_l rin oR0 1r-Ym>kn D Za)o o c'a] /Agei0 Pr ILrr, Fii6 Q- * l tG 26101) - ] May 2003 , - .4 w _- - mmm-du~~, r,M*. tiu p4k I ,z, : , - .SII ~ THE WORLD BANK ~~~~ . An Economic and Social Editors A Vicente Fretes-Cibils en a da l Marcelo M. Giugale Jose Roberto L6pez-Calix e New Millennium T HE W OR L D B AN K WASH IN GTO N, DC Copyright (© 2003 The International Bank for Reconstruction and Development / THE WORLD BANK 1818 H Street, N.W Washington, D.C. 20433, USA All rights reserved Manufactured in the United States of America First printing May 2003 1 2 3 4 05 04 03 The findings, interpretations, and conclusions expressed in this paper are entirely those of dth authors and should not be attributed in any manner to the World Bank, to its affiliated organ- izations, or to members of its Board of Executive Directors or the countries they represent. The World Bank does not guarantee the accuracy of the data included in this publication and accepts no responsibility whatsoever for any consequence of their use. The boundaries, col- ors, denominations, and other information shown on any map in this volume do not imply on the part of the World Bank Group any judgment on the legal starts of any territory or the endorsement or acceptance of such boundarics. The material in this publication is copyrighted. Tlhe World Bank cneourages dissemina- tion of its work and will normally give permission to reprodluce portions of the work promptly. Permission to photocopy items for internal or personal use, for the internal or personal use of specific clients, or for educational classroom use is granted by the World Bank, provided that the appropriate fec is paid directly to the Copyright Clearance Center, Inc., 222 Rose- wood Drive, Danvers, Massachusetts 01923, USA; telephone 978-750-8400, fax 978-750- 4470. Please contact the Copyright Clcarance Center before photocopying items. For permission to reprint individual articles or chapters, please fax a rcquest with com- plete information to the Republication Department, Copyright Clcarance Center, fax 978- 750-4470. All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, World Bank, 1818 H Street NW, Washington, DC 20433, USA, fax 202-522-2422, e-mail pubrightsCa)worldbank.org. Cover design: Carol Levie Photograph: Ronald Jones Art: Duenos de /a Noche (1987) by Gonzalo Endara Crow ISBN 0-8213-5545-7 Libray of Congress Cataloging-in-Plublication Data has beea applied for. Contents Preface. xix Editor Biographies .......................................... xxi Acknowledgments .......................................... xxiii Acronyms and Abbreviations .................................. xxv Synthesis ............................................... xxxiii A. Purpose and Organization ................................... xxxiii B. Central Message .......................................... xxxiv C. The Development Agenda-Diagnostic Study and Policies .... ..... xxxviii Preserving Stability with Fiscal Discipline and Accelerating Growth with Competitiveness ............................ xxxix Tax Reform ............................................ xlii Spending Cuts, Reorientation, and Transparency ................ xliv Sustainability of Public Debt ............................... xlv Strengthening the Financial System .......................... xlvi The Oil Sector ........................................ xlviii Commercial Reform ..................................... xlix Development of Basic Infrastructure ........................... li Boosting Sustained and Equitable Social Development ............. iii Building a Quality Government That Serves All Ecuadorans and Fights against Corruption .................................. lx D. The Vision of a New Ecuador ................................. lxv Table 1. Ecuador: A Possible Order of Priorities in the Design and Implementation of Policies for Boosting Economic and Social Development ......... ........................ lxvi Part I Preserving Stability with Fiscal Discipline and Accelerating Growth with Competitiveness 1. Maintaining Stability with Fiscal Discipline and Competitiveness ..... 3 A. Background ............................................... 4 iii iv ECUADOR: AN ECONOMIC AND) SOCIAL AGENDA IN THE NEW MILLENNIUM B. Recent Macroeconomic Performance ............................. 7 C. The Challenges of Maintaining Stability ......................... 12 D. Policy Recommendations ............... .............. 27 E. Conclusion ............................. 34 Policy Matrix .... . ... ....... 37 Annex: Ecuador: Selected Economic Indicators . .40 Box 1. The Economic Transformation Law. 6 Box 2. The Law on Responsibility, Stabilization, and Fiscal Transparency .30 Box 3. Suggestions on a Draft of the Vetoed Law on Competition in Ecuador .35 Figure 1. Relationship between Fiscal Deficits (% GDP) and Inflation, 1980-2002. 5 Figure 2. Macroeconomic Indicators. 8 Figure 3. Credit to the Private Sector (growth rate, percent). 9 Figure 4. Ecuador's Urban Poverty, 1988-2001 .11 Figure 5. Percentage of Four Principal Goods as a Share of Total Exports ... 13 Figure 6. The Effect of Petroleum on the Economy .14 Figure 7. Distribution of Government Revenues (2001) .15 Figure 8. Total External Debt (% GDP) .17 Figure 9. Ecuador's Financial Risk .18 Figure 10. Ecuadoran Migration and Family Remittances ................ 20 Figure 11. Relationship between Productivity and Relative Prices of Tradable/Nontradable Goods ........ .................... 21 Figure 12. Real Bilateral Exchange Rate with the United States, Based on CPI and Unit Labor Costs (1994 = 100) ............. 21 Figure 13. Financial System Indicators ........ ..................... 24 Table 1. Volatility in Ecuador, 1990-2002 ....... ................. 12 Table 2. Index of Economic Freedom ........ .................... 26 Table 3. The Financial Gap of the Nonfinancial Public Sector .... ...... 28 2. Tax Policy and Administration .............................. 43 A. Background ........................ ..................... 44 B. The Three Primary Problems of the Tax Policy ...... ............... 46 The Problem of the Proliferation of Taxes ...... ................ 47 The Recurring Problem of Exemptions ....... ................. 48 The Problem of Preallocations ......... ..................... 52 C. Two Priority Problems for the Tax Administration ..... ............. 54 The Independence of thc SRI ......... ...................... 55 The Efforts of the CAE ............ ....................... 55 D. Recommendations . ........................................ 56 Tax Administration Recommendations ....... ................. 57 CONTENTS V Recommendation Matrix ............. ........................... 60 Annex .................................................. 62 Table 1. Total Income by the Nonfinancial Public Sector and the Central Government, 1995-2002 (expressed as a percentage of the GDP) ........................................ 44 Table 2. Some SRI Management Indicators ........................ 46 Table 3. The Structure of the Tax System ......................... 48 Table 4. Estimated Tax Cost of the Internal VAT Exemptions, 2001 (in millions of U.S. dollars) ................. 50 Table 5. Tax Cost of Exemptions on Customs Tariffs and on the VAT on . Imports, 2000 and 2001 (mlns $US) .51 Table 6. Preallocation Percentages of the ICE Tax Revenues .53 Summary Table of the Tax Revenue Effects of the Recommendations (in percentage of GDP) .58 Summary Table of the Orcler of Priorities of the Recommendations .... ..... 59 3. Debt Administration and Sustainability . . 65 A. Background .............................................. 66 B. Present Debt Structure ...................................... 67 C. Ecuador's Debt Reduction Plan ................ ................. 71 Debt Sustainability Analysis .. 74 D. Policy Recommendations .................................... 76 First Stage: Recouping Credibility . ........................... 77 Second Stage: Modernizing Debt Management . . 77 Recommendations for the Short Term . ........................ 79 Recommendations for the Medium Term . . 80 Policy Matrix .......................... 81 Annex: Public Debt Dynamics .82 Box 1. On Public Indebtedness in the Organic Law on Fiscal Responsibility, Stabilization, and Transparency .73 Box 2. Base Scenario Assumptions .75 Figure 1. Composition of Public Debt .67 Figure 2. External Debt .68 Figure 3. External Debt and Interest Payments by Creditor .69 Figure 4. External Debt by Debtor, 2002 .70 Figure 5. Public Domestic Debt (October 2002) .71 Figure 6. Debt Service for Current Debts, 2003-15 (mlns $US) .72 Table 1. Results of the Public Debt Sustainability Model .76 4. The Banking System ...................................... 85 A. The Postcrisis Financial System: Structure and Depth ...... .......... 86 The Structure of the Banking System ......... ................ 89 vi ECUADOR: AN ECONOMIC AND SOCLAl. AGENDA INTTII NFw MILLENNIUM B. Trends in Bank Balances, Solvency, and Yield ...................... 90 Balance Trends . . ........................................ 90 C. Strengthening Individual and System Risk Management ........... ... 99 Institutional Structure and Management of Cash Risk .......... ... 99 Strengthening Supervision and Regulation .................... 102 D. Issues in the Settlement of Payments and Securitiesl7 ..... ......... 102 E. The Financial Safety Net .................................... 105 F. Policy Recommendations . .................................. 107 Policy Matrix ......................................... 110 Figure 1. Total Bank Assets over GDP .88 Figure 2. Financing Lines Abroad (mlns $US) .96 Figure 3. Gross and Net Recovery Provision Expenditures (mlns $US) .98 Figure 4. "Onshore" Credit (percentage granted in $US) .99 Table 1. Number of Institutions in the Financial Systcm .87 Table 2. The Costs of Restructuring the Banking System (mlns $US) .89 Table 3. Number and Size of Institutions in the Financial Systcm in October 2002 .91 Table 4. Private Banks: Balance Sheet (thds $US and percentages of Total Assets) .93 Table 5. Private Banks: Profit and Loss Statement (thds $US) .95 Table 6. Private Banks: Financial Indicators .97 Table 7. Liquidity in the Banking System .100 5. Petroleum Policy ........................................ 115 A. The Evolution of the Petroleum Sector and I.egal Framework .... ..... 115 B. The Main Problems of the Petroleum Industry in lcuador ..... ...... 119 The Problem of VAT Reimbursement anid Contractual Stability ....... 120 Increasing Petroleum Production ........ ................... 121 Reserves .............................................. 124 General Subsidy for Liquid Petroleum ....... ................. 125 Price and Tax Policy, and Lack of Competitior in the Derivatives Market . ..................................... 125 Investments in Refining ........... ....................... 126 Administrative System for Petroleum Revenues ..... ............ 127 Legal and Institutional Framework .......................... 129 Environmental and Social Impact ........ ................... 130 C. Recommendations and Implementation ....... .................. 131 A Solution to the VAT Problem ........ .................... 131 Increasing the Production of PetroEcuador's Oil Fields ..... ....... 132 CONTENTS Vii Increasing Reserves ...................................... 132 Elimination of Indiscriminate Subsidies for Gas ..... ............ 133 New Price and Tax Policy ........... ...................... 134 Investment in Refin ing ............. ...................... 135 Improvements in the Administration of Petroleum Revenues .... ... 135 New Legal and Institutional Framework ...... ............... 136 Management of Environmental and Social Impact ..... .......... 137 Policy Matrix .................. ....................... 138 D. Economic Results ......................................... 141 Annex 1: Historic Evolution and Description of the Sector .144 Annex 2: Updated Study on Taxes and Subsidies for Derivatives .155 Annex 3: Economic Performance .158 Figure 1. National Petroleum Production and Consumption .123 Figure 2. Price of Products in Terminal (incl. VAT) .126 Figure 3. Petroleum Sector Support to the National Economy (projection through 2007) .142 Table 1. Importance of the Petroleum Sector to the Economy (bins/mlns $US) .116 Table 2. Projections for National Petroleum Production (Mins of bbl) .123 Table 3. Economic Results of Refining and Commercialization (thds $US) .128 Table 4. Petroleum Revenues Distribution Structure (Average 1995-2000) .128 Table 5. Indicators of the Petroproducci6n Affiliate .130 Table 6. Suggested and Current Prices for the Public .134 Table Al. Reserves through December 31, 2001 (Binslmins of bbl) .145 Table A2. Current Petroleum Production (BPD) ........ ............ 146 Table A3. Refining Capacity .149 Table A4. PerroEcuador's Economic Performance (blns/mlns $US) .151 Table A5. Central Government Oil Revenues Headings .152 Table A6. Oil Revenues Distribution Scheme .153 Table A7. Prices FOB US-GULF .155 Table A8. Calculation of Parity Prices for Derivatives ($US/gal.) .155 Table A9. Calculation of Efficiency Prices in Terminal ($US/gal.). 156 Table AIO. Tax Collection: Calculation of Taxes or Current Subsidies ($US/gal.) .156 Table Al 1. Public Efficiency Prices: Calculation of Terminal Prices Eliminating Subsidies Applying VAT and Suggested Consumption Tax ($US/gal.) .157 viii EcUADOR: AN ECONOMIC AND SociAL AGENDA IN THE NEW MILLENNIUM Table Al2. Comparison of Consumer Price Changes ($US/gaQ) .......... 157 Table A13. Estimated Production of Private Companies (BPD) .... ...... 159 Table A14. Production Scenarios (Thds of bbl) ...... ................ 160 Table Al5. State Crude Exports (Thds of bbl) .............. ........ 160 Table A16. Petroleum Sector Support for the Treasury (blns/mlns $US) . .................................... 161 Table A17. Price Sensitivity of Treasury Support (blns $US) ............. 161 Table Al 8. Capitalization of FEIREP ........ ..................... 162 6. Trade Policy and Competition ..............................1 63 A. Precedents ............................................. 164 Liberalization of the Ecuadoran Economy in the 1990s .... ....... 164 B. The Foundations of Ecuadoran Development ...... .............. 168 Recommendations ...................................... 169 Other Recommendations ........... ...................... 175 C. Price Bands ............................................ 177 Recommendations ...................................... l81 D. Technical Regulations . ..................................... 183 A Lack of "Domestic Treatment" . ........................... 183 INEN and WTO Regulations .......... ................... 183 Recommendations ................ ..................... 185 Policy Matrix ............................................ 187 Annex I ................................................ 189 Annex 2 ................................................ 191 Figure 1. Ecuador Trade Composition .165 Figure 2. Evolution of the Effective Rate of Ad Valorem (VAT or TariffJCIF Imports) .166 Figure 3. Percentage of Trade Requiring Prior Authorization .173 Figure Al. Soya Oil .192 Figure A2. Powdered Milk .193 Figure A3. Palm Oil .194 Table 1. Licenses Issued by Institutions .172 Table 2. Variability in Ecuadoran Benchmark Prices, 1998-2001 . 179 Table 3. Types of Ecuadoran Technical Regulations (to October 4, 2001) ........ ................. 184 7. Basic Infrastructure: Water and Sanitation, Electricity, Telecommunications, and Trasport ......................... a95 A. Introduction ................................... 196 Description of the Sectors ................................ 197 B. Diagnosis of the Main Problems and Challenges ...... ............ 204 Water Supply and Sanitation Sector ......... ................ 204 CONTENTS IX Management of Water Resources ....... .................... 213 Energy Sector ......................................... 214 Telecommunications Sector ........ ....................... 219 Transport Sector ........................................ 225 Highway Safety ........................................ 229 C. Sectoral Policy Recommendations ............................. 230 Water Supply and Sanitation Sector ...... ................... 231 Energy Sector ......................................... 235 Telecommunications Sector ........ ....................... 237 Transport Sector . ........................................ 239 Community Infrastructure ........ ........................ 240 Sectoral Action Plan .......................................... 244 Box 1. Stormwater Drainage-A User Surcharge for Improvements in the Context of a Concession Contract ..... .............. 234 Figure 1. Water Supply and Sanitation Coverage in Latin America (in percentage, compared with per capita GDP) ............... 205 Figure 2. Access to Potable Water Supply by Income Level ..... ......... 207 Figure 3. In-home Water Treatment by Income ...................... 208 Figure 4. Aggregate Income and Costs of Water and Sanitation Services ... . 210 Figure 5. Percentage of the Population with Fixed Telephone Line (2001) . 220 Figure 6. Percentage of the Population with Cellular Phones (2001) ....... 220 Figure 7. Competition in the Cellular Phone Market (Sept. 2002) ........ 223 Figure 8. Average Cost per Minute: Cellular Prepayment Plan (Nov. 2002) ......................................... 224 Table 1. Institutions Related to the Water and Sanitation Sector .... ..... 198 Table 2. Water and Sanitation Service Providers (SPs) ................ 198 Table 3. Comparison of Selected Electricity Sectors in Latin America and the Caribbean .................................... 200 Table 4. Coverage of Potable Water and Sewage Services, 1999 (percent) . . 206 Table 5. Operational Efficiency of Water Utilities in Large and Medium-Size Cities .209 Table 6. Distribution of the Telephone Tax and Municipal Expenditure on Water and Sanitation ($US/inhabitant in 2001) .211 Table 7. Machala: Monthly Expenditure on Water Supply and Sanitation Services-Families with and without Home Connection .212 Table 8. Main Characteristics of Distribution Companies in 2001. 215 Table 9. Characteristics of the Ecuadoran Road System by Regions . 226 8. Urban Development ............................. 251 A. Diagnostic Study ......... .................... 252 Urbanization ............................. 252 Land and Housing in Urban Areas .......................... 254 Urban Services ............................. 256 X ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLrNNIUM Economic Vulnerability and Vulnerability to Natural Disasters ...... 259 B. Recommendations .................. ..................... 260 Policy Matrix ............................................... 262 Figure 1. Urbanization in Ecuador in Comparison with Latin America ..... 252 Figure 2. Urban Poverty in Ecuador, 1995-99 .254 Table 1. Percentagc of the Population without Formal Property Titles (1998) .254 Table 2. Housing Ownership Rates in Ecuador and in Other Countries .255 'I'able 3. Effects of the Subsidy on Purchasing Power for Housing .256 Table 4. Housing Conditions in Urban Areas of Ecuador (1998) (percent) .257 Table 5. Access to Water, Sanitation, and Trash Collection in Urban Areas of Ecuador (1998) (percent) .257 Table 6. Tariff and Operation Costs for Water Companies in Ecuador, 2001 (millions of dollars) .258 PiatE RR BoE$tl¶g ES$tnEasib and DEqutabke $cigl dDevelopmenit 9. Education .......................................... 265 A. Introduction ............................................. 266 B. The Educational Systcm: Principal Problems ..... ................ 266 Limited and Unequal Access to Education ..... ............... 271 L.ow Quality of the Education Imparted ..... ................. 275 Serious Difficulties for Financing Education ..... .............. 277 Problems in Sector Administration ...... .................... 279 C. Recommendations . ....................................... 281 Policy Matrix ............................................... 283 Annex ................................................ 286 Box 1. Ecuador's Institutional Framework for the Fducation Sector ..... 267 Box 2. Government Strategies and Initiatives ...... ................ 269 Figure 1: Net Enrollment Rates, by Consumption Quintiles and by Educational Levels ......... ......................... 272 Figure 2. Public Spending on Education by Consumption Quintile ....... 275 Figure 3. Quality of Schools, Based on the Opinion of the Business Sector ....................................... 276 Figure 4. Spending on Education as a Percentage of the GDP in Ecuador and in Latin America and the Caribbean, 1980 to 2001 ........................................ 278 CONTENTS Xl 10. Health ............................................... 293 A. Introduction . ............................................ 294 B. Ecuadoran Health: Characteristics and Diagnosis ..... ............. 297 Problems with Record Keeping and Premature Mortality from Preventable Causes ........... ........................... 297 High Infant Mortality Rates ........ ....................... 299 High Prevalence of Risk Factors for Infant Mortality .... .......... 300 High Maternal Mortality Rates ....... ...................... 301 C. Problems in the Health Services System ...... ................... 301 Background ........................................... 302 Fragmentary Organization and Underutilized Resources .... ...... 303 Insufficient Government Spending and Inequitable Private Spending on Health .......... ........................... 304 Nontransparent Financing ................................ 305 Limited Health Insurance Coverage ...... ................... 306 Inadequate Performance of the Essential Functions of the Ministry of Public Health, Shortfalls of the IESS, and Difficulties in Achieving the Millennium Development Goals ..... ............ 308 Limitations of the IESS Health Area ...... .................. 309 Difficulties in Achieving Millennium Development Goals .... ..... 310 D. Recommendations ........................................ 312 Extension of Access to Basic Services ...... ................... 313 Decentralization for a Better Supply of Health Services .... ....... 314 Sectorial Coordination and the Future for the Ministry of Public Health and the IESS ....... ........................ 315 Policy Matrix ............................................... 317 Box 1. Organization of the Health Sector ...... .................. 303 Figure 1. Relationship between Income and Life Expectancy, 2000 .... .... 295 Figure 2. Correlation between Life Expectancy and Household Consumption, 1999 ...... .................... 296 Figure 3. Mortality by Types of Causes, 1999 ........................ 298 Figure 4. Incidence of AIDS by Sex, 1990 to 2000 .................... 299 Figure 5. Percentage of Income used for Out-of-Pocket Health Expenses, by deciles, 1998 ........... ........................... 306 Figure 6. Mortality in Children under Five Years of Age ..... ........... 312 Figure 7. Maternal Mortality .................................... 312 11. The Social Assistance System ............................... 319 A. Introduction ............................................. 320 B. Principal Features of the Social Assistance System ..... ............. 321 C. Supply and Demand for Social Assistance ...... ................. 322 Vulnerable Groups ........... ........................... 322 xii ECUADOR: AN ECONOMIC AND SOciAL AGENDA IN THE NEW MILLENNIUM Social Risk Management Strategies ...... .................... 329 D. Problems of the Social Assistance System ...... .................. 331 E. Recommendations . ....................................... 336 Increase the Flexibility of the Social Assistance System .... ........ 337 Improve Coordination and Targeting in Existing Programs .... .... 337 Reorient the Bono Solidario Cash Subsidy Program toward Becoming a Program of Conditioned Subsidies ..... ............ 339 F Conclusions .341 Policy Matrix ............................................... 342 Annex: Incidence of Social Assistance Programs (Selected) .... ........ 345 Figure 1. Concentration Curves for Some Social Assistance Programs ...... 333 Table 1. Selected Features of the Social Assistance System's Priority Programs for 2000-01 ........ ......................... 323 Tablc 2. Outstanding Features of the Most Significant Social Assistance Programs . .......................................... 324 Table 3. Targeting of the Bono Solidario Cash Subsidy Program (Individual Beneficiaries) ....... ........................ 335 12. The Pension System .......... ........................... 347 A. System Diagnostic . ....................................... 348 The Institutional Organization of Ecuador's Pension System .... ... 348 Structure of the Pension System Prior to the Reform .... ......... 349 Financial Situation .......... ............................ 351 The Level of the Benefits ........ ......................... 353 Coverage .............................................. 354 The Reform . .......................................... 357 B. Proposed Solutions . ........................................ 358 Problems of Covcrage, in Terms of Broadness and Depth .... ...... 359 The Financial Management of the IESS ..... ................. 362 Partial Implementation of the Reform of the Social Security System . ....................................... 363 Policy Matrix ............................................... 365 Figure 1. Financial Trends in the IESS (as a perccntage of GDP, 1993-2002) ..... ................. 352 Figure 2. Financial Trends: Insurance for Disability, Old Age, and Death (as a percentage of GDP, 1993-2002) ..... ................. 352 Figure 3. Average Benefit per Month per Person, in Dollars, Insurance for Disability, Old Age, and Death: Rural People's Social Security Program; and the Bono Solidario Cash Subsidy 1995-2002 ......................................... 354 CONTENTS xiii Figure 4. Percentage of the Labor Force Participating in Contributive Pension Programs in South Arnerica in and about the Year 2000 ................................... 355 Figure 5. Participation of Active Workers in Ecuador's Pension Systems (as a percentage of the economically active population in each program and in the system as a whole, 1965-2002) ........... . 356 Figure 6. Coverage of Pension Systems with Respect to the Population Age 55 and Older (by age group and in total, 2002) ..... . 356 Table 1. Cost of Increasing Coverage or Benefits under Rural Social Security and under the Bono Solidario Cash Subsidy Program for the Elderly (absolute values and as percentage of GDP) . 361 13. Rural Development .369 A. Introduction ............................................ 370 B. Three Strategic Goals for Rural Development ..... ............... 374 C. Key Issues in Rural Development in Ecuador . 376 D. The Institutional Framework of Rural Development .. ....... 383 E. Conclusions and Recommendations ........................... 384 Recommendations ................ 385 Policy Matrix ............................... ....... .. 388 Figure 1. Yield per Hectare in 2002 (tons) . ................ 372 Figure 2. Agricultural GDP/Total GDP ........ . 372 Figure 3. Producer Price Index ..................... 373 Table 1. Ecuador's Agricultural Trade Balance with Colombia and Peru ........................................ 373 Table 2. Illiteracy Rates, 1999 (percentage of population over age 15) ..... .......... ....... ...... 377 14. The Environment and Sustainable Development .393 A. Introduction ............................................. 394 B. Poverty and the Environment ................................ 394 Environmental Pollution ................................. 396 Natural Disasters .................................. .. 397 C. Sustainable Development ................................... 399 Comprehensive Resource Planning and Management ...... . 400 Natural Resource Management and Economic Growth ........... 401 D. Recommendations ........................................ 404 Environmental Regulation .... ....... ....... .... 404 Environmental Investment ................ .... .... 407 Box 1. Environmental Policy and Management . .403 xiv ECtJADOR: AŽN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Figure 1. Poverty Decilcs in Ecuador's Cantons ...... ................ 395 Figure 2. GDP and Natural Disasters .............................. 398 Figure 3. Soil Use Conflicts ..................................... 406 IPart HHH 1 I3d:g a C ' ,Govemment That Serves AU Ecuadorans a1 IFR~ts againtst Corrsuption 15. The Envirnmen-, and Governance and Corruption .............. 411 A. Governance in Ecuador from a Comparative International Perspective . . 412 B. Corruption and Its Impact . . ................................ 414 The Cost of Corruption ................................. 415 C. Local Government and Decentralization ........... ............. 427 D. Institutional Vulnerability ................................... 430 E. Recommendations ........................................ 432 The Climate for Reforms .......... ....................... 433 Openness, Transparency, and Accountability in Society .... ....... 433 Imperatives for Public Administration ...... .................. 434 A Broad and Inclusive Approach ........ .................... 435 Policy Matrix ............................................. 437 Annex: Governance in Ecuador: Citizens and Public Employees Give Their Opinions ........... ....................... 438 Figure 1. Government Effectiveness (Latin America and the Caribbean Region, 2000-01) .......... .................. 413 Figure 2. The Rule of Law (Latin America and the Caribbean Region, 2000-01) ........................... 414 Figure 3. Control of Corruption (Latin America and the Caribbean Region, 2000-01) ............ ................ 415 Figure 4. Changes 1997-98 and 2000-01 .......... ................ 416 Figure 5. Opinion of Companies on Obstacles to the Development of Their Business ................................... 417 Figure 6. Corruption as a Regressive Tax on Users ....... ............. 418 Figure 7. How Conm-non Is Payment of Bribes to Public Employees? ................................... 422 Figure 8. How Common Is Corruption? (by region) ................... 422 Figure 9. Perception of Honesty ................................. 423 Figure 10. Forms of Corruption .................................. 424 Figure 11. Experience with Corruption . ............................ 425 Figure 12. The Impact of Being Victimized by Corruption (on support for the system) ................................... 426 Figure 13. Evaluation of Municipal Services .......................... 428 Figure 14. Satisfaction with Municipal Services and Locality .............. 429 CONTENTS XV Figure 15. Comparative Attendance at Municipal Meetings and Open Town Councils .......... ........................ 429 Figure 16. Who Responds Better to Local Problems (by locality) .... ...... 430 Figure 17. Willingness to Pay More Municipal Taxes: International Comparison ............................... 431 Figure Al. Pride in the Ecuadorian Political System vs. Pride in Being Ecuadoran ........... ........................ 439 Figure A2. Comparative Support for the System ...... ................ 440 Figure A3. Support for Institutions ......... ....................... 441 Figure A4. Approval of Conventional or Aggressive Forms of ............... Political Participation .......... ........................ 442 Figure A5. Professional Participation and Fear of Crime ..... ............ 443 Figure A6. Participation in a Parents' Committee and Support for the System .............. ......................... 443 Table 1. Frequency and Amount of Bribes (According to Citizens) ...... 420 Table 2. Frequency and Amount of Bribes (According to Companies) ..... 421 Table 3. The Most Serious Problem Faced by the Municipality (by Region) . ......................................... 428 16. The Labor Market and Civil Service in Ecuador ................ 445 A. Introduction .............................................. 446 B. The Labor Market in Ecuador ......... ....................... 447 Employment and Unemployment ....... .................... 447 Labor Income and Salaries ......... ....................... 449 C. Problems in the Private Market ......... ...................... 452 Setting Salaries, Salary Unification, and Incentives for Creating Formal Jobs .......... ......................... 452 Outsourcing and Flexibility in the Labor Market: ..... ........... 454 D. Recommendations for the Private Labor Market ..... .............. 455 Recommendations for Setting Salaries ...... .................. 455 Recommendations on Labor Market Flexibility ..... ............ 456 E. Civil Service in Ecuador ........... ......................... 456 Number of Personnel ........... ......................... 456 Policy Matrix for the Private Labor Market ...... .............. 457 Public Employee Systems in Ecuador ...... .................. 459 Public Sector Salary Expenses ........ ...................... 460 Human Resources Management ....... ..................... 460 Salary Policy . ......................................... 461 F. Principal Problems .463 G. Recommendations ........................................ 466 Recommendations on Salary Reform ........ ................. 466 Recommendations on Human Resources Management and SENDOSEP ...................................... 467 xvi ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Policy Matrix .................. .................... 468 Technical Annex: Detcrmining Real Salaries in Ecuador, 1998-2001 .......................... 469 Annex 1: Civil Service and Administrative Career, Salary Schedules, 1997-2002 .472 Annex 2: Budgetary Classification of Expenditures .474 Annex 3: Basic Salary Schedule for Public Employment Governments, 2002 ......... ....................... 476 Table 1. Active Work Force, Employment and Unemployment in Urban Areas, 1998-2001 ......... ...................... 447 Table 2. Underemployment and Informal Employment in Urban Areas, 1998-2001 (as percentages of employed people) ..... ......... 448 Table 3. Growth of Urban Employment by Sector, 1998-2001 (percentage changes) ............ 448 Table 4. Real Monthly Labor Income in Urban Areas, 1998-2001 (at constant 1998 $US values) .449 'Fable 5. Monthly Labor Income in Urban Areas According to Employment Situation, 1998-2001 (in constant 1998 $US values) .450 Table 6. Labor Income, Average and Minimum Salary in the Private Sector in Urban Areas, 1998-2001 .451 Table 7. Public Employees of Ecuador and Other Selected Countries . 458 Table 8. Number of Government Jobs under the Public Employees System, 2002 .459 Table 9. Personnel Expenses by Type in Five Ministries and Departments, 2002 .462 Table Al. Price Index and Exchange Rate Series ..... ................. 469 Table A2. Monthly Labor Income in Urban Areas, 1998-2001 (at constant 1998 $US values) ....... .................... 469 Table A3. Monthly Labor Income in Urban Areas by Employment Situation, 1998-2001 (at constant 1998 $US values) .... ...... 470 Table A4. Labor Income and Basic and Average Salaries in the Private Sector in Urban Areas, 1998-2001 ...... .................. 471 17. Decentrzantinn ........................................ 479 A. The Principal Problem and the Challenges of Decentralization .... .... 480 B. Diagnosis ............................................... 482 Structure of the State and Intergovernmental Relations .... ....... 482 Administrative Decentralization: Transfer of Powers .... .......... 485 Fiscal Decentralization: Transfer of Resources ..... ............. 487 Management of the Decentralization Process ..... .............. 493 C. Policy Recommendations .......... ......................... 494 CONTENTS Xvii Structure of the State and Intergovernmental Relations . .......... 494 Administrative Decentralization: Transfer of Powers ..... ......... 495 Fiscal Decentralization ................................... 497 Management of the Decentralization Process ................... 501 Policy Matrix ............ ........................ 503 Annex: Special Laws Governing the Transfer of Resources and Revenue-Sharing for the Benefit of Municipalities and Provincial Councils ................................... 509 Figure 1. Subrogation of External Debt (1998) .489 Figure 2. Per Capita Resources Received, by Province (in $US, 1998) . 491 18. The Administration of Justice .............................. 515 A. Persistent Problems ........................................ 516 Lack of Access ... . . .................. 516 Costs ................ 516 Legal Assistance ........................................ 518 Functionality .......................................... 518 Lack of Confidence in the System ........................... 518 B. Recommendations ...... .................................. 522 Legal Reform ................................... .. 522 C. Conclusions ..................... 525 Policy Matrix ............................................ 526 Annex 1: Reforms of the System ................... ........... 530 Annex 2: Institutions ......................... 533 Table 1. Civil Cases Filed in Ecuador's Courts . .516 Table 2. Spending on Justice as a Percentage of the State Budget ......... 517 Table 3. Per Capita Judicial Budget in the Andean Region . .......... 517 Table 4. Breakdown of Spending (2001) . .518 Table 5. Duration of Ordinary Cases (Quito) . ............... 521 Table 6. Cases Completed Compared to Those Entering the System in Pilot Courts (percent) ............................... 522 Bibliography .......................... 535 Preface Ecuador is at a crossroads as it enters the new millennium. Political, economic, and social instability have long affected this country's path of development. Though it is rich in cultural traditions and natural endowments, the stop-go cycles of past pub- lic policies have prevented the country from fully utilizing its potential for economic prosperity and social equity. The newly inaugurated administration has the oppor- tunity to break with the past by defining a development agenda that is based on a shared vision. In this agenda, stability, growth, competitiveness, social development, decentralization, and anticorruption efforts would constitute the mileposts along a road benefiting all Ecuadorans. We at the World Bank feel honored by the authori- ties' invitation to publish this compendium of policy notes for Ecuador that we have prepared and which, from an independent point of view, provides an account of Ecuador's current development challenges, many of the reasons behind those chal- lenges, and some options to overcome them. The analysis here does not claim to provide definitive solutions to all of Ecuador's challenges. Rather, we hope that this volume can enrich the national debate among Ecuadorans as they search for their own solutions to these challenges. The work presented here is organized around three overarching themes: Fiscal Consolidation and Growth, Social Development, and Quality of Government. The main messages within each of these themes are captured in their respective Thematic Chapters, and summarized and brought together in an opening Synthesis. The importance of these three broad themes has become increasingly evident all around the world during the last decade, and has been accentuated by globalization (finan- cial and commercial) and by the information technology revolution. Understanding those forces is critically important because, in the end, their value will be measured by one simple yardstick-their impact on people's quality of life, especially among the poor. Any government operating under these conditions would confront the need for difficult reforms. For Ecuador, the twin-banking and currency-crises that led to dollarization make reform even harder. Current regional and international condi- tions do not facilitate matters, and are unlikely to do so in the near future. The financial crisis in the Southern Cone restricts access to external funding, and sagging global growth is dampening Ecuador's exports. The country is also beginning to feel the impact of the illegal drug trade. Finally, the reforms necessary to consolidate dol- larization are still only half completed. Yet, inaction brings higher costs than action. xix xx ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Without strengthened reform, the Ecuadoran economy risks spiraling into a cycle of recession and increasing poverty. The new government has expressed its determination to address, head on, the challenge of reforms. In the few months since taking office, the administration has rallied early support for some major changes in policy direction in the fiscal, struc- tural, and social areas. We at the World Bank stand ready to support those efforts. We view this as central to our institution's mission of poverty reduction and to our commitment to see Ecuador succeed. This book is the product of the analytical work of a large number of World Bank staff members. It documents Ecuador's main development trends, policies, and options, and places the country in the context of relevant international com- parisons. Extensive dialogue, reflection, and direct operational work widt our coun- terparts in the Ecuadoran government and elsewhere are detailed in this volume, which spells out critical lessons and challenges that are relevant for Ecuador and for Latin America as a whole. Finally, the book proposes policy matrices for each sector and topic, including a proposed sequencing of policy steps. I am extremely grateful for the cooperation and contributions of our many friends in Ecuador to this very important endeavor, both directly and through sev- eral years of working side by side with us. I would like to thank the staff members who have compiled this book-editors, authors, and producers. Their work reveals not only their professional talents, but also, and more importantly, their passion for poverty reduction. Finally, I wish to express our gratitude to the Ecuadoran authorities for giving us the privilege of being partners in their country's quest for development. David De Ferranti Vice President Latin America and the Caribbean Regional Office Washington, D.C. March 7, 2003 Editor Biographies VICENTE FRETES-CIBILS, a native of Argentina, completed his undergraduate work at the Universidad Nacional del Nordeste, in Argentina, and subsequently pursued postgraduate studies at the University of Pennsylvania and North Carolina State University, where he received, respectively, a master's degree in Business Adminis- tration and a Ph.D. in Economics. Following his university studies, he joined the World Bank in 1987 through the latter's Young Professionals Program. Following stints in the Bank's Office of the Vice-President for Europe and the Middle East and its Treasury Department, he served from 1988 to 1992 as Economist in the Office of the Vice-President for West Africa Operations. Subsequently, from 1992 to 1996, he served as Chief Economist in the Department of Operations for Andean Coun- tries, supervising adjustment programs and heading up economic and analytical missions to Bolivia. From 1996 to 2002, Mr. Fretes-Cibils served as Senior Econo- mist for Venezuela, and subsequently for Colombia and Mexico. He is currently Lead Economist in the Poverty Reduction and Economic Management Sector for the subregion of countries that includes Bolivia, Ecuador, Peru, and Venezuela. Additionally, he has taught at Argentina's Universidad Nacional del Nordeste and at North Carolina State University, and has published numerous works addressing top- ics in the areas of finance, applied econometrics, public finance, international eco- nomics, and economic development. MARCELO M. GiUGALE, of Argentine/Italian nationality, obtained his Ph.D. and M.Sc. in Economics from the London School of Economics and his bachelor's degree in Economics from Argentina's Universidad Catolica. Upon completion of his university studies, Mr. Giugale joined the Word Bank in 1989 as an Economist in the Department of Financial Research. From 1990 to 1994, he served as Chief Economist in the Office of the Vice-President for Middle Eastern Operations, supervising structural adjustment programs in Egypt and directing the Bank's post- war reconstruction effort in Lebanon. From 1994 to 1998, Mr. Giugale served as Chief Economist for the Eastern Europe and Central Asia regions, where he was responsible for the Bank's loan portfolio as well as for economic analysis work involving Lithuania and Kazakhstan. From September 1998 to October 2002, he occupied the post of Lead Economist for the Colombia, Mexico, and Venezuela Department. He is currently Subregional Director for the Andean countries of Bolivia, Ecuador, Peru, and Venezuela. In addition, he has lectured at the London xxi XXii ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN ThE NEW MILLENNIUM School of Economics and at the American University in Cairo, and has also pub- lished widely on applied econometrics, finance, business economics, and economic development. Josi ROBERTO LOPEZ-CALX, a native of El Salvador, is Senior Economist in the Economic Policy Group for the World Bank's Latin America and the Caribbean Region. Mr. L6pez-Calix obtained his Ph.D., M.Sc., and bachelor's degrees from the Catholic University in Louvain, Belgium, and an M.Sc. degree with a major in International Finance from the University of Pittsburgh. He began his professional career by working in a number of international organizations, including the United Status Agency for International Development, the Canadian International Develop- ment Agency, the United States Congress, and the Inter-Americanl Development Bank, specializing in macroeconomic policy, econometric analysis, public finance, international migration, and foreign debt management. From 1989 to 1991, Mr. L6pez-Calix served as General Director for the Ministry of Planning's Economic and Social Advisory Group with responsibility for El Salvador's special budget, and in this capacity was a member of the team that designed and implemented structural adjustment policies to govern the transition between the pre- and postwar periods. In 1994, he joined the World Bank in Washington, D.C., where he worked in the Department of Central American Operations. Two years later, he was named Man- ager of the Bank's Office in Guatemala. In 1999, together with Guatemala's Inte- grated Financial Management Project Team, he was awarded the prestigious "Presi- dent James D. Wolfensohn Award." In 2000, he returned to Washington, D.C., and since that time has worked primarily with the Department for Ecuador, Bolivia, Peru, and Venezuela. Mr. L6pez-Calix has been a Visiting Professor at Florida Inter- national University in Miami and has published numerous books and articles on specialized subjects, induding parallel exchange markets, international coordination in macroeconomic policy, public finance, public expenditure monitoring surveys, trade policy and free trade agreements, and family remittanccs. Acknowledgments This volume is the result of a team effort and, as such, it has benefited from an array of invaluable contributions. Our thanks are therefore due to a large number of peo- ple. First, the chapters' authors, for not only providing material of outstanding tech- nical quality, but also for their remarkable effort, even working in record time dur- ing New Year's and Christmas holidays, and thus enriching the Ecuador debate at a crucial time. We consider ourselves fortunate to share this book with these principal authors-Gabriela Arcos, Marcelo Bortman, Robert Buergenthal, Maria Dakolias, Maria Donoso-Clark, Franz Drees, Daniel Dulitzky, Philippe Durand, Jonas Frank, Mario Guadamillas, Dominique Hachette, Anthony James, Emmanuel James, Gio- vanni Majnoni, Yira Mascar6, Eleodoro Mayorga, Alexandra Ortiz, Juan Quintero, Francesca Recanatini, Jeffrey Rinne, Rafael Rofman, Carlos Rojas, Carolina Sanchez-Paramo, Ernesto Sanchez-Triana, Osvaldo Schenone, Mitchell A. Seligson, Ilias Skamnelos, Elaine Tinsley, Eloy Vidal, and Pierre Werbrouck. All authors are affiliated with the World Bank Group unless otherwise indicated in the respective chapter. Other authors of individual chapters are recognized in the credits of each specific chapter. While this book reflects the authors' views (and not necessarily the views of the World Bank, its Board of Directors, or its member countries), its production was institutionally housed at the World Bank. We thus benefited greatly from the gen- eral guidance of Guillermo Perry (Chief Economist for the Latin America and the Caribbean Region) and from the auspices of the office of David de Ferranti (Vice President for Latin American and the Caribbean Region). We also thank McDonald Benjamin, Daniel Cotlear, Andrea Silverman, and Fernando Montes-Negret for their support and comments. We also recognize the importance of and thank the participants of the workshop held on January I 1th, 2003 in Quito, Ecuador. This workshop not only brought together a majority of the authors under one roof for a day of candid discussions but also, and more important, included officials and consultants from both past and cur- rent government administrations. Of the consultants and government officials pres- ent at the workshop, we would especially like to thank the following: Sr. Presidente Lucio Gutierrez, Patricio Ortiz, Luis Felipe Mantilla, Nina Pacari, Nelson Herrera, Luis Macas, Doris Solis, Carmen Tene, Marcelo Cevallos, Marco Paez, Nelson Alvarez, Alberto Andino, Saul Velasco, Ing. Patricio Pugarin, Estuardo Pefiaherrera, Patricio Acosta, Mauricio Calder6n, Antonio Tramontana, Edgar Isch, Augusto Bar- xxiii xxiv ECUADOR: AN ECONOMIC AND SoCIAL AGENDA IN THE NEW MILLENNIUM rera, Hernan Plaza, Victor Acosta, Maria Fuentes, Manuel Chiriboga, Alberto Wray, Gabriel Montalvo, Frederic Pinel, Rosa Maria Torres, Diego Mancheno, Marfa Belen Freire, Oswaldo Aguirre, Mauricio Yepez, Victor Hugo Jij6n, Mauro Teran, Juan Granja, Patricio Ruiz, Rocfo Boh6rquez, Ramiro Galarza, John Arroyo, Javier Game, Pedro Paez, Francisco Hidalgo, Fernando Suarez, A. Polibio C6rdova C., Patricia Carrera, Carlos Arboleda, Bayardo Granjas, Juan Escalante, Mauricio Pareja Cevallos, Fernando Buendia, Mauricio Pozo, Virgilio Hernandez, Jose Vallejo, Horacio Yepez, Lenin Parreiio, Aase Smedler, Fernando Uzcategui, Antonio Albifiana, Juan Villacfs, Mario Acosta, Roberto Salazar, Fernando Alban Bonilla, Romelio Gualan, Benito Suarez, Luis Tapia, David Yuravlivker, and Francisco Andino. Their comments, suggestions, and inputs along with those from the many others who attended this workshop added greatly to this volume. We are especially thankful for the work of Esperanza Berrocal and her entire team from Comunicaci6n Global, Mellen Candage, Robert A. Croese, Richard Crum, Jan D. Gibboney, Andrea Harold, and Carol Levie for their exceptional work in preparing the Spanish version of this publication as well as piecing together the Eng- lish version. We are especially grateful for the work of Michael Geller who gave key support to the editorial process of this work; as well as to Chris Humphrey for hav- ing collaborated on the English version's technical editing for various chapters. The World Bank team in Ecuador should also receive a well-deserved thank-you for their outstanding support and help in coordinating the January 11th workshop in Quito: Gabriela Beltrin, Alexandra Del Castillo, Edmundo Espinoza, Ana Lucia Jimenez, Pilar Larreamendy, Raul Subia, Vinicio Valdivieso, Ana Maria Vicufia, and Ana Maria Villaquiran. Without them, achieving the right environment for these impor- tant discussions would not have been possible. The World Bank team in Washing- ton was also a strong component during this whole process: Oscar Avalle, Sara Calvo, Ivonne