Documentof The WorldBank For OfficialUse Only ReportNo. 37948-PE INTERNATIONALBANKFORRECONSTRUCTIONAND DEVELOPMENT PROGRAMDOCUMENT FORA PROPOSED FIRSTPROGRAMMATICFISCALMANAGEMENT AND COMPETITIVENESS DEVELOPMENTPOLICYLOAN INTHEAMOUNT OFUS$200MILLION FOR THE REPUBLICOFPERU November15,2006 Poverty Reduction and Economic Management Bolivia-Ecuador-Peru-VenezuelaCountry Management Unit Latin America and Caribbean Region This document has a restricteddistribution and may be used by recipients only inthe performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. REPUBLICOFPERUFISCALYEAR January 1-December 31 CURRENCYEQUZVALENTS (Exchange Rate Effective: November 14,2006) Currency Unit= Nuevos Soles 3.22 Nuevos Soles = US$1 WEZGHTSAND MEASURES Metric System SELECTEDABBREVIATIONSAND ACRONYMS APRA Alianza Popular Revolucionaria Americana (Popular Revolutionary American Alliance) ATPDEA AndeanTradePromotionandDrugEradication Act BCRF' Banco Central de Reserva del Peni (Central Reserve Bank of Peru) CAF Corporacidn Andina de Fomenro (Andean Development Corporation) CPS Country Partnership Strategy CEM Country Economic Memorandum CFAA Country Financial Accountability Assessment CFMS Country Financial Management Strategy CGR Contraloria General de la Repu'blica(Comptroller General) CITES Centros de Znnovacidn Tecnoldgica pechnological InnovationCenters) CND Consejo Nacional de Descentralizacidn (National Decentralization Council) CONASEV Comisi6n Nacional Supervisora de Empresasy Valores (National Stock and BusinessSupervisory Commission) CONSUCODE Consejo Superior de Conrraracionesy Adquisiciones del Esfado (National Procurement Council) CPAR Country Procurement Assessment Report CRECER CreatingConditions for EconomicRevitalization DCDPL Decentralizationand Competitiveness Development Policy Loan DPL Development Policy Loan DFlD Department for InternationalDevelopment (United Kingdom) DNPP Direcci6n Nacional de Presupuesro Pu'blico (National Office of Public Budgeting) EITI Extractive Industries Transparency Initiative ESSALUD Znsrituto Peruano de Seguridad Social (Health Social Institute) EU European Union FMCDPL Fiscal Management and Competitiveness DevelopmentPolicy Loan FONAFE Fondo Nacional del Financimienfo de la Acrividad Empresarial del Esfado (National Fund for Financing State-Owned Enterprises) FONCAM Fondo Nacional de Camisea(National CamiseaFund) FONCOR Fondo de CompensacidnRegional (Regional Compensation Fund) FONCOMUN Fondo de CompensacidnMunicipal (Municipal Compensation Fund) FSL Fixed Spread Loan I T A Free Trade Agreement FY Fiscal Year GDP Gross Domestic Product GoP Government of Peru IADB Inter-American DevelopmentBank IBRD InternationalBank for Reconstruction and Development ICT Informationand Communications Technology IFC InternationalFinance Corporation IMF InternationalMonetary Fund INEI Znstituro Nacional de Esradistica e Znform4tica (National Statistics Institute) ITF Zmpuesto de Transacciones Financieras (Financial Transactions Tax) KfW German DevelopmentBank LDF Ley de Decentralizacidn Fiscal (Fiscal DecentralizationLaw) LPTF Ley de Prudencia y TransparenciaFiscal (Law of Fiscal Prudence and Transparency Law) LRTF Ley de Responsabilidad y TransparenciaFiscal (Law of Fiscal Responsibility and Transparency) M&E Monitoring and Evaluation MEF Ministry of Economy and Finance MFN Most Favored Nation MINCETUR Minisrerio de Comercio Exreriory Turismo (Ministry of Trade and Tourism) MMM Marco Marcroeconomico Multianual (Multiannual Macroeconomic Framework) M O Middle Office MSME Micro, Small and Medium Enterprises NITS Non-financialPublic Sector NGO Non-governmentalOrganization OECD Organizationfor Economic Cooperationand Development PCM Presidencia del Consejode Ministros (Office of the PrimeMinister) PER PublicExpenditureReview PRODES Program ProDecentralizacidn (Pro-DecentralizationProgram) PRODUCE Ministerio de la Produccidn (Ministry of Production) PFM PublicFinancialManagement RENIEC Registro Nacional de Zdentidad y Estado Civil (NationalIdentity and Marriage Registry) ROSC Reporton Observanceof Standardsand Codes RUC Registro lhico de Contribuyentes (SingleTaxpayer Registry) SBS Superintendencia de Banca y Seguros (Bank and InsuranceSuperintendent) SEACE SistemaElectrdnico deAdquisiciones y Contrataciones del Estado (Electronic Systemfor StateParchasesandContracting) SIAF SistemaIntegrado deAdministracidn Financiera (IntegratedFinancialManagementSystem) SNIP SistemaNacional de lnversidn Pliblica (NationalPublicInvestmentSystem) SSEGP Sistemade Seguirnientoy Evaluacidn del GustoPu'blico (Public ExpenditureMonitoringandEvaluationSystem) SUNARP SistemaNacional de Registros Pliblicos (NationalSystemfor PublicRegistry) SUNAT Superintendencia Nacional de Administracidn Tributaria (GovernmentTax Agency) TAL Technical Assistance Loan TSA Treasury Single Account UCPS Unidadde Coordinaci6nde F'ri?stamosSectorials (SectoralLoans Coordination Unit) UPP Unidnpor el Ped (Unionfor Peru) USAID United States Agency for InternationalDevelopment Country Director: Marcelo Giugale Sector Director, PREM: Ernesto May Sector Manager: Mauricio Carrizosa Task Team Leader: RossanaPolastri ACKNOWLEDGEMENTS The World Bank Group greatly appreciates the close collaboration with Government o f Peru in the preparation of this Development Policy Loan (DPL). The DPL team would like to express its gratitude to the entire country team for their contributions. This DPL was prepared by an IBRD team composed of Messrs/Mmes. Rossana Polastri, Fernando Rojas, Chris Humphrey, Henry Forero, Fernando Hernindez-Casquet, Antonio Velandia, Hela Cheikrouhou, Miguel Navarro- Martin, Luis Schwarz, Jeffrey Rinne, Alejandro Alcald Gerez, Jose Luis Guasch, Eduardo Urdapilleta, Linette Lecussan and Inks Thorne. Valuable assistance was provided Keith Mackay, Lisa Bhansali, Rosmary Cornejo, Juan Manuel Quesada; by staff from KfW including Peter Weinert and Markus Riihling; and from the IFC Technical Assistance Facility staff including Luke Haggarty, Javier Aguilar, and Giinther Schulz-Heiss. The team was lead by Rossana Polas.tri (LCSPE, Task Team leader) and Fernando Rojas (LCSPS, Co-Task Team leader) and worked under the general guidance o f Messrs. Marcelo Giugale (Director, LCC6C), Vicente Fretes- Cibils (Lead Economist and Sector Leader, LCC6C), Ernesto May (Director, LCSPR) and Mauricio Carrizosa (Sector Manager, LCSPE). Special thanks to Todd Crawford (LCOQE), Keith Mackay (IEGKE) for valuable comments, as well as LEGLA and LOAGI. PERU FIRSTPROGRAMMATICFISCALMANAGEMENTAND COMPETITIVENESS DEVELOPMENTPOLICYLOAN TABLEOF CONTENTS Loan andProgram Summary..................................................................................................... i I Introduction....................................................................................................................... . 1 I1 Country Context................................................................................................................ . 1 A. Political Developments............................................................................................... 1 B. Economic Developments ............................................................................................ 2 C Macroeconomic Outlook andDebt Sustainability ...................................................... . 4 111 The Government Program................................................................................................. . 6 7 B Competitiveness ........................................................................................................ A. Efficiency and Quality of FiscalManagement ........................................................... . 19 IV. The Proposed Operation ................................................................................................. 26 .......................... 26 B. Lessons Learned........................................................................................................ A. Linkto Country Partnership Strategy and Other Bank Operations 27 27 D ProgrammaticFramework......................................................................................... C. Design of DPL and Analytic Underpinnings ............................................................ E Co-FinancingArrangements, Institutional CoordinationandPartnerships ..............30 .. 28 V. Operation Implementation .............................................................................................. 32 32 B. Implementation, MonitoringandEvaluation........................................................... A. Poverty and Social Impact ....................................................................................... 33 C. 33 D. Disbursement andAudits......................................................................................... Fiduciary Arrangements ........................................................................................... 35 E. Environmental, Forest andNaturalResource Aspects ............................................. 36 F RisksandRiskMitigation ........................................................................................ . 36 Annexes Annex 1 Letter of Development Policy.......................................................................... 39 Annex 2 Bank-Supported Fiscal Management and Competitiveness Program Matrix................................................................................................ 52 Annex 3 58 Peru At-A-Glance ............................................................................................ Peru-IMF Relations.......................................................................................... Annex 4 59 Annex 5 62 Debt Sustainability Analysis............................................................................ Peru Key Economic Indicators ........................................................................ Annex 6 64 Tables Table 1 2 PeruFinancing Requirements and Sources 2003-2009 ..................................... Key Economic Indicators................................................................................... Table 2 5 Table A1 Peru Public Debt (US$ millions) ..................................................................... 65 Table A2 Peru: Debt Determinants (% o f GDP) ............................................................. 67 Table A3 RequiredPrimary Balance 26% of GDPPublic Debt in 2011........................ 67 Table A4 RequiredPrimary Balance 20% of GDPPublic Debt in 2011........................ 67 Table A5 Debt Dynamics................................................................................................. 68 Figures Figure 1 Central Government Tax Revenue (% of GDP) ................................................ 3 Figure 2 Urban Employment inFirms of 10 or More Employees (monthly data)...........4 Boxes Box 1 Natural Resource Income Transfers................................................................. Box 2 IFC Technical Assistance to Baiios de IncaMunicipality on the MiningCanon ......14 15 Map of Peru (IBRD#33465) ................................................................................... inside cover REPUBLICOFPERU FIRSTPROGRAMMATICFISCALMANAGEMENT AND COMPETITIVENESS DEVELOPMENT POLICY LOAN LOAN PROGRAM AND SUMMARY Borrower ReDublic of Peru ~~~ ImplementingAgency MinistryofEconomy andFinance Amount US$200million Terms Commitment-linked Fixed Spread Loan (FSL) in US$, with; repayment period of 11.5 years, including 6.5 years of grace and customized maturity profile; at six-month LIBOR plus fixed spread; with a front-end fee of 1 percent on principal amount; commitment charge of three-fourths of one percent (3/4 of 1percent) per annum on the undisbursed loan balances, less waivers as approved. The Borrower requested to maintain all the embedded conversion options that FSLs currently offer. Tranching The loan is expected to be disbursed in a single tranche of U S $200 million. Description The proposed DPL i s the first in a series of possibly three or four loans supporting the GoP's reform plan to improve the functioning of Peru's public sector institutions and business environment. The loan focuses on two broad areas of policy reform: Efficiency and Quality of FiscalManagement Competitiveness In each of these areas, the GoP has begun to implement a detailed series of important policy measures as part of an integrated strategy to progressively reform fiscal administration, public spending and the business climate in ways that will lead to specific results that have a broad impact on growth and will be difficult to reverse. Benefits Inthe short term, the DPLwill havethe twin benefits o f Strengthening the GoP's fiscal position with timely budget financing at reasonable terms; and Supporting the GoP's public sector and competitiveness reformagenda. In the medium and long term, reforms supported by the proposed loan series will solidify Peru's overall fiscal framework, improve the efficiency and quality of public sector spending, and reduce bottlenecks to faster economic growth. This will inturnresult in budgetary savings that can be directed toward priority poverty programs; more and higher quality public services for the citizenry; and more sustainable and broad-based growth. Risks Political Risks include a slowing of reform momentum, especially if the November local elections are unfavorable to the administration and the divided Congress becomes less cooperative. Reforms to promote results-based management could generate opposition from politically active interest groups, such as public employee unions. President Garcia has launched a high-profile series of actions for his first 180days in government as a way to quickly demonstrate his determination to move forward on reform and mitigate political risks. Government officials are re-engaging with the Acuerdo Nacional, a group of political parties, civil society and community groups, academics and NGOs who came together in 2002 to help generate a consensus on abroadnational agenda. Social risks relate principally to resource extractive industries, which have been accused by community residents near some mines and oil wells of polluting, leading to protests, particularly in remote areas with limited state presence. To address these problems, the new administration has for the f r s t time created a Conflicts Unit in the Presidential Council of Ministers for negotiating conflicts as they arise which, together with the Defensoriu del Pueblo (Human Rights Ombudsman), will create a space for dialogue with disaffected groups. A first result has been the peaceful negotiations with the Achuar indigenous group in Loreto in October 2006, which has protested pollution and lack of social benefit from oil production in their region. The work of IFC's Technical Assistance Facility on improving mining canon use around the Yanacocha gold mine has also been successful in illustrating how the industry can benefit local communities. Economic risks include Peru's vulnerability to a drop in the international commodity prices, in particular minerals, which form a large share of exports. A slow-down in the U.S. economy or the failure for the U.S. Congress to ratify the Peru FTA could also impact exports. Political pressures could leadto a deterioration of fiscal accounts should the GoP attempt to placate opposition with increased public spending. The high level of dollarization of the banking system could become a problem in the event of currency devaluation. These risks are mitigated by growing non-traditional exports as well as a broadening of export markets through trade agreements. The Government's disciplined fiscal performance inthe past several years has greatly reduced country risk and lowered interest rate spreads, meaning the cost of rising international interest rates will be lower than previously. To reduce vulnerabilities associated with dollarization, the authorities have tightened prudential regulations on foreign exchange credit risks and are promoting mortgage lending indomestic currency. Project IDNumber .. 11 I.Introduction 1. Peru's evolution over the past several years and the country's current political and economic context make clear that this middle-income country is facing a unique opportunity to take a significant leap in its development. Following free and fair elections and an orderly transition between government administrations, coupled with a solid track record of economic growth and macroeconomic stability, Peru i s putting behind its years of instability and looking optimistically toward the future. Nevertheless, significant challenges remain. Half of the population still lives in conditions of poverty, the private sector faces numerous obstacles to greater economic activity, and many government institutions are riddled with inefficiencies and poor management. The new administration i s fully aware of these challenges, and has designed a comprehensive development plan to address them. During the past five years, the Government of Peru (GoP) focused successfully on disciplined fiscal and monetary policies to solidify the economy. Now the challenge i s to move beyond the "bottom line" to the second generation of reforms: strengthening fiscal management, public expenditure quality and competitiveness to achieve accelerated and broader-based economic growth. These goals form the core of the World Bank's support to Peru in this proposed Fiscal Management and Competitiveness Development Policy Loan (FMCDPL) programmatic series. 2. In keeping with the relationship with Peru outlined in the Country Partnership Strategy (CPS) for the coming five years, this programmatic series was developed at the expressed request of the new administration and tailored to meet Peru's specific needs. The GoP has a strong vision for how it wishes to move forward, buildingon recent economic successes to achieve higher growth and better social outcomes; constructing a new contract between the government and citizens based on effective social development; and modernizing the institutions of the state. This FMCDPL, along with a series of social sector DPLs also proposed in the CSP, was designed in close partnership with GoP officials and in line with their vision. Inkeeping with the CPS's strategy, the FMCDPL series builds in a degree of flexibility for the future operations to accommodatethe evolving priorities and needs of the country. 11.Country Context A. Political Developments 3. Peru is strengthening and consolidating its democratic political system. Following the Fujimori regime and a brief transitional government, the administration of former President Toledo governed a country at peace and with economic growth during 2001-2006.Despite many political difficulties and a generally low public approval rating, Toledo faced no major threats to his democratic authority, and was able to not only complete his mandate in office but also to muster enough support in Congress to undertake several reforms and to maintain disciplined control over economic policy. B y the end of Toledo's term, it appeared that a majority of Peruvians hadcome to see the benefits of a stable, democratic political system. 4. President Alan Garcia won the second round of presidential elections in June 2006 by 53 percent against 47 percent for Ollanta Humala, a former military officer. Humala failed to convince a majority of voters, who preferred the platform of Garcia, despite the 1 memories of his difficult first presidential term in the late 1980s. At the same time, the narrowness o f Garcia's victory and the success of Humala in Peru's poorer regions--especially the southern Andes-points to dissatisfaction of many Peruvians with the thus-far limited improvements for the poor after recent years of economic growth. 5. President Garcia faces a fragmented Congress, which will require building coalitions to pass legislation. H i s Alianza Popular Revolucionaria Americana (APRA) party has 37 seats, compared to 44 seats for Humala's Unibn por el P e d (UPP) and 39 seats divided among five other parties. UPP has said it will strongly defend their candidate's platform, meaning it will likely form the core of opposition to Garcia's agenda, requiring APRA to seek coalitions with the other parties. Garcia's cabinet, led by Prime Minister Jorge del Castillo and Finance Minister Luis Carranza, is a mix o f APRA members and well-respected technocrats, with a record six women in ministerial posts. The latest poll numbers show Garcia's public support between 60 and 70 percent. The first major test for the new government will be the November 19 elections for 26 regional presidents and all 1,832 municipal governments. B. Economic Developments 6. In the past four years, Peru has had one of the best-performing economiesinLatin America, surpassed only by Venezuela-an oil exporting country-and Argentina-which i s coming out of a deep recession. Based on sound macroeconomic policies and strong demand for Peruvian commodity exports, GDP grew 5 percent on average in the four years since 2002, and reached 6.4 percent in 2005. This growth has been all the more impressive considering the external shock of the region in the early 2000s as well as the political instability that prevailed duringthe Toledo administration. Table 1:Kev Economic Indicators 2000 2001 2002 2003 2004 2005 Annual GDP growthrate 3.0 0.2 5.2 3.9 5.2 6.4 Inflation rate (CPI, endof period) 3.7 -0.1 1.5 2.5 3.5 1.5 OverallPublic Sector Balance/GDP -3.3 -2.5 -2.2 -1.7 -1.0 -0.3 Public Sector DebVGDP 45.7 46.1 46.9 47.5 45.1 37.8 32.8 Exports(FOB); change p.a. 14 1 10 18 41 35 Imports (CIF); change p.a. 9 -2 3 11 19 23 ExternalCurrent AccounVGDP -2.9 -2.3 -2.0 -1.6 0.0 1.4 1.1 Source: Banco Central Reserva de Peru' (BCRP), MEF (RevisedMarco Macroecondmico Multianual2007-2 19). 7. Growth has been led by an upswing in exports, which rose 26 percent annually on average in 2002-2005, and the external current account posted a surplus of 1.4 percent of GDP in 2005. This increase was driven in good measure by the boom in commodity prices, particularly for mineral exports, as well as the coming on line of new mining and hydrocarbon projects. Although mining production accounts for over half of all Peruvian exports, non- traditional exports have grown rapidly, 20 percent on average annually since 2000, particularly specialized agricultural products such as asparagus, grapes and avocados. Other export sectors such as fisheries and textiles have also posted significant gains in recent years. Private investment, encouraged by the growing economy and sound policies, has also helped fuel growth, risingnearly 14percent inreal terms during 2005. 2 8. Fiscal and monetary policy has been well-managed during recent years, with steady declines in public sector deficits and low, stable inflation rates. The combined public sector deficit has come down every year since 2001, falling from 2.5 percent of GDP in 2001 to 0.3 percent of GDP in 2005, lowering public debt from 46 percent of GDP in 2001 to 38 percent of GDPin2005 (of which 28 percent was foreign and 10percent domestic), and down to 32 percent of GDP by October 2006. These gains came from increases in revenue from mining taxes, as well as from cuts in public investment spending. Tax collection for the combined public sector will reach 15 percent of GDP in 2006, low by international standards and below the 18 percent of GDP collected in the mid-1990s. This indicates that improvements in broadening the tax base and increasing collections remain needed. Year-end inflation for 2005 was 1.5 percent, at the low end of the target range of 1.5-3.5 percent. Fiscal consolidation has continued in 2006, with the non-financial public sector expected to report a surplus of 0.6-0.8 percent of GDP, only the secondbudget surplus in 40 years. Tax revenue i s estimated to reach 15 percent of GDP in 2006 (Figure l),pushedparticularly by increasesinincome tax. Figure 1.Central Government Tax Revenue (% of GDP) l6 I 14.9 3I"K a 14 0 (3 ae 13 12 11 10 2000 2001 2002 2003 2004 2005 2006 Source: BCRP and projectionsfrom MMM2007-2009MEF. 9. While Peru's macroeconomicperformance has been very good inthe past few years, poverty remains high. The national poverty rate dropped only two percentage points between 2002 and 2004, and half the population (51.6 percent) lives in conditions of poverty. However, since 2003 per capita incomes of the poor and the rates of poverty and extreme poverty have started showing improvements, especially in rural areas, driven by broadening economic growth. Average incomes of the poorest tenth of the population rose 33 percent between 2001 and 2004, while the incomes of the wealthiest tenth of the population remained level over the same period. Growth has had the most impact on extreme poverty rates, especially in rural areas. Extreme poverty declined from 24 percent to 19 percent between 2001 and 2004 nationally, but rural extreme poverty fell from 50 percent to 40 percent over the period, while urban extreme poverty declined from 10 percent to 8 percent. Although no poverty numbers are available after 2004, recent improvements inemployment inurban areas indicate that the growth of 2005 and this year (Figure 2) is having further impacts on poverty. Income inequality also remains relatively high, with the Gini coefficient improving slightly from 0.52 to 0.50 duringthe same period. 