologist engineer, and journalist. 460 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENN1UM Public Sector Salary Expenses Although the number of public employees increased very slowly between 1998 and 2002, government salary expenses fluctuated noticeably during the same period. The principal reasons for this are relatively simple. The fiscal crisis of 1998-99 caused runaway inflation and a drastic decline (more than 70 percent) in the real value of the basic salary between 1997 and 1999.9 Although GDP fell by more than 5 percent between 1998 and 2000, the personnel expenses of the central govern- ment shrunk as a portion of the GDP from 7.7 percent to 5.2 percent.'0 With dollarization in 2000, the deterioration in real salaries stopped and an opposite trend began to take hold. However, and despite significant salary increases in March and May of that year, the basic salary of public employees was equal to only half of its 1997 value in the case of the lowest salaries and one-third in the case of the highest salaries." In early 2002, basic salaries rose another 50 percent, thus restoring the lost buying power, but government spending increased in any case. (Annex 1 provides a synopsis of the evolution of basic salaries for employees in the system governed by the Civil Service and Administrative Career Law). It is much more complicated to measure changes in the total compensation of public employees in the late 1990s. Today's basic salaries typically represent barely a fraction of an employee's total compensation. Countless monetary allowances have been added over the years and have been accumulating. Consequently it is not uncommon for an employee's salary to include between 20 and 30 different items. Annex 2 shows a list of possible allowances. Table 9 shows the relative importance of the basic salary and the allowances in a sample from six ministries and govern- ment departments for which we have reliable data. Basic salaries represent no more than one-fourth of government spending on personnel in any of the six agencies. The highest percentage of spending goes to "supplemental payments" (for example, the 13th and 14th salaries and other bonuses). Human Resources Management In the Civil Service and Administrative Career Law (LSCCA) of 1964, the key human resource management functions were transferred to the National Personnel Directorate (DNP). These responsibilities included controlling hiring in govern- ment agencies, developing salary policies, and recording data on public employees. Although in principle it was created as an autonomous agency, the DNP later car- 9. This comparison of real salaries in Ecuador's public sector and subsequent comparisons are calculated according to the salary figures that appear in annexes 1 and 3; the sucre/$US exchange rate is from the Central Bank's BoetfnAnuaio, No. 24, 2002, p. 154. 10.Central Bank of Ecuador, BoletlnAnuario, No. 24, 2002, p. 104. 1 .As of April 2000, civil service salaries are paid in U.S. dollars. THE LABOR MARKET AND CIVIL SERVICE IN ECUADOR 461 ried out these same functions as a division of the Secretariat for National Adminis- trative Development (SENDA). 2 However, in 1998, President Jamil Mahuad dis- solved SENDA through Decree No. 41, and the DNP along with it. The decree stipulated that, from that point on, each government agency would be responsible for its own decisions on hiring and personnel management."3 At the same time, a new government agency was created: the Civil Service and Institutional Develop- ment Office (OSCIDI), which is responsible for analyzing human resources policies and for providing guidelines on personnel management to government ministries, departments, and agencies (MDOGs). However, OSCIDI's authority and resources are meager in comparison with those of its predecessor. 14 Salary Policy In an attempt to reassert central control over public salaries, the Law on Reform of Public Finances (LRFP) of 1999 created the National Public Sector Compensation Council (CONAREM) to control total personnel spending in all government agen- cies.'5 However, the authority of CONAREM was immediately questioned by vari- ous autonomous agencies. These agencies made a presentation to the Office of the General Comptroller in which they asserted that CONAREM did not have author- ity over the salary policy it applied to their employees, given that they were autonomous institutions. 6 The Office of the Comptroller, also an autonomous agency of the central government, supported these petitions and, as a result, the autonomous agencies were free to design their own compensation policies. 17 In prac- tice the only limits were those that the Ministry of Economy and Finance imposed on them through budget allocations. 12.Law No. 16 (R.O. 143, 17-3-1989). 13. Only the reclassification of positions and general pay policy were beyond the authority of the ministries and departments. (Executive Decree No. 41, Art. 5; RO-S 11, 25-8-98). 14. For example, the DNP had four separate divisions and SENDA, of which it was a part, had 388 employees. OSCIDI had only 44 employees in 1999 (OSCIDI 1999). 15.Law 99-24 (RO-S 181: 30-4-99). CONAREM was empowered to set ceilings on salary cost increases for each MDOG. Compensation includes wages, salaries, transportation, lunch subsidies, termination indemnity fund, and so on. The council has three voting members: the Minister of Economy and Finance (chairman), the Minister of Labor and Human Resources, and a member appointed by an electoral college of workers, employ- ees, and teachers. Decisions are reached by consensus. 16. For example, the Office of the Attorney General and the Judiciary made presentations to the Office of the Comptroller in which they asserted that, because they were autonomous agencies, they were not under the authority of CONAREM. 17 As for the sectional agencies (namely, municipalities and provincial councils), the Office of the Comptroller determined that they were subject to the authority of CONAREM. Table 9. Personnel Expenses by Type in Five Ministries and Departments, 2002a 4 Office of the President and Office of the Ministry of Ministry of General Secretariat Vice President Economy Agrisdsture Ministry of Ministry of of the Administration of the Republic and Finance and Livestock Social Welfare Tourism % total % % total % % total % % total % % total % % total % spending on inremase spending on increase pending on increase spending on increase spending on increase spending on increase Paymentsb personnel 2001-02 personnel 2001-02 spersonnel 2001-02 personnel 2001-02 personnel 2001-02 personnel 2001-02 0 Basic 21.2 9.5 24.0 47.2 10.7 73.7 17.8 39.2 16.5 55.6 24.1 9.9 Supplemental 46.7 17.9 49.5 59.8 66.0 130.7 50.0 54.3 51.4 78.1 51.3 40.8 Compensatory 19.1 45.7 21.7 97.3 6.0 34.9 28.2 21.8 21.9 38.6 20.7 38.9 Subsidies 0.4 4.4 0.3 8.6 0.3 97.0 0.9 53.0 0.4 -3.8 0.3 32.3 z Temporary 8.9 15.5 1.7 -5.1 8.0 174.8 0.2 -57.2 7.0 329.8 0.0 0.0 0 Social Security i- Contributions 3.8 30.9 2.8 45.4 7.0 93.1 2.9 41.7 2.8 87.8 3.5 43.3 z 0 TOTAL 20.5 60.5 113.5 40.0 70.1 31.5 CO) a. The percentage increase for 2001-02 is based on cumulative figures for 2000 and coded numbers for 2002. o b. Excludes payments for any type of indemnity. z z THE LABOR MARKET AND CIVIL SERVICE IN ECUADOR 463 Since 1999, CONAREM has issued more than 150 resolutions. Several of these have applied to all or most public employees, while others have been directed to a small group of employees to establish a particular benefit (for example, resolutions establishing or increasing the allocation of bonuses for physicians or civil engineers). Meanwhile, the ministries and autonomous agencies have sought the direct approval of the Ministry of Economy and Finance to obtain new or better allowances for their personnel.'" Political leaders and bureaucrats have often acceded to these demands, either in order to gain support or based on their own conviction regarding the fairness of the claims. The ultimate result is a salary system with many separate components that make up a monthly salary and the consequent loss of control over salary policy. F. Principal Problems There are two areas that require attention. The first is salary policy. Base salaries for most public employees are still slightly below their 1997 equivalents. However, the proliferation of allowances (both general and specific to a sector) has led to alarming increases in salary expense. Certainly, increases that range from 60 percent to 1 10 per- cent cannot be sustained (see Table 9). It is difficult to anticipate the impact of a salary increase owing to the large number of allowances and their complex interconnections. The second problem, related to the previous one, is the issue of human resources management authority over authorized positions (that is, the staffing list) and super- vision of the selection and appointment of personnel. The state's authority to deal with these problems seems to have deteriorated significantly since the dissolution of SENDA. There is no government agency that has a complete overview of the num- ber of public employees in each department, its positions, and categories. There is no department for tracking employees who have been terminated in the public sec- tor (and who have received indemnities) and for ensuring that they have not returned to government employment through some other avenue. In addition, since the disappearance of the DNP, there is no agency working to ensure that the merits of the applicant are considered when vacancies are filled. To be fair, we should point out that these two problems are addressed in the draft Law on Managing the Income of Public Servants that President Gustavo Noboa sent to Congress in November 2002 as a matter of urgency. In December, Congress rejected the bill, in part because of the transition phase the country was going through. Nonetheless, many are in agreement on the need for salary unification in the public sector.19 The objectives of the draft law should be taken up again by the new government. 18. Of the general allowances established in the LRFP, the academic degree bonus is the only one that can vary (and in fact does so) depending on the MDOG. 19.See the newspapers "El Universo" and "El Hoy" for December 10 and 11, 2002. 464 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEw MILLENNIUM The primary objective of the law is salary unification. The large number of ele- ments that make up the salary of a public employee would be reduced to the basic salary, the 13th salary, the 14th salary, the time in service bonus, and bonuses for having relevant academic degrees that exceed the minimum required for the posi- tion. A new salary schedule was proposed that would be designed, quite appropri- ately, on the basis of the same 14-category schedule that was developed and approved by CONAREM in 2000.20 The 14-category schedule (with a base salary between four and five times greater than in the existing 21-category schedule) only applies in certain ministries and departments. Before adopting the new schedule, the government agency must go through an administrative restructuring process implemented by OSCIDI. This leads to the definition of processes, design of an appropriate structure, and the assignment of qualified human resources to that structure. Currendy 11 ministries and 25 gov- ernment agencies have gone through this process in OSCIDI. Nonetheless, these do not include the agencies with the highest concentrations of public employees (that is, those relating to agriculture, social insurance, health, and public works). Annex 3 presents the current salary schedule and the schedule proposed by the law. However, it is difficult to calculate the impact of salary unification. The Min- istry of Labor has calculated that making all public employees subject to the new schedule will cost $US240 million. This figure is twice what the Ministry of Econ- omy and Finance calculated it would cost to make all public employees subject to the existing 14-category salary schedule.21 The final cost will be determined by three variables, which are explored below. o What is the true monthly salary that employees receive in a ministry or department on the eve of salary unification? The increase in the real salary would be considerably less than the difference between the current salary schedule and the future one given that the state is already paying salaries well above the current base salary owing to cumulative allowances. If an employee already receives a monthly salary (including allowances) higher than the one he or she would get under the new schedule, he or she will receive no salary increase.22 o Many employees would be reclassified during the salary unification process. But how many would there be and to what levels would they be assigned? 20. Resolution No. 46; 1-11-2000. 21.Memorandum No. SIP-DM-2002-236. The precise calculation was $US1 19.9 million. 22. The draft law sensibly recognizes that it will be neither legally nor politically possible to reduce the current salary of an employee. Therefore, the new base salary will be calculated by dividing by 12 all payments that an employee receives (setting aside the 13th salary, the 14th salary, the time-in-service bonus, and the bonus for a relevant academic degree) in order to arrive at the new base salary. THE LABOR MARKET AND CIVIL SERVICE IN ECUADOR 465 Employees with academic and work histories that do not correspond to the position they currently occupy would be placed in a lower or higher category, as applicable. Reducing their salaries would be very painful from both a polit- ical and administrative perspective. But they could be frozen until the posi- tion they occupy merited a salary increase beyond their current level. The OSCIDI calculates that in the ministries and departments that it has already restructured it has reclassified nearly half the staff. How many of the employees who are not needed to carry out the functions of the department can be terminated with an indemnity? How many would get the maximum indemnity of $US 10,000? How many indemnities paid all at once can the state handle in the short term in order to reduce its long-term obligations in this way? The possibilities for saving by reducing personnel (to mitigate the impact of the salary increase) and increasing efficiency through the reassignment of personnel are considerable. Nonetheless, in the 37 MDOGs that went through this restructuring process before the salary unification law was approved, staff cutbacks amounted to an average of only 3 percent. The cost of the indemnities is an important factor that limits the restructuring process (we will continue with this topic below).23 Nonethe- less, if the money is available, the human resources management (HRM) systems must be alert in order to ensure that those who have received indemnities do not reenter government employment through another channel. The Law on Managing the Income of Public Servants provided for the strength- ening of HRM systems by replacing OSCIDI with a new agency, the National Sec- retariat for Organizational Development of the Public Sector (SENDOSEP), with powers similar to those of the old DNP. In the draft law, this objective is not as vig- orously promoted as the objective of streamlining the salary system. It is imperative to recreate the central government's internal capacity to analyze, design, administer, and supervise government human resources. 23.The OSCIDI is completing a restructuring plan for the General Civil Registry Direc- torate. This organization has more than 1,500 employees and the OSCIDI believes that only half are needed. However, the proposal indicates eliminating only 50 positions, in large part because the cost of hundreds of indemnities would be prohibitive. Public employees do not have a right to stability in employment, but they do have a right to an indemnity if their position is eliminated (LSCCA, Art. 59). The payment value is calcu- lated as the average salary over the last 12 months, multiplied by the years of service (or fraction thereof) times four (L. No. 93, R.O. No. 340, June 16, 1998). This is a relatively generous benefit. One month of salary per year of service is much more common through- out the world. SinceJanuary 2001, there is a mandated limit of$US10,000 (CONAREM Resolution No. 70, R.O. No. 248, January 19, 2001). 466 ECUADOR: AN ECONOMIC AND SOcIAL AGENDA IN THE NEW MILLENNIUM G. Recommendatiomns Salary unification in the public sector is an appropriate initiative that seeks to resolve serious defects in public administration in Ecuador. How could this proposed reform be improved or broadened? Recommendations on Salary Reform • Restructuring is a way to counteract the impact of the salary increase by elim- inating unnecessary personnel. Given that the list of positions that should be eliminated could remain in effect for various years (as indicated during con- versations at the OSCIDI), it would be possible to terminate only a few peo- ple each year, as the funds for paying the indemnities become available. How- ever, it is likely that the lists would become public knowledge, and the productivity of a public employee who knows he or she will be terminated will fall to zero (or worse). It would be unfortunate not to take advantage of the opportunity to discharge superfluous staff. The Bank would offer support through an adjustment or investment operation under appropriate circum- stances. o Although it is logical, in an effort to achieve salary unification and simplifica- tion, to incorporate nearly all allowances in the base salary, it might be better to continue the allowance for geographic location. In many communities throughout the world this allowance is used to ensure that physicians, teach- ers, and other providers of essential services set up in rural areas and help the poor. Almost invariably, urban areas have a disproportionate number of physi- cians and teachers, given that they are considered more attractive places to live. For this reason, many employees who were originally assigned to rural areas fight to negotiate a transfer to the cities. Monetary incentives can be used to at least retain service providers in rural areas where they are most needed. o Physicians and teachers have their own employment laws. The unified sched- ule can be used as a reference point but not a rigid model. Perhaps the allowances for geographic location could be retained for these groups but not for other groups. What should be done with employees in the Galapagos? Maintaining the geographic allowance could be the lesser evil. However, if Ecuador decides to use this monetary tool, it is particularly important to set up strong HRM systems to check whether the employees transfer to urban areas and whether they continue collecting the rural area allowance. o Salary compression: In 1997, the ratio of the highest base salary and the low- est base salary on the LSCCA schedule was 5.2:1. (Compressed salary ratios vary considerably from country to country, but the 5.2:1 ratio was in a good range). With the deterioration of real salaries in the late 1990s and their later recovery, the compression ratio fell to 3.6:1 in 2000. Further, according to the THE LABOR MARKET AND CML SERVICE IN ECUADOR 467 unified salary schedule in the law proposed by the government of Gustavo Noboa, the effective compressed ratio would be only 3:1. * A highly compressecl salary structure reduces public employees' incentives to pursue a long and successful career in civil service, in that it makes promotion less attractive. If it is neither possible nor desirable at this point to slightly lower the salary floor on the proposed salary schedule, it is then extremely important to resist any change in the salary schedule that would further increase salary compression. The fiscal cost of increasing salaries at the upper end of the salary schedule may be low, given that there are relatively few pub- lic employees with high salaries. * Those charged with formulating policies in the government have expressed interest in proceeding rapidly (in just a few months) with the restructuring of all government ministries, departments, and agencies (MDOGs) and with applying the unified salary schedule to all of them (once a salary unification law is approved). Nonetheless, it would be advisable to act more calmly, estab- lish priorities among the MDOGs, and complete the process over a period of one or two years. Recommendations on Human Resources Management and SENDOSEP * In view of all the energy that will likely