Escobedo, Maria Antonieta Gonzalez, Christopher Hale, Patricia Holt, Francisco Irfas, Crummella Myers, Marianella Rivadeneira, Judy Rivers, Ros- alia Rushton, Esther Samuel, Margaret Stroude, and Eduardo Wallentin. Finally, we would like to thank the World Bank publication team. Santiago Pombo-Bejarano and Stephenie DeKouadio supervised the entire process and pro- vided key information and assistance at all stages of publication. The team from Alfaguara, Colombia turned out a wonderful product in Spanish under a high level of stress and a strict deadline. Patricia Endara and Ronald Jones led us to the won- derful artwork of Gonzalo Endara Crow that graces the cover of this volume. Our sincere thanks to all of them. Vicente Fretes-Cibils, Marcelo M Givgale, and Jose R. Ldpez-Cdlix Washington, D.C. April 2003 Acronyms and Abbreviations AADT Annual average daily traffic ADV Added distribution value AFTA American Free Trade Agreement AGD Deposit Guarantee Agency (Agencia de Garantia de Depdsitos) ALADI Latin American Integration Association ALCA Free Trade Zone of the Americas (Area Libre de Comercio de las Americas) AME Association of Municipalities of Ecuador API American Petroleum Institute APRENDO Academic achievement testing BCE Central Bank of Ecuador (Banco Central de Ecuador) BEDE Ecuadoran Development Bank BIRF The International Bank of Reconstruction and Promotions (Banco Internacional de Reconstruccidn y Fomento) BNF National Development Bank (Banco Nacional de Fomento) BPD Barrels per day CAE Ecuadoran Customs Corporation (Corporacidn Aduanero de Ecuador) CAF Andean Corporation of Promotion (Corporacidn Andina de Fomento) CAN Andean Community of Nations (ComunidadtAndina de Naciones) CEDEGE Center for Development of the Guayas Basin CEL Special Bidding Committee CELADE Latin American Demography Center Centro (Latinoamericano de Demografia) CEMs Educational Matrix Centers (Centros Educativos Matrices) CENACE National Center for Energy Control CEPE Centre for Energy Policy and Economics CET Common External Tariff xxv XXVi ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MIl LENNIUM CETUR Ecuadoran Tourism Corporation CFN National Finance Corporation CGC Comptroller General Office (Controloria General de Cuentas) CID Center for International Development Harvard University CIF Cost and Freight CNJ National Council on the Judiciary CNRH National Council on Hydraulic Resources CNT National Transport Council (Consejo Nacional de Transporte) CNTTT National Land Transit and Transport Council CODENPE Council for the Development of the Indigenous Nations and Peoples of Ecuador COMEXI Trade and Investment Council (Consejo de Comercio Exterior e Inversiones) CONADES National Wages Council (Consejo Nacional de Salarios) CONAM National Modernization Council CONAREM National Council for Public Sector Remuneration CONATEL National Telecommunications Council CONCOPE Consortium of Provincial Councils of Ecuador CONELEC Ecuador National Electricity Council (Consejo Electrico de Ecuador) CONSEP National Council for the Control of Substances COPEFEN Coordinator of the Emergency Program to Cope with the El Nifio Phenomenon CORPECUADOR Ecuador Corporation (Corporacidn del Ecuador) CORPEI Exportation and Investment Promotion Corporation (Corporacidn de Promocion de Exportaciones e Inversiones) COSUDE Consejo Superior de Educacion CPC Code of Civil Procedure CREA Center for the Economic Reconversion of Azuay CRM Center for the Reconversion of Manabf CTI Technical Commission on Investrments of the IESS (Comisidn Tecnica de Inversiones) DAC Civil Aviation Office DECEVALE S.A. Depository of Stocks (Depositaria de Valores) DIGMER Maritime Transport Administration DINEPP National Directorate of Continuing Popular Education (DirecciMn Nacional de Educacidn Popular Permanente) ACRONYMS AND ABBREVIATIONS xxvii DNP National Personnel Directorate DVP Delivery versus Payment EAP Population, Environment, and Energy Program ECAPAG Guayaquil Potable Water and Sewage Company (Empresa cantonal deAgua Potabley de alcantarillado de Guayaquil) ECOPETROL Colombian Petroleum Company (Empresa Colombiana de Petrdleo) ECORAE Amazon Development Fund (Fondo para desarrollo de la region Amazonizo) EDAP Pension Savings Deposit Institutions (Entidades Depositarias delAhorro Previsional) EEQ Quito Electric Company (Empresa Electrica Quito) EMAAP Water and Sanitation Municipal Enterprise (Empresa Municipal de Alcantarillado y Agua Potable) EMAAP-Q Water and Sanitation Municipal Enterprise of Quito (Empresa Municipal de Alcantarillado y Agua Potable de Quito) EMELEC Electricity Municipal Enterprise (Empresa Municipal de Electricidad) EMETEL Telecom Municipal Enterprise (Empresa Estatal de Telecommunicaciones) ENAP National Petroleum Enterprise (Empresa Nacional del Petrdleo), Chile ENDEMAIN III Survey on Demographics and Maternal and Infant Health (Encuesta Demografica y de Salud Materna e Infantil) ENFE Ecuadoran National Railway Company ENTEL Telecom State Enterprise EPHF Essential Public Health Functions EPR Effective protection rate ESMAP Energy Sector Management Assistance Programme FASBASE Strengthening and Expanding the Scope of Basic Health Services in Ecuador (Fortalecimiento y Ampliacidn de los Servicios Bdsicos de Salud en el Ecuador) FEIREP Fund for Stabilization, Social and Productive Investment, and Reduction of Public Debt (Fondo de Estabilizacion, Inversidn Socialy Productiva, y Reduccidn del Endeudamiento Publico) FENAJE National Federation of Judicial Officials FERUM Rural and Marginal Urban Electrification Fund FISE Emergency Social Investment Fund xxviii ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN TnE NEW MILLENNIUM FLAR Latin American Reserve Fund FODESEC Municipal Development Fund (Fondo de desarrollo seccional) FONDEPRO Credit Fund for the Development of Production (Fondo de credito para el desarrollo de la produccidn) FONDIFA National Children's Fund FONDVLAL Transportation Fund (Fondo vial) FOPEDEUPO Permanent Fund for University and Polytechnic Development FTAA Free Trade Agreement of the Americas FTA Free trade agreement GDP Gross domestic product GEF Global Environmental Facility GSP General System of Preferences GSRT Gross Settlement in Real Time GUO Global Urban Observatory of the United Nations HDI Human Development Index HRM Human resources management ICE Special Consumption Tax (Impuesto a los Consumos Especiales) ICT Information and commtnications technology IDB Inter-American Development Bank IEOS Ecuadoran Institute for Water and Sanitation Works IESS Ecuadoran Social Security Institute (Instituto Ecuatoriano de Seguridad Social) IMCI Integrated Management of Childhood Illness IMF International Monetary Fund INEC Survey on Employment, Unemployment, and Underemployment INECEL Ecuadoran Electricity Institute (Instituto Ecuatoriano de electrificacidn) INEN Ecuadoran Standardization Institute INERHI Ecuadoran Institute of Hydrological Resources (Instituto Ecuatoriano de los recursos hidrizos) INGALA National Galapagos Institute (Instituto nacional galapagos) INIAP National Institute for Agriculture and Livestock Research (Instituto Nacional de Investigaciones) Agropecuarias INNFA National Child and Family Institute INTERAGUA International Water Services Guayaquil IPP Independent Power Providers ACRONYMS AND ABBREVIATIONS XXiX ISP Internet service provider ISR Income Tax (Impuesto Sobre la Renta) ISSFA Social Security Institute of the Armed Forces ISSPOL Social Security Institute of the Police ITT Ishpingo- Tambococha- Tip utini ITU International Telecommunications Union IVA Value-Added Tax (Impuesto al Valor Agregado) JASS Water and sanitation councils LEXI Law on Foreign Trade and Investment LIBOR London Interbank Offered Rate LMG Law on Free Maternity Care LPG Liquid petroleum gas LRFP Law on Reform of Public Finances LSCCA Civil Service and Administrative Career Law MDMQ Municipality of the Metropolitan District of Quito MDOGs Government ministries, departments, and agencies MEC Ministry of Education and Culture MEF Ministry of Economy and Finance MEM Wholesale Electricity Market MIDUVI Ministry of Urban Development and Housing (Ministerio de Desarrollo Urbano y Vivienda) MIVI Ministry of Housing MODERSA Modernization and Developmenr of Comprehensive Health Services Networks (Modernizacidnny Desarrollo de Redes Integrales de Servicios de Salud) MOP Ministry of Public Works MSP Ministry of Public Health NAP Network access point NFPS Nonfinancial Public Sector NTB Nontariff barrier NTE Trechnical Norms of Ecuador OCP Heavy crude oil pipeline ODEPLAN P'lanning Office OLADE Latin American Energy Organization (Organizacidn Latinoamericana de Energia) ONN National Standardization Agency ORI Children's Rescue Operation (Operacidn Rescate Infantil) OSCIDI Civil Service and Institutional Development Office OTA Trans Andean Pipelines (Oleoducto Transandino) PACMI Supplementary Food Program for Mothers and Infants (Programa de Alimentacidn Complementaria Materna- Infantil) xxx ECUADOR: A.N ECONOMIC AND SOCIAL AGENDA IN TtiE NEW MILLENNIUM PAHO Pan-American Health Organization PANN National Food and Nutrition Program (Progyama Nacional de Alimentacidn y Nutricidn) PDI Children's Development Program (Programa de Desarrollo Infantd) PDM Municipal Development Program PHO Panamerican Health Organization PRAGUAS Water and Sanitation Program for Rural Communities and Small Municipalities-financed by the World Bank PROBONA Native Andean Forests Program PRODEPINE Indigenous and Afro-Ecuadoran Peoples Development Project (Proyecto para el desarrollo de los Pueblos y nacionalidades del Ecuador) PROLOCAL Poverty Reduction and Local Rural Development PROMEC Power and Communcations Sectors Modernization and Rural Services Project PROMECEB Program for Better Quality Basic Education (Programa de Mejoramiento de la Calidad de la EducaciSn Bdsica) PROMSA Program for the Modernization of Agricultural Services (Programa de Modernizacidn de los Servicios Agropecuarios) PRONEPE National Preschool Education Program (Programa Nacional de Educacidn Preescolar) PROST Pension Reform Options Simulation Toolkit PSP private sector participation RER Real exchange rate RISE Ecuadoran Simplified Tax System (Regimen Impositivo Simplificado Ecuatoriano) ROAA Return on average assets ROAE Return on average equity ROSC Report on the Observance of Standard and Codes RUC Centralized taxpayers registry (Registro Unico de Contribuyentes) SAPYSB Sub-secretariat of Potable Water and Basic Sanitation SBS Superintendency of Banks and Insurance (Superintendencia de Bancosy Seguros) SCT Secretary of Communications and Transportation (Secretaria de comunicacionesy transportes) SELBEN Ecuadoran Beneficiary Identification and Selection System (Sistema de Identificacidn y Seleccidn de Beneficiarios) ACRONYMS AND ABBREVIAFIONS XXXI SENATEL National Secretariat of Telecommunications SENDA Secretariat for National Administrative Development SENDOSEP National Secretariat for Organizational Development of the Public Sector SESA Ecuadoran Animal and Plant Inspection Service SGO General Obligatory Insurance (Seguro General Obligatorio) SG sectional government SICA Agricultural Census SIGEF Integrated Governmental System of Financial Statistics SIISE Integrated System of Social Indicators of Ecuador Social Indicators System of Ecuador (Sistema Integrado de Indicadores Sociales de Ecuador) SIV Housing Incentives System SME Small and medium-sized enterprise SOTE TransEcuadoran Pipeline System (Sistema de Oleoducto Transecuatoriano) SPC Service-providing company SPNF Sector Pzublico No Financiero (see NFPS) SP Service provider SRI Internal Revenue Service (Servicio de Rentas Internas) SSC Rural People's Social Security Program (Seguro Social Campesino) SSO Obligatory Social Security (Seguro Social Obligatorio) SUMA Single Environmental Management System SUPTEL Telecommunications Authority SWIFT Wiring Financial Service TROLE I Economic Transformation Law UCV Local Road Works Unit UDENOR Development Unit of the North UOST Trolleybus System Operating Unit URC Credit Restructuring Unir (Unidad de Reestructuracion de Creditos) USAID United States Agency for International Development VAT Value-Added Tax WLL Wireless Local Loop WTI West Texas Intermediate WTO World Trade Organization Synthesis Vicente Fretes-Cibils andJose R. Lipez-Cdlix A. Purpose and Organization In recent years, the World Bank has had the honor and privilege of welcoming incoming administrations of member countries with a series of integrated diagnos- tic studies and policy recommendations in priority areas of social and economic development, with the goal of reducing poverty. This practice is particularly relevant for Ecuador today, where President Lucio Gutierrez has taken office to govern a country that is rich in natural tesources and has enormous potential to combat poverty and improve the well-being of all citizens. However, these tasks will be ham- pered by structural economic and social problems, low competitiveness, corruption, and inefficient use of petroleum resources. Ecuador is still suffering the conse- quences of recent banking and exchange rate crises, which led to the dollarization of the economy. While dollarization helped reverse some of the macroeconomic imbal- ances, it caused greater economic vulnerability to changes in relative prices in the midst of a global and regional slowdown in economic growth. The fundamental challenges facing the country are identified within this book, and the solutions represent a break with the past. This is a proposal for an agenda with a broad and integrated vision of economic and social development in Ecuador. The chapters are grouped into the three thematic categories of the new administra- tion's program: (a) Stability and Growth with Competitiveness, (b) Socially Sustain- able and Equitable Development, and (c) Quality Government and the War on Cor- ruption. Each category includes selected subjects. Within Stability and Growth with Competitiveness, the following subjects are included: fiscal sustainability, tax reform, management of public debt, consolidation of the banking system, expansion of petroleum-related and commercial activities, development of basic infrastructure- electricity, telephone systems, water, and transport-and urban development. Socially Sustainable and Equitable Development contains an analysis of the following sectors: education, health, social safety networks, social security and pensions, rural xxxiii xxxiv ECUADOR: AN ECONOMIC AND SOcLAL AGFNDA IN THE. NEW MILLENNIUM development, and the environment. Within Quality Gov'ernment and the War on Corruption, the following themes are examined: improved governance, civil service reform, judicial reform, and decentralization of public services. These chapters are meant to be informative rather than exhaustive. They strive to initiate a frank and cordial dialogue, and to gather valuablc insights from authorities on all these subjects. The chapters show that the views of the World Bank and the new Gutierrez administration converge in making poverty reduction the central strategic goal of both the new government's agenda and future Bank assistance to Ecuador. This document was written based on the Bank's rich experience in the coun- try, complemented by recent interviews and data gathered during a Bank mission in November 2002, and presented to the incoming authorities in a workshop held in Quito on January 11, 2003. The World Bank appreciates the efforts of both outgo- ing and incoming officials in helping facilitate the preparation of this document. 13B CenEtral Message Since 1979, when it returned to democracy, Ecuador has suffered from high exter- nal vulnerability, poor macroeconomic performance, and poor governance. A suc- cession of external adversities-linked to the volatility of oil prices and violent vari- ations in capital flows-and natural calamities, all in combination with poor economic management, resulted in macroeconomic imbalances, with negative impact on growth and social development. During this period, the country went through four severe recessions (1982-83, 1987, 1989, and 1998-99) and three periods of hyperinflation (1983, 1988-93, and 1999-2000). It incurred a high and unsustainable external debt, reflected in various moratoriums on payments and the recent exchange rate depreciation and banking crises, which destroyed 20 banks that accounted for over 50 percent of banking deposits. These bad economic policies were partly caused by weak and too-often-changing public management, and the governance problems that traditionally characterize oil-producing countries. In the last 23 years Ecuador has had 29 finance ministers, meaning each spent an average of 10 months in the post. In addition, Ecuador has been the Latin American coun- try perceived as having the least control over corruption. Even more important, the last crisis (1998-99) had a devastating effect on employment levels, poverty, and income distribution. While the rate of formal unem- ployment grew from 10 to nearly 15 percent, poverty incidence increased from 34 to 56 percent between 1995 and 1999, and the Gini coefficient increased from 0.52 to 0.54 during the same period. These indicators imply that the number of poor Ecuado- rans grew by over 2 million during the crisis. This crisis severcly affected the rural poor, the indigenous population, and particularly those living in the mountains, where the poverty rate increased by 7 percent just between 1998 and 1999. More than a quarter of a million people emigrated and another half million moved into marginal urban areas within the country. Other human and social development indicators, such as SYNTHESIS XXXV infant mortality, malnutrition, and the school desertion rate, also worsened. The level of deterioration of these indicators reveals the depth of the crisis, and the greater vul- nerability of the poor, both urban and rural, in confronting the loss of income. The Ecuadoran economy has begun to recuperate, but it remains fragile. The adoption of the dollar as the local currency, favorable oil prices, rapidly increasing family remittances, and macroeconomic management with mixed results, have all helped gradually to stabilize expectations. These factors have also helped to gradu- ally eliminate hyperinflation, to begin to restore and reestablish the banking system, reach moderate growth levels, and partially reverse the increase in unemployment and poverty levels. Although economic growth is a necessary condition to combat poverty, it will be insufficient unless it is sustainable and participatory, and includes broad sectors of the most vulnerable population (such as the marginalized indige- nous population). With this challenge in mind, the central question posed in the book is as follows: What should the new government's agenda be in order to ensure abandoning thefail- ures of the past, bringing about Ecuador's economic and social recovery and reducing poverty? The answer to this question is based on three lines of action: * Preserving stability with fiscal discipline and accelerating growth with com- petitiveness; * Boosting sustainable and equitable social development; and * Building a quality government that serves all Ecuadorans and fights against corruption. PRESERVING STABILITY WITH FIsCAL DISCIPLINE AND ACCELERATING GROWTH WITH COMPETITIVENESS. The number one priority for Ecuador continues to be sustained economic growth. Both international experience and the experience of Ecuador itself show that the best tool to combat poverty and protect the most vulnerable cit- izens is to accelerate economic growth. It is estimated that on average, with each 1 percent increase of the gross domestic product (GDP) per capita, poverty is reduced by approximately .7 percent. It will not be easy to keep the economy on a track of rapid growth in the medium term, but it is feasible and can be achieved through the following key actions: * First, guarantee a balanced macroeconomic framework, particularly with ref- erence to public accounts, that fosters stability and private investment, and that allows debt reduction to continue. This means fiscal adjustment through collecting more and spending less, addressing liquidity problems in the short term and solvency problems in the medium term, and lowering interest rates to stimulate greater private investment in the economy. * Second, promote economic expansion and competitiveness by making input markets-particularly the labor market-more flexible, by opening the econ- omy to foreign trade, and by eliminating trade policies that punish exporters. xxxVi ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM These actions should be complemented by finishing the reorganization and reform of the financial system, and by promoting the expansion of financial intermediation, access to credit, and economic growth. • Third, accelerate expansion of the petroleum sector through a legal and regu- latory change to bring about legal and fiscal stability, and promote private investment in the oil fields with the greatest reserves. This expansion should be accompanied by programs and projects that fosters transparency in resource management, and also promote the local population's right to be consulted. The legal framework should include provisions to guarantee better management of the environmental and social impact of the oil industry. At the same time, the regulatory framework should eliminate distortions in the prices of and taxes on combustible fuels. o Fourth, develop physical infrastructure in four main services: water and sani- tation, electricity, telecommunications, and transport (highways and roads, railways, ports, and airports). Owing to fiscal restrictions, the government should facilitate private sector expansion in the provision of these services. This will require legal and regulatory changes with the corresponding adjust- ments in prices and tariffs, the elimination of subsidies (for propane, gasoline, and electricity), and the correction of distortions (such as the lack of incen- tives to increase investment in road maintenance). o Fifth, the government needs to direct its attention to the rapid urbanization process in Ecuador, and the resulting growth of poverty in urban areas. To combat this problem, integral urban development programs should be con- sidered in order to raise the standard of living in marginal urban zones and lower the physical, economic, and social vulnerability of residents. In this con- text, the detection of restrictions on the functioning of real estate markets is a priority, because these restrictions affect accessibility for the poor-and iden- tifying them will permit proposing changes to correct the obstacles con- fronting the poor. BOOSTING SUSTAINABLE AND EQUITABLE SocIAL DEVELOPMENT. Economic growth will be meaningless if Ecuadorans living in poverty (over 7 million) cannot partici- pate in the progress. The government can ensure this participation through the fol- lowing actions: o First, facilitate growth, accumulation of human capital, and the strengthening of the social fabric through dedicating more resources and improving the quality of education and health services, particularly for the poor and indige- nous in marginal urban and rural areas. On top of the recent reduction in gen- eral levels of spending, the public sector is currendy not receiving the corre- sponding returns on resources directed toward education and health. This should be reversed if the intention is to expand coverage and improve the quality of these services. SYNTHESIS xxxvii * Second, the accumulation of human capital should be complemented by eliminating rigidities in markets, particularly the labor market, so that the exchange of goods and services can be achieved with minimal transaction costs, and by promoting an improvement in the income of the poor who have made efforts to improve their education and health (human capital). * Third, the social safety network should improve efficacy and efficiency in pro- tecting these groups. The accumulation of human capital and elimination of labor market rigidities will not satisfy the needs of all Ecuadorans, particularly the marginalized rural and indigenous poor. In the formal sector, the social security system needs to be reformed, with a better separation of different services such as pensions and health, modernizing their institutional frame- work and financial management, and broadening coverage. The coverage of noncontributive regimes needs to be extended to the informal sector (such as Small Farmer Social Security) with better targeting and maximizing of the scarce resources allocated to these programs. * Fourth, despite the prominence of problems brought on by rapid urbaniza- tion, the government also needs to diversify its focus to include poverty in general, especially extreme rural poverty. The preparation of a strategy for the development of multisectoral rural development is needed that is diversified and has a territorial approach. This strategy should have three main goals: (a) social and economic cohesion through development of local space; (b) adjust- ment of agriculture and rural economic diversification; and (c) environmen- tal protection. Ecuador's geographic, economic, and sociocultural diversity means that this strategy must be differentiated and supported by policies that in turn facilitate the following: - development by jurisdiction or rural space, in a participatory form, to cre- ate economic and social cohesion; - the diversification of the rural economy; - the creation of nonagrarian employment through investment in rural and social infrastructure; - competitiveness of the agrarian sector through transference of technology and research; and - environmental conservation through improved territorial organization, reviving methods of soil conservation and appropriate use of natural resources. BUILDING A QUALITY GOVERNMENT THAT SERVES ALL ECUADORANS AND FIGHTS AGAINST CORRUPTION. The new government begins from a weak institutional standpoint, with an image of being highly corrupt and having problems governing. This image negatively affects the new administration's credibility as it designs and tries to implement public policies, and also influences the ability to provide public services. The government should reestablish governability and prevent corruption through the following actions: XXXViii ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN TtiE NFW MILLENNIUM o First, the government should carry out reforms in functions such as supervi- sion, regulation, provision of direct services, acquisition of goods, and con- tracting of services, among others, and promote total transparency. The gov- ernment needs to change incentives and separate economic and political links, promoting public oversight and avoiding, wherever possible, state cap- ture by certain economic interest groups. This will not be an easy task and will require an integral plan, because both governance and corruption have an impact on all aspects of public activity and affect the majority of eco- nomic and social sectors. This difficult task could begin with a governance pact between the state and civil society, and with the development of an anti- corruption strategy. o Second, this pact and strategy should be complemented with the strengthen- ing of the civil service and the deepening of judicial reform. These measures will allow all Ecuadorans, particularly those who are excluded today, to have access to justice. o Third, those who initiate the process of public reform must keep in mind the general context of decentralization and work within this framework. This process faces three challenges to improving public services: (a) improvement of functional decentralization; (b) the transfer of resources and spending competencies to subnational governments; and (c) the delineation of fiscal responsibility of subnational governments, including limits on public debt. C. The Development Aenda-D)agnostic 5=dy a& IPoliciez Ecuador is committed to the Development Goals of the Millennium. These goals were adopted by the international community within the framework of the United Nations for compliance between 1990 and 2015. They cover the areas of poverty, malnutrition, mother-infant health, education, gender equity, and environmental sustainability. Although data are incomplete for projecting the level of compliance with all goals for Ecuador, our calculations are based on an average annual GDP growth rate in the medium term of 2.7 percent. According to World Bank estimates, it is "probable" that Ecuador will reach goals for primary education (100 percent coverage) and malnutrition (50 percent reduction); it is "possible" that Ecuador will meet goals for lowering infant mortality and mortality of children under age five (66 percent reduction), and also goals for sanitation (a 50 percent drop in the number of people without access to potable water). The Bank believes it is "highly improb- able" that Ecuador will meet poverty reduction goals of 50 percent (rates for poverty and extreme poverty). The high sensitivity of these goals-particularly for poverty- to the rate of economic growth demonstrates why Ecuador needs to grow in an accelerated and sustained manner, with rates higher than historical levels, in order to reduce poverty during the next decade. This will be possible only with an inte- grated development agenda. SYNTHESIS XXXiX Preserving Stability with Fiscal Discipline and Accelerating Growth with Competitiveness Sustained growth acceleration can take place only within a context of macroeco- nomic stability and based on a multidimensional agenda of competitiveness. Unfor- tunately, for several decades, instability has been the rule and not the exception in Ecuadoran macroeconomic policy, and as regards competitiveness, the country is a latecomer to reform. Dollarization was especially necessary for Ecuador because it needs to build a new reputation and change its image as a country that historically has been politically unstable. By "lifting the veil" of money, dollarization made it evident that problems were not only fiscal in nature, but also social and financial to an even greater degree. The suppression of monetary policy not only remedied a previous fiscal illusion, but also resolved the financial imbalances introduced by hyperinflation and the depreci- ation of the exchange rate. At the same time, it established new rules for competi- tiveness, and made it clear that only solid structural reforms will consolidate stabil- ity, reactivate the economy, strengthen the financial system, and combat poverty efficiently in the medium term. It is no secret that in 1999 Ecuador's economy was in such a bad state that a suc- cessful dollarization process seemed unlikely. The country had a high fiscal deficit, an unsustainable external debt on which the country had defaulted, exports that depended excessively on oil and were highly vulnerable to unfavorable terms-of- trade shocks, and a banking system in crisis affected by high regional capital flight, which had brought international reserves down to their lowest level. Obviously, this dark landscape was inhospitable for attracting investment. The combination of poor competitiveness and rigid factors markets for the production of services and non- tradable goods (labor and property), made price adjustments that were required to preserve external competitiveness after losing the exchange rate instrument more dif- ficult. Despite all this, and within a short time, Ecuador met two goals through dol- larization: the elimination of hyperinflation and the reestablishment of confidence in the banking system. At the same time the Law of Economic Transformation established minimum conditions and the structural reforms needed to ensure that dollarization was sustainable in the medium term. Ecuador has begun an economic recovery with stability. Economic growth has reached moderate levels (3.6 percent average during 2000-02) and inflation slowly came down to single-digit levels by the end of 2002, after remaining high since 1998. Both of these results are due to a favorable external environment, the recov- ery of the financial system, the reactivation of domestic demand, and the dynamics of relative prices. The favorable external environment has been characterized by high oil prices, low international interest rates, and significant remittance flows from Ecuadorans living abroad. The financial system has seen a marked recovery of bank- ing deposits and a slight drop in nominal interest rates. The increase in domestic demand is due to the sharp drop in inflation, high oil prices, growing remittances, XA ECUADOR: AN ECONOMIC AND SOCiAL AGENDA IN THE NEW MILLENNIUM and the decision by authorities to approve the construction of a new Heavy Crude Oil Pipeline (OCP), which has attracted new foreign investment flows. The adjust- ment of prices has been determined by international inflation, the later adjustment of prices that comes with the postdollarization dynamic, the maintenance of gov- ernment prices for products in the basic food basket, and the expansion of domes- tic demand resulting from the increase in the nominal minimum and average wages in dollars, which practically doubled between April 2000 and October 2002. The economic recovery, combined with emigration and the ensuing remittances, has contributed to the drop in levels of open unemployment and poverty, although these have not returned to precrisis levels. Despite this progress, significant internal and external imbalances still exist. Inter- nally, while current public sector revenue has improved, primary spending remains expansive. Consequently the primary surplus achieved during the year of dollariza- tion has been cut in half Externally, an appreciated real exchange rate and the tem- porary rise of imports related to construction of the new oil pipeline have provoked a strong deficit in the current account of the balance of payments. However, this deficit has been partly mitigated by family remittances from abroad and has been partly compensated for by positive foreign investment flows in capital accounts. As a result, the level of freely available international reserves is still very low (to prevent contingencies), with a tendency to decline, which should be reversed. The structural reforms that should accompany the dollarization process are either absent or inconclusive. Fiscal adjustment is among the inconclusive reforms, as is the strengthening of the financial system, while the promotion of private investment in the petroleum sector is glaringly absent. Other reforms that have not been carried out include trade reform, the promotion of competitiveness, and private participation in basic infrastructure. For their part, the structural reforms that should have accompanied dollarization remain incomplete or nonex- istent. Notable among the incomplete reforms are fiscal adjustment and reforms relating to the strengthening of the financial system. Notable among the nonex- istent reforms are reforms to promote private investments in the petroleum sec- tion, trade reform, reforms to promote competitiveness and private participation in basic infrastructure. The likelihood of the collapse of dollarization in the medium term should not be underestimated. To avoid it, Ecuador must move ahead quickly not only on the fis- cal front but also with the structural reforms needed to counteract the rigidity involved in the unilateral decision to adopt the dollar as legal currency for circula- tion, savings, and payments for domestic goods and services transactions. In view of the loss of control over monetary and exchange-rate policy, and of the inability to "inflate" fiscal imbalances and alter relative prices by depreciating the domestic cur- rency, in order to sustain dollarization Ecuador must simultaneously ensure macro- economic stability through solvency and fiscal stability and introduce flexibility in goods and services markets-particularly for inputs. This course of action would maintain the competitiveness of the country's products on domestic and foreign SYNTHESIS xli markets, while at the same time increasing the individual (and total) productivity of the factors of production. From a macroeconomic perspective, given the initial situation of high public debt (60 percent of GDP in 2002), Ecuador must achieve and maintain significant primary fiscal surpluses tfhat will allow it to lead its stock of debt along a sustainable path-that is, by ensuring short-term liquidity and guaranteeing the country's sol- vency for promptly meeting its public debt service obligations in the medium term. This means making adjustments in order to obtain primary surpluses in the fiscal accounts estimated at an average of 4 to 5 percent of GDP over the next five years, which would bring the stock of debt below 40 percent of GDP at the middle of the decade. The fiscal adjustment must take into account the volatility of tax revenues as a result of the variability in petroleum prices. To offset it, particularly during a foreseeable scenario of future price reductions, it will be necessary to apply auto- matic stabilizers and make more efficient use of the extraordinary resources obtained during the current petroleum boom period. From a microeconomic perspective, and in the absence of control over exchange- rate policy, there is a limited range of instruments available to respond to adverse external shocks or to correct public policy errors in the economy's real sector. Should high rigidity continue in the operations of markets and prices in Ecuador, with high costs not only for production but for goods and services transactions as well, there will be negative effects on competitiveness, economic growth, and job creation, which could also make dollarization unsustainable. The risk lies in the fact that, given the existence of inflexible markets-such as the formal labor market-adjustments to shocks will occur primarily through reductions in amounts produced (and sold), with the corresponding contraction in demand based on inputs, particularly in labor (an abundant factor in Ecuador). This potential situation would not only create pressure to "abandon" the model, in view of increased unemployment, but would also con- tribute to an increase in commercial banks arrears, as a result of the decline in gen- eral economic activity. This would in turn make achieving both fiscal adjustment goals and recovery of the banking system less feasible-creating a vicious circle that would be difficult to break. Two external shocks require particular attention: first, devaluations or depreciations (discrete or continuous) of the currencies of Ecuador's trade partners; and second, appreciation of the dollar against other "strong" curren- cies in the world. In both cases, the "appreciation" of the dollar will have to be offset by increases in productivity and/or by deflationary adjustments in production and transaction costs so as to be able to maintain competitiveness and avoid the loss of markets. In summary, the sine qua non conditions for sustaining dollarization are to achieve and deepen fiscal solvency, expand and introduce flexibility in goods and services markets, and increase the productivity of the factors of production. The Need for Adjustment and Fiscal Discipline Postdollarization fiscal performance has not resolved the main obstacles to sustain- ability in the medium term. On the one hand, the average primary surplus of the xlii ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEw MILLENNIUM Non-Financial Public Sector (NFPS) has been significant but decreasing-it is pro- jected to fall by more than half, from 7.7 percent in 2000 to 4.0 percent in 2002. On the other hand, it has had to cover high interest payments on public debt, leav- ing the authorities with a meager fiscal surplus (close to zero in 2002). The primary surpluses could have been higher if not for the expansive spending on salaries and investment. The lesson is clear: there is no point to saving on debt service through successful renegotiations if these savings are consumed by increases in public spending. Fiscal fragility is rooted in the inherent weaknesses of fiscal revenue and tax pol- icy-rigidity, low quality, and the lack of transparency in spending-and in the per- sistent threat of loss of liquidity and insolvency of public debt. These problems were identified during the approval process of a fiscal law at the end of 2002-the Law of Responsibility, Stabilization, and Fiscal Transparency. An analysis of each of these fiscal problems follows, taking into account the law's content and possible solutions that go beyond mere legal compliance. Tax Reform Fiscal revenue is characterized by the low level of tax collection on non-petroleum- related tax income, which is a consequence of the low Value-Added Tax (IVA) and the excessive number of exemptions, particularly on the Income Tax (ISR), and the high volatility of oil income, which gives fiscal income a procyclical nature. Each dollar drop in the price of a barrel of oil means an income reduction of .4 percent of GDP. Tax policy is highly subject to the different demands of special interest groups, and this is reflected in the excessive use of tax distortions such as the prolif- eration of taxes, exemptions, and earmarking. The proliferation of taxes (more than 80) has a negative impact on tax efficiency because it makes it impossible for officials in power to focus on the taxes that are a priority. The multiple exemptions are part of the inefficient goal of trying to "fine- tune" tax policy. Because of this policy, authorities meticulously choose the sector that should pay benefits to be received by other chosen beneficiaries, robbing the process of transparency, as well as equity and efficiency when assigning resources. Failure is particularly acute in terms of meeting redistributive goals in the case of the IVA, and authorities are also inefficient in promoting socially profitable processes in the case of income tax exemptions or exemptions on customs tariffs. Finally, the excessive preallocations or earmarking (over 50) impedes more efficient use of fiscal resources (1.7 percent of the GDP) and also discourages tax collection efforts on the part of sectional governments (provincial or municipal), as they become accustomed to the bad habit of receiving transferences from the central government. Strengthening of the fiscal position requires various types of tax policy actions. First, we propose increasing non-petroleum-related tax collection by a minimum of 2.5 percent of GDP. This is the amount stipulated in the fiscal law to guarantee a primary surplus that will lower the debt to sustainable levels in the medium term. SYNTHESIS xliii To meet this goal it will be necessary to first approve a series of tax policy measures that will generate approximately 1.4 percent of GDP. One of the most important is to limit sales tax exemptions solely to basic unprocessed foodstuffs. This will allow the cancellation of all other exemptions, particularly on income tax and customs tar- iffs, with a collections effect estimated at 1.1 percent of the GDP. Second, given that the proposed increase in collection is still not enough to ensure a minimal primary surplus, particularly when faced with the perspective of a highly probable drop in oil prices to "normal" historic levels of below $US18 a bar- rel, we also recommend increasing the sales tax. It is estimated that collections would increase by .7 percent of GDP for each additional point that the tax is raised. Third, we propose the repeal of minor taxes. Even if this does not have a signif- icant impact on collections efforts, it will allow tax authorities and contributors to reduce administrative costs and focus on better compliance with sales and income taxes. Fourth, we recommend eliminating all preallocations of sales and income tax for reasons that extend beyond tax collection, with the exception of the payroll tax ear- marked for the Ecuadoran Institute of Social Security. This could be carried out in accordance with Article 22 of the original draft of the fiscal law. Fifth, it would be very beneficial to reverse or prevent the approval of measures of "relaxed tax collection" proposed at the end of 2002, including the donation of 25 percent of income tax to municipalities, the reduction of the percentage of reten- tion in the sales tax source from 1 percent to .1 percent, and the reduction to zero of the tariff on 158 products. The internal tax administration has shown a positive change in orientation in recent years, with tangible results. After reforms in the Service of Internal Income (Ecuador's Internal Revenue Service, SRI, which stands for Servicio de Rentas Inter- nas in Spanish) and the Ecuadoran Customs Corporation (CAE), there has been a notable improvement in the control of evasion in the SRI, although there has not been evidence of significant improvement in the CAE. The SRI's institutional design and the CAE's low performance are both priority matters for tax administra- tion. Any strengthening of the fiscal position will also require tax administration measures such as the following: * Reinforcing the independence of the SRI's directorate, thus preventing the use of its resolutions to introduce new discriminatory tax treatments and genera- tors of distortions, and concentrating its efforts solely on the rigorous collec- tion of taxes created by the laws. * Considering merging the SRI with the CAE, to take advantage of economies of scales and oversee the collection of customs tariffs within the same universe of contributors. * Reforming the Customs Law, incorporating modifications on the customs labor code that will permit a restructuring similar to the one that had positive results in the SRI. xliv ECUADOR: AN ECONOMIC AND SOCIAL AC/ENDA IN THE NEW MILLENNIUM Promoting strict compliance with Law 41 of 1999, with official backing at the highest possible level to apply this control mechanism on contraband and the evasion of sales tax, without exceptions or discretion. Spending Cuts, Reorientation, and Transparency There are three fundamental problems with public spending: it is inflexible (partic- ularly spending on salaries), it is fragmented, and it is not transparent. Inflexibility is an obstacle to containing spending. Fragmentation means spending cannot be efficiently allocated to meet government priorities. And lack of transparency pre- vents adequate control and public auditing, and converts it into an involuntary stimulus for tax evasion. These three problems have reached alarming levels in Ecuador. The rigidity of spending, particularly current accounts, is very severe. For over a decade, primary spending has increased up to around 21.4 percent of GDP This inflexibility is mainly due to the inertia of the public payroll, and excessive income earmarking- oil-related and non-oil-related-written into over 50 current legal regulations. Fragmentation is due to preallocated revenues in 217 sectional (subnational) gov- ernments and multiple objectives mandated by special laws. In 2001, budgetary pre- allocations corresponded to approximately 30 percent of the total of current income, or about 6 percent of GDP. This fragmentation and rigidity of spending leaves meager freely-available resources. If the public payroll is deducted from the total current accounts income (30 percent), from service on the net debt (35 percent), and from preallocations (30 percent), the amount left over is barely 5 percent of the total current accounts income, or the equivalent of 1.2 percent of GDP as of 2001. This tiny percentage of domestic resources reflects serious cash flow problems and means the government cannot formulate a minimum budget for poverty reduction without affecting other programs. Finally, this spending is not transparent because (a) there is no centralized public payroll; (b) controls on preallocated spending are absent; (c) central budget- ary standards are weak, which also fosters decentralized execution without adequate control mechanisms; and (d) there is no integrated system of financial administra- tion that allows control of consolidated spending, not only of the central govern- ment, but also of decentralized entities and sectional governments. There are various elements to spending reform. First, the 2003 budget should be declared a "national emergency" budget, with concrete measures to limit spending and confront the causes of rigidity. To do this the following is proposed: (a) the lim- iting of spending growth to zero in real terms in 2003, implying the establishment of limits on the salary mass, on goods and services, and on investments; (b) the immediate suspension of the salary-indexing mechanism based on projected infla- tion (and not yet carried out) by the National Council for Public Sector Remuner- ation (CONAREM); (c) the approval of a Salary Unification Law with a neutral fis- cal cost; and (d) the repurchase of the most expensive debt in Global Bonds. SYNTHESIS xlv Second, fragmented spending should be consolidated and reoriented toward pri- orities. For this reason it is necessary to explicitly prohibit any new preallocations of income or spending and eliminate nearly all existing preallocations (with the excep- tion of the Ecuadoran Social Security Institute [IESS]). Within the framework of a new decentralization policy, and during the period covering the emergency budget, additional transferences of over 10 to 11 percent assigned to sectional governments should be frozen, with the preparations of a future simultaneous transference of resources and additional competencies, auditing of the subnational debt and the Reprogramming Plan, and new regulations for subnational debt of large cities. Third, budgetary transparency should be institutionalized at all levels of govern- ment by using modern instruments. Once the law is approved, the design and implementation of a modern and consolidated version of the Integrated Govern- mental System of Financial Statistics (SIGEF) is urgently needed. This entity covers sectional governments. Sustainability of Public Debt Ecuador's public debt has been poorly managed for several decades and as a result, the current level of public debt is very high. As a percentage of GDP, it is the sec- ond highest in the region. At the same time it carries a heavy debt load: net service consumes 35 percent of the budget. About 80 percent of Ecuador's total debt is external. The debt has three characteristics that somewhat alleviate the situation: 60 percent of the debt is multilateral and bilateral; only 1.4 percent is short-term debt; and after the restructuring of the onerous external debt in 2000 Brady bonds, 75 percent of the debt was set at a fixed rate, reducing the volatility of debt service. The liquidity situation of Ecuador's public external debt is delicate. The coun- try has immediate problems to resolve over arrears with the Paris Club, estimated at approximately $US 181 million in 2002, and a programmed debt service amount of 8.1 percent of GDP (4.7 percent in amortizations and 3.4 percent of GDP in interest) for 2003 and 2004. To bring the debt to sustainable levels in the medium term, Ecuador will need primary surpluses of 5 percent of GDP. To close the finan- cial gap in the next two years, Ecuador will require additional resources of about 4 percent of GDP. In addition, compared to other deeply indebted Latin American countries, Ecuador has limited administrative institutional capacity to manage their debt: it is strictly operative and not analytical, lacks transparency, and is frag- mented and suffers from a lack of coordination between the Finance Ministry and the Central Bank. Ecuador should develop a debt reduction strategy at the same time as it strength- ens its institutional capacity. This will entail, first, ensuring a financing plan for 2003 and 2004, based on the following: a solid macroeconomic plan with credibil- ity that permits capture