3 Figure 2. Urban Employment inFirmsof 10 or More Employees (monthly data) I 8.0 1 6.0 - 4.0 8 2.0 Y 0.0 -2.0 lSource: Labor Mnistry. C. Macroeconomic Outlook andDebt Sustainability 10. Economic activity for 2006 and 2007 is expected to remain strong. GDP growth i s projected at 6.6 percent for this year and 5 percent for 2007-09. The projected deceleration o f economic growth for 2007 i s due in part to expected global economic slowdown and deteriorating terms o f trade. Nevertheless, it i s expected that internal demand and tax revenues will remain strong, supported by large investment projects planned in the mining and gas sectors and by the "public investment shock" program. Approval o f the recently-signed free trade agreement (FTA)' with the US may improve growth even more, stimulating greater trade and investment. Exports could be hampered if the U.S. Congress fails to approve the signed FTA with Peru before the end of 2006, when the ATPDEA trade benefits granted by the U.S. to the Andean Countries expire. However, the new administration i s committed to continue implementing a trade policy conducive to global integration. The GoP i s already working in establishing free trade agreements with Chile, the European Union, Mexico, Singapore, India, China, Canada and Central America; as well as in expanding the current agreement with Brazil. At the same time, the GoP has developed an agenda of competitiveness and a National Export Strategic Plan. The goal i s to increase non-traditional exports from 25 percent to 40 percent of total exports by the end of the current administration. 11. Based on sound fiscal policy and proactive debt management, Peru has reduced fiscal and debt vulnerabilities, and is expected to continue improving in coming years. The country's debt service profile and its currency and interest risks exposures have improved significantly as a result of Peru's ample access to various funding sources, including multilateral banks, U.S. and European markets, and local markets. Re-profiling operations and pre-payments 'The agreement, formallyknownas the US-PeruTradePromotionAgreement, was signedby the two governments inApril 2006 andwas ratifiedby the PeruvianCongressonJune 28,2006. Formoredetailssee http://www.ustr.govrrade_Agreements/Bilatera~eru-TP~Section-Index.html 4 reduced public sector borrowing requirements by 2-3 percent in the medium-term, and provided amortization relief on average o f US$480 million annually between 2006 and 2010. These transactions also improved the structure of public debt, with domestic issues increasing from 15 percent o f total debt in 2004 to 23 percent in 2006, and local currency issues up from 10percent of total in 2004 to 17 percent in 2006. Assuming continued primary fiscal surpluses, favorable external conditions and a stable macro-economic environment, public debt i s projectedto remain stable at its current level of 32 percent of GDP and possibly decline to as low as 26 percent of GDP by 2011 (see Annex 6 for details on Peru's debt sustainability, and Annex 5 for macroeconomic projections). While this sustained reduction of public debt will help the GoP achieve its goal of investment grade status, dollarization in the financial system and its external debt structure should also be improved. Table 2. Peru Financinp Reauirements and Sources. 2003-2009 2003 2004 2005 2006e 2007e 2008e 2009e Total 2781 2815 4636 1984 2280 2850 1506 Foreign -2502272810222215471115 Fast DisbursingLoans 527 862 595 465 450 420 500 InvestmentProjects 328 315 350 500 600 600 600 Bonds 1250 1299 1,682 0 0 500 0 Other 64 26 100 57 28 27 15 Domestic - 313 612 __ 1908 - 1203 962 1303 -391 Bonds 492 737 2,017 1732 700 700 700 PPP 51 113 56 84 24 23 23 Deposits and other 69 -537 -225 -854 479 581 -332 Memo item GDP growth 3.9 5.2 6.4 6.6 5.0 5.0 Government Balance %of G D P - 1.7 - 1.1 -0.3 0.6 - 5.5 0.8 - 0.6 0.01 Source: BCRP, INEI and MEFprojections. 12. Consolidation of Peru's medium term fiscal stance relies on external financing. Under the assumption of compliance with fiscal deficit targets and growth o f an average of 5.5 percent during the period 2006-09, Peru's financing needs are approximately US$8.6 billion. Projected external sources of financing represent 55 percent (US$4.7 billion) of total needs, of which US$1.8 billion is expected to be budget support. Peru's debt management strategy under the revised Murco Mucroecondrnico Multianuul (MMM) and the recently published debt management strategy aims at minimizing the cost of new borrowing, mitigating refinancing risk, increasing the share of domestic debt in soles, lengthening the maturities o f fixed-rate debt, and continuing to develop the market for international sovereign bonds. The medium-term plan is to reduce the ratio of public debt to 26 percent of GDP at the end of 2011, which coincides with Bank projections, and to reduce foreign currency participation to 69 percent (from 74 percent in 2005). A summary o f Peru's net financing requirement flows are as shown inTable 2. 13. The recent 26-month Stand-By Arrangement with the IMF expired in August 2006 and the IMF is currently negotiating a new arrangement covering the 2007-08 period. The 5 IMF Executive Board recently completed the fourth and fifth reviews under Peru's 26-month Stand-By Arrangement, in an amount equivalent to SDR 287 million (about US$424 million), which expired in mid-August 2006. Discussions for the 2006 Article IV Consultation and negotiations for a new Stand-By Arrangement started in October 2006 at the request o f the Peruvian authorities. This arrangement, as with the previous one, i s likely to be treated as precautionary. A renewal of a program with the IMF together with this proposed development policy loan will bolster market confidence at the early stage o f the new government. 111.The Government Program 14. The GoP's program for 2007-2011 intends to build on the solid macroeconomic framework to generate increased growth and ensure a more equitable distribution of the fruits of growth to poorer segments of the population. To accomplish this, the GoP program (discussed in more detail in the CPS) aims to balance both human and economic development, and i s conceptually divided into three main areas of action: accelerating and broadening economic growth; improving social development; and modernizing public sector institutions. The GoP's priorities are reflected in the 2007 budget, which calls for an increase of 0.5 percentage points of GDP in public investments, with a particular focus on key obstacles to growth, and with a strong emphasis on poorer regions of the country. Measures are also underway to encourage private investment, which i s expected to grow by 20 percent in 2006. Key among these measures are finalizing the FTA with the U.S., offering concessions on regional airports, approving a timetable to put infrastructure projects out to bid, and unilaterally lowering tariffs on imported capital goods andintermediate inputs. 15. The GoP has made extensive efforts to establish a broad consensus on its policy program with the previous administration, the legislative branch and society at large, a process that the Bank has actively supported. During the transition in government after the elections, high level officials from the previous and current administration met together with the Bank's country team to discuss the policy notes collected in Peni: La Oportunidud de Un Pais Diferente-Prbspero, Equitativo y Gobemable, andthere was considerable agreement among on the principal areas of reform needed inthe country. The government plan and cabinet, presented by Prime Minister Del Castillo, was approved in Congress by a large majority on August 24, 2006. At the initiative of the Prime Minister's Office, the National Accord (Acuerdo Nacional) has been reactivated as a forum for discussion of long term objectives agreed among representatives of all political parties, religious groups, unions and civil society. The National Accord was first signed in 2002 and has served as the most important vehicle for developing a common vision for the future of the country. Several working commissions on different sectors, such as health, transportation, and education, are formulating policies with input from government officials, specialists inthe sector, and civil society representatives. 16. To achieve faster and more equitable economic growth, the GoP intends, on the one hand, to strengthen the efficiency and quality of fiscal management, and on the other, to improve competitiveness. On the fiscal side, this means continuing to strengthen control of overall fiscal balances through a more efficient tax system and greater control over spending, and a better management o f public debt. But beyond the quantity, the GoP also will focus on the 6 quality of public accounts, implementing more rigorous monitoring and evaluation of spending programs using results-based budgeting techniques and simplifying and rationalizing the tax system to reduce distortions. To improve competitiveness, the GoP will enact policies to support private sector, such as key public investments, export promotion and greater credit to small and medium-sized companies. Butjust as important-if not more important-the GoP intends to get the public sector out o f the way o f private economic activity, by removing numerous obstacles in administrative procedures. 17. Inthe view of both the GoPand the Bank, these two areas are mutually reinforcing and, if reforms advance as planned, will offer a significant payoff in terms of economic growth, social development and poverty reduction. Strengthened fiscal management i s a desirable end in itself, to maximize limited public resources, but it also supports country competitiveness by generating private sector confidence in overall macroeconomic stability and the ability to undertake long-term investments and planning. As well, greater country competitiveness will improve the fiscal situation by generating increased tax revenues and decreasing the need for government intervention to stimulate economic growth. Together, improvements in these two areas will strengthen the ability to achieve the GoP's ultimate goal: accelerating and broadening economic growth to improve the standard o f living o f all Peruvians, especially the poor. The following sections discuss the principal challenges and the administration's plans ineach o f these two areas. A. Efficiency and Quality of FiscalManagement 18. A central element of the administration's policy agenda is to continue policies that strengthen macroeconomic stability and fiscal prudence, while improving the quality of public expenditure. The GoP has set a series of clear targets related to that objective, which coincide with the outcome objectives o f this proposed loan series. Policy areas to achieve these goals include strengthening fiscal rules, public debt management and tax policy; improving the efficiency of budgetary accounting; making the transfer system more equitable; and implementing efficient, performance-based budgeting. StrengtheningFiscalRulesand Debt Policy 19. Fiscal policy has remained prudent in recent years and supported macroeconomic stability, although it has been moderately pro-cyclical. The deficit of the non-financial public sector has declined steadily in the last four years and will record a surplus o f 0.8 percent o f GDP in 2006. The Fiscal Responsibility and Transparency Law (LRTF), adopted in 2003, aims to guarantee fiscal sustainability using two rules: a deficit ceiling of 1 percent of GDP, with the principle of a zero deficit over the cycle; and a 3 percent annual real growth limit on non- financial public expenditure. During periods of strong economic growth, the 3 percent real increase in expenditure becomes binding, adding a countercyclical component to fiscal policy.2 However, since 2003 a waiver for the expenditure rule has been extended every year. The non- financial general government primary expenditure in 2005 increased by 8.3 percent inreal terms, and by over 6.5 percent in 2006, above the 3 percent limit established in the LRTF. The * This law also establishes that a deficit o f 2.5 percent o f GDP is allowed ifreal GDP growth is zero, and authorizes the use o f funds from a fiscal stabilization fund when revenues fall by 0.3 percentage points o f GDP. 7 economy has institutional safeguards designed to ensure fiscal discipline while granting flexibility to manage economic shocks, but if these rules are not complied with, it undermines fiscal credibility and makes the fiscal situation more vulnerable in the event of an economic downturn. 20. Legislation to strengthen compliance and monitoring of the macro-fiscal rules at the national level has been approved by the Executive and submitted to Congress. This new legislation will complement existing fiscal responsibility law by establishing sanctions for non- compliance with LRTFprovisions. These rules will be monitored by the recently-createdFiscal Policy Coordination Committee, which includes the Minister o f Economy and Finance (MEF), the two deputy MEF ministers, executive director of the National Fund for Financing State- Owned Enterprises (Fondo Nacional del Financimiento de la Actividad Empresarial del Estado-FONAFE), director of PetroPeru, and the ESSALUD president. The Committee will define the objectives and fiscal targets included inthe MMM, approve the annual fiscal program, review monthly budget execution, and verify the compliance with the LRTF fiscal rules. Committee members are responsible for the compliance o f two rules: (i) that the deficit o f the non-financial public sector deficit does not exceed by 0.1 percent or more of GDP the target established in the MMM; and (ii)that the growth o f non-financial general government expenditure does not exceed by 0.5 percent or more the limit established under the LRTF (3 percent in real terms). Sanctions to Committee members include their immediate removal from public office, with a four year prohibition of participation in public appointments. Granting waivers to compliance with the fiscal rules (as was common inthe past) are prohibited according to the new law. 21. Monitoring the reporting and compliance of the fiscal rules by sub-national governments has also been strengthened. The new legislation on sanctions establishes that sub-national authorities (governors, mayors, and legislatures) are responsible for complying with the fiscal rules. The Law of Fiscal Decentralization (LDF) established that regional and local governments must provide the central government with medium-term fiscal projections (including plannedexternal and domestic debt issues), which must be consistent with the MMM. Also, sub-national governments must report on their quarterly fiscal performances and describe adjustment actions needed to comply with annual targets. The LDF required that by end-2005 local and regional governments will provide the MEF a fiscal management report, including information on compliance with fiscal rules. The MEF has started a proactive policy of providing institutional capacity to sub-national authorities, and has launched a series of seminars to train local and regional authorities in report preparation. The strategy o f de-concentrating MEF offices to the regions will also strengthen institutional capacity at the local level. MEF estimates that fiscal reports will be submitted by 2008. 22. The administration intends to place more emphasis on public investment and social programs within a context of fiscal discipline. Redirecting public expenditure has been extremely difficult as the budget lacks flexibility. Fiscal rigidity has increased since the mid- 1990s as wages, interest, and transfers have increased to nearly 89 percent of central government spending by 2005, from 78 percent in 1995.The ceiling for public expenditure growth under the LRTF will be modified, with the 3 percent increase limit applying only to current expenditure, not investment, allowing for control over wage spending but more space for productive 8 expenditure. To further strengthen planning a multi-year program of public investment and maintenancehas been adopted. The 2007 budget proposal recently submittedto Congress targets a deficit of 0.8 percent of GDP and limits the growth of current expenditure to 3 percent in real terms. Public investment will rise from 2.7 percent of GDP in 2005 to 3.9 percent of GDP in 2007. 23. Declining public external debt and prudent debt management have reduced solvency and liquidity vulnerabilities, and led rating agencies to upgrade Peru's sovereign rating, bringing it closer to investment grade.3 Steady improvement in Peru's credit ratings has further reduced funding costs, made it easier to lengthen domestic bond maturities and facilitated access to markets and hedging instruments (see Annex 6 for details). Central to the modernization of debt management in Peru are the formulation and implementation of a government debt management strategy. The strategy i s now contained in a formal document that was made public early in 2006 after being sharedwith Congress and the Comptroller. Peru i s one the few countries in Latin America that have a formal, published strategy, greatly enhancing the transparency and accountability of the debt management process and illustrating the substantive progress in public debt managementover the last four years. Such progress includes the revision of Credit0 Pliblico's organizational structure and division of responsibilities and the reorganization of the middle office (MO) in 2005. The MO was expanded to strengthen the analytical work leading to the preparation of a borrowing strategy and to help promote debt market development 24. The debt management strategy aims to mitigate refinancing risk, increase the share of domesticdebt insoles, lengthenthe maturities of fixed-rate debt, and continue to develop the market for international sovereign bonds. Following these guidelines, Peru prepaid US$1.55 billion worth of Paris Club debt in August 2005, reducing refinancing risk significantly for the period 2005-09. Similarly, the share of local currency debt rose from 8 percent to 16 percent in the last three years. An illustration of the GoP's efforts in this regard i s the debt exchange conducted in 2005 which allowed the exchange of US$262 million worth of dollar- denominated bonds for bonds in soles (S/. 851 million), including a bond with a 10-year maturity; and an additional US$119 million exchange of dollar-denominated bonds for inflation- indexed bonds maturing in 2024. There i s a consistent drive to increasing the share of fixed-rate debt, not only using the new borrowing but also through interest rate swaps on existing debt4. Fixed-rate debt has increasedfrom 47 percent of total debt in2002 to 59 percent in 2005. 25. With approximately 80 percent of all public debt denominatedinforeign currencies, Peru is vulnerable to exchange rate risk, in particular if commodity prices decline or if the BCRPimplements a monetary policy more oriented towards domesticgoals'. As part of its strategy to reduce this vulnerability, and as a result of the very good fiscal and monetary policy track record of recent years, the MEFhas begun issuingdebt denominated in soles on a regular basis. The "market makers system" developed by the h4EF in 2003 has helped strengthen the Standard and Poor's upgradedPeru's long-term foreign currency ratings to BB inJune 2004 and its long term local currency rating to BB+inJuly 2005. At end August 2006, Fitch raisedPeru to BB+,the first adjustmentby this agency since 2004. With this upgrade,Peru is one step away from investment grade. Such as swap transactionsfrom floating to fixed interestrateson four IBRDloans and Brady Bonds. See Monetary andExchangeRate Issues inMacroeconomicsPolicy Note. 9 market, allowing the MEFto gradually extend debt maturities (upto 15 years for fixed-rate paper andup to 30 years for variable rates) and consolidate the yield curve. 26. Peru is one of the first countries to use IBRD Fixed Spread Loan (FSL) and has taken advantage of increasedBank flexibility to manage financial risksas part of its overall debt management strategy. Peru used the FSL flexibility to customize the repayment terms o f their Third Programmatic Decentralization and Competitiveness Development Policy Loan (DCDPL), for US$l50 million. This helped smooth the repayment profile and reduce refinancing risks of their overall debt. Also, Peru has used the embedded risk management options o f the fixed-spread loans by converting four of the 18 existing FSL IBRD loans to fixed rates, which correspond to 16 percent of the total portfolio with the IBRD.This helpedreduce the interest rate riskof Peru's overall debt. 27. Prior Actions for FMCDPL I:Presented legislation to Congress to strengthen monitoring and enforcement offiscal rules, including the Sanctions Law and the creation of a Fiscal Policy Committee; and published a public debt management strategy for 2006-2008 that provides guidance to the debt manager's actions infunding andportfolio management, based on cost and risk analysis. The continuity of the existing sound fiscal framework i s crucial inthe first year of the new administration, before moving on to tackling more difficult fiscal reforms in the future. The Sanctions Law and the Fiscal Policy Committee send a signal to all levels o f government within the country, and to international markets, that the GoP is committed to maintaining fiscal discipline, and that it i s moving ahead with legal and institutional measures to ensure that. On public debt strategy, as noted above, by being one of the first countries in the region to have a formal debt strategy, Peru i s making a strong statement that it has a well- conceived plan for how it will manage its debt in the coming years, and that it i s willing to make that plan public. The Bank policy note on public debt indicates that this i s a key signal to both domestic and international markets that the GoP intends to maintain a stable macroeconomic environment conducive to long-term investment and economic planning. Policy Measures Going Forward: To strengthen and enforce fiscal rules, following the approval of proposed legislation, the GoP will next year begin applying sanctions to sectors and sub-national governments that violate fiscal rules, with the aim o f creating conformity with a single set o f national rules to tighten control over public spending. The following year, the GoP plans to begin issuing reports on compliance with fiscal rules by sub-national governments. External audits on the quality and content o f standard fiscal and financial reports are expected to start in 2009, to improve the quality of public accounting. Legislation will be enacted to introduce sanctions for sub-national governments not complying with their fiscal rules or reporting requirements, and to make more precise the conditions under which the central government would intervene. By 2008, the MEF intends to begin publishing reports on sub-national fiscal management, and will define incentives to encourage municipalities to pay over-due debt. By 2009, the MEF will establish payment and fiscal sustainability agreements with four o f the 10 largest municipalities in the country. In the primary public debt market, challenges include creating a detailed strategy for domestic market development and a study o f investor demand for domestic issues; 10 exchanging fragmented, short-term bonds for longer-term issues to help consolidate the yield curve; and making the necessary policy changes to continue increasing the proportion o f fixed-tern debt. The importance of a viable and growing domestic debt market i s recommended in several Bank studies, including policy notes on the financial sector and public debt, as well as the Country Economic Memorandum. Increasing the share o f domestic debt i s a sound strategy that will reduce Peru's vulnerabilities to exchange rate risk, and it also i s an important catalyst for the private sector, particularly the highly-liquidpension funds inneed of highquality domestic investment instruments. 