be directed to salary reform, care should be taken to give this area of reform a lot of attention. Divisions should be developed within the new SENDOSEP (or similar agency) to collect and organize the data on personnel in all the ministries, departments, and agen- cies, including the state companies. This division will need visible support from the President in the initial phases of operation. Otherwise, it is likely that many state agencies will ignore the request for information (as happened in the past at PetroEcuador). * The new position lists should be connected with the Integrated Financial Management System (SIGEF)-Ecuador's computerized payroll. * Separate lists should be kept of those who have left civil service (voluntarily or otherwise) and those lists should be linked with the unit in charge of proce- dures for authorizing appointments, so that employees who have received indemnities do not return to civil service in the short or medium term. * The application of merit-based principles for personnel hiring is perhaps the weakest area in the draft law. Article 12 (k) mentions that the new SENDOSEP will ensure that the MDOGs apply the pertinent statutes to their hiring practices. But no mention is made of how this will be achieved. The law may leave certain details to be resolved later, but a clause such as this could be considerably strengthened by briefly indicating in the text of the law how compliance mechanisms will be established and who will have the responsibility for verifying compliance with the mechanisms and the author- ity to enforce them. PoLicy Matrix Policy measures Short term Medium term Problems (to June 2003) (2003-07) Progress indicators Objectives/goals Overly complicated pay Approve a Unification Ensure that the education Seventy percent of all Consistent and sustainable system that leads to lack Law. and health sectors, where central government public salary system in fiscal terms- of consistency and loss Study the funding the majority of public employees subject to the target an average reduction of of control over salary sources for paying employees are concen- new schedule. staff in the restructured min- 0 policy in the public indemnities when trated, adapt their salary istries and departments of more sector. restructuring the systems to the new than 5 percent (however, this ministry or policy, maintaining some objective should not be applied department. flexibility to meet their indiscriminately; keep the addi- special characteristics. tional long-term cost below 0 $US 100 million through selective reduction). Lack of complete Develop a separate Develop a complete HRM data easily Limited civil service based on information in division in an agency database of public obtainable merit, with relatively well-paid g government on the such as SENDOSEP employees. All appointments in employees (the size of the civil number and location that is assigned to Draw up and dissemi- higher categories, starting service, in each of its compo- of public employees; each of these tasks. nate procedures for at grade 5, based on nents, is a figure that those Z lack of merit central supervision merit considerations responsible for formulating supervision. of vacancy appoint- policy in the central govern- z ments based on merit. ment can access easily). 3 z C THE LABOR MARKET AND CIVIL SERVICE IN ECUADOR 469 Technical Annex Determining Real Salaries in Ecuador, 1998-2001 The calculation of real salaries and labor income uses three types of information: a) Consumer price index, two different series obtained from BCE (Table Al); b) Sucre/dollar exchange rate, obtained from BCE (Table Al); and c) Salaries (or labor income), obtained from the Survey of Employment, Unem- ployment, and Underemployment. The evolution of consumer prices is considerably different depending on the deflator considered. While the deflator used up to October produces a high inflation scenario for the entire period, the corrected deflator indicates that prices fell between 1998 and 1999 and between 1999 and 2000, and rose only between 2000 and 2001. it is not surprising then that, as indicated earlier in the chapter, the use of one deflator or the other would have significant implications in terms of the evolution of salaries and real labor income. While labor income seems to have risen some 20 percent between .1998 and 2001 when the corrected deflator is used (Table 4), real labor income would have fallen some 70 percent during the same period when the alternative deflator is used (Table A2). Table Al. Price Index and Exchange Rate Series Price index Exchange rate BCE (October) BCE (corrected) (su/$US) $US 1995 $US 2001 BCE 1998 221.1 108.7 6,780 1999 336.7 78.0 20,100 2000 660.2 71.9 2001 908.9 100.0 Source. Data obtained from BCE. Table A2. Monthly Labor Income in Urban Areas, 1998-2001 (at constant 1998 $US values) Total Formal Informal 1998 146.5 209.4 103.6 1999 45.2 65.3 33.3 2000 41.2 57.3 31.8 2001 39.7 53.8 30.4 Note: Labor income indudes salary income and independent worker income (INEC). The calculations for 1998 and 1999 use the sucre/dollar exchange rate provided by BCE: 6,780 and 20,100, respectively. Source: Calculations by the authors using data from BCE and MEE 470 ECUADOR: AN ECONOMIC AND SOCLAL AGENDA IN THE NEW MILLENNIUM Given the different implications of the two scenarios in terms of economic pol- icy recommendations as well as our understanding of the poverty trends, we feel it is absolutely necessary to explore in detail what the methodological differences are between the two deflators and to understand them. Tables A3 and A4 below reproduce the calculations in Tables 5 and 6 of the chap- ter in order to facilitate the reader's analysis. Table A3. Monthly Labor Income in Urban Areas by Employment Situation, 1998-2001 (at constant 1998 $US values) All employees Salaried Salaried Independent employees in the employees in the Employers workers public sector private sector Otbers 1998 - - - - - 1999 113.8 34.0 63.6 44.1 14.2 2000 129.3 38.2 55.6 39.2 13.1 2001 109.0 34.3 54.7 38.9 15.6 Formal Sector Salaried Salaried Independent employees in the employees in the Employers workers public sector private sector Others 1998 - - - - 1999 191.0 93.5 63.6 54.3 2000 171.5 86.8 55.6 48.9 2001 163.0 61.6 54.7 46.0 Informal Sector Salaried Salaried Independent employees in the employees in the Employees workers public sector private sector Others 1998 - - - 1999 80.1 33.5 26.3 2000 100.8 37.2 22.1 2001 75.4 33.1 27.5 -. No data available. Note: The calculations for 1998 and 1999 were done with the sucre/dollar exchange rate provided by BCE: 6,780 and 20,100, respectively. Source: Calculations by the authors using data from BCE and MEF. THE LABOR MARKET AND CIVIL SERVICE IN ECUADOR 471 Table A4. Labor Income and Basic and Average Salaries in the Private Sector in Urban Areas, 1998-2001 Basie salary and Labor income Average salary basie supplements Nominal Real Nominal Real Nominal Real ($US) ($US 1998) (US$) (1998 $US) ($US) (1998 $US) 1998 146.5 146.5 - - 84.5 84.5 1999 68.9 45.2 67.1 44.1 29.68 19.5 2000 123.0 41.2 117.0 39.2 91.9 30.8 2001 163.0 39.7 160.0 38.9 125.3 30.5 -. No data available Note: The calculations for 1998 and 1999 were done with the sucre/dollar exchange rate provided by BCE: 6,780 and 20,100, respectively. Source: Calculations by the authors using data from BCE and MEE 472 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Amnex I CivGl Service and Administrative Career, Salary Schedules, 1997-2002 Ministerial CONAREM Category Agreemnt Resolutions 356 d& 357; RO 133 01 RO 262 06 RO-S 350 (8-19-97) (08-25-99) (12-30-99) A B A B A B 1 260,000 330,000 380,000 2 270,000 340,000 390,000 3 280,000 350,000 400,000 4 290,000 360,000 410,000 5 320,000 380,000 430,000 6 330,000 400,000 450,000 7 350,000 420,000 470,000 8 370,000 440,000 490,000 9 390,000 470,000 520,000 10 420,000 500,000 550,000 11 450,000 540,000 590,000 12 490,000 590,000 640,000 13 520,000 620,000 670,000 14 550,000 660,000 710,000 15 580,000 290,000 690,000 350,000 750,000 350,000 16 600,000 300,000 720,000 360,000 780,000 360,000 17 620,000 310,000 760,000 370,000 820,000 370,000 18 650,000 325,000 800,000 390,000 860,000 390,000 19 820,000 410,000 1,000,000 490,000 1,060,000 490,000 20 1,100,000 550,000 1,300,000 660,000 1,360,000 660,000 21 1,350,000 675,000 1,600,000 810,000 1,660,000 810,000 A = Salaries (S/.) B = Expenses and housing allowances (each one) THE LABOR MARKET AND CIVIL SERVICE IN ECUADOR 473 CONAREM Categoyy Resolutions 10 RO-S 48 13 S.R.O. 88 129 RO 545 (03-31-2000) (05-31-2000) (04-01-2002) A B A ($US) B ($US) A B 1 440,000 750,000 30.00 45.00 2 450,000 765,000 30.60 45.90 3 460,000 780,000 31.20 46.80 4 470,000 800,000 32.00 48.00 5 490,000 825,000 33.00 49.50 6 510,000 850,000 34.00 51.00 7 530,000 875,000 35.00 52.50 8 550,000 900,000 36.00 54.00 9 580,000 950,000 38.00 57.00 10 620,000 1,000,000 40.00 60.00 11 660,000 1,050,000 42.00 63.00 12 710,000 1,100,000 44.00 66.00 13 750,000 1,150,000 46.00 69.00 14 780,000 1,200,000 48.00 72.00 15 830,000 350,000 1,250,000 50.00 385,000 15.4 75.00 17.50 16 860,000 360,000 1,300,000 52.00 395,000 15.8 78.00 20.00 17 900,000 370,000 1,380,000 55.20 405,000 16.2 82.80 22.50 18 945,000 390,000 1,460,000 58.40 430,000 17.2 87.60 25.00 19 1,165,000 490,000 1,700,000 68.00 540,000 21.6 102.00 27.50 20 1,495,000 660,000 2,200,000 88.00 720,000 28.8 132.00 30.00 21 1,820,000 810,000 2,700,000 108.00 870,000 34.8 162.00 35.00 A = Salaries (SI.) B = Expenses and housing allowances (each one) 474 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Annex 2 Budgetary Classification of Expenditures (R-S 249:22-1-2001) Classrfifation of current expenses 5 1 Personnel expenses 5 1 01 BASIC COMPENSATION 01 Wages 02 Salaries 03 Day wages 04 Community workers 5 1 02 SUPPLEMENTAL COMPENSATION 01 Bonus for years of service 02 Responsibility bonus 03 Thirteenth salary 04 Fourteenth salary 05 Fifteenth salary 06 Sixteenth salary 07 Supplemental bonus 08 Bonus for academic degree, specialization, and special training 09 Representation allowance 10 Differentials and additional bonuses 11 Monetary incentive 12 Armiversary bonus 13 Christmas bonus 14 Functional percentage 15 Addition to grade 10 16 Teacher economic stimulus 18 Monthly Galapagos bonus = 100% minimum salary or base salary 19 75% additional for special Galapagos system 20 Border bonus 21 Dental bonus 22 Medical bonus 23 Physicians' Day bonus 24 World Health Day bonus 25 Nurses' bonus 26 Annual economic bonus (administrative personnel) 27 Amazon region addition 28 30% supplemental Galapagos compensation 29 Extracurricular activity in the Galapagos 5 1 03 COMPENSATORY PAYMENTS 01 Residence allowances 02 Subsidy for geographic circumstances 03 Cost of living allowance 04 Transportation allowance 05 Overseas allowance 06 Breaks 07 Administrative office 08 Education allowance 5 1 04 SUBSIDIES THE LABOR MARKET AND CIVIL SERVICE IN ECUADOR 475 01 Family 02 Education 03 Maternity 04 Death 05 Daycare 06 Vacation 07 Economic incentive for years of service 99 Other subsidies 5 1 05 TEMPORARY COMPENSATION 04 Orders and substitutions 05 Personnel replacements personal 06 Remunerated license 07 Fees 08 Food 09 Overtime and supplemental time 10 Contracted personal services 11 Night shift special compensation OTHER PERSONNEL EXPENSES: 5 1 06 EMPLOYER CONTRIBUTIONS TO SOCIAL SECURITY 01 Employer contribution 02 Reserve fund 03 Employer retirement fund 04 Private termination indemnity 5 1 07 INDEMNITIES 01 Compensation for voluntary resignation 02 Elimination of position 03 Untimely dismissal 04 Compensation for dismissal 05 Restoration of position 06 Retirement 99 Other labor indemnities 5 1 99 ALLOCAT'IONS TO BE DISTRIBUTED Annex i3 Basic Salary Schedule for ]Public Emplloyment Govermments, 2002 Civil Service Proposed Organic and Administrative Scheduled Senior Level Law on Incomes Career Law Professionald Physicians Official of Civil Servants Human Resources x National Position Management Classification System System (14 Grades) 0 z Basic Basic Basic Basic Basic Basic Grade Salary Grade Salary Grade Salary Grade Salary Grade Salary Grade Salary > 1 45.00 Service 70.00 1 60.00 Resident 120.00 Director of 400.00 1 Service 210.00 0 Assistant Physician I Govt. Inst.b Assistant cn0 2 45.90 Admin. 80.00 2 67.20 Resident 125.00 Director of 2 Admin. 240.00 n Asst. A Physician 2 Govt. Inst.c 500.00 Asst. A 3 46.80 Admin. 85.00 3 75.26 Resident 130.00 Under- 850.00 3 Admin. 255.00 Asst. B Physician 3 secretary Asst. B c 4 48.00 Admin. 90.00 4 84.30 Resident 135.00 Vice 1,100.00 4 Admin. 270.00 Asst. C Physician 4 Minister Asst. C Z 5 49.50 Tech- 95.00 5 94.41 Resident 140.00 Minister 1,500.00 5 Technician A 285.00 nician A Physician 5 z 6 51.00 Tech- 100.00 6 105.74 Treating 145.00 Vice 2,400.00 6 Technician B 300.00 nician B Physician 1 President 7 52.50 Pre-pro- 110.00 7 118.43 Treating 150.00 President of 3,200.00 7 Pre- 330.00 fessional Physician 2 the Republic professional z 8 54.00 Profes- 120.00 8 132.64 Treating Physi- 155.00 8 Professional 1 360.00 sional I cian or Admin. 3 9 57.00 Profes- 130.00 9 148.56 Treating Physi- 160.00 9 Professional 2 390.00 sional 2 cian or Admin. 4 10 60.00 Profes- 140.00 10 166.38 Treating Physi- 165.00 10 Professional 3 420.00 sional 3 cian or Admin. 5 11 63.00 Profes- 150.00 11 186.35 Treating Physi- 170.00 11 Professional 4 450.00 sional 4 cian or Admin. 6 12 66.00 Profes- 170.00 12 208.71 Treating Physi- 175.00 12 Professional 5 510.00 sional 5 cian or Admin. 7 13 69.00 Profes- 190.00 Treating Physi- 180.00 13 Professional 6 570.00 sional 6 cian or Admin. 8 14 72.00 Director 210.00 Treating Physi- 185.00 14 Area Techni- 630.00 cian or Admin. 9 cal Director 15 75.00 Treating Physi- 190.00 National 1,050.00 cian orAdmin. 10 Director 16 78.00 Treating Physi- 195.00 Director of 2,500.00 cian or Admin. 11 Govt. Inst.b 17 82.80 Treating Physi- 200.00 Director of 3,000.00 cian or Admin. 12 Govt. Inst.c 18 87.60 Treating Physi- 204.00 Under- 3,500.00 cian orAdmin. 13 secretary 19 102.00 Treating Physi- 208.00 Vice 4,000.00 cian or Admin. 14 Minister 20 132.00 Treating Physi- 210.00 Minister 5,000.00 cian or Admin. 15 21 162.00 Vice 6,000.00 President President of 8,000.00 the Republic a. There are nine so-called scheduled professionals. These are physicians, attorneys, professional administrarors, economists, civil engineers, geological/mining engineers, chemical engineers, architects, and journalists. Physicians have their own pay scale, which is shown separately. The other professionals have the same pay scale, except that the professional scales for architects, professional administrators, and chemical engineers only have the first 10 grades. b. Region A. c. Region B. 17 Decentralization1 Jonas Frank To build an efficient and fiscally responsible decentralized government, Ecuador must face three challenges. The first is to clearly define the areas of responsibility of a second layer ofpublic administration (functional decentralization)-made up of the regional development agencies, executing units, socialfunds, and attached entities-with respect to the provincial councils and municipalities. Given the magnitude of the resources these entities manage and their type of organization, they do not encourage accountability. The second challenge is to halt the transfers of resources that occur without being tied to the transfer ofpowers. This process is in high gear and has contributed to thefiscal pressures besetting the central government. The third challenge is to manage the indebtedness of local governments with fiscal responsibility, sustainability, and transparency. Without rules and a clearframework of incentives, decentralization has no foundation. In order to achieve it successfully, thefour most important actions are: (i) undertake an interme- diate (provincial) level transition strategy in which the decentralized entities of the lower- level system will be accountable to elected authorities, the Prefect, and the Provincial Council; (ii) amend the transfers stipulated by the "15 Percent Law" that are the major source offundingfor local governments, making them contingent on the transfer ofpow- ers and the delivery of results; (iii) regulate and create transparency concerning the indebtedness of local governments in order to promote fiscal responsibility, which means entering into a rescheduling plan for existing debt with municipalities and provincial councils that are today overindebted, and establishing new regulations for the future indebtedness of the largest ones; and (iv) introduce provisions in the contractual system oftransferringpowers in order to clarify the responsibilities and rights of each level ofgov- ernment. 1. Jonas Frank is a decentralization specialist at the World Bank. 479 480 EcUADoR: AN ECONOMIC AND SociAL AGENDA IN THE NEW MILLENNIUM A. The Principal ProbleMm and the Challenges of Decentralization THE PRINCIPAL PROBLEM. In Ecuador, decentralization is one of the most significant and important challenges in reforming the state and society. The principal problem is that centralized decisionmaking has a negative effect on the quality of public serv- ices. The central government cannot provide solutions that are as creative as those provided by the provincial councils and municipalities, which currently execute only 7 percent of total public spending. Since they are closer to the problems, local gov- ernments2 can direct spending to the community's most important needs. Under certain minimum circumstances, decentralization contributes to more efficient and effective services. THREE CHALLENGES. Ecuador faces three challenges along the path to a more decen- tralized government: (i) adequately decentralize the autonomous entities of the cen- tral government which interact with local governments; (ii) change the process of decentralization, which is currently based solely on the transfer of resources, with- out the transfer of powers; (iii) control and regulate the debt of municipalities and provincial councils in order to promote fiscal responsibility. THE FIRST CHALLENGE: PARALLEL PUBLIC ADMINISTRATION-"FUNCTIONAL DECEN- TRALIZATION." The current structure of public administration shows that the chal- lenge of decentralization does not lie with the sectoral ministries, as is commonly thought. In reality, what affects local governments most today are the many autonomous entities that are part of the central government but do not have clear jurisdictions and responsibilities. Under this sort of "functional decentralization" would be grouped, for example, the regional development agencies, the social funds, and the many institutes, executing units, and agencies attached to the ministries. These entities manage a total of about $US1.4 billion; for the regional develop- ment agencies alone this amounts to close to $US400 million per year (GTZ 2002a, 2002b, 2002c). These are considerable amounts compared to the resources that are currently being negotiated in the decentralization process in the context of the agree- ments that all 22 provincial councils and 140 municipalities have signed with four ministries (Roads, Environment, Tourism, Agriculture). Close to $US200,000 is being negotiated in the Ministry of the Environment; and less than $US100,000 is being negotiated in the Ministry of Tourism.3 The new government should evaluate how this second layer of administration 2. The term "local government" refers both to the provincial councils and the municipali- ties. We also use the term "subnational governments." 