of additional resources from multilateral agencies that can be quickly disbursed, a reprogramming of payments with bilateral creditors, and a repurchase of onerous debt held with private creditors. This reprogramming should Xlvi ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM include the goal of eliminating all arrears in 2003. Second, this program should require that the fiscal efforts mentioned above achieve a primary surplus of at least 5 percent of GDP. Third, debt management should be transparent, with regular publication of commitments and payments on debt service, including floating debt as stipulated in the fiscal law. Fourth, Ecuador should strengthen institutional sup- port for debt management with the designation of a highly specialized team with adequate technical assistance. The Competitiveness Agenda Despite dollarization, both competitiveness abroad and the investment climate at home still do not look very promising. Nearly all global indicators show indis- putable and consistent evidence that the competitiveness gaps are significant and growing. Ecuador ranked 54th out of 62 countries evaluated in terms of global com- petitiveness during the World Economic Forum in 2001. In 2002, Ecuador's rank- ing deteriorated even further when it was classified as 73rd among 80 countries, with the highest relative percentage for innovation and the lowest in terms of busi- ness climate, and respect for countries and for laws. The implementation of a competitiveness agenda is critical to the sustainability of the dollarization process in the medium term. In consultation with the private sector, the Central Bank and Ministry of Foreign Trade have proposed Agendas for Competitiveness. However, these agendas lack priorities and a consensus on sequencing, which calls into question the realism of the measures proposed and the difficulties of implementing them. This is why one of the first steps of the new administration should be to design a simplified agenda of policies and laws that arc critical to strengthening competitiveness. This agenda should begin with the revi- sion of the Law of Competitiveness. The agenda should also include support meas- ures to strengthen both the financial system and the petroleum industry, reform commercial policy, develop basic infrastructure, promote internal competition among firms, and eliminate both market entry-level barriers for new enterprises and rigidity of labor markets. Strengthening the Financial System The Ecuadoran financial system has been gradually recovering from the grave twin banking and exchange rate crises of 1998-99, and has been adapting to changes caused by the dollarization of the economy at the onset of 2000. The banking crisis drastically reduced the number of active financial institutions. Meanwhile, dollar- ization and related institutional changes-particularly those caused by the formal absence of an emergency lender-encouraged surviving institutions to favor hold- ing assets and liabilities with the most liquidity in their balances, and promoting a greater concentration of banking. We are just beginning to see the end of the most dramatic part of the restructuring postcrisis process, thanks to the adoption of a new regulatory framework and more efficient supervision. SYNTHESIS xlvii The structure and responsibilities of the supervising authorities have also changed. The banking restructuring process has been a test by fire for the entity charged with guaranteeing deposits (the Agency to Guarantee Deposits, AGD, also known as the Deposit Guarantee Agency-Agencia de Garantia de Depdsitos in Span- ish), and for the Superintendency of Banks and Insurance (SBS). On top of that, dollarization has modified the role of the Central Bank of Ecuador (BCE). In effect, because of the lack of monetary policy within a dollarization scheme, the BCE today focuses on liquidity management of the financial system, both to ensure proper functioning of payment mechanisms and to provide liquidity under similar condi- tions as an emergency lender. In summary, there are important institutional and operational challenges that are blocking a definitive resolution to the crisis in the financial system. Some of the most pressing problems within the credit portfolio are that there is a high concen- tration of large loans in the unproductive portfolio and these are frequently awarded to related parties; the insurance coverage on deposits for many banks in the process of dissolution is too high and distorts the incentives of borrowers, increasing the "nonpayment culture"; portfolio quality has greatly deteriorated and credit contin- ues to contract (the credit portfolio as a percentage of GDP is still half of what it was at precrisis levels); and the cost of credit is higher and small borrowers have access to lower amounts of credit. Another problem is that bank levels of liquid assets are high, which is justified in large part by the contraction of credit mentioned above. The impossibility of cushioning against external shocks through exchange policies, together with the Lack of a lender of last resort, means that these assets are needed so that banks can absorb the terms-of-trade or international interest-rate shocks. This means a considerable additional financial cost. Finally, other relevant problems include the following: the interbanking payment system is still ineffective, the SBS's supervision of the quality of banking assets is also deficient, the role of the SBS and the AGD in the process of resolution and banking liquidation is too weak, and the balance established by public banks in their dual commercial and social function is inappropriate and works against their financial profitability. In response to these challenges, banking credit activities need to be improved. First, we propose more efficient management of banking liquidity through central- ized management. The BCE is a natural candidate for this central role given its cur- rent responsibility in the payment system. Second, the payment system needs to be reformed. The sequence of steps required for this reform should be codified in a public document, and a single net compensation system for checking transactions should be defined. Third, it is vital for the SBS to continue to improve its procedures, particularly those related to the evaluation of credit risk and portfolio supply rules. In addition, it is important to consider the possibility of formulating procyclical provisions as Spain has done, since the Ecuadoran economy is extremely exposed to oil price cycles. It is also very important that SBS authorities be protected legally as they carry out their duties, and to make the legal changes that will allow them to improve pro- xlviii ECUADOR: AN ECONOMIC AND SOCIAL AcFNDA IN THE NEw MILLENNIUM cedures for bank resolution and liquidation. At the same time, the SBS accounting system should be strengthened. Finally, there must be total compliance with inter- national laws governing money laundering (that is, coordinated efforts with related authorities) to increase confidence in the system, ensuring that the SBS can take legal action within a fully integrated legal system. Fourth, we propose a normalization of exit mechanisms for banks. The formal- ization of the roles of the SBS and the AGD in the bank resolution and liquidation process should be strengthened, and the AGD functions revised. The alternative of converting them into a "pay box" should be considered. And fifth, we propose a reform of existing public banks (particularly first-tier banks), limiting their activity to targeted areas where subsidies, if needed, are transparent and minimal. The Oil Sector The strength of the oil sector is the main factor that determines the growth of the Ecuadoran economy, but it suffers from very serious distortions. The solution requires important actions that in turn depend on a large dose of political will. Some of the main problems in this sector are as follows: • Lack ofjudicial andfiscal stability. Perhaps the most recent example is the elim- ination in August 2001 of the right to reimbursemcnt of the IVA, which oil companies have been receiving for their exports. The previous administration was not sufficiently diligent in finding a solution to this problem, which seri- ously affects investments in the short and medium term. Without a quick solution, the IVA problem will reduce the fiscal impact hoped for when the new heavy crude oil pipeline (OCP) becomes operative. o Low production offields with the greatest reserves and a low level of exploratory activity. The level of investment in the exploration and development of this sector does not match its potential. Important oil reserves have been found, particularly in fields operated by PetroEcuador, and with new transport capa- bilities these could be put into production. The new investments should help resolve significant environmental liabilities, and work within programs and projects that respect the consultation rights of local populations. Their bene- fits should also be subject to a new framework of income distribution. o Numerous distortions in the prices and taxes of combustiblefuels. This is reflected in the prices and subsidies for natural gas (GLP). The management of oil income is totally incompetent, and this provokes distortions and promotes a fragmented and unproductive use lacking in transparency. The legal and insti- tutional framework of the sector is outdated. PetroEcuador's monopoly does not allow nondiscriminatory treatment that would provide access to mar- kets-treatment necessary to attract foreign investment and modernize refineries, improve product quality, and reduce the current elevated costs of commercialization and marketing. SYNTHESIS xlix The following measures are proposed. First, there should be an immediate solu- tion to the IVA problem, adopting international arbitration or another procedure to resolve this conflict as quickly as possible. Second, PetroEcuador's oil fields should increase production. The Law of Hydro- carbons contains several legal provisions that could be applied so that private enter- prise can participate with PetroEcuador in oil activities. One possible framework is the formation of mixed-ownership corporations. A private investing partner for the Petroproduccidn enterprise could be found through an international bidding process. Third, oil reserves should be increased. This will require the adoption of a new contract model; the recommendation here is to use the participation model. Fourth, prior legislation should be complemented by a new legal and institu- tional framework that suppresses PetroEcuador's monopoly, favors competition, and provides incentives to invest in refineries and new distribution and marketing instal- lations. A new legal framework should include provisions to rationalize responsibil- ities and ensure better management of the environmental and social impact of oil operations. Fifth, the elimination of distortions in pricing policies is proposed to provide greater fiscal income, eliminate contraband, and eliminate the government's need to perform the onerous task of managing the price of combustible fuels. At the same time a targeted GLP subsidy should be established to compensate the poorest in the country. The proposed bono gas-cash payments to be given to families that cur- rently receive the Bono Solidario (cash transfer)-is a good option, and can be improved upon. Sixth, the system of preallocations of oil income should be revised and made more transparent, with the final identification of funds and accounting done as needed. In the amendment to the fiscal regulations proposed above, the government should establish new rules for oil income, promoting the gradual elimination of ear- marking and promoting the optimal use of oil income. The government should cre- ate a permanent virtual database for income management that is universally accessi- ble, in order to guarantee complete transparency. And seventh, legal dispositions should be established to eliminate extrabudgetary spending in the oil sector and prohibit public indebtedness based on projected crude oil sales. Commercial Reform Commercial reform is fundamental to promoting nontraditional exports. While it is true that oil exports will continue to be the main engine of growth in Ecuador for the present decade, with the extension of extraction and oil export through the com- ing OCP, the diminishing role of oil and its replacement by nontraditional exports can be foreseen to occur in less than two decades. Unfortunately, a strong anti- export bias is blocking the development of nontraditional exports. This bias is not new and should not be erroneously attributed to dollarization, but rather has been I ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN TIIE NEW MILLENNIUM generated by the discriminatory support given to certain nonproductive sectors that have been favored by an import substitution policy based on high tariffs and other nontariff barriers. This situation is preventing these sectors from modernizing and competing based on profitability. The combination of Ecuadoran tariff levels and tariff dispersion comprises such a wide and diverse range of effective protection rates that they escape government control. Tariff structure totally lacks rationality, desir- able in an efficient import substitution policy. The generalized Ecuadoran custom of protecting "final goods" with a higher tar- iff than that established for inputs, raw materials, and capital goods used in direct and indirect production, generates effective protection rates (the true protection of the aggregated value of final goods) that are unjustifiably high and vary among prod- ucts. These rates benefit the sectors with the most efficient lobbies in terms of gain- ing the desired protection, but are not necessarily the most beneficial to the coun- try's consumers. In addition, the tariff protection provided to many agricultural, agroindustrial products and derivatives, through a "Price Band System" that favors 138 different products, does not function efficiently. Very few bands comply with the goal of reducing price volatility, and if they comply with it, they cannot do it simultaneously with two other objectives of the bands-defending producers and consumers against the price distortions prevailing in international markets, and link- ing domestic prices with international prices. The Bands System used constitutes an ad valorem variable rate that lacks transparency, and has an upward bias that severely punishes Ecuadoran consumers, particularly the poorest. It has not slowed the ten- dency of prices to increase in the medium term. The anti-export bias is reinforced by the discriminatory application of nontariff barriers such as prohibitions, licenses, technical norms, customs procedures, cus- toms evaluations, norms on origin, safeguard measures, and public purchases. The import licenses are one of the most notable nontariff barriers. They arc distributed in a nontransparent manner through a tortuous and fraudulent process. They are still applied to more than 20 percent of Ecuadoran imports, and are concentrated in the health and agricultural sectors. The majority of these licenses contradict the norms of the World Trade Organization (WTO). The lack of a national procedure for the application of technical norms is particularly insidious because an additional protectionist measure is added by not applying these norms to domestic products similar to the imported products. Several measures are recommended to solve these problems. First, the customs tariff should be simplified to two rates of 5 and 10 percent. To the extent to which these efforts are successful and the 0 percent rate is eliminated, the fiscal impact would be neutral. The recent Latin American tendency is toward this type of struc- ture and level. The measure would also have the advantage of homogenizing the effective protection rates, and would signify a huge step toward compliance with the future demands of the Free Trade Agreement of the Americas (FTAA). Second, prior authorizations that did not register commercial activity from 1991 through 2000 (or 919 tariffs) and prior authorizations with a specific prerequisite SYNTHESIS li (health and phytosanitary, among others) should be immediately eliminated. A sin- gle license is sufficient. Those remaining that require prior authorization should be submitted for technical analysis to justify remaining on the list of applicable licenses. If they do not pass this test, they should be eliminated from the legally mandated list. Third, the number of bands should be drastically reduced, and they should be submitted to markers for an eligibility test applied to imports, and sensitive to the volatility of external prices. In the medium term, given that these bands are incom- patible with WTO and FTAA norms, they should be eliminated. Fourth, an increase in the productivity of the agricultural sector, especially the sector with export potential, should become a focus of permanent public effort, through technology development and transfer, particularly for small and medium producers. Fifth, 759 existing obligatory technical standards should be evaluated to decide on their future. At the same time, the "deregulation or dismantling" process of oblig- atory norms should be carried out in a parallel manner with the "regulation or set- ting up" of the "WTO Regulation" system, information on which is found in the pertinent WTO legal documents. At the same time, laboratories should approve the test for ISO norm 17025. Sixth, the draft of the Law of Competitiveness should be approved with minor modifications to accelerate the process, and supported with reinforced efficiency of customs controls and reduced corruption. Development of Basic Infrastructure The development of physical infrastructure represents another fundamental chal- lenge for Ecuador because of its direct impact on growth, poverty levels, and the quality of life for the most vulnerable population. Four sectors require urgent atten- tion: water and sanitation, electricity, telecommunications, and transport (highways and roads, railways, ports, and airports). The sectors of water and sanitation, electricity, telecommunications, and trans- port confront problems such as low coverage (particularly in rural areas), efficiency and quality of services, an uncertain mobilization of resources for new investments and, with the exception of the electricity sector, incomplete institutional and regu- latory frameworks. In general terms, the national government should address these challenges by seeking greater local, national, and international private sector partic- ipation, by consolidating institutional and legal arrangements. Above all, in the water and sanitation sectors and transport, the government should use central trans- ferences of resources to encourage service providers to improve service and increase coverage. In addition to these problems, the water and sanitation sector is characterized by low recovery of costs through charges, a high dependency on transferences from the central government to cover the deficit, and the lack of an integral national system of water resources. Given that all water and sanitation services comes from decen- lii ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM tralized providers that depend on municipal governments, the central government has two main instruments for improving the quality and efficiency of services and ensuring their extension to rural and urban populations that do not yet have cover- age: reforming the use of central transferences to provide incentives for profitability among service providers, and perfecting the legal and institutional framework. The most urgent problems of the electricity sector also include inefficiency that is attributable to an incomplete reform process, institutional vulnerability, the uncertain sustainability of the wholesale electricity market, the rate readjustments needed to ensure the financial sustainability of this sector, and incomplete implementation of sectoral environmental policy. To confront these challenges it is imperative to reacti- vate the participation of the private sector in distribution and generation; moderate or eliminate state interference in the regulatory entity Companla EkIctrica del Ecuador (CONELEC); normalize the wholesale electricity market's financial situation; reiniti- ate the adjustment of rates with the appropriate "lifeline"-type protection for poorer households; confront the problem of the Empresa Elictrica del Ecuador (EMELEC) enterprise; develop a strategy for rural energy-, and consolidate planning and sectoral environmental management systems, particularly in the Ministry of Energy and Min- ing and in CONELEC. In addition to the general problems of national infrastructure, the telecommuni- cations sector faces specific challenges induding artificially low, unsustainable local rates for fixed telephone service; lack of competition in the cellular telephone mar- ket, leading to user costs that are among the highest in the region; and very limited Internet access. It is essential for the government to consolidate the institutional and legal framework and encourage greater private sector participation, attracting private capital to Andinatel and Pacifitel in order for them to make the investments the sec- tor requires and to break up the duopoly in the cellular market. The challenges in the transport sector include the poor condition of the highway network, the poor condition of local roads and the lack of transit services to rural areas, environmental problems, incoherent and insufficient sectoral and modal plan- ning, and insufficient capacity and resources available to sectional governments to maintain provincial and local highways in the context of the decentralization process. The national government must contract maintenance services on the basis of results and promote private sector participation through microenterprises to maintain and pave rural roads, foster the creation of mixed ownership cooperatives for rural trans- port, award prizes for the best performance by sectional governments, improve envi- ronmental management in each sector, and transform the Ministry of Public Works into a new Ministry of Transport with regulatory and planning functions. Urban Development The "urbanization" of poverty has brought with it the "marginalization' of the cities, especially the large and medium-size ones. The percentages of population living in slums in Quito (30 percent) and Guayaquil (60 percent) are significandy higher than those found in other Latin American cities of a similar size. The situation in SYNTHESIS liii certain medium-size cities in the Sierra is also of concern. This has obvious implica- tions for the proliferation of social problems, crime, and violence. Living conditions in marginal areas are extremely precarious: houses are made of impermanent materials and sometimes even of items scavenged from trash; families live in overcrowded conditions with several persons sleeping in a single room and several families living in each dwelling, in many cases with no sewage hookup or running water. Statistics show that these conditions are most severe in the Sierra. The great number of recent natural disasters in both Quito and in Guayaquil makes living conditions even more precarious for the poor. The formal housing market has problems of both supply and demand. On the one hand, the poorest population does not have sufficient income to live in accept- able housing, while on the other hand, the prices of developed land are inflated because of urban planning regulations and deficient market conditions. While land partially prepared for development may cost between $50 and $60 per square meter, completely undeveloped land in marginal areas costs $4 per square meter, the only price accessible to the poorest population. The Housing Incentives System (SIV), created in 2000 to improve this situation, provides direct subsidies on demand, but has managed to benefit only the richest 40 percent of the population. An urban development policy should consider several factors. First, a compre- hensive urban improvement program should be designed and implemented based on current and foreseeable quantitative and qualitative deficiencies in housing. This program should be national in scope, and have the fundamental goal of improving living conditions in marginal areas and reducing the physical, economic, and social vulnerability of the people living in these areas. It should be implemented by the municipalities, thus promoting a high degree of community participation. Second, the workings of urban land markets in the big cities must be reviewed to determine the obstacles hampering the availability of serviced land to the poorest population. Third, a system for preventing disasters must be designed and implemented at the national, municipal, and neighborhood levels. Such a system must be based on geo- referenced information systems, risk maps, technical training, public education, and institutional mechanisms that enable the integration of the different agencies that make up "the system." Fourth, it is advisable to examine the distribution of respon- sibilities for providing urban services, in order to locate and remove bottlenecks, redefine responsibilities among the different state agencies, and boost the capacity of municipal governments to understand, analyze, and reduce urban poverty. Boosting Sustained and Equitable Social Development High rural-to-urban migration, natural urban growth, and the country's deteriorat- ing macroeconomic situation in the 1990s have led to increased urban poverty in Ecuador. Whereas in 1995, 19 percent of urban dwellers were poor, in 1999 this fig- ure had jumped to 42 percent-more than double. It is clear that poverty is no longer only rural, and in fact is becoming increasingly urban in Ecuador: 33 percent liv ECuADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NFW MILLENNIUM of the country's poor lived in cities in 1995, while the 1999 figure was 48 percent, which means that almost half the poverty in the country was in urban areas. At the same time, social spending has declined. During the 1990s, there was a significant reduction in spending on education and health. Education spending dropped from 6 percent of GDP in the 1980s to 2.7 percent in 2000, and health expenditures dropped to 1.7 percent, far below the 2.8 percent spent in 1990. Meanwhile, spending on social protection has risen to 1.5 percent of GDP in recent years (not including the hydrocarbons subsidy). The health and education sectors share similar problems in terms of poor cover- age and low-quality services, especially for poor and indigenous people in the urban periphery and rural areas. There are no anticyclical social programs in Ecuador, despite the country's having an oil-based economy subject to great fluctuations in international prices. The main social protection program is the Bono Solidario and various food assistance programs. The social security system is the traditional "pay-as-you-go" type, combining pensions and health care. It maintains a financial surplus thanks to a young, formal labor force, payment of low benefits, poor coverage, and low-quality health services. This surplus has attracted the interest of several actors, especially the national gov- ernment, which has deposited a large part of its reserves here, and private groups that have demanded the creation of social programs that have not been very well focused, such as the Seguro Social Campesino (Rural People's Social Security Pro- gram, SSC), a noncontributory fund for pensions and health services to benefit rural groups in selected areas of the country. Education Despite the great advances in primary coverage at the national level, major chal- lenges remain in the area of education: 11 percent of the population over age 15 is illiterate, and the net rate of primary school attendance is close to 90 percent. This drops to 51 percent in secondary school and 14 percent in higher education, There are great differences in coverage between rural and urban areas and between indige- nous and nonindigenous populations. The system is unbalanced at all levels: the poor and indigenous school-age population is at a great disadvantage compared to the rest of the population, and basic, diversified, and university education are aimed mainly at the urban population with above-average income. The quality of basic education is quite low. Results of academic achievement test- ing (APRENDO) show deficiencies in the quality of teaching at the basic level. This involves factors related to the educational establishment, teachers, and the socioeco- nomic conditions in which students live. Limited access of students and teachers to scholastic materials affects student results. Nearly a third of primary schools have only one teacher, who in most cases has not been trained in multigrade methodology. As a result of the severe reductions in public spending, the necessary investments have not been made in the education sector, the maintenance of infrastructure is minimal, teaching supplies provided are insufficient, and teacher salaries have been SYNTHESIS IV reduced. Spending on education is very poorly balanced: the fifth quintile of the population with the lowest income receives 12 percent of public spending, while the fifth quintile with the highest income receives 25 percent. The sector has serious problems of governance and administration. The system is characterized by high turnover of top-level authorities; the Ministry of Education and Culture (MEC) has administrative units with identical functions; the administration is excessively centralized; there is little communication among the MEC, its provin- cial offices, and schools; the selection, hiring, and promotion of teachers is an opaque process; the distribution of teachers is not adequate (there are too many teachers in some areas and not enough in others); and the salary structure for teachers has no relation to the objectives of improving the quality and balance of the system. Solving these problems requires comprehensive educational reform. First, all Ecuadoran children should have access to and should complete basic education, and should have access to better-quality schooling. Programs aimed at increasing cover- age must be focused on groups that are now underserved, such as those with the low- est income levels and those living in rural and indigenous areas. The MEC must consider innovative choices of methodology, such as "tele-high school," to reach the most underprivileged groups. Second, to improve quality, the MEC must evaluate different options or strate- gies to attract new teachers on an ongoing basis, design a plan to provide the edu- cational system with at least the minimum teaching materials that are necessary, and institutionalize the APRENDO system for measuring results, while giving special attention to strengthening bilingual education in the country. Third, public spending on education must be gradually increased to 1980s lev- els-that is, 6 percent of GDP. Fourth, it is essential that the sector be better managed in order to properly allo- cate economic resources and achieve the desired results. At the same time, pilot decentralization projects must be initiated, offering greater autonomy to the educa- tional system and greater parent participation in school management. Health As in education, there are numerous coverage problems in the health sector. About 30 percent of the population still does not have access to basic health services. More than two-thirds of the population does not have formal health insurance and the Ministry of Public Health (MSP) and other public institutions are unable to provide service to almost half of these individuals-precisely those with the worst health indicators. Insufficiently attended births and lack of access to basic health care are the main factors responsible for an unbalanced epidemiological profile. A direct result of poor coverage is reflected in high infant and maternal mortal- ity rates and premature births. It is estimated that for every 100,000 births, 160 mothers die as a result of complications related to pregnancy, birth, or postnatal problems, and 4,300 children die before their first birthday. Deaths due to infec- tions and violence that particularly affect the young population are as common as Ivi ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM mortality due to cancer, and interregional differences in these indicators are so great that life expectancy in the province of Pichincha is 15 times as high as in the Ama- zon provinces. Public health spending is insufficient and private spending is unfairly distributed. Private spending represents 80 percent of all health spending, and it is the poorest people whose income is most proportionally affected by this expense (up to 40 per- cent of their income). Reform of the health sector requires a number of actions. First, we propose that the Law on Free Maternity Care (LMG) be strengthened and broadened. A model must be established that avoids duplication of coverage and promotes the broaden- ing of coverage, while considering the social and cultural factors that limit the demand for basic services. Second, coverage by the SSC must be increased along with that of the LMG. The SSC's financial limitations are too great for it to be broadened to cover the remain- ing 3 million people, but the mother-child population not covered currently may benefit from the services provided under the LMG. Third, we propose that basic health services be included through the Bono Soli- dario for the retired and disabled: preventive and informational services, outpatient treatment, and hospitalization for prevailing acute illnesses, and a basic package for chronic illnesses and surgery. This would provide coverage to approximately 230,000 pensioners and 8,000 disabled persons who have no other resources for medical attention. Fourth, the essential functions of the MSP must be redefined, shifting from its role as a supplier of services to a new role as an organism accrediting establishments, monitoring the quality of services, creating a health monitoring system, and provid- ing training in order to intervene in situations of epidemiological risk, among other tasks. As part of the redefinition of the MSP's functions, service provision arrange- ments could be established with the Ecuadoran Social Security Institute (IESS). Fifth, we propose creating a regulatory framework for developing a system of regional health services networks with levels scaled according to their complexity. The MSP installations, decentralized establishments, and the SSC would all partic- ipate, and at the local level would focus their efforts on primary care and programs for providing basic services. Sixth, we propose broadening SSC coverage, possibly creating a new insurance program for the poor population, which would consolidate and progressively replace the benefits of the LMG and the provisions of the Bono Solidario. Protecting the Most Vulnerable The banking and exchange rate crises have generated new demands for social assis- tance. The most vulnerable groups facing chronic poverty have been joined by groups requiring temporary social assistance. In 2001, Ecuador planned to spend close to $264 million on 22 Priority Social Programs (PSPs), which represents about 1.5 percent of GDP, similar to the average in the countries of the region. About 60 SYN'lTHESIS Ivii percent of this amount was allocated to two programs for transferring cash: the Bono Solidario and the Beca Escolar (Educational Scholarships). The two most important programs immediately became the School Breakfast and Lunch program-$US24 million-and the Bono Solidario-$US154.5 million, in 2001. Though the subsi- dies for the consumption of natural gas and gasoline are not included among the 22 PSPs, they came to about $US500 million for 2000. This social assistance network has its problems. Its functions (and budget) are not countercyclical-that is, they do not have the ability to expand in times of crisis and contract in normal circumstances. This manifests itself in the absence of PSPs with established minimum spending levels, and in the lack of a mechanism for automat- ically updating the list of beneficiaries. The network also contains several programs with regressive spending, and lacks consistent criteria for maintaining a steady focus. This is not an exception in the area of social spending; in fact, a high percentage of spending on universal social programs ends up benefiting rhe population with higher-than-average income (for example, energy subsidies or school meals). Also, targeted programs vary in their effectiveness in reaching the lowest-income groups, and do not use consistent targeting criteria (for example, the Bono Solidario and National Child and Family Institute [INNFA] programs). Several programs cover vulnerable groups inadequately, despite their multiple interventions. Finally, the Bono Solidario has several flaws: it does not have a mechanism that enables it to include new beneficiaries; there were errors in its original focus on the target popu- lation; there is a lack of clarity in the program's objectives and benefits are insuffi- cient; and it does not generate mechanisms for ending dependence on the Bono. The lack of an evaluation of the impact of the Bono prevents a more complete overview of its performance. To improve the social assistance network, we propose the following. First, its flex- ibility must be increased. For example, the establishment of minimum budgets for certain PSPs would enable it to set up a "virtual" social assistance fund with pro- tected amounts within the budget to resist cyclical fluctuations. Second, the creation of a clearly counter-cyclical program, for example, in pub- lic works, is feasible. This should offer a sufficiently low salary to attract only very poor persons in crisis. Third, it is crucial to improve the coordination and targeting of existing pro- grams. To do so, we suggest adopting a single criterion for targeting social assistance programs. Fourth, it is necessary not only to increase, but also to redirect the Bono Solidario toward a conditioned subsidies program. The Bono should be oriented toward pro- tecting the health of children and pregnant women in poverty. Social Security The Ecuadoran social security system has problems with coverage, management, and institutional status. The coverage of the active and elderly population protected by the formal system (the Obligatory Social Insurance of the IESS) is one of the low- lviii ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THIE NEW MILLENNIUM est in the region. An overview of other noncontributory programs, such as the SSC and the Bono Solidario, reveals broader coverage, but their benefits are too small to constitute effective protection for the elderly. Another problem is the IESS's uncer- tain financial balance. The IESS counts as active a state debt corresponding to con- tributions that have not been deposited for more than a decade. The amount of this debt differs significantly depending on whether it is calculated by the IESS or by the Ministry of Economy and Finances. Furthermore, IESS reserves are not clearly sep- arated or earmarked for health, old age, disability, and death, making it possible that there are invisible cross-subsidies. Another issue is that the state is legally obligated to contribute 40 percent of pensioner benefits each year, even when the IESS pen- sion program has a surplus, thus generating unnecessary fiscal pressure. The legal status of system reform presents another problem. In November 2001, a new Social Security law sanctioned a new institutional design that was to be immediately imple- mented. However, its full application was blocked by a decision of the Constitu- tional Court, which in turn was overruled by the judicial system. As a result, the new law is only partially applicable, and the IESS has opted to apply certain aspects of it while ignoring others at its own discretion. We propose several measures to correct these deficiencies. First, the amount paid out by the SSC (and the Bono Solidario) must be corrected to levels close to 50 per- cent of the poverty line. This would mean redefining a strategy for broadening SSC coverage and noncontributory payments. Second, there must be a quick resolution of the differences between the IESS and the government regarding the government's debt to the IESS, based on clearly presented documentation. Third, we propose effectively separating the accounts and reserves of the IESS according to type of insurance. Fourth, an amendment should be made to correct the Law Reforming the Social Security to eliminate its current confusions and errors and to completely sep- arate pension and health policies. Consideration could also be given in this amend- ment to reducing the percentage contributed by the state, thus reducing fiscal pres- sure on it. This could become effective once the state has paid its pending debt with the IESS. Fifth, in the medium term, an integrated coverage model should be applied, extending coverage to segments of society now excluded, especially the poor and the elderly. Rural Development Three essential factors highlight the importance of rural development for Ecuador: (a) the economy's high dependence on natural resources, including agricultural products, hydrocarbons, and forest and mining products; (b) the concentration of poverty in predominantly rural areas; and (c) the great natural, social, and cultural wealth and diversity in the rural areas of the country. The contribution made by natural resources from four sectors (agriculture, mining, forestry, and hydrocar- bons) comes to about 40 percent of GDP. However, not enough environmental care is taken in the exploitation of these resources, nor are the resulting benefits fairly shared. The result is the accelerating degradation of soils, rivers, and coasts, SYNTHESIS lix and a great economic gap between rural and urban areas. Despite the severity of this situation, public policies dealing with rural development in Ecuador have suf- fered from a lack of coordination, excessive fragmentation by sector and central- ization, resulting in inefficient public and private investment. Many rural policies have concentrated on the agricultural sector, while little attention has been given to other areas. Therefore, a new set of policies must be established to guarantee the sustainabil- ity of natural resources, reduce rural poverty, and recognize the value of the cultural and natural wealth of the rural sector. The emphasis on agricultural production as the engine for rural development is shifting in favor of diversified production, links between the rural environment and the cities, access to markets as an engine for growth, and the development of local capacity. At the same time, centralized admin- istrative approaches are being replaced by demand-driven processes and local deci- sionmaking, in which the aim is to try to discover and incorporate antipoverty strategies proposed by the beneficiaries themselves in their own surroundings. In this context, with a view toward diversified economic growth and reduced rural poverty, a strategy of diversified, multisectoral rural development with a terri- torial approach must be designed. This strategy would have three main goals: (a) economic and social cohesion through the development of local spaces, (b) changes in agriculture and rural economic diversification, and (c) environmental protection. Ecuador's geographic, economic, and sociocultural diversity requires that this strat- egy take a variety of forms and be backed by development policies focusing on par- ticipatory action in local or rural spaces to foster economic and social cohesion; diversification of the rural economy; nonagricultural job creation through invest- ment in rural and social infrastructure and fostering a competitive agricultural sec- tor through up-to-date technology and research; and promoting environmental pro- tection through better regulation of land use, recovery of land conservation methods, and other uses of natural resources. This strategy will also require an institutional structure that facilitates the coor- dination of the different institutions involved. The institutional regulations that can guide this effort must be based on cooperation among the national public sector, the private sector, the rest of civil society, municipalities and provincial governments, and local governments; coherence among the regulations and activities of the differ- ent institutions; programming based on the strategic plans of each jurisdiction; and financial allocations based on the concept of "additionality" as incentives for guar- anteeing the implementation of strategic plans. Environment The problem of poverty in Ecuador is exacerbated by two key variables: environ- mental pollution and natural disasters. Any strategy for the country's economic growth and social development will depend on controlling the degradation of the biophysical environment and on the sustainable management of natural resources. Controlling pollution and preventing the effects of natural disasters on the popula- Ix EcuADoR: AN ECONOMIC AND SociAL AGENDA IN THE NEW MILLENNIUM tion both demand the highest priority and greatest attention on the part of envi- ronmental authorities. There are two basic ways the state can intervene to develop environmental pol- icy: environmental regulations, and environmental administration and investment. Environmental regulation includes different tools such as economic instruments, direct regulation, and administrative procedures. Environmental administration and investment include the management of state-owned assets and environmental investment in sectors that face the environmental conditions associated with poverty in Ecuador. Among the choices of tools for environmental regulation, the development and strengthening of command-and-control regulations merits special attention, partic- ularly regulations on zoning ordinances and land use, monitoring of water and air quality, management of dangerous wastes, and final disposal of solid wastes. At the international level, instruments for strategic environmental evaluation are also used to define environmental investment priorities in the various sectors. To reduce rural vulnerability to natural disasters, investment in structural and nonstructural damage prevention resources is urgently needed. Structural measures include resettlement of populations living on flood plains, public works for flood control, use of wetlands as buffers against flooding, and public works to control erosion and stabilize embankments. Nonstructural measures include regulating land use, designing pro- grams for responding and attending to emergencies, and equipping and preparing the population for such events. Building a Quality Government That Serves All Ecuadorans and Fights against Corruption The problems of poor government and high levels of corruption in Ecuador are leg- endary and contribute to poor public services. Moreover, it is worrisome that com- pared to recent developments in Latin America as a whole, almost all indicators of governance and control of corruption in the country have shown significant and constant deterioration since 1998. The most dramatic changes can be seen in the quality of the country's regulations, civil society control and participation, effective government, respect for the law, and control of corruption (for which Ecuador has the lowest rating of any country in the region). While Ecuadorans are proud of themselves, they express a generalized lack of confidence in national government institutions and a slightly higher level of confidence in subnational governments. On a scale of 0 to 100, the confidence of Ecuadorans in their political system was 37, among the lowest ratings in Latin America. The results of recent surveys, one by the University of Pittsburgh/Cedatos/ Gallup and another by the World Bank, confirm that corruption is a very serious problem, especially in the awarding of contracts and when receiving public services. The frequency of bribery varies according to the service provided, and it is less com- mon among local government services. Nonetheless, if decentralization continues SYNTHESIS lxi and efforts are not made to establish appropriate controls, people believe that the level of municipal corruption could increase. Evidence shows that corruption wors- ens poverty and inequality, since the income of the poorest users is proportionally more affected by bribery, which does not necessarily translate into better-quality services. Also, this phenomenon is a disincentive to the population, and limits access to public services. As a result, it is estimated that corruption reduces the state's potential tax income by about a third, rerouting it inappropriately to private hands. A reform program must focus on both the public sector and the civil service. International experience suggests that public institutions with merit-motivated staff, transparent management, efficient anticorruption mechanisms, high morale, and the will to carry out reforms, both perform better and are capable of significantly reducing corruption. In general, a multidimensional reform plan focusing on three areas is necessary: (a) strengthening existing regulations and institutions in the fight against corruption, which covers not only the public sector, but also the private sec- tor and civil society in general; (b) educating the population regarding the people's right to supervise public functions, which implies the development of mechanisms for monitoring public spending, guaranteeing the population-especially Congress, the media, and civil society organizations-easy, permanent access to fiscal accounts; and (c) improving governance to prevent corruption in its various forms, whether administrative or linked to specific areas such as purchasing from and contracts with public agencies. Each form of corruption is associated with a specific institutional weakness and thus requires an equally specific solution. In accordance with this general approach, we propose several short-term meas- ures, including a Governance Pact between the state and civil society. The partici- pation of political parties and civil society in the Pact must be actively encouraged by forming an executive committee with broad powers and a clear mandate to design and implement an anticorruption strategy. The Pact must be complemented by similar efforts on the part of the government, aimed at reforming the public administration, such as developing new procedures for providing updated budget information, hiring staff, establishing public service quality standards subject to sanctions if not met, and quickly and reliably reporting corruption. Given their spe- cial importance, offers and contracts for public purchasing must be published regu- larly and immediately on the government's Web site, including all information relat- ing to its decisions in this area. In the medium term, complementary measures would include modernizing budget management to make it accessible to citizens in electronic form, and regu- lating finances and contributions to political campaigns to make them transparent and to prevent "state capture" by specific economic interests. Similarly, it is impor- tant to ban or strictly limit the use of state resources for political campaigns. It is also essential to strengthen mechanisms for administration, control, and public moni- toring of sectional governments, taking advantage of citizens' more moderate per- ception of corruption at these levels of government. Finally, a National Transparency Campaign would have to be part of the ongoing task of reeducating the populace. Ixii ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Labor Markets and the Civil Service Ecuador's dollarization led to a complete transformation of the role of the labor mar- kets, since it meant that their external and internal competitiveness no longer depended on devaluations. This has made a flexible and productive labor market a central feature of sustained economic growth. Also, as mentioned, an efficient civil service is essential in the fight against corruption and to achieve significant improve- ments in the provision of public services. Labor indicators show there has been some recovery from the impact of the end- of-century crises. Formal employment declined until 2000, then gradually rose to around the 1998 level. This recovery is partial, however, and hides deeper effects such as that of half a million Ecuadorans (the most economically active population) emigrating to other countries; the continuous migration from the countryside to the cities; and the fact that the underemployment rate remains three times as high as in 1998, which reflects that a growing number of workers work fewer than 40 hours a week (visible underemployment), or are paid less than their stipulated wages (invis- ible underemployment). The growth of income and real wages shows a similar trend: a steep drop in 1999, followed by a slight recovery to above 1998 levels (both in nominal and real 1998 dollars), with a relatively greater increase in thc informal sec- tor than in the formal sector. Although the Economic Transformation Law simplified wage policy in the pri- vate sector and introduced new and more flexible forms of hiring through hourly and temporary contracts, the system continues to be excessively rigid. On one hand, the Sectoral Tables, based on the minimum wage established by the National Wages Council (Consejo Nacional de Salarios, CONADES), involve automatic indexing which, in case the parties do not reach an agreement, grants a minimum annual increase similar to the inflation rate projected for the following year. These increases not only have nothing to do with productivity, but also act as just the starting point for additional increases negotiated within each sector or as part of collective agree- ments. This indexing mechanism, while desirable as a means of quickly lowering inflation, becomes a serious obstacle to competitiveness when inflation stabilizes near international levels. On the other hand, the proliferation of temporary work agencies (about 200 created in recent years, covering about 10 percent of formal employment)-a phenomenon known as "outsourcing"-does not allow for ade- quate monitoring, worsens labor relations, and makes it difficult to ensure that the minimum labor requirements are being met by the companies doing the hiring. The civil service also presents serious problems. First, the proliferation of salary perks and contracting under inappropriate categories (services) makes it practically impossible to determine the exact number of workers and the size of the payroll, while raising the cost of "base" salary increases granted by the government. Also, the regulations promulgated by the new CONAREM are virtually irrelevant (more than 150 regulations in less than three years). No agency controls the public payroll, thus leading to ad hoc bilateral labor negotiations between each public institution and the Ministry of the Economy and Finances. The situation is chaotic. SYNTHESIS Ixiii Special attention must be paid to wage levels and the degree of labor flexibility. We propose two measures for the private sector. First, future wage increases must be brought in line with increases in work productivity, simplifying the wage negotia- tion process by no longer revising wages according to predicted inflation, minimiz- ing the role of the "sectoral tables" and establishing a single minimum wage. Second, sufficient labor flexibility must be guaranteed in the formal sector without imposing excessive costs on workers and reducing the nonwage costs of formal employment through better regulation of the use of temporary work agencies by companies car- rying out permanent activities, promoting the use of temporary and by-the-hour contracts when this is necessary, and eliminating the rule on redistributing 15 per- cent of profits to workers. Regarding the civil service, the fundamental goal of the new government must be to begin to rationalize the public sector. The draft of the proposed Wage Unifi- cation Law (Ley de Unificacidn Salarial) is a good start, though it could be improved. In the context of wage unification, it is advisable to maintain wage sup- plements based on geographic location for doctors and teachers to guarantee min- imum health and education services in remote areas. Wage unification must also be combined with a process for restructuring public employment-reducing person- nel if necessary-and reinforcing the system for controlling public hiring by means of a centralized register, as proposed in the draft of the Wage Unification Law, in the SIGEF. Judicial Reform Despite the progress made in specific areas of judicial reform, people do not have confidence in the formal Ecuadoran justice system because it is not easily accessible, is slow and inefficient, and is perceived as vulnerable to corruption. These problems, in turn, are associated with the low level of professional training received by those who operate the system, limited resources, and the use of inadequate administration and control models. The initial stage of the Comprehensive Reform Plan, approved in 1996 and revised in 2001, has been completed, and is aimed at laying the ground- work for bigger future changes. But it has not yet managed to improve the admin- istration of justice to a degree perceptible to the public. In this context, the private sector and the rest of civil society are convinced that a coherent and comprehensive process is essential to achieve medium-term results. This involves actions aimed at recovering public confidence in the administration of justice, improving the professional quality of judges, increasing efficiency in the management of justice, and broadening access to justice. Such a process must enhance what has already been achieved, using it as starting point. This will neces- sitate a reconsideration of regulations, operators, costs, infrastructure, and adminis- tration and management systems. It will also necessitate a reconsideration of the structure of the judicial system and of institutions such as the Constitutional Court and the Justice Ministry, each formally independent but which have an impact on the judicial system. WXiV ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM IDecentrafization The main problem of the Ecuadoran public administration system is that central- ized decisionmaking has negatively affected the quality of services. Decentralization can-subject to certain rules and principles-contribute to solving this problem. Since the provincial and municipal councils are closer to users of services, these councils could provide more creative and efficient solutions than the central gov- ernment. Ecuador faces three main challenges on the road to decentralization: (a) clearly defining areas of responsibility for a second tier of public administration (functional decentralization)-comprising regional development agencies, executive units, social funds, and attached bodies-in relation to the provincial and municipal coun- cils; (b) modifying the transfer of resources to include transfers of authority; and (c) managing local government debt with fiscal responsibility, sustainability, and trans- parency. Without rules and a framework of clear incentives, decentralization cannot be maintained. The four most important recommendations for reinforcing decentralization are as follows: First, at the intermediate (provincial) level of government, we propose that a transition strategy be implemented in which dependent, decentralized bodies must report to elected authorities-that is, the Prefect and the Provincial Council. At the ministerial level, this means appointing provincial sectoral managers (decen- tralized ministerial area) with a list of three candidates proposed by the Prefect; and at the level of regional development bodies, establishing the Directorate according to the provincial prefects that correspond to each jurisdiction, with a representative of the central government. The budget must be approved by this new Directorate. Second, regarding the special law transferring 15 percent of the central govern- ment's current income, we propose that the exact amount transferred be determined and that this transfer process be carried out transparendy. If the central government has the fiscal room to raise transfers beyond the current 10 to 11 percent, and once the budget emergency is over, transfers should be made based on the additional income effectively received, and these resources should be pegged to the simultane- ous transfer of powers and the delivery of results. Third, regarding subnational debt, we propose regulating this in a transparent process to promote fiscal responsibility, which means rescheduling debt with munic- ipalities and provincial councils with excessive debt and reporting this in the gov- ernment's annual budget document. We also suggest publishing the debt write-offs made in the past five years; researching and publishing different ways that local gov- ernments can acquire debt (contingencies, floating debt); and requiring that outside agencies give an independent credit rating for new loan applications from the three biggest cities. Fourth, we propose introducing safeguards to the system for contracting transfers of powers in order to clarify responsibilities and rights at each level of government. This means limiting access to the program for transferring powers by requiring that subnational governments meet minimum standards of accounting, budget manage- SYNTHESIS IXV ment, and regular financial reporting-and completing the transfer agreements with clauses stipulating financial calculations (debt, investments), sanctions for noncom- pliance, the reversibility of the transfers, and dispute settlement procedures. D. The Vision of a New Ecuador This book highlights the difficult fiscal and debt situation faced by the new Ecuado- ran officials, and the limitations they themselves see in terms of being able to imple- ment ambitious development while maintaining fiscal discipline. For that reason, the extensive agenda described above requires correct prioritization and sequencing, possibly beginning with measures to consolidate fiscal sustainability and deal with urgent foreign debt commitments. This could be accompanied by a prioritization of spending and the preparation of institutional reforms-especially ones such as the Governance Pact, aimed at eradicating corruption and strengthening governance on the basis of consensus, participation, and active social monitoring-giving the new government an image that suggests change and transparency. The officials should, to the extent possible, avoid giving in to pressures of a populist nature, which usually have a high fiscal cost with only a brief impact on demand. Not only the design but also the implementation of the agenda must be consistent. We believe that a solid start on the part of the government will enable it to earn the political capital to make further medium-term advances in the reform agenda. To facilitate this work, we have attached a set of suggestions for priority action. The intention is not for all of these to be adopted; rather, they represent an independent opinion of the work involved in developing a government agenda. The World Bank recognizes the com- plexity of creating this vision of a new Ecuador, and will continue to offer its sup- port to officials in the design and implementation of its strategy for economic and social development aimed at reducing poverty. Table 1. Ecuador: A Possible Order of Priorities in the Design and Implementation of Policies for Boosting Economic and Social Development FIRST STAGE Protecting the Macroeconomic Framework Send Early Confidence-Building Signals Make Poverty Reduction an xplicit Priority • Pass an austere 2003 budget o Review and widely publicize the state of o Approve greater spending on education and " Announce tax reform (with compensatory fiscal accounts health in 2003 m social measures) " Approve a solid and credible o Replace the gas subsidy with a more specifi- o Reverse "relaxed tax collection" policies macroeconomic program cally focused subsidy o o Announce the amalgamation of SRI with o Announce a 2003 plan for financing " Increase and apply conditions to Bono Customs within one year foreign debt Solidario benefits o At least freeze overall salary mass - Settle disputes with the oil companies o Approve spending on priority social (zero growth) in real terms " Make privatization and deregulation programs at least similar to 2002 levels 0z priorities on the agenda 0 - Pass the Labor Unification Act (Ley dce Unificacidn Laboral) with neutral fiscal cost and give up automatic wage indexing ( and mandatory application of the Sectorial Tables The First Steps toward Accelerated Growth Design and Initiate the Strategy against Poverty Put Governance at the Top of the Agnda z o Approve new forms of contracts with oil " Combine the coverage of the Rural o Sign a Governance Pact z companies to allow mixed investment People's Social Security program (SSC) " Present a Plan for Fighting Corruption and o Restart electric rates adjustment and the Free Maternity Care program a National Transparency Campaign o Allow Andinatel and Pacifictel to take part o Institutionalize the APRENDO program to " Approve a Law on Oil Income Trans- z in private ventures monitor advances in the quality of education parency o Approve an amended Competition Act and " Complete the participatory evaluation and " Post acquisitions and quarterly reports on simplify the business registration process focus of the Priority Social Programs the fiscal situation on the government web- • Eliminate preallocations, marginal taxes, and (and the Bono) site Z pre-import licenses that have specific Evaluate the feasibility of insurance for the * Turn the Ministry of Public Works into a prerequisites elderly, of health care for the retired and regulatory body and create a Concessions Evaluate state-owned banks and stiffen disabled through the Bono Solidario, and of Office regulations on precautionary monitoring a cycle-resistant social employment program * Unify payrolls in an SIGEF module * During the fiscal emergency, freeze contri- * Approve unified municipal financial system butions by sectional governments above the regulations 10-to-I1 -percent level, increasing them * Complete design of reformed judicial afterward, based on new responsibilities system * Clear up the state's debt to the IESS and clarify the Law Reforming the Social Security System SECOND STAGE Develop Measures for Consolidate Stability and Growth Implement Poverty-Reduction Strategy Rural and Urban Development * Simplify customs tariffs, reduce the number * Refocus spending on longer-term social * Design Urban Improvements Plan of bands, and eliminate pre-importation objectives * Prepare a Disaster Prevention System authorizations * Reevaluate the state's contribution to the * Create technological and financial * Eliminate most of the 759 technical IESS and its links with the Ministry programs with export potential for the regulations and use WTO regulations of Health agricultural sector * Complete the reform of the hydrocarbons * Begin transferring budget resources on sector the basis of results * Centralize BCE liquidity management and * Expand virtual SIGEF to other reform payment system public bodies * Improve banking systems for resolution * Regulate subnational debt, modify and liquidation system for taking on powers, and * Complete sectoral reforms and crossed develop transition strategy at subsidies in infrastructure mid-ministerial level * Pass Water and Sewage Act Part I Preserving Stability with Fiscal Discipline and Accelerating Growth with Competitiveness Maintaining Stability with Fiscal Discipline and Competitiveness1 Jose R. Ldpez-Cdlix Ecuadorfinds itself at a crossroads. Dollarization has allowed the country to overcome hyperinflation, restore confidence in the banking system, and lifi the veil of money that prevented itfrom seeing clearly the serious imbalances in the fiscal, financial and real sectors that plagued its economy. Based on that achievement, and on their countrys tem- porary boom in petroleum revenues and remittances, the new authoritiesface a dilemma. They must either take the path of austerity and competitiveness, achievingfiscal disci- pline as a prerequisite for the structural changes needed to raise Ecuadors productivity and eliminate serious distortions in domestic markets, or once again squander the coun- try' petroleum riches with expansive, anachronistic, and corrupt spending policies that protect private incomes. The known effects on demand of the latter course might be pos- itive in the short term but are undoubtedly disastrous in the medium term, as demon- strated by the crisis of 1999. Although this dilemma is independent ofdollarization, there is no doubt that such an exc-hange system is unsustainable if the latter course isfollowed. 1. Jose R. L6pez-Calix is a principal economist at the World Bank. The chapter was prepared with the valuable research assistance of Elaine Tinsley and Branko Maric. The author appre- ciates the contributions rnade by Norbert Schady (Poverty), Carolina Sanchez-Paramo (Labor Markets), and James Hanna (Competitiveness) as well as the valuable suggestions of Vicente Fretes-Cibils, Sara Calvo, and McDonald Benjamin. He is also indebted to the authorities at the Central Bank of Ecuador, Mauricio Yepez, Leopoldo Baez and Francisco Hidalgo; as well as the Ministry of Economy and Finance, Mauricio Pozo, Gilberto Pazmifio, Daniel Badillo; Roberto Salazar, Diego Mancheno, and Mauricio Pareja for their support in the preparation of this chapter and for their comments at the seminar held in Quito on January 11, 2003. At the request of the authorities, this chapter was updated with the new statistical information in the national accounts available as of January 22, 2003. 3 4 ECUADOR: AN ECONOMIC AND SocILu AGENDA IN THE NEW MILLENNIUM A0 Background Since its return to democracy in 1979, Ecuador has been characteri¢d by high external vulnerability, weak macroeconomic performance, and ungovernability. Successive external shocks-tied to reductions in petroleum prices or violent fluc- tuations in the country's capital flows as in 1998-and natural disasters have com- bined with poor macroeconomic management reflected in high fiscal deficits. These developments often preceded very high rates of inflation (Figure 1) and foreign exchange instability. This led the country to four severe recessions (1982-83, 1987, 1989, and 1998-99); three hyperinflationary periods (1983, 1988-93, and 1999-2000); high and unsustainable external debt reflected in various payment moratoria; and a recent twin crisis-in foreign exchange and banking-that destroyed 20 banks holding 40 percent of bank deposits. Misguided policies were the result of unstable government administration and the traditional ungovernabil- ity that is characteristic of the petroleum countries. In 23 years, Ecuador had 29 finance ministers who remained in office an average of 10 months, and was the country with the least perceived control over corruption in Latin America (see chap- ter 15 on Governance and Corruption). The twin crisis led to formal dollarization of the country in 2000 (Box 1). This chapter analyzes recent macroeconomic per- formance, challenges on the horizon, and possible solutions. Ecuador dollarized not by choice but as the inevitable way out foCr dealing with its twin crises in 1999. The country was very far from having met all the pre- conditions for successful dollarization, including a solid fiscal position; sustainable public debt; a diversified export structure to accommodate unfavorable shocks to its terms of trade; a sufficiently high level of international reserves (at least to cover the monetary base) as a mechanism for absorbing capital outflows; a sound and com- petitive banking system under strong supervision to prevent the formation of con- tingent liabilities; flexible markets for nontradable production factors-particularly labor and real estate-to accommodate the price adjustments required to preserve the competitiveness of the nontradable goods sector or adjust them in case of reces- sion; and a suitable climate for attracting investment that would provide access to technology and respect for the law. Despite these disadvantages, dollarization allowed the country to achieve two short-term objectives. It brought down hyperin- flation and restored confidence in the banking system. The law also explicitly indi- cated the minimum conditions under which Ecuador should gradually achieve sus- tainable dollarization in the medium term. The crisis of 1998-99 had a devastating effect on poverty levels. The inci- dence of poverty (the headcount) increased dramatically from 34 to 56 percent of the population between 1995 and 1999 (Parandekar, Vos, and Winkler 2002). This means that the number of poor people grew by more than two million during the crisis. Similarly, the number of people living in extreme poverty (that is, people whose income is insufficient to cover basic needs) increased from 12 to 21 percent in a similar period. The crisis hit rural areas most severely, especially in the highlands Figure 1. Relationship between Fiscal Deficits (% GDP) and Inflation, 1980-2002 2 z 120- 4 100 U . . Deficitright scale) --2 80*1 E - 60 jil --4 40- . < . [ .Inflation (left scale) M HAD \ 20- ROLD-S R:N . \ - 20. .OLD~S BORJA DURAN BALLENWBUCARAM 0-HURTADO FEBRES CORDERO .- RU ~~~~~~~~~~~~~NOBOA 0 , , . S i . , i . ; -12 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 '00 '01 '021 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 '00 '01 '02 Z Deficit -4.7 -5.6 -6.7 -0.06 -0.56 1.91 -5.16 -9.48 -5.29 -1.21 0.47 -0.56 -1.15 -0.11 0.6 -1.13 -2.97 -2.55 -5.7 -4.7 1.32 -0.3 0 a Inflation 11.9 14 16.2 47.8 32.8 28.1 23 29.4 57 78.1 48.5 48.8 54 46.4 27.5 23 24.4 30.7 35.8 52 95.8 20 9.7 Source: Gallardo (2001); World Bank. 6 ECUADOR: AN ECONOMIC AND SOCLAL AGENDA IN THE NEW MILLENNIUM Box 1. The Economic Transformation law Approved by Congress in March 2000, the Law contains measures for transi- tioning to dollarization and a program of structural reforms, most of which are still incomplete. These measures are as follows: o Dollarization: prohibits the issuance of new sucres, except coins; obli- gates the Central Bank to a fixed exchange rate (25,000 sucres per $USI) and to withdraw all sucres in circulation; and requires all companies to convert their accounting to dollars. o Interest rates- approves a debt conversion mechanism called desagio to transfer all dollar loans and deposits to lower interest rates, which is also appli- cable to prior debt issued in dollars for a short period; and approves a proce- dure for establishing maximum legal interest rates in the banking system equal to the London interbank offered rate (LIBOR) plus country risk (as deter- mined by the Central Bank), plus four percentage points. o Financial reforms: strengthens and introduces flexibility in financial supervision, placing legal limits on the immunity of senior officials, and giv- ing greater autonomy to the Superintendency to intervene in troubled banks and dispose of the assets of closed banks; it establishes a limit of $US8,000 on the previously unlimited guarantee on deposits; and establishes provisions for restructuring private sector debt to the banking system. o Public spending and deficits: the fiscal deficit cannot exceed 2.5 percent of GDP, and the three-year moving average must be limited to zero; the meas- ure establishes a limit on increases in current spending; and establishes provi- sions to make government contracting more transparent. o Privatization: allows the construction of a new heavy crude oil pipeline (OCP) by a private consortium; and authorizes the privatization of telephone companies and the sale of 51 percent of the shares in state electricity compa- nies. o Labor marketr approves a reform making it possible to hire hourly work- ers at a minimum salary of $US0.50 per hour, as well as provisions making it possible to unify extra benefits based on base salary. where the rate increased by 7 percentage points between 1998 and 1999 alone. The degree of deterioration in these indicators reveals the depth of the crisis and the greater vulnerability of the rural poor in dealing with their income losses. The sub- sequent emigration of more than 300,000 people-3 percent of the labor force- since 1997 made the country a significant recipient of family remittances. These remittances improved national income; had a positive effect on the balance of pay- MAINTIAINING STABILITY WITH FISCAL DISCIPLINE AND COMPETITIVENESS 7 ments, financing the current account and contributing to the accumulation of reserves; and in particular allowed for improvements in private consumption that partially offset the decline in real salaries. In addition, emigration artificially reduced unemployment, although at the price of eroding the country's human capital (and its social capital in rural cornmunities) in the medium term. B. Recent Macroeconomic Performance The Ecuadoran economy is recovering from the crisis but continues to be frag- ile. The adoption of the dollar, combined with favorable prices for petroleum, strong family remittances, and macroeconomic management with mixed results, has helped to gradually stabilize expectations, eliminate hyperinflation, begin the reor- ganization and reestablishment of the banking system, start up a fragile economic recovery, and reverse the increases in unemployment and poverty levels. This section summarizes recent trends in the economy (see also Figure 2 and the annex). In the year 2000, the first year in the transition, economic growth was slight and hyperinflation reached its highest point. The rate of growth was 2.8 percent and inflation was more than 90 percent. This latter figure was the result of the adjustments in the exchange rate and in relative prices that accompanied dollariza- tion and of excessive monetary expansion in sucres in the preceding year. However, the macroeconomic balances improved noticeably: the fiscal accounts showed a strong primary surplus of 7.7 percent of GDP, thanks to higher petroleum revenues and salary compression in dollars (derived primarily from the depreciation in the exchange rate). For its part, the current account showed an exceptional surplus equal to 6.3 percent of gross domestic product (GDP) as a result of good petroleum prices, low growth, the lack of bank credit, and exchange rate depreciation. Bank deposits were unfrozen in the first half of the year but bank credit remained stagnant (Beck- erman and Cortes 2002). The relief of the external position led to successful nego- tiation in March 2002 of the Contingency Agreement with the International Mon- erary Fund for $US304 million. This agreement was key to ensuring multilateral financing that same month, in order to substitute new 12- and 30-year Global Bonds for the old Brady bonds and Eurobonds at a discounted value of 60 centavos to the dollar (above their value on the secondary markets) in August, and to resched- uling the debt with the Paris Club in September of the same year. By late Decem- ber 2002, Ecuador's external position, measured in terms of "excess freely disposable reserves," had gone from a deficit of $US254 million in 1999 to a surplus of $US776 million. Economic recovery began and hyperinflation ended in 2001. Benefiting from a positive external environment characterized by high petroleum prices, low inter- national interest rates, and significant flows of remittances, GDP grew 5.1 percent in 2001 and an estimated 3.0 percent in 2002. Average annual inflation fell to 38 percent in 2001, and was down to single digits by late 2002. The recovery is lFigwre 2. Macroeconomic Indicators Real economic growth (annual percentage) Inflation and reserves 19 199 100%- 1000 5 0/,2I 80% 50 00/0. F -7 r-i60%- -100/0'Lif50 0% ' .-500 1997 1998 1999 2000 2001 2002 1997 1998 1999 2000 2001 2002 x GP GDI Inflation - Excess reserves (US$M) ..~~~~~~~~~~~~~~~~~~t Nonfinancial public sector (as percentage of GDP) Balance of payments (as percentage of GDP) 15 10.0 C 10 5.0 5 0.0 0 -5.0 -5 --10.0 0 -10 -15.0 1997 1998 1999 2000 2001 2002 1997 1998 1999 2000 2001 2002 l Primary balance c NFPS balance Eo Current account L[ Foreign investment Real effective exchange rate (Base: 1994=100) Salaries and Employment (percent) (1995 = 100) i 175- 1251 120 150-- 125- ~~~~~~~~~~~~~~~~~~100 [ 7f 100- 75- 75-~~~~~~~~~~~~~~7 50 .50 9 . 10 1997 1998 1999 2000 2001 2002 1997 1998 1999 2000 2001 2002 r Real effective exchange (- appreciation) l = Unemployment (right scale) - Real salary (left scale) Source: BCE, IMF, and World Bank estimates. MAINTAINING STABILITY WITH FISCAL DISCIPLINE AND COMPETITIVENESS 9 explained by the increase in domestic demand (particularly private demand), stim- ulated in turn by high petroleum prices; growing remittances; the increase in nom- inal minimum and average salaries in dollars, which practically doubled between April 2000 and October 2002; and the slow reactivation of private credit (Figure 3) consistent with recovery of the banking system. Construction of the OCP has also attracted new flows of foreign investment. The slow deceleration of inflation corre- sponds to the behavior expected of a recently dollarized economy, in which the rate of prices tends to be determined by international inflation, the lag in relative price adjustments,2 control of certain managed prices that belong to the basic basket, and expansion of domestic demand. Economic recovery and migration have helped to bring employment/unemployment rates practically back to their January 1998 lev- els, but underemployment continues to be three times as high as its pre-crisis level, reflecting more profound changes in labor markets (See chapter 16 on the Labor Market and Civil Service in Ecuador). Figure 3. Credit to the Private Sector (growth rate, percent) 40 30 20 10I - I 0 -10 -20 -30 -40 -50 96 97 98 99 00 01 02 Source: BCE and World Bank estimates. 2. The initial and significant increase in prices-and the slow and gradual decline after dol- larization-is not an experience unique to Ecuador. Many Soviet republics experienced the same phenomenon when establishing their Currency Boards. This is explained by the difficulty of determining the "correct" exchange rate. On the one hand, there may be sig- nificant undervaluation of the domestic currency at the rate selected, especially if the cur- rency has depreciated significantly during the months preceding dollarization (Beckerman and Cortes 2002). On the other hand, there is the risk of overvaluarion of the domestic currency to the point that it is not credible to economic agents. Ecuador chose the risk of undervaluation. 10 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEw MILLENNIUM Postdolarization fiscal performance has been m-ixed, expansive in terms of spending and positive in terms of revenues, which has made it impossible to achieve medium-term fiscal sustainability. The primary surpluses of the Nonfi- nancial Public Sector (NFPS) have been declining. From 7.7 percent of GDP in 2000, they are projected to fall by more than half, to 4.0 percent of GDP, in 2002. These surpluses have been almost exclusively the result of an increase in current rev- enues-from petroleum and taxes-which have fluctuated irregularly between 2 and nearly 5 percentage points of GDP as compared to 1999. Unfortunately, these revenues have had to cover a heavy burden of interest on public debt, which left decreasing and meager positive global balances during these three years-close to zero in 2002 (see the annex).3 In addition, the primary surpluses would probably have been higher if not for the expansive behavior of current primary spending. Spending on salaries and on goods and services almost doubled compared to predol- larization levels-from $US1.181 billion and $US511 million in 1999 to $US2.083 billion and $US923 million in 2002-and investment spending regained its high crisis level of more than 6.5 percent of GDP in 2002. External balances have also shown mixed results. After the strong capital out- flow of 1999, and capital recovery in 2000, "excess freely disposable international reserves" have declined two years in a row, and are projected to be about $US400 million in 2002. However, this result conceals very important changes in the com- ponents of the balance of payments. On the one hand, the balance in the current account went from a surplus of 6.3 percent in 2000 to a high deficit of a projected 6.6 percent for 2002. More than 80 percent of this imbalance corresponds to the deficit in the trade balance. Short-term factors that explain this are the "boom" in demand that accompanies extraordinary petroleum earnings and import consump- tion financed by remittances; diseases and difficulties in accessing European markets that have affected the exportable supply of Ecuadoran shrimp and bananas, respec- tively; the appreciation in the real rate of exchange; and the temporary increase in imports that typifies the construction of the OCR On the other hand, positive fac- tors in the current account have been the decline in the net interest payments on external debt (nearly $US500 million) and rapid growth in family remittances-the second most important source of foreign currency, about 5.4 percent of GDP in 2002, which financed a large part of the accelerated growth in demand for imports during the postdollarization period. For its part, the capital account shows tempo- rary foreign investment inflows for construction of the OCP; these are estimated by the authorities to be about 3 percentage points of GDP for 2002. 3. It should be noted that fiscal surpluses in the NFPS do not include extraordinary oudays to support the recapitalization of the banks, equal to an estimated 1.5 percent of GDP in 2001 and 1.0 percent in 2002, with which they would become a deficit. The 2002 sur- plus includes the floating debt estimated to be $US722 million in late 2002 ($US181 mil- lion in arrears to the Paris Club and $US541 million in accounts payable, the breakdown of which is unknown) according to top officials. MAINTAINING STABILITY WIl'H FISCAL DISCIPLINE AND COMPETITIVENESS 11 The beginning of economic recovery made possible a decline in urban poverty levels between 2000 and 2001. The employment survey shows a clear 20 percent decline in poverty levels between 1990 and 1997, followed by a sharp increase of nearly 17 points in 1998 and 1999 as the result of the crisis, and subse- quently a partial recovery of about 12 points starting in 2000 (still not reaching the rates seen in 1997) (Figure 4). The same survey estimates that the decline in poverty between 2000 and 2001, measured on the basis of incomes, affected both rural areas and cities to an almost identical degree (Le6n 2002)4. Figure 4. Ecuador's Urban Poverty, 1988-2001 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% X C\ O - S rn 'I' VI\ \0 tr- X 07i - 00 00 allG GE GE G EN \ Go N o Co C>N O O _N _N _N _N _N _N _N _N _N _N ON cSON 0 Source: Le6n (2002), based on Surveys of Employment, Unemployment, anid Underemployment. 4. With respect to measuring poverty according to income, the calculations can be done on the basis of two sources. First, the Urban Survey on Employment, Unemployment, and Underemployment has been conducted each year since 1987. Up to 1999, it covered only urban areas, while as of 2000 it covers both urban and rural areas. Second, since March 1998, the Central Bank of Ecuador has been conducting an employment survey each month in the country's three major cities (Quito, Guayaquil, and Cuenca). To calculate poverty according to income, the poverty line has been set at $US2 per person per day. This has the advantage of facilitating comparison with other countries. Poverty measured according to income has serious disadvantages in comparison with poverty measured according to consumption. Income generally fluctuates cyclically (particularly in rural areas) and is more subject to measurement errors. However, in Ecuador measurements of poverty according to income are indispensable in that they make it possible to track the evolution of poverty since 1999. 12 ECUADOR: AN ECONOMIC AND Soc AL AGENDA IN THE NEw MILLENNIUM C. The Chalenges of Maintaining §tability The transition to dollarization has allowed Ecuador to achieve its immediate objec- tives of eliminating hyperinflation, with rates slowly approaching international lev- els, restoring some degree of confidence in the banking system, and beginning the economic recovery. However, its more medium-term objectives are still to be attained: achieving fiscal and external sustainability as preconditions for its program of key structural reforms for consolidating the recovery, strengthening financial sys- tems, and improving competitiveness within a context of changes in relative prices. This section summarizes the most serious macroeconomic challenges to be faced in the next four years. Ecuador's fiscal position is weak It is weak for three principal reasons: the high volatility and procyclical character of revenues, particularly petroleum revenues; extreme rigidity, low quality, and lack of transparency in spending; and the high degree of illiquidity and insolvency of public debt. The volatility and procyclical character of ta= revenues remain excessive. Although general economic volatility has declined under dollarization, the behavior of inflation, tax revenues, and the terms of trade continues to be an exception (Table 1). The volatility of Ecuador's terms of trade was not only more than five times as high as the regional average in the second half of the 1990s (19.2 versus a regional average of 3.4 percent) but has also increased by 20 percent in the period after dollarization. It is thus obvious that the Ecuado- ran economy's high degree of dependence on international petroleum prices Table 1. Volatility in Ecuador, 1990-2002 1990s 2000-02 Change Real GDP 3.2% 1.3% -61% NFPS Balance' 1.7% 0.6% -65% Current revenues/GDP a 1.0% 1.3% 29% Petroleum 1.4% 0.9% -35% Nonpetroleum 1.3% 1.8% 38% Primary spending/GDP a 0.6% 1.1% 86% Inflation 12.1% 43.1% 256% Monetary base 23.4% 5.5% -77% Terms of trade 19.2% 23.1% 20% Real salary growth b 10.8% 6.9% -37% Growth in private consumption 3.5% 0.9% -74% Notes: Volatility defined as standard deviation, in percentage terms, of the above-mentioned variables. a. Data since 1995. b. Data since 1997. Source: World Bank estimates. MAINTAINING STABILITY WITH FiscAL DISCIPLINE AND COMPETITIVENESS 13 makes it very sensitive to external shocks. After Venezuela and Trinidad and Tobago (also petroleum countries), Ecuador has the third-highest concentra- tion of (in excess of 60 percent) exports in a few traditional products in Latin America (Figure 5). This high degree of dependence on petroleum prices is shown in various ways (Figure 6). For example, (i) the correlation between petroleum prices and economic growth is obvious; (ii) the correlation between petroleum prices and tax revenues is even higher (a coefficient of 0.66 in the period 1990-2002); and (iii) for each dollar reduction in the international price per barrel of oil, exports fall by 0.6 percent of GDP and tax revenues fall by 0.4 percent of GDP (Artana 2002), which also reflects their procyclical behavior. It is not surprising that petroleum tax revenues would show strong swings: in terms of GDP, they grew from 3.9 percent in 1998 to 9.2 percent in 2000, falling later to a projected 5.7 percent of GDP in 2002 (see the annex). Spending remains expansive, to a large extent because of budgetary iner- tia. Contrasting with the highly variable behavior of revenues, primary spend- ing shows close to zero volatility since the mid-1990s, which reflects its rigid- ity and explains its expansion (Table 1). Between 1997 and 2002, despite the crisis and subsequent dollarization, primary spending in the NFPS continued its upward trend. In GDP terms, it grew from 19.4 percent in 1997 to 19.9 percent in 2000, and since that time has increased by 1.5 percentage points up to 2002, reaching 21.4 percent of GDP (see the annex). Obviously, this reflects the absence of any adjustments.5 There are three principal reasons for budgetary inertia: the generous mechanism for indexing salaries based on pro- Figure 5. Percentage of Four Principal Goods as a Share of Total Exports Argentina Brazil Chile - Colombia Ecuador _ 1995 Mexico E _ _*19-955 l ParaVieauy =1_ Trinidad and Tobago _ l VeUnreuzueala = - = _ - Central America Caribbean_ __ _ _ 0 10 20 30 40 50 60 70 80 90 Source: World Bank. 5. Alternatively, this figure could include the late recognition of floating debt that has been carried over for years, at about 0.3-0.4 percent of GDP. 14 ECUADOR: AN ECONOMIC AND SocIAL AGENDA IN THiE NEW MILLENNIUM Figure 6. The Effect of Petroleum on the Economy ;30- Growth and petroleum prices 15 r 25- lo0 B o20 0 5- v O -10 1987 1989 1991 1993 1995 1997 1999 2001 = GDP (%) Petroleum price Petroleum prices and fiscal income 30 35 U25- 1-5~ 020r ~~~15- - -- p~~~~~~~~~1 510- 1995 1996 1997 1998 1999 2000 2001 2002 0 Tax0revenues(%GDP) -Petroleumprice(rightscale) Petroleum exports and trade balance - US$M 3000- 2000- 1000- -1000- 197 19 1999 2000 200 2002 -2000- -3000- Petroleum exports Trade balance Source: World Bank estimates. jected inflation that was adopted after dollarization; the many benefits associ- ated with increases in the base salaries of public employees, which act as a multiplier (see chapter 16 on the Labor Market and Civil Service in Ecuador); and the ex ante preallocation of "projected" tax revenues in the pro forma budgets contained in more than 50 applicable legal provisions, which make readjustments difficult once they are approved (see chapter 2 on Tax Admin- istration and Policy). T The rigidity of spending becomes extreme when debt service payments are added to it. If we subtract from total current revenues spending on pay- roll (30 percent), preallocated revenue (30 percent), and debt service pay- ments (35 percentincluding net amortization), the remaining freely disposable MAINTAINING STABILITY WITH FISCAL DISCIPLINE AND COMPETIT IVENESS 15 balance for nonsalary primary spending is barely 5 percent of the budget, which was equal to about 1.0 percent of GDP in 2001 (Figure 7). In practice, this percentage amounts to a small budgetary contingency reserve. This flexi- ble amount of internal resources that the authorities have to finance invest- ment or purchases of goods and services (particularly social spending) by the central government is negligible. Given the seasonal nature of tax revenues and the unpredictability of external disbursements, this situation contributes to continuous cash problems. Thus, the inflexibility of spending makes it impossible to adequately plan cash outlays and to redirect spending effectively and efficiently to the priority objectives of a new poverty reduction strategy.6 Government spending is highly fragmented and thus uncoordinated, sub- ject to weak controls, and lacking in transparency. The preallocation of some 30 percent of income to more than 50 different agencies and 242 sec- tional governments (provinces and cantons) that are not subject to any regu- lar coordination, monitoring, or evaluation mechanism leads to fragmented execution of spending,7 a lack of control over spending, and creates serious obstacles for transparency in spending. The limited number of studies done on the quality of spending in Ecuador is precisely a reflection of its lack of transparency. Financial management is decentralized by law to executing Figure 7. Distribution of Government Revenues (2001) Freely disposable funds 5% Salaries Preallocated 30% revenues i_ ~ ~ ~ ~ ~ r - ~~~30% Debt service 35% Source: World Bank based on Gallardo (2001). 6. For example, note that the Solidarity Bond alone used resources equal to 0.7 percent of GDP in 2001, which would be equal to more than half of freely disposable funds. 7. The fragmentation of spending is understood in the broad sense, that is, based on the pre- allocationi of revenues. 16 EcUADOR: AN ECONOMIC AND SociAL AGENDA IN THE NEW MILLENNIUM agencies, but is carried out under an integrated financial information system (known as SIGEF in Spanish) that covers a nonconsolidated budget, encom- passes only a portion of spending by the central administration, excluding the decentralized and sectional agencies,8 and reveals spending actions late and not in a virtual format. The absence of control and transparency is deeply rooted. For example, the Social Security Institute did not publish its financial balance sheets for five years and was operating without any external oversight (it now operates under the Superintendency of Insurance). The municipali- ties, for their part, did not publish their financial statements, either. In turn, while the pro forma budget is not approved before the start of the year, budg- ets are closed out more than a year after the end of the year, with subsequent verification by the Office of the Comptroller even later. Public debt is illiiquid and very high. The stock of total external debt was estimated at 65.7 percent of GDP in 2002, more than twice the level of exports of goods and services and the highest in Latin America after Argentina, before that country's crisis (Figure 8). Public debt represented 60 percent of GDP that year. The burden of external public debt service is exces- sive, which creates continuous problems of illiquidity and increases the risk of default. Approximately one out of every three dollars entering the Treasury is used to pay external debt. As of the end of 2002, the spread of Ecuadoran bonds is the second highest in the region with an upward trend: above 1,850 basis points-above Brazil and the average for Latin American bonds-and has been increasing since April 2002, when the government failed to reach an agreement with the IMF (Figure 9).9 Ecuador also has immediate liquidity problems with arrears to the Paris Club estimated at $US181 million at the end of 2002, and a scheduled amount of debt service of about 8.1 percent of GDP (4.7 percent in amortizations and 3.4 percent in interest for 2003-04). About four-fifths of total debt is external debt. Of this, some 65 percent is official debt-40 percent multilateral and 25 percent bilateral-making it somewhat less vulnerable to changes in emerging markets and offsetting the country's lack of access to international markets. Finally, nearly two-thirds of domestic debt consists of bonds issued by the Deposit Guarantee Agency (AGD) and the National Finance Corporation (CFN) to cover the costs of bank interventions during the banking crisis. The outlook of the three major risk-rating agencies is that the country's ability and desire to pay have improved with dollarization, but with a CCC+ (Standard & Poor's) or Caa 2 (Moody's) rating, Ecuador is still not eligible for a level of investment that 8. SIGEF covers about 84 percent of central government spending. 9. Note that the spread did reduce significantly after dollarization, but it remains very sensi- tive to internal and external events. MAINTAINING STABILITY WITH FIscAL DISCIPLINE AND COMPETITIVENESS 17 Figure 8. Total External Debt (% GDP) 160- 9 z ~~~~~~~~~~1997 *2000 120 80 40 .' #U E C) U I'~~~J o~~~~~~~ Sourrc: World Bank. would allow it to issue new sovereign bonds on international capital markets in the near future.10 Family remittances have led to a positive transformation in the Ecuadoran economy but have had some adverse effects that should be corrected. Ecuador has become one of the principal recipients of remittances in Latin America (Central Bank of Ecuador [BCE] 2000). It receives about $US 1.4 billion in remittances each year, equal to 5.4 percent of GDP in 2002. This inflow of capital has relaxed the restriction on foreign exchange, improving private consumption, which had been affected by the decline in real salaries during the crisis, and helping to alleviate the decline in incomes. Ecuadoran remittances have five distinct characteristics in com- parison with the trend in Latin America (Figure 10): (i) remittances intensify with a rather delayed migration toward the end of the 1 990s; (ii) they are concentrated in three regions of the country-Azuay (Cuenca), Guayas, and Pichincha, with a clear predominance of the first-that receive about two-thirds of the remittances; (iii) nearly half (45 percent) of the remittances do not come from the United States; (iv) a relatively higher percentage is invested in housing; and (v) in per capita terms they are the third highest in Latin America, with a positive effect on the rapid recov- ery of precrisis income and poverty levels. Despite these positive aspects, remittances 10.A risk rating of C means that the issuing institution has obvious deficiencies, probably related to the quality of its assets or the poor structuring of its accounts (fiscal in this case). This leads to a considerable degree of uncertainty and reasonable doubts regarding the institution's ability to confront additional problems in the future. Figare 9. Ecuador's Financial Risk x 5000 4500 Moraroria f Il 4000 I i-ri 3500 3000 K4 Z z J-- 111~~~~~~~~~~~~ Agreemen~~Lti Aerc 12/29/1998 5/29/1999 10/29/1999 3/29/2000 8/29/2000 1/29/2001 6/29/2001 11/29/2001 4/29/2002 9/29/2002 2 Source: JP Morgan. r r- z MAINTAINING STABILITY WITH FISCAL DISCIPLINE AND COMPETITIVENESS 1 9 also have some macroeconomic effects that are quite similar to those of the coun- try's petroleum boom periods and that contribute to (i) a change in relative prices, given that the inflow of foreign currency increases the demand for and prices of trad- able goods; (ii) an increase in the real exchange rate, as measured by the decline in the ratio of prices for tradable and nontradable goods; and (iii) a deterioration in the trade account of the balance of payments, owing to the decline in exports (particularly nontraditional exports) and the increase in imports that result from exchange appreciation. However, there are two important differences between the remittances and the petroleum booms: their duration, in that remittances tend to provide a more permanent positive external shock-usually 7-10 years-than booms; and the productive use of resources, given that in comparison with petro- leum earnings, higher percentages of remittances tend to be consumed in invest- ments in nontradable goods, rather than in imports. Both differences make remit- tarices a welcome phenomenon, the use of which can be maximized. Of the adverse effects of increased remittances, the change in relative prices to the detriment of tradable goods is the principal problem to be corrected. Goods whose prices are determined by international markets are known as "tradable" goods and goods whose prices are determined by the domestic market are known as "nontradable" goods. The change in the relative prices of tradable and nontradable goods in a dollarized system is one of the possible approximations of the real exchange rate. An increase in the real exchange rate may be due to a decline in productivity in the production of tradable goods as well as to an increase in prices for nontradable goods. In Ecuador, after dollarization, the productivity ratio of these two sectors dete- riorated, primarily affecting the tradables sector. At the same time, the ratio of rela- tive prices for tradable/nontradable goods rose in 2000, propelled by an increase in prices for tradable goods that were affected by the sharp depreciation in the sucre. However, it subsequently fell because of constant, although smaller, increases in prices for nontradable goods (Figure 1 1).I1 The result of both trends has been an appreciation in the real exchange rate (see Figure 2). Note that estimated real appre- ciation is much lower when calculated on the basis of unit labor costs (8.1 percent) than when calculated on the basis of consumer price indexes (62 percent), in the case, for example, of Ecuador's principal trade partner-the United States-between 2000 and 2002 (Figure 12). In any case, this change in relative prices is a manifestation of a deterioration in Ecuador's external competitiveness that should be corrected.12 11 .The labor productivity series (product/labor) are constructed using data on urban employ- ment rather than national employment because the latter is only available for 2000 and 2001, whereas product is national in that there are no urban product series. The price series use the BCE's producer price index for tradable goods and the urban consumer price index, also produced by the BCE, for nontradable goods. Thus, both indexes are approx- imations of real values. 