0 Secondary debt market development will require greater institutional coordination (through a formal committee) between the MEF, BCRP, Bank and Insurance Superintendent (Superintendencia de Bancas y Seguros-SBS) and National Stock and Business Supervisory Commission (Comisibn Nacional Supewisora de Empresas y Valores-CONASEV); unifying different valuation methodologies among different types of investors; and creating well-functioning securities funding tools, such as repurchase agreement (repo) and securities lending systems. 28. Triggers for FMCDPL 11: Comply withfiscal rules-including a limit of 3 percent real increase annually on current spending-with a fully functioning Fiscal Policy Committee, and Comptroller is monitoring compliance withfiscal rules to all levels of government. This trigger i s intended to ensure a continued disciplined fiscal stance, which i s an essential precondition for Peru to achieve the levels of growth it has targeted, as has been amply documented in numerous Bank studies, including the Country Economic Memorandum, the Bank thematic policy note on growth, andBank policy notes on macroeconomics and the fiscal framework. Making the Tax System More Neutral and Stable 29. The GoP intends to undertake tax system reforms to correct the relatively low collection as a percentage of GDP, excessive complexity in types of taxes and procedures, and numerous distortionary exemptions. Tax revenue collection of the central government increased from 12.5 percent o f GDP in 2001 to an estimated 15 percent o f GDP in 2006, but it remains below the 18 percent o f GDP o f the mid-1990s. The recent improvements in revenue collection are partly a result o f high commodity prices. The tax base i s limited by a highlevel of informality (about 60 percent o f the economy operates under informal system) and by a number o f sectoral and geographic exemptions (244 at last count), which cost an estimated 2 percent of GDP. The GoP has tried in the past to eliminate tax exemptions without success. A further issue relates to the Financial Transactions Tax (Zmpuesto de Transacciones Financieras-ITF), which was introduced in April 2004, with a declining rate schedule and a December 2006 sunset clause. This tax was introduced as a temporary measure, but in the 2007 draft budget the authorities propose keeping the ITF one more year. While the ITF is useful to track financial transactions, it also negatively affects financial intermediation. On the administrative side, lengthy procedures to receive tax rebates limit the incentive for tax payers to follow the legal system, encouraging evasion. Poor coordination among different government institutions limits the ability to pursue non-compliant citizens and companies. 30. The GoP strategy on reforms to tax policy and administration is to involve the private sector in discussions on policy design. The MEF, with the support of the Bank, has 11 organized a six-week consultation process with business associations, and will submit proposals by December 2006. Technical assistance has been providedby the WIF in coordination with the Bank. Regarding exemptions, a cost-benefit analysis of the existing exemptions has been finalized and will be used to define the road map for their elimination. The GoP has decided to reduce the ITF rate to a minimumlevel and credit it against income tax. Inthis way it could still be used as a tracking tool, but would not act as a disincentive to financial transactions. The GoP has already implemented administrative reforms to the tax system this year, including an overhaul of the information of the Internet-based Single Contributor Registry (Registro Unico de Contribuyentes-RUC), and also allowed the inscription of individuals into the Registry for the first time. 31. Overall, the GoP intends to raise tax revenue to 16 percent of GDP by 2009. While this target is not high, both the IMFand the Bank team concur that it is reasonable, considering the possibility of revenue lost from lowering tariffs and reduced ITF, as well as the possibility o f declining commodity prices, which form a large share o f tax revenue. However, such a low target for tax revenue will imply a greater need for prudence in spending to achieve the desired overall fiscal targets, as well as needed increases to investment in infrastructure and social programs. This reinforces the need to find savings through a more results-oriented, effective use of scarce fiscal resources, and also to enforce fiscal rules to control the growth in spending on wages. 32. Prior Actions for FMCDPL I:Implementedfirst phase of tax reforms: prepared a cost- benefit analysis of eliminating existing sectoral and regional tax exemptions, enabled Internet registration for the single taxpayer identification number (RUC) and made updated RUC database available by Internet. This prior action is intended to begin the process of reducing the distortionary character o f the Peruvian tax system and facilitating the processes faced by taxpayers, which as pointed out in the Bank's fiscal policy note and the Country Economic Memorandum are key obstacles limiting the broadening of the tax base and encouraging informality and non-compliance. Policy Measures Going Forward: The administration will implement several measures to rationalize the tax system and improve collections. One important step will be to implement in 2007 a strategy to eliminate sectoral exemptions, and to continue negotiations to eliminate remaining regional exemptions. Also in 2007 the GoP will reduce the ITF to a minimumlevel, and credit it against corporate or personal income tax, and implement a broad-based minimum tax. Plans are being designed to facilitate the currently complex and time- consuming process o f tax refunds, which would encourage greater compliance. By 2008 the GoP intends to electronically integrate the tax collection agency (Superintendencia Nacional de Administracibn Tributaria-SUNAT) with the fiscal courts, to improve the ability to pursue non-compliant tax payers. By 2008 the GoP will submit a law to devolve management o f specific taxes to the regions. 33. Triggers for FMCDPL 11:Implement the secondphase of reforms to increase eficiency and neutrality of the tax system, for example (i) initiate a strategy to eliminate sectoral and 12 regional exemptions based on a cost-benefit analysis, or (ii) reduce the effective rate of the ITF to a minimum level. The trigger on tax reform furthers the prior action noted above. Improving the Efficiency and Transparency of Public Accounts 34. The GoP has taken actions towards strengthening transparency, accountability and efficiency through reforms in public sector financial management and accounting. Important steps towards these objectives include the recently approved Treasury System Law and the Accounting System Law. The Treasury Law will bring the budget classification system in line with international standards, budget classification will be incorporated into the charts of accounts, the integrated financial administration system (SIAF) will be modernized according to external evaluation, and the coverage o f short-term debt under the General Public Debt Law will be expanded. 35. Currently, the GoP is pursuing a Treasury Single Account (TSA) to consolidate the availability of all public resources. There are roughly 5,000 accounts of government entities in the Banco de la Nacibn, most of them with balances. The build-up of balances reduces the effectiveness o f an overall cash management strategy and also reduces the information and control over spending. A TSA system for each level o f government would promote greater transparency, better cash management, and allow for strategies to manage financial surpluses. All activities of the three levels of government would be programmed through the budget and only executed through the TSA, although the Treasury does not control the daily operations o f the individual correspondent's accounts. Implementation needs to take into consideration the decentralization process, meaning regional and local governments need adequate systems to meet international standards with regardto information quality. 36. Prior Actions for FMCDPL I:Defined action plan and implemented first steps for adopting a TSA; aligned budget classification to international standards and with the chart of accounts, and automatic accounting by SIAF; and approved Treasury System Law and Accounting Law. A 2005 report by the IMF6highlighted the problems occasioned by weaknesses inthe budgetclassification system and SIAF accounting, and also pointedto the inefficiency and confusion caused by different government entities having multiple bank accounts. The actions taken here are all fully in line with the recommendations considered most important by the IMF report. In particular, the report strongly recommended instituting a TSA to improve available information on government funds, strengthen appropriation authority and budget execution, and minimize the financing costs o f the budget. Policy Measures Going Forward: The GoP will initiate the first stage o f the action plan for implementing TSA and formalize the application of a matrix to unify budgetary and accounting classification systems, and apply them in an integratedfinancial system. 37. Triggers for FMCDPL 11: Consolidate TSA in the Banco de la Nacih, establish revenue and payments mechanism ensuring automatic conciliation, and unify budgetary and Peru: Modernizing Budget Processes, Institutions and Information Systems (2005). 13 accounting classification systems, including incorporation of the chart of accounts into the SIAF. This trigger follows directly on the prior actions inthis area, and isjustified for the same reasons. Making the Transfer System Sustainable and Equitable 38. Peru has made a number of improvements to its system of transfers between different levels of government in recent years as part of the decentralization process. However, several problems remain to be addressed, most particularly: the high level of sub- national dependence on transfers and a low level of own-revenues; the difficulty in efficiently spending the growing public resources derived from natural resource income (Box 1); and a high and growing regional inequality accentuated by the transfer system. Box 1.NaturalResourceIncome Transfers Beginning with the creation of the petroleum canon for Piura and Tumbes in 1983, Peru has established a series of mechanisms to transfer income derived from natural resource exploitation to regional and local governments. By far the largest is the mining canon and mining royalties, but the Camisea Development Fund (FONCAM) is expected to grow significantly in coming years as well. The mechanisms are as follows: Mining Mining GasCanon Other Canon Royalties Canons Sourceof 50% of 1-3% of 50% of income 50% of Funds income tax production tax paidby gas income paid by value at int'l companies, and tax/rights mining prices 50% of gov't minus canon. sales by paid by companiesto service companies hydro power, gov't contracts fishing and forestry companies to Distribution 75% to 80% for Same as mining Split between Formula municipal municipal canon municipal and canon mining gov'ts in gov'ts in regional gov'ts canon department department and universities of resource, of resource; accordingto and 25% for 15%for different formulas regional regional for Ucayali, gov't gov't; and Ayacucho, 5% to local Huancavelica, Ica universities and Lima regions Total 212 70 91 18 160 43 Amount in 2005 (US$ millions) 3.3) 39. Natural resource-based transfers have increased sharply in recent years, driven by the commodity price boom. Efficiently and productively spending a substantial and largely unexpected amount of revenue is not an easy task. Utilization rates can be as low as 60 percent for sub-national governments receiving these types of transfers. Canon and royalty resources are earmarked to investment, with 20 percent o f resources allowed for maintenance and another 3 percent for project preparation. The National Public Investment System (Sistema Nacional de Inversibn Pziblica-SNIP) evaluates investment projects according to standardized criteria. 14 However, the SNIP office at the MEF does not count with the necessary human resources to fulfill demands for providing technical assistance to project-avid regions and municipalities. Pilot projects supported by the IFC Technical Assistance Facility in Cajamarca have helped improve this situation (see Box 2), but more work i s needed. The GoP has begun to open regional offices o f the SNIP and other instances of financial oversight in two regions, and plans to continue expanding this program. Box 2. IFC TechnicalAssistance to Baiiosde Inca Municipalityon the Mining Canon The IFC's investment in the Yanacocha gold mine in Cajamarca, Peru has been extremely successful financially. However, local citizens have often felt that they are not benefiting from the wealth generated by the mine, despite the devolution of a portion of the mine's income to local governments through the mining canon. In part this is because many municipalities do not have the capacity to design effective investment projects, and as a result much of the canon remains in bank accounts instead of being used productively in the region. To address this bottleneck, the IFC's Technical Assistance Facility has been working with municipal governments in Cajamarca to improve the use of canon resources. The rural, poor Baiios de Inca municipality has received millions of dollars in recent years from the mine, and the mayor committed to work with the IFC on how to best manage the canon. The IFC team worked closely with the municipality to improve the assessment of investments, speed their approval through the SNIP, and involve civil society in the entire process. This work was undertaken directly with the municipality on specific projects inan on-the-job style, rather then merely supplying standardizedinformationon best- practice procedures. The resultshave beenimpressive.Municipal investment capacity increasedfive-fold from 2001-2003 (before the project started) to 2005, and is on its way to surpass US$6 millionby the end of FY 2006. This has translated into over 100 projects in 50 communities, with roughly half addressing health and education needs and more than 20 percent on productive infrastructure like roads and irrigation. As well, information on mining income and investment projects is publicly available. While this work has not eliminated poverty in the municipality or social tensions around the mine, it has increased awareness of the ability of the project to improve the lives of local people, and also strengthenedthe ability of the municipal governmentto address local needs. 40. The pro-cyclicality and volatility of these resource transfers could become a problem should commodity prices fall or if production falls from resource depletion or other reasons. For some municipalities, mining canon and royalties represent more than 90 percent of their total annual budget. Sub-national governments receiving resources from the National Camisea Fund(Fondo Nacional de Camisea-FONCAM) and (to a lesser degree) other canons for fishing, hydrocarbon, and forestry face a similar situation. The previous administration proposed a stabilization fund to smooth out the transfer of these resources, but the proposal remains in a congressional committee. As well, the low level of own-revenue collection exacerbates the dangers in dependingon transfers. 41. Wide divergences in natural resource endowments and economic concentration have the potential negative effect of increasing "horizontal" inequalities, as has been the case in other countries. The amount of per capita resources varies widely across regions, from a low of 45 soles per capita in Lambayeque to a high of 1,176 soles per capita in Moquegua in 2005. Moreover, the variation of transfers does not correlate strongly with poverty. For example, in 2005 the department o f Ayacucho, with a poverty rate o f 65 percent, received 145 soles per capita in transfers, while Moquegua, with a poverty rate o f 37 percent, received 1,176 soles per capita. The revenue sharing arrangement for canon has exacerbated inequalities. These disparities can be mitigated by a well-designed system o f intergovernmental transfers. 15 However, although the formulas used to calculate the distribution of canon resources and the Municipal Compensation Fund (Fondo de Compensacibn Municipal-FONCOMUN take poverty into account, this has not been sufficient to adequately offset high regional inequalities. The GoP has submitted a proposal to Congress to assign a portion of mining canon to the Regional Compensation Fund (Fondo de Compensacibn Regional-FONCOR), a fund intended to help redress regional imbalances. Policy Measures Going Forward: 0 Before the end of 2006, the GoP will undertake a thorough territorial mapping of all transfers to the sub-national level, including FONCOMUN, canon, and public investment, as a first step to building a coherent transfer system in pursuit o f national objectives. 0 The GoP i s seeking to reformulate the existing system of fiscal transfers, so regional governments that are not natural resource-endowed can also benefit from the current high cycle of commodity prices. Changing the system of transfers i s a challenging task and requires careful planning, in terms of objectives, impact and political economy. The GoP i s evaluating movingtowards an equalization transfers system, which would be supported by potential future Bank operations, taking into account experiences in other countries that have similar economic structure as Peru. 0 The GoP intends to deconcentrate SNIP along with other instances o f the MEF to facilitate project evaluation, technical assistance, and approval at the sub-national level, and thus improve the flow of investment spending from canon resources. 0 To reduce sub-national transfer dependence, the GoP plans to implement fiscal incentives to improve tax collection at the regionaland local levels. Implementing Performance-Based Budgeting 42. The GoP has decided to formally introduce the use of performance information (measures and evaluations) in the budgeting process and gradually implement a system of performance-based budgeting, with the objective of improving the efficiency and effectiveness of public expenditure. The new administration i s placing strong emphasis in improving the quality and impact of public spending, and performance budgeting could be used a powerful tool for such objective. Performance results will support better decision making, leading to improved performance and/or accountability for public spending. The authorities have decided to implement a gradual approach, by which they will start utilizing performance information indirectly but systematically to enrich budget decisions, with as much coverage o f the budget as can be technically achieved. In this case, "indirectly" means that performance measures are systematically used during all stages of the budget process: preparation, discussions, execution, evaluation and liquidation of the government's annual or multi-annual budget. Direct performance budgeting, which links performance results to budget allocations, will come at a later stage. The performance budgeting system will be developed, implemented, managed and overseen by the MEF, and will require close coordination with sectoral ministries. 43. The GoP has experimented in recent years with linking results to funds allocation. Examples of these are the performance-based budgeting pilots in the agricultural extension program SENASA and the Seguro Integral de Salud (Integral Health Insurance), a public health 16 insurance program that has a fee-for-service reimbursement and receives budget allocations based on the services rendered by health facilities. Additionally, two types of tools with bonudrewards for productivity have been widely used for improving quality and impact of public expenditure. However, although some of these efforts produced good results, these were not conceived under a coherent system for performance budgeting, and had little or no link with the budget formulation process. 44. A culture of performance measuring is being fostered and the linkage between the MEF-based M&E system and the budget process has been formally established. The GoP has prepared an action plan for institutionalizingperformance-based budgetin . The draft 2007 budget submitted to Congress includes performance indicators for 23 sectors$. These indicators have been prepared by the sector ministries and subsequently discussed and revised with the MEF, in order to jointly construct budget-relevant performance indicators that reflect government priorities and form the basis for a future M&E system. The design, implementation and institutionalization of an M&E system for performance-based budgetingi s a long-term task; in the meantime the GoP has proposed to use transitional M&E tools. The MEF has prepared technical terms of reference for executive sector evaluations as a first step to introduce more independent evaluations linked to the planning and budget processes. These executive evaluations have the advantage of being low cost, quick and provide the required flexibility to use the findings in the budgetary process', as opposed to other evaluation tools, that while providing more in-depthinformation, are more time consuming, more expensive, and require of better information sources9 that are not yet available. Gradually, performance indicators and evaluations will be used during the budget discussions and in some cases to directly determine resource allocation, particularly for priority programs. The emphasis during the first stages i s on identifying good outcome indicators and reliable information, before proceeding to use that informationinbudgeting. 45. An important but challenging step is to produce meaningful programmatic formulations to link budget cost data to outcomes. At this stage, performance budgeting relates resource allocation to measurable results in form of outputs/outcomes. While performance measures will be used systematically to inform budget decisions along with other information on performance, macroeconomic situation, and policy priorities, at the initial stage only few programs will link cost information to results. Ministries should identify four to five priority results, and specify the activities that they would need to undertake to achieve those results. Inthis phase, the goals will not be overly ambitious. There will be an effort to introduce this results orientation in three to four ministries and to have this approach account for perhaps 40 percent of total expenditure within a ministry. For this i s necessary to introduce programmatic formulation of budgets and identification of targets at the sectoral level. This implies identifying meaningful programs and associating them to priority targets. 