3. The Ministry of Public Works and Agriculture has not yet completed the costing phase, but it is estimated that the values in these cases are really higher. DECENTRALIZATION 481 affects the provincial councils and municipalities in terms of (a) evaluating which level of government provides services best; (b) accountability, given that there is a series of overlapping powers and a large majority of these entities answer to the cen- tral government; (c) fiscal sustainability, considering the enormous financial resources being managed, often based on credit; (d) the implementation of the gov- ernment's policy, given that the form of financing and organization allows them to be managed with flexibility and discretion, a situation unlike that in ministries. Given how advanced and rapid the decentralization process is at present, these issues must be resolved in the short term. THE SECOND CHALLENGE: TRANSFERS OF RESOURCES TO PROVINCIAL COUNCILS AND MUNICIPALITIES. Contrary to the general perception, in the last five years decentral- ization has made notable and rapid progress. Since 1997, significant resources have been transferred to subnational governments-up to 15 percent of the state's cur- rent revenues (the "15 Percent Law"),4 and in 2002, 25 percent of income. How- ever, a critical look at these transfers would also reveal that they are not based on the principles of decentralization: * The transfers occur without being tied to an assumption of powers; * Given that these transfers are not contingent on local governments' generat- ing their own revenues, they have diminished the autonomy of local govern- ments; municipalities, and provincial councils-which are now more depend- ent than they were in 1997, when the 15 Percent Law was adopted; * There are significant discretionary transfers and these are sometimes con- cealed bailouts; * Other transfers are uneven and favor specific municipalities and provincial councils; and finally * Much of the decentralization is executed without affecting the structures of central government because the process channels only international credit resources to the local levels.5 Thus the challenge is to reverse this trend in fiscal decentralization that has con- tributed to the financial pressure besetting the central government and cannot be sustained over the long term. 4. The law's complete name is as follows: "Special Law on the Distribution of 15 Percent of Revenues from the Budget of the Central Government." With the exception of 2002, there has never been a transfer of more than 11 percent in a given year, or about $US500 million. 5. For example, the Municipal Development Program (PDM), which has been in operation since 1990, transferred $US300 million to the municipalities. For the administration of President Borja, that program has officially been the decentralization program. 482 EcuADoi: AN ECONOMIC AND SocIAL AGENDA IN THE NEW MILLENNIUM THE THIRD CHALLENGE: INDEBTEDNESS AND FISCAL RESPONSIBILITY. Decentralization generally creates pressure to take on debt when the process is started. Not only new investment needs but also existing gaps between resources transferred and powers assumed are funded through credit. However, the country has a history of concealed bailouts that have led to moral hazard. Although access to credit at the Ecuadoran Development Bank (BEDE) is handled transparendy, there are pressures to relax the payment conditions once credit is obtained. The data used to monitor indebtedness are not always reliable. The Municipal Development Program (PDM) has left most local governments overindebted. Today the challenge for the future administration is to manage indebtedness with clear rules that encourage fiscal responsibility. Responsibility is affected because local governments are highly dependent on transfers from the central government. This leads to inefficient decisions on spend- ing, because no budgetary restriction is more effective than that based on local gov- ernments own revenues. FOUR LINES OF ACTION. To confront these three principal challenges, we recom- mended developing four lines of action: (i) The structure of the state and of intergovernmental relations: the search for the optimum number of levels of government, their jurisdictions, and political authorities; (ii) The transfer of powers: the assignment of responsibilities to each level of government; (iii) Decentralization and fiscal responsibility: determining the coordination and efficiency of spending in the context of the country's financial possibilities; (iv) Management of the decentralization process: clarifying who is responsible for which activity in the process of change. B. Diagnosis Structure of the State and Intergovernmental Relations Over recent decades, the structure of the Ecuadoran state has undergone unprece- dented complications. The petroleum resources that have been available since the late 1960s contributed significantly to the increase in public spending and there are now a variety of entities with a duplicate responsibilities (Frank 2001; CONAM 1998a). This expansion of the state has had a negative effect on intergovernmental relations and the autonomy of subnational governments in many ways. A marked tendency has been the growth of public spending through functional decentralization. There are entities that are autonomous in political, administrative, and financial terms and that maintain only a minimum level of coordination with the sectoral ministries. With no clear jurisdiction, they interfere not only in decen- DECENTRALIZATION 483 tralized agencies of the central government but also in the municipalities and provincial councils as autonomous governments. REGIONAL DEVELOPMENT AGENCIES. The regional development agencies are part of this group of functionally decentralized entities. They were created starting in the 1950s, an era when the state was seen as the promoter of development. These enti- ties, including CREA, CEDEGE, CRM, CORPECUADOR, UDENOR,6 and oth- ers, violate the principles of decentralization in at least three ways: * Their jurisdictions are ambiguous: The regional level in Ecuador does not for- mally exist and each entity defines its own jurisdiction. Thus these entities cover many provinces or establish their limits irrespective of the legal-admin- istrative division of the country. * Their powers are ambiguous: They provide services in social sectors such as edu- cational infrastructure, health; they have productive projects in fishing, forestry, and other areas; they invest in highways and rural roads. Reviewing this list of powers, we conclude that all could be decentralized under provin- cial councils and municipalities.7 * They are accountable to the central government- Their authority is assigned by the sectoral ministries, which do not answer to the users. Given that they administer an enormous amount of resources, partially financed with international loans, the regional development agencies have grown in human8 and financial resources to the point of exceeding the size of some of the ministries to which they report. Given the resources they manage, these agencies are autonomous and have no incentives coordinate at local levels. Thus, they work inde- pendently of the provincial councils and municipalities. SOCIAL FUNDS. The social funds, conceived as programs to combat poverty with interventions at the local level, are another set of functionally autonomous entities. Programs such as FISE (Emergency Social Investment Fund) or the Comprehensive Rural Development Project (run by the Ministry of Social Welfare) finance social projects such as primary schools, basic health centers, centers for children and the 6. CREA (Center for the Economic Reconversion of Azuay); CEDEGE (Center for Devel- opment of the Guayas Basin); CRM (Center for the Reconversion of Manabl); UDENOR (Development Unit of the North). 7. The only justification for continuing to administer such powers at the "regional level" is economies of scale compared to the provincial level (where they exist). 8. For example, CREA maintains a staff of 700 people. In contrast, the Ministry of Educa- tion at the central level has a staff of about 600, and the Ministry of the Environment has a staff of 150. 484 EcUADOR: AN ECONOMIC AND SOcIAL AGENDA IN THE NEW MILLENNIUM elderly, potable water and basic sanitation projects, and rural roads.9 Like the regional development agencies, the powers of the social funds could be decentral- ized. Only as an exception-infrastructure construction, for example-do they include the municipalities in the management of services. In practice they operate parallel to the municipality, making coordination difficult and working against effi- ciency in service delivery. THE INTERMEDIATE LEVEL. In this complex institutional framework, the government level most affected is the provincial level, where institutional complexity creates an extremely counterproductive framework for the delivery of services and negatively affecting accountability. There are two authorities, one elected (the Prefect) and one appointed (the Governor), the ministers, and the regional development agencies. PROVINCLAL COUNCILS. This complex institutional framework has had an extreme effect on the provincial councils. It can be shown that many of the councils' powers overlap those of other entities (Frank 2001). In addition, the legitimacy of the provincial councils suffers from another dilemma: the Constitution gives them juris- diction in rural areas, although they are elected by citizens who live in both urban and rural areas. Thus, they provide services for only a minority of those who elect them, those living in rural areas. The fact that the majority of the council members come from urban neighborhoods further accentuates this dilemma of legitimacy. The Constitutional reforms of 1998 sought to formalize the role of the provin- cial council as the link between the national and municipal levels. These reforms provide for indirect representation of the municipalities on the council. This leads to some coordination between municipalities and provincial councils, whereas their relationship previously had been antagonistic and competitive. Resources flow directly from the central government to each of the subnational governments, some- thing that does not encourage collaboration between the provinces and cantons. The subnational elections of 2000 took place under this new rule but there were various attempts to declare indirect representation "unconstitutional." If this form of repre- sentation were eliminated, the provincial council and the municipalities would lose an important instrument of coordination. 9. Other programs include Friendly Networks, School Backpack, Improvement of Bilingual Intercultural Schools, School Meals, Our Children, Operation Child Rescue, School Scholarship, Producer Credit, Solidarity Bonus, Community Dining Halls, Generic Med- icines, Mobile Health Units, Free Maternity Care, National Food and Nutrition Program (PANN) 2000, Expanded Program of Immunizations, Epidemiological Control-Tuber- culosis, Epidemiological Control-Malaria and Dengue Fever, Peasant Housing, Marginal Urban Housing, Housing for Solidarity Bond Beneficiaries, and Potable Water and Envi- ronmental Sanitation. DECENTRALIZATION 485 MUNICIPALITIES. Since the reintroduction of a democratic system of government in 1978, the number of municipalities has more than doubled. While Ecuador used to have about 100 cantons, last year it had nearly 220. This means that the possibili- ties for providing services with economies of scale have been reduced, with a nega- tive effect on efficiency. Thus, the municipalities' technical capacity on the one hand and financial capacity on the other have diminished. Nonetheless, Congress contin- ues to approve requests from parishes to convert to municipalities. The situation is so serious that today 80 percent of the municipalities can be considered illegal because the Municipal Regime Law requires a minimum of 50,000 inhabitants for a community to become a municipal government. PARISH BOARDS. The Constitutional reforms of 1998 represent a great effort to democratize the state. Part of this effort is changes in the status of parish boards, which to this day are appointed by the municipality and thus are without any legiti- macy backed by the citizens. The Constitution provided for popular elections in rural parishes. However, the more radical measure was to convert them into "autonomous governments," whereby they were not only entided to their own political authority but powers and financial resources as well. In this way, from one day to the next Ecuador created about "parish municipalities" because legally they are not well dif- ferentiated from the country's municipalities. 1 Still unclear are the financial conse- quences of this for the central governmenand how these parish boards will be financed. The country should ask itself whether it is in a position to pay for four lev- els of government. This legal ambiguity affects the government's relationship with the citizens as well as coordination with the municipality in the delivery of services. JURISDICTIONS. Looking at intergovernmental relations as a whole, it does not appear that they provide a favorable context for decentralization. This situation seems more serious when we consider that there are currently as least seven border conflicts between provinces or between cantons. Nonetheless, having clear jurisdic- tions and authorities is a sine qua non to build a more decentralized system of gov- ernment. Administrative Decentralization: Transfer of Powers The provincial councils and municipalities currently carry out only 7 percent of total spending. In international terms, this is relatively little if we use the example of countries such as Colombia, Argentina, and Brazil, where close to 40 percent of spending is decentralized. Further, Ecuador's data are probably overestimated 10.The Constitution is ambiguous here. According to the constitutional provision, provin- cial councils and municipalities have "full autonomy" as compared to the simple "auron- omy' that parish boards have. This has been part of an extensive debate regarding the powers of this governmental body. 486 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM because they do not reveal the autonomy that local governments in Ecuador actu- ally have over this spending. Cumbersome procedures, delayed transfers, and a lack of local decisionmaking are part of the centralist reality that provincial councils and municipalities continue to face. In addition, since the end of the National Commission on Decentralization and Autonomy, the country has begun to define the powers that each level of govern- ment would have in four sectors: environment, tourism, agriculture, and public works. Motivated by the political pressure exerted by the provincial councils and municipalities because of the central government's failure to provide a concrete response, the process of organized negotiation among the three levels of govern- ment-national, provincial, and municipal-began in 2001. The first step was to define the existing situation regarding the existing powers. The second was an agreement between the executive branch and the "province," that is, between the provincial council and the municipalities, on the management of powers. The third was detailed negotiations between the provincial council and the municipalities. The fourth step, begun just recently, was the actual transfer agreements and the start-up of services. This form of negotiation has no precedent in Latin America. It is happening in an organized context and with the participation of the ministries. It is proof that it is feasible to organize local governments around common objectives. Although there have been cases of local governments seeking their own advantage and wanting to withdraw from collection negotiations,"1 the process has been quite successful so far. All of the 22 provinces and 140 of the municipalities, representing two-thirds of the total, are participating-indicating the great desire that exists at local levels to go further with decentralization. However, the risk of this procedure lies not in the way powers are defined, which seeks to minimize duplications and assign responsibilities according to the capacity of each local government, but rather in the contractual system. In addition, the par- ticular traits that the process took on in Ecuador through the signing of a series of agreements-a "Promotion Agreement" and various separate "Transfer Agree- ments"-are a source of risks because they could be mutually incompatible.'2 In addition, the lack of provisions for penalties, of reversibility in the process, and of conflict solutions are other risk factors (World Bank 2002). Further, in many cases it seems premature at this point to sign transfer agree- ments, given that there is still no complete clarity regarding the human resources, I . The province of Esmeraldas is an example. CONAM and the GTZ have estimated that about 18,000 individual agreements would be created in the province if this collective negotiation scheme were not adopted. In addition, the evidence that local governments are less willing to engage in collective negotiation in the health and education sectors must be taken very seriously. 12. However, the signing of the "Promotion Agreement" in March 2001 was a political neces- sity and is an important milestone in the process in Ecuador. DECENTRAIIZATION 487 financial resources, and infrastructure (assets) to be transferred in each case. More- over, the Ministry of Economy and Finance is just beginning to participate in the preparation of these reforms. The second risk lies in the political, financial, and administrative structure that provides the framework for the agreements. As we have mentioned, in Ecuador there are few conditions for accountable service delivery. This is due, on the one hand, to the existence of dual authorities at each level of government, the duplication of func- tions, and the complex arrangement of jurisdictions. On the other, it is due to the dispersed fiscal system that ultimately directs the local government spending. In this adverse context, the Committee on Powers has been created to settle conflicts in the administration of powers, but it does not have sufficient legal capacity because it is only an administrative body. In other words, in the legal hierarchy, its rulings are only "recommendations" to each of the parties, which in turn are not obligated to implement them. Fiscal Decentralization: Transfer of Resources In Ecuador, the fiscal system is at the center of the discussion regarding decentral- ization. Transfers of resources are the central tools that governments use to maintain their legitimacy, and political crises loom if resources are not transferred to the sub- national governments. In other words, their legitimacy is volatile and fickle given that a legitimacy based on fiscal resources "cannot be saved up." This was Ecuador's experience in the fiscal crisis of 1999 when it ceded the flow of resources, and the coastal provinces in particular sought "autonomy," a legal status that had never been completely clarified in the debate about decentralization. 3 The system of fiscal decentralization in Ecuador has some specific characteristics that merit careful study. We mention this not only because of its political repercus- sions but because to a great extent it determines the conditions for the delivery of services. It is not the decentralization laws that ensure coordination among levels of government, nor the transfer of powers agreements, but rather the financial system available to the subnational governments. We analyze it from the perspective of transfers, own revenues, debt, and fiscal responsibility. TRANSFERS. The public finances system depends above all on transfers. However, the system has various deficiencies from several perspectives. First, it is a dispersed system 13.The differentiation betweern "decentralized provinces" and "autonomous provinces" has not been very helpful given that any process of decentralization involves a greater degree of autonomy. This is one of the reasons why those participating in decentralization in Ecuador cannot communicate very well with each other. However, symbols such as "'autonomy" take on a political function within the process of decentralization that must be taken into account. 