12.Another manifestation of the loss of competitiveness was the evolution of nontraditional exports, which reached an annual growth rate of 20 percent in 2001, but a rate close to Figure 10. Ecuadoran Migration and Family Remittances Remittances per capital (in U.S. dollars) Ecuador: Emigrants and remittances Ecuador aL ,. 12%- 100 0. Dominican Republic - 10%- 80 . 8%- 1 0 El Salvador I 60_o 60 °o Braz,0 4% \ 40 c Mexico U0 - 90 91 92 93 94 95 96 97 98 99 00 01 02 0 50 100 150 200 250 300 350 E Remittances(%ofGDP) -Annualeemigrants n z 0 Remittances received Remittances: Estimate by country of origin (Distribution in dollars, 2000) O ~~~~~~~~~~~~~~~Others ,lg 15%0 Rest of the country Azuay y 38% 46% Italy U.S. 10% 45% z Spain ; Guayas Pichincha 30% ' i 11% 5% Z z Source: BCE and World Bank estimates. m C MAINTAINING STABILITY WITH FISCAI. DISCIPLINE AND COMPETITIVENESS 21 Figure 11. Relationship between Productivity and Relative Prices of Tradable/Nontradable Goods 2.0 1.8 1.6 1.4 oo 1.2 0.8 0.6 0.4 - Productivity: Tr/Ntr 0.2 - Prices: Tr/NTr 0.0 1998 1999 2000 2001 Yea-r Source: World Bank, based on data from the BCE and Urban Employment Surveys. Figure 12. Real Bilateral Exchange Rate with the United States, Based on CPI and Unit Labor Costs (1994 = 100) 180 - 160 - 140 - 120- 100 _ 80 1994 1995 1996 1997 1998 1999 2000 2001 2002 -Labor costs -CPI Source: World Bank, based on data from the BCE and Urban Employment Surveys. zero in 2002. The tax authorities indicated that the latter figure reflects to some extent a significant underassessment of exports, which is explained by tax evasion. 22 EcuADOR: AN ECONOMIC AND SOCIAL AGENDA IN THIE NEw MILLENNIUM The external position is weak. Given the inflexibility of the exchange rate, Ecuador must also find alternative mechanisms for absorbing real and financial shocks. Its high degree of dependency on a few primary products makes it more vul- nerable to deterioration in its terms of trade. In addition, the development of mech- anisms for absorbing financial shocks, typical of a dollarized economy, is nonexist- ent. There are three options: "abundant" international reserves in the Central Bank; contingent credit lines with multilateral agencies; and resources from a counter- cyclical stabilization fund. • The level of Freely Disposable InternationaR Reses-ves is declining. Although the amount of international reserves required under dollarization is lower than under a flexible exchange rate system, because the monetary sup- ply is always greater than the monetary base and the traditional role of the lender of last resort no longer exists, it is advisable to increase this amount in order to avoid minor contingencies.13 "Excess" freely disposable reserves in Ecuador recovered slowly in 2000 with multilateral support anid debt restruc- turing but the current level is low (close to $US400 million) and the trend downward (see the annex).14 o After the crisis in Argentina, the possibilities for obtaining contingency lines from abroad are minimal. Nor has the United States shown any inter- est in implicitly sharing its seniorage with dollarized countries. o The recently created Petroleum Fund will not have any significant money until 2004 and the amount it can be expected to have to meet contin- gencies is marginal. The Fund for Stabilization, Social and Productive Investment, and Reduction of Public Debt (FEIREP) was created with the recently approved tax law. According to the law, the funds that go to FEIREP will be primarily funds from the OCP that do not derive from lower utiliza- tion of the Trans-Ecuadoran Pipeline (SOTE) for light petroleum. Given the delay in completing the construction of the OCP until late 2003, this means 13.Note that the role of lender of last resort was unsuccessful in avoiding the banking crisis prior to dollarization. We speak of "minor" contingencies that do not include the possi- bility of a large number of depositors withdrawing their deposits from the banks. Should that happen, either interest rates would have to rise to extremely high rates in an attempt to recapture deposits or another banking crisis would occur. 14. "Excess" reserves, a concept that is appropriate to a dollarized system, results from deduct- ing from the total amount of freely disposable reserves from the internal liabilities of the Central Bank, which include the currency and paper it issues as well as the deposits of commercial banks in the Bank. Excess reserves increase in parricular when the government makes deposits to the Single Treasury Account, and thus these deposits become a key vari- able/goal of the macroeconomic program. MAINTAINING STABILITY WITH FISCAL DISCIPLINE AND COMPETITIVENESS 23 that a very small amount of funds will be transferred in 2004 and thereafter to FEIREP In addition, according to the law, only 20 percent of the funds in FEIREP will have a countercyclical function, and thus the amount for con- tingencies will be marginal. The financial system remains vulnerable. The Ecuadoran financial system has made a remarkable recovery since the crisis of 1999, with stable growth in deposits in the banking system and credit to the private sector since the negative levels of 1999. However, there are still various critical areas that need improvement. Some key problems are as follows (Figure 13):'5 * Real active interest rates are slightly positive, while passive rates remain negative and do not strengthen financial intermediation. Real active inter- est rates were negative during the hyperinflationary episode and only became marginally positive again starting in 2002. * The decline in nominal interest rates after dollarization has been late in coming and limited, and has not provided sufficient stimulus for eco- nomic recovery. With dollarization, the elimination of exchange risk should have allowed for a rapid and significant decline in nominal interest rates, but this did not happen. Between April 2000 and late 2002, the decline was slight-barely 3-4 percentage points, and less than the nearly 5 percentage point decline in international interest rates.'6 However, as inflation has fallen and the financial system has been strengthened, the rates have gradually fallen. As of late 2002, with a lending rate of 12 percent and inflation at 9 percent, Ecuador's real active rates are slightly lower than the prime rate in the United States. * The liquidity of commercial banks remains high and continues to fluc- tuate. The net liquidity of the banks (the ratio of funds available to deposits up to 90 days) recovered noticeably in late 2000, but since that time has fluc- tuated in a high and broad range of 30-45 percent. This behavior reflects the banks' preoccupation with having provisions that would allow them to meet their obligations in the event of a run on deposits. * The delinquent portfolio percentage is high and credit for housing or microenterprise remains stagnant. Ten percent of the portfolio is delin- quent. This average conceals the difficult situation that some commercial 15.Chapter 4 on the Banking System analyzes this subject in detail. 16.At the end of an inflationary episode, commercial banks tend to raise real interest rates in order to generate greater revenues and recover part of the losses from the decapitalization, in real terms, that occurrecl during the episode. This happens because interest rates never increase as much as prices during crises. Figure 13. Financial System indicators Active interest rates in Ecuador a Interest rates and nominal interest rate (%) Percent 40 Nominal rates 20 Nominal rates. Ecuador 20- 0 . 15 -20 10 . -40-'--~ 0 *.' Real rate Prm R USA -800 -100 .. ,. - - .0 . . . . . 0 0 , - r Go, C% GEl CO 0 CD O\ O G ' g O O O O cO 0 0 0 0 000 ON cN ON 0 0 0c 0 0 0) 0 0 Z -d -i v - _1 A -l . (d M, IV ) Net liquidity coefficient of Banking system arrearso 100% - private banks (Portfolio past due/total portfolio) n (December 99-September 02) 14 I F 80%- 12 - - 60% ~~~~ ~ ~~10 - __ _ _ _ _z 40% 8 - - 40%-H6 20 %h fl 0 0 k| u q 1 lii Iil H11 4 -1 ___ __ __ __ __ __ __ __ __ __6 |_ 0% - , ,.o u N 1- C- *u eq Fl Iq ClNc r , > c 5C ~~~~ 0~~~~~~~~ 0 ~ ~ ~ ~ ~ c, C Z rz a. Nominal and real active rates are from the Superintendency of Banks of Ecuador. Source: Central Bank of Ecuador; Superintendency of Banks of Ecuador; IMF. MAINTAINING STABILITY wiTH FIScAL DISCIPLINE AND COMPETITIVENESS 25 banks went through with extremely high levels of delinquency. The highest proportion of credit continues to be concentrated in the segment with the most delinquency-commercial credit-with only a marginal amount (less than 10 percent) goes to housing or microenterprise, two sectors that make intensive use of unskilled labor, and whose reactivation would encourage eco- nomic recovery (Multiplica 2002). Both trends reflect, on the one hand, the difficulty that economic agents encounter in meeting their debts and not seek- ing rollovers and, on the other, the banking system's limited trust in granting medium-term credit, despite dollarization. External competitiveness has not improved and the investment climate con- tinues to be discouraging. Perhaps the other element that is key to dollarization in Ecuador in the medium term is growing gaps in competitiveness and rigidities in the country's factors markets. Earlier we analyzed the loss of competitiveness due to the trend toward real exchange appreciation as a result of the decline in the ratio between prices for tradable and nontradable goods. Another option is to focus on the global analyses of a country's competitiveness. Generally, global classifications and their rates should not be a source of great concern, but this is not the case in Ecuador. Almost all indicators provide evidence that the country's competitiveness gaps are significant and growing in most areas in comparison with other medium- income countries-and there is no evidence that domestic conditions are conducive to reversing these trends. For example, the Global Competitiveness Report of the World Economic Forum provides an overview of a country's basic competitiveness in terms of its macroeconornic situation, public institutions (corruption, contracts, and respect for law), the quality of its business environment, technological innova- tion, and computer technology. In 1999, Ecuador ranked 54th out of the 62 coun- tries rated. In 2001, it ranked 68th of the 75 countries evaluated, with a relatively higher grade (59th) for innovation, and lower grades for the quality of its business environment (72nd) and for contracts and respect for law (73rd). This trend con- tinued to deteriorate in 2002 when Ecuador ranked 73rd of the 80 countries con- sidered. Similar indicators are found in the Heritage Foundation's Index of Eco- nomic Freedom, which also shows a deterioration in the country's relative position, which went from 72nd in 1999 to 117th in 2002, ranking ahead of only Cuba and Venezuela in the region (Table 2). The breakdown of the index's components indi- cates that the country's situation has worsened, particularly in terms of its invest- ment climate and property rights, and has improved slightly in terms of its fiscal sit- uation. The rigidities in labor markets represent another important challenge. Labor flexibility is critical to the sustainability of dollarization, particularly as a mechanism for adjusting to unfavorable shocks. Initially, the private sector labor market became somewhat more flexible after the crisis of 1999. The approval of the Economic Transformation Law made it possible both to diversify hiring methods and to unify the many benefits based on one's base salary in the private sector, thus setting a good 26 ECUADOR: AN ECONOMIC AND SOCiAL AGENDA IN THE NEW MILLENNIUM Table 2. Index of Economic Freedom Foreign Relative Tax Monetary direct. Property position burden policy investment rights 1999 2002 1999 2002 1999 2002 1999 2002 1999 2002 Argentina 14 38 2.0 3.0 2.0 1.0 2.0 2.0 2.0 3.0 Bolivia 49 45 3.5 3.5 3.0 2.0 2.0 1.0 3.0 4.0 Brazil 95 79 3.0 3.5 5.0 3.0 3.0 3.0 3.0 3.0 Chile 14 9 3.0 3.0 3.0 2.0 2.0 2.0 1.0 1.0 Colombia 55 58 3.0 3.0 4.0 3.0 2.0 2.0 3.0 4.0 Costa Rica 69 43 3.0 3.0 4.0 3.0 2.0 2.0 3.0 3.0 Cuba 158 153 3.5 3.5 5.0 5.0 5.0 5.0 5.0 5.0 Ecuador 72 117 3.0 2.5 5.0 5.0 2.0 3.0 3.0 4.0 El Salvador 19 17 1.5 2.0 3.0 1.0 1.0 2.0 2.0 3.0 Guatemala 43 55 1.5 2.0 3.0 2.0 3.0 3.0 3.0 4.0 Honduras 106 88 2.5 2.5 5.0 3.0 3.0 3.0 3.0 3.0 Nicaragua 118 88 3.0 3.5 5.0 3.0 2.0 2.0 4.0 4.0 Panama 35 45 3.0 3.5 1.0 1.0 2.0 2.0 3.0 4.0 Paraguay 62 79 2.0 2.0 3.0 3.0 1.0 2.0 4.0 4.0 Peru 39 53 3.0 2.5 4.0 2.0 2.0 2.0 2.0 4.0 Dominican Republic 80 72 2.0 1.5 3.0 3.0 3.0 3.0 4.0 4.0 Uruguay 43 41 3.5 3.5 5.0 3.0 2.0 2.0 2.0 2.0 Venezuela 95 130 2.0 2.5 5.0 5.0 3.0 3.0 3.0 4.0 Note: the range from 1 to 5 goes from best to worst. Source: Heritage Foundation. precedent for the public sector, but reform in the latter did not happen. Labor law on Ecuador's civil service is still focused on promoting labor stability rather than on encouraging the efficient delivery of services, which would encourage growth and competitiveness. This is particularly true of the civil service, which has two areas that urgently need improvement: salary policy and the number of public employees. In general, salaries are not freely determined in the informal markets, but rather by a National Salary Council. The result is that real salaries have not fallen during the postdollarization period, despite the downward trend in labor productivity (see the annex). In addition, in civil service in particular, because of the proliferation of allo- cations (general and specific), each official increase in the base salary of a public employee sets off a chain of complex multiplier effects. This makes it impossible to precisely estimate in advance the cumulative effect of official increases. Nonetheless, it is estimated that salary increases have been high, from 60 to 10 percent above the preceding salary level (see chapter 16 on the Labor Market and Civil Service in Ecuador). For its part, public employment is without any effective controls. The exact number of public employees is unknown. Because there is no centralized con- MAINTAINING STABILITY WITH FIScAL DISCIPLINE AND COMPETITIVENESS 27 trol of payroll, the number is approximated indirectly based on budgetary alloca- tions. The state's authority to manage civil service has deteriorated completely since the Secretariat for National Administrative Development (SENDA) was dissolved in 1998. The lack of central control also applies to state companies, decentralized agen- cies, and sectional governments. D. Policy Recommendations Perhaps the greatest achievement of dollarization in the medium term has been to eliminate the "veil of money" and reveal problems in the fiscal, real, and financial sectors more convincingly. With the suppression of monetary policy, the gradual elimination of the distortions caused by hyperinflation, and the assumption of contingent liabilities from the banking crisis, the fiscal, currency exchange, and price "illusions" have to a great extent disappeared, forcing the authorities to deal with correcting fiscal imbalances. This is why under a dollarized scheme, financial leveraging is the first and only way to gain credibility and keep inflationary expec- tations low. In turn, dollarization made even clearer the need for the program of structural reforms that Ecuador has postponed for decades. Combining fiscal discipline with the implementation of structural reforms is no longer just an option. Indeed, it is a critical requirement for consolidating macroeconomic stability and reactivating the economy by strengthening the finan- cial system, improving competitiveness, and eliminating market distortions in the medium term. A credible approach to correcting fiscal imbalances by improving prudential supervision, eliminating trade barriers, and introducing flexibility in fac- tors markets is the best route in terms of economic policy. These reforms would have been essential for Ecuador even if the country had not dollarized, and will continue to be so even if the government should voluntarily decide to "de-dollarize" in the future. The previous section identified the principal problems. We present below the principal recommendations for overcoming these obstacles and holding on to the achievements attained. The governments first macrofiscal priority is to deal with the economy's illiquidity and develop a plan to close the country's financial gap for 2003. In 2003, Ecuador has total net financial requirements'7 in the amount of $US2.150 billion, which after including already scheduled financing, leaves a gap of financing to be identified of $US871 million (Table 3). The heaviest burden comes from mul- tilateral and bilateral debts, which together represent more than 90 percent of total external debt amortization and two-thirds of total public debt amortization over the 17.This is stated as "net" because it does not include $US827 million in interest on public debt, half of which is for payment of AGD and National Development Corporation bonds. 28 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM next three years. Given the specific composition of its debt, it is clear that the liq- uidity of Ecuador's public finances is critically dependent on (i) developing and car- rying out a sound and credible macroeconomic program; (ii) implementing a pro- gram of structural reforms that will allow the country to obtain rapidly disbursing and freely disposable funds from the multilateral agencies, which could close the gap; and (iii) rescheduling its bilateral external debt with the Paris Club. One of the objectives of this rescheduling should be the prompt elimination of all pending arrears in 2003. Table 3. The Financial Gap of the Nonfinancial Public Sector 2001 2002 2003 2004 2005 Financing required 1915 2150 2116 1534 1534 NFPS deficit 0 0 0 0 0 NFPS deposits f 49 0 100 100 100 Amortization 1121 1105 1294 1304 1304 External 731 672 816 904 865 Internal 390 433 479 400 439 Other 745 1045 722 130 130 Arrears 285 655 181 Accounts payable 122 541 Assist., banking sector 300 268 0 Other ab 160 0 0 130 130 Financing identified 1915 2150 1245 1087 1031 NFPS surplus f 155 215 237 259 137 Internal financing c 335 278 130 237 259 External disbursements d 584 472 873 578 613 Governments 85 148 100 100 IDB 92 111 124 124 WB 26 71 94 129 CAF 96 250 175 175 IMF 143 150 0 0 Others 30 144 85 85 Other 841 1185 5 13 22 Cumulative arrears 407 181 Floating debt 122 541 Other b,' 312 463 Financing gap 0 0 871 447 503 Notes: a. includes payments to IESS. b. Excludes $US240M in 2002 for advance purchase of petroleum, which became a financing requirement in 2003. c. Internal financing means domestic bonds and disbursements. d. Since 2003, data from BCE. e. Financing gap. f. Starting in 2003, possible goals to be negotiated with the IME Source: BCE and World Bank estimates. MAINTAINING STABILITY WITH FISCAL DISCIPLINE AND COMPETITIVENESS 29 The government's second macrofiscal priority is to deal with its insolvency risk, taking steps that will allow it to obtain the high primary surpluses needed to pay interest on its debt. Ecuador has scheduled interest payments that will fluc- tuate at about $US800-900 million (3.5 percent of GDP) over the next four years. Meeting these payments is synonymous with complying with a fiscal standard: the recentdy approved Law on Responsibility, Stabilization, and Fiscal Transparency (Box 2). The two fundamental objectives of this law are to achieve a goal of sustainable pub- lic debt in the medium term (40 percent of GDP)-with an intermediate reduction goal of 16 percentage points of GDP in the next four years-and to create the FEIREP, the petroleum fund designed to repurchase commercial debt (12- and 30- year Global bonds) and to play an countercyclical fiscal role. Under a basic scenario, a debt sustainability analysis indicates that the primary fiscal surplus needed to achieve the intermediate goal of reducing the debt is above 5 percent of GDP in 2003 and 2004 (see chapter 3 on Debt Administration and Sustainability). Note that although the law does not specify what fiscal efforts would lead to achieving this goal, it does at least suggest combining a number of countercyclical fiscal resources, equal to 2.5 per- cent of GDP (the intermediate value in the range of revenue variation in recent years). Given that the law lacks any essential elements for leveraging the fiscal sur- plus goal, a third priority is to supplement it. On the revenue side, a tax reform is suggested for the purpose of increasing the level of nonpetroleum receipts by a minimum of 2.5 percent of GDP, the amount suggested by the tax law. This will require at least three actions: (i) approving a series of tax policy measures that will generate approximately 1.4 percent of GDP, based primarily on limiting VAT exemptions exclusively to unprocessed basic foods and home rental and eliminating all other exemptions, particularly those on income tax and customs duties, with an estimated effect on collections of about I percent of GDP (see chapter 2 on Tax Administration and Policy); (ii) increasing the rate of the VAT given the possibility that petroleum prices will fall to their "normal" historic levels-below $US 18/bar- rel-considering that each additional point in the rate would generate increased col- lections of about 0.7 percent of GDP; and finally but no less important, (iii) not approving the "tax relief" measures proposed by the outgoing government in the last quarter, including donating 25 percent of income tax (ISR) to municipalities, reduc- ing the withholding at the source percentage on the VAT from 1 to 0.1 percent, and reducing to zero the duty on 158 products. A fourth priority is to adjust and reallocate spending and make it transpar- ent. The lessons learned in the three years of transition should be utilized so as not to continue postponing fiscal adjustment of spending. The only way to achieve sig- nificant primary surpluses is to adjust current and capital spending, redirecting the savings to key priorities of the government's strategy. There are three aspects to a reform of government spending. It is recommended that an emergency budget phase be dedared in order to contain spending. The 2003 budget should be declared a national emer- 30 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Box 2. The lLaw on Responsibility, Stabilization, and Fiscal Transparency This legislation was approved in late 2002. It has several objectives: to reduce public debt, contribute to stabilization and fiscal sustainabiity, use the savings by directing it to investments that encourage economic and social develop- ment, and establish regulations on public finances and transparency for effi- cient management and effective citizen oversight. The law approves the fol- lowing commitments: o There will be a multiyear plan at the start of each government for a period of four months to guide spending and investment and establish quarterly goals for each institution in the NFPS that can be monitored. o Central primary spending may not grow by more than a real rate of 3.5 percent per year. o The total central government deficit, without petroleum export rev- enues, will be reduced by 0.2 percent each year. o The debt/GDP ratio will fall 16 percentage points during the period 2003-06, and a similar provision will be applied to subsequent years until the ratio reaches 40 percent. o The real value of the state's debt to the Ecuadoran Social Security Insti- tute (IESS) will be paid off in four years. o For sectional (provincial and municipal) governments: Total annual lia- bilities must not be greater than 100 percent of revenues, and debt serv- ice must be less than 40 percent of total revenues. o Resources from the budget surplus and revenues from the OCP (incre- mental based on the not lower utilization of the SOTE for light petro- leums) will be the principal source of the FEIREP. o FEIREP resources will be distributed as follows: 70 percent to repur- chase external debt and pay off debt to the IESS, 20 percent to stabilize petroleum revenues until reaching 2.5 percent of GDP and to cover emergencies, and 10 percent to education and health. o The MEF will establish an official information and dissemination sys- tem, as will the sectional governments. o The annual budget will include the quarterly projection of revenues and tax spending (and budget headings to offset it), the list of productive and unproductive assets, contingent liabilities and fiscal risks, and an estimate of profits from state companies and autonomous systems. MINrTAINING STABILITY WITH FiscAL DISCIPLINE AND COMPETITIVENESS 31 gency budget and developed under strict austerity rules. This means con- fronting rigidities in spending. Various measures are suggested for achieving this: (i) limiting increases in spending to zero in real terms in 2003, which means establishing limits (possibly negative limits in nominal terms) on spending for salaries, goods and services, and investments; (ii) immediately suspending the application of the mechanism that automatically indexes salaries to projected (rather than actual) inflation that is used by the National Council on Public Sector Remuneration (CONAREM) and replacing it with a new restrictive mechanism; (iii) approving a Salary Unification Law with a neutral tax cost, which can lead to finding extraordinary external financing; (iv) immediately freezing the hiring of new permanent public employees and reviewing existing positions; and (v) using FEIREP funds to repurchase the most expensive debt in Global Bonds so as to reduce annual interest pay- ments. * It is recommended that fragmented spending be consolidated and redi- rected to priorities. This will require (i) explicitly prohibiting any new preal- location of revenues or expenditures; (ii) eliminating all existing prealloca- tions, except that for the Ecuadoran Social Security Institute (IESS); (iii) consider freezing the current transfer of 10-11 percent to sectional govern- ments during the emergency budget period, and (iv) condition future trans- fers (once the emergency budget has ended) on the concomitant transfer of responsibilities, the auditing of sub-national debt, and the requirement of evaluation by independent rating agencies before allowing further debt by large cities. * It is recommended that budgetary transparency be institutionalized at all levels of government and that it be strengthened with modern tools. Hav- ing approved the law, it is now urgent to design and implement a modern and consolidated version of the SIGEF, its principal instrument. The tax law also calls on sectional governments to "establish their own information systems for citizen oversight and reporting to the Ministry of Economy and Finance (MEF)." However, the implementation of a similar provision has proven to be chaotic in other Latin American countries that have seen a proliferation of incompatible systems supported by different computer platforms. The future version of SIGEF, supported by a single modern computer technology, must consolidate the accounts of the nonfinancial public sector-including the decentralized agencies and the sectional governments-and provide not only user-friendly access to the budget through a virtual user network but also bet- 18.Another of the law's problems is that the process for preparing the indicated mulriyear budger (as of January 31 of the month when the new government takes office) is inap- propriate given the serious problems with closing out the budget for 2001 and 2002, with late preparation of the 2003 annual budget, and the lack of transparency in spending. It 32 ECUADOR: AN ECONOMIC AND SocIAL AGENDA IN THE NEW MILLENNIUM ter control of compliance with established physical and financial policy goals.18 For the future, a fifth priority will be to amend the law to leverage greater fiscal discipline and reduce the burden of external debt. The law has various goals that are not sufficiently restrictive. For example: o The goal of reducing the nonpetroleum central deficit by 0.2 percent of GDP per year has a marginal impact. This deficit was -5.2 percent of GDP in 2002, and it would take decades to eliminate the deficit. This low annual objective could be increased. O The goal of 3.5 percent growth in central primary spending is inconsistent with a policy of spending austerity. In addition, productivity trends in the tradable goods sectors are negative and do not justify this. This goal should be reduced. o The law should reestablish a provision on the primary earnings of sectional governments and place limits on the their internal indebtedness. In addition, the law's limits on external indebtedness for the sectional governments (100 percent of total revenues for debt, and 40 percent of total revenues for debt service) are too high. International practice suggests 100 percent in the first case, but with respect to current revenues only (thus eliminating capital rev- enues that are usually extraordinary), and 25 percent in the second case. o The potential revenues of the FEIREP over the next four years are too limited to efficiently perform a countercyclical function: less than $US100 million each year projected for the period 2004-07.'9 Thus, we suggest that it would be better to allocate these funds exclusively to the debt repurchase fund. A sixth priority is the required strengthening of the extenmal position. The downward trend in excess freely disposable reserves increases the vulnerability of a recently dollarized system with a banking system that is still being restructured. To turn this situation around, it would be highly advisable to gradually accumulate a reserve "cushion" of about $US900-1,000 million.20 This would make it possible to provide extraordinary financing should it be needed to deal with situations such as a sharp drop in petroleum prices, a regionalized outflow of private capital, or mini- would be best to postpone budget preparation until mid-2003, with a plan to approve it for the period 2004-07, in conjunction with preparation of the year 2004 budget. The possibility of preparing the budget on a participatory basis, as Peru is already doing, could be explored. 19.This estimated amount does not include the funds that the Congress allocated to FEIREP to cover the state's debt to the IESS. 20. Note that the financial projection envisions an annual increase of $US 100 million in gov- ernment deposits in the Single Account of the Nation, which deposits are in turn part of "excess freely disposable reserves." MAINTAINING STABILITY WITH FiscAL DISCIPLINE AND COMPETITIVENESS 33 deposit runs on bank in the process of restructuring. Given that the projected FEIREP funds are minimal, that the recommendation is that they be used exclu- sively for debt repurchase, and that the chances of obtaining contingent credit lines overseas are nil, a possible alternative for financing this cushion would be to use a portion of the future revenues from the pending privatization program, which cur- rently go exclusively to the Solidarity Fund (see chapter 7 on Basic Infrastructure). A seventh priority is to mitigate the change in relative prices. Improving external competitiveness requires eliminating the bias against exports, promoting the diversification of nontraditional exports. In recent years, Ecuador has seen an appreciation in its real rate of exchange that is not favorable to its exports. There is a series of mutually consistent policies that Ecuadoran authorities could implement to generate a depreciation in the real rate of exchange, which would be favorable to its exports. These policies include (i) reducing government resource requirements with fiscal consolidation, which would lower interest rates and stimulate private investment; (ii) accelerating trade liberalization in order to increase the demand for tradable goods (see chapter 6 on Trade Policy and Competition); (iii) increasing national savings with a total reorganization of the financial system (see chapter 4 on the Banking System), development of the capital market, and reform of the social security system (see chapter 11 on the Social Assistance System); and (iv) promot- ing global external competitiveness with the measures indicated below. To the extent that this pro-export agenda is implemented, it will also be possible to achieve a reduction in the deficit in the trade balance and in the current account of the bal- ance of payments. The eighth priority is to implement an effective agenda of external competi- tiveness. In consultation with the private sector, the authorities have proposed a Competitiveness Agenda with eight themes (BCE 2002a). The agenda is compre- hensive, but its priorities and sequence still need to be defined and consensus must still be built with the private sector, making it difficult to implement the agenda. Ask- ing for simultaneous progress in so many areas weakens its content in practical terms. This is why one of the first steps the new administration should take is to develop a trimmed-back agenda of policy and laws to strengthen competitiveness, to be com- pleted in the first 12 to 18 months. This agenda should give priority to reformula- tion of the Law on Competitiveness adopted by Congress and vetoed by the past president (Box 3). The agenda could include measures needed to support the finan- cial system, trade policy, and private participation in infrastructure as mentioned above, in addition to measures on developing human capital (see chapter 9 on du- cation) and rural development (see chapter 13 on Rural Development). Added to this are activities in three specific areas: internal competition among companies, entry into the market, and labor markets. These areas include the following measures: * Promoting domestic competition. In the vetoed Law on Competition, the concept of competition should be clarified, the autonomy of the Competition Council should be improved, and the role of the Consultative Council, cur- 34 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM rently in the Ministry of External Trade, Industrialization, Fishing and Com- petitiveness (MICIP), should be clarified. • Eliminating barriers to entering the market. Attracting new companies promotes technology and new investment. However, a recent survey estab- lished the existence of 62 different steps that are needed to register a business in Ecuador, certainly one of the highest figures in Latin America. A drastic regulatory and administrative simplification is needed to lower the legal and operational barriers to the creation of new businesses, which extends to the agencies responsible for the registration of businesses, taxes, employment, health, and environmental licenses. o Flexibilization of labor markets. Chapter 16 on the Labor Market and Civil Service in Ecuador examines the reforms needed to improve salary policy, labor mobility, and the redeployment of the labor force among firms, and between the public and private sectors. In addition to this are reforms to the public vocational training system, which should encourage training in firms so that they can attain the necessary technical and administrative standards that are essential to their competitiveness. Beyond focusing on specific policies, an effective agenda must be one that can be monitored as a process. This means an explicit determination of intercompany com- petitiveness goals-defined primarily in terms of changes in product/service design, quality, cost, and delivery times. Corporate cluster organizations use a similar methodology to establish standards and monitor the evaluation of goals by the Competitiveness Council, analyzing policy options to improve its impact. E. Conduasion Ecuador's stability and recovery are promising, but fragile. Its fiscal and external posi- tion is vulnerable, in part because of its structural characteristics of high volatility in response to real or financial external shocks, in part because of the still heavy burden of its external indebtedness, and in part because of the persistence of expansive spending policies that have resulted in meager fiscal surpluses and high current account deficits. The probability that dollarization will collapse in the medium term is not negli- gible. Factors such as a drop in petroleum prices, loss of neighboring markets due to competitive exchange rate depreciations, or regional capital flight which indirectly impact the Ecuadoran economy are some of the foreseeable external shocks which would affect the economy to a greater or lesser degree, depending on how prepared the country is to face them. Thus, the future credibility of the country's economic program will not be achieved by the mere existence of a foreign exchange provision, but rather through a combination of consistent and credible policies that make it possible to provide appropriate management of the waning of the current petroleum boom, which may happen at any moment. MAINTAINING STABILITY WITH FiscAL DISCIPLINE AND COMPETITIVENESS 35 Box 3. Suggestions on a Draft of the Vetoed Law on Competition in Ecuador The vetoed law represents an excellent starting point for an initiative designed to strengthen Ecuador's private sector. However, from an international per- spective, certain aspects of the initiative need to be developed further and made clearer: * Types of conduct that are considered "illegal per se" (Art. 6) are not clearly differentiated from those that are to be considered punishable under the "rule of reason" (Art. 8). In effect, some behaviors (such as price discrimination and linked purchases) are examples used in both articles. It is highly recommended that "cartel" type conduct by com- panies be clearly distinguished from behaviors considered as abuse of a dominant position. * Institutionally, neither the independence of the government's antimo- nopoly authority (Consejo Ecuatoriano de la Competencia-CECON) nor its separation from the investigative and prosecutory body (the Superintendencia de Compafilas through the Intendencia de Competencia) is clearly established. For example, one of the functions of CECON (Art. 19) is to "establish national policies for the promotion and defense of competition, in accordance with the guidelines established by the President of the Republic..." In addition, the Director of the Secretariat has a subordinary Superintendency-the Superintendency of Com- panies-and also presides over CECON. International experience indi- cates that this type of institutional design increases the risk of state "cap- ture" and reduces effective compliance with the law. * Clarification of the role of the Consultative Council (Art. 20) and its relationship with CECON should prevent an overburdening of the agency and its mandate (Art. 7). The European Union and the antimo- nopoly authority of the Netherlands have tried to reformulate a similar provision. After the presidential veto and reformulation of the law, the new adminis- tration should make these revisions and proceed to discuss them with the pri- vate sector. Without seeking to be exhaustive, this chapter provides key elements for a sound and credible program for the next four years. It is essential to close Ecuador's imme- diate financial gap and resolve the insolvency of its debt position. Both tasks require the strong leveraging of the economy's fiscal discipline with tax reform, an austere 36 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM national emergency budget, and the repurchase of the debt using funds from FEIREP as prerequisites for fiscal sustainability. Improving prudential supervision of the financial system and strengthening the country's external position will also allow Ecuador to create a financial "cushion" of contingent resources for liquidity pres- sures on the banking system or outflows of capital owing to regional movements. In real terms, the objective is to adjust the relative prices of tradable and nontradable goods in order to promote a depreciation of Ecuador's real rate of exchange. This means, on the one hand, a comprehensive reform of its trade policy to eliminate the anti-export bias and correct the many and chronic distortions that still "protect" its economy-and on the other, closing competitiveness gaps by stimulating the factors of production: making labor markets more flexible, eliminating barriers to the domestic market in order to attract technology, and promoting human resources training and development. The risk of a failure to reform the real sector is that, given the existence of inflex- ible markets-such as the formal labor market-adjustments to shocks will occur primarily through reductions in production, with the corresponding contraction in demand derived from inputs, particularly labor. This potential situation will not only create pressure to "abandon" the model, in view of increased unemployment, but will also contribute to an increase in commercial bank arrears, as a result of the decline in general economic activity. This in turn would make achieving the goals of both fiscal adjustment and recovery of the banking system less feasible-creating a vicious circle that would be difficult to break. In summary, the sine qua non-condi- tions for sustaining dollarization are to achieve and then deepen fiscal solvency, introduce flexibility in goods and services markets, and increase the productivity of the factors of production. Policy Matrix z Measures z Short term Medium z Problem (first six months) term Progress indicators Objectives/goals CA High illiquidity and Design and implement Meet program goals Program performance Maintain stability, gain large financial gap a sound and credible during all indicators credibility, obtain multilateral macroeconomic management financing, and open Paris Club program negotiations Risk of insolvency of Achieve primary fiscal Goal achieved Reduce debt/GDP by a medium-term debt surplus of at least 5 minimum of 16 percentage percent of GDP in points as of 2007 2003-04 Low, volatile, and Approve tax reform Tax laws submitted to and Raise the nonpetroleum tax procyclical fiscal Review inherited tax approved by Congress burden by at least 2.5 percent z resources relief measures of GDP 0 Excessive, fragmented Declare a 2003 Prohibit any new Real salary indexation Adjust, consolidate, and spending that is not national emergency hiring of permanent equal to 0 percent redirect spending in a context transparent budget public employees and Amendments to law of greater budget transparency Establish spending evaluate existing submitted to and and an established poverty z limits (zero real growth positions approved by Congress reduction strategy - in 2003) Repurchase Global Gradual transfer of Suspend indefinitely Bonds resources to subnational automatic salary indexa- Transfer resources governments as they tion mechanism based on assumption comply with the new Prohibit new pre- of new functions, plan national investment allocations and to reschedule sub- policy exemptions, and national debt submit bill to (contingent included) (Matrix continues on the following page.) Policy Matrix (continued) %u Measures Short term Medium Problem (first six months) term Progress indicators Objectives/goals eliminate most and new rules for preallocations and future debts con- exemptions that are tracted by large cities not constitutional Modernize SIGEF o Suspend during emergency phase of subnational transfers m in excess of 10 per- 0 cent of current 0 revenues if there is n no information on their use, and transfer functions in con- ° junction with resources Approve an improved > SIGEFE z Tax law is not Prepare amendments Amendments to the law Strengthen fiscal discipline and > sufficiently restrictive, to the Law submitted to and reduce the burden of external does not have potential Use FEIREP to approved by Congress debt for collecting counter- repurchase debt z cyclical funds, but does have potential for debt repurchase p The change in relative Approve fiscal Complete financial Contain greater appreciation in Z prices in favor of measures reorganization the real rate of exchange prices for non- Eliminate customs Develop capital tradable goods and noncustoms market z (trending to barriers Reform social appreciation in security Z the real rate of Z exchange) harms external competitiveness Vulnerable external Establish annual goal Goal achieved Create a contingent liquidity position for increase in NFPS cushion of $US1 billion deposits in the Single Account (at least $USIOOM) Low competitiveness Select three to five New agenda and laws Establish the priorities of the and poor investment key priorities of submitted to and approved Competitiveness Agenda w climate the agenda by Congress Approve Law on a Internal Competition n Complete an inventory Create the single window Window in operation in Eliminate barriers to the of existing barriers and for recording and early 2004 creation of businesses the institutional approving new regulations reform plan Approve the Salary Amend labor laws Law submitted to and Increase the flexibility of labor Unification Law Develop plans approved by Congress markets and provide training Design plan for Plans underway through firms company training Annex ]Ecuador Selected EEconomic Indicators (As a percentage of GDP, unless otherwise indicated) 1997 1998 1999 2000 Est. 2001 Est. 2002 Proj. 2003 I. National Accounts Gross National Investment 21.5 25.3 14.7 20.1 25.7 27.2 26.4 Gross National Savings 18.4 15.9 20.5 26.4 23.2 20.6 20.1 Financing Gap 3.0 9.3 -5.7 -6.3 2.4 6.6 6.3 Government Investment 3.1 3.6 3.8 2.9 3.5 4.5 3.7 Government Savings 3.5 0.4 0.9 6.9 7.5 7.3 7.9 o Government Savings Gap -0.4 3.2 2.9 -4.0 -3.9 -2.8 -4.2 0 Private Investment 18.4 21.7 11.0 17.2 22.1 22.7 22.7 Private Savings 14.9 15.5 19.6 19.5 15.8 13.4 12.2 Private Savings Gap 3.4 6.1 -8.6 -2.3 6.3 9.4 10.5 II. Nonfinancial Public Sector 0 Current Revenues 21.6 19.1 22.5 27.6 24.7 25.7 26.6 Taxes 7.8 8.5 9.1 11.7 12.3 12.3 12.3 Petroleum Revenues 5.4 3.9 6.2 9.2 6.4 5.7 6.5 6 Current Spending 18.2 18.9 21.2 21.0 17.3 18.5 18.7 z Interest 4.3 4.2 8.1 6.6 4.7 3.6 3.6 Capital Spending 5.5 5.2 6.0 5.5 6.7 6.5 5.5 z Primary Balance 2.2 -0.9 3.4 7.7 4.6 4.0 5.4 Global Balance -2.1 -5.1 -4.6 1.0 -0.1 0.4 1.8 Z NFPS Balance without Petroleum -7.5 -9.0 -10.9 -8.1 -6.5 -5.2 -4.7 III. Balance of Payments GNFS Exports 25.8 21.5 31.6 37.1 27.1 24.3 22.2 GNFS Imports 24.4 27.2 22.1 28.2 29.0 30.9 28.9 Trade Balance 2.5 -4.3 10.0 9.2 -1.4 -5.3 -5.6 Remittances 2.7 3.4 6.5 8.3 5.8 5.4 5.4 z Current Account Balance -3.0 -9.3 5.7 6.3 -2.4 -6.6 -6.3 Current Account Balance z without Petroleum -5.4 -9.5 -0.2 -5.6 -7.2 -11.4 -10.5 Direct Investment 2.9 3.6 3.8 4.5 6.3 4.9 4.3 ;y Reserves* - - -1.5 4.9 2.8 1.6 2.3 IV. Indicators of credit capacity ** Total External Debt/GDP 63.9 70.5 97.6 85.1 68.5 65.7 60.8 Total External Debt/Exports 248.1 327.5 309.4 229.4 252.9 270.7 273.5 Total External Debt Service/Exports 97.6 151.3 125.0 202.4 118.6 114.9 124.8 Memo: GDP Growth 4.1 2.1 -6.3 2.8 5.1 3.0 3.5-4.0 GDP in $US $23,636 $23,255 $16,674 $15,934 $21,024 $24,507 $26,725 Q Z -. No data available. w *Excess freely disposable international reserves. Includes arrears and adjustment for exchange rate variation and differs from records in balance of payments in that the latter does not include earlier payments or refinancing. 0 Source: Central Bank of Ecuador, MEE and IME Information updated as of January 22, 2003. 3 2 Tax Policy and Administration' Osvaldo Schenone The three principal tax policy problems in Ecuador are lack of simplicity, a small tax base, and an inefficient use of resources. The reasons behind these problems are, first, the proliferation of taxes, a trend that lacks transparency and hides inequity and inefficiency in the allocation of resources. A second reason is the tax exemptions, which introduce dis- tortions and do not comply with any of the tax policy objectives, especially with respect to redistribution in the case of the Value-Added Tax (VAT)(Impuesto al Valor Agre- gado-IVA) and are inefficient in achieving the goal of promoting socially equitable undertakings in the case of ISR (Impuesto Sobre la Renta-Income Tax) exemptions or import duties. Finally, a third reason is the tax revenue preallocations, which do not allow for the efficient use of tax resources and discourage the collection effort by those jurisdictions that prefer to count on transfersfrom the central government. A tax simpli- fication-by abolishing minor taxes; broadening of the base through the elimination of exemptions; and reorienting taxes, through the elimination of preallocations-would result in lower administrative costs for collecting taxes, an increase in tax revenues, and more efficient allocations. Regarding tax administration, the two most serious problems are the inadequate institutional design of the Internal Revenue Service (Servicio de Rentas Internas-SRI), whi.ch makes it vulnerable to constant pressures from private interests, and the poor anti-evasion efforts by Customs, which has not been reformed and, consequently, has not had the same dynamism as SRI, in spite of the fact that they share the same computer system. Good practice would suggest reinforcing the independence of the SRI and merging with Customs under a single authority. 1. Osvaldo Schenone is a tax specialist and World Bank consultant. He is professor of eco- nomics at the Universidad de San Andres, Bueonis Aires, Argentina. 