46. The performance-based system will be based at MEF and will operate in coordination with all sectors for identification of sector-relevant indicators, advancing budget 'Thefirst set of indicators includes at least four indicators per sector, two for programs and two for projects and *activities. K.Kumar (1993).Rapid Appraisal Methods. The World Bank, Washington, D.C. Roche, C. (1999)Impact Assessmentfor Developing Agencies: Learning to Value Change. Oxfam, Oxford 17 programming, discussion and preparation of evaluation reports, sector commitments to improve program structuring and performance, and reporting to Congress and civil society. The GoP realizes that the impact and sustainability of the system depends on its use and institutionalization. This project will support policy decisions geared to ensuring installation of a quality system, increased utilization and institutionalization. A social sector DPL under preparation will support the implementation o f M&E systems for social programs, focusing on standards and accountability in the social sectors. Working closely, in a collaborative manner, with committed sector entities i s an important element for the success o f the performance-based budgeting system, particularly at the early stages o f the development o f the M&E system. This will help showcase to all other government entities the value of M&E. 47. Prior Actions for FMCDPL I:Enacted regulatory framework for pe$ormance measurement and reporting, linking the budget presentation cycle with performance indicators, by which all sectors and regional governments are required to generate output and pe$ormance indicators as part of their budget submission. The 2007 sector budget submission included sectorpe$ormance indicators (programs, activities andprojects), including for the environment. The need for improving the results focus of Peru's budgeting framework was noted as a key obstacle to obtain better results with scarce public resources in the 2003 Public Expenditure Review. The first prior action in this area initiates the required first stage of implementing a result-based budgeting system. This strategy for a phased implementation of performance-based budgeting i s validated by the experience o f numerous countries that have moved in that direction, as discussed in a 2005 OECD document surveying the experiences o f OECD countries inthis area." Policy Measures Going Forward: Gradual implementation of performance budgeting will be defined in an action plan which will describe the sequencing strategy. The new performance indicators will be incorporated in the 2007 budget evaluation and progressively linked to the financial management system (SIAF) with a view to enriching budget decisions. On the basis of the budget performance indicators, the MEF will begin a program to introduce M&E information in the budget cycle, through executive evaluations of programs, linked to the budget cycle, beginning with four in 2007. Results will be publishedand used to adjust goals for the following budget year starting in 2009. These executive evaluations will be accompanied with the implementation and institutionalization of an M&E system at the national and sub-national level that will allow a gradual transition from desk evaluation to impact evaluations, and from these to formal evaluations and monitoring of ministerial programs andpresidential goals Performance measurement and monitoring will cover key competences devolved to sub-national governmentsas part of the decentralization program. 48. Triggers for FMCDPL 11: Review and launch action plan for institutionalizing results- based budgeting (performance measurement, reporting, and subsequently budgeting), managed and overseen by the MEF and based on the use of the government-wide M&E system and relatingfund allocation to measurable results in theform of outputs andlor outcomes. Introduce lo"Performance Informationinthe Budget Process: Results o f the OECD 2005 Questionnaire," T. Curristine, OECD Journal on Budgeting, Vol. 5, No.2,2005. 18 programmatic formulation of budgets at the sectoral level for key programs, and issue regulations toformalize executive evaluations as a component of the budget cycle, and undertake two pilot executive evaluations each in two diferent sectors. This next phase of performance budgeting implementation again responds to lessons learned in other countries, as discussed above. The usefulness of executive evaluations i s noted in a World Bank overview of rapid appraisal methods. B. Competitiveness 49. The new administration bases its plans to improve development and reduce poverty inPeru on reforms to increase the private sector's competitiveness in the world economy. Planned policy measures in this area include continuing to promote export-led growth, reducing transaction costs through procedure simplification and streamlined public-private sector interface, and strengthening the investment climate for micro, small and medium enterprises (MSMEs). Competitiveness and the investment climate will benefit from several of the reforms noted in the previous section, in particular fiscal consolidation. However, a number of bottlenecks to private sector activity noted in the Investment Climate Survey (2004) will be addressed by specific policies on competitiveness, which are part of the program described below. Promoting Export-led Growth 50. Peru's export performance has shown impressive gains in recent years, with compound annual growth rates above 20 percent between 2001and 2004, and 25 percent in 2005. However, the country still faces many challenges if it wishes to reap greater gains from trade. Although non-traditional exports are growing fast, mining (which i s capital-intensive and hence generates relatively few jobs) still accounts for more than half of exports, and manufactured exports are low. As well, total exports in Peru still represent a low percentage of GDP, only 21 percent in 2005. This figure is particularly striking when compared to other countries in Latin America such as Chile (34 percent), Venezuela (32 percent), Mexico (28 percent), andeven Bolivia (24 percent). 51. The Garcia administration has stated clearly that it views international trade as a key engine for growth and poverty reduction in Peru. Peru signed and ratified the FTA with the U.S. in 2006, and the administration is expecting the U.S. Congress to ratify the trade agreement. It i s also pursuingother trade agreementswith countries inthe region and throughout the world. Undertaking the necessary competitiveness reforms to spur greater value-added exports i s a top priority, both to reduce dependence on volatile commodity prices, to encourage activities with a higher impact on employment and poverty, and to reap the opportunities of market access opened by the negotiated trade agreements. A major program to promote export development in the poor Andean region, Sierra Exportadora, i s one of the administration's flagship projects. 52. A crucial element in a pro-export strategy is the reduction of costs of inputsused in the production process of exporters and the facilitation of trade-related processes. Tariffs 19 have gradually been reduced since 1991, as have the levels of dispersion. Currently, average nominal tariff i s 10.1 percent, close to average protection in Latin American and middle income countries, and the rate of dispersion i s 6.3 percent. Average tariffs for 196 tariff lines-on inputs and capital goods not manufactured in the country-were reduced by the end o f 2005, falling to 4 percent, and resulting in a slight reduction (0.1 percent) in average nominal protection. Tariff dispersion has increased rather significantly with the tariff reductions in the 199Os, leading to economic distortions. Simplification, transparency and further reductions in the most favored nation (MFN) tariff, especially in intermediate and capital goods, would foster competitiveness, increase private investment, and reduce the cost of trade deviation produced by bilateral trade agreements. To this end the MEF has issued a Resolucidn Ministerial establishing the need to reduce protection and dispersion in order to foster competitiveness, and the World Bank will provide technical assistance on modeling the impact o f such reforms. Regarding facilitation of processes to exporters, an agenda o f modernization o f customs and ports of the GoP has already translated into reduction of logistic and customs clearance costs. Among further actions envisaged in the country's agenda are the improvement o f customs procedures in line with the commitments under the FTA and the creation of a Ventanilla Unica ("single window") establishing uniform procedures for the authorization and control of imports and exports subject to non-tariff regulations. 53. Prior Actions for FMCDPL I:Signed the FTA with the US. and ratified by Peruvian Congress. Reduced from 7 to 3 percent tanfs on capital goods in 196 lines and published national guidelinesfor tarifSpolicy. Created Ventanilla Unica, one stop-shop with the objective of establishing uniform authorization and control of imports and exports subject to non-tan! measures. The completion of the FTA with the U.S. is a crucial sign that Peru i s committed to an export-led growth strategy, and that it intends to integrate further into the world economy by lowering constraints to trade. While the impact o f this action may be limited at first-pending ratification by the U.S. Congress-it nonetheless has a strong positive impact on how national and international markets view Peru, and acts as a catalyst to improve country competitiveness in advance of lowering trade barriers, opening new market opportunities and consolidating existing preferences. Complementary measures envisaged by the GoP are the reduction o f MFNtariffs, particularly in capital and intermediate goods, to foster competitiveness and reduced trade deviation caused by bilateral preferences, and the pursuit of an agenda to reduce costs for clearing import and export goods. Numerous Bank studies, in particular the Country Economic Memorandum, the thematic policy note on growth, and the policy note on trade, demonstrate clearly how far behind Peru i s compared to other developing countries in the region and the world on international trade, and how powerful trade can be as an engine to create faster, broader economic growth and poverty reduction. Policy Measures Going Forward: 0 The current administration intends to continue negotiating and signing trade agreements with other countries that offer strategic opportunities to Peru. Talks are underway with Mexico, Singapore, the E.U., Chile and Brazil, and future negotiations are being considered with Canada, India and China. 0 An important component of the GoP's trade facilitation agenda is to continue improving the institutions and regulations that govern trade transactions. The administration plans to integrate the different administrative units participating in customs clearance 20 with the objective of simplifying the process of authorization, payment and control in compliance with non-tariff regulations. Additionally, and partly as a result of commitments assumed under the FTA, a strategy to improve customs procedures and times i s underway, covering issues like introducing express shipments, advance rule issuing,improvingrisk management. 0 To promote export growth in the regions, the GoP intends to open new export promotion offices, following on the experiences in Loreto, Chiclayo and Huancayo. As part of the Sierra Eportadora project, the focus will be to open these offices in the Andean region, to help small producers in poorer regions develop products that can be competitive in external markets. The Sierra Exportadora project will also include measures to increase infrastructure and the flow of credit to the Andean region, geared toward export growth. 0 To improve Peru's low level of technological innovation and quality accreditation for exporters, the GoP plans to evaluate the operations of existing Centers of Technological Innovation (Centros de Znnovacidn Tecnoldgica-CITES), public-private funded centers that provide technological support to firms in specific productive chains, includingtesting and certification, technical training, knowledge dissemination, and assistance in marketing strategies. Based on an assessment of their impact, a plan for improvements and expansion will be designed and implemented. As well, a program on science and technology will be designed to provide financial incentives for the development of innovation and research and development projects in firms and other institutions that demonstrate linkages and counterpart funding from the private sector. 54. Triggers for FMCDPL 11: Continue trade negotiations to expand market access to Peruvian exporters. Implement complementary measures to facilitate trade and customs clearance, for example implementing Ventanilla Unica or reducing average tarif and tarif dispersion. While the signing of an FTA with the U.S. was a very important policy move, Bank analysis also highlights the importance for Peruto diversify its export markets to reduce the risk of terms-of-trade shocks. As a result, the Bank i s supporting the GoP's intention to move forward with negotiations to expand access to other markets for Peruvian products, such as the European Union, Canada, China, Chile and elsewhere. The complementary agenda to trade openness, including facilitating trade transactions, reducing the cost to access to inputs and capital goods in the production process, and reducing tariff dispersion, i s equally important as trade agreements to generate greater economic returns from trade, as noted in the Country Economic Memorandum, the Bank policy note on trade, and the 2004 study Peru: Microconstraints to Growth. The Bank i s also supporting the GoP with a Trade Facilitation and Competitiveness Technical Assistance Loan in improving the environment for trade related transactions in issues like logistic management, quality, innovation and promotion of exports in developing regions. Procedure Simplification and Streamlined Public-Private Sector Interface 55. As in many developing countries, bureaucratic procedures in Peru are time- consuming and costly, and act as a disincentive to greater economic activity. Particularly onerous and harmful to economic activity are the complex and lengthy procedures to open a new business, title land, and undertake international trade. There have been advances in procedure 21 simplification at both the national and municipal levels in recent years. At the national level, the government has implemented a portal where processes and procedures for a number of services are published. This effort will continue to cover all services. 56. At the municipal level, IFC, USAID and other donors have worked extensively on pushing the simplification agenda to ease bottlenecksto greater economic activity. The IFC Technical Assistance Facility and the local non-governmental organization (NGO) Ciudadanos al Dia have been integral in assisting the provincial municipality of Lima simplify business permit and administrative procedures, startingin 2005 under a program called TrarniFaciZ. As a result of the simplifications that went into effect in the beginning of 2006, permits that formerly required 60 days to process are now finished in three days. Business owners formerly needed to visit government offices 11times on average duringthe process, but now only have to go once or twice. While previously a uniform process was required for all companies, now risk categories help the municipality differentiate services. Importantly, the cost for undertaking these processes for small and medium enterprises has fallen by over half. The response has been impressive: while the municipality processed on average about 1000 licenses for commercial activities per year previous to the reforms, they processed over 5000 in the first seven months of 2006. A "Toolkit for the Simplification o f Municipal Procedures" was developed out of this experience to extend these results to other provincial municipalities, which in turn can influence district municipalities to follow suit. 57. Peru has developed a strategy for the inclusion of information and communication technologies (ICT) inthe development agenda of the country. According to a United Nations E-Government Readiness Index, Peru ranked 56 out of 179 countries in 2005, a drop of three rankmgs from the previous year. This compares to 22 for Chile, 31 for Mexico, and 33 for Brazil. The index highlights e-governance infrastructure as a key area of weakness in Peru. The GoP currently has a Digital Agenda and an e-government strategy, as well as an institutional structure and a legal framework that facilitates the coordination and execution o f activities in this area. There have been advances in the development and implementation o f the SIAF, and the GoP has put in place a web portal of public services, including tax administration and the civil registry. The GoP has defined the rules for applying the e-Signatures Law, which will promote the creation and implementation of digital certification, an important step to facilitate the use of electronic signatures, payments and exchange o f information. On a broader level, there i s a need to begin the integration of information platforms for all public sector institutions, to facilitate the flow of data and improve communications. This process requires, first, the development o f an overall framework that different agencies can then adapt to. 58. Peru has initiated the development of an e-procurement system (SisternaElectrdnico de Adquisicionesy Contratucionesdel Estudo-SEACE). Its development was planned inthree modules: i)publication and dissemination of government procurement; ii)small purchases under specific threshold; and iii)large purchases. The first module i s in operation and the results are positive. There are 5,862 users from 2,234 public entities already registered on the system. SEACE has become a tool of public consultation for procurement opportunities and processes. Recently, a tool to support small purchases was developed and applied as a pilot in 25 organizations. The results were positive and the plan i s to scale up its use in the medium term. 22 Also, there have been pilots for reverse bidding", and the plan i s to make this possibly electronically via SEACE. While the design of SEACE i s adequate, new technology that was not available when SEACE was first developed could greatly improve the system's functioning. Another procurement issue i s to implement the framework needed to make corporate purchases, which would allow the public sector to take advantage of economies o f scale and save significant public resources. 59. Prior Actions for FMCDPL I:Launched a strategy of e-government, including putting in place a web portal of public sewices such as tax administration and civil registry, and issued the National Digital Agenda. The gradual implementation of e-governance procedures i s essential to help improve the efficiency o f the public sector in Peru, as noted in the Bank policy note on e-governance. A key recommendation of that study was to publish the regulations to allow electronic signatures, which opens up a wide range o f possible transactions on the Internet, and also to move ahead quickly with placing important and useful government information on the Internet for public access and use. This recommendation i s also supported by the 2005 Country Procurement Assessment Report Update (CPAR Update). Policy Measures Going Forward 0 The plan i s to extend procedure simplification to five additional provincial municipalities during the coming years. Arequipa, Ica and Piura are already committed to begin simplification in the coming year, and at least two other provincial municipalities are expected to begin by 2007. On the national level, the GoP intends to develop and implement a "single window" for certain types of procedures (foreign trade and land titling will likely be first). 0 In the area of e-government, the GoP plans to scale up the electronic payment system, based on the results of the current pilot. As a first step toward harmonizing e-government systems, an interface between SUNAT, business registry (SistemaNacional de Registros Ptiblicos-SUNARP) and the National Identity and Marriage Registry (Registro Nacional de Zdentidad y Estado Civil-RENIEC) will be developed in 2007, whereby data and processes are shared between the entities. A mechanism for periodic evaluation and update of the e-government strategy will be established, in order to take into account the technological and business advances. T o advance integration among government agencies, the GoP will design by 2008 an overall framework for inter-operability among different government agencies, where platforms, communications, forms, catalogs, etc. are compatible. 0 Regarding SEACE and procurement, the GoP's first priority for 2007 i s to migrate the first two modules o f SEACE to the new technological platform now available, and ensure the third module i s designed for this technology. At the same time, SEACE will be integrated with SIAF at the process level (commitments, payments, etc.) and adopting the U N ' s catalogue of goods and services, to ensure that the purchases are controlled by SIAF and published in SEACE. By 2008, an analysis of public sector procurement and market opportunities will allow the GoP to begin corporate purchases, which will offer important savings to the public sector. Inthe longer term, it will be important for SEACE "Reversebiddingiswhenvendorscompetetooffertheirgoodsandservicesatthelowestprice,asopposedtothe auctionprocess of selling to the highestbidder 23 to continue expanding throughout the public sector and that other actors (NGOs, civil society) are involved inmonitoring tenders and purchases on the system. 60. Triggers for FMCDPL 11: Continue efSective promotion of e-government,for example (i) integrate SEACE with SIAF at the process level (e.g., commitments and payments) and at the catalogue level (adopting international accepted catalogue of goods and services), (ii) issue and implement the new regulation of Electronic Signatures, or (iii) submit to Congress Draft Law on National Information System; and expand the TramiFacilprogram to reduce the time and cost of receiving a business operating licenses to at least three provincial municipalities. The importance o f integrating SEACE with SIAF i s essential to enable a better integration between public budget and procurement planning and execution tasks, and to provide a statistical information source for monitoring and measurement o f performance and management quality, and i s one of the principal recommendations of the CPAR Update. As discussed above, the time and cost o f obtaining a business license from municipal governments i s excessive in Peru. This sort of bureaucratic obstacle to greater private sector activity-especially on the part o f job- creating MSMEs-has been highlighted as a key constraint to growth by several Bank studies, including the Country Economic Memorandum, Microconstraints to Growth, and the annual Doing Business reports. The impressive results o f TramiFacil in Lima indicate that scaling up the program would likely have a significant impact on business activity and employment growth inthe rest of the country. Promote SustainableFinancial Deepening and Improve CreditAccessfor MSMEs 61. While it has continued to grow, Peru's financial system relative to GDP is smaller than those of most large countries in Latin America. As of end-2005, total financial sector assets were about US$42 billion, equivalent to 53 percent of GDP. This ratio compares to about 100 percent of GDP in Brazil (2002) and Chile (2003), and 61 percent of GDP in Colombia (2003). Financial deepening has slowed in Peru since 2001, and local companies lack adequate access to capital to grow and create jobs. 62. Banks' soundness has substantially improved, although vulnerabilities remain. These vulnerabilities should be addressed strategically as banks are the backbone o f financial intermediation in Peru. Any meaningful deepening in the access to financial services will include a major role of local banks, which represent 65 percent of the financial sector. As such, the following actions should be considered: Strengthen the active regulatory and supervisory role of the SBS Roll out an agenda for enhanced risk management Set up an effective framework for large bank resolution 0 Carefully weight the advantages and disadvantages of increased credit activity by public banks, trying to limit it to second tier role. 63. Given the recent shift in banks' portfolios to new areas, the lack of appropriate risk management tools and disclosure could lead to costly learning, or even disrupt existing practices. Credit risk models, tools and stress testing techniques are yet to be fully implemented in many banks. Moreover, banks (and other lenders) may lack the expertise to manage risks involved in new types of lending. As an illustration, a bank with purely corporate expertise 24 which penetratesmicro-credit segment by lendingto good payers basedon the credit information systems could inadvertently lead to over-indebtedness of micro-enterprises and default on pre- existing micro-credits from non-bank intermediaries. This i s because micro-lending techniques are based on motivating debtors to repay through the promise of increased loan amount. The Bank will support measures to ensure sound intermediation practices, in particular, the approval of regulations for sound management of growth in consumer and micro-loans, with the objective of reducing the risk of over-indebtedness. Approving this regulationi s critical in an environment of high and growing liquidity. 