488 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM given that transfers to subnational governments derive from no less than 16 "special laws" (see the annex). Each begins from the concept of not allocating resources that are already assigned, that is, based on the notion that additional resources are created to protect "earned rights." Each law applies its own distribution principles and dif- ferent spending conditions. It is a highly complex system that makes it impossible to create a framework conducive to efficient service delivery. Given that these are direct transfers from the central government to each of the country's provincial councils and municipalities, these levels of government have absolutely no incentive to coordinate their investments in a more reasonable manner. A second characteristic of the system of transfers is that is allocates resources without the corresponding powers and thus violates a basic principle of decentral- ization. The most remarkable case is the 15 Percent Law, whose regulations expressly prohibit using these resources to assume new powers and thus set up a considerable amount of funds that have put a straightjacket on the central govern- ment. Given the amount of resources involved in this law, it constitutes a landmark in the demands for more resources by the country's regions, demands that were unleashed after the return to democracy in 1978. This has also contributed to the financial crisis the country is facing, although there has never been a transfer of more than 11 percent, something that regularly helps to distort intergovernmental relations. As if these negative experiences were not enough, in September 2002 Congress approved a law that allocates up to 25 percent of income taxes to the country's municipalities, without any link to the assumption of powers.14 Once again, this confirms that the country's provinces and cantons have strong ties in Congress that guarantee them access to the country's revenues. Third, the system of transfers only puts the central government under pressure to finance powers that are to be decentralized. A process has been unleashed of metic- ulous definition of how much the central government "owes" each provincial coun- cil and municipality. Although this is understandable in the atmosphere of distrust that exists between the levels of government, this rule does not foster shared respon- sibility at local levels. Fourth, the system does not apply the principles of partnership that sharing pro- portionally in the nation's revenues would imply. For example, in the case of the 15 Percent Law, only the resources approved in the budget at the start of the fiscal year are transferred. If revenues are later higher than projected in the budget, the central government does not use the actual revenues it has as a reference. Just as the possi- 14.The distribution system is also surprising. Each taxpayer can freely decide to which municipality the resources will be allocated, even though he or she may not live in that jurisdiction and receive certain services. This violates the principle of fiscal federalism that there should be a correspondence between taxes and the services that citizens receive in a specific locality. DECENTRALIZATION 489 bility of sharing "upwards" is excluded, so too is the possibility of "sharing down- ward" in times of economic contraction. The Constitution protects the subnational governments from having lower revenues from year to year. This creates a ratchet effect that also contributes to the financial pressures on the central government. The rigidity of the budget is also aggravated by a series of preallocations amounting to about 30 percent of tax and petroleum revenues. Fifth, transfers are discretionary and ambiguous. The 15 Percent Law is again an example: it was approved based on the current revenues of the central govern- ment and then the 1998 Constitution amended it, using the general budget as a reference. This situation has not yet been clarified and the distribution base is not clear. In addition, and although there are no reliable data, a series of transfers are discretionary, favor particular municipalities and provinces, and are used as con- cealed bailouts for subnational governments and regional public companies, unleashing a series of similar actions owing to moral hazard. For example, in 1990 alone the central government assumed debts for about $US100 million, 80 per- cent of which belonged to ECAPAG, the water company for the city of Guayaquil (Figure 1). Given this ambiguity in transfers, in the past the debate has focused on the inequities existing among localities, even though information is unreliable and coastal and mountain institutions have published their own data in an effort to Figure 1. Subrogation of External Debt (1998) oANDINATEL o ETAPA 1.5% 1.7% o EMAAP Quito 0.0% * CRMMunicip 2.8/ QUito oEMELORO t EMELMANABI .1%CE 0o 4O Aut Port. 11.8% 0 Aut. Port. Puerto Gua sEA Gu 0 1.2% a ECAPAG 79.5% Source: CONAM (2000). 490 ECUADOR: AN ECONOMIC AND SocALK AGENDA IN THE NEW MILLENNIUM demonstrate the inequities. This debate-focused on what each locality receives and what each locality contributes-shows the high level of mistrust that exists in the country. No doubt the differences in fiscal capacities are enormous (CONAM 2000). On the other hand, based on the per capita transfers that each province receives, Ecuador's allocations are relatively equitable in comparison with international standards. Surprisingly, the provinces that receive the least include the most economically powerful provinces, such as Pichincha and Guayas (Figure 2). However, only if the above-mentioned discretionary transfers are also counted is it possible to obtain a clear picture of what the provinces actually receive and on that basis build a new decentralized fiscal system. OWN REVENUES. Local governments have own revenues, but these are either unpro- ductive (as in the case of provincial councils) or subject to a series of administrative obstacles or exemptions that prevent more autonomous tax management. This is evident, for example, in the urban and rural property tax, the tax on vehicles, the patent tax, the tax on total assets, improvement contributions, levies, and others (CONAM 2001b). This precarious revenue situation is demonstrated by the fact that 96.3 percent of all tax revenues are still administered by the central government and only 3.7 percent by the municipalities (Wiesner 1999). In addition, the transfers as they are currently applied do not encourage fiscal effort. They are not contingent on increases in the municipalities' and provincial councils' own revenues, and the continuous increase in transfers has led not only to a vertical imbalance in subnational governments but also to dependence on the cen- tral government: o Municipalities: While in 1998 the municipalities had a dependency rate of 47 percent (transfers/total revenue; CONAM 2000), this figure was 74 per- cent in 2000 (MEF/CONAM 2002). O Provincial councils: Although there are no recent data, in 1998 the depend- ency rate was 76 percent (CONAM 2000) and this has also probably wors- ened owing to the effect of transfers. This leads to a series of problems in public finances and in the efficiency of spending: subnational governments incur oversized expenses. Given their depend- ence on transfers, there are incentives for them to overexploit the common resources (in other words, the free rider problem). In this situation, they do not feel any effec- tive budgetary restriction. Such restrictions are more effective when based on the subnational governments' own revenues. INDEBTEDNESS. The municipalities and provincial councils can take on debt with the BEDE in order to make investments. With a high rate of dependency and a high percentage of transfers, subnational governments also have incentives to contract Figure 2. Per Capita Resources Received, by Province (in $US, 1998) 600_ z 500- -- Z 300 2000- 100- OS O 00 ~ (~A P 9 C)~I C~O C) m Special laws c3By secrors Source: CONAM (2000). 492 ECUADOR: AN ECONOMIC AND SOCDAL AGENDA IN THE NEW MILLENNIUM excessive debt. Although no credit push"5 can be seen as in other countries of the region (Colombia, for example), several local governments find themselves overindebted, in part as a result of the Municipal Development Program (PDM). The government has still not begun debt-restructuring reforms, which is compul- sory under the Law on Transparency and Fiscal Responsibility. In addition, the data and references that the government uses to determine the level of indebtedness must be revised and supplemented (MEF/CONAM 2002) in order to produce a more reliable view of the situation. The Ecuadoran system of gov- ernment debt is difficult to monitor. Local governments do not produce reliable data and do not regularly send their financial reports to the central government. Although access to credit can be regulated transparently, the BEDE is often under pressure to make concessions to politically strong local governments. In addition, a system of indebtedness based on administrative principles-and not on market principles-creates monitoring requirements that cannot always be satisfied in an informal environment. Although the BEDE has begun to take credit risk into account with respect to municipalities and provincial councils, this situation is not changing significantly. FISCAL RESPONSIBILITY. In this context of incentives created by the fiscal system, it is doubtful whether the measures proposed in the Law on Responsibility, Stabilization, and Fiscal Transparency of 2002 can actually help to bring public sector revenues and spending into line. The reasons for this assessment follow: o Measuring the degree of indebtednessl6 does not determine the actual ability to pay in the future, given that the indicators are based solely on the past. o Although indebtedness indicates the future payment on debts and the fiscal pressures on the debt portfolio, it does not reveal (i) the risks in the debt port- folio, (ii) the impact of the fiscal balance sheet on the sustainability of the debt, (iii) the obligations to be converted to debt, and (iv) the budgetary flexi- bility at the subnational level for meeting obligations. o Although a broader notion of debt and its various forms is being introduced, the subnational financial data in Ecuador have never been all that reliable; var- ious extrabudgetary activities continue to exist. o In addition, the penalties imposed on individuals (such as mayors and pre- fects) do not take into account the pressure exerted by the provincial councils and municipal councils. 15."Credit push" is understood to mean accelerated indebtedness. 16. Measured by the percentage relationship calculated each year between total liabilities and total annual revenues and the relationship between annual debt service and total revenues (Art. 7). DECENTRALIZATION 493 Finally, the law opens the door to new debt given that the subnational gov- ernments-in the event of a budgetary cutback-"will have to approve credit changes in the expense budget equal to the value of the revenues not obtained" (Art. 41). Management of the Decentralization Process Except when working to draw up the transfer of powers agreements, provincial councils and municipalities do not currently participate in the decisionmaking on decentralization. The situation is radically different from 2000, when the National Commission on Decentralization and Autonomy represented both social forces and the subnational governments. The President of the Republic had a forum he could use and the members of the commission also found an atmosphere of open discus- sion regarding the future model of the state. The ability to call together a broad forum has been key to managing the decentralization process. However, the National Commission on Decentralization now functions only as an internal agency of the central government in support of decisionmaking by the Office of the President. Without any type of representative function, the only par- ticipants are the Ministry of Economy and Finance, the Planning Office, and CONAM as the Technical Secretariat. Although the formal participation of the Decentralization Commission of the National Congress as a guest ("with a voice but no vote")'7 is a sign of enormous progress, the commission does not currently have sufficient legitimacy in the eyes of local governments. Moving the location of the commission's sessions from one of the country's major cities to another in order to lend a tinge of representativeness to the proceedings is not enough. Furthermore, Ecuador still has no simple and practical system for monitoring decentralization. Various attempts have already been made to establish such a sys- tem, with support from ODEPLAN and CONAM. It is enormously useful to have this instrument so as to be able to verify whether decentralization is really meeting the high expectations that it creates in the country. This also means strengthening the open information policy that CONAM has had since the beginning of the National Commission on Decentralization and Autonomy. A link has been estab- lished between the institutions of decentralization, but this role must still be con- solidated with the systematic and ongoing dissemination of information directed to the broadest target groups in society. 17.Recently, the chairman of the Congressional Commission on Decentralization chose not to participate in the sessions as a protest against the central government's "lack of politi- cal will" for supporting decentralization. 494 ECUADOR: AN ECONOMIC AND SociAL AGENDA IN THE NEw MILLENNIUM C. IPoRicy Recommendations Structure of the State and Intergovernmental Relations Ecuador's complex institutional framework is not conducive to decentralization. Different levels of government, autonomous entities, and agencies compete among themselves without any clear reference point. In this context, no one is clearly responsible, which contradicts the principle of accountability. Making more finan- cial transfers based on this institutional framework is risky, and thus reforms are needed in the various spheres of the government's structure. REFORM OF THE INTERMEDIATE LEVEL. Reform of the intermediate level'8 will only be viable if it is designed as part of a slow strategy, with successive steps moving toward complete transfer to the provincial councils or municipalities. This must be organized as a transition strategy. To do this, it is extremely important to choose a starring point that potentially determines the remaining actions needed. REGIONAL DEVELOPMENT AGENCIES. If the government is willing to give a strong sig- nal of support for decentralization, it should focus on transferring powers and resources from the regional development agencies. As a first step, it is recommended that a new board be established for the development agencies. This would be made up of the provincial councils in provinces where the development agencies have jurisdiction, given that they cover various provinces. A neutral representative from the central government should also participate. This board would be responsible for managing services until proceeding to transfer them in a later phase. It would have to determine the human, material, and financial resources that belong to each of the provincial councils or municipalities in the province. Until the transfer is com- pleted,'9 the new board should approve the annual budget of the Regional Devel- opment Agency. DECENTRALIZED ENTITIES OF THE SUBORDINATE SYSTEM. The transition strategy also applies to the subordinate system at the provincial level. As a first step toward decen- tralization, a framework of incentives promoting coordination with the autonomous system (provincial councils and municipalities) should be created. Using Chile and Bolivia as a reference, a scheme could be considered in which the provincial direc- tors currently appointed by the ministries (Ministries of Health, Education, and 18. Like Ecuador, several other countries in the region, including Venezuela, Colombia, Peru, Bolivia, and Chile, are also reforming or discussing the future functions of the intermedi- ate level. 19. Based on international experience, transferring human resources in particular entails many problems. DECENTRALIZATION 495 others) would appoint a short list proposed by the provincial council. In this way, the provincial directors would owe their positions, at least in part, to the autonomous governments of the province or enjoy their confidence. A second measure would be to submit the ministries' operational plans to the provincial coun- cil for approval. Thus, although the central government would continue to develop operational plans, it would be possible to coordinate activities so that the provincial council would acquire a certain degree of control over the actions carried out by the ministries on a decentralized basis. As long as decentralization does not actually progress, this is the only way to arrive at a transition. THE GOVERNOR. Another debate in Ecuador concerns the role of the provincial gov- ernor, who is currently appointed by the Ministry of the Interior. Although this gov- ernor is an authority in addition to the Prefect (elected), his or her involvement in public life is minimal given that his or her resources are extremely limited. A provin- cial cabinet has operated in only a few provinces. However, undertaking a reform of the governorships now would divert attention from the administration's more seri- ous and important problems. The real problem lies in the multiple entities of the subordinate system that in the province of Guayas, for example, amount to 220 dif- ferent agencies and in Azuay to 180 different agencies (CONAM 1998). Looking at them from this perspective, flashy reforms of the subordinate system such as the elimination of the governor are basically unimportant.20 If the government is successful in organizing the intermediate level in accordance with this phase of the transition, it will have made great progress toward decentral- ization. Any further steps would require a transfer of resources and powers within the framework of the negotiations that have been in progress since 2001. Administrative Decentralization: Transfer of Powers The transfer of powers should seek to produce the smallest possible fiscal impact and promote conditions for accountability. The agreements are the principal route whereby the transfer of powers is achieved in Ecuador and should continue to be used. In order for the agreements to fill in the gaps in decentralization, the follow- ing specific aspects should be taken into account: 20.1n 1998, the administration of President Mahuad launched a project to strengthen the governors offices based on the provincial cabinets (following the Chilean model) with the governor in charge of a territorial budget (CONAM 1998). If Ecuador is consistent in fol- lowing the Spanish model of "provincial autonomies," it should retain the governors' offices, given that in Spain they also exist parallel to the elected authorities. On the other hand, the provincial councils have indicated that they should be the only governments in the province. A part of this clamor is the fact that some of them call themselves "provin- cial governments" in order to express the idea that they are actually the only legitimate government. 496 ECUADOR: AN ECONOMIC AND SOcIAL AGENDA IN THE NEW MILLENNIUM o The agreements may transfer resources appropriately only if intergovernmen- tal transfers guarantee a minimum of correspondence between responsibility and resources. o The agreements can establish a clear division of responsibilities only when (i) the labor problem is resolved (contracting, rights, labor liabilities) and (ii) clear jurisdictions and authorities are established. o The agreements can contribute to the efficiency and quality of services only when (i) goals are set for the delivery of services and (ii) penalties are levied for failing to meet goals. Ecuador's reform program should resolve these open issues. However, it is a sine qua non condition that the Ministry of Economy and Finance participate regularly, actively, and on a committed basis in the negotiations. Only then will we know whether the central government takes decentralization seriously and is committed to it. The intergovernmental agreements mentioned below could commit the Ministry in this respect. MAKING ACCESS TO THE NEGOTIATIONS CONDITIONAL. Access to the transfer of pow- ers program should be subject to subnational governments' meeting minimum stan- dards of accountability and submitting financial reports. This is necessary because it is likely that not all of the 22 provincial councils and 140 municipalities that are par- ticipating can meet this minimum level of quality that will later contribute to responsible management. PROVISIONS IN THE CONTRACTUAL SYSTEM. The government should work rapidly to generate sufficient provisions for the contractual system. The model agreements that have been designed still do not adequately address the many adverse situations that may occur. In particular, there should be more in-depth treatment of penalties in the event of noncompliance and of the reversibility of the process.21 PRODUCTION OF INFORMATION. Additional information should be produced for decisionmaking; the "Study of the Consequences of the Transfer of Powers" begun in 2000 should be carried out for each of the sectors. This is important because as of yet not all ministries-such as Roads, Tourism, Agriculture, and Environment- know the effects that decentralization would likely have. The Ministry of Education is the only central government agency that participated in the study. 