43 44 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN 1HE NEW MILLENNIUM A ]Backgrouind The advent of the new millennium not only brought a new monetary system-that is, dollarization-to Ecuador, but also put an end to the deficit in the Nonfinancial Public Sector (NFPS, SPNF in Spanish), which characterized the final decades of the last century, by generating a primary surplus through primary cost containment (as a percentage of GDP) and an increase in tax revenues, primarily VAT. The NFPS comprises the central government, the municipal governments, the Ecuadorian Social Security Institute (Instituto Ecuatoriano de Seguridad Social-IESS), and a multitude of other public enterprises. The income from taxes and non-taxes (pri- marily from oil) of the NFPS have, during recent years, amounted to 22 percent of GDP, with a recent tendency to increase, as indicated in Table 1. This table also shows the portion of the income received by the central government under the headings of income from oil and income from taxes. The income from taxes, in turn, are shown in the table, separating, on the one hand, the taxes collected outside the SRI and, and on the other hand, the taxes collected by this Service-that is, ISR, VAT, ICE (Impuesto a los Consumos Especiales-Special Consumption Tax), and others. As indicated in Table 1, the increased income by the central government and, in general, by the entire Nonfinancial Public Sector is primarily due to the increase in VAT revenues, since the increase in ISR, ICE, and others were significantly less, in terms of percentage of GDP, as of the middle of the last decade. VAT revenues account for more than 60 percent of all SRI collections. Table 1. Total Income by the Nonfinancial Public Sector and the Central Government, 1995-2002 (expressed as a percentage of the GDP) Central Government Taxes Within the SR1 Non-financial Public Outside Year Sector Total Oil the SRI Total ISR VAT ICE Other 1995 22.7 15.5 5.9 3.7 6.0 2.0 3.0 0.5 0.4 1996 21.8 15.7 7.3 2.7 5.6 1.9 3.0 0.4 0.4 1997 19.9 13.8 5.3 2.5 6.0 1.8 3.2 0.7 0.4 1998 17.2 13.2 3.8 3.2 6.2 1.8 3.6 0.5 0.3 1999 20.8 13.2 4.4 1.3 7.6 0.6 3.4 0.5 3.0 2000 25.8 17.4 6.7 1.1 9.6 1.6 5.4 0.6 2.0 2001 23.4 17.9 5.8 1.5 10.6 2.6 6.8 0.8 0.4 2002(e) 24.2 18.0 6.0 1.4 10.6 2.5 6.9 0.9 0.4 (e). Estimate. Source: Actual preparation from the database of the Ministry of Economy and Finance, SRI, in E Andic and A. Mann, Report on the Internal Revenue Service of Ecuador. Tax Revenue andAdministrative Policy (Salto Project), May 2002; and J. Bour, D. Artana, and F. Navajas, Fiscal Problems in Ecuador (International Development Bank), September 2002. TAx POLICY AND ADMINISTRATION 45 At present, the tax income of the central government not administered by the SRI consists primarily of customs tariffs, collected by CAE (Corporacidn Aduanero de Ecuador-Ecuadorian Customs Corporation).2 The SRI director is a member of the CAE board, in what may be interpreted as an indicator of the intention to merge the two institutions, which, up until this date, has not yet occurred. The fact that the improvement in the VAT collection efforts has not been accom- panied by a parallel improvement in ISR may be attributed to several factors, one of which is the zigzagging policy of first abolishing and then re-adopting the ISR in 1999. Another factor is that, as indicated in a later section, in recent years the ISR has suffered the effects of repeated and varying exemption proposals with greater severity than other taxes. The tax administration also shows a change in orientation during the final years of the last decade. The SRI was created in December 1997 as a replacement for the discredited Internal Revenue Office. Likewise, in 1998, the CAE was created as a replacement of the previous National Customs Office. At the time of its creation, the SRI did not have a central taxpayers' registry-only several registries at the dif- ferent regional offices throughout the country. This used to make it possible for a delinquent or tardy taxpayer to simply register at another regional office, and avoid punishment for previous delinquencies. A number of improvements have been made since then. A centralized taxpayers registry (Registro O}nico de Contribuyentes-RUC) has been created, with 1.1 million registrants (80 percent of them individuals and 20 percent legal entities). The num- ber of personnel was reduced and training was increased. More than 95 percent of the print shops authorized to print sales and withholding receipts were verified in 2002 (with an electronic authorization system for printing invoices, which reduces the time duration of the process-including taxpayer verification-to just a few minutes). The large taxpayers (approximately 3,000 companies, which generate around 80 percent of SRI revenues) are subject to special procedures, since a special unit for attending to their needs is not considered necessary. And finally, the management indicators show satisfactory levels for 2001 and 2002, as indicated in Table 2. The SRI is making use of third-party information to increase taxpayer compliance. Cross-checks performed during 2001 and 2002 detected approximately 100,000 per- sons not registered in the RUC. The fact that companies and public entities are sub- ject to VAT, offers excellent possibilities for cross-checking information, because when these entities request a reimbursement of VAT credits, they automatically reveal their identities to their suppliers. Because of the large volume of purchases made by the state, the volume of resultant cross-checked information is also very large. 2. Other sources of tax income, which are of lesser significance in terms of size, are two taxes on transportation and oil by Sistema de Oleoducto Transecuatoriano (TransEcuadoran Pipeline Systen [SOTE]), administered by the Central Bank, and the taxes on lubricants and aviation fuel for international service and the airport tax, administered by the Civil Aviation Office. 46 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MiLLENNIUM Table 2. Some SR1 Management Indicators 2001 2002 Debt collected versus outstanding debt 23% 41% Forced collections versus collections under management 1.7% 2.8% Taxpayers who declare nothing versus taxpayers who declare a gain 47.2% 41.4% Taxpayers who declare versus taxpayers who should declare 43.4% 33.5% Notifications to actual non-filers versus (special) non-filers 94% 89% Notified taxpayers with cross-checked differences versus planned notifications 47% 91% Source: SRI. As a result of cross-checking the information, however, delays have been created that have to be resolved. The cross-checked information of ISR and VAT declara- tions by one taxpayer and the various taxpayers who buy and sell among themselves, have been delayed and the results from the cross-checked declarations of 2000 are not yet available. The SRI is a proponent of the strategy of limiting to a minimum any visits to companies, in order to avoid needless discussions (which, it is feared, could lead to opportunities for corruption) among its auditors and the accountants of the com- panies, and has replaced said visits with information cross-checks and subsequent notifications of irregularities to the taxpayers. Even though the SRI has the legal power to contract private collection agencies, it refrains from using them because a large number of the delinquent accounts come from the old Internal Revenue Office and it has not yet been possible to verify the legitimacy of the claims. The so-called Ecuadorian Simplified Tax System (Rdgimen Impositivo Simplifi- cado Ecuatoriano-RISE), an initiative for small producers and informal vendors, is pending legislative action. According to this initiative, these taxpayers would pay a monthly sum based on their estimated income, and they would not be obligated to maintain an accounting system, but they must issue and receive invoices. The SRI estimates an annual income from this of approximately $US20 million, or 0.1 per- cent of GDP. 13. The Three IPrimary IProbhlenms of the Tar PoRicy The main difficulty of Ecuadorian economic policy is its subordination to immedi- ate political urgencies. The Economic and Public Investment Balance from January 2000 to January 2003 provides a good example: "Once the goal of economic stabil- ity was reached, the national political front became complicated again. By not hav- ing a political party or a majority in Congress, the government was obliged to incur TAx POLICY AND ADMINISTRATON 47 expenses and recruit economic authorities that provided it with greater discretionary space. This produced a reduction in the primary fiscal surplus which would have been better used as a contingency fund, but which unfortunately was used to guar- antee the short term political governability in the absence of a long-term national pact."3 In the specific issue of tax policy, this subordinarion led to the creation of multi- ple taxes to satisfy the demands of different interest groups, while at the same time conceding exemptions for the same purpose. With the same desire to expand inter- est group accommodation, what remains of tax revenues after exemptions is preal- located to different beneficiaries. This delicate balancing act leaves few resources for the government to be able to provide public goods and infrastructure to benefit the entire population, rather than a few interest groups. Even though various problems exist with the Ecuadorian tax system, three stand out owing to their importance and the urgency with which they require a resolution. They are the proliferation of taxes, tax exemptions, and preallocation of tax rev- enues. Among the problems not chosen for detailed treatment in this chapter-despite their importance-are the limited progressiveness of personal income tax and the collection repercussions of reduced customs tariffs.4 The Problem of the Proliferation of Taxes Even though nearly all of the country's tax revenues stem from 10 different taxes, and half of them (VAT, ISR, ICE, customs tariffs, and the vehicle tax) generate more than 75 percent of the tax revenues, the SRI has identified more than 80 taxes according to the classification shown in Table 3. This situation implies unnecessarily high administrative costs for both the tax- payers and the administration. It discourages payment on the part of the taxpayers, and supervision on the part of the tax authority. The proliferation of taxes demonstrates the need to "fine-tuning" the tax policy, carefully selecting which sector must pay the benefits received by the ones selected- which also requires detailed exemptions and, possibly, also exceptions to the exemp- tions. This type of tax policy lacks transparency and hides inequity and inefficiency in the allocation of resources. Without pretending to be an exhaustive list, some well-known examples are as follows: (1) the tax on company assets by the Superin- tendency of Companies, which then receives and uses those same taxes; (2) financial societies also being subject to the asset tax, which is allocated to the Superintendency 3. D. Badillo and R. Salazar, Economic and Public Investment Balancefrom January 2000 to January 2003 (Ministry of Economy and Finance, November 2002), p. 5. 4. The reasons why the customs tariffs must be reduced and made more uniform are treated in the chapter on Commerce and Competitiveness. 48 ECUADOR: AN ECONOMIC AND SOCIAl AGENDA IN THE NEw MILLENNIUM Table 3. The Structure of the Tax System Benefieiaries Number Central Munic- Type of Tax of Taxes Gov. palities Pro= Others Income and Capital Earnings Tax 5 3 1 1 Payroll Tax 1 1 Property and Net Worth Tax 26 1 l 1 2 12 Real Estate Transfer Tax 24 8 2 14 Financial Asset Tax 6 1 5 Sales Tax on Goods and Services 17 7 3 7 VAT 1 1 ICE 7 6 1 Telecommunications 1 1 Electricity 4 4 Public Entertainment 3 1 Betting 1 2 Foreign Trade Tax 1 1 Various Taxes 4 2 1 1 Totals 84 15 24 4 41 Note. The Others category is composed of an enormous variety of institutions. For example, the Guayaquil Beneficence Council, the State University of Guayaquil, the Guayas Transit Commission, the Ecuadorian Social Securiry Institute, the Osvaldo Loor Foundations, the Potable Water Company, the National Promotion and Development of Sports, the Superintendency of Companies, the Superintendency of Banks, the Ecuadorian Tourism Corporation, the National Children's Fund, and so on. Source- SRI. of Banks; (3) the tax on the total assets of Act 006-88, which is allocated to the municipalities; (4) the tax on luxury and first-class hotel assets, which is allocated to the Ecuadorian Tourism Corporation (CETUR); and (5) the additional tax of Act 92-88 on bank profits of Act 92-88 whose tax revenues are allocated to the National Children's Fund (FONDIFA). The Recurring Problem of Exemptions Tax policy is constandy confronted by the challenge of exemptions. Despite the dif- ficulty in eliminating them, Ecuador has been successful in reducing exemptions between 1999 and the first half of 2001. But following this period, within the space of a little more than one year, renewed efforts have been made to reinstate them. During the first period, the ISR exemption was eliminated for the financial sec- tor on the income from securities and shares issued by the government, for cooper- 3. It should be noted that some of those "reforms of the state," while necessary, would reduce fiscal costs only in the medium- and long-term (and may increase them in the short-run, for example, because of related severance payments). TAX POLICY AND ADMINISTRATION 49 atives and provident societies (except for the ones established by farmers or officialy recognized indigenous people) and the for promoting development (directed pri- marily at tourism and industrial endeavors). As well, the list of items subject to VAT was replaced with a tax list of VAT-exempt services (fundamentally, housing rentals and financial services)-which, therefore, leaves all other services subject to VAT. Nevertheless, since the middle of 2001, initiatives to create new exemptions have become more intense. The most important of these are as follows: * To exempt interest on mortgage loans from ISR. * To defer the VAT payments on the import of goods until the sale or use of such goods generate a tax debit against which the VAT can be credited. * To reinstate exemptions in the tourism sector (with the feature-still under discussion-of allowing the acquisition of shares in a tourism project to be deductible from the ISR to be paid by the purchaser of the shares). * "Tax-free zones" of large geographic dimensions (significant parts of a province or county) in which companies would be exempt from most taxes, regardless of the final destination of their products (internal market or export) .5 * The Export and Investment Promotion Corporation (Corporacidn de Promo- cidn de Exportaciones e Inversiones-CORPEI) granting a subsidy up to 5 per- cent on the freight on board (FOB) value of the exports. * A reduction of 1 to 0.1 percent of the retention that the buyers of agricultural goods for export charge the producers, at the expense of the ISR to be paid by the latter. * Generous deductions on the payment of ISR. The SRI has called this set: of initiatives "the dismantling of the tax base." In spite of the importance with which the authorities perceive the problem of the ISR and VAT exemptions, a tax cost calculation of these tax expenditures has not been made. A team of outside consultants began a quantification study on this matter in mid- November, 2002. Aside from the results that may be obtained through these estimates, provisional calculations of the internal VAT exemptions can be made right now (that is, exclud- ing the VAT on imports) on the basis of a sample of 3,055 large taxpayers during 2001, which represents 84 percent of the SRI tax revenues. This provisional estimate is presented in Table 4, and indicates a tax cost on account of the internal VAT exemptions of approximately $US237 million; or 1.1 percent of GDP for the year 2001. Approximately half of this comes from the commerce and industry sectors. 5. Hence the quote marks around the expression "tax-free zone," since the term is usually reserved for places where goods are produced only for export. 50 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Table 4. Estimated Tax Cost of the Internal VAT Exemptions, 2001 (in nillions of U.S. dollars) Taxable Export of income Income Exempted Tax Total goods and before actually estimated eredit on Fiscal Sector Income services exemptions taxed income purchases cost Agriculture 1,339 363 976 86.6 889.4 533.6 42.7 Commerce 7,162 507 6,655 5,148.6 1,506.4 903.8 72.3 Construction 523 1 522 467.8 54.2 32.5 2.6 Energy and gas 572 0 572 89.9 482.1 289.3 23.1 Energy and mining 571 431 140 65.3 74.7 44.8 3.6 Finance and insur. 1,499 63 1,436 1,190.0 246.0 147.6 11.8 Industry 5,468 899 4,569 3,469.9 1,099.1 659.5 52.8 Others 25 1 24 13.0 11.0 6.7 0.5 Comm. Services 3,089 909 2,180 1,982.4 197.6 118.6 9.5 Transp. and comm. 1,405 30 1,375 998.7 376.3 225.8 18.1 Total 21,654 3,204 18,450 13,512.4 4,936.6 2,962.2 237.0 Notes: (1) The tax credit for purchases was estimated as 60 percent of the estimated exempt income. (2) The fiscal cost was calculated as 12 percent of the difference between the estimated exempt income and the tax credit for purchases. Source: Ministry of Economy and Finance. An alternative estimate is shown in the annex, using National Accounts data, giv- ing as the combined result of the exemptions and tax evasion a tax cost of 1.9 per- cent of GDP. This result is not inconsistent with a tax cost of the exemptions of 1.1 percent of the GDP. Attributing the tax cost to the exemption on the basic food items and relating that to the entire agricultural sector (and admitting that this is an overestimate), it can be concluded that the remainder of the exemptions imply a tax cost of at least $US195 million for 2001, or approximately 0.9 percent of GDP. The exemptions on customs tariffs and VAT on imports,6 according to an esti- mate for 2000 and 2001, are concentrated in five tax codes which account for 93 percent of these types of exemptions, shown in Table 5. Their tax cost represents approximately $US123 and 148 million (for 2000 and 2001, respectively), or 0.7 percent of the GDP of these years, without including the exemptions for commer- 6. The exemption of VAT on imports has a limited tax revenue effect, since the majority of the import operations are not performed by end users, but by wholesalers, with the result that when they pay VAT they would claim the corresponding tax credit when they sell the products to retailers. In this way, the net VAT collection on import operations tends to disappear and show up as VAT on domestic operations (that is, in the retail sales to the end consumer). TAx POLICY AND ADMINISTRATION 51 Table 5. Tax Cost of Exemptions on Customs Tariffs and on the VAT on Imports, 2000 and 2001 (mlns $US) Cost and Freight (CIF) Value Tax cost of imports rate Code number and name of the exemption 2000 2001 Tariff VAT 2000 2001 407-Exempt from VAT 712.8 848.4 12% 85.5 101.8 395-Pharmaceutical products 29.0 27.0 5% 12% 5.0 4.6 464-Public sector 115.2 161.9 10% 12% 25.3 35.6 343-Public secror donations 1.8 11.6 10% 12% 0.4 2.6 413-Exempt from VAT (Public sector) 59.1 30.5 12% 7.1 3.7 Total 917.9 1,079.4 123.3 148.3 Note: The tariff is the average of the tariff positions involved. Source: Ministry of Economy and Finance. cial agreements, such as the Andean Community Nations (Comunidad Andina de Naciones-CAN), or the Aladi, as indicated in the same table. Nevertheless, as explained in the footnote, it would be an overestimate of the tax cost of the exemptions to include the VAT exempted from imports. Leaving only the exempted tariffs in the previous calculation, the final cost of the exemptions are estimated at 5 and 10 percent, respectively, for 2000 and 2001, on the imports under Codes 395, 464, and 343. This makes for a total tax cost of between $US13 and 18 million, or approximately 0.1 percent of the GDP, for 2000 and 2001, respectively. The exemptions based on trade agreements, on the other hand, represented a tax cost, in 2001, of approximately 90 percent of the tariff revenues of that year-or 1.4 percent of GDP-broken down as: * Exemptions by CAN: $US247 million; * Exemptions for trade with Chile: $US18 million; * Exemptions for trade with Mexico: $US 11.2 million; * Exemptions for trade with Argentina: $US6.2 million; and * Exemptions for trade with Brazil: $US12.8 million. The promoters of exemptions generally draw on two arguments. First, the exemptions promote certain select activities whose competitiveness must, presum- ably, be safeguarded and increased through tax or tariff policies; and second, the argument of equity. The first argument is generally used when exemptions to the ISR or to the customs tariffs are proposed, while the second argument is used for proposing exemptions on VAT, for a variety of products. Neither of the two arguments are particularly valid. Promoting business through tax or tariff exemptions requires the identification of those ventures whose promo- 52 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM tion would be beneficial to the society as a whole and not only to the investors involved. The errors of identification that might result would be too cosdy for tax- payers who were not selected. Furthermore, there is no mechanism to ensure that only involuntary and honest mistakes would be committed which thereby opens up opportunities for corruption and is another disadvantage of the exemption policy. Exemptions on customs tariffs have, in general, strongly prejudicial effects on the economic efficiency, as they can generate widespread protection and, therefore, can create business opportunities that may be be profitable, but are disastrous to the national economy.7 The equity argument in favor of exemptions also has limited validity. VAT exemptions on popular consumer goods constitute a highly inefficient way of intro- ducing progressiveness into the tax system. Although it is generally true that the exempted consumption represents a greater percentage of the total consumption by poorer families, it is the richer homes that benefit more from the exemptions. In the case of Ecuador, it was calculated in 1999 that out of every 100 sucres the tax office did not collect because of the exemptions on education, books, health, transporta- tion, water, and electricity (in other words, except basic food items, house rental and financial services) 43 sucres benefited the richest 25 percent of the population and only 14 sucres benefited the poorest 25 percent.' Techniques have to be found to get the 14 sucres to the poorest sector, without, automatically, having to award the rich- est sector with 43 sucres. Moreover, VAT exemptions complicate the tax administration for the taxpayers and the SRI alike. Taxpayers who sell exempted products as well as taxed products have to attribute the credits for VAT paid on their purchases on some of their sales, thereby complicating the accounting system of the business. Furthermore, the exemption creates a temptation to claim all of the VAT credits, as if all of the pur- chases were dedicated to the supply of taxed products. This gready complicates the taxation task of the SRI and the CAE. The Problem of Preallocations Income preallocations, whether they are from tax revenues or oil, are found scattered throughout 50 pieces of legislation-laws, decrees, or ministerial agreements. In 2001 there were 32 preallocations from tax revenues and 25 preallocations from oil income. The amount of preallocated tax revenues for that year were $US303 million, that is, 1.4 percent of GDP, of which 81 percent corresponded to VAT and ISR ($USI 12 million to VAT and $US 133 million to ISR). 7. This matter is discussed in detail in the Commercial and Competitiveness chapter. 8. G. Kopits, E. Haindl, E. Ley, and J. Toro, Ecuador: Modernization of the Tax System (Inter- national Monetary Fund, Department of Public Finances, November 1999), p. 24. TAX POLICY AND ADMINISTRATION 53 The percentage of the preallocated VAT revenues is 12 percent (1.5 percent to SRI, 10 percent to the Permanent Fund for University and Polytechnic Develop- ment (FOPEDEUPO), and 0.5 percent to the state universities), which is approxi- mately equal to the average percentage of the preallocation of all taxes, which, for 2001, reached 14.3 percent of total tax revenues.9 In the case of the ISR, the percentage of preallocation is at least equal to 28.5 per- cent of the tax revenues designated for various purposes. But furthermore, each tax- payer has the right to request, in writing to the tax authority, that up to 25 percent of the tax said taxpayer pays be transferred to the municipality where he or she main- tains his or her home. If all of the taxpayers would make use of this right, 53.5 per- cent of the ISR's tax revenues would be preallocated. Preliminary data for 2002 indicate that, possibly because of the use the taxpayers make of this right, the average percentage of preallocation of all taxes increased to approximately 19 percent of the total tax revenues. As an example, the ICE preallocations are shown in Table 6. Of the six categories of goods and services subject to taxes, only one (telecommunications) does not pro- vide any income for to the central government. All of the others provide income that fluctuates between 83.5 percent and 89.5 percent of their respective tax revenues, as can be observed in the last row of the table. The preallocations of the customs tariffs consist of 3 percent for the Water Resources Council and 3 percent for the CAE. The other 94 percent goes to the cen- tral government. Preallocation procedure prohibits the tax resources from being oriented to where their productivity is greatest. It promotes inefficient, and possibly also inequitable, use of the tax resources. The problem is particularly dire in the case of the funds allocated Table 6. Preallocation Percentages of the ICE Tax Revenues soft Cigarettes Beer drinks Alcohol Telecomm. Luxuries Hospital Equipment 10 10 10 10 - 10 Free Maternity Care 3 3 3 3 - - Osvaldo Loor Foundation - - - 2 - Internal Revenue Service 1.5 1.5 1.5 1.5 1.5 1.5 Potable Water Company - - - - 65.67 - National Sports - - - - 32.83 - Central Government 85.5 85.5 85.5 83.5 - 88.5 Source: Ministry of Economy and Finance. 9. See J. Gallardo, Tax Reform: Guarantyfor the New Generations (Ministry of Economy and Finance, August 2001), p. 53. 54 ECUADOR: AN ECONOMIC AND SOCIAL. AGENDA IN THE NEW MILLENNIUM to regional governments, since the automatic transfers discourage these governments from collecting their own taxes, thereby promoting irresponsible expenditure behav- ior, since the governments do not have to face the political costs of collecting taxes. In March 2001, the government sent the parliament a bill for a Fiscal Discipline and Prudence Act, whose Article 22 abolishes "the preallocations in the same way in which they were established." Likewise, the bill legislated that "the General State Budget for the year 2002 would compensate, in the same amount, the Public Sec- tor entities or organisms for the aLlocation actually received by them during the pre- vious year." The proposed preallocation elimination mechanism attempted to soften the tran- sition, preventing the public sector entities or organizations from suddenly experi- encing a shortage of financing." Nevertheless, this component of the bill was not approved, leaving the preallocation regime unchanged. C. Two IPriority Piroblems for the Taz A6ministration After the SRI and CAE reforms at the end of the last decade, a notable improvement was observed in the tax evasion control of the former, while the latter did not show evidence of significant improvement. The institutional designs of the SRI and the CAE are the most pressing issues of the tax administration. Other matters are less urgent and of a more operational nature, such as the adop- tion of a checking account for each taxpayer, and for each type of tax, so that pay- ments and reimbursements may function in the same way as a bank account. As a result, tax evasion control should improve, since the payments of each taxpayer and for each type of tax could be electronically reported to the SRI without delay. The delay in processing the information cross-checks needs to be resolved, as the results of the tax returns of 2000 are still not available. Likewise, in the tax returns of 2001, filed in April 2002, taxpayers have been detected who wrongly calculated the rein- vestment deduction into the ISR, but at this writing (November 2002), they have not been notified yet. Finally, a prompt adoption of filing tax returns via the Inter- net must be taken into consideration. 10.Kopits and others, Ecuador: Modernization of the Tax System (International Monetary Fund, Department of Public Finances, November 1999), p. 14. This proposal is consis- tent with the recommendation included in this study: not exceeding the proportion of preallocated revenues by the Constitution to the sectional governments effectively reached in 1999 (9 percent of the current income, instead of 15 percent preallocated), and not exceeding the preallocarion for educational expenses above the effectively reached per- centage in 1999 (12.5 percent of the current income, instead of 30 percent preallocated). Finally, the abolition of all other revenues preallocated by law was recommended, except the revenues of the Ecuadorian Social Security Institute. TAX POLICY AND ADMINISTIlATION 55 The Independence of the SRI The SRI board consists of six members with voice and vote, and the executive direc- tor of the SRI, with voice but no vote. The members of the board are as follows: The Minister of Finance (with two votes in case of a tie); the Superintendent of Com- panies; the Superintendent of Banks; the Undersecretary of the Budget; the Minis- ter of Industrialization, Commerce, Integration, Fishing and Competitiveness; and one representative of the private sector. This board needs to be reinforced to put it into a better position to resist pres- sures (from the public sector itself and, naturally, from the private sector) that tend, without breaking the law, to satisfy objectives outside of the scope of collecting taxes-such making a profit promoting the competitiveness of a given sector, or improving the equity of the distribution of tax revenues. These may all be noble aims, but they are outside the objective of tax collection-which should be the exclusive goal of the SRI-and may impede its effective. The Efforts of the CAE The anti-evasion efforts of the CAE has not had the same dynamism as that of the SRI, in spite of the fact that it shares the computer system that was upgraded and modernized by the SRI before sharing it with the CAE. This includes online infor- mation from the moment the merchandise is shipped from the point of origin, in such a manner that the taxes can be paid and the merchandise liberated from cus- toms at the moment of arrival in the port, preventing all storage problems and their corresponding delays." CAE has not been completely reconstructed, as was the case for the SRI, which practically replaced all of its personnel. CAE failed to replace hardly anyone, since the labor regulations prevent the dismissal of employees, unless the department within the CAE is abolished in which the employees work. (The managers, for example, are appointed for four years and cannot be removed by the board, even for negligence or other type of substandard performance). The possibility of overhauling the CAE should be considered, or an evaluation should be made concerning the advantages of merging this institution with the SRI, without endangering the efforts of the latter. The tax reform legislation of March 2001 merged the two institutions, but Congress rejected this initiative as a result of strong pressure from the importation sector. Later, in November 2001, the partici- pation of the executive director of the SRI as president of the CAE board was approved by law. 11. Payment by the taxpayer is immediately recorded in the network of banks, which also pre- vents possible fraud at the bank counters. This computer system also provides better con- trol of temporary admission mechanisms and tax deposits for merchandise. 56 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM A bill is currently before Congress on the Reform of the Internal Customs Act, which incorporates labor reforms that would allow a personnel restructuring similar to that of the SRI. Law 41 of 1999 provides that the merchandise in warehouses or storage areas may be inspected to verify whether the property is backed by documents proving merchandise ownership (commercial invoice if it is national, or a shipping bill in the case of international shipments). These documents must also be shown by trans- porters who move the merchandise from one place to another. The absence of these documents provides permission for seizure of the merchandise and to uncover cases of evasion of VAT or contraband. This procedure has practically not been used in Ecuador. Decided official backing for the observance of this law coupled with an adequate reform of the Internal Customs Act could be a substitute for the disappearance of the Customs Office and its merging with the SRI. D. Recommenmdalios The tax revenue value of this set of recommended tax and administration policies would be approximately 1.2 percent of GDP. If this increase in tax revenues were not sufficient for the macroeconomic balance, it would be recommended to increase the VAT rate, since each percentage point (within the scope of an existing rate) added to this rate is estimated to generate an increase in tax revenues of approxi- mately 0.6 percent of GDP. . The adoption of these recommendations would produce a less complicated tax system that is broad-based and consistent with an efficiently functioning economy. ELIMINATION OF MINOR TAXES. We recommend that the collection and disburse- ment of these minor taxes be eliminated. It is well known that the financial effects of their elimination would be of little significance, but the design of an orderly elim- ination strategy would require more detailed knowledge of the structure of each of these taxes. Their elimination would allow the tax authority and taxpayers to reduce administrative costs and to concentrate on the truly important taxes. The tax rev- enue effect is ambiguous, since an improved compliance with the important taxes may provide greater tax revenues than the one generated by the minor taxes whose elimination we are recommending. ELIMINATION OF EXEMPTIONS. We recommend that VAT exemptions only be applied to unprocessed basic food items and residential rentals that are in addi- tion to a primary home. Consequently, we recommend the elimination of exemp- tions on agricultural input items (such as seeds, balanced feed, tractors, fungi- cides, herbicides, plows, harrows, and so on); on financial services; different types of paper, books, and magazines; medicines and their raw materials; on trans- TAX POLICY AND ADMINISTRATION 57 portation services, electricity, water, and sewage; public entertainment events; professional services; tolls; fumigation services; on the cooling and storage of foods and on all other services used in the preparation of foods or other goods. This list is not exhaustive., but it illustrates the exemptions to be eliminated in order to leave only on unprocessed basic foods and residential rentals that are not people's only home. The tax revenue increase of this elimination is estimated at 0.9 percent of GDP. We also recommend the elimination of the ISR exemptions. The calculations of the tax revenue effect of this elimination have not yet been performed, but the Min- istry of Economy and Finance, the Central Bank, and the SRI are committed to gathering the necessary information. Likewise, we recommend the elimination of the customs tariff exemptions. Although the primary purpose of this elimination is not an increase in tax revenues but to reduce protection, an additional estimated tax income of 0.1 percent of GDP would be obtained. ELIMINATION OF PREALLOCATIONS. We recommend the elimination of the majority, if not all of the preallocations, except for the payroll tax, which is allocated to the Ecuadoran Social Security Institute (see the chapter on the Policy on Preserving Fis- cal Stability and Competitiveness). The gradual application of this measure could take place in the manner described in Article 22 of the Discipline and Fiscal Pru- dence Act of March 2001. This measure would have the effect of permitting (although not guaranteeing) a more productive use of tax resources. The amount involved in 2001 is $US1 12 mil- lion of VAT and $US 133 of ISR, plus other preallocated taxes up to a total of $US303 million (1.4 percent of GDP). This is in addition to a better use of these tax resources based on greater productivity for the public sector and for the econ- omy as a whole. In this manner, the total benefit of the elimination of preallocations may be estimated as the productivity increase multiplied by the total amount of pre- allocated funds. If the increase in productivity consists of 10 percentage points, the elimination of the preallocations will be equivalent to having more resources in an amount that is equal to 0.15 percent of GDP Tax Administration Recommendations APPROVE THE RISE (ECUADORAN SIMPLIFIED TAX SYSTEM) LEGISLATION. This meas- ure would allow greater control over the suppliers of small taxpayers in the system, because they have to have invoices from their suppliers. As the number of taxpayers in RISE grows, it will be more difficult for the suppliers to avoid registration with the SRI, since the demand for invoices will be greater for sales made to taxpayers in the RISE. It is estimated that at the outset of its implementation, this measure will generate a tax revenue of $US20 million, or 0.1 percent of GDP. 58 ECUADOR: AN ECONOMIC AND SOCLAL AGENDA IN THE NEW MILLENNIUM CORRECT DELAYS IN INTERNAL PROCESSES. Delays on account of information cross- checking (among different taxes of the same taxpayer and among different taxpay- ers) must be reduced, as must the delays in sending notifications to taxpayers regard- ing incorrect tax returns. REINFORCE THE INDEPENDENCE OF THE SRI BOARD. The purpose for this recom- mendation is to prevent the SRI resolutions from being used as instruments for introducing discriminatory and distorted tax treatments. The SRI must not get involved in satisfying any objective other than the strict collection of the taxes cre- ated by law. In particular, the competitiveness of any sector, or the promotion of industry, agriculture, or a given region should never be an element of judgment in the deliberations of the SRI board of directors. CONSIDER THE MERGER OF THE SRI WITH THE CAE. Because VAT contributors make up the major part of taxpayers who pay customs duties, and because they are satisfactorily controlled by the SRI, this institution could take advantage of economies of scale to also supervise the collection of customs duties from the same group of taxpayers. Certainly, this result could also be undertaken through a narrow collaboration between SRI and CAE. The question is whether this collaboration could be more easily obtained under a single authority that governs both institu- tions.'2 AMEND THE CUSTOMS ACT. The Customs Office labor system should be reformed, which would permit a restructuring similar to the one that has worked so well at the SRI. PROMOTE A STRICT COMPLIANCE WITH LAW 41 OF 1999. This evasion control mech- anism of VAT and contraband requires official backing at the highest level so that it can be applied without exceptions or discretion. Summary Table of the Tax Revenue Effects of the Recommendations (in percentage of GDP) Reduction of VAT exemptions 0.86 Reduction of customs duty exemptions 0.09 Elimination of preallocations 0.15 Ecuadoran Simplified Tax System 0.09 Total 1.19 12.ln 1999 the International Monetary Fund recommended the evaluation of this merger. See Kopits and others, Ecuador: Modernization of the Tax System (International Monetary Fund, Department of Public Finances, November 1999), p. 9. TAX POLICY AND ADMINISTRATION 59 Summary Table of the Order of Priorities of the Recommendations Essential and Immediate Medium-Term Recommendations Recommendations (during 2003/2004) - Elimination of exemptions - Elimination of minor taxes - Elimination of preallocations - Considering the SRI-CAE merger - Correction of the delays in cross- - Promoting the strict compliance with checking information in the SRI Law 41 of 1999 - Reinforcing the independence of the - Approval of the RISE SRI board of directors - Amending the labor system of the Customs Act Recommentdation Matrix Probkms Policy Measures (including annual Short Term Medium Term tax cost-if applicable) (UntilJune 2003) (2003-07) ProgressIndicators Objectives/Goals Exaggerated number Eliminate the minor Gradually eliminate Approval of repealed laws. Reduce adminisrrative costs for of minor taxes, of low taxes and their corres- the minor taxes. the tax authority and for the tax revenues and ponding collections. t taxpayers. preallocations. Exemptions of ISR, VAT (except Eliminate the ones Completely eliminate Approval of repealed laws. Reduce distortions in the unprocessed basic that create less exemptions (except economy; increase the tax foods, financial services, conflict politically. unprocessed foods, revenues by 0.95 percent z and home rental), financial services, of GDP. 0 and customs tariffs. and home rentals). Preallocation of taxes Eliminate the ones Completely eliminate Approval of repealed laws. Increase productivity of the o (except preallocations that create less preallocation (except use of fiscal resources by 0.15 C to the Ecuadorian conflict politically, the Ecuadoran Social percent of GDP. n Social Security Institute). Security Institute-IESS). Small producers and Adopt the Ecuadoran Approval of the law. Reduce the informality and merchants that are Simplified Tax System generate tax revenues of 0.09 not taxpayers. (RISE). percent of GDP. z Vulnerability of the Strengthen the SRI Prevent erosion of the tax base x SRI to private interest institutionally. through administrative means. Z pressures. Stagnation of CAE Evaluate the merger Improve contraband control. efforts. between the CAE and 2 the SRI. Delays in information Start resolving the Complete elimination cross-checks and in delays. of the delays and sending out notifications prevent causing ° to taxpayers. new delays. Labor System of the Approve a legal Restructure Customs Z Customs Act. reform that allows personnel, similar to the restructuring of the way it was done the personnel situation. at the SRI. Z z 62 ECUADOR: AN ECONOMIC AND SocIAL AGENDA IN THE NEW MILLENNIUM Ainime. An alternative estimation of the tax cost of the VAT exemptions is presented here. Utilizing the information from the Final Consumption of Households on the National Accounts, a maximum potential VAT income can be estimated, which will be different from the tax income observed, for two reasons: exemptions and evasion. Value in milUiom Potential Final Consumption of Households of dollars Tax Revenues Bananas, coffee, and cacao 53.88 6.47 Grains 54.00 6.48 Flowers 18.45 2.21 Other crops 408.24 48.99 Breeding animals 229.14 27.50 Forestry and lumber 14.26 1.71 Fish and shellfish 183.40 21.99 Mineral products 2.63 0.32 Meat and meat products 728.71 87.45 Processed fish and shellfish 104.31 12.56 Oil and fats 204.83 24.58 Milk products 236.01 28.32 Grain milling and bakery products 549.04 65.89 Refined sugar 127.93 15.35 Candies and chocolates 67.99 8.16 Other foods 185.18 2.22 Drinks 384.12 46.09 Tobacco and cigarettes 52.21 6.27 Textiles and clothing 844.93 101.39 Wood products 26.24 3.15 Paper and related products 184.88 22.19 Petroleum products 197.02 23.64 Chemical products 620.41 74.45 Rubber and plastic products 109.06 13.09 Nonmetal minerals 39.45 4.73 Products made of metal 209.83 25.18 Machinery and equipment 319.75 38.37 Transportation equipment 201.40 24.17 Other manufactured items 401.86 48.22 Electriciry and water 142.20 17.06 Hotels and restaurants 438.23 52.59 Shipping and storage 1,216.34 145.96 Mail and telecommunications 329.15 39.50 Financial and insurance services 130.98 15.71 Home rentals 683.88 82.07 Other activities 51.24 6.15 Public administration 10.36 1.24 Education 274.80 32.98 TAx POLICY AND ADMINISTRATION 63 Value in milions Potential Final Consumption of Households of dollars Tax Revenues Social and health services 182.05 21.85 Other social, personal, and domestic services 138.88 16.66 TOTAL 10,357.52 1,242.90 Source, Central Bank of Ecuador. Using the 2000 data, it is calculated that the tax income results together with exemptions and evasion end up being equal to the difference between $US 1,242.90 million and the effective tax income for this year, $US893.4 million; that is, $US349.5 million, or approximately 2.2 percent of GDP. The estimated amounts in the text of this report, which attributes a tax cost of 1.3 percent of GDP to the exemptions, is not inconsistent with the results of this annex. 3 Debt Administration and Sustainability' Elaine Tinsley Ecuador is no stranger to inefficient public debt management; during the last 30years it has been struggling to control the enormous burden ofservicing its debt. Part of the prob- lem lies in the fiscal structure the country inherited from the military regime: a big bureaucracy coupled with dependence upon highly volatile oil revenues, subsidies, and earmarked expenditures. However, there are other reasons: persistent badfiscal manage- ment practices, including sizable wage hikes in the public sector; inflation; and the dis- torted exchange policies of the past. All of these factors have conjoined to make fiscal accounts especially vulnerable to external crises, compelling the country to restructure its debt on two occasions. Thefirst was in 1994, after a seven-year suspension of debt serv- ice, with the introduction of Brady bonds, and the second in 1998, when the government became thefirst country to default on its Brady bonds, necessitating restructuring in the form ofglobal bonds. Any new external debtpolicy will be irrelevant withoutfiscal dis- cipline, which means achievingsignificantprimary surpluses in the nextfewyears. If this prerequisite is met, good debt administration will be the other side of the coin of success- fully attaining efficient management and lowering debt profile andfinancial cost. Proper debt management will improve credibility on the basis of thefollowing: a strictfiscal dis- cipline will reduce Ecuadors currently very high sovereign risk classification, which in turn impacts private sector competitiveness; it will buy back debt or reschedule the exist- ing debt service, especially that which is most onerous to the fiscal accounts; and mod- ernize the countrys debt management team. 1. Elaine Tinsley is an economic policy analyst for the World Bank. The author wishes to thank the following individuals from the World Bank: Lenin Parrefio, Katy Yinez, Alfredo Astorga, and Silvia Burbano-and especially, from the Public Credit Office of the Min- istry of Economy and Finance, Mauricio Pareja and Gino Minoli. 65 66 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM A. 3ackgound Ecuador's present public debt problems can be traced back to the 1970s, when large- scale oil exports enabled the military government of the time to finance large investments and boost public sector employment. Oil revenues also made it possi- ble to provide subsidies to the electricity sector and to domestic oil consumption. As a result, public expenditure experienced a sharp increase between 1972 and 1975. In 1975, owing to a number of external shocks, including El Nifio and the low prices of crude oil, public revenues declined. Instead of raising taxes or reducing expenditures, the government attempted to cover its deficit by borrowing, which led to a rapid increase in the volume of public debt. In the early 1980s, in the aftermath of monetary tightening in the United States, the situation worsened because of the resulting high interest rates on variable debt and increased public wages. In 1982, the combination of high interest rates, the recession, and the deterioration of fiscal accounts, compelled the government to devalue its exchange rate, which in turn generated a series of devaluations that increased the external debt service obligations of the private sector (mainly commercial banks). In 1983, to relieve pressure arising from the banking sector's debt burden, the government assumed most of the private external debt, swapping it for a debt in sucres , a move that considerably increased the volume of public debt. In the following years, economic volatility and poor fis- cal management generated high fiscal deficits, which finally led to the suspension of public debt service from 1987 to 1994. During that period debt slowly climbed, mainly through accumulation of arrears. In 1994, the authorities reached an agree- ment with its private creditors to restructure the debt with the issuance of $US6 bil- lion in Brady bonds, an agreement supported by the multilateral agencies which helped by financing the guarantee for the bonds. After the restructuring, Ecuador's external public debt totaled $US13.5 billion or 80 percent of GDP, making it one of the highest debt burdens in Latin America and the Caribbean (Figure 1). In 1998, the high debt situation, combined with the collapse of oil prices, the effects of El Nifno, and the resulting banking crisis led to a loss of confidence in the economy and a downward spiral of the exchange rate. Although each devaluation enabled the government to garner more petrodollars to service its deteriorating fis- cal account, the increase in the dollar denominated debt stock counteracted what- ever benefits the devaluation could generate. The situation became unsustainable and in August 1999, Ecuador defaulted on its debt obligations, making it the first country to default on its Brady bonds. After the default, in July 2000, Ecuador offered to swap its Brady bonds and Euro bonds, valued at $USO.60 on the dollar, for new 12- and 30-year bonds. The thirty-year global bonds would pay an initial coupon of 4 percent, increasing by one percentage point annually up to a maximum of 10 percent in 2006. In exchange for an additional discount on the value of the debt, 12-year bonds were offered at a 12 percent fixed coupon. The offer was accepted and the debt stock in bonds dropped from $US6.5 billion to $US3.9 billion. DEBT ADMINISTRATION AND SUSTAINABILITY 67 Figure 1. Composition of Public Debt 18 - 140 16 - 120 14 - 12 1X00 I70 75 8 8 0 5 0 8 Dl60 6 40 2 ~~~~~~~~~~~~~~~~20 0 70 75 80 85 90 95 00 Domestic External - Debt (percentage of GDP), RHS Source: International Monetary Fund (IMF). This chapter examines some of the main topics relating to public debt manage- ment in Ecuador. The second section describes the structure of the public debt. The third section suggests some guidelines for a debt reduction plan based on a debt sus- tainability analysis model. Finally, the fourth section offers recommendations aimed at improving the level and administration of the public debt. B. Present Debt Structure Ecuador's total external debt amounts to $US 15.7 billion (64 percent of GDP). Of this amount, 71 percent is public debt and 29 percent is private. While nearly all of the official external debt is medium- or long-term, short-term debt is only signifi- cant in the composition of the private debt (45 percent). Thus, although private sec- tor debt is relatively small, its short-term debt represents 13 percent of total exter- nal debt, and accordingly could impact the economy to some degree in the event of regional capital flight. Public debt is $US14 billion. About 80 percent is external debt, and 20 percent internal. Almost all of the external debt is medium- or long-term, and only 7 per- cent short-term. Thus, only 1.4 percent of total public debt is short-term. This long- term debt maturity structure avoids some of the risks associated with the refinanc- ing of short-term debt, though its high interest rate results in a much heavier debt load. Despite renegotiation of its debt, Ecuador continues to have the highest pub- lic debt/GDP ratio in the region after Argentina. Net debt service of the country's debt (including disbursements) consumes about 35 percent of the budget. 