64. Peru has a challenging agenda for improving access to credit by MSMEs, especially rural and agricultural sectors, through stronger lending infrastructure, releasing constraints to alternative lending tools and enhanced capacity of microfinance institutions. Impressive progress has been achieved in terms of microfinance development, and Peru can boast advancedcredit reporting systems, a pilot commercial courts program, fast-growing formal microfinance institutions, and growing leasing volumes. Yet further outreach and preservation of credit history i s needed, execution of collaterals delays should be shortened, residual constraints to well developed leasing, factoring, warehouse and trade financing have to be eased, and enhancedgovernance and institutional capacity should be promoted in microfinance institutions. 65. The authorities have a catalytic role to play in creating the enabling environment for structured financing solutions to flourish, thus meeting the growing demands of institutional investors, while channeling much-needed financing to under-served sectors. A concerted, multi-agency effort-ideally spearheadedby a much stronger CONASEV-is needed. Regulatory clarity and taxation stability are pre-requisites to develop structured financial instruments, and tap the potential demand from the pension funds and other institutional investors. Structured finance helps pool small issuers and improves the creditworthiness of securities above that of the issuer. Deeper capital markets could aid development of under- funded sectors such as housing, infrastructure projects and MSMEs, while providing more lucrative investment vehicles for emerging market investors seeking high yields. 66. As part of Peru's program to address bottlenecks hindering greater commercial activity, especially among MSMEs, the GoP intends to implement measures to facilitate sound credit expansion. This proposed operation will support the adoption of a regulation for sustainable widening of the scope of financial services and operations by smaller financial institutions (mostly focused on micro entrepreneurs) by the SBS. The GoP will conduct an analysis of strategic policy options for more effective institutional setup in capital markets regulation and oversight. This analysis will provide the basis for designing legal and regulatory changes to promote financial innovation for MSMEs, including reforms for a more efficient and agile capital market. Potential future operations will support efforts to foster innovative financial deepening, such as innovativecorrespondentbanking. Policy Measures Going Forward The GoP will implementlegal reforms for more advancedriskmanagementpractices inthe industry andarisk-basedsupervision approach, andconsequently issue needed regulations for risk managementand capital adequacy rules, allowing for flexibility in line with intermediaries' level of sophistication. 25 To foster greater outreach by formal financial sector, the GoP will issue regulations to promote increased use o f banks in innovative ways, such as correspondent banlung; and in the longer term use grass-roots financial literacy initiatives to promote financial intermediation. The GoP will promote the setup of institutional and technological infrastructure to implement the new collateral law, namely the consolidated and automated collaterals information system. It will also support legal and regulatory changes to promote financial innovation for MSMEs, including reforms for a more efficient and agile capital market regulatory and supervisory framework. 67. Triggers for FMCDPL 11: Adopt regulations for sound and sustainable deepening of micro and consumer lending, for example (a) regulation on widening of the scope of financial services and operations by smaller financial institutions (mostly focused on micro entrepreneurs); or b) regulation for well managed growth in consumer and micro-loans, reducing over-indebtedness risk. The importance o f these actions to improve the climate for the growth o f MSMEs-and hence have a greater impact on employment growth and poverty reduction-is amply supported by Microconstraints for Growth study as well as the policy note on Peru's financial sector. IV. The Proposed Operation A. Link to Country Partnership Strategy and Other Bank Operations 68. This programmatic series on improvingfiscal management andcompetitiveness is at the core of the CPS's proposed assistance program, and is envisioned as part of the country's base-case lending scenario. The CPS foresees several thematic "clusters" forming the basis o f the Bank's partnership with Peru, and this proposed loan series directly addresses aspects o f maintaining macro stability; accelerating growth and widening the base o f growth; and modernization of institutions. Policies which form part of the FMCDPL series include, among other reforms, simplifying and improving tax collection, controlling sub-national debt, implementing incentives for greater sub-national revenue creation and judicious use o f natural resource revenues, promoting performance-based budgeting, expanding e-governance procedures, streamlining administrative obstacles faced by the private sector, and strengthening Peru's ability to take advantage of opportunities offered by international trade. All of these directly promote the goals stated inthe CPS. 69. The proposed operation also fits into a series of Bank operations that support the GoP's reform agenda. It was developed jointly with another multi-year DPL series for the social sectors and a Health APL, which address issues of improved service quality and performance-based management, as well as the on-going Accountability for Decentralization Technical Assistance Loan (TAL), which also focuses on the social sectors. The overall intention of these loans i s to strengthen the focus o f public spending in areas of greatest impact to the poor, particularly in health, education and social safety net support, and the performance- oriented management reforms that form part o f this FMCDPL will be a critical tool to help ensure this occurs, by allowing a more accurate assessment of the impact o f priority programs throughout the public sector. Because o f the importance of monitoring indicators in the social sectors, the Bank will exploit synergies between these two series to ensure that the monitoring 26 and evaluation component supported by this loan brings together both the overall budgetary and fiscal goals o f the MEF as well as the sectoral improvement goals in the line ministries. Actions under this loan will be supported by the on-going Institutional Capacity for Sustainable Fiscal Decentralization TAL, designed to improve fiscal planning, expenditure efficiency, and decentralized public investment. The on-going Justice Reform Project will help support implementation of improvements in the conciliation system, which form part o f the competitiveness component o f this loan. In addition, the FMCDPL i s complemented by three IFC technical assistance projects, one in Cajamarca and a second under the Extractive Industries Transparency Initiative (EITI) in Cuzco, both of which aim to build capacity at the municipal level for management o f natural resource-based revenues and investments, and a third on administrative simplification inprovincial municipalities. B. LessonsLearned 70. The experience of designing and implementing previous policy-based loans in Peru, in particular the three-stage Decentralization and Competitiveness DPL (DCDPL) series, provided important input in the design of this programmatic series. The aim of DCDPL programmatic series was to establish a conceptually coherent and fiscally sound foundation on which to build a decentralized system of governance in Peru, a process that will take a number of years. The DCDPL series helped ensure that Peru began the process of decentralization in a deliberate, well-conceived manner, strengthening fiscal responsibility and administrative efficiency at all levels o f government and avoiding the pitfalls seen in other countries of deteriorating public services and confusion of responsibilities. In parallel, significant legal, institutional and administrative initiatives were undertaken to enhance competitiveness, many with a strong focus on promoting growth in non-traditional exports and in economic activity outside the capital region. The results and pending agenda from the DCDPL series informed the designof aspects of this proposedloan series. 71. One key lesson from the DCDPL series is the importance of choosing reform areas carefully and not pressing for the government to make too many changes too fast. Complex and technical processes like e-government and the devolution of service delivery to the sub- national level need critical time for development and implementation, or capacity constraints will impede progress. Moreover, time is also needed to overcome the resistance o f groups that may feel threatened by the uncertainty brought about by changes and the accountability brought about by performance-oriented reforms. Because the GoP is moving ahead with the devolution of resources and service delivery to sub-national governments, this operation will focus only on fiscal management aspects o f decentralization, and specific sectoral issues regarding oversight and service delivery will be addressed in other operations. C. Designof the DPLand Analytic Underpinnings 72. The proposed FMCDPL series responds to the GoP's request for Bank support to its public sector institutions and competitiveness reform program. This operation is intended as the first in a series of possibly three or four loans, each marking progressively advanced stages in the reform program. The two broad areas addressed by the operation are (i) efficiency and quality o f fiscal management; and (ii) competitiveness. In view of governmental 27 priorities, the first proposed loan will focus more on fiscal management, while later loans in the series will be more weighted toward competitiveness. 73. This proposed DPL series takes into account lessons learned during past programmatic operations in Peru, as well as current best practices in policy-based lending to well-performing middle income countries.l2As such, the FMCDPL emphasizes ownership and up-front actions based on a well-defined government reform program. This loan is motivated by Peru's laudable performance in recent years in consolidating its economy, and the clear desire of the new administration to move into the next stage o f reform by improving the efficiency and impact o f governance institutions and public resources. The programmatic approach i s intended to support the government with a reliable source of low-cost financing linked to its budgetary cycle. 74. The Bank team selected a sub-set of specific policies within the GoP's program to support with the FMCDPL series which it considers will have the most impact, based on the Bank's diagnostic work. Among the principal pieces of research and analysis used in the preparation o f this loan are: the policy notes collection for the new administration collected in the volume Peni: La Oportunidad de Un Pais Diferente-Prbspero, Equitativo y Gobemable, Public Expenditure Review, Country Financial Accountability Assessment, Country Procurement Assessment Report, Investment Climate Assessment, Poverty Assessment, Country Economic Memorandum, and sector specific studies such as MunicipalDebt, Microconstraints to Growth, and Environmental and Social Impact of the Mining Sector. The links between these works and the specific policies supported by the FMCDPL series are outlined in each prior action andtrigger description in the previous section of this document. D.Programmatic Framework 75. As discussed above, this DPL is proposed as part of a programmatic approach that supports actions in the areas of: (i)efficiency and quality of fiscal management, and (ii) competitiveness. A Letter of Development Policy i s attached (Annex 1) and the policy framework i s included in Annex 2. The key measures highlighted as prior actions for this DPL are listed below: Efficiency and Quality of Fiscal Management 0 Presented legislation to Congress to strengthen monitoring and enforcement o f fiscal rules, including the Sanctions Law and the creation o f a Fiscal Policy Committee. Published a public debt management strategy for 2006-2008 that provides guidance to the debt manager's actions in funding and portfolio management, based on cost andrisk analysis. 0 Implementedfirst phase of tax reforms: Prepared a cost-benefit analysis of eliminating existing sectoral and regional tax exemptions, enabled Internet registration for the single taxpayer identification number (RUC) and made updatedRUC database available by Internet. l2IncludingPeru's DECSAL andPSRL series, and the Development Policy Lending Retrospective,July 7,2006. 28 0 Defined action plan andimplementedfirst steps for adopting a TSA, aligningbudget classification to international standards and with the chart o f accounts, automatic accounting by SIAF, and approved Treasury System Law and Accounting Law. 0 Enactedregulatory framework for performance measurement andreporting, linking the budget presentation cycle with performance indicators, by which all sectors and regional governments are required to generate output and performance indicators as part o f their budget submission. The 2007 sector budget submission included sector performance indicators (programs, activities andprojects), including the environment. Competitiveness 0 Signed Peru-US FTA andratified by Peruvian Congress. 0 Reducedfrom 7 to 4 percent tariffs to capital goods on 196lines and published national guidelines for tariff policy. 0 Created a Ventanilla Unica, one-stop shop, with the objective o f establishing uniform authorization and control of imports and exports subject to non-tariff measures. 0 Launched a strategy o f e-government, including a web portal of public services such as tax administration andcivil registry, and issuedNational Digital Agenda. 76. The key measures highlighted as triggers for the next DPLinthe series are listed below: Efficiency and Quality o f Fiscal Management Comply with fiscal rules-including a limit of 3% real increase annually on current spending-with a fully functioning Fiscal Policy Committee, and Comptroller i s monitoring compliance with fiscal rules to all levels o f government. Implement the second phase of reforms to increase efficiency andneutrality of the tax system: for example (i) initiate a strategy to eliminate sectoral andregional exemptions based on a cost-benefit analysis, or (ii) reduce the effective rate of the Financial Transactions Tax (ITF) to a minimumlevel. Consolidate TSA inthe Banco de la Nacidn, establish revenue and payments mechanism ensuring automatic conciliation, and unify budgetary and accounting classification systems, including incorporation of the chart of accounts into the SIAF. Review and launch action plan for institutionalizing results-based budgeting (performance measurement, reporting-and subsequently- budgeting), managed and overseen by the MEF and based on the use o f the government-wide M&Esystem and relating fund allocation to measurable results inthe form of outputs and/or outcomes. Introduce programmatic formulation o f budgets at the sectoral level for key programs, and issue regulations to formalize executive evaluations as a component o f the budget cycle, and undertake two pilot executive evaluations each in two different sectors. Competitiveness 0 Continue trade negotiations to expandmarket access to Peruvian exports. Implement complementary measures to facilitate trade and customs clearance, for example (i) the implementation of the Ventanilla Unica or (ii) reduction o f average the tariff or tariff dispersion. 0 Continue effective promotion of e-government, for example (i) integrate SEACE with SIAF at the process level (e.g., commitments and payments) and at the catalogue level 29 (adopting international accepted catalogue of goods and services), (ii) and issue implement the new regulation of Electronic Signatures, or (iii) submit to Congress Draft Law on National Information System. 0 Expandthe TrumiFuciZ program to reduce the time and cost o f receiving a business operating licenses to at least three provincial municipalities. 0 Adopt regulations for sound and sustainable deepening of micro and consumer lending, for example (a) regulation on widening of the scope of financial services and operations by smaller financial institutions (mostly focused on micro entrepreneurs); or b) regulation for well managed growth inconsumer and micro-loans, reducing over-indebtedness risk. E. Co-FinancingArrangements, InstitutionalCoordinationandPartnerships 77. The Bank has deepened partnership arrangements established for the DPL series for the previous administration. KfW, the German Development Bank, co-financed DCDPL I1 and 111, and plans to co-finance the first loan of the proposed new programmatic series to the amount o f US$25 million. KfW participated in the Identification, Pre-Appraisal and Appraisal missions and worked with the Bank and the Government to develop the agreed policy matrix. The co-financing arrangement serves as an important step in improving donor cooperation in Peru. KfW i s preparing a program evaluation report for the German government, which will make the final decision on co-financing FMCDPL I.Due to the excellent cooperation o f the two institutions during the previous programmatic series, a strong partnership has been established with KfW. 78. KfW has approved a related operation aiming to bolster the role of local governments in the Peruvian state organization and in the fight against poverty. The operation i s now awaiting the final approval from the GoP. Financing of social infrastructure at the local level in Lambayeque and the northern part of Cajamarca will be combined with competitive and performance-oriented measures to stimulate good practices of local governance, as well as training in several areas including the use of SIAF. As well, the German Peruvian Fund-Debt for Development-was created in April 2003 with the mission o f financing small projects of poverty reduction within the priority areas of German cooperation with Peru, which are (i)democracy, civil society and public administration, (ii) drinkingwater and sewerage, and (iii)sustainable rural development. 79. The FMCDPL series has been coordinated with other donors, and serves as an important reference for other donor activities in Peru related to fiscal management and competitivenessissues. GoP i s currently in discussions with the IADBon a three-year, US$600 million policy-based operation. The Bank, the IADB, and the GoP have discussed both policy matrixes to ensure complementarity and avoid overlap. The IADB operation takes as its principal focus the management of the pension funds (APPs) and public investment. A component of the program addresses aspects o f results-based budgeting, as does the Bank operation. However, the IADB actions in this regard are focused specifically on public investment spending, rather than the entire budgetary framework. The initial guidelines and pilot supported in the IADB operation will provide a useful test that can be employed as the GoP scales up results-based budgeting to the entire public sector, supported by this proposed series. USAID i s implementing three related technical assistance and grant programs: Pro- Decentralization Program (Programa Pro-DecentruZizuci6n-PRODES), which provides 30 assistance to regional and municipal governments in budget planning and expenditure management in 537 municipalities in five regions (active until 2008); Participa Peni, which supports civil society participation in the design and oversight o f the decentralization process (active until end-2006); and Creating Conditions for Economic Revitalization (CRECER), addressing issues of administrative simplification for growth (active until 2008). The CRECER project i s proceeding with input from the IFC Technical Assistance Facility simplification project inLima (see below), and i s taken into account inthis loan design. 80. IFC experiencesinPeruhavebeeninstrumentalinhelpingshape thisproposedloan series. The IFC Technical Assistance Facility has been very active in Peru in two areas o f particular interest to this loan: use o f the sub-national resources derived from miningindustries, and in administrative simplification on the municipal level. Regarding mining income, the IFC has considerable experience with municipalities in the area o f the Yanacocha mine in northern Peru, helping governments to manage the increasing resources from the mining canon and finding efficient and effective ways to put those resources to use. In administrative simplification, the IFC experience with the provincial municipality o f Lima has been highly successful, and i s now being scaled up to other provincial municipalities. Bank-IFC dialogue on both of these issues strongly informed the policies supported by this proposed loan series. 81. The World Bank and the IMFhave engaged ina continuousdialogueon the World Bank'scountry partnershipimplementation. FMCDPLhas been coordinated with the IMFat all stages. The dialogue has concentrated on the macroeconomic background, setting of triggers, and risks, and estimation of fiscal implications of Bank's operations. The IMF has provided technical assistance in the area of tax policy and administration. Joint work in particular continues inthe area of fiscal decentralization andtax reform. 