21.In this regard, the work previously done by CONAM, AME, the Consortium of Provin- cial Councils of Ecuador (CONCOPE), and the World Bank can be a guide for com- pleting the agreements (World Bank 2002). In addition, the Powers Commission should be empowered to be the final arbiter in resolving conflicts, perhaps with the support of the Attorney General, provided this arrangement is operative. DECENTRALIZATION 497 TRANSFER OF HUMAN RESOURCES. The institutions of the central and subnational governments still do not have sufficient knowledge of the labor issue. Experience in all the countries of Latin America shows that if human resources are not paid by the subnational governments, the central government continues to have influence on spending decisions at the local level. The government should hold strategic discus- sions with the unions in each of the sectors. There was an initial dialogue in the edu- cation sector but it would probably be more productive if there were concrete data on labor liabilities, indemnities, and the future rights of public employees. INCLUDE THE ENTMTIES OF "FUNCTIONAL DECENTRALIZATION." The agreements still focus on transferring powers from the sectoral ministries. As we have mentioned, the principal problem facing decentralization in Ecuador is the fact that an enormous amount of resources is administered outside the ministries in a second layer of administration made up of the regional development agencies, the social funds, and other entities. Thus, the entire transfer of powers process could fail to attack the central task of decentralization. TRANSFERS OF POWERS SUBJECT TO RESULTS. In the sectors that have made the most progress in the negotiations, such as the environment and tourism, Ecuador should experiment with agreements based on results. As we mentioned, without clear goals that can be monitored there is no knowledge concerning the usefulness of decen- tralization, and the debate will continue to revolve around the amount of resources to be transferred, an important issue but not what is essential in a decentralization effort, which seeks improved efficiency and qualiry of services. Fiscal Decentralization Since the National Commission on Decentralization and Autonomy presented the "New Management Model" in 2000, there have been no new proposals for exten- sive reform of public finances. In 2001, the Ministry of Economy and Finance took the lead and developed the Fiscal Reform, which contains some ideas submitted by the National Commission. However, this reform has gradually encountered resist- ance both in the ministry and in Congress, and consequendy it has not been possi- ble to do much. One exception is the Law on Responsibility, Stabilization, and Fis- cal Transparency, but this still needs to be put into practice. Thus, there are many other fiscal decentralization reforms that are still pending. INFORMATION. Reforming public finances and adopting a new system of transfers presupposes having more reliable, complete, and transparent data. As a first step, we recommend quantifying not only the transfers that each provincial council and each municipality receives but also how much the central government spends in each province and canton through the following:22 22.The work done previously in the context of the National Commission on Decentraliza- tion and Autonomy is not sufficient. 498 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM o Ministries, o Regional development agencies, o Social funds, o International loans, and o Extrabudgetary allocations and discretionary transfers. Only if these data are available and reliable will the debate about decentralization be more informed and the conditions right for making well-founded decisions. This is a condition for being able to adopt a new system of transfers. In addition, infor- mation could be produced-such as GDP generated in each province-that would measure the economic potential of the jurisdictions.23 This also means having budgetary management based on the principles of uniry and universality, at both the national and local levels. The submission of reports by the subnational governments must be enforced-and probably the only way to do this is to exclude from the decentralization process those government entities that do not meet the minimum standards. Having more information on public finances also means having the instrument of SIGEF at subnational levels. Since 2000 there have been plans to expand the system to the municipalities and provincial councils. It has not yet been possible to consolidate these plans in the network of participat- ing institutions such as the Comptroller's Office, AME, and the Consortium of Provincial Councils of Ecuador (CONCOPE). The parties must make a commit- ment to move ahead-in an initial phase-with pilot programs and later a gradual extension to other subnational governments. TRANSFERS. Reforming transfers is one of the most important reforms that the new administration must undertake. This means defining the distribution bases and clear distribution criteria. For the future system of transfers, a vision should be developed that takes several considerations into account. The transfers of resources should be based on the delivery of results; without this rule is it impossible to say with cer- tainry what impact resources would have in terms of service quality. If this condi- tion is met, the rules on the use of resources for current expenses and investment can be less strict; these rules are generally difficult to monitor and it is best to encourage autonomous decisions by local governments rather than determine at the central level how resources are to be used. As well, a healthy balance should be struck between freely assignable resources and other resources for specific uses in each of the sectors (such as health and education). And finally, transfers should encourage the generation of local government's own resources. Given that the financial system is so disperse, a first step should be to focus on what has the most impact-for example, the 15 Percent Law and the social funds- 23.On this subject the government should take the lead in order to avoid new discussions regarding the reliability of the data obtained by institutions from the different regions of the country-that is, the coast and the mountains. DECENTRALIZATION 499 leaving for a second phase the numerous transfers that benefit particular provinces. In addition, consideration should be given to establishing two matching grants at different levels of government. THE 15 PERCENT LAW. The resources that the 15 Percent Law transfers-actually in violation of the principles of decentralization-are politically unrecoverable. In the event that the government decides to transfer more than the current 11 percent, any additional resources should be subject to the assumption of powers and the man- agement of results. This would send an important signal to the local governments on the responsible management of finances. This reform would be viable only with changes in the law's regulations. Second, the calculation basis should be clearly defined. The difference between the Constitution, which takes the general budget as the reference, and the law, which refers to current revenues, should be resolved, reaf- firming current revenues as the base. Third, the distribution criterion that distrib- utes 10 percent of the law's resources in equal parts should be nullified. This rule has contributed substantially to the growth in the number of municipalities given that for a small parish (to be converted into a canton) these resources represent an enor- mous amount. Fourth, the transfers should be effected in proportion to the revenues actually obtained, whether they are higher or lower. With these rules, the principles of shared participation would be reaffirmed. SOCIAL FUNDS. Under the current scheme, the many functionally decentralized agencies do not coordinate their actions with the provincial councils and munici- palities. This is because in practice it is the financing systems-and not the decen- tralization laws-that determine the entities' powers. Thus, in the long term, social funds such as the FISE and others should be incorporated in current transfers from the central government to the municipalities and provincial councils. These funds should be contingent on a specific use.24 In its first phase, a transition strategy should provide that operational plans be approved by the respective municipalities in which activities are carried out, and that the fund be managed with the partici- pation of the provincial councils or municipalities. MATCHING GRANTS. Given that resource flows are the most effective tool for improving intergovernmental relations, efforts should be made to establish links between the provincial councils and the municipalities. Except for their approaches to the negotiations on powers, the two levels have for the most part had an antago- nistic relationship. In order to encourage greater cooperation between them, a matching grant could be set up and offered by the provincial councils25 to the 24. However, any effort to place conditions on spending also implies having the ability to monitor their application. 25.The provincial councils are financially in a weaker position than the municipalities. But even so, the resources offered by rhe provincial councils to the municipality in a matching grant 500 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM municipalities for services with externalities. For example, in sectors such as health and highways, this grant could be funded with resources from existing transfers. In addition, there could be a matching grant between the central government and the provincial councils,26 and directly between the central government and the munici- palities. In this way, there would be a sufficient level of competition among the lev- els of government and greater cooperation would be ensured at the same time, pro- vided that the rules were well defined. OWN REVENUES. Given the high degree of dependency of the subnational govern- ments on transfers, it is imperative that they improve their own revenues. The gov- ernment has already begun to examine the principal obstacles to improving this sit- uation (CONAM 2001b). It is important to reform the many administrative obstacles, particularly in the property tax, as this is the principal source of revenues for the municipalities. Making regular transfers contingent on increases in the sub- national governments' own revenues can be an excellent way to encourage these reforms. In addition, it is important, particularly for the provincial councils, to generate a base of their own revenues that will make them more autonomous from the central government and will provide the opportunity for greater accountability on the part of electors and taxpayers.27 However, considering the situation of national public finances and the informality in the management of resources, it is difficult to con- sider granting new own revenues to the subnational governments. The only possi- bility in the medium term is to establish surcharges on national taxes that are trans- ferred to the subnational governments. Tax management would be the responsibility of the central government but the resources would go to the provincial councils.28 However, this reform should be contingent on minimum conditions of responsible finance management on the part of the provincial councils. INDEBTEDNESS AND FISCAL MESPONSIBILI. With respect to indebtedness, the govern- ment should think strategically about how to send market signals to the local govern- ments. Large municipalities such as Quito and Guayaquil should, in addition to are surely attractive to the municipal governments and can encourage coordination. It would be advisable to review the experience of some of the states in Mexico in this respect. 26. In reality, the grouping of provincial councils in the "G-8" has been promoted through fiscal incentives provided by the central government (such as the possible construction of the highway to Manaus, Brazil). 27.It should be kept in mind that the indicators of dependency and self-sufficiency would be even worse in the event of transfers for the assumption of powers, given that these would also be financed through transfers (see the case ofVenezuela). This makes it necessary for local gov- ernments to increase their own revenues or to seek their own new sources of financing. 28.Technically, the surcharges are transfers. However, for the taxpayer this distinction is not generally made and they thus would stimulate accountability. DECENTRALIZATION 501 administrative controls, have their debt capacity evaluated by specialized and interna- tionally recognized firms. Ihis is important, given that the national government has not yet been able to indicate to the local governments in a credible way that it will not engage in any form of debt forgiveness. In this sense, a policy could be adopted whereby financially incapable local governments would be supervised by the central government until they recovered their stability. These political incentives are possibly more effective than fiscal incentives and have been implemented in other countries.29 In addition, making public the debts that have been cancelled in the past could be a useful way to demonstrate the severity of the problem and the government's decision to implement a different policy. Also, all existing debt in subnational gov- ernments should be disclosed as pending payments and contingencies. As the crite- ria used by the Law on Responsibility, Stabilization, and Fiscal Transparency only measure past debt capacity, these criteria could be supplemented with indicators that show the budgetary flexibility of local governments, some of the risks in the debt portfolio, the impact of the fiscal balance sheet on the sustainability of the debt, and the obligations to be converted into debt. In this regard, it is important to check whether the indicators and the information that the BCE uses to rate credit risk are valid for decisionmaking. With these data, it would be possible to begin with a debt restructuring plan as provided in the Law on Responsibility, Stabilization, and Fiscal Transparency. It is not clear how many local governments are actually overindebted-in part because of the financial effect of the Municipal Development Program-and consequently need substantial reforms. However, it is imperative to begin strategically with debt refinancing that is based on clear criteria. In order for the mechanisms of the Law on Responsibility to operate properly, the Ministry of Economy and Finance must again take the initiative by eliminating preallocations, thus ensuring that the budget will be more flexible. Finally, the Min- istry's entire budget management process must be reviewed, as many governments have already tried to do. Without a properly functioning budget, there is no guar- antee whatsoever that the law will have any effect. As a first step, the Ministry of Economy and Finance should analyze in detail what organizational and procedural changes it should make internally in order to fully implement fiscal responsibility based on this law. Management of the Decentralization Process It is unlikely that the government will be able to undertake a reform of the magni- tude of decentralization witlhout the support of the subnational governments. Con- 29. Fiscal penalties include, for example, restricted access to credit or transfers. Countries that impose political penalties include the United States (as in the case of the cities of Wash- ington, D. C. and New York) and Germany. 502 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM tinuing to exclude them from the decisionmaking process means provoking politi- cal resistance. The opposite approach, welcoming their participation, can be a key tool for legitimizing actions. Thus, we recommend increasing the number of partic- ipants on the National Decentralization Commission to include the Association of Municipalities of Ecuador (AME), and CONCOPE. There is no need to increase the number of participants so much that the Commission starts off in an environ- ment of disturbance and political crisis. At this point, what is needed is a well-func- tioning coordinating body. Meanwhile, CONAM will continue to operate as the technical secretariat for the Commission, but will delve deeper into a policy of open dialogue. To start the government's work, consideration could be given to signing a com- mitment agreement on results among central government agencies. This could be signed by the President of the Republic, the Ministry of Economy and Finance, selected ministers, and the Decentralization Commission and would provide a frame of reference based on clear goals for decentralization. The agreement should be pub- lished. Given that decentralization is a process of incremental changes, the "New Man- agement Model" developed by the National Commission on Decentralization and Autonomy was designed as an open frame of reference. The idea was to regularly publish and distribute the progress made in the design of the new state. Unfortu- nately, this never happened. For the central government, the ideal is still perfect and polished models of decentralization. This initial idea should be taken up again and, as an example, the progress the provinces have made in the negotiation of powers should be publicized. A monitoring system has yet to be put into effect. Preferably, it would operate with the active involvement of participating institutions and service users. It would also have a component providing neutral evaluations performed by universities and research institutes. In addition, the production and dissemination of information at all levels should be promoted. Target groups such as students, parents, service users, communities, indigenous peoples, blacks, and other citizens still do not have specific information. If decentralization moves ahead at its current pace-22 provincial councils and 140 municipalities have already signed the transfer of powers agree- ments-this would become an urgent requirement. Policy Matrix n Poliey measures Short term Medium term Problems (to June 2003) (2003-07) Progress indicators Objectives/goals 1. Government The government undertakes a Carry out a gradual transfer of In late 2003, at least Objective: Improve ° structure and inter- transition or exit strategy mov- powers to provincial councils, two Regional Develop- accountability at the governmental rela- ing toward an intermediate from both ministries and ment Agencies, among intermediate level and tions: decentralized level. Short-term Regional Development Agen- them CEDEGE and increase the efficiency Problem: The com- actions planned are as follows: cies. CREA, have a new of services. plexity of the institu- * For the Ministries: appoint- Extend the jurisdiction of board. Goals: Services are tional framework, ment of provincial sectoral provincial councils to urban In 2004, at least 40 delivered at the inter- particularly at the directors (decentralized minis- areas considering that election is percent of spending by mediate level without intermediate level, terial sphere) with a short list by electoral district in urban and Regional Development overlaps and with effi- does not allow for suggested by the (elected) Pre- rural areas. Agencies is decided in ciency. accountability and fect. Remove the status of coordination with the leads to inefficient * For Regional Development "autonomous government" from provincial councils. services. Agencies: Board set up com- parish boards in exchange for a posed of provincial prefects participatory agency. Extend according to jurisdiction jurisdiction to urban areas with (PREDESUR, CEDEGE, flexible arrangements in large CRM, UDENOR, CREA, municipalities. others) and a central govern- Reintroduce indirect representa- ment representative. Approval tion of municipalities on the of budget by this new board. provincial councils. In 2003, there are 10 (one per sector) Presidential Decrees on appoint- ing provincial directors from a short list. (Matrix continues on the following page.) Policy Matrix (continued) Policy measures Short term Medium term Probkms (to June 2003) (2003-07) Progress indicators Objectives/goals 2. Administrative The government introduces Conduct pilot cases of transfers By 2005, at least 30 Objective: Transfer decentralization: provisions for the contractual based on results in the context municipalities and 10 powers with less poten- t Transfer of powers transfer of powers system, with of agreements. provincial councils tial fiscal impact and Problem: There is a the following reforms: exercise new powers in within a framework of high degree of cen- 1. Make access to the transfer three sectors. accountability. tralized decisionmak- of powers program contingent By 2007, at least 50 Goal: Public adminis- ing in delivery of on subnational governments municipalities and 15 tration meets its services. meeting minimum standards provincial councils responsibilities at all of accounting, budgetary man- exercise new powers in levels of government. 