68 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEw MILLENNIUM PUBLIC ExTERNAL DEBT. Since the 1990s, public external debt from multilateral loans has practically doubled, while bilateral debt has remained almost constant. Taken together, the two represent 60 percent of external debt. Brady bonds (the main component of external debt to the private sector) represent another 36 percent (Figure 2). Before 2000, about 60 percent of external debt was at variable interest rates and the remaining 40 percent was fixed. Renegotiation of the Brady bonds reversed these percentages: at present 75 percent of the external debt is fixed and 25 percent is variable. Though the foregoing helps reduce volatility of debt service, the government must still bear high interest rates for a long period unless restructured. It is estimated that interest payments on the external debt will total $US581 mil- lion in 2002, or 2.4 percent of GDP, and the global bonds represent half that amount and one-third of total external debt (Figure 3). This is not surprising, con- sidering that Brady bonds are the most onerous in terms of interest. Of the public external debt, the Central Government is the primary debtor responsible for 88 percent of the debt, while the public financial sector represents 9 percent, and public companies and subnational entities account for the remaining 3 percent (see Figure 4). Subnational entities have little chance of mobilizing external funding, partly because of limited administrative capability, but also because of the country's non-payment culture. Since all payments in the Nonfinancial Public Sec- tor (NFPS) are channeled through the Public Credit Office of the Ministry of Econ- omy and Finance (MEF), the government is ultimately responsible for ensuring that these payments are made. Although many entities are punctual in their payments, others, especially electrical utilities, either do not pay or are consistently late. Figure 2. External Debt 14.0 12.0 - 10.0 8.0 6.0 - 4.0 2.0 - 0.0 -~.. ..... ..U.._ ............... 0.0 I,- . 90 91 92 93 94 95 96 97 98 99 00 01 02 Ol Multilaterals El Bilaterals O Banks O Suppliers Source: Ministry of Economy and Finance (MEF). Figure 3. External Debt and Interest Payments by Creditor External Debt Stock by Creditor, 2002 Interest Payments to Creditors, 2002 Z Global bonds Others Others Global o 34% 6_ bonds z 45% z Bilateral Multilateral Bilateral Multilateral 23% 37% 18% 33% Source: BCE, MEF. 70 ECUADOR: AN ECONOMIC AND SOCiAL AGENDA IN THE NEW MILLENNIUM Figure 4. External Debt by Debtor, 2002 Financial Others Fmanclal3% public sector 9% Central government 88% Source: MEF, Statistical Bulletin 68. PUBLIC DOMESTIC DEBT. Of the $US2.7 billion public domestic debt, almost half ($US 1.2 billion) relates to the Deposit Guarantee Agency (Agencia de Garantia de Depositos-AGD), created to rescue the banking system during its crisis. With a nom- inal interest rate of 9.4 percent, AGD bonds are the most onerous of the internal public debt and they mature in 2014. The holder of this debt is the Central Bank (BCE) and the interest payments on these bonds constitute that entity's main source of income. The second source of debt is dollar bonds. The public domestic debt fig- ures do not include debt to the Ecuadoran Social Security Institute (Instituto Ecua- toriano de Seguridad Social-IESS), which is estimated at $US2 billion. Unlike other countries, Ecuador's public domestic debt is not especially vulnera- ble, since almost 50 percent of it is with the Central Bank and only 7 percent is short-term. This debt, however, is more sensitive to changes in interest rates: approx- imately 58 percent of the domestic debt bears a fixed rate, 30 percent is linked to LIBOR, and 12 percent has other variable rates. Overall, interest rates on the domestic debt stock vary from around 5 percent to 12.5 percent, with an average of 8.7 percent for fixed rate and 8.8 percent for variable. (See Figure 5.) While the current structure of the domestic debt is adequate, it still faces vul- nerabilities. Cash management problems compel the government to stretch legal limits to the maximum on issuing Treasury Certificates (currently this is capped at 1 percent of the previous year's GDP). Moreover, owing to the country's low capac- ity to absorb such issues and the concentration of a small number of buyers, the gov- ernment's situation remains vulnerable and desperate, forcing it to accept high inter- est rates in order to cover its cash flow problems. DEBT SERVICE. Public debt service in 2003 and 2004, exceeding $US2 billion, or approximately 33 percent of revenues each year, is troublingly high (Figure 6). Of the total public debt service for 2003-04, multi- and bilateral payments constitute almost 50 percent of the load, domestic debt nearly 30 percent, and global bonds DEBT ADMINISTRATION AND SUSTAINABILITY 71 Figure 5. Public Domestic Debt (October 2002) 100% U Others 80%o 3 Treasury certificates 60% 0 Filanbanco 40% - * CFN * Dollar 20% - bonds *AGD 0% - Source: MEF. about 20 percent. On the other hand, Ecuador is facing serious liquidity problems. The intensive amortization of domestic debt for the capitalization of Filanbanco and medium-term dollar bonds will be particularly high, at $US478 million in 2003, though it will drop to $US270 million in 2004. In the medium term, external amortizations will rise sharply in 2007, when the buy-back of 10 percent or more of 2012 global bonds is due to kick in, represent- ing $US125 million each year until maturity. This amount is equivalent to 15 per- cent of current amortizations and its burden must be handled with timely planning. In the short term, interest payment on global bonds represents a sizable proportion of debt service. Every quarter a Brady bond payment comes due, causing peaks in total debt payments (for example, these abruptly jump from $US22 million to $US123 million from one month to the next), with traumatic impact on cash flow management. C. Ecuador's Debt Reduction Plan In approaching the high levels of public indebtedness, the Law on Government Fiscal Responsibility outlines the core goal of a debt reduction plan: reduce debt to 40 per- cent of GDP by the year 2010 (Box 1). The law fails to indicate how this goal is to be achieved, but includes two complementary measures to reduce the debt. The first is to limit spending in order to restrict any future indebtedness, and the second is to buy back its debt with surplus oil revenues generated from the second oil pipeline. The law provides two approaches to reduce the debt, the first is by limit spend- ing and the second by repurchasing expensive debt. The first approach limits spend- ing by two rules. The first rule place a cap of 3.5 percent on real non-interest expen- Figure 6. Debt Service for Current Debts, 2003-15 (mlns $US) Amortizations Interest Payments 1400 1400- 1200 X 1200 1000 10 800 - GO O 600 - 600 400 -_ _ _ _ __ _ _ _ __ _ _ _ 200 ,.-- 200 ggr= =__. 2000 2003 04 05 06 07 08 09 10 11 12 13 14 15 2003 04 05 06 07 08 09 10 11 12 13 14 15 n0 z 0 oMultilaterals oBilaterals oBanks oProviders oDomestic oMultilaterals oBilaterals oBanks oProviders o Domestic Debt Service o 2500 2000 1500 -->= m 1000 ___ z 1500 100 500 - ;- -^-> 0_; =; =____ _ ___ Z 2003 04 05 06 07 08 09 10 11 12 13 14 15 5 oMultilaterals oBilaterals oBanks oProviders oDomestic c Source: MEF, BCE. DEBT ADMINISTRATION AND SUSTAINABILITY 73 Box 1. On Public Indebtedness in the Organic Law on Fiscal Responsibility, Stabilization, and Transparency Art. 5 Reduction and limitation of public indebtedness. * The Ministry of Economy and Finance will implement a permanent public debt reduction policy, aimed at a minimum 16 percentage point reduction in the ratio between the total public debt balance and the GDP during the four-year governmental period reckoned from January 15, 2003. The same policy shall apply to subsequent four-year periods until a debt/GD]' ratio of 40 percent is achieved. * Once it reaches the 40 percent debt/GDP ratio, the level of public indebtedness will not be allowed to exceed this limit or percentage. Sourre: Law No. 72. RO/589 ofJune 4, 2002. diture growth. Since this rate is equivalent to our medium-term GDP projections, in essence, the cap will maintain expenditures as a fixed proportion of GDP, except in years of high growth when this proportion will diminish or vice-versa. The sec- ond rule requires that the non-oil-related fiscal deficit be reduced by 0.2 percent per year until it reaches zero. F[owever, given that the present non-oil-fiscal deficit is 4.5 percent, it will not reach zero for 22 years, which renders the rules irrelevant. The two rules thus bring little pressure to bear to contain spending. The second approach reduces the debt by placing the royalties derived from the marginal increase in private production (that is, over and above what is being cur- rently transferred via the first pipeline) into the oil fund (FREIRIP). Of these amounts, 70 percent will be allocated to buy back debt, 20 percent will go into an oil stabilization fund, and the remaining 10 percent will go to social and health spending. Of the 70 percent earmarked for buy-back of the debt, only up to 15 per- cent can be used to reimburse social security debt. The remaining 85 percent would be used to buy back external debt, that is, the 2012 Brady bonds,-which are cur- rently the most expensive debt. In addition, once the oil stabilization fund reaches 2.5 percent of GDP, these funds will also be applied to debt repurchasing. FREIRIP funds are not expected to materialize until 2004. Within the framework of the Law on Fiscal Responsibility, the Ministry will pres- ent its Debt Reduction Plan next February. At the same time, the Law provides that the Technical Secretariat, in this case the Central Bank, will support this task by (a) supplying the figures; (b) submitting technical reports with recommendations for policies to be adopted with respect to the debt, such as the debt buy-back policy; (c) submitting reports to Congress; and (d) implementing a transparent debt buy back system. 74 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Debt Sustainability Analysis Based on the medium-term goal stipulated by the law, our debt sustainabiity analy- sis determines what primary deficit is required to attain a debt level of 40 percent of GDP, which also could combine with reasonable, attainable financing parameters. The model includes maximum non-interest expenditure growth of 3.5 percent and debt buy-back with resources from the oil fund. We have also verified that the model meets the condition of the plan to reduce the non-oil-related fiscal balance by an average 0.2 percent annually. Box 2 lists the assumptions of the base scenario. THE MODEL. The model starts with the government's amortization plan. Interest payment is calculated from the current level of debt and newly contracted debt. A public spending path is projected (on the basis of the fiscal law) and non-oil income (set as 20 percent of GDP), making it possible to arrive at an initial primary surplus. Then the target primary surplus corresponding to the declining annual debt/GDP ratio is calculated. Next, the difference between the target and initial primary sur- pluses is calculated as the additional fiscal effort required, which can take the form either of reduced spending or higher taxation. Finally, after subtracting amortiza- tions from the total fiscal balance (corresponding to the target primary surplus), the remainder represents the extra financing required. The additional fiscal effort and the extra financing are substitutive, that is, a lower additional fiscal effort means greater financing requirements and vice-versa. RESULTS. In order to reduce the debt/GDP ratio from 57 percent to 51 percent in 2003, the government needs an estimated primary surplus of 4.4 percent of GDP and extra financing of 3.4 percent. Neither this fiscal adjustment nor the necessary amount of financing are by any means figures to be taken lightly. The picture is sim- ilar for 2004. Because of the recent adjustment in GDP, it is quite probable that Ecuador will achieve its goal of 40 percent of GDP before 2010, as the country also has an aggres- sive amortization plan. Nonetheless, in order to accomplish that goal, the country must obtain successive primary surpluses of approximately 3.7 percent of GDP over the years 2005-08. (See Table 1.) Thus, Ecuador's debt problem is one both of solvency and of liquidity. Though prospects for 2003 seem daunting, this is partly due to the existing debt, which increases financing needs for 2003. It should be noted that as the debt stock diminishes, the debt service/GDP ratio also gradually decreases. The upside of the fiscal law is that it places a ceiling on spending; however, as has been noted, this ceiling is not sufficiently restrictive, requiring an additional fiscal effort, either via increasing revenues or reduc- ing expenditures, and this is only possible with a solid policy commitment. Our analysis also shows that the oil fund will have a marginal impact on debt buy-back. First, the government has modified what it believes will be maximum use of the pipelines to 600,000 barrels per day, that is, 200,000 barrels fewer than its DEBT ADMINISTRATION AND SUSTAINABILITY 75 Box 2. Base Scenario Assumptions 1. GDP growth will be 4 percent for 2004 and 2005, and 3.5 percent for the 2006-10 projection period. 2. Inflation is exogenous and will decline to 2 percent over the long term. 3. Debt buy-back will begin in 2004 with the 2012 global bonds, which are the most onerous part of the debt, as they carry an interest rate of 12 percent. 4. Complete rollover of the domestic debt, which assumes disbursements from domestic debt equivalent to 1 percent of the GDP of the previous year will be reimbursed the following year. This is in keeping with cur- rent directives stipulating that treasury certificates cannot total more than 1 percent of the GDP of the previous year. 5. Average price of oil will be $US18 per barrel for 2003-10. 6. The new pipeline will go on line and start contributing to the oil fund in 2004. 7. Debt to the IESS is not included in internal debt, although resources from the fund will be diverted to pay it. 8. Non-oil-dependent fiscal revenues will be kept constant at 20 percent of GDP. 9. Nonfinancial spending will comply with the new law and will not climb to more than 3.5 percent annually in real terms (though this law applies to nonfinancial spending of the central government, it is also being applied as a spending limit for the nonfinancial public sector). 10. The conflict concerning the oil VAT'rebate will delay investments by private companies by one year. Production by these companies will reache 108 million barrels or 295,000 barrels per day in 2007, which represents the use of only 65 percent of the heavy crude oil pipeline's (OCP) capacity. Petroecuador will increase its investment by $US140 million per year, its operating costs will rise 4 percent, and its produc- tion will reach 91 million barrels in 2007. The gas subsidy will be elim- inated as of 2003. 11. Of the 70 percent earmarked for debt reduction, a maximum of 15 per- cent will be used to reimburse the IESS. original projections. This will inevitably reduce the expected windfall in government oil revenues. Second, the fund's resources will depend on the marginal increases in oil production over those of the existing pipeline. Third, the problems that have arisen in resolving the controversy surrounding the VAT rebate dispute between the government and the oil companies have delayed investments in the oil fields, caus- 76 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Table 1. Results of the Public Debt Sustainability Model BASE CASE 2002 2003 2004 2005 2006 2007 2008 2009 2010 Key Assumptions Prelim. Proj. Nominal GDP (bln $US) 24.5 26.7 28.3 30.1 31.7 33.5 35.4 37.4 39.4 Real growth (%) 3.0 3.5 4.0 4.0 3.5 3.5 3.5 3.5 3.5 GDP deflator (%) 13.1 5.4 2.0 2.0 2.0 2.0 2.0 2.0 2.0 Key Results (as a percentage of GDP) Primary balance 4.0 4.4 4.5 3.9 3.8 3.7 3.5 3.3 3.1 of which fiscal effort 0.4 1.0 0.4 0.4 0.4 0.5 0.5 0.5 Interest payments 3.6 3.4 3.5 3.4 3.3 3.2 3.0 2.8 2.6 Overall fiscal balance 0.4 1.0 1.0 0.5 0.5 0.5 0.5 0.5 0.5 Balance less oil exports -3.8 -2.8 -2.4 -2.8 -2.7 -2.6 -2.4 -2.2 -2.0 Required financing 0.0 3.4 2.7 3.2 2.5 2.4 1.7 1.5 1.3 Total debt/GDP ratio 57.1 51.4 47.4 44.2 41.4 38.7 36.1 33.7 31.5 Total debt service/ GDP ratio 8.0 7.8 7.3 7.1 6.3 6.1 5.3 4.8 4.4 Source: MEF, IMF, and the World Bank. ing a marginal increase in production than initially expected. Thus, at $US294 mil- lion, buy-back of the external debt will be more modest during 2004-07 than the originally estimated $US712 million. D.), IPollicy Recommendaimonn Management of the public debt is an important indicator for predicting the eco- nomic future of a country, since a government's debt portfolio is usually the biggest portfolio and hence can pose a considerable risk to the general balance sheet of the government and the financial stability of the country. Although it is possible that debt will not be the initial cause of a crisis, the structure, currency, and composition of its maturity can contribute enormously to aggravating a crisis. The better a coun- try can manage its debt, the less vulnerable it will be to external crises capable of destabilizing an economy. This is even more critical in a dollarized system, since there are few alternative policies to absorb the impacts. And, since solid manage- ment of the public debt is not sufficient in and of itself, it must be complemented by prudent fiscal policies. The transformation of Ecuador's public debt management style must pass through two main stages. The initial stage consists of strengthening investors' con- fidence in the new government's commitment to pay its debt. The second stage con- DEBT ADMINISTRATION AND SUSTAINABILITY 77 sists of modernizing management of the public debt, which brings with it reduction of the debt and the burden of servicing it. Accompanied by steady fiscal discipline, this should lead to reopening access to international markets in, one hopes, a not- too-distant future. First Stage: Recouping Credibility A number of rating agencies reduced their risk classifications of Ecuador in recent months owing to problems they foresee for the country in covering its financial needs, which are indeed significant for 2003 and 2004. Amortizations alone will consume on average about 4 percent of GDP, and interest payments another 3.5 percent. Further complicating the situation is the fact that the local market is highly saturated with domestic bonds, meaning the government has few available instru- ments to raise additional funds. In this environment, accessing new debt will be more expensive, particularly if markets perceive a high probability of default. For this reason, the sooner the government succeeds in obtaining a contingency agreement with the International Monetary Fund, the stronger the signal to the investment community that it can cover its financial requirements in the next two years. An agreement with the Fund will allow new multilateral disbursements to help cover capital amortizations and open the possibility of debt rescheduling with the Paris Club. Based on that fact, the government must maintain an austere fiscal regime to meet its financing needs if it wishes to achieve the primary surpluses men- tioned above. It should be observed that an average oil price higher than $US 18 will partially reduce the value of the required additional fiscal effort or financing need and vice-versa. On the other hand, since most of the government's bilateral debt comprises debts with the Paris Club, a conversion or rescheduling is feasible. With regard to global bond and fixed-interest debt, the government should concentrate on rescheduling or buying back the most onerous debt with new borrowings. In view of recent uncer- tainties in the country, bond prices are low, hence it is a good opportunity to buy back. Logically, both recent initiatives can be implemented once the government has signed the agreement with the IMF and improved its credibility sufficiently to be granted more advantageous conditions. Second Stage: Modernizing Debt Management Although the focus of Ecuador's current public debt management is on its immedi- ate reduction, the country will also have to strengthen its administrative capability to manage it. The government needs to develop the institutional capability to man- age and direct the debt portfolio in such a way as to take its cue from the goals of New Zealand's debt management goals: "identify a low-risk portfolio of liabilities consistent with the government's aversion to risk and negotiate efficiently to achieve and maintain that portfolio"-that is, reduce the cost of debt. 78 ECUADOR: AN ECONOMIC AND SOCLAL AGENDA IN THE NEW MILLENNIUM Ecuador's present public debt management is at a rudimentary stage when com- pared to other countries of Latin America and the Caribbean. The Public Credit Office of the Ministry of Economy and Finance is in charge of debt operations, in terms of both issuance and authorization of payments. Its function is primarily oper- ational and it performs practically no analysis of risk management. The Public Credit Office responds to the financial needs of the Budget Office (Oficina de Pre- supuesto), either issuing bonds or Treasury certificates to help cover the financing deficit and loans sought by the government. Given the weaknesses of this office, the Central Bank is the entity responsible for debt analysis. Before the office can process any debt, the Central Bank must approve it, with the exception of debts issued among public sector entities. The Central Bank issues a report examining conditions and assessing the macroeconomic effect of the potential new debt. Though it gen- erally approves most debt requests, the BCE has on occasion rejected some and forced the government to find alternative financing, including ordering the suspen- sion of deposit accumulations, drawing down the deposits, or requesting funds from other public institutions that have deposits. Debt analysis is therefore done at the micro level - one loan at a time and only prior to approval. The Central Bank does not analyze the overall debt profile, nor does it evaluate contingency options in case of external shocks. Weak institutional capability is common in public debt management within emerging economies. To confront it, one initial step is to create clear and strategic directives to manage the debt profile other than establishing reference levels for liq- uidity, interest rates, and, to a lesser degree, their exchange composition. For exam- ple, Colombia has reference levels for liquidity (less than 15 percent of unsolved debt must mature within one year, while average maturity must be five years or more); interest rates (less than 13 percent must carry a floating rate); and composition of the debt (83 percent in $US, 13 percent in euros, and 4 percent in yens). Ecuador, on the other hand, has practically no guidelines or norms limiting the level of its domes- tic debt, although in practice the debt is limited by the relative saturation of the mar- ket. The issuance of debt in Ecuador is exclusively to satisfy immediate financial needs, as opposed to creating a sustainable medium-term debt profile. As a second step to modernize debt management, a debt manager position could be created, to monitor compliance and also to advise oni adjustments to the debt structure when necessary. Because it is important that the government commits to maintain a certain public debt structure, the manager should be given a high degree of independence. At present, the team in charge of debt responds to the needs of the Treasury and of the budget offices, no matter how precarious the evolution of the debt profile. In the end this is a counterproductive arrangement. The debt manager, though he or she must be sensitive to the needs of the country, must have the authority to protect the integrity of the debt structure. Thus, fiscal policies must be coordinated with the debt manager to limit spending growth based on the country's manageable debt capacity. DEBT ADMINISTRATION AND SUSTAINABILITY 79 A third step would be the creation of a highly professional team responsible for debt management. Appropriate for the second most indebted country in Latin America, its creation would help to improve the government's credibility, espe- cially considering that there have been no institutional changes in debt manage- ment since the country's default in 1999. The lack of a debt management team is an impediment not only to the possible reduction of the cost of debt, but also to the identification of risks and their anticipation, which helps create a more stable profile for public debt. So far, political support for the formation of this team has been small. It is, however, a necessary step toward achieving best practices for debt management. Finally, Ecuador could work out alternative strategies to lessen the effects of eco- nomic volatility, such as issuance of anti-cyclical bonds-that is, bonds that are read- justable according to the price of oil (following Mexico's example) or bonds that are readjustable according to the GDP (following Bulgaria's example)-whose pay- ments are made only when oil prices or the country's growth show positive devel- opment, thus reducing returns when the former show poor performance. Though the premium of this kind of insurance can be high, it could help relieve Ecuador's vulnerability to fluctuations in the price of oil. If the government is able to meet the above-described stages and continues to demonstrates solid fiscal management, Ecuador should be able to access interna- tional markets, in which case it would obtain various benefits that would improve the conditions of its public debt. First of all, placing on international markets would enable the country to access a wider pool of buyers. This would eliminate some of the monopolistic pressures that it currently confronts from only having access to a few national institutional actors. Second, the government would not crowd out the private sector in the domestic market, which would facilitate access to credit and would lower business costs. Recommendationsfor the Short Term * Secure the financing plan for the year 2003 by creating a solid, credible macroeconomic program. Renegotiate outstanding arrears with the Paris Club. Supplement these measures with possible debt buy-back or reschedul- ing of the most onerous debt. * Increase the liquidity cushion of public finances with a fiscal adjustment that eliminates the uncertainties affecting public debt management. * Improve the transparency of the debt structure and payments. These must be public knowledge. The change would accomplish a number of things: first, it would enable citizens to monitor the performance of public servants; second, it would demonstrate future financial requirements; and third, it would improve the country's credit image among foreign investors, who maybe over penalizing the country. 80 ECUADOR: AN ECONOMIC AND SocIAL AGENDA IN THE NEW MILLENNIUM Recommendations for the Medium Term • Create guidelines and reference levels to generate a debt profile that is appro- priate for a dollarized, oil-dependent country. o Create a highly professional and politically independent team charged with managing the debt, headed by an independent debt manager and explicitly charged with the task of reducing the cost of debt service and developing an appropriate performance curve (as in the examples of Chile and Brazil). This includes improving the technical capability of the Ministry of Economy and Finance, in particular the Office of Public Credit. Policy Matrix Policy measures Short term Medium term Problems (to June 2003) (2003-07) Progress indicators Objectives/goals Very high debt service Approve solid macro- Punctuality in payments. Gain initial credibility with during 2003-04. economic program. foreign investors. Identify sources of additional financing and urgent cutback measures in spending z or increase in revenues. High level of Maintain high fiscal Buy back onerous Decrease in interest Reduce debt/GDP ratio by at indebtedness. surpluses, limit increases external debt. payments/revenue least 16 percent in 2007. in spending. Improve cash flow over time. Reduce global bond debt as Reduce debt stock management to Evolution of credit percentage of total debt. with Paris Club. prevent bond satura- indicators. tion in local market. Develop capital market. Inadequate strategy Ensure timely pay- Create guidelines to Reduction of the spread Reduce risk and the cost of for medium-term ment of debt and determine objective on the country's debt. public debt. debt management. elimination of arrears. indebtedness structure. Greater transparency in Decrease debt risk premium. (Gains derived from Regularly publish Create the job of the decisionmaking Recoup international credibil- good debt management public debt indica- Debt Manager process with regard to ity and obtain access to could cover greater tors, increasing Create a professional debt strategy. international markets. personnel costs.) their transparency. team to administer the debt and improve the technical capability of the Office of Public Credit. Annex Public Debt Dynamics 2002 2003 2004 2005 2006 2007 2008 2009 2010 Assumptions Est. Proj. Proj. Proj. Proj. Proj. Proj. Proj. Proj. GDP (Bln $US) 24.5 26.7 28.3 30.1 31.7 33.5 35.4 37.4 39.4 Real GDP growth (%) 3.0 3.5 4.0 4.0 3.5 3.5 3.5 3.5 3.5 GDP deflator (%) 13.1 5.4 2.0 2.0 2.0 2.0 2.0 2.0 2.0 Interest rate on new debt 8.0 8.0 8.0 8.0 8.0 8.0 8.0 8.0 0 Oil price ($US per barrel) 21.30 18.00 18.00 18.00 18.00 18.00 18.00 18.00 18.00 Results (percentage of GDP) Primary balance 4.0 4.4 4.5 3.9 3.8 3.7 3.5 3.3 3.1 0 Additional fiscal effort 0.4 1.0 0.4 0.4 0.4 0.5 0.5 0.5 z Interest payments 3.6 3.4 3.5 3.4 3.3 3.2 3.0 2.8 2.6 0 Fiscal balance 0.4 1.0 1.0 0.5 0.5 0.5 0.5 0.5 0.5 Balance less petrol revenues -3.8 -2.8 -2.4 -2.8 -2.7 -2.6 -2.4 -2.2 -2.0 z Financing required 3.4 2.7 3.2 2.5 2.4 1.7 1.5 1.3 C Total debt 57.1 51.4 47.4 44.2 41.4 38.7 36.1 33.7 31.5 ° Debt service 8.0 7.8 7.3 7.1 6.3 6.1 5.3 4.8 4.4 Model Primarybalance 971 1,177 1,279 1,180 1,211 1,246 1,241 1,238 1,239 Z 0 Interest payments 873 918 995 1,029 1,052 1,078 1,064 1,051 1,042 > Interest payments, existing debt 873 881 892 856 810 771 700 640 589 Z Interest payments, new debt 0 36 104 173 243 307 364 411 453 Fiscal balance 98 259 283 150 159 168 177 187 197 Z Net amortization of existing debt 109 1,164 1,063 1,102 959 971 795 747 691 Financing (new debt issue) 10 905 779 951 800 803 618 560 493 Debt service 982 2,082 2,058 2,131 2,012 2,049 1,859 1,798 1,733 lmplicit interest rate 6.2 6.7 7.4 7.7 8.0 8.3 8.3 8.3 8.4 C Level of Public Debt (Mln $US) 13,985 13,725 13,442 13,292 13,133 12,965 12,788 12,602 12,404 r,1 New debt 905 1,684 2,636 3,436 4,239 4,857 5,418 5,911 Existing debt 13,985 12,820 11,758 10,656 9,697 8,726 7,931 7,184 6,493 Domestic 2,521 2,172 2,040 1,854 1,746 1,645 1,606 1,562 1,529 External 11,464 10,648 9,718 8,802 7,951 7,081 6,325 5,621 4,964 Debt buy-back 0 0 26 51 76 97 97 97 97 Fiscal Accounts (Mln $US) o Primary balance 971 1,177 1,279 1,180 1,211 1,246 1,241 1,238 1,239 > Additional fiscal effort 94 0 132 136 144 160 178 202 Z Core primary balance projected 1,083 1,004 1,047 1,075 1,101 1,081 1,060 1,037 Petrol rcvenues 1,427 1,340 1,373 1,419 1,465 1,465 1,465 1,465 Non-petrol revenues 4,915 5,345 5,670 6,015 6,350 6,703 7,077 7,471 7,887 Primary expenditures 5,217 5,689 6,006 6,341 6,694 7,067 7,460 7,876 8,314 Non-petrol primary balance -419 -251 -61 -194 -208 -219 -224 -227 -225 Non-petrol primary balance (percentage of GDP) -1.71 -0.94 -0.22 -0.64 -0.65 -0.65 -0.63 -0.61 -0.57 Petrol revenues (Min $US) 1,390 1,427 1,383 1,459 1,547 1,628 1,628 1,628 1,628 Petrol revenues - to Fund 0 0 43 85 128 164 164 164 164 Petrol revenues - to Budget 1,390 1,427 1,340 1,373 1,419 1,465 1,465 1,465 1,465 Production (million barrels) 148 150 162 175 188 199 199 199 199 PetroEcuador 82 84 86 88 89 91 91 91 91 Private 66 66 77 88 99 108 108 108 108 FEIREP details Royalties from OCP (FEIREP) 0 0 43 85 128 164 164 164 164 =>20 percent to stabilization fund 0 0 9 17 26 33 33 33 33 =>70 percent to debt buy-back 0 0 30 60 90 115 115 115 115 to IESS 0 0 5 9 13 17 17 17 17 External debt buy-back 0 0 26 51 76 97 97 97 97 =>10 percent to social spending 0 0 4 9 13 16 16 16 16 oo 4 The Banking System' Mario Guadamillas, Giovanni Majnoni, and Yira Mascaro' Ecuadors financial system has been recoveringfrom the serious crisis of 1998 and 1999 and adapting to the changes involved in the dollarization of the economy in early 2000, which eliminated the sucre as the local currency (and thusformalized the systems de facto heavy dollarization). Nevertheless, the characteristics of the system that emergedfrom the crisis differfrom those of the past, not only in their impact on individual banks, but also in the dollarizationr effect on the institutional framework. The crisis has drastically reduced the number of active financial institutions, while dollarization and associated changes have led surviving institutions to hold their assets in a more liquid form owing to the absence of a lender of last resort, and depositors have consequently preferred more liquid deposits. This change in asset composition has also led to a greater concentration of the banking sector, as the institutions seek to compensate the high proportion of low- yield liquid assets through larger-scale operations. The country is coming to the end of the most dramatic period of the postcrisis restructuring process that led to the adoption of a new regulatory framework and more efficient supervision. The structure and responsi- bilities of the supervisory authorities have also changed. Not only has the process of restructuring the banking system been a trial by firefor the agency in charge of deposit insurance, the Deposit Guarantee Agency (Agencia de Garantfa de Dep6sitos-AGD) andfor the Superintendency of Banking and Insurance (Superintendencia de Banca y Seguros-SBS), but dollarization has also changed the traditional role of Ecuadors 1. This chapter was written by Mario Guadamillas, Giovanni Majnoni, and Yira Mascar6, with the research assistance of Ilias Skamnelos (all with the World Bank). The authors acknowledge the collaboration of the Ecuadorian authorities and the useful comments of Macdonald Benjamin, Fernando Montes-Negret, and the participants in the seminar in Quito on Economic Policy Notes. 85 86 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN TIHE NEW MILLENNIUM Central Bank (Banco Central de Ecuador-BCE). Now, instead of functioning as a director of monetary policy, with dollarization, the Central Bank has the role of central manager of the system' liquidity, to ensure that the payments system functions well and to provide liquidity under conditions similar to those of a last resort lender. This chapter documents the progress of Ecuador's banking system over the last two years, highlighting economic policy actions that can help consolidate the progress achieved and lay the foundations for a stronger system. Section A describes the effects of the crisis on the structure of Ecuador's financial system, with a particular focus on the banking sector and its greater concentration as a result of the restructuring process. It also provides an estimate of the cost of the restructuring process that includes the management of the AGDand other parallel efforts such as the recent asset recovery process by the Credit Restructuring Unit (Unidad de Reestructuracidn de Creditos-URC) with its single representative. Section B analyzes the trends in bal- ances and yield of private banks and their present prospects. Section C evaluates pol- icy issues that authorities are currently considering to strengthen the banking system's capacity to resist exposure to the external shocks typically involved in dollarization. The main theme is proper management of the system's overall liquidity position by strengthening the existing liquidity fund to make it more effective. Section D con- siders the actions required to ensure that the banking sector truly functions as a prin- cipal provider of means of payment within the new dollarized economy. Section E briefly analyzes the characteristics of the safety net that will be in place once the liq- uidity fund is reformed and the AGD is restructured. Section F concludes with a list of policy actions included in the matrix of recommendations. A. The Postcrisis Financial System: Structure and Depth Ecuador's financial system underwent a serious, twin crisis (financial and exchange) in 1998 and 1999, which drastically reduced its size. The total number of 82 finan- cial institutions in 2002 is down 30 percent from 1998 (Table 1). Specifically, 12 of the 38 private banks that were in business four years ago are now under AGD administration, along with 4 finance companies, for a total of 16 institutions. These banks, along with Filanbanco (the system's largest in 1998) and other institutions now closed, held 50 percent of the system's total deposits in 1998.2 This reduction brought the level of the system's intermediation in October 2002 to half its 1998 value (measured as total assets over the GDP-see Figure 1), and the reduction was especially marked following the closing of Filanbanco in 2001 (in liquidation since July 2002). The value of the performing loan portfolio dropped to 11 percent of GDP, with only two-thirds channeled to the commercial and industrial sector. 2. SBS Annual Report, 2001. THe BANKING SYSTEM 87 Table 1. Number of Institutions in the Financial System Dec. Dec. Dec. Dec. Mar. 1998 1999 2000 2001 2002 Financial intermediation 114 104 89 85 82 Private banks Operating* 38 28 26 21 21 Operating with public capital 2 2 Offshore 15 18 10 8 6 Operating abroad 4 4 4 4 4 State-owned banks Operating 1 1 1 1 1 Second tier 1 1 1 2 2 Finance companies 23 19 14 13 12 Savings and loan associations 25 26 26 27 27 Mutual associations 7 7 7 7 7 Other institutions in the financial system 72 68 67 61 62 Exchange houses 13 13 13 8 8 Bonded warehouses 8 7 7 7 7 Public institutions 5 5 5 4 4 Credit cards 1 1 1 1 1 Securitization houses 1 1 1 1 1 Insurance companies 42 39 38 38 39 Reinsurance companies 2 2 2 2 2 Institutions under reorganization 4 15 16 16 16 Banks 1 12 12 12 12 Finance companies 2 3 4 4 4 Mutual associations I Institutions in liquidation 22 24 29 33 34 Banks 3 2 2 2 2 Finance companies 9 9 12 12 13 Mutual associations 3 4 4 4 4 Saving associations 2 2 2 2 2 Exchange houses 1 1 2 6 6 Bonded warehouses 3 4 4 4 4 InsLirance companies 1 2 3 3 3 Total general 212 211 201 195 194 Includes Filanbanco, which enitered liquidation beginning in July 2002. Source: SBS. The crisis had high fiscal costs aside from its direct effects on the system, with serious macroeconomic consequences such as the drastic fall in GDP (see the sec- tioni on macroeconomics). The Deposit Guarantee Agency (AGD)-created in December 1998 as a result of the difficulties experienced by Filanbanco (in the first round)-has been managing the financial institutions that entered a reorganization 88 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Figure 1. Total Bank Assets over GDP 50% 45% 40% 35% 20% 15% 10% 0%- 1998 1999 2000 2001 2002 Source: BCE. process after the crisis to recover or sell off assets to pay the deposit insurance.3 By late October, the AGD had paid at least the first $US25,000 of all individual deposits in the institutions it is managing, for a total payment of over $US800 mil- lion (Table 2). Based on preliminary figures for the assets and liabilities of banks under AGD management, plus the cost of capitalizing Filanbanco (which was ulti- mately handled outside the AGD) and Banco Pacifico (open), the total outlay to date is estimated at $US2 billion (approximately 12 percent of the 2001 GDP). This does not take into account the opportunity cost of money that resulted from the freezing of deposits in early 1999, or other costs of the negative impact on the econ- omy in various areas. The Credit Restructuring Unit (URC) made progress in recov- ering the portfolios of banks under reorganization and by December, after six months work, had managed to restructure approximately half of the total $US400 million representing the value of the largest loans. The cost may be lower, depend- ing on how many additional assets can be recovered or sold off, although time makes 3. The AGD was created with broad powers for restructuring banks with access to deposit insurance, but this capacity was transferred to the SBS by two laws enacted in 2000 (the Ecuadorian Economic Transformation Act and the Investment and Citizen Participation Promotion Act). In January 2000, several characteristics of deposit insurance were also modified, including the elimination of the cxisting unlimited coverage, imposing a maxi- mum coverage limit equivalent to four times the per capita GDP, while excluding deposits in offshore institutions. THE BANKING SYSTEM 89 Table 2. The Costs of Restructuring the Banking System (mins $US) AGD Assets Liabilities Total assets 2,154 Assets to be sold* 800 Auctions implemented** 100 Recovered portfolio*** 599 Recoverable portfolio 655 Total liabilities 1,601 Debts paid 832 Debts outstanding"555 769 Capitalization of banks 1,350 Banco del Pacifico 250 Filanbanco 1,100 Actual cost at in December 2002 2,251 EXPECTED COST (Appraisinig Assets assets at 100%) 797 Notes. * Estimated. Mainly includes buildings. 't Excludes allocated assets awaiting sale. As of October 31, 2002. " Includes: primary and secondary depositors; debts for foreign trade, not guaranteed by the risk central; amounits owed to other institutions (open and closed). Source: The authors' estimates based on AGD and SBS data. this process increasingly more difficult (see the section on recent institutional efforts at debt restructuring). The Structure of the Banking System By October 2002, the 22 existing private banks had 82 percent of the total financial assets in the country (Table 3), concentrated in turn in the four largest banks (which held 63 percent of the total assets in private banks). These banks include Banco Paci- fico (the largest in 1998), which is state-owned (by the BCE) as a result of its restruc- turing, but has been under the administration of a team of international bankers that has improved its operations.4 The total private banks also include two mid-size for- eign banks (Citibank and Lloyds) that remained in Ecuador. Another two foreign banks left the system by selling their assets to other banks or through mergers (ABN- 4. The restructuring of this bank's operations is still in progress, but has already logged sig- nificant achievements. It continues to work with two consultants from the international team that managed the bank until October. 90 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM AMRO and ING), owing to the high risk they faced following the crisis (aggravated by a climate of high instability and heavy banking losses by foreign banks in neigh- boring countries) and because they had not achieved sufficient scale to justify oper- ating as retail banks. The remaining institutions have a small share in the system, par- ticularly the state-owned banks-Corporaci6n Financiera Nacional (CFN), Banco Nacional de Fomento (BNF), Banco del Estado, and Banco Ecuatoriano de la Vivienda-whose operations are directed toward specialized areas of production. Given the structure of the sector, the consolidation process is likely to continue. In addition to the concentration of the banking subsystem, the majority of insti- tutions are members of financial groups, which further concentrates the financial sys- tem as a whole. These groups include private banks (typically a group's main com- ponent), foreign branches, finance companies, securities houses, fund administrators, real estate companies, insurance companies, bonded warehouses, and computer serv- ice companies. The offshore banking that had predominated prior to the crisis and contributed to the system's deterioration, lost importance with the exit of almost half the private banks to which it was associated, via reorganization, merger, or liquida- tion. By the end of 2002, the four offshore banks that were still open belonged to the largest banks in the system,5 although their growth was limited by the new restriction that each offshore bank had to keep assets under their levels of March 2000. Four new foreign banks have entered the system, operating almost exclusively abroad-as opposed to the offshore banks, which focused on operations with Ecuadorian banks-and are under the supervision of the authorities of the countries in which they are based (namely, Colombia and Peru). These four institutions belong to the financial group of the largest private national bank, Pichincha (which holds 27 per- cent of total assets in private banks), which in turn owns two other, small, private banks through one of these institutions operating abroad. Owing to Pichincha's rapid growth by acquiring banks that experienced troubles during the restructuring process and to foreign banks' deciding to leave the system over the last few years, the Pichin- cha group is now the system's largest, with 35 percent of the total assets of the finan- cial groups. The owners of this group also own the system's largest finance company (Diners Card), with 64 percent of all finance company assets, which reveals the high degree of concentration resulting from the crisis management. B. Trends in Bank Baiances, Solvency, amd ielld Balance Trends Balance sheets show that banks have recovered since the period following the crisis, to a large extent through an improved macroeconomic environment that brought 5. Formally, there are five offshore banks (see Table 1) if one includes Banco Continental, which is not operating. Table 3. Number and Size of Institutions in the Financial System in October 2002 Total Net credit Investments Deposits with z assets Portfolio net the public 7 Thousands Thousands Thousands Thousands Number of $US % of$US % of $US % of $US % Total in the country 69 6,951,074 100% 3,559,719 100% 996,496 100% 4,919,225 100% Private banks 22 5,726,339 82% 2,683,543 75% 890,550 89% 4,242,060 86% o/w PICHINC-A 1,529,505 22% 707,217 20% 195,905 20% 1,189,434 24% GUAYAQUIL 841,932 12% 353,185 10% 136,744 14% 567,203 12% PACIFICO* 621,985 9% 154,366 4% 190,377 19% 325,709 7% PRODUBANCO 601,615 9% 314,666 9% 89,569 9% 463,060 9% State-owned banks** 2 493,020 7% 310,365 9% 54,842 6% 192,464 4% Finance companies 11 327,201 5% 231,689 7% 16,459 2% 199,872 4% Savings and loan associations 27 246,481 4% 176,089 5% 19,715 2% 169,091 3% Mutual associations 7 158,033 2% 158,033 4% 14,930 1% 115,739 2% Total institutions abroad 9 1,284,057 100% 571,169 100% 393,683 100% 946,248 100% Offshore 5 476,937 37% 222,260 39% 146,467 37% 367,113 39% Operating abroad 4 807,120 63% 348,910 61% 247,215 63% 579,135 61% Total 78 8,235,131 4,130,888 1,390,179 5,865,474 Memoriam: Second- tier state-owned banks 2 433,634 73,637 181,711 1,351 Notes: Pacdfico with public capital. - Does not include second tier. Source: SBS. 92 ECUADOR: AN ECONOMIC AND SOciAL AGENDA IN THE NEW MILLENNIUM higher GDP growth and lower inflation (see the Chapter 1). Nevertheless, credit growth is still restricted owing-on the supply side-to the banks' need to maintain liquidity surpluses against the macroeconomic uncertainty heightened in this elec- tion year and to the greater caution of the banks that survived the crisis and experi- enced a severe deterioration of their portfolios. On the other hand, the gradual improvement in portfolio quality has been reflected in greater yields for banks. Total assets of private banking rose by 16 percent over the first 10 months of 2002, reaching $US5.726 billion by October (Table 4). Productive assets (loan and investment portfolios) rose slightly to 63 percent of total assets (in other countries they are 80-90 percent), while investments accounted for 25 percent of the banks' total productive assets. Approximately half of all investments are in the public sec- tor, largely as a result of the crisis resolution process.6 The buyers (large banks) received bonds from the government as productive assets, in the absence of a qual- ity portfolio. The government's debt exposure is concentrated in large banks (par- ticularly in Banco Pacifico, with a 28 percent share of its assets). This increases the risk for these banks in the event the fiscal situation deteriorates. Private investments are mostly placed abroad (close to 100 percent of total investments with the private sector, according to data from the largest banks), as are available funds (including cash, bank deposits, and reserves in the Central Bank), in order to keep the high liquidity that allows them to deal with potential bank runs.7 The 2002 election campaign and the lack of a true last resort lender in the system increased the perception of a high risk of liquidity for the banks, resulting in the maintenance of a liquidity "cushion" that reached $US 1.1 billion in October 2002. These liquid assets accounted for 23 percent of total assets, restricting portfolio growth during the year and negatively affecting yields. The banks reported their intention to restrict portfolio growth at least until the second quarter of 2003, con- tinuing the high liquidity that prevailed during 2002, until the new government better defines its economic policies. The total gross portfolio grew by 16 percent during the first 10 months of 2002, in contrast to a 3 percent decrease for the prior year, and remained concen- trated (62 percent) in the commercial sector, although the year saw a healthy 6. This is the result of either the government bonds that some banks, such as Pacifico, received as capital contributions, or of the acquisitions or mergers by some large banks that absorbed others experiencing difficulties. 7. For example, by mid 2002 the system's largest bank had 19 percent of its deposits with- drawn in one month owing to a perception of system instability, but it was able to man- age with the surplus liquid funds it regularly maintains. The run on Pichincha may have had more to do with the perception of macroeconomic and political risk than with a par- ticular risk of the bank, because during the crisis it had been on the receiving end of the "flight to quality" along with other surviving banks. Pichincha also has by far the greatest number of branches in the system (almost 150), which facilitates massive withdrawals. THE BANKING SYSTEM 93 Table 4. Private Banks*: Balance Sheet (thds $US and percentages of Total Assets) Dec. 2001 Oct. 2002 TOTAL ASSETS 4,928,812 100% 5,726,339 100% AVAILABLE FUNDS 1,077,508 22% 1,115,639 19% INTERBANK OPERATIONS 1,480 0% 3,120 0% NET INVESTMENTS 729,046 15% 890,550 16% With the private sector 304,394 6% 336,632 6% With the public sector 306,152 6% 436,913 8% Of limited availability 146,976 3% 131,025 2% NET CREDIT PORTFOLIO 2,151,682 44% 2,683,543 47% Gross portfolio 2,601,952 53% 3,016,617 53% Commercial 1,826,930 37% 1,879,947 33% Consumer 529,981 11% 863,406 15% Housing 245,041 5% 237,632 4% Microenterprise 0 0% 35,632 1% (Provisions for bad debts) -450,270 -9% -333,074 -6% FI)XED ASSETS 255,637 5% 324,905 6% OTHER ASSETS 713,459 14% 708,582 12% o/w: Allocated goods 42,874 1% 88,164 2% TOTAL LIABILITIES 4,549,522 92% 5,143,995 90% DEBTS TO THE PUBLIC 3,669,223 74% 4,265,304 74% Sight deposits 2,530,676 51% 2,929,933 51% Term and other deposits 1,138,546 23% 1,335,371 23% INTERBANK OPERATIONS 51,412 1% 4,000 0% OTHER LIABILITIES WITH COST 442,211 9% 462,831 8% o/w: Foreign lines 256,283 5% 222,584 4% CONVERTIBLE OBLIGATIONS & CONTRIBUTIONS FOR CAPITALIZATION 169,717 3% 194,655 3% OTHER LIABILITIES 216,960 4% 217,205 4% NET WORTH 379,290 8% 582,344 10% TOTAL LLABILITIES & NET WORTH 4,928,812 100% 5,726,339 100% TOTAL UNPRODUCTIVE PORTFOLIO: 456,882 9% 287,213 5% Commercial 297,578 6% 204,809 4% Consumer 45,655 1% 62,293 1% Housing 113,649 2% 18,281 0% Microenterprise 0 0% 1,829 0% Notes: *Includes Pacifico, with public capital. Data to October is preliminary. Source: SBS. increase in financing for the consumer sector (Table 4). Banks focused their new loans on the consumer sector, which had grown more than 60 percent by October 2002. This growth was largely because large companies-including many multina- tional companies that accounted for much of the banks' commercial portfolio-had 94 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM chosen to take direct lines of credit from abroad as international interest rates dropped. The improved economic growth also favored the consumer portfolio. The housing portfolio decreased, reflecting the banks' preference for shorter-term place- ments. These patterns predominated for banks of all sizes. The microfinance port- folio also benefited from the year's macroeconomic recovery, but remained at low as a proportion of the system's total portfolio.8 The quality of the net portfolio improved significandy. The nonperforming pro- portion of the portfolio (problem loans plus portfolio not earning interest) to gross portfolio dropped from 17.5 percent in December 2001 to 9.5 percent in October 2002 (Table 6). This was due to the increase in the productive portfolfi during the year and to the sustained increase in provisions that cover 116 percent of the non- performing portfolio (up from 99 percent coverage in December 2001).9 By type of loan, the nonperforming portfolio (problem loans plus portfolio not earning interest) is concentrated in commercial loans, but less than its share in the total gross portfo- lio. Furthermore, both the commercial and the housing portfolios, stable in absolute value, saw their share in this total decrease, while the mature consumer portfolio dou- bled its share-reaching 20 percent of the total nonperforming portfolio. During 2002, the improvement in portfolio quality also benefited from the activ- ities of the Credit Restructuring Unit (URC).'