82. Regarding this operation, the GoP-via the Ministry of Finance (MEF), the operation's main counterpart-led discussions with the Bank team and other relevant government agencies. The GoP involved all sectoral ministries and the National Decentralization Council (CND) in the design of this loan, as well as representatives of sub- national governments. Issues related to this operation were also discussed in meetings held under government auspices for the preparation of the CPS, including representatives of small- scale farmers and businesspeople from the mountain region in Ayacucho, private sector representatives in Lima, regional and local government representatives, urban and rural businesspeople, and a mixed group with members of community organizations, indigenous groups, academia, religious groups, and NGOs. The importance o f improved service delivery and strengthening the capacity of sub-national governments was highlighted at several of these meetings. On decentralization-related issues, the US AID-funded PRODESl3 has taken the lead in the last three years in organizing various forums for government officials and civil society to discuss issues raised by the decentralization process. The Defensoria del Pueblo (Human Rights Ombudsman, elected by Congress) has participated in many o f these events. At the request of the MEF, the Bank organized two workshops on October 24 and 25 o f this year on results-based budgeting, the first to give an overview of the requirements and benefits of the process for Peruvian legislators, and the second to outline international experiences on the issue to h4EF officials. l3 For more information on PRODES,see their website at www.prodes.org.pe. 31 V. OperationImplementation A. Poverty and SocialImpact 83. The proposed loan is expected to have significant poverty and social effects, mainly positive but some negative. Both the fiscal management and competitiveness components of the loan are expected to reduce poverty. Reforms to improve the transparency and quality o f public spending and the provision of public services will allow programs that promote human capital development and act as a social safety net for the poor have a greater impact on the targeted population, and overall public savings through better fiscal management will allow the GoP to dedicate more resources to pro-poor programs. As well, steps to promote strengthened fiscal management at the decentralized level will increase the effectiveness of fiscal resources, devolving spending authority to lower levels o f government that are more aware of local needs. Policy actions to improve the distributional impacts o f fiscal transfers, including natural resource income, will also help redress the large disparities between the coastal, mountain, and jungle regions. The competitiveness component o f the proposed loan is also expected to have a largely positive and significant impact on poverty. Policies supported by the series involve removing existing obstacles to faster and broader economic growth. Changes like reducing the time and cost o f obtaining a business license or resolving a business dispute will have a strong impact on the growth o f smaller and medium-sized businesses, which in turn will have the greatest impact on employment. Likewise, policies to expand exports beyond commodities to non-traditional exports will leadto greater employment growth and poverty reduction. 84. At the same time, Peru's greater integration into the world economy-which is supported by this loan-will provide greater opportunities for economic growth and lower consumer prices for the poor, but may also lead to economic dislocation in some sectors of production. The GoP is working to minimize possible impact. One of the flagship programs of the new administration i s Sierra Exportadora, a package of measures designed to promote greater economic opportunities through trade and market integration to poorer, heavily indigenous Andean mountain region. Proposals include directing significant technical assistance, infrastructure investment, and credit to boost export-oriented agriculture, forestry and artisan produce based on local knowledge and specialties. The Bank's Sierra Development Project, proposed as part of the CPS, would support aspects of Sierra Exportadora. A study to review progress of FTAs i s also planned under the CPS, which will provide information on impact of trade opening on small producers and other vulnerable populations, among other things. This would complement studies done under the Peru CEM on the distributional impact of FTAs, which based on strong assumptions of elasticities and demand functions, found a possible short term negative effect of trade liberalization mainly in populations and regions dedicated to traditional agriculture. The GoP intends to present to Congress a proposal of compensatory measures to affected sectors, and they have requested assistance from the Bank to design and evaluate appropriate mechanisms. A policy package comprising compensations to affected segments o f the population, modernization o f agriculture, promotion of exports of the Sierra and incentives for the transfer of resources towards higher value exportable agricultural should help mitigate short-term transition costs and distributional impact. As well, the GoP intends to precede these reforms with dialogue and negotiations among interested parties to smooth their implementation. 32 B. Implementation, Monitoringand Evaluation 85. The Bank will monitor actions and review progress of the implementation of the proposed operation using the different sources, among them: Fiscal Transparency Reports -MEF, www.mef.aob.pe LeadingIndicators Reports -MEF,www.mef.aob.pe Central Bank of Peru, Reports and ResearchPublications, www.bcrp.gob.pe SIAF -MEF, www.mef.aob.pe InstitutoNacional de Estadistica (INEI),www.inei.aob.pe Investment Climate Survey Credit RatingAgencies Reports - several sources World Bank Governance Indicators DoingBusinessIndicators Zndice de Gestibn Gubernamental -Universidad del Pacific0 Ciudadanos a1Dia-Reports and Technical Notes, www.ciudadanosaldia.org Government Tax Agency SUNAT - www.sunat.pob.pe IMFandIADBreports 86. The GoP and the Bank have agreed to monitor progress in the DPL program regularly, including the annual reviews of CPS progress. The Sectoral Loans Coordination Unit (Unidad de Coordinacibn de Pre'stamos Sectoriales-UCPS) in the MEF is the main counterpart agency for the proposed loan, which will be in charge of M&E for the loan and for collecting the appropriate data to follow the proposedindicators. The UCPS will also coordinate with the Bank to collect baseline numbers for numerical indicators. Other important agencies are the BCRP, SUNAT, PCM and MINCETUR. 87. Semi-annual reviews will take place between the MEF and the Bank team aimed at identifying areas of strengths and weaknesses. The mid-tern review will be made in the first quarter of 2007, when the GoP and the team will jointly evaluate progress in achieving the outcomes laid out for the program. Indicativetargets for this medium-term review include: Fiscal deficit < 1percent of GDP Real current expenditure growth <3 percent 0 Numberof executive evaluations of public expenditure 0 Execution of public investment by regional governments in the two regions with MEF deconcentratedoffices increasesfrom 55 percent to 75 percent 0 Numberof new exporting firms locatedindevelopingregions increaseby 20 percent Numberof businesswith operating licensesinmunicipalities C. Fiduciary Arrangements 88. The Bank reviewed the current status of the public financial management (PFM), and concludedthat although progresshas been made, many of the same issuesidentified in the 2001 Country Financial Accountability Assessment (CFAA) remain problems today. This conclusion is supported by the draft Country Financial Management Strategy (CFMS) 33 currently under preparation, as well as the conclusions o f the I M F ' s 2004 Fiscal Transparency Report on Observance of Standards and Codes (ROSC). The review looked at public sector financial accountability arrangements; the legislative framework; the application o f appropriate accounting standards and the reporting formats; the competence of financial staff generally, and the adequacy o f financial management systems and practices, including cash management, planning, control, and supervision of financial operations. Overall, Peru has made reasonable progress in financial management and transparency, particularly with the implementation o f the SIAF. However, a number of problem areas remain, including: (i)lack of comprehensive legislation governing financial administration; (ii) excessively complex regulations and overly- centralized control by the MEF; (iii) lack of sufficient funding to the Comptroller General (Contraloria General de la Repziblica-CGR) to maintain its independence and do its job; (iv) improved but still insufficient information provision to Congress and the general public to properly oversee public expenditure; (v) the need to expand SIAF and harmonize its systems with other instances of public finances; (vi) under-developed anti-conuption measures; and (vii) inadequate oversight of spending by the Ministry of Defense. 89. A n update of the 2001 CFAA (or some proxy thereof) is planned. The main activity that would fill the information gap will be for the GoP to conduct (with Bank assistance) a PFM Systems Self-Assessment, using the Public Expenditure and Financial Accountability (PEFA) Framework. This exercise provides a common platform for assessing essential PFM systems and monitoring PFM performance. The assessment would include Peru's oversight environment, accountability and transparency policies, and information systems. The self-assessment would also give the GoP and IBRD an opportunity to analyze together various fiduciary issues, and provide the government with a sense of ownership that encourages addressing identified weaknesses. During the preparation of each project the Bank will review the progress in addressing the issues identified through the PEFA self-assessment, which in turn would feed sector or project specific information into the country dialogue. In keeping with the new push toward decentralized fiscal management, the Bank will also be encouraging two local governments to undertake self-assessments as well, likely the municipalities o f Lima and Arequipa. 90. Overall, reforms related to transparency in the public sector have been weak, and efforts to enforce anti-corruption laws even when auditor findings support enforcement have been limited. The current approach to ethics in government i s not supported by comprehensive legislation, funding or even a commitment to enforce an anti-corruption plan. The CGR developed and published a proposal for a national anti-corruption plan that would bring Peru's approach and legislation in line with the practices applied in other countries in the region. This has been developed into the new CGR strategy document, "Lineamientos Estratkgicos", but it has not yet been formalized. Although the Fiscalia de la Nacibn (part of the judicial branch) has financial specialists to investigate allegations o f corruption, CGR believes that there have been few successful prosecutions because of the absence o f specialized courts to try these types of offenses and the limitedresources available to the CGR for prosecution. 91. Due to the importance of fiscal management in this operation, the team closely assessed the performance of SIAF, and noted several weaknesses that should be addressed, coinciding with the IMF ROSC conclusions in this area. Among the principal shortcomings noted were poor flexibility in report preparation and account details for project management, and lack of reconciliation between the SIAF and other information systems that may create 34 information gaps, involuntary errors or mistakes, and lack o f transparency on information management. Recommendations to address these problems include: 0 Improve the SIAF software to allow its use on the Internet 0 Extend the use of the SIAF to project implementing units 0 Use other information technology systems only when they are compatible with SIAF or could be interconnected with SIAFby the transfer o f archives 0 Record information on budget amendments 0 Allow the formulation of monthly and quarterly budget allocations 0 Allow the record of commitments 92. The Bank is preparinga CFMS to cover the new CPS period that will focus primarily on three main areas: a) improving the country's disbursement ratio; b) promoting the anticorruption and governance agenda; and c) modernizing national and decentralized PF'M systems and practices. 93. The implementation of PFM reforms to increase the transparency of processes is likely to reduce transaction costs and generate of economiesof scale. The Bank's experience in other Latin American countries such as Chile, Brazil and Mexico indicates that efficiency in public financial management generates savings that greatly exceed the government's investment inreforms. Practical observations inthe field on the implementation of integratedPFMsystems clearly show that more reliable, transparent, accurate use of data benefits the decision-making process. The Bank will work closely with the Government to create the necessary tools to ensure the provision o f statistical information as part o f these CFMS objectives. 94. The IMF Fiscal ROSC of 2004 noted that the BCRP enjoys statutory autonomy in managing monetary policy, and its relations with the GoP are clearly defined by law. The BCRP has its own legal status and charter, and its sole responsibility i s to preserve monetary stability. The BCRP's Board of Directors i s appointed on an equal basis by the executive and legislative branches. The BCRP i s not allowed to provide financing to the Treasury or to official development financial institutions, or to extend collateral or guarantees. Its activities are governed by Article 84 o f the Constitution and its own charter o f December 1992.It i s subject to ex post control by the CGR and to supervision by the SBS. It demonstrates fulfillment o f its functions through publication of an annual report (including audited financial statements) and reports on the performance of the monetary program. A BCRP safeguard assessment update with regard to the new arrangement with the IMF i s currently underway and will be ready by 2007. D.Disbursement andAudits 95. Disbursement arrangements will follow the procedures for DPL set out in OP 8.60: "Except as the Bank may otherwise agree (i)the single tranche withdrawal from the Loan Account shall be deposited by the Bank into an account designated by the Borrower and acceptable to the Bank which forms part of the country's foreign exchange reserves at the Central Bank of Peru; and (ii) the Borrower shall ensure that upon deposit of the Loan into said 35 account, such amount or an equivalent amount i s credited inthe borrower's accounting system to an account, acceptable to the Bank, that finances budget obligations." The Government will be required to provide confirmation o f steps (i)and (ii) as soon as the tranche i s received. The proceeds of the loan may not be used to finance expenditures typically excluded under the Loan Agreement. E.Environmental, ForestandNaturalResourceAspects 96. The policies supported by this DPL operation are expected to entail significant effects on the environment, primarily positive but some negative. Some policies will likely prove positive for environmental management, particularly aspects related to improved monitoring and evaluation for government expenditure, including environmental expenditure. This will allow the GoP to set clear environmental priorities, to coordinate with environmental authorities on developing indicators to evaluate the impact o f spending on achieving these priorities, and to ensure that all sectors follow legal norms related to the environment. The fiscal space created through making the budget and expenditure process more efficient could also serve to strengthen under-funded environmental spending. As well, the decentralization of SNIP offices and the capacity buildingprogram for investment-project preparation launched at the sub- national level should lead to improved environmental assessment o f investment projects. And lastly, this loan's aim of broadening exports to the non-traditional sectors will work to reduce Peru's dependence on resource extraction, which has significant environmental impacts. 97. However, in the medium and long term, further trade liberalization and economic activity in Peru-though desirable for growth and poverty reduction-will lead to greater infrastructure development and resource use that could negatively affect the environment. The Bank recently completed a Country Environmental Assessment, highlighting shortcomings inPeru's institutional framework for environmental protection and sustainability. It also pointed to the need to not only continue focusing on protection natural areas such as tropical forests, but also mitigating the serious health impacts and high costs of environmental degradation, particularly related to air and water contamination. As a result of this study and the ensuing dialogue with GoP, the Bank i s planning two environmental DPLs in coming years. Principal topics to be addressed in the loans will be reordering the institutional and legal oversight for the environment, both at the national level-possibly through the creation of a new, single authority-and at regional and municipal levels. The Bank i s also exploring the possibility of requesting an Institutional Development Fundgrant or partnering with other donors interested in environmental issues to promote capacity building. Decentralized environmental oversight o f the mining sector will be a priority, as well as adjusting spending priorities to achieve concrete results in reducing air and water contamination. In addition, the Bank will explore with the authorities the possibility of including environment and resource management as part of the desk evaluations pilots programmedfor the next years. F.Risksand RiskMitigation 98. The most significant political risk is if political momentum slows, especially if the November municipal elections are unfavorable to the administration, and the reform 36 agenda is scaled back. Although currently supportive, Congress i s divided and could make reforms difficult to push through. The administration must move quickly to demonstrate its ability to make changes and maintain growth, and to convince voters that President Garcia is a different kind of leader than during his first government. It will be particularly important to undertake high-visibility programs in the poorer, highland regions, whose population voted strongly against President Garcia in favor of the more populist opponent Ollanta Humala. A weakening of support for the goals of the administration could be somewhat problematic for this first operation, but would be more so for future planned loans inthis series, which call for more ambitious advances in policy reform. The process of decentralization and efforts to create a more equitable transfer system to reduce regional inequalities could be compromised if politicians opposed to the administration take power in local and regional governments. As well, the administration could move forward with decentralization more quickly than prudentfor political reasons, possibly running up against local capacity problems or creating administrative confusion. Reforms to promote performance-basedmanagement could generate opposition from politically active interest groups, such as public employee unions. 99. President Garcia is aware of the importance of creating and maintaining political momentum to move his program forward. H e has launched a high-profile series of actions for his first 180 days in government as a way to quickly demonstrate his determination to move forward and to take advantage of the political honeymoon following his election. Governance reform and decentralization are particularly high on this agenda. Also key i s the President's proposed Sierra Exportadoru program, to boost economic activity in the Andean region where his support was low during the election. This is a salutary change from the frequent practice withholding support from regions opposed to the victorious party during an election. Government officials are also reaching out by re-engaging in the Acuerdo Nacional, a group of political parties, religious and community groups, academics and NGOs who came together in 2002 to help generate a consensus on a broad national agenda. The Bank and IFC, as well as bilateral donors such as KfW and USAID, have also been active in meeting with civic groups and local governments in an effort to strengthen consensus behindthe reforms embodied in this loan series. Regarding public employee opposition to results-oriented budget reforms, the GoP intends to implement these reforms gradually, starting with a few selected programs in three or four ministries. As well, the administration will emphasize that newly-designed performance indicators will not be usedas a threat to reduce funding for certain programs, but rather as a way to ensure priority programs achieve desired outcomes, which in some cases may result in increasedfunding. 100. Social risks relating to protests do exist in Peru, but they are generally isolated and limited to specific grievances, and have not had a major destabilizing impact on either the economy or the political system. One area of tension i s the resource-extraction industry, which has been accusedby community residents near some mines and oil wells of polluting, leading to protests, particularly inremote areas with limited state presence. The new administration has for the first time created a Conflicts Unit in the Presidential Council of Ministers, a high-level office for negotiating conflicts as they arise. The unit works hand-in-hand with the Defensoria del Pueblo (Human Rights Ombudsman) to create a space for dialogue with disaffected groups. A first result has been the peaceful negotiations with the Achuar indigenous group in Loreto in October 2006, which has protested pollution and lack of social benefit from oil production in their region. The negotiations led to a decree mandating that a portion of the oil canon for Loreto be specifically dedicated to ethnic groups in the region, as a way to finance projects to 37 improve their living conditions, and also commitments by the oil company to undertake environmental rehabilitation. The work o f IFC's Technical Assistance Facility on improving the use of miningcanon use around the Yanacocha gold mine has also been successful in illustrating how the industry can benefit local communities. As part of the CPS, the Bank i s planning a series of environmental DPLs to help strengthen the GoP's ability to address the environmental impact of resource extraction industries. 101. The most important economic risks relate to Peru's vulnerability to changing international conditions and its ability to maintain fiscal discipline. If Peru's economic stability were to be reversed, this could have a negative impact on the continuation of the reform program and on the country's ability to service its loan obligations. The most serious threat to macroeconomic stability would come from a deterioration o f the currently favorable external economic conditions. A drop in the international prices o f Peru's main traditional exports, in particular minerals, which has powered a good portion of the country's impressive export growth inrecent years, would be a major blow to the export sector andthe economy as a whole. As well, the U.S. economy-the largest market for Peruvian exports-could slow down, reducing demand, and the ending of preferential access to the U.S. in 2006 could hurt textile exports in particular if the FTA i s not ratified in the U.S. Congress by the end o f this year. An increase in U.S. interest rates would impact the ability of both the Government as well as the economy as a whole to access credit on reasonable terms. On the fiscal side, political pressures and increased government revenues could lead to a deterioration of fiscal accounts should the GoP attempt to placate opposition with increased government spending. While the financial sector is generally sound, Peru's banks have a very high ratio o f dollar liabilities, while most o f their assets are in local currency, which could become a problem inthe event o f a currency devaluation. 102. These economic risks are being mitigated in a number of ways. Most importantly, while non-traditional exports remain relatively low, they now comprise a significant portion o f total exports and are growing very rapidly, much faster than traditional exports. Further, the Government i s actively pursuing trade agreements, having completed and signed the Peru FTA with the U.S. and lobbying actively in the U.S. Congress for its ratification, and also branching out in search of other export markets in Europe, Asia, and elsewhere in Latin America. The combination of these two trends-diversification of products and o f markets-is reducing the risk of major shifts in Peru's terms of trade due to exogenous factors. Regarding interest rate increases, the Government's disciplined fiscal performance in the past several years has greatly reduced country risk and lowered interest rate spreads, meaning the cost o f rising international interest rates will be lower than previously. Should current trends continue, Peru may soon be qualified as investment grade by the major international rating agencies. As well, the increasing liquidity of the local currency debt market for both sovereign and corporate debt-supported by a stable currency and low inflation-is easing the country's dependence on external credit, and also reducing dollarization of financial markets. A new regulation on credit risks in dollar credits to uncovered borrowers implemented in 2005 i s a positive step to make banks internalize the credit risk associated with borrowers' currency mismatches and reduce incentives for dollarization. 