0 agement, and regular submis- three sectors. sion of financial reports. 2. Clarify rights and obliga- tions among levels of govern- o ment and complete model agreements in terms of penal- ties and reversibility of trans- fers. Empower the Commis- sion on Powers to be the final arbiter in resolving disputes over powers. 3. Produce proposed solutions Z in the transfer of human resources to local governments r (labor rights, indemnities). r Conduct in-depth discussions Z with unions with precise data on public employees affected by decentralization. 4. Indude the Ministry of Economy and Finance in sec- toral negotiations. 5. Information generation: z Conduct a study of "the conse- quences of decentralization" for each sector (environment, agriculture, public works, tourism, social welfare, health). Publish the results and discuss them with provincial councils, municipalities, and Ministries. 3. Fiscal decentral- The government undertakes a Carry out reforms of the system In 2003, nominally 15 Objective: Establish ization reform of subnational finances of transfers based on the follow- percent (though in transparent fiscal Problem: Dispersed with three starting points: ing six policies: reality only 11 percent) incentives for coordi- and discretionary fis- 1. "15 Percent Law": Define 1. Set up a matching grant of current revenues is nating spending. cal framework does the calculation basis; make berween levels of government distributed based on Goal: Services are not allow for effi- increased transfers (resources for powers with externalities revenues actually delivered efficiently cient spending at all above 11 percent) contingent (health, highways): provincial- obtained. and with coordination levels of government. on the assumptions of powers municipal, central-provincial, In 2004, 20 percent of among the levels of and service management central-municipal. The fund current transfers oper- government. results. should be supplied by current ate in a matching 2. "Fiscal Responsibility transfers and clearly delineate grant. Law": Announce that the the powers and sectors it In 2007, the special national government will not finances. laws and corresponding assume the debts of local gov- 2. Include social funds in a sys- transfers are unified ernments; publish debt cancel- tem of current transfers. and operate transpar- lations over the last five years; 3. Add different special laws for ently. (Matrix continues on thefollowing page.) Policy Matrix (continued) - Poliay measures Short term Medium term Problems (to June 2003) (2003-07) Progress indicators Objectives/goals track and publish forms of transferring resources and make In 2007, municipalities indebtedness (contingencies, them subject to clear and trans- have increased their floating debt, late payments) parent distribution rules and own revenues by 30 j in local governments; plan and based on management results; percent. implement organizational and relax the rules on the use of cur- ° procedural changes in the rent spending and investment; Ministry of Economy and make transfers contingent on Finance to achieve fiscal increases in own revenues. 8 0 responsibility in practice. 4. Introduce basic principles of Z 0 3. Indebtedness: Undertake partnership: allow subnational K the Debt Reconversion Plan governments to share propor- ' for overindebted municipali- tionally in times of economic ties and provincial councils. contraction (avoid ratchet 0 4. Information: Begin the effect); and distribute shared installation of a single comput- resources according to effective erized system (SIGEF) that revenue. will provide data revealing how 5. Experiment with surcharges 3 much the government spends on national taxes for provincial > in each province and canton councils and municipalities that through the ministries, demonstrate financial responsi- regional development agencies, bility. z social funds, extrabudgetary 6. Have the Ministry of Econ- allocations, and international omy and Finance send draft loans, laws to the Congress to reduce m preallocations in the budget. 2 Z Own revenues of municipali- ties and provincial councils: Send a series of legal reforms to Congress to eliminate adminis- trative obstacles and introduce flexibility in financial self-man- agement of local governments. Indebtedness: Regulate indebtedness with additional indicators that show real ability to pay debt and port- folio risk. Make access to credit (additionally) contingent for Quito and Guayaquil on evalua- tions of credit risk conducted by international firms. Information policy: 1. Develop information: provin- cial GDP. 2. Introduce the subnational SIGEF along with the Office of the Comptroller, AME, and CONCOPE. 4. Management of Expand the membership on The commission should regu- Local governments par- Objective: Make cen- decentralization the National Commission on larly update the "Management ticipate voluntarily in tral government deci- process: Decentralization and Auton- Model" (developed in 2000) in the National Decen- sions legitimate in the Problem: Decisions omy: include AME and CON- political-territorial, fiscal, and tralization Commis- view of local govern- on decentralization COPE, in addition to the cur- administrative areas according to sion. ments and civil society process are not rent members of CONAM (as advances in formulation. Sectoral ministries, and guarantee coordi- accepted by munici- technical secretariat), the Min- AME, and CON- nated implementation. ( (Matnxs concinucs on the fr/lowuing page.) Policy Matrix (continued) Polity measures Short term Medium term Problems (to June 2003) (2003-07) Progrcss indicators Objectives/goals palities, provincial istry of Economy and Finance, Issue regular reports on moni- COPE seek technical Goal: Central govern- councils, and civil and the Office of the President toring conducted based on the assistance from ment, provincial coun- society. of the Republic. participation of actors involved. CONAM. cils, and municipalities Intragovernment commitment: Publish this information. CONAM is invited to accept the process of The President signs an agree- Conduct a dissemination cam- forums on decentraliza- decentralization and ment based on meeting short- paign, tailored to cover target tion by civil society. implementation is term (six monrhs) goals with groups. Updates to "Manage- coordinated. m the Ministry of Economy and ment Model" are pub- Finance, selected sectoral min- lished and distributed o istries, and the Commission regularly. on Decentralization. This Monitoring reports are agreement is published. prepared regularly and Develop a simple monitoring published. system concept that is based on the active participation of the ministries, subnational govcrnments, and users. z Define a base line in the can- > tons and provinces that are in H rhe process of negotiating powers. r Annex M Special Laws Governing the Transfer of Resources and Revenue-Sharing for the Benefit of Municipalities and Provincial Councils 0 Law No. R.O. Date Amt./% Source Criteria Use Cultural Heritage 82 838 23/Dec/87 0.03 Local public Restoration, conservation, and Recovery Fund performances protection of historical, artistic, and cultural assets 0.1 National Emergencies Investments Fund (FONEN) Budget Bolivar Provincial 46 281 22/Sep/89 7.5% 1% of credit operation 20% Provincial Council Environmental sanitation Development Fund transactions in domestic 16% Guaranda Sewers currency 16% Chillanes Urban development 16% Chimbo 16% San Miguel 16% Echeandia Legislative decree 47 281 22/Sep/89 5% Energy bills from 60% municipalities of 100% for infrastructure on allocations to INECEL to electrical Azuay, Cafiar, and the provinces of companies for generation Morona Santiago Azuay, Cafiar, and at power stations in 40% CREA 80% execution of projects Morona Santiago Pisayambo, Paute, and 20% forestation Agoyan Environmental 57 344 28/Dec/89 10% Puerto Bolivar Port 20% Provincial Irrigation, drainage, and roads Sanitation, Roads, Authority Revenues Council and Irrigation Fund 5% 1% of operations in 60% municipalities Sanitation and roads of the Province of El domestic currency 20% municipalities Oro (FONDORO) based on population (Annex continues on the following page.) Annex (continued) 0 Law No. R.O. Date Amt./% Source Criteria Use Provincial Develop- 65 395 14/Mar/90 2% Total current 47.5% contribution to To back BdE credits ment Fund budget revenues the capital of the BEDE (FONDE1'RO) 47.5% Provincial Development projects Councils and INGALA: 25% based on population m and 75% level 0.5% CONCOPE CONCOPE 0 Sectional Develop- 72 441 21/May/90 2% Net current budget Municipal provincial ment Fund distri- revenues capitals: 25% Quito, m (FODESEC) buted: 25% Guayaquil, I0 2% 50% others level Z0 98% 20% Provincial Coun- 70% current expenses and cils (60% population, investment 20% UBN, 20% 30% rural area investment administrative efficienciy anid fiscal effectiveness) n 75% municipalities: 40% BEDE: Investment fund 60% municipalities ° (60% population, 30% UBN, 10% administrative efficiency and fiscal effectiveness); 40% BdE 5% emergencies Sectional agencies z 3 Prior to distribution billion of petroleum revenues received by the state c Rural Roads Program 75 455 11/Jun/90 10 General Government BEDE credits counterpart BEDE credit trust of the Province of billion Budget Manabi up to 2 2002 Other budge- 0 z tary allo- cations Irrigation Fund of 93 501 16/Aug/90 I General Government Provincial irrigation plan the Province billion Budget of Cotopaxi since 1991 Fund for the 115 612 28/Jan/91 12.5% 1% of credit operations 30% Provincial Council Neighborhood roads, Agricultural Sector in domestic currency irrigation, forestation of the Province 20% municipality of Area market and of Chimborazo Riobamba environmental sanitation 50% evenly among the Collection centers and remaining cantons environmental sanitation Development Funds 122 676 3/May/91 2.5% Billing for petroleum 50% Provincial Council Urban and rural infrastructure for the Provinces of services to PetroEcuador 20% provincial capital projects in Sucumbios, Napo, the Amazon Region from national companies 30% evenly among Pastaza, Morona Santiago, remaining provincial Zamora Chinchipe, and councils Orellana 4.5% Billing for petroleum services to PetroEcuador from foreign companies 40 S. 248 7/Aug/89 5 US Per barrel of petroleum Evenly for Napo, Esme- 50% municipal infrastructure cents transported by pipeline raldas, and Sucumbios projects 50% provincial council infrastructure projects (Annex continues on the following page.) Annex (continuea) Law No. R.O. Date Amt./% Source Criteria Use 10 30 21/Sep/92 10 US Per barrel of petroleum BEDE distributes 80% road and environmental cents produced in the Amazon 30% provincial sanitation projects region councils 20% current expenses 60% municipalities (55% evenly, 45% n population) 10% Regional fund 0 Development Fund 145 899 23/Mar/92 15% 1% of credit operations 25% Provincial Council Studies, construction, of the Province in domestic currency 25% Quito improvement of of Pichincha 50% evenly among neighborhood roads and 8 z remainiing cantons infrastructure projects in o urban and rural parishes Development Fund 146 899 23/Mar/92 15% Exchange differential in 20% Provincial Council Road and urban and rural z of the Province weekly transactions of 27.5% Tulcan infrastructure projects of Carchi the BCE 16.5% Montufar ° 15% 1% of credit operations 11% Espejo in domestic currency 9% Bolfvar 9% Mira 7% Dacha 15% Distribution s/n 27 20/Mar/97 15% Revenues from central 70% municipalities Economic, social, and cultural z of the Central government budget with (50% UBN, 40% development plans Government Budget the exception of revenues population, 10% z from internal and evenly) external credits 30% provincial councils (50% UBN, 40% population, 10% area) z z c: Law replacing the 92 335 9/Junl98 100% 1% tax on the purchase 70% municipalities Road projects law creating the and sale of used vehicles 30% Provincial Council Roads Fund of the Province of Loja (FONDVIAL) Highway equipment Creation of 10 S. 378 71Aug/98 100% Tolls, rehabilitated Reconstruction of areas CORPECUADOR roads affected by the El Nifio 25% Annual net income phenomenon from Solidarity Fund. Investment in proportion to Donations and subsidies damage caused by El Nifio 10% State share in increased petroleum exports 0.7% Banana exports Loans on behalf of the state Loans on behalf of CORPECUADOR Budgetary allocations Source: CONAM (2000) New Management Modelfor Ecuador 18 The Administration of Justice' Maria Dakolias Despite the progress achieved on specific aspects of the judicial reform program, people do not trust the formaljustice system in Ecuador because it is not easily accessible, it is slow and inefficient, and it is perceived as being vulnerable to corruption. These problems are in turn associated with the limitedprofessional training of those running the system, lim- ited resources, and the use of inadequate administration and oversight models. A Com- prehensive Reform Plan, which was designed to establish the bases for future, farther- reaching changes, approved in 1996 and revised in 2001, has completed its final phase. However, it has notyet been possible to improve the administration ofjustice to an extent that is perceptible to the public. Against this backdrop, the view of the private sector and the rest of civil society is that a consistent and comprehensive process is essential for achieving medium-term results. This means actions designed to recoverpublic trust in the administration ofjustice, to improve the professional quality ofjudges, to make the man- agement and administration systems more efficient, and to increase access to justice. This process must avoid overlooking thefoundation that has already been built; it must deepen and expand on it. This requires a consideration of regulatory aspects as well as the qual- ifications of those operating the system, the systems costs, infrastructure, and administra- tive and management issues. It also requires a reconsideration of the status of the judi- cial branch, and that of institutions such as the Constitutional Court and the Office of the Attorney General, which are formally autonomous but whose actions affect the func- tioning of the justice system. 1. This chapter was prepared by the Legal and Judicial Reform Unit, Legal Vice Presidency, World Bank. 515 516 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEw MILLENNIUM A. Persistent Piroblems Despite the progress made in specific aspects of earlier reforms (see annex 1), the problems remain the same: the formal system set up for the administration of jus- tice is not easily accessible, it is slow, and verdicts offer little security. As a result, the population has no confidence in the system. Lack ofAccess Although the subject has not been dealt examined systematically, there is evidence supporting the assertion that the high cost of the services of the justice system lim- its public access to it. Geography seems to be another limiting factor, in addition to the dysfunction of the resolutions offered and their lack of timeliness. Costs Since the National Council on the Judiciary (CNJ) established the system of judi- cial fees, the number of civil suits filed throughout the country has been decreasing, despite population increases (Table 1). The cost of the fees has been high enough during a time of economic crisis that the population appears to prefer to give up the opportunity to sue for its rights, reducing the demand for formal services by looking for other ways to resolve legal problems. The spread of alternatives for resolving conflicts has been one of the positive aspects of the reform process and should be expanded upon. However, although 30 mediation centers have been legally established and programs have been developed to train community mediators in marginal areas, it cannot be said that reduction in the number of civil suits means that people would necessarily prefer to resort to mediation or arbitration. The reports from the centers with respect to the number of cases handled do not allow us to reach this conclusion (Projusticia 2001). The actions of some local officials who act outside the scope of their legal pow- ers continue to be a frequent occurrence, particularly in rural areas. The most well- known case is that of the political deputies, who are administrative authorities answering to the executive branch. They act as judges at the request of one of the parties, with no authorization to do so. This type of solution is problematic not only Table 1. Civil Cases Filed in Ecuador's Courts 1998 1999 2000 2001 139,354 125,057 106,659 92,427 Source: National Council on rhe judiciary, "National Report on the Movement of Cases,' 2001. THE ADMINISTRATION OF JUSTICE 517 because it is illegitimate but also because there is no formal ability to enforce deci- sions and because the system is prone to abuses. The solution is not necessarily the elimination of court fees but rather a review of the system, including not only the current fees but also the items for which fees are required so that, while the principle is maintained, the burden does not fall on the party seeking to claim a right. For example, instead of being collected when a case begins, fees should be collected once the judge establishes whether or not there was justification for filing the case. Finally, consideration must be given to the fact that the administration of justice is an essential service for society and should be financed primarily by the state. In this respect, it should be noted that despite quantitative increases, the percentage share of the judicial budget in the state budget has been declining and is the lowest in the Andean region (Table 2). In addition, Ecuador invests the least per capita in justice of any country in Latin American (Table 3). Without disparaging the goal of improving budgetary planning and management systems, we cannot overlook the fact that the reform process includes actions that require investments that cannot be funded with the current budget, which is allo- cated exclusively to covering current expenses, primarily compensation (Table 4). Table 2. Spending on Justice as a Percentage of the State Budget Country Percentage of budget Bolivia 3.00 Chile 0.83 Colombia 4.62 Ecuador 0.74 Peru 1.43 Venezuela 2.39 Source: Andean Commission of Jurists, "Judicial Indicators," 2000. Table 3. Per Capita Judicial Budget in the Andean Region Amount Population Indicator Country (in $US) (in thousands) (SUS per capita) Bolivia 64,166,666 7,773 8.3 Chile 155,339,806 14,622 10.6 Colombia 347,631,979 37,065 9.4 Ecuador 20,949,272 11,937 1.8 Peru 132,319,506 24,371 5.4 Venezuela 653,059,868 22,777 28.7 Source: Andean Commission of Jurists, "Judicial Indicators," 2000. 