38 ANNEX 1 Letter of Development Policy (English Translation Follows) "AN10 DE LA CONSOLlDACldN oEMOC~TlCA* MINJSTERIODE ECONOMMY FtNANZAS DespachoMinisterial Luis Cnrranzi,Ugerte #Inisfro CARTADE POLlTfcASECTORML SpiEor Paul Wolfowitz Presidenfe Banco Mundial Presente.- Referencia: Prbstamo ProgmmBlicode Apoyo a/ Foti8/ecimit?ntoa la GestirSn Fiscal para el Cmim&nfo Ecan6mjco Estimadoseifor WolfowHr, Mediante la presente b manifiesto el compromiso del Gobienio del Presidente Alan Garcia P&ez de consolider una pditics econ6mice y fiscal orientada a/ crecimiento ysostenidocondel gasto ptihljm, y la disminucicin de las hequidades existentes, de base en el aumento de la inversidnptibtica y privsda, la reestructumcidn eficienciia manere que 10s beneficios del crecimiento econhico y la descentrafizacibn seen empliamenfe canpartidm por /apoblaci6n. En este marco, se he desamllado el "Pdstamo Pivgrarndtico de Apoyo a/ Fortalecirnientade la Gestic513Fiscal y Crecimiento Econcirnico"con el Banco Mundial (EM), soticitado por el monto de US$ 200 millones. que comprendera acciones especfficas en dos campos: (i) efktencia y celidad de la gestion fiscal y gasto pliblico y (/i) fotialecimientode Is competitividaddel pais. A contitwacih sa describe el contexto ewrn5mico del Per0 y posteriomente /os objetivos y las reformes restiradas y /as propuestas para el prestamo sdth5tarlo. A. Context0 econ6tnico Duranfe 10s Olt!mas aiios, /as indimdares econdmicos del Perti hon rnostrado un notable grad0 de estabilidad debida a1 consenso poli'tko sobre la irnportancia de msntener un confexfo mameconbrnico sostenible y una gestibn fmanciem responsable. - - - __I . - Minrsteriode Economla y Finanrtls - . Jr Junin 319, Lima- Pis04. lel&fonos (511) 428-9630 39 40 41 42 43 44 45 46 Letter of Development Policy English Translation Lima, November 9", 2006 Mr.PaulWolfowitz President World Bank Reference: Programmatic Loan for FiscalManagement and Competitiveness Dear Mr.Wolfowitz, Through this letter Iwould like to express you the commitment of the government of President Alan Garcia to consolidate economic and fiscal policy to sustain growth through increasing public and private investment, restructuring public expenditure and making it more efficient, and reducing inequalities, in such a way that the benefits of economic growth and decentralization are widely sharedby the population. The Programmatic Loan for Fiscal Management and Competitiveness was developed in this framework with the World Bank (WB), asking for an amount of US$200 million, which will entail specific actions in two areas: (i) improving the efficiency and quality of the fiscal policy and public expenditure, and (ii) strengthening country competitiveness. Inthe following paragraphs, we describe the economic context of the country, the objectives and reforms carried out, and the proposals for the requested loan. A. Economic Context During recent years, Peru's economic indicators have shown a notable degree of stability due to the politic consensus on the importance of maintaining a sustainable macroeconomic framework and responsible financial management. The Government will continue implementing economic policies which allow sustainable growth on the basis of an increase of private and public investment, increased tax collection, the restructuring of public expenditure, and a stable currency and national savings. During year 2005, gross domestic product (GDP) grew 6.4 percent, thus consolidating four years of continuous growth with an average of 5.1 percent. The Government intends to maintain a stable economic framework to achieve growth of, initially, 6 percent, and then 7 percent of GDP. The growing economy will allow an increase in investment expenditure-reducing current expenditure and increasing social expenditure-with the purpose of, principally, allocating resources to improve life quality of the poorer part of the population. In five years, the goal i s to raise investment spending such that investment expenditure accounts for 25 percent of total public spending and current spending 75 percent. At the same time, social, economic, political and judicial stability will be promoted in order to 47 attract private investment, with a particular focus on encouraging strategic associations between public and private investment to generatethe necessary infrastructure for the country. On fiscal policy, tax collection i s expected to increase to 15 percent of GDP this year. In 2007, the fiscal deficit i s expected to be 0.8 percent of GDP, and several actions will be taken in order to improve public debt managementand prevent unnecessaryborrowing at all levels of government. The goal is to gradually reduce public debt from 32 percent of GDP in2007 to 26 percent of GDP by 2011. Regarding the monetary policy, the Government guarantees total independence of the Central Bank, in order to maintain monetary stability. The inflation target i s not expected to surpass 2.5 percent annually, with a margin of 1percent. Several measures will be taken to promote national savings and reduce the dollarization of the banking system from 56 percent to 40 percent by 2011. This will reduce the financial risk to families and companies who have loans denominated indollars while their income i s denominated insoles. B. Reformsrelatedto the Program 1.Efficiency and Quality ofFiscalPolicyandPublicExpenditure Fiscal Policy 1.1 The Government's economic program has as a central objective to maintain sustainable growth with low inflation, a controlled fiscal deficit and a level of international reserves consistent with the sustainability of foreign accounts. The final objectives of this policy i s reducing poverty, promoting the participationof all the sectors of society in the productive process, and in this way improve the quality of life of all Peruvians. 1.2 To ensure economic sustainability, the fiscal policy guidelines-established in the Law No. 27245, Fiscal Prudence and Transparency Law (LPTF), modified by the Law No. 27958, Fiscal Responsibility and Transparency Law (LRTF)-are aimed at assuring fiscal equilibrium or surplus inthe mediumterm, accumulating fiscal surplusesin favorable periods and allowing only moderate but not recurrent deficits inperiods of lower growth. 1.3 Fiscal Rules. As part of the reforms related to the program, with the goal of guaranteeing adequate public finance management, several mechanisms and responsibilities have been established for the compliance of fiscal rules contained in the Law. The Executive has presented to Congress the Draft Law which authorizes the creation of a Fiscal Policy Coordination Committee and establishes sanctions for violating the fiscal rules contained in the LRTF. This law includes the rule by which the increase in current non-financial expenditure-excluding maintenance expenditure-cannot be greater than 3 percent in real terms. This restriction to the increase in current expenditure, and the application of sanctions to the violation of parameters contained in the LRTF, will allow an improvement inbudget reallocation and a gradual reversion of the current bias against public investment. An important increase in investment i s expected, private and public of at least 3 percentage points of GDP by 2011 and 1percentage point in the short term. 48 1.4 Public Debt. Public debt management constitutes a key element to attain fiscal sustainability. Its goals should be to attract the necessary financing resources to cover the financing needs of the public sector at reasonable costs and risks, to contribute to the adequate public debt market functioning and to seek mechanisms that will allow a smooth payment profile in the coming years. The objective i s to smooth the repayment profile of the public debt, extend maturities and favor domestic market issuances in soles as a mechanism not only to reduce financial vulnerability but also to strengthen the transmission channel of monetary policy. Public debt management also has as a goal reducing public debt/GDP to a level that permits attaining investment grade qualification, which will allow more credits and preferential interest rates. 1.5 As well, a significant effort is being made to quantify the debt stock of the principal municipalities of the country in order to evaluate their fiscal sustainability, which has required coordinating with several suppliers, the Banking and Insurance Superintendent, and the Tax Agency, among others. In the medium term, mechanisms are being studied to reward municipalities which clear their debt stock. 1.6 Tax Policv. The principal guidelines in the short term are: a) continue with the improvement of regulations and tax management in order to enhance efficiency and citizen service; b) continue with the elimination of tax exemptions and other preferential treatments, and avoiding creating new ones; c) continue to combat the serious problem of tax evasion in Peru; d) avoid creating new taxes; and e) continue with the gradual elimination of tariffs as a mechanism for economic integration. Public Expenditure Quality 1.7 One major goal i s a more efficient and effective use of public resources, prioritizing to those who need it most. For this purpose, one important advance will be the identification of the high- priority results for the country, the connection between these results and the products and services that the public sector provides, and the quality standards that these products must fulfill to satisfy the needs of the population. The present program develops mechanisms to link instruments and incentives to results-based management and the improvement of accountable management of public expenditure. 1.8 Government Transfers. During the last years, the transfers to regional and local governments from the miningcanon have grown tremendously as a result of an increase in the income tax paid by mining f m s . These resources, as established by the Canon Law and the Budget Law of the Public Sector for each fiscal year, must be used by the regional and local governments to finance public investment projects. Nevertheless, despite the increase observed in transfers, regional and local governments have not been using much of these resources. Among the main reasons limiting execution are weak managerial capacities on the part of local governments, including a long term vision; the definition of the source of funds that assures the current expenditures neededto maintainthe investment; and future income projection after the budgetary formulation. 1.9 With the purpose of improving regional and local capacities on multi-annual budget formulation, pre investment studies, and investment execution, technical assistance offices are being implemented as decentralized instances of the MEF. During this year, the first offices will be implemented in the regions of Ayacucho and Piura, and agreements of inter-institutional cooperation between the MEFand the respective regional governments are being signed. 49 Results-based management. Traditional analysis of the quality of public expenditure has been limited to the financial effectiveness of public institutions, disregarding the accomplishments or goals that were achieved with the public resources. The growth of the state, the small size of the public budget in relation to social needs, and increasing interest for accountability have led to a change in the approach, demanding more information on performance, in terms of goals and accomplishments of the public resources. The Government considers it necessary to promote results-based management in order to harmonize and complement policies and actions at the sectoral level and within all three levels of government (national, regional and local); to link strategic and budgetary planning; to reduce budgetary inertia linking allocations to increases in products, services and results; to develop effective evaluations that generate adequate information for decision making; and to implement incentives to improve public administration. For this purpose, the Government has been working with different sectors to strengthen indicators formulation and information registration, so that the 2007 budget law includes clearly defined performance indicators, reflecting development policies. Also, during the first semester of 2007 the Government will have an Action Plan for results-basedbudget and rapid evaluations, and institutional managementevaluations will begin. Additionally, the System of Monitoring and Evaluation of Public Expenditure (SSEGP) will continue to be developed, expanding to the national and regional levels of government. The SSEGP will contribute to a better allocation of public resources, improved administrative and accounting management, stronger oversight on whether different levels of government conduct their actions with effectiveness, and greater transparency to civil society and the public ingeneral. Inthemediumterm, the strategic andprogrammaticplanningofthe sectorsarebeingcoordinated with the Comptroller General to institutionalize both the rapid and more in-depth institutional management evaluations. Imulementation of a Treasury Sinple Account (TSAZ. Today, there are more than 5,000 accounts from different organizations of the public sector dispersed between the private banking institutions and the National Bank. This system i s inefficient inasmuch as it facilitates the accumulation of large balances without use in the financial system and generates a banking intermediation cost. Inaddition, this prevents the consolidation of the financial situation of the entire public sector. The implementation of a TSA has multiple advantages that will solve these inefficiencies and will fortify the management of the fiscal policy. 2. Strengthening the Country Competitiveness 1.14 InternationalTrade. Because Peru is a small economy, its sustained development depends on the growth of internationaltrade and the access of its exports to larger markets. Statistics indicate that Peru has great trade potential: in 2005 exports exceeded US$17 billion, with nearly US$1 billion inagriculturalproducts. The PeruvianGovernment has been establishing commercial agreements with strategic countries like Chile-already signed-Mexico and Singapore-in process-and others, including the European Union. Inparticular, the U.S. Free Trade Agreement (FTA) offers an opportunity to sell products to a market with a purchasing power 180 times stronger than in Peru. With the negotiations for the U.S. FTA agreement, and ratification by the Peruvian Congress, the country has taken an important step towards consolidating export expansion to give producers the external markets they need to grow. 1.15 Investment Climate Imurovement. The objective is to support firms by simplifying processesand costs, through the presentation to Congress of the Framework Law of the Construction License and the Framework Law of the Firm Operation License, as well as continuing with procedure 50 simplification in several government institutions. Additionally, in order to support firm development, one-stop shop services will be implemented to save time, money and human resourcesfor entrepreneursand public sector entities. 1.16 Institutionalize State Coruorate Purchases. The corporate purchase is a management tool which allows the aggregation of demand with the objective of achieving significant savings through economies of scale. By the end of this year, the number of entities participating in corporate purchasing i s expected to increase nearly 50 percent, with estimated savings of around 50 percent of resources. 1.17 Transparency and Access to Information. The Government seeks to promote transparency in the routine action of the state, in terms of internal procedures and for the citizens. To this end, the Citizen and FirmService Portal, which provides systematic information regarding the procedures required by citizens and firms inone portal, will be strengthened. Conclusion The Government continues making important actions to consolidate sustainable economic growth with the objectives of achieving greater efficiency and fairness inthe allocation of the public resources, within a fiscal framework basedon responsibility and transparency. The Government i s committed to continue advancing toward these goals, for which it requires continued support by the World Bank inthe indicated areas. Hereby, the Peruvian Government asks for the approval of the "Programmatic Loan for Fiscal Management and Competitiveness". Yours sincerely, 51 1 E e & rr a0 Q) E sh B 0 83 e e e e e e * W 0 820 .CI Y$ c) k .I M k- .I Yu 0 r- e e e e e e e m v) ~i r 88 Y e e e 0 . c kk .I E E 1 J a t- \o 8 c.l .s8 YY h 0 & .I L ANNEX 3 Peru-IMFRelations Press ReleaseNo. 06/170 InternationalMonetary Fund August 1,2006 700lgthStreet,NW Washington, D.C. 20431 USA IMFExecutiveBoardCompletesFourthandFifthReviewsunderPeru'sStand-By Arrangement The Executive Board of the International Monetary Fund completed the fourth and fifth reviews o f Peru's economic performance under a 26-month Stand-By Arrangement, in an amount equivalent to SDR 287.279 million (about US$423.6 million), approved on June 9, 2004 (see Press Release No. 04/112). The completion of the final reviews makes available for purchase the full amount of the arrangement. The Peruvian authorities have been treating the arrangement as precautionary and indicated that they will not make any drawingsbefore the arrangement expires on August 16,2006. In completing the reviews, the Board granted a waiver of applicability of the June 30, 2006 quantitative performance criterion on the borrowing requirement o f the combined public sector, for which data were not available yet. Staff anticipates that this quantitative performance criterion will be met with a margin. Press ReleaseNo. 06/224, October 20, 2006 Statement by an IMFStaff Mission inPeru "An IMFmission, led by Gilbert Terrier, has been inLima the last two weeks to conduct the 2006 Article IV Consultation and discuss the new government's economic program that the authorities have requested to be supported by a Stand-By Arrangement from the Fund. "The mission has been pleased to hold extensive discussions with government and central bank officials, and a broad spectrum of representatives from the business community, financial institutions, academia, and civil society. These discussions focused on the policy options for Peru to entrench its strong economic performance of the past several years and to give assurance that its benefits reach all segments of the population-key objectives of the government. The IMF mission has been impressed by the strong consensus in society on the need for Peru to take advantage of these favorable economic conditions to consolidate macroeconomic policies andpursuereforms that would enhance medium-term growth prospects and decisively reduce still highpoverty levels. "The discussions have been very productive. The WTt; mission supports the key elements of the authorities' economic program for the period 2007-08. In the coming weeks, the authorities and Fund staff will finish specifying the remaining elements o f the economic program. Both sides are working toward a timetable for presenting the program to the IMFExecutiveBoardaroundthe endofthe year.'' 58 ANNEX 4 Peru at a glance 8/11/06 Latin Lower Key Development Indicators America middle PeN &Carib. income Age distribution, 2005 (2005) Male Female Population.mid-year(millions) 28.0 551 2,475 7074 Surface area (thousandsq. km) 1,285 20,418 39,948 8064 Populationgrowth(%) 1.5 1.3 1.0 Urbanpopulation(Yoof totalpopulation) 75 78 49 5054 4044 GNI (Atlas method, US$ billions) 73.9 2,210 4,746 3(M4 GNIpercapita(Atlas method, US$) 2,840 4,008 1,918 2024 GNIper capita(PPP,international$) 5,830 8,111 8,313 1014 0.4 GDPgrowth (%) 8.4 4.4 8.9 15 10 5 0 5 10 15 GDP per capitagrowth("A) 4.9 3.1 5.9 carcent (mostrecent estlmate,2000-2005) Povertyheadcountratio at $1 a day (PPP,Oh) 13 9 I Povertyheadcountratioat $2 a day (PPP,Oh) 32 23 Under-5mortality rate(per 1,OOO) Life expectancyat birth(years) I'"1 70 72 70 Infantmortality(per 1,OOO livebirths) 24 27 33 Childmalnutiiion("hof childrenunder5) 7 7 12 I 75i n Adult liieracy,male(%of ages 15andolder) 93 91 93 Adult Iieracy, female( O hof ages 15andolder) 82 90 85 50 Gross primaryenrollment,male("hof age group) 114 121 115 Gross primaryenrollment,female ("hof age group) 114 117 113 25 Accessto an improvedwater source (% of population) 83 91 82 0 Accessto improvedsanitationfacilities lsw 1095 2Mo 2104 ( O hof population) 83 77 57 0Peru B LatinAmerica8 the Caribbean Net Aid Flows 1980 1990 2000 2005 a (US5millions) Net ODA andofficial aid 202 400 401 487 irowth of GDP and GDP per capita (%) Top 3donors (in2004): UnitedStates 53 79 92 178 15I I Japan 11 40 192 90 Spain E 19 56 Aid ( O hof GNI) 1.0 1.6 0.8 0.7 Aid per capita(US$) 12 18 15 18 Long-Term EconomicTrends m e5 W Consumer prices(annual% change) 59.1 7481.7 3.5 1.5 GDP implicitdeflator(annual% change) 65.9 6,836.9 3.6 3.4 -GDP - GDP per capita Exchangerate (annualaverage,localper US$) 0.0 0.2 3.5 3.3 Terms of trade index(2000= 100) 121 100 108 198C-90 1990-2000 200045 (averapannualgrowth %) Population,mid-year(millions) 17.3 21.8 28.0 28.0 2.3 1.8 1.5 GDP (US$millions) 20,861 28,294 53,088 79,283 -0.1 4.8 4.2 (% of GDP) Agricutture 11.7 8.5 10.3 7.2 3.0 5.5 2.8 Industry 42.8 27.4 29.9 34.6 0.1 5.0 5.5 Manufacturing 23.5 17.8 15.9 16.3 -0.2 3.8 3.2 Services 45.5 64.1 59.8 58.0 -0.4 4.2 3.5 Householdfinal consumptionexpenditure 57.5 73.7 71.0 66.1 0.7 4.0 3.5 Generalgov'tfinal consumptionexpenditure 10.5 7.9 10.6 10.2 -0.9 5.2 3.1 Grosscapitalformation 29.0 16.5 20.2 18.5 -3.8 7.4 3.8 Exportsof goodsandservices 22.4 15.8 16.1 24.8 -0.9 8.5 9.8 Importsof goodsandservices 19.4 13.8 18.0 19.4 -3.2 9.0 5.7 Grosssavings 28.1 18.4 17.5 19.6 Note:Figuresin italicsarefor years otherthan those specified. 2005 dataare preliminaryestimates...indicatesdata are not available. a. Aid data arefor 2 W . DevelopmentEconomics,DevelopmentDataGroup (DECDG). 59 Peru Balance of Payments and Trade 2000 2005 IGovernance Indicators, 2000and 2004 (US$millions) Total merchandiseexports (fob) 6,955 17,336 Total merchandise imports (cif) 7,366 12,076 Voice and accountability Net trade in goods and services -1,146 4,426 Politicalstability Workers' remittancesand compensation of employees(receipts) 999 1755 Regulatoryquality Current account balance -1,527 1,105 Ruleof law as a % of GDP -2.9 1.4 Controlof corrupbon Reserves, includinggold 8,180 14,097 0 25 50 7s rm Central Government Finance Counby`spercentilerank (0.100) hrghervaluea rmplybelrerrsl~ngs (xofGDP) Revenue 14.9 15.7 Source: Kaufmann-Kraay-Maotrzzi, World Bank Tax revenue 12.2 13.6 Expense 18.0 16.5 Technology and Infrastructure 2000 2004 Cash surpiusldefin't -2.8 -0.7 Paved roads (% of total) 13.4 13.1 Highest marginaltax rate (%) Fixed line and mobile phone Individual 20 30 subscribers (per 1,000 people) 115 223 Corporate 30 30 High technologyexports (Ohof manufacturedexports) 3.6 2.1 External Debt and Resource Flows Environment (US$ millions) Total debt outstandingand disbursed 24,241 22,279 Agricultural land ("hof land area) 17 17 Total debt service 2,117 4,995 Forest area ("hof land area, 2000 and 2005) 54.1 53.7 HlPC and MDRl debt relief (expected flow) - - Nationally protected areas (% of landarea) 6.1 Total debt (% of GDP) 45.7 28.1 Freshwaterresources per capita (cu. meters) 56,631 Total debt service (% of exports) 30.4 23.0 Freshwaterwithdrawal (% of internal resources) 1.2 Foreign direct investment (net inflows) 581 2,488 CO2 emissions per capita (mt) 1.1 0.95 Portfolioequity (net inflows) 123 -47 GDP per unit of energy use (2000 PPP $ per kgof oil equivalent) 9.8 Composition of total external debt, 2004 11.3 Energy use per capita (kg of oil equivalent) 483 442 BBRD. 2 . w riDA;iME, iM h - (US$ ml//ions) IBRD Total debtoutstanding and disbursed 2,590 2,816 Disbursements 266 192 Principal repayments 93 210 \ I Interestpayments 189 105 US$ millions I IDA Total debt outstanding and disbursed 0 0 Disbursements 0 0 Private Sector Development 2000 2005 Total debt service 0 0 Time requiredto start a business (days) - 102 IFC (fiscalyear) Cost to start a business("hof GNI per capita) 36.0 Total disbursed and outstanding portfolio 292 287 Time requiredto register property (days) -- 33 of which IFC own account 157 236 Disbursementsfor IFC own account 70 0 Ranked as a major constraintto business Portfolio sales, prepayments and ("6 of managerssurveyedwho agreed) repaymentsfor IFC own account 10 2a Economicand regulatoly policy uncertainty 71.1 Anti-competitiveor informal practices 64.3 MlGA Gross exposure 329 65 Stock market capitalization(% of GDP) 19.9 45.9 New guarantees 40 0 Bank branches (per 1 W , Wpeople) .. 