518 ECUADOR: AN ECONOMIC AND SOCtAL AGENDA IN THE NEW MILLENNIUM Table 4. Breakdown of Spending (2001) Item Percentage Compensation 92.5 Services 5.8 Supplies 1.7 Source: National Council on the Judiciary, "Report to the Supreme Court: Year 2001," Quito, 2002. Legal Assistance However, neither the spread of alternative methods nor a review of the fee system is enough. We must not forget the legal requirement in Ecuador that the signature of a practicing attorney must support any suit or petition submitted to a public official. Thus, the cost of professional services must be added to the cost of the court fee. The lack of professional services, particularly for people with limited resources and for the most vulnerable groups in society, must be counteracted by expanding existing services and creating new services. Functionality For a population in which most people are poor, a system of justice ultimately based on monetary reparation for harm after a proceeding that can last, in the best of cases, slightly more than a year, is dysfunctional. It is also dysfunctional in economic terms, given that the monetary value of these disputes is less than the cost it would take to recover it. The review of the procedural system should consider among its objectives a dif- ferentiation of proceedings, creating a special procedure for cases involving small amounts that would be very accessible, particularly flexible, allowing for the possi- bility that solutions would be better adapted to the requirements in each case. Lack of Confidence in the System The public perceives the justice system as being unreliable. Four factors contribute to this: corruption, politicization, lack of professionalism, and slowness. Corruption Ecuador signed the Inter-American Convention against Corruption in 1996 and ratified it in May 1997. However, national law has not yet been amended to reflect the provisions of the Convention. Standards of conduct for the exercise of public offices in which conflict of interest situations are clearly identified have not been defined, nor are there systems to protect those who in good faith report acts of cor- THE ADMINISTI RATION OF JUSTICE 519 ruption. In criminal law, crimes such as unlawful enrichment do not have the scope provided under the Convention. The literature on corruption usually refers to a set of factors that create a climate that is conducive to the institutionalization of corruption: procedures that are not transparent, unreliable records and statistics, decisionmaking powers concentrated in the same officials, low salaries, the lack of mechanisms for evaluating perform- ance, and the lack of incentives. All of these elements can be found in the Ecuado- ran justice system. In the justice sector, no anticorruption policy has been defined, nor is there an adequate institutional response to reduce the incidence of corruption. The problem is handled on a case-by-case basis through measures taken after the fact whenever misconduct is discovered for any reason, but neither the judiciary nor the Office of the Attorney General has internal monitoring systems that would allow it to iden- tify cases of corruption. There is no prevention plan or any methods for carrying out effective investigations. There is no code of conduct for judicial officials or attornies. The general prin- ciples enunciated in the current law are not in line with the requirements of the Inter-American Convention or with international guidelines. The lack of rules clearly establishing expected ethical conduct is another factor to be considered. The standards contained in the law are very general and are far from providing the detailed provisions that would be expected of a code of conduct for judges and officials. Corruption certainly cannot be combated by focusing attention on judicial offi- cials and support staff alone. Attention must also be given to attorneys and their standards of professional conduct. In this area, we note the same absence of a code of professional conduct. There is a system of penalties that operates irregularly and is entrusted to the professional associations themselves; it focuses on offenses involv- ing unfair competition in professional practice and the lack of solidarity and cour- tesy in relationships between attorneys, rather than on cases of corruption. Politicization The independence of judges is an essential condition for impartiality in the admin- istration of justice. No reforn initiative could be considered successful if it did not first of all ensure that judicial decisions reflect the merits of the evidence submitted rather than conditions associated with the exercise of political power.2 The interest of the political class in the administration of justice is not just bureaucratic, in the sense of obtaining judicial positions as political rewards. It is also practical and has to do with the exercise of power and particularly with what is called the judicialization of politics-that is, the use of legal procedures as an instrument to obtain certain practical ends directly associated with immediate political benefit. 2. World Bank, Legal Vice Presidency, "Initiatives in Legal and Judicial Reform," 2002. 520 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Criminal justice has been pointed to as the setting in which political influence is most often noticed. This influence is selectively exercised so that it does not affect most cases, although it does affect the most visible cases or those that, given the nature of the issue or the identity of the parties involved, are important to the pub- lic or have political consequences. There are some easily documented cases. For example, the National Congress, without having the power to do so, has more than once ordered that criminal pro- ceedings be filed against specific people, asserting that they have committed crimi- nal violations, but without submitting them to a prior procedure in which the rules of due process had been honored. Cases like this call into question the independence of the Office of the Attorney General, rather than that of the judges. The position of the Attorney General is par- ticularly vulnerable to political influence because of the possibility of impeachment and removal by a legislative majority in specific circumstances. Something similar happens with the Constitutional Court, whose level of politi- cization has been publicly admitted by the most diverse sectors of opinion and by the political class itself. The absence of impartiality in the decisions of this body cre- ates dangerous levels of uncertainty owing to the significance of its powers, powers that even include the ability to invalidate an applicable law or any other source of authority. Another sphere in which political influence is often noted is in the appointment of magistrates and judges. Instead of looking at the judiciary as a victim, there is a tendency to present it as being to blame for its politicization. In order to combat politicization, judicial inde- pendence must be strengthened-and this cannot be achieved by encouraging inter- vention. In this respect, efforts designed to manipulate the composition of judicial bodies by replacing people rather than by dealing with the system itself are particu- larly dangerous. Limited Professionalism The public usually associates inconsistency in court decisions with corruption. This becomes obvious when different judges resolve the same type of issue differently. In the case of Ecuador, however, there is another factor that leads to the same result, namely the limited professional training of judges. In order to find consistent solu- tions a judge must be knowledgeable about the subject and must know what other judges have done in similar cases. As for the first, we must consider that judges receive no professional training at all other than their law studies. As for information, except Supreme Court rulings, court rulings are not published, although on rare occasions judges do cite precedents in their rulings or discuss how other judges have resolved similar cases. The situation appears even more complicated when one considers that the Supreme Court itself suffers from the same defect: cases with contradictory decisions are numerous and the Court rarely exercises its power to unify jurisprudence THE ADMINISTRATION OF JUSTICE 521 through general guidelines. Factors contributing to frequent contradictions are the existence of various chambers for the same area of law, and the fact that, when rul- ing on cases, one chamber does not consult the logic behind decisions in another chamber. Rather than hoping that the problem will be resolved after the fact through the issuance of a general rule, it would be healthier to change the way things work so that a potential contradiction could be detected before a decision is formally adopted. The alternative solution is more radical, but more complicated to imple- ment: reduce the number of chambers so that there is only one chamber for each area of law. Slowness The administration of justice is slow in Ecuador. An ordinary civil case takes an aver- age of three years in Quito. In most judicial divisions, more cases enter the system each year than are settled during the same period. According to information from the CNJ, the number of cases postponed in the entire system in December 2001 was probably about 800,000. The numbers vary according the type of division and its location. In Quito, Guayaquil, and Cuenca, the Supreme Courts have fewer cases postponed than the courts of first instance. In the other provinces, the opposite is true: the courts of first instance have a small caseload while the number of cases postponed in the Supreme Courts is higher. The factors contributing to this have more to do with management systems than with the number of courts or their location (Buscaglia and Dakolias 1996). Accord- ing to data in the reports from Projusticia, the performance of pilot courts estab- lished under the judicial reform program indicates that the average length of a civil case has been dramatically reduced (Table 5). In addition, the implementation of the new management system has made it pos- sible to increase the ratio of cases settled to cases entering the system (Table 6). Table 5. Duration of Ordinary Cases (Quito) Average number Average number Court of days, nonpilot of days, pilot First 1,185 266 Second 1,207 175 Third 1,732 332 Fourth 1,260 297 Fifth 1,096 204 Eleventh 1,717 422 Twelfth 840 236 Source: Projusticia. 522 ECUADOR: AN ECONOMIC AND SociAL AGENDA IN THE NEW MILLENNIUM Table 6. Cases Completed Compared to Those Entering the System in Pilot Courts (percent) City 2000 2001 Quito 8.56 27.38 Guayaquil 19.1 54.29 Cuenca 44 134.66 Source: Projusticia. The new management system was implemented in just 26 courts of first instance in the initial phase and extended in the second phase to another 45 courts in the cities of Quito, Guayaquil, and Cuenca. B. Recommendatiions Legal Reform The Organic Law The new Law on the Judicial Branch, meant to implement and develop constitu- tional reforms with respect to the management and administration of the system, has not yet been issued. It is this law that must define the issues that are fundamental to the organization and operation of the administration of justice, such as the following: o The procedure for selecting candidates to fill vacancies on the Supreme Court through the co-optation system; o The age limit for magistrates; o The procedure for judging and removing magistrates; o The labor system within the courts; o The scope and characteristics of the judicial career; and, o The disciplinary system for judges, attorneys, and support staff. The importance of these subjects has led to the introduction in Congress of com- peting bills. Despite attempts to reconcile positions, none of the bills have been sub- mitted for discussion at this writing. The chance to push forward with promulgation of this law offers a unique opportunity to profoundly alter the judicial branch's organization, labor system, and oversight mechanisms, and the ways that civil society participates in the workings of justice. Since this is an organic law, its approval requires a qualified majority of Con- gress or a strategy designed to gain popular support for the fundamental provisions for which sufficient legislative support is not obtained. THE ADMINISTRATION OF JUS1i1CE 523 The bill prepared by the Supreme Court itself can serve as a starting point (Andrade 2002), to which should be added at least two essential items that the Court did not approve: the procedure for selecting candidates when vacancies must be filled on the Supreme Court and the age limit for serving on the court. Both mechanisms serve to achieve transparency and energize the composition of the highest court, without impairing judicial independence (USAID 2001). The subject is critical to the operation of the justice system.3 Regulations must also be issued to implement the principle of jurisdictional unity. This principle has to do with independence in the administration of justice, as well as the need to ensure access to judicial review of administrative decisions con- sistent with the principles of due process. Procedural Reform The reforms needed for the implementation of oral argument have not been issued, even though the period established for doing so by the Constitution of 1998 expired on August 10, 2002. The change is important not only for reasons of quality, but also in terms of guaranteeing greater transparency in proceedings. The system of oral argument provides direct access to the submission of evidence and to discussion of its procedural importance, as well as to the reasons for the court's ruling. In this way, the actions of the judge and of attorneys for the parties remain open to public scrutiny. The appointment of judges and establishment of procedures adequate to meet the needs of the poorest members of society-with guarantees but without the for- mal rigors of ordinary civil court procedures-is also considered urgent. In this regard, the experience of the Special Federal Courts established in Brazil could offer interesting input for the design and implementation of the reform. Criminal procedural reform should be supplemented with the introduction of reg- ulations that convert the oral proceeding into one that is adversarial in nature, with- out inquisitorial trappings4 and with the establishment of the public defender system.5 Small Claims Court and Legal Rights for Indigenous Groups The law needed to define functions and procedures for judges in the Small Claims Court, for which a provision was made in the reforms, has not been issued. In con- trast, although the territorial jurisdiction and powers of Family Court judges were defined through the reform of the old Law on the Judicial Function, no provision has been made for the positions. The lack of consensus within the Supreme Court 3. If the age limit is set at 70, as has been proposed, nine judges would leave the Court in 2003. With the two vacancies that currently exist, this would leave 11 seats that must be filled. 4. For instance, there is a bill developed by the Esquel Foundation, with support from USAID. 5. For instance, there is a bill prepared as part of the Projusricia program. 524 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM has held up approval of the bill designed to transform various labor courts and land- lord-tenants' courts in Quito, Guayaquil, and Cuenca into family courts, as long as there are resources available to establish them in the rest of the country. Nor has the necessary legislation been issued to implement the orderly exercise of the constitutionally recognized judicial functions of authorities among the indige- nous peoples for the resolution of their internal disputes. Judicial lIndependence Respect for the independence of judges does not depend on the judiciary alone. No mechanism to preserve it will be more effective than a public with the conviction that this is necessary, a conviction that would be transformed into effective policy and a standard of conduct for the other branches of government. The Executive Branch, as co-legislator, has a central role in this area, given that no reform initiative could become a reality without its participation. The provisions for strengthening judicial independence involve the aspects dis- cussed below. APPOINTMENTS. The Supreme Court has the power to fill the vacancies on its bench, but there are no rules governing the selection procedures. The new Law on the Judi- cial Branch should include such rules in order to ensure disclosure and transparency in the procedure and guarantee the participation of civil society. Regardless of the nominating body, if more than one nomination must be made at the same time, there is the possibility that a mutually beneficial agreement will be reached, consequently invalidating the effectiveness of any selection process. Thus, everything should be done to provide for filling only one position at a time, so that the process for filling the next vacancy is not begun until the other position has been filled. This is particularly important for filling vacancies on the Supreme Court and nominations to the Constitutional Court, the National Council on the Judiciary, and other bodies with several members. ACCOUNTABILITY. The Supreme Court and the Constitutional Court are examples of extreme positions in terms of their systems of accountability. While the Supreme Court is not subject to the oversight of any other body, the Constitutional Court is exposed to the vicissitudes of the legislative majority, given the possibility of impeachment. The Office of the Attorney General is similarly exposed. Both extremes are inadvisable. Impeachment has proven to be an area in which partisan considerations and political circumstances predominate. The definition of a common system should clearly distinguish the type of liabil- ity involved. Criminal liability for the commission of crimes requires an adequate system of investigation, particularly for cases in which the Attorney General may be involved. This assumes a system of internal controls and the participation of an out- side body such as the Anticorruption Commission to oversee the process. THE ADMlNISTRAriON OF JUSTICE 525 The same criterion could be applied in the case of Supreme Court judges, par- ticularly with respect to the investigation of possible acts of corruption. Political responsibility to the country requires transparency. In this respect, meas- ures must be taken to ensure transparency, with public disclosure of information on the performance of judges and officials: the number of cases handled, the justifica- tion for their decisions, compensation, and record of attendance. MANAGEMENT CAPABILITY. If the new management system used in the pilot courts is extended to the other judicial divisions, the problem of slowness in the processing of cases will be considerably diminished. In addition, the installation of mediation offices attached to the courts must be extended to the entire system. This mechanism allows cases to be settled without requiring the involvement of a judge's decision at the end of the process. Trained mediators have succeeded in reaching agreement in 32 percent of the cases sent to them, whereas in the past it was exceptional for parties to reach a direct agreement (Proj usticia 2001). The need to provide adequate equipment to streamline tasks and maintain reli- able records has become more obvious with procedural reform, including the tran- sition from the written system to the system of oral argument. PROFESSIONALIZATION AND THE JUDICIAL CAREER. A permanent training system and a similarly permanent performance evaluation system must be established, both to improve quality and to provide objective criteria for the selection, promotion, and removal of staff. With a clear distinction made between judicial functions and administrative functions, the training and evaluation systems would be the back- bone of a judicial career system in which seniority would cease to be the only factor that is valued and rewarded. C. Conclusions In this context, the private sector and the rest of civil society feel that a consistent and comprehensive process is essential for achieving medium-term results. This means actions designed to regain public confidence in the administration of justice, to improve the professional quality of judges, to increase efficiency in the manage- ment and administration of the justice system, and to provide greater access to jus- tice. This will require making use of measures already put in place, maintaining judi- cial independence, introducing evaluation and oversight systems, combating corruption, and increasing the levels of public access to justice. The process requires a comprehensive approach: all areas must be given attention and actions that must be developed in each area are indicated. The proposal is sum- marized in the policy matrix. Policy Matrix c Goal Policy measures Actions Establish n-les and Regulate the process for selecting candidates for judicial Promote the issuance of the new Organic Law on the procedures to strengthen positions, particularly on the Supreme Court and the Judicial Branch, incorporating the standards needed to judicial independence National Council on the Judiciary in order to ensure achieve the objectives sought. disclosure, transparency, and the participation of civil society. Ensure that such mechanisms also guarantee compliance i with Constitutional requirements, particularly those relating to alrernating backgrounds: academics, career judges, practicing attorneys. Establish the age limir for serving on the bench. 