4.2 R Note: Figures in italics are for years otherthan those specified. 2005 data are preliminary estimates. ..indicatesdata 8/11/06 are not available. -indicates observation is not applicable. Development Economics. Development DataGroup (DECDG). 60 Millennium Development Goals Peru Withselected targets to achieve between 1990and 2015 (estimateclosestto dateshown, +I- years) 2 Goal 1:halve the ratesfor $1 a day poverty and malnutrition 1990 1995 2000 2004 Povertyheadcountratio at $1 a day (PPP, %of population) <2 6.9 18.1 12.5 Povertyheadcountratio at nationalpovertyline (% of population) 49.0 Share of incomeor consumptionto the poorest qunitile ("A) 3.2 Prevalence of malnutrition(% of children under 5) 1 1 8 7 Goal 2: ensure that children are able to complete primary schooling Primaryschool enrollment(net,%) 98 97 Primarycompletionrate (%of relevantage group) 90 103 100 Secondaryschool enrollment(gross,%) 67 86 92 Youth literacyrate (% of peopleages 15-24) 94 97 Goal 3: ellminate gender disparity in educatlon and empower women Ratioof girlsto boys in primaryandsecondaryeducation("A) 96 97 100 Women employedinthe nonagricuituralsector ("A of nonagricunuraiemployment) 29 32 33 37 Proportionof seats held by women in nationalparliament(%) 6 11 11 16 Goal 4: reduce under-5 mortality by twc-thirds Under-5mortalityrate (per 1,ooO) 60 60 42 29 Infant mortalityrate (per 1,000live births) 60 46 24 Measlesimmunization(proportionof one-year olds immunized,%) 64 98 97 33 ' 89 Goal 5: reduce maternal mortality bythree-fourths Matemaimortality ratio (modeledestimate, per 100,000 live births) 410 Birthsattended by skilledheanhstaff ("Aof total) 56 59 71 Goal 6: hait and begin to reverse the spread of HlVlAlDS and other malor dlseases Prevalence of HIV (%of populationages 15-49) 0.6 Contraceptiveprevalence (%of women ages 15-49) 55 64 69 incidenceof tuberculosis(per 100,000 people) 394 178 Tuberculosiscases detected under DOTS ("A) 101 87 83 Goal 7: halve the proportion of people without sustainable accessto basic needs Access to an improvedwater source ("A of population) 74 83 Access to improvedsanitationfacilities(% of population) 52 63 Forest area (% of total landarea) 54.8 54.1 53.7 Nationallyprotectedareas (% of total landarea) 6.1 C02 emissions (metrictons per capita) 1.0 1.0 1.1 1.0 GDP per unit of energy use (constant 2000 PPP $ per kg of oil equivalent) 8.4 9.6 9.8 11.3 Goal 8: develop a global partnership for development Fixedline and mobile phonesubscribers(per 1,000people) 26 50 115 223 lntemetusers(per 1,000 people) 0 0 31 117 Personalcomputers(per 1,000 people) 15 40 98 Youth unemployment ("1.of total laborforce ages 15-24) 15.6 13.3 13.6 19.2 Educationindicators (??) :,1L Jleasles immunization (%of 1-year olds) CT lndlcators (per 1,000 people) 125 n 7 --a m 75 150 50 1w 50 75 1998 2Mo 2w2 2004 25 Eo 0 0 1990 1995 2Mo 2004 xoo 2002 2w4 +Primary net enrollment ratio -0- Ratioofgirls10boysinprimary& 0Fixed mbtlesubscribers + secondary education 0Peru 0LatinAmerica&theCaribbean B2 Internet users Note:Figuresin italicsare for years other than those specified...indicatesdataare not available 8/11/06 DevelopmentEconomics,DevelopmentData Group (DECDG). 61 ANNEX 5 Peru Key Economic Indicators - Actual Estimate Projected Indicator 2002 2003 2004 2005 2006 2007 2008 2009 National accounts (as % of GDP) Gross domestic product" 100 100 100 100 100 100 loo 100 Agriculture 7 7 7 7 6 6 6 6 Industry 28 28 30 32 31 32 34 35 Services 57 56 54 53 53 52 51. 49 Total Consumption 81 81 80 80 73 74 74 75 Gross domestic fixed investment 17 18 18 19 20 20 21 21 Government investment 3 3 3 3 2 2 2 2 Private investment 15 15 15 16 18 18 18 19 Exports (GNFS)b 16 18 21 25 26 25 25 24 Imports (GNFS) 17 18 18 19 19 20 20 19 Gross domestic savings 19 19 20 20 27 26 26 25 Gross national savings' 18 17 17 16 21 21 20 19 Memorandum items Gross domestic product 57328 61125 69932 79283 92094 98675 104322 111203 (US$million at current prices) GNIper capita (US$, Atlas method) 2040 2170 2390 2640 2840 3070 3270 3390 Real annual growth rates (%, calculated from 79 prices) Gross domestic product at market prices 5.2 3.9 5.2 6.4 6.6 5.5 5.0 5.0 Gross Domestic Income 5.4 4.6 7.9 7.8 9.0 4.7 3.9 3.8 Real annual per capita growth rates (%, calculated from 79 prices) Gross domestic product at market prices 3.6 2.4 3.7 4.9 4.7 3.6 3.1 3.2 Total consumption 2.6 1.7 2.0 3.5 3.9 3.5 1.7 2.0 Private consumption 3.1 1.6 2.0 2.9 3.6 3.7 1.9 2.1 Balance of Payments (US$ millions) EXPOITS (GNFS)~ 9,169 10,807 14,802 19,625 24,205 24,942 25,843 26,380 MerchandiseFOB 7,714 9,091 12,809 17,336 21,754 22,240 22,907 23,157 Imports (GNFS)~ 9,871 10,854 12,530 15,199 17,769 19,258 20,883 22,140 MerchandiseFOB 7,422 8,238 9,805 12,076 14,197 15,427 16,820 17,805 Resource balance (702) (47) 2,272 4,426 6,436 5,684 4,960 4,240 Net current transfers 1,041 1,233 1,433 1,755 2,228 2,642 2,525 2,468 Current account balance (1,118) (958) 19 1,105 743 525 258 195 Net private foreign direct investment 2,156 1,275 1,816 2,519 3,212 2,254 2,284 2,156 Long-term loans (net) 438 -750 109 -2142 -730 -637 -1269 -1229 Official 270 -12 130 -2508 132 -32 -86 32 Private 169 -738 -21 366 -862 -605 -1183 -1261 Other capital (net, incl.enors & ommissions) -643 910 407 146 -2041 -992 -888 -702 Change inreservesd -833 -477 -2351 -1628 -1184 -1150 -385 -420 Memorandum items Resource balance (% of GDP) -1.2 -0.1 3.2 5.6 7.0 5.8 4.8 3.8 Real annual growth rates ( YR79 prices) Merchandise exports (FOB) 7.1 8.7 24.1 18.7 5.8 5.2 8.6 8.4 Primary 9.9 9.3 27.0 22.8 12.3 2.9 5.7 4.6 Manufactures 0.8 7.1 16.9 7.8 13.8 14.7 19.3 20.1 Merchandise imports (CIF) 2.2 6.3 14.3 15.4 9.7 8.o 5.7 8.0 62 Peru Key Economic Indicators - (Continued) Actual Estimate Projected Indicator 2002 2003 2004 2005 2006 2007 2008 2009 Public finance (as % of GDP at market prices)' Current revenues 14.2 14.8 14.9 15.7 16.9 16.0 16.0 16.4 Current expenditures 14.6 14.8 14.4 14.6 14.3 14.1 13.7 13.4 Current accountsurplus (+) or deficit (-) -0.3 0.0 0.5 1.1 2.6 1.9 2.3 3.0 Capitalexpenditure 2.0 1.9 1.8 1.9 2.3 2.8 3.O 3.2 Capitalrevenue 0.2 0.2 0.1 0.1 0.1 0.1 0.1 0.1 Overall Balance -2.1 -1.7 -1.2 -0.7 0.4 -0.8 -0.6 -0.1 Foreignfinancing 2.0 1.6 1.6 -1.2 -0.3 -0.2 -0.2 0.0 Monetary indicators M2lGDP 25.2 24.3 22.7 23.2 22.6 23.1 23.8 24.2 Growthof M2 (%) 4.8 2.8 12.5 15.1 13.4 9.4 8.6 8.6 Price indices( YR94=100) Merchandiseexportprice index 97.8 105.9 129.6 150.8 204.6 198.5 196.5 197.9 Merchandiseimportpriceindex 178.2 194.0 223.1 246.7 262.0 267.8 275.6 283.0 Merchandiseterms of trade index 54.9 54.6 58.1 61.1 78.1 74.1 71.3 69.9 Realexchangerate (US$/LCU)f 99.3 103.1 105.1 105.8 106.0 105.1 104.6 104.0 Realinterestrates Consumer price index (W change) 1.5 2.5 3.5 1.5 1.5 2.5 2.5 2.5 GDP deflator (% change) 0.8 2.6 5.6 3.4 1.6 2.1 2.1 2.3 a. GDP at marketprices b. "GNFS"denotes "goodsand nonfactor services." c. Includesnet unrequitedtransfers excludingofficial capitalgrants. d. Includesuse of IMFresources. e. Consolidatedcentral government. f. "LCU" denotes"local currencyunits." An increase inUS$/LCU denotesappreciation. 63 ANNEX 6 DEBT SUSTAINABILITY ANALYSIS A. Debt Trends Peru's debt levels have been on a declining trend. The total gross stock of Peru's public debt declined from over 63 percent of GDP in 1993 to about 40 percent in 1997. The debt ratio increased to about 50 percent in 1999 and declined again to an estimated 32.8 percent of GDP in 2006.19 These trends were mainly as a result o f improvements in fiscal balances at different levels of government during the economic expansions of 1995-97 and 2003-05, privatizations, and revaluation o f the local currency during 2001- 05. These outcomes are inline with a study on emerging market debt dynamics that finds that primary fiscal surpluses and real GDP growth were the main contributors to reductions inthe debt-to-GDP ratio in a set of 21 countries from the period 1991-02.20 The general government and the non-financial public sector ( N I T S ) have posted a series of improving balances, strengthening from -2.8 percent of GDP and -3.3 percent of GDP respectively in 2001 to surplus of 0.6 percent of GDP in 2006. These balances reflect increases in revenues and to lesser extent declining expenditures. On revenues, tax collection improved since 2002 due to transitory factors such as the increase in Peru's export prices, economic growth and the tax reform enacted in 2002. Total revenues for 2006 are estimated at 19.3 percent of GDP, up from 17.4 percent in 2001. On the expenditure side, total general government expenditures decreased to an estimated 18.8 percent o f GDP in 2006 from an average o f over 21 percent of GDP in 1999 and 2000. Although the current debt-to-GDP ratio of about 32 percent may be considered an acceptable level for Peru, research has shown that high levels o f debt can have significant negative impact on growth,21 and that countries with high inflation and default history have higher risks of a debt crisis even with low external debt levels of 15 percent of GNP.22 IMF research suggests that the conditional probability of a crisis is zero with debt levels of less than 18.7 percent o f GDP and increases to 10 percent at debt levels above that threshold23.In Latin America, only Chile has reached levels o f debt to GDP below these levels. The recent crises in Argentina and the Dominican Republic illustrate the fact that debt to GDP ratios of 40 and 27 percent cannot be considered as safe levels. Inthe case of Peru, further declines indebt-to-GDP ratio would be beneficial. Ultimately, fiscal surpluses must be achieved according to the government lifetime budget constraint to ensure fiscal sustainability. Debt Structure and RiskAnalysis The estimated 2005 total public debt in Peru stood at US$30 billion: US$22.5 billion (28.1 percent of GDP) external and the remaining US$7.5 billion (9.7 percent of GDP) l9Net debt is total gross debt minusdomestic public debt held by all public sector entities. The evolution of debt aggregatesinthe last decade is discussed with reference to gross aggregatesbecause estimates of net debt inPeru are not available. 2oBudina and Fiess (2005). 21Patillo, Poirson and Ricci (2004). 22Reinhart, Rogoff and Sevastano (2003). 23International Monetary Fund(2002). 64 domestic (Table Al)24. External debt thus represents 75 percent of the total, but the total funding raised in foreign currencies is even higher since more than 22 percent of the domestic debt i s denominated in dollars. TableAl. PeruPublic Debt (US$ million) 2000 2001 2002 2003 2004 2005 2006e TotalPublic Debt 24,273 24,756 26,502 28,896 30,936 29,966 30,457 (% of GDP) 45.4 46.1 46.9 47.5 45.2 37.8 32.8 Domestic Debt 5,068 5,790 5,787 6,128 6,470 7,688 8,131 (% of GDP) 9.5 10.8 10.2 10.1 9.5 9.7 8.8 ExternalDebt 19,205 18,966 20,715 22,768 24,466 22,278 22,326 (% of GDP', 35.9 35.3 36.7 37.4 35.7 28.1 24.0 Source:BCRPandMEF. The issuance o f dollar-denominated liabilities in the local market i s a reflection of the financial dollarization process underway in the economy since the early 1990s. Conscious of the increased vulnerabilities due to dollar-denominated public and private sector debt, the authorities have adopted a number of measures to gradually reverse this process, including actions to promote a broader and deeper local currency market for government securities. The greater use of local currency instruments started in 2001 and has accelerated since 2003 (through the Programa de Creadores de Mercado), as evidenced by the greater size and longer terms o f local currency bonds. However, because of the large debt stock relative to the borrowing flows, external debt in Peru is still dominant. Although the external debt i s mainly denominated in dollars, 36 percent o f external liabilities from official funding sources and the Paris Club are denominated in other currencies. Currently the debt unit at the MEF lacks a benchmark for the currency composition o f the overall portfolio. The portfolio structure by funding source is changing rapidly as a result o f Peru's greater access to the international capital markets and the refinancing and prepayment of Paris Club loans with the proceeds o f bonds denominated in dollars and soles. Paris Club was the main government creditor in 2002, but in 2005 outstanding bonds and multilaterals were far more important. This trend is expected to continue for the next 10 years, reflecting outstanding Paris Club loans coming due, and highlights the importance of increasing the size o f the domestic market andthe need to strengthen access to the international capital markets. Refinancing exposure relates principally to maturing Paris Club loans. Following the pre- payment of US$1.55 billion worth of Paris Club debt in August 2005, refinancing risk has been reduced significantly for the period 2005-09. The stream of annual repayments fluctuates around US$350 million from 2006 to 2009; however, it surpasses US$600 million from 2010 to 2013, and these flows, combined with maturing bonds, produce an important humpof repayments in 2012,2014 and 2015. 24Informationas reflectedintheMarc0 Multianual Macroeconomico (updatedto August 2006). 65 With 84 percent of the total debt denominated in foreign currencies, currency risk is the authorities' main concern. To reduce currency risk, the debt management unit i s developing a market for securities in soles and i s gradually changing the portfolio's currency mix. The share of local currency debt has risen from 8 percent to 16 percent between 2003 and 2005. Issuance of dollar-denominated debt in the domestic market was suspended since 2000, when dollar-denominated debt accounted for over 80 percent of the domestic debt; by September 2005 this percent had fallen to under 25 percent. As well, a portion of the external bonds i s being refinanced with local currency bonds. An illustration of the Government's efforts in this regard i s the debt exchange conducted in 2005 which allowed to redeem US$262 million worth o f dollar-denominated bonds in exchange for bonds in soles (S/851 million), including a bond with a 10-year maturity; and an additional US$119 million exchange o f dollar-denominated bonds for inflation- indexedbonds (VAC) maturing in 2024. Of the total debt, 41 percent has a floating interest rate, while most of the remaining 59 percent has fixed rates2'. Floating-rate debt consists o f the external debt contracted with multilateral institutions. This percentage takes into account Paris Club loans refinanced with funding from the international and domestic capital markets. Going forward, currency risk may increase if the Central Bank (BCRP) lessens its intervention in the exchange rate market and implements a monetary policy more oriented towards domestic goals. In addition, a downturn in commodity prices or a relaxation o f capital controls may result in net foreign currency outflows that would pressure the exchange rate. Given its currency structure, this clearly represents the debt portfolio's chief exposure. 11.DebtSustainability26 Public debt in Peru has improved considerably, decreasing to an estimated 32.8 percent of GDP in 2006. The primarybalance has steadily improved from a deficit o f 0.8 percent of GDP in 2000 to a surplus o f 2.5 percent of GDP in 2006, and the Government is forecasting primary surpluses averaging 1.3 percent for the rest of the decade. An analysis of Peru's debt determinant^^^ show the positive strong contribution of real growth during periods o f economic expansions: from 2001-2005, the growth effect contributed to about a 9 percentage point decrease in the debt-to-GDP and to a decrease of about 8 percentage points in the 1995-98 period. A revaluation effect contributed to about a 5 percentage point decrease in the debt-to-GDP ratio from 2001-05, whereas in the 1995-98 period, it only contributed to about a 1 percentage point decrease. Privatization proceeds greatly contributed to the decrease in the debt ratio in 1995-98 by 25 A small percentage of the domestic debt is indexed to inflation. 26 The required primary deficits differ from the CPS, although the debt path is the same. The differences result from using more up to date public debt information, which places the 2006 debt to GDP ratio at 33 percent. The debt sustainability exercise of the CPS assumes a starting point of 38.5 percent o f GDP. In addition, for comparison purposes this section sets the target at 26 percent of GDP in 2011which the GoP own target. The CPS section does simulations covering only until 2010. 27 The debt dynamics decomposition is carried out following Craig Burnside methodology as described in Fiscal Sustainability in Theory and Practice (2005). Methodology is described in Annex Iof this note. 66 transferring not only assets but liabilities to the private sector, but their impact has declined with the slowing o f the privatization program after 2000. Other factors captured by the residual of the model accounted for a 4 percentage point decrease and a 5.6 percentage point decrease in 2005 and 1997, respectively, and could be attributed to the reduction of the Paris Club debt in September 2005 and the restructuring o f Brady Plan debt in 1997. TableA2. Peru:DebtDeterminants(% of GDP) 1995-98 1999-00 2001-05 2001 2002 2003 2004 2005 Change in publicsector debt -8.7 4.7 -6.9 0.3 1.2 0.7 -2.6 -6.5 interest payments 10.4 4.9 11.0 2.3 2.2 2.2 -1.o 2.1 2.2 Primarydeficit (-a surplus) -5.2 1.7 -2.4 0.2 0.1 -0.4 -1.3 Growth effect -7.6 -1.6 -8.5 -0.1 -2.1 -1.7 -2.1 -2.6 Inflationeffect -0.8 -0.4 -0.8 -0.1 0.0 -0.2 -0.4 -0.1 Revaluation effect -0.7 1.5 -5.4 -2.0 1.4 -0.3 -3.9 -0.5 Privatization -0.8 -11.o -7.1 -1.6 -1.8 -0.6 -0.1 -0.2 -0.1 Predicted change in debt 4.5 -7.9 -0.3 0.7 -0.4 -5.5 -2.5 Residual (other factors) -4.1 0.2 1.o 0.6 0.5 1.1 2.9 -4.0 Source: Peru Policy Note Fiscal and Debt Sustainability, World Bank 2006. Peru's growth prospects are favorable inthe medium term. Growth is projected to hover around 5 percent per year in the next five years, inflation will remain low at 2.5 percent per year and fiscal revenues will continue strong. The GoP medium-term plan of maintaining a fiscal surplus of about 1.4 percent of GDP will allow reducing the debt ratio to 26 percent of GDP by 2011 the end of the decade (Table A3). Compared to the primary surplus achieved in 2006 it is merely a 0.1 percent of GDP effort. Debt scenarios simulations show that Peru's debt ratios are robust to changes in the assumptions of macroeconomic variables. If growth reverts to the long term rate of 4 percent, lowering the debt to GDP ratio to 26 percent will require a primary surplus o f 1.5 percent o f GDP, a fiscal effort o f 0.2 percent points of GDP compared to 2006. A more ambitious target o f reducing the public debt to GDP ratio to 20 percent by the end o f the Garcia administration will require a primary balance of 2.6 percent o f GDP, or a fiscal effort o f 1.3 percentage points with respect to 2006. Growth Primary Actual' Required Rate Balance Effort 3.0 1.6 1.3 0.3 3.0 2.8 1.3 1.5 4.0 1.5 1.3 0.2 4.0 2.7 1.3 1.4 5.0 1.4 1.3 0.1 5.O 2.6 1.3 1.3 6.0 1.4 1.3 0.1 6.0 2.6 1.3 1.3 7.0 1.3 1.3 0.0 7.0 2.5 1.3 1.2 67 Under a low case scenario of 2 percent growth of GDP annually and a real interest rate of 6 percent, a primary surplus of 1.8 percent of GDP is needed to bringpublic debt down to 26 percent of GDP by 2011, or a primary surplus of 3 percent to achieve public debt levels of 20 percent of GDP by 2011(Table A4) Table A5 depicts the probabilities associated with the two scenarios, and shows that under a growth scenario of 5 percent, even with shocks to the exchange rate, the debt-to- GDP ratio has a more than 50 percent chance to fall under 30 percent by the year 2010. However, under a low growth scenario of 2 percent and lower primary surplus of 0.5 percent o f GDP, the debt-to-GDP ratio i s more likely to increase, given the same shocks to the exchange rate. Table A5. DebtDynamics 2006 2007 2008 2009 2010 Prob. that debt is above 38 percent (basecase) 12 4 2 1 1 Prob. that debt is below 30 percent (basecase) 0 1 9 31 54 Prob. that debt is above 38 percent (lowcase) 61 62 68 73 78 Prob. that debt is below 30 percent (lowcase) 0 0 0 0 0 Source: Staff calculations based on Burnside (2005). In conclusion, the official forecasts for the next five years of an average of primary surplus of about 1.4 percent of GDP2*and growth of 5 percent of GDP puts Peru's debt- to-GDP ratio on a downward trend, and Peru could very well reach levels of 26 percent of GDP by 2011. Given the good external conditions, growth in the rest of the decade could be as strong as it has been in the last two years. However, if global conditions should change, and the scenario turns less positive, leading to a slowdown in economic activity and lower primary surpluses, Peru's debt path changes, and could lead to an increase in debt-to-GDP to over 35 percent. ''Primary balances are defined here with respect to the non-financial public sector. Although inthe assumptions we do account for seigniorage, which inthe case o f Peru has remained very low, and in2005 our estimates have it at around 0.2 percent of GDP, and it i s expected that inthe medium term it remains at around that level. 68 MAP SECTION IBRD 33465R 80°W 7575°W 7070°W 0° 0° ECUADORECUADOR ArcadiaArcadia COLOMBIACOLOMBIA Napo Corrientes Putumayo Puerto Curaray Puerto Curaray Tigre To To MachalaMachala Tumbes Amazonas TUMBESTUMBES Santiago To To A CaballocochaCaballococha LojaLoja MA A Pastaza Iquitos Iquitos L O R E T O BRAZIL BRAZIL Talara alara Ayar Manco ar Manco Yavari SullanaSullana ZOMA 5°S P I U R A SanSan C 5°S IgnacioIgnacio NZO Marañon PiuraPiura A Ucayali n AJA ANS Yurimaguas urimaguas Tamánco amánco d M Chachapoyas Chachapoyas Moyobamba Moyobamba LAMBA- e Tarapoto arapoto YEQUE S A N Chiclayo Chiclayo PERU s AARCA M A R T I N Cajamarca Cajamarca To To CruzeiroCruzeiro do Sul do Sul Trujillo SantaSanta LuciaLucia LA LIBE LA LIBERTARTAD LIBERTAD Pucallpa Pucallpa NevadaNevada SihuasSihuas HueascaránHueascarán Chimbote (6768 m) (6768 m) Hualaga ANCASHANCASH Tingo María ngo María Huaraz Huaraz HUANUCOHUANUCO Ucayali Huánuco Huánuco 10°S NevadaNevada Yerupaja erupaja 1010°S (6634 m) (6634 m) U C A Y A L Í GoyllarisquizgaGoyllarisquizga PPAASSCCOO Purús M Cerro de Cerro de PACIFIC Pasco Pasco Huacho SayánSayán SatipoSatipo AtalayaAtalaya OCEAN L I M A t LaLa C A L L A O n OroyaOroyaJ U N I N Apurimac M A D R E Callao LIMALIMA s Huancayo Huancayo Urubamba Madre D E D I O S . de PuertoPuerto AynaAy CC Z C O UU S C O Dios SintuyaSintuya Maldonado Maldonado Huancavelica Huancavelica 0 100 200 300 Kilometers QuillabambaQuillabamba HUANCA- NevadaNevada HUANCA-HUANCA- Ayacucho acucho SalcantaySalcantay VELICA (6271 m) (6271 m) LanlacuniLanlacuni AstilleroAstillero BajoBajo 0 100 200 Miles VELICAVELICA Pisco I C A AYACUCHO URIMAlcaAlca AP Cusco Cusco Abancay Abancay NudoNudo Inambari Ica Ica AusandateAusandate AC (6384 m) (6384 m) P U N O To San San BuenaventuraBuenaventura PuquioPuquio PERU Caballas NazcaNazca CaillomaCailloma 1515°S To To San Juan NevadaNevada JuliacaJuliaca CoropunaCoropuna CarabucoCarabuco SELECTED CITIES AND TOWNS (6271 m) (6271 m) Andes Lago Titicaca REGION CAPITALS Antiquipa A R E Q U I P A PunoPuno To To NATIONAL CAPITAL Atico Arequipa Arequipa Mtns. La Paz La Paz DesaguaderoDesaguadero RIVERS MAIN ROADS Mollendo Moquega Moquega RAILROADS MOQUEGUA T A C N A REGION BOUNDARIES To To BOLIVIABOLIVIA Tacna acna Visviri isviri INTERNATIONAL BOUNDARIES To Belén Belén 75°W To Iquique CHILE CHILE NOVEMBER 2006