0 Avoid having various vacancies at the same time that must 0 be handled through procedures for selection and appointment to positions on the courts and on CNJ. Adopt procedures that, without endangering judicial independence, ensure responsibility and effective accountability on the part of Supreme Court justices and 2 members of CNJ. Extend the same procedures and requirements to Introduce the reforms necessary to extend the same c magistrates of the Constitutional Court and the procedures and requirements to the Constitutional z Attorney General. Court and the Attorney General. Provide professional Establish a permanent training system, such as a judicial Regulate thc judicial career, establishing requirements training for judges school, as the first step in the career path and meet needs with respect to professional training, ongoing educa- and evaluate their for continuing education. tion, continuous evaluation, and the application of performance Create incentives for those whose performance is above performance-based incentives and penalties. the criteria for excellence established by the system, as Adopt the administrative measures needed to imple- well as penalties for those who do not meet the ment both the training and the evaluation systems. minimum criteria. Establish a system for continuous monitoring and eval- z uarion of judges' performance. i Combat corruption Create appropriate legal instruments. Introduce the reforms needed to adapt national law to the requirements of the Inter-American Convention. Establish codes of conduct and codes of ethics for judges and attorneys. Design and implement a plan to combat corruption- Improve the disciplinary and penalty systems for both with an emphasis on preventing and eliminating factors judges and attorneys involved in ethical violations and that contribute to the creation of an environment that cases of corruption. encourages corruption. Establish systems of protection and legal benefits for 0 those who collaborate with justice in discovering and punishing acts of corruption. Provide professional Select and train government attorneys by applying the Provide regulations for the Organic Law on the Office training for government principles and procedures indicated earlier for judges. of the Attorney General. attorneys, evaluate their Adopt the administrative measures needed to imple- performance, and give ment both the training and evaluation systems. the Office of the Install a system for the evaluation of each government Attorney General attorney, establishing a ratio between the cases on which technical equipment he or she decides to bring an indictment and the results. and resources Adopt a management system that prevents prosecutory Redesign the management system and adapt facilities. backups. Give the Office of the Attorney General the personnel, equipment, and technical resources it needs to perform the new tasks assumed as a result of procedural reforms. Improve the Reform legal education. Modernize the teaching system by disseminating pro- professional quality grams and methods designed to develop skills. of attorneys Establish ongoing education programs for attorneys, Give the Supreme Court and CNJ the power to define starting with programs to train them in the techniques of requirements beyond a university degree that attorneys oral argument. must have in order to litigate. (Matrix continues on the following page.) Policy Matrix (continued) 0o Goal Policy measures Actions Extend to the entire Introduce complete procedural reform and improve Introduce the reforms needed to adopt the system of system the application office management systems. oral argument in all matters, as provided by the Con- of procedural institu- stitution. Accordingly, encourage promulgation of the tions introduced by the new Code of Civil Procedure (CPC). constitutional reform Extend to the entire justice system the management system implemented in the pilot courts. Improve the managerial capability of the National ° Council on the Judiciary. Expand opportunities Create and implement a public defender system that is Encourage the promulgation of the Organic Law on for access to justice national in scope and has adequately trained staff. the Public Defender's Office and establish the service. ° z Establish a more flexible, less expensive, and more Incorporate the rules needed in the new Code of Civil 0 accessible procedure for resolving disputes involving small Procedure prepared by the Supreme Court. amounts that would serve the majority, particularly in rural Take the necessary steps to put small claims courts and and marginalized areas. family courts into operation. Be sure that the application of the system of court fees does Review the system of court fees, so that they are con- ° not hamper the exercise of the right to effective judicial sistent with the population's income and do not affect protection. those who claim rights with justification. > Expand opportunities for applying alternative dispute Institutionalize and extend the network of mediation resolution methods. offices attached to the courts in order to take advan- tage of alternative methods for resolving disputes. c Review the criteria regarding matters in which alterna- tive methods for resolving disputes can be used in order to increase opportunities for applying them. m Provide the courts and tribunals, as well as the Office of the Attorney General, with the tools and equipment needed to meet the requirements of the oral argument procedure, particularly with respect to recording 'Z systems. Encourage and Establish channels that will allow the participation of Consider including mechanisms in the Organic Law to increase citizen civil society as an additional entity to oversee the guarantee the timely provision of information to the participation operations of the system for the administration of justice. public regarding future nominations for judicial posi- tions and on the identities and characteristics of candi- dates aspiring to the positions so that the views of the public can be considered in the selection process. Publicly disclose information on the work of each o magistrate and judge-the number of cases they have Z overseen, the justification for their decisions. Promote the incorporation of objectives relating to improved justice in the civil agenda and encourage consensus-building on topics central to the process. Establish civic education programs to promote values relating to the status of law, the rule of law, and use of the justice system to resolve conflicts and protect rights. 530 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Annex I Reforms of the System The last 10 years have seen more changes and reforms introduced in the system for administering justice than the entire period from 1812 to 1992. In certain cases, the changes made to regulations have not yet been implemented in practice. In other cases, the process of adaptation has led to new problems, while the problems that the reform sought to remedy have not been completely eliminated. Finally, there are changes that are having a profound effect on the performance of the courts that are not based on legislative changes but rather on the application of new systems or new policy directions. These changes are unprecedented in the nation's history. Although the subject of judicial reform is not new and has been a recurring theme in presi- dential addresses since the very beginnings of the republic, the direction and scope have changed radically in the last 10 years. Earlier efforts sought only to reform pro- cedural rules or to replace the members of the highest court. Starting with the Com- prehensive Plan of Reforms approved by the national government in 1995 and for- mally adopted by the Supreme Court in 1996,6 attention is being given for the first time to reforming administrative organization, management systems, and the pro- fessional qualifications of judicial personnel. A reform of the system cannot be lim- ited to new legislation, or much less to the mere replacement of current officials with others who are supposedly more suitable. LEGISLATION. The system for the administration of justice provided in the Consti- tution of 1979 was modified in 1992, 1995, 1997, and 1998. The reform of 1992 changed the structure and functions of the Supreme Court, converting it into a court of cassation, and introduced the Council of the Judiciary, the intent being the separation of judicial tasks from administrative tasks, relieving judges of the latter. It established the principle that judicial positions should be filled on a competitive basis and that cases should be distributed among judges and courts in the same juris- diction by lot. The reforms of 1995 expanded the powers of the Constitutional Court and changed its composition, requiring that its members meet the same criteria as Supreme Court judges. They established the principle of the independence of the Office of the Attorney General, jurisdictional unity, the Public Defender's Office, 6. Before this plan, there were some attempts in a similar direction. The first signs that the traditional viewpoint would give way did nor appear until 1990 in the 'Proposed Studies Regarding the Administration of Justice in Ecuador," developed by the Center for the Administration ofjustice of Florida International Univerisry and ILANUD. In February 1991, the Supreme Court approved a "Biennial Development Plan." The document includes both legal and administrative reforms and also deals with financial aspects, among them the suggestion on charging fees for the traditionally free services ofjustice. THE ADMINISIRATrlON OF JUSTICE 531 decentralization of judicial services, recognition of alternative methods for resolving disputes, and the power of the National Council on the Judiciary to establish fees for court services. Two important reforms designed to consolidate the principle of judicial branch independence were introduced by popular referendum in 1997. First, Congress was relieved of its power to appoint Supreme Court judges and its ability to control the Court's performance through impeachment. The limit on the term of office of Supreme Court judges, which had been set at six years by the reforms of 1992, was eliminated so that judges came to have an indefinite term. Second, the reforms introduced by the National Constituent Assembly of 1998 were designed to change judicial procedures. They defined explicit rules for due process and applied the prin- ciples of the adversarial process, personal appearances by the parties to a case, dis- closure, oral argument, and flexibility to all court proceedings. They introduced the principle of indictment in the criminal procedure so that this action was reserved to the Office of the Attorney General. They recognized the right of indigenous peoples to resolve their internal conflicts by applying their own customary rules, established provisions for enforcing the principle of jurisdictional unity, and created small claims courts and family courts. Making these changes a reality through laws developing the constitutional provi- sions has turned out to be a difficult task. The issuance of some of these laws has been obstructed by the resistance of groups that benefit from the status quo or sim- ply by a lack of political will to promote their approval. In other cases, new law, by defining compromise solutions, has limited the scope of the reforms. A good example is the law on the organization and operations of the National Council on the Judiciary. Although the existence of CNJ has been constitutionally provided for since 1992, the law regulating its composition and the method for appointing its members was not issued until 1998. The delay is evidence of the fierceness of the fight to gain the power implicit in the existence of the Council. Var- ious bills were submitted, each with its own method. Appointment by Congress with the participation of the branches of the state, or with the participation of civil society organizations only, or direct appointment by the Supreme Court were the options that merited the most consideration. Only after a majority of Congress was satisfied with the composition of the current Supreme Court did the way open up for the method whereby the Council, presided over by the President of the Supreme Court, would be made up of seven members appointed in the manner described in annex 2. Despite the source of its appointments, the Council came into conflict with the Supreme Court immediately after it was formed. The definition of the powers that should be transferred to the new body and the scope of those powers was the cause of the dispute, formally fanned by the lack of clarity about what should be understood by "management" of the judicial branch. In effect, the Con- stitution gives the Council powers that encompass management, but the organic law considerably limits the scope of these powers by expressly assigning to the Supreme Court the power to define "general policies for action on administrative, economic, 532 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM human resources, and disciplinary matters," with the Council relegated to the status of executing agency. JUDICLAL REFORM. The Comprehensive Plan of Reforms identified objectives and priorities in the reform of procedural rules, and of the systems for administrative organization and management of the judicial branch and the Office of the Attorney General. It also reformed human resources management, with goals directed to the training ofjudges and strengthening of the judicial career-and to a lesser extent, it improved professional education. Although the design of the goals for the different components is quite uneven and in certain cases limited to recognizing some "for- gotten requirements," the areas of action identified in the Comprehensive Plan include nearly all the aspects that at the time were already common in judicial reform processes in Latin America (Carothers 1999). In the process, some of the les- sons learned by international cooperation agencies while executing judicial reform projects in other countries will be incorporated later. Two aspects are particularly interesting in these plans: the attempt to coordinate initiatives for support from var- ious international cooperation agencies on the one hand and the establishment of a coordinating unit (Projusticia) to centralize the administration of projects on the other. The assistance of international cooperation agencies covered three areas: the institutional area directed to eliminating conflicts of power and strengthening the judicial branch, the Office of the Attorney General, and the National Police; the operational area, with objectives designed to facilitate access to justice; and struc- tural reorganization. THE ADMINISTRATION OF JUSTICE 533 Annex 2 Institutions Although the Constitution established the principle of jurisdictional unity, accord- ing to which only judicial branch bodies would be responsible for administering jus- tice, there are other bodies not incorporated in that branch that do so. In some cases, such as the Constitutional Court, the Constitution itselfhas given the judicial body its autonomy. In others, it has simply not been possible as yet to put the principle into practice, as happens with the court for minors and the military and police courts. In addition, there are important auxiliary bodies of justice that also do not form part of the judicial branch. The Office of the Attorney General is independent by constitutional mandate and the Judicial Police is subordinate to the executive branch in terms of hierarchy and discipline, as are the agencies of the prison system. The agencies of the judicial branch have been set up so that each canton has at least one judge of first instance for civil matters and one for criminal matters, with the provision that more populated locations will also have labor judges, traffic judges, landlord-tenant judges, and customs judges.7 At least one criminal court operates in each province' to hear criminal matters. Appeals are heard by the Superior Court, with one court per province. Unlike the lower courts, they consist of three-member chambers.9 To hear administrative and tax matters, the provinces have been grouped into four dis- tricts, each with courts that resolve cases within their competence in a single instance. ° In principle, the decisions of superior courts, district courts, and criminal courts are final. Only when decisions contain errors of law, specifically catalogued in the law, can an appeal be filed for a hearing before the Supreme Court. The Supreme Court, located in Quito, has national jurisdiction. It comprises the President and 30 magistrates, organized into 10 three-member chambers"1 that 7. There are currently 246 civil judges, 152 criminal judges, 31 labor judges, 50 traffic judges, 16 landlord-tenant court judges, and 5 customs judges. 8. Currently there are 43 criminal courts. 9. The superior courts of Quito and Guayaquil have six chambers each; that of Cuenca has four chambers; those of Portoviejo and Loja have three chambers; those ofAmbato, Ibarra, Machala, Riobamba, Babahoyo, and Latacunga have two chambers; those of Macas, Puyo, Tena, Nueva Loja, Esmeraldas, Zamora, Guaranda, Azoguez, and Tulcan have only one chamber. Galapagos is the only province for which a superior court has not been appointed. 10.There are three district courts for administrative matters in Quito, with two chambers; Guayaquil, Cuenca and Portoviejo, have a chamber each. There are district tax courts in Quito, with three chambers; and Guayaquil, Cuenca and Portoviejo each have one chamber. 11.There are three civil chambers that also hear commercial matters, two chambers hearing criminal matters, three hearing social and labor maters, one hearing administrative mat- ters, and one hearing tax disputes. 534 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM divide up the work based on the criterion of subject specialization. Although the Supreme Court is a cassation court in principle, the criminal and civil chambers are called upon to hear issues of both fact and law in jurisdictional cases. In addition, the Supreme Court has the power to issue binding resolutions of a general nature in the case of contradictory decisions from its own chambers or from the superior courts. The magistrates hold their seats for an indefinite term. Vacancies must be filled by the court itself with the favorable vote of two-thirds of its members, seeking to ensure that the candidates who are appointed are successively officials with judicial careers, academics or law professors, and attorneys in independent practice. The National Council on the Judiciary was created to administer and manage the judicial branch. It is also responsible for administering the judicial career and impos- ing disciplinary procedures on all judicial personnel, except for Supreme Court mag- istrates. The Council consists of seven members, appointed by the Supreme Court; four of them must be selected from short lists submitted by the superior court and district court magistrates; the National Federation of Judicial Officials (FENAJE); the deans of the country's law schools, and bar association presidents. The Supreme Court determines the number and territorial jurisdiction of the criminal courts and of the civil and criminal judges. The number and jurisdiction of the remaining judges are determined by each superior court. For the appointment of all judges and magistrates, the National Council on the Judiciary is in charge of a selection process that culminates with the submission of a short list to the Supreme Court or the superior court as applicable. Each superior court names judges. The Supreme Court names the magistrates of the superior court and the members of the district courts. The Constitutional Court and the Office of the Attorney General are by defini- tion autonomous under the Constitution and are not part of the judicial branch. The Constitutional Court is directly responsible for constitutional issues and for protecting certain fundarnental rights by ruling on appeals regarding constitutional guarantees, habeas corpus, and habeas data. The Office of the Attorney General is responsible for investigations in the case of criminal violations and for conducting government criminal proceedings. 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