° Since late 2001, the URC had made use of a single representative to facilitate the restructuring of cases for $US 1.357 bil- lion (45 percent of the Filanbanco portfolio, 14 percent of the Pacffico portfolio, and 18 percent of the total portfolio of the banks administered by the AGD). By early December the URC had restructured 85 percent of the total portfolio value and estimates predicted that 95 percent of the debts transferred to the URC would be restructured by the December 20, 2002 deadline. Debts restructured in the last few weeks are mainly those of Filanbanco (which accounted for 40 percent of the unstructured debt in mid-November). The accounts that make up these restructured debts are few but sizeable. In terms of funding, private banks continue to have little access to foreign lines of credit, as in the crisis period (Figure 2). Only six banks had positive balances by 8.The microfinance sector is mainly covered by two banks (Pichincha and Solidario), which account for 75 percent of the total, followed by one savings association (Ecuarorial), which accounts for 13 percent. Authorities are focusing on the recent rise in microfinance, partic- ularly considering that the savings associations are the institutions that best survived the cri- sis. Furthermore, a study done by the International Project Consult (IPC) found great mar- ket potential for rural agricultural financing through saving associations and banks interested in the sector (see Proposed Strategic Plan for Long-Term Development for Ecuador, 2002). 9.Using as a reference the portfolio classified as C, D, and E as the systerrs most risky, the present coverage of constituted provisions is 83 percent and the deadline has passed for constituting the provisions required by the latest increase in the provisions rule in 2001. 10. Supported by the World Bank's technical assistance loan to the financial sector. THE BANKING SYSTEM 95 Table 5. Private Banks*: Profit and Loss Statement (thds $US) Oct. 2001 Oct. 2002 Interest and discounts earned 383,857 173,954 Interest accrued 158,588 49,588 NET MARGIN OF INTEREST 225,268 124,366 Income and commissions for service 160,167 67,879 Expenses and commissions paid 69,808 14,606 GROSS FINANCIAL MARGIN 315,627 177,639 Operating expenses 348,336 150,361 Other net operating income 61,309 25,469 NET OPERATIONAL MARGIN BEFORE PROVISIONS 28,600 52,746 Provisions 123,250 27,851 NET OPERATIONAL MARGIN -94,650 24,895 Net extraordinary income 69,050 28,270 PRE-TAX PROFITS -25,600 53,165 Taxes and employee profit-sharing - 10,371 EARNINGS OR LOSS FOR THE BUSINESS YEAR -25,599 42,794 Memorandum: Operating expenses/gross financial margin 1.10 0.85 Provisions/grossfinancial margin 0.39 0.16 Notes: *Includes Pacifico, with ptblic capital. Source. SBS. the end of 2002,11 while deposits from the general public were concentrated in sight deposits (70 percent of the total), revealing the preference for short-term assets owing to recent political and macroeconomic uncertainty. In fact, by mid-year high volatility was evident in system deposits, with withdrawals concentrated in mid-size banks, including foreign banks. The drop in deposits with foreign banks was largely due to the loss of a few, but large, accounts (some of them multinational compa- nies). Driven by the marked increase in sight deposits, the majority of system deposits are at terms of under 90 days, and a high percentage are in deposits of under $US5,000 (63 percent of sight deposits). The average volatility remains high, and is even higher for at least one of the foreign banks and other small banks.'2 Conse- quently, the ratio of liquid assets to total assets was at a high 20 percent, sufficient 1 . Including only one small bank, Solidario, which focuses on the microfinance sector and maintains broad access to fireign lines of credit from multilateral agencies. 12.The SBS calculates the average volatility based on monthly data on variations in each component of deposit liabilities in the last 18 months, weighted by their percentage of the total. Volatility reached 18 percent in 97 percent of the cases, with certain banks having much higher volatility rates (24 percent for Citibank). 96 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Figure 2. Financing Lines Abroad (mlns $US) 800 - 600 - 400- 200- o0 Dec. Sep. Jun. Mar. Dec. Sep. Jun. 1997 1998 1999 2000 2000 2001 2002 Source: BCE. to withstand a monthly withdrawal of 30 percent of banks' liquid liabilities, although the liquidity index (liquid assets over liquid liabilities, as defined by the SBS) was at its lowest level of the last 12 months. Solvency Banks have also improved their solvency by capitalizing profits, in some cases (as with the second largest bank, Banco Guayaquil) with significant contributions of new capital from shareholders.13 The strengthening of bank capital resulted in sol- vency indexes above the 9 percent regulatory minimum for all banks, with 11.8 per- cent for the system by October 2002. This index is also positive considering the time schedule imposed for reducing the ratio of primary to secondary capital, which must be brought to the 1:1 ratio established by Basel by March 2003. Several banks have already met, or are close to meeting, this ratio, while the system as a whole main- tains a ratio of 1:1.10. Yield The management of private banking during the first 10 months of the year brought an improvement in profit generation as well as improved levels of solvency. This was evident despite the maintenance of high liquid balances, partly attributable to much lower expenses for provisions in 2002 as compared to 2001 (from 39 to 15 percent of the gross financial margin-see Table 5). Interest expenses were also significantly 13.This includes the capitalizations of Banco Pacifico since 2001, which came to $US250 million in February 2002, including contributions for future capitalization of $US152 million-which will double the present paid capital of $US 155 million. THE BANKING SYSTEM 97 Table 6. Private Banks*: Financial Indicators Oct. 2002 Solvency Required capital / assets weighted by risk 11.80% Primary capital/ assets weighted by risk 6.40% Capital/ assets 9.40% Quality of the assets Portfolio C, D & E / gross portfolio 13.40% Unproductive portfolio */ gross portfolio 9.50% Provisions/ portfolio C, D & E 82.70% Liquidity Liquid assets (Ist.) / total assers 22.50% Liquid assets (2nd.) / total assets 23.90% Liquid assets (Ist.) / liquid liabilities (lst.) 30.40% Liquid assets (2nd.) / liquid liabilities (2nd.) 29.00% Net portfolio/ deposits 62.90% Yield Net margini of interest / gross income 40.00% Operating cost / gross income 48.30% Operating cost / average assets 3.40% Return on average assets ROAA 1.00% Return on average equity ROAE 11.20% Notes: 'Includes Pacifico, with public capital. Source. SBS (preliminary data) and the authors' estimates. lower, partly through the effect of lower international deposit rates, although income from interest in October 2002 was also down, but to a lesser extent. Profits approximated $US42.8 million in the first 10 months of the year, com- pared to a loss of $US25.6 million in December 2001, which was affected by the enormous losses of the Banco Pacifico-reversed in 2002 through its capitalization and rationalization of expenses."4 Improved yield levels are partly attributable to the fact that coverage of the nonperforming portfolio had already increased significantly in 2001, requiring lower expenditures for provisions in 2002. Nevertheless, the high cost of maintaining liquidity continues to decrease the banks' capacity for profit generation, which in turn restricts the reduction of lending rates (to be addressed later in this document). Banks have dealt with the crisis by diversifying their sources of income genera- tion, increasing income from commissions (which is more stable), and offsetting the lower relative growth of their loan portfolios. In some banks extraordinary income 14.The return on average equity (ROAE) was 11.2 percent, while the return on average assets (ROAA) was 1 percent. 98 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM was particularly significant, especially income from the recovery of asset write-offs that were able to offset the expense for provisions. In effect, Figure 3 shows the total expenses for provisions and the same expenses after income from recoveries-with negative balances indicating a net income, illustrating the effect of high recoveries for some banks. This could reflect a very aggressive portfolio write-off policy, or unexpected recoveries via the debt restructuring plans undertaken during the year. Between December 2001 and October 2002, the spread (measured as the differ- ence between the average lending and borrowing rates, and excluding Filanbanco) dropped from 10 to 8 percent, owing largely to a marked reduction in operating costs. In effect, during this period operating costs (including personnel expenses) as a percentage of average assets were reduced from 7 percent to 3.4 percent. This reduction in operating costs is crucial because, as with most countries in the region, operating costs make up the principal component of the spread and are partially off- set by greater operating income not originating in interest. 5 Figure 3. Gross and Net Recovery Provision Expenditures (mlns $US) 2,500 2,000 _,500 L 1,000 average FMles (fosfo ners ivnoy flaso eGross bu fc s 500u -500 <== Net -1,000 -1,500 0- u 5 0 00 -.' 00u FM CS 0 0 0 ~ ~ -~ .~ * 'c o- 4 , U 0 cies - -~ ~ ' -n rh d U ~~~~-0 ~~~~ o CS o "r U 0 U~~~~ Source: SBS. 1 5.The accounting breakdown of the spread was done with reference rates instead of with average rates (flows from interest /inventory of loans or deposits) because of inconsisten- cies in the data with the recent cha-nge of the accounting plan. This exercise reveals that operating costs account for over half the spread and are offset in part by non-interest income (fee income). These patterns are similar to those in other countries in the region (see Dick, "Banking Spreads in Central America: Evolution, Structure, and Behavior," Harvard Institute for International Development, Discussion Paper No. 694, April 1999. THE BANKING SYSTEM 99 C. Strengthening Individual and System Risk Management Institutional Structure and Management of Cash Risk The need for a high proportion of liquid assets and the corresponding concentra- tion of the banks' investment portfolio in foreign bonds are closely associated with the official dollarization of January 2000. Nevertheless, the maintenance of these high liquidity ratios is also typical in countries that have a high defacto dollarization, as Ecuador had prior to 2000, with over 60 percent of the banking portfolio denom- inated in dollars in 1998 and 1999 (Figure 4). The progressive loss of monetary effectiveness in processes of high dollarization16 reduces the monetary authority's capacity to protect the economy from external shocks and leads banks to maintain their assets in more liquid forms. In Ecuador, excessive liquid holdings have at least two negative effects on the economy. The first is that they reduce the funds available for long-term investment, which has negative effects on bank yield. Second, the need to keep these liquid assets abroad reduces the amount of internal savings that can be invested domestically. For both reasons this issue has become an important economic policy question: How can banks reduce holdings in liquid assets beyond the level required by a dollarized economy? The remainder of this section addresses this question. Figure 4. "Onshore" Credit (percentage granted in $US) 80% 60%- 4~~~~~~~~~~~,1l Dec. Dec. Dec. Dec Dec. Dec. Dec. 1992 1993 1994 1995 1996 1997 1998 Source: SBS. 16. See Patrick Honohan and Anquing Shi, "Deposit Dollarization and the Financial Sector," World Bank, WPS 2748, October 2001. 100 ECUADOw: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Owing to the difficulty of establishing precisely the proper level of liquidity the system needs, the following exercise is based on a level of liquid reserves similar to that already maintained by the banks as a whole. Nevertheless, the exercise seeks to achieve a more efficient way to manage liquidity in the system, based on the alter- natives currently under consideration by the Central Bank. Table 7 presents the value of banks' liquid assets in December 2001, which exceeded 25 percent of total reservable deposits. The Central Bank was also maintaining deposits equivalent to an additional 7 percent as a result of the required 4 percent mandatory reserves and funds in the liquidity fund (2.9 percent). In general, the reductioni of the liquid assets that banks maintain could result in lower lending rates (for a given margin of net interest) or greater bank yield (keep- ing the lending rate constant). In the former case, improved credit conditions would tend to increase access to credit, while in the latter, a greater bank yield would tend to reinforce the soundness of the system. The right side of Table 7 presents a differ- ent allocation of the liquidity that could result from access to reserves managed by the Latin American Reserve Fund (FLAR by its Spanish acronym) via a contingent line of credit, which could be as high as $US41 0 million (based on Ecuador's cur- rent participation in the FLAR). A centralized management of liquidity could offer the opportunity to invest, for example, the $US410 million in high yield bonds, permitting a reduction of the lending interest rate. On the other hand, if banks were to decide to keep lending rates constant, they could achieve a better bank yield. Based on a 5 percent spread Table 7. Liquidity in the Banking System Situation in Hypothetical Dec. 2001 scheme MilL $US Yo deposits MilL $US % deposits Private funds 932 25.7% 522 14.4% Voluntary reserves 54 1.5% 54 1.5% Available funds (net of reserves) 878 24.2% 468 12.9% Public funds 251 6.9% 661 18.2% Reserves (mandatory) 145 4.0% 145 4.0% Liquidity fund 106 2.9% 106 2.9% Contribution from Corporaci6n Andina de Fomento 70 1.9% 70 1.9% Contribution from the banks 36 1.0% 36 1.0% Contingent credit 0 0.0% 410 11.3% Total liquidity 1,183 32.7% 1,183 32.7% Memorandum: Reservable deposits 3,623 100.0% 3,623 100.0% Source: SBS, BCE, and the authors' estimates. THE BANKING SYSTEM 101 between portfolio yield and the yield of liquid assets, profits could increase by $US20 million. The overall result would probably be even stronger than foreseen here. In fact, a centralized reserve fund would bring the total quantity of liquidity reserves lower than its level of early 2003. A public scheme of greater liquidity provisions, however, faces two fundamental difficulties that must not be underestimated because they require changes in the legal framework. The first requirement for the viability of a greater "Liquidity Fund" is to instill, in the commercial banks, full confidence in the Central Bank's capacity to man- age this fund with the required level of confidentiality. Furthermore, to date, the legal restriction that prevents the Central Bank from managing trusts has made it necessary to delegate management of the liquidity fund to the CFN, a state-owned bank expe- riencing problems in its balances. In addition, the Central Bank's share in ownership of the third-largest bank in the system (Banco Pacifico) makes the former subject to potentially significant conflicts of interest that could potentially hinder the full effec- tiveness of the liquidity fund. A second requirement is the need for close monitoring of the liquidity fund's investment policies, which could be delegated to a reputable financial institution that would act as trustee and even as administrator of these funds. The reform of the liquidity fund centers on addressing the need for a more effi- cient management of the liquidity "supply" and therefore does not directly solve the problems resulting from a volatile liquidity "demand." One of the factors that could most stabilize this demand is effective supervision of the banks' liquidity position and of bank solvency in general. In fact, one of the more relevant reasons behind bank liquidity squeezes is when the banks have losses while they are at the bottom of the cycle. These affect their capital position and lead them to sell off their most liquid assets. Consequently the stabilization of the banks' demand for liquidiry could be improved with procyclical provisioning policies that increase the volume of reserves against portfolio losses during periods of high portfolio growth (and high bank yield) and reduce it during periods of weak or negative growth (and low bank yield). Over the last two years, the high level of provisions created to deal with the exces- sive nonperforming portfolio following the crisis has prevented Ecuador from con- sidering the requirement of additional procyclical provisions. Even so, for an econ- omy such as Ecuador's, with high exposure to cyclical variations in oil prices, a procyclical provisioning policy is an important option to consider. Based on Spain's successful experience, a dynamic provisioning process causes banks to put aside larger amounts during periods of expansion up to a given level. Using these accum- mulated reserves in low periods would avoid reductions of capital and liquid assets and, consequently, reductions of credit. Efficient management of liquidity depends, to a great extent, on the existence of excellent relations with foreign correspondent banks, considering the low liquidity of Ecuador's financial activities and the considerable quantity of liquid investment that the country's banks maintain abroad. That is why it is very important that legislation on money laundering be established before a negative assessment of existing regula- tions can generate a sudden cooling of relations with foreign correspondent banks. 102 ECUADOR: AN ECONOMIC AND SOCLAL AGENDA IN THE NEW MILLENNIUM Strengthening Supervision and Regulation In the last two years, the SBS has been immersed in an important plan to improve supervision of the banking system, including the introduction of a new Standard Chart of Accounts (in operation since July 2002), which provides a clearer and more reliable source of information on the financial position of the banks. On-site and off-site supervision procedures have been reviewed in detail (including recently a CAMEL analysis that laid the foundations for an early warning system that helps expedite taking corrective measures), with a focus on risk analysis that is more in line with the best international practices. Resolutions were issued for market risk analy- sis, concentrating first on putting into effect liquidity risk analysis, with reports from the banks beginning in January 2003 (a three-month testing period). The next areas of concentration are (new) operational risk and credit risk (improving practices implemented in the past). The SBS has also been moving toward a consolidated approach to supervision, but this is still in progress. In addition, the SBS has restructured its organization to provide a greater har- mony between its supervision practices for all the institutions it oversees. In doing so, it has been able to better coordinate its on-site and off-site supervision, which are not integrated into the new structure, and to seek a more timely intervention or investigation into issues brought to light by either of the two areas working together. System monitoring seems to have improved with the new inspections performed this year under new criteria centered on risks, and the SBS hopes to be able to perform at least one supervision of each bank per year. (It has already completed the arduous process of training its personnel in the new rules of play). To complement these efforts and improve transparency by increasing the reporting by the authorities, we recommend that the SBS provide a detailed report of its activities in its annual report. On the other hand, the effort to improve bank supervision has led the SBS to give less attention to problems in other sectors, particularly the insurance sector (which the authorities acknowledge). Because there is a high degree of concentration in the system between banking and nonbanking institutions, it is important to strengthen supervision of the latter and other institutions, despite their smaller size. ID). lIssues in the Settdement of ]Payments and Securities'7 An analysis of a more efficient management of bank liquidity must not neglect con- sideration of its effects on the functioning of the payments system. The system's effectiveness and security level for large transactions, along with the dematerializa- 17.This section was prepared on the basis of the report, "Assessment and Observations on the Payments and Securities Clearance and Settlement Systems of Ecuador," September 2002, which was produced in the context of the Initiative on Compensation and Clearance of THE BANKING SYSTEM 103 tion and easy transfer of financial assets used as (enforceable) collateral, are funda- mental elements for reversing the incentives for foreign investment to obtain basic liquidity services. Nevertheless, Ecuador's payments system is characterized by the lack of Real Time Gross Settlement (RTGS), as well as the lack of an effective asset depository that can allow for an effective method of Delivery Versus Payment (DVP). The security of financial transactions and assets could be increased signifi- cantly by putting into effect some policy actions, such as those discussed below. Cash and checks are the means of payment most commonly used in Ecuador. In addition to the check clearinghouse, the Central Bank operates a funds transfer sys- tem through its current accounts, either through SWIFT or over the counter with a mix of manual and automatic procedures. Those systems are being reformed at pres- ent. In addition to operating low-value payments, the check clearinghouse also processes high-value payments, which entails considerable risk for the payments sys- tem. One of the purposes of reforming the payments system is to launch a RTGS system to reduce the main risk in high-value transactions. However, this system in turn requires a highly efficient management of liquidity to prevent liquidity risk and the problems associated with a gridlock in the system. To eliminate principal risk in high-value transactions, it is not enough to launch and run the RTGS. The Central Bank, in cooperation with private financial inter- mediaries, must take an active approach, establishing adequate incentives for high- value payments to be cleared through the RTGS and not through the check clear- inghouse. One fundamental requirement for this to occur is increased efficiency of the payments system as a whole and, specifically, endowment of the RTGS with the proper characteristics. The following is a list (though not exhaustive) of issues to be considered: scarcity of total liquidity in the system; unequal distribution of liquid- ity, limited functioning of the interbank monetary market; lack of intraday credit; the Central Bank's limited capacity under the current monetary and exchange framework to deal with liquidity problems; and possible preference of institutions for a net settlement system or, in a gross system, for end-of-day deferral of pay- ments." The reform also calls for establishing two high-value systems, the RTGS and the Net Value Payments System, which doesn't seem to be an efficient solution for a country with Ecuador's characteristics. A net system of high value would not reduce principal risk, unless it establishes costly mechanisms to mitigate the risk, nor would it lead to payments in real time. In addition, the securities market in Ecuador is clearly dominated by public secu- rities, fundamentally government bonds and Treasury certificates. The settlement of Payments and Securities of the Western Hemisphere (IHO, see http://www.ipho- whpi.org/). For detailed aspects of the evaluation of these systems, we recommend con- sulting the above-cited document. 18.Some specific proposals to resolve some of the problems mentioned here can be found in the report mentioned in the previous footnote. 104 ECUADOR: AN ECONOMIC AND SoCLAL AGENDA IN THE NEW MILLENNIUM securities is far from efficient because they are transferred through the delivery of physical certificates. The depository institution, DECEVALE S.A., created in 1994 by the two stock exchanges, has not been operating except for a very specific issue of CFN securities and the securities regtilator has recently suspended its operations because of financial troubles. Nevertheless, the Central Bank is only capable of transferring ownership of securities apart from their payment. In other words, it does not have a DVP system. This fact is not only relevant for the settlement of cap- ital market transactions, but also for the management of liquidity in the financial system. Specifically, it hampers the development of a collateralized interbank mon- etary market for which the setdement of securities through DVP is fundamental and which requires a connection between the deposit of securities and the RTGS system. The efficient establishment of a securities depository requires dealing with a number of urgent issues-which institution(s) should be the depositor(s), what ownership structure should the depositor have, and so on. The lack of consensus on these basic questions usually leads to a significant delay in the improvement of sys- tems, as has occurred in Ecuador, with negative consequences for the development of the financial system. Because of public interest in this issue due to its implications for fiscal and monetary policy, systemic liquidity management and risk manage- ment, and capital market development, the pertinent government authorities (Cen- tral Bank, the securities regulator, and the Ministry of Finance) must take the lead in defining, establishing, and implementing a centralized securities depository. The proposed solution must be adapted to the existing legal framework (or the latter must be modified if the chosen course does not fit it) and must carefully consider the subject of corporate governance to ensure that the system functions efficiently and allows equal access to all participants. The 4 percent reserves for eligible deposits plus the existing 1 percent on the part of the liquidity fund could be insufficient to provide the liquidity required for the proper functioning of the payments system. Also, in the context of reform of the payments system, the launching of a RTGS system that has the virtue of eliminat- ing principal risk increases the system's liquidity needs and requires meticulous man- agement. The interbank monetary market is not very active and system liquidity is distributed through a system facilitated by the Central Bank. Each quarter, the Monetary Council approves the quantity of Central Bank securities that can be issued ($US30 million for the third quarter of 2002), using a formula that takes into account the level of international reserves. This quantity is in turn the quantity of funds that the Central Bank is authorized to inject into the market through open market operations (basically using securities issued by the government as collateral), thus permitting the redistribution of liquidity between the banks. This liquidity dis- tribution system may not be sufficient for the functioning of the new payments infrastructure. The reform of the payments system currently in process must take into account not only the objective of improving the provision of payments services, but also broader objectives such as improving the system's liquidity distribution through an THE BANKING SYSTEM 105 efficient working of the interbank monetary market and the development of the securities market, among others. Preparing a strategic vision document that identi- fies these and other objectives would help to expand the sphere of influence of the payments system reform and would thereby improve the security and efficiency of the financial system. It's not only the operating aspects that are important; the reform must also consider providing a proper legal and regulatory framework and establishing a function of oversight of the settlement systems, which is normally the responsibility of the Central Bank. This entails a far-reaching reform involving many participants. It requires a high degree of coordination among regulators and cooperation with the private sector and with all stakeholders in general. Some organizational change with regard to the existing arrangements through the Central Bank's interinstitutional committee could help. Therefore, the Central Bank's coordination with other participants could change from being merely informational, as it now is, to a more active participation in the discussion and design of the reform, which is very important in broadening the reform's framework. It is necessary to bring the users of the new systems into the process. The Central Bank must be prepared to establish and exercise, with the proper legal basis, the function of oversight of the payments systems. It is not enough to launch and implement the reform; the Central Bank must seek a way to continuously improve the systems and be attentive at all times to its proper opera- tion owing to the implications of systemic risk and efficiency of the financial system. E. The Financial Safety Net This discussion of liquidity management has already introduced the more general question of how Ecuador could adapt its "financial safety net" to the needs of a dol- larized economy. The new role of the Central Bank and of the SBS in managing and stabilizing liquidity requirements is only part of a more general problem, which this section will analyze. The three main components of the safety net are usually identified as (a) lender of last resort, (b) deposit insurance, and (c) banking supervision. In Ecuador the three government institutions discussed above (BCE, AGD, and SBS) have been pro- foundly affected by the crisis. Their roles in the new dollarized financial structure has also been changed several times, while alternatives are being evaluated for each one's future role in the system. Under the alternative that seems to have the highest degree of consensus among the authorities,19 the Central Bank could keep its central posi- 19.The main elements of this are addressed in the document. "Una propuesta de plan estrat6gico de desarrollo de largo plazo para el Ecuador," prepared in July 2002 as part of a joint committee that is analyzing the new architecture in Ecuador, composed of the Cen- tral Bank, the SBS, and the Ministry of Economy and Finance. 106 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM tion in the management of the payments system and of the system's liquidity needs, the AGD could be reduced to a pay box that delegates the settlement and solution of responsibilities to the SBS, while the SBS would maintain only responsibility for individual-but not systemic-interventions in the financial sector. Under the new scheme, the Central Bank would be responsible for managing the overall liquidity of the economy, including being responsible for supervising the payments system and managing system liquidity. The main obstacles to the success- ful functioning of the payments system appear to be technical in nature, such as the dematerialization of the financial paper. There are also several legal matters with regard to system liquidity that would have to be resolved in order to ensure that this management can be delegated to the Central Bank. Also, the Central Bank's man- agement role could be affected by the potential conflict of interest associated with its ownership of Banco del Pacifico. The Central Bank is aware of this issue and has delegated the administration of Pacffico to international consultants and is awaiting a change in the trend of withdrawal of foreign investment from Latin American banks, which could facilitate the privatization of Banco del Pacifico. The alternative that is being explored, to reduce the AGD to a pay-box mecha- nism, could be accelerated if the AGD is relieved of responsibility for managing the remaining assets in banks under reorganization. In this case, the AGD would focus on strengthening the deposit insurance fund (with the premiums that are being charged to active banks), instead of having to use these premiums to pay the debts of banks under reorganization. The resolution of banks outside of the AGD was already put into practice at the time of the response to Filanbanco's second and final fall, which ended with its placement in liquidation in July 2002. Meanwhile, other schemes under consideration call for the possibility of the AGD handing over the management of the portfolio and the sale of allocated goods and buildings to an international professional administrator. This could expedite the collection of the portfolio based on scale issues (and better technologies) and on the lack of a rela- tionship between this potential institution and the system's debtors (particularly the largest). Finally, the SBS has had a greater sphere of activity with regard to the restruc- turing of banking. The strengthening of its internal processes of supervision and the use of new manuals for on-site and off-site supervision in its recent inspections is having positive effects on the institution's reputation-which is crucial to increasing confidence in the system-and thereby giving support to the institu- tional project of liquidity management proposed by the monetary authorities.20 Another important matter is ensuring that supervisors have legal protection against lawsuits having to do with the performance of their duties. The high turnover in personnel in recent years is probably linked to the lack of this protection. (There 20.These efforts have been supported by the World Bank's technical assistance loan to the financial sectoL THE BANKING SYSTEM 107 have been about two superintendents per year, despite the fact that the position has a six-year term. Another crucial requirement is that improving the quality of banking supervision requires strengthening the legal framework governing the process of bankruptcy in the corporate sector and increasing the protection currently provided to creditors (within Latin America, only Haiti provides less protection than Ecuador2"), as well as the bankruptcy law and the law concerning chattel and real property collateral. This would also increase incentives for lending, as has been the case with the improved availability of information provided by the credit register, although the credit register could be complemented by a credit bureau that also analyzes data from the real sector (especially with the rise of consumer loans). Within the legal sphere, it is also important to develop an antitrust law in keeping with the best international practices, to provide effective protection of the market. F. Policy Recommendations The double impact of the twin crises and the official dollarization of the system have required, and will continue to require, important institutional and operational adjustments to the financial system. The main issues to be addressed are summarized below. * The need to improve banks' prudent credit activities, providing greater access. Large loans, frequently made to related parties, form a high propor- tion of the nonperforming loan portfolio. The broad coverage of deposit insurance for many of the banks undergoing processes of resolution distorted incentives for debtors, promoting a "nonpayment culture." The result has been a heavily deteriorated portfolio quality (with the ratio of credit portfolio to GDP at half its precrisis level); the cost of lending has risen, while small debtors have had much fewer opportunities for access to credit even consid- ering that typically have less access to the formal sector. The challenge of increasing access to credit is even greater in dollarized economies owing to the circumstances described earlier, but this access could be improved by means of the policies discussed below. * A more efficient management of banking liquidity. The reduced possibil- ity of softening external shocks via economic policy makes dollarized economies more exposed to shocks resulting from exchange or of interna- tional interest rates. This vulnerability, together with the lack of a lender of last resort, leads banks to maintain a higher level of liquid assets. However, an 21.See Galindo, Arturo, "Creditor Rights and the Credit Markets: Where Do We Stand?" IADB Working Paper. March 2001. 108 ECUADOR: AN ECONOMIC AND SocALL AGENDA IN THE NEW MILLENNIUM efficient management of system liquidity could free up some of these assets, which would permit increasing the quantity of resources available for pro- ductive uses. Centralized management of system liquidity could also permit access to contingent lines of credit on better terms. The Central Bank is a nat- ural candidate for this central role owing to its present responsibility for the payments system. Separating this function from the responsibility of central- ized management of liquidity does not appear to be efficient and could nega- tively affect the provision of a public good such as liquidity. Therefore it is crucial to reduce the legal impediments and to eliminate the potential conflict of interest that could weaken the effectiveness of the Central Banlks actions. Reforms of the payment systems. The provision of liquidity cannot be suc- cessful if there is not an effective payments system. Consequently, the sequence of policies needed to reform the payments system must be codified in a public document. The essential steps include the following: introducing the Real Time Gross Settlement (RTGS) system; ensuring availability of a security deposit to achieve the dematerialization and which allows for carry- ing out DVP procedures; and, finally, defining a single net clearance system for check transactions. A delay in reforming the payments system will inevitably lead to the change of position of the country's payments services in a time horizon that, for a dollarized economy, may not be very long and would deprive the local banking system of an additional source of profit. o Banking supervision and regulation. The banks' large holdings of liquid assets cannot be reduced solely through interventions related directly to liq- uidity, because one of the principal reasons behind bank runs is a lack of con- fidence in the quality of bank assets (aside from reasons of macroeconomic instability). Therefore it is vital that the SBS continue to improve its proce- dures, especially in relation to the evaluation of credit risks (urging banks to also modernize these processes) and in relation to the rules of portfolio provi- sioning. Accordingly, it is important to consider the possibility of establishing procyclical provisions as Spain has done, seeing that Ecuador's economy has characteristics of high volatility. Legal protection for SBS authorities in the performance of their functions is also vital, as are legal changes that allow for the improvement of the systems of bank resolution and liquidation. At the same time, the SBS's reporting must be strengthened. Finally, to increase con- fidence in the system and to prevent potentially dramatic consequences for the management of system liquidity-such as the suspension of correspon- dent reports between national and foreign banks-will require full compli- ance with international standards to prevent money laundering (coordinating efforts with the pertinent authorities), ensuring that the SBS can carry out legal actions in this regard within a fully integrated legal system. • Codification of exit mechanisms for banks. The formalization of the role of the SBS and of the AGD in the process of bank resolution and liquidation must be strengthened and the AGD's functions must be revised, considering THE BANKING SYSTEM 109 the alternative of converting it into a pay box. The latter would consider the resolution of the management of assets of banks undergoing reorganization through a specialized foreign agency, to permit a greater return and less ero- sion of the debtors' will to pay. Reform of state-owned banks. Owing to the difficult equilibrium that state- owned banks must establish in their dual commercial and social function, it is important to consider reforming the existing banks (particular the first-tier banks), limiting their activity to focalized areas where subsidies, if needed, are transparent and minimal. This effort would have to include an evaluation of alternatives for the development of the microfinance market that has been undergoing development (particularly with the greater success of the savings and loan associations in surviving the crisis) and of rural financing. This last option presents good market potential, which could motivate institutions (even formal ones) already leaning toward these sectors to improve sustainable access to credit and other financial services, based on extensive international experience (as in Bolivia, for instance). Policy Matrix Policy measures and progress indicators Areas offocus and goals Short Term (to June 2003) Medium Term (2003-07) LIQUIDI7TYFUND Legal authorization permitting the BCE Transfer of management to the BCE could to manage trusts. The present law does not increase public confidence in the permit this, which is why the CFN was Liquidity Fund. assigned the role of trustee for management of the liquidity fund. z Definition of a new organizational Create the Financial System Oversight Create an agency to manage the technical part G 0 structure for management of the Committee comprising the BCE, SBS, of the liquidity fund. z liquidity fimd. Coordinator of and the Ministry of Economy and 2 responsibilities between the lender of Finance. last resort and the bank supervisor. Efficient exchange of information Prepare for the creation of a "data bank" ° between the BCE, SBS, AGD, and the that the different agencies can access. oversighit committee (to be created). :> c) Reduction of the Central Banks conflict Sustain progress in the bank's Revise the plan for the bank's privatization in Z of interest as owner of Banco Pacffico. restructuring plan. the medium term. AGD Finalization of AGID activities related Contract with external consultants to sell assets 2 to the crisis. Payment of outstanding to prevent their rapid erosion, permitting the liabilities, sale of portfolio and other assets. payment of pending accounts. Restructuring of the AGED. Allowing it to Revise its structure, consider converting 5 focus on partial deposit insurance. it into a pay box. SUPERINTENDENCY OF BANKING Legal protection for the superintendent Modify the Banking Act, to include and other functionaries in performing explicit protection. their duties. Improvement of the SBS's reporting Include a section in its Annual Report with statistics that reflect the oversight activity of the SBS. Compliance with international Introduce a law to bring the country into Introduce regulations to be carried out by banks standards against money laundering compliance with Financial Action and insurance companies. (coordinating efforts with the related Task Force (FATF) principles of authorities). Guaranteeing that the SBS money laundering. can carry out legal actions in this sphere within a fully integrated legal system. Strengthening of mechanisms for credit risk analysis, for both on-site and off-site inspections (to improve analysis systems in banks). PROTECTIONFOR DEBTORS Introduction of Bankruptcy Act in line Perform an analysis of corporate with the best international practices. insolvency (Insolvency Report on the Redefine the legal framework for the Observance of Standards and Codes property rights of creditors in the [ROSC]). restructuring of debts. PAYMENTS SYSTEM Formulation of a strategic vision of the Formulate a strategic vision of a report from the payments system beyond operational Central Bank for the settlement of payments aspects, focused on improving payment and securities that is comprehensive and goes (Matrix continues on the follo wing page) Policy Matrix (continued) Policy measures and progress indicators Areas offocus and goals Short Term (to June 2003) Medium Term (2003-07) services. Extend the scope of the reform to beyond operational aspects. include legal issues, the oversight function, i securities, government payments, and so on. C: Legal aspects: protection of the payments Perform in-depth review of the legal 0 systems against individual bankruptcy, framework for a payments system and purpose of liquidation, legal basis for design a plan of action for implementing collateral, legal recognition of the the necessary reforms. Incorporate 0 estimation of net balances, and so on. into the legal framework all aspects z identified for increasing the soundness of the payments system. n Creation of a system of Real Time Gross Follow the guidelines set down in the strategic Setdement. Significant risks because vision document to establish the different 0 high-value payments are made through elements necessary for modernizing the checks. The funds transfer system between payments system. Central Bank accounts sriU contains manual processes that reduce its effectiveness. Securities depository. The failure to Establish the function of securities depository develop the function of securities based on the guidelines set down in the strategic depository does not allow a Delivery vision document, with a connection to the z Versus Payment (DVP) system. This high-value funds transfer system.n puts limitations on management of K system liquidity because the lack of this function hinders the development of an z interbank monetary market with collateral. Establishment by the Central Bank Have the Central Bank establish the function of of the oversight function. There is no oversight of the payments system and coordinate legal capacity and no practical oversight with other regulators (on the subject of of the payments system by the Central securities, for examnple). Bank. A reform cannot be considered Z complete unless this function has been activated, which permits controlling the risks and periodically checking that the liquidation arrangements are efficient and secure at all times. Coordination by the Central Bank Establish a mid-level committee that with other related parties. There is room provides better liaison between the for improvement in the existing high-level committee and the present organizational arrangements through technical committees. the Central Bank's Interinstitutional Committee. 5 Petroleum Policy' Eleodoro Mayorga The importance of the petroleum sector to the Ecuadoran economy is undeniable. Given the weight of external debt and the need to generate fiscal resources, there is an urgent need to increase exports and reduce inefficiencies in this sector. The country has consid- erable proven reserves, and by the end of 2003 will also have acquired the greater trans- port infrastructure it needs. However, the sector still suffers from serious structuralprob- lems: a legal. contractual and institutional framework that preserves PetroEcuador's monopoly and limits access to capital and technology; distortions in the management of oil profits; high costs resulting from low operational efficiency in the state enterprise; low quality products sent to market at a high cost; and atsor;n.on.;nn ntal record that needs resolution in order to open vast regions of the country to sustainable development. The new government needs to undertake profound sectoral reforms. The most urgent - __-- I_---L I .L--fTJL_. A ILl r__I /TAT' - -------- - _L. I_.L acumtnin-ctuade slving treI problrn lIJ ulv'idue-Adued t ix C v'AT I reimburserneri, £ULC LULK of stability in the judicial system for investors, the elimination of the gas subsidy, and the adoption of a formula to allow PetroEcuador to form partnerships with private compa- niesfor operations in its most important oilfields. A. The Evolution of the Petroleum Sector and Legal Framework The importance of the petroleum sector to the Ecuadoran economy cannot be over- stated, as it comprises approximately 15 percent of GDP and a third of state revenues. Petroleum and its derivatives account for an average of 40 percent of total exports, a 1. This chapter was elaborated by Eleodoro Mayorga Alba, the World Bank's main petroleum .co norr.ist, and Horacio Yepez, forld Bank consulatant.. 116 ECUADOR: AN ECONOMIC AND SOcIAL AGENDA IN THE NEW MILLENNIUM number expected to rise in future years given the productive potential of this sector. Table I reveals the fragility of the trade balance, and in general of Ecuador's economy as export volume and oil prices fluctuate on the international market. It is probable that the year 2002 will close with acceptable gains because of sustained oil prices. Since 1971, the year in which the first Law on Hydrocarbons was passed, the srare has rnken on a maior role in sectoral management and operations. With the exception of exploration and production activities that are also carried out by pri- vate companies, PetroEcuador maintains a monopoly over wholesale industrializa- tion an.d commcrcialization of petroleum derivatives. H- investments are subject to the dispositions of the Finance Ministry within the state's general budget. Annex I contains a historical chronology, as well as a detailed description of the sector. Proven reserves are estimated at 4.6 billion barrels, of which Petroproducci6n- PetroEcuador's affiliate for exploration and oil and gas development-controls nearly 75 percent, including the majority of light crude oil fields. The state enter- prises' production has decreased markedly from a maximum of 120 million barrels (bbl) in 1994 to 80 million bbl per year owing to a lack of investment and transport capacity. Private sector support for national production is nearly 65 million bbl. This means a national daily average of 400,000 barrels per day (BPD), limited by pineline capacitv with Petroproducci6n accounting for 56 Dercent, and private com- Table 1. importance of the Petroleum Sector to tme -Economy (blns/mins $US) 1995 1996 1997 1998 1999 2000 2001 Crude oil exports 1.395bl 1.520bl 1.411bl 789m 1.312bl 2.144bl 1.722bl Export of petroleum derivatives (in millions) 134.5 227.9 145.9 134.0 167.4 298.4 177.7 Total crude exports anJ derivatives I.C29blI 1.748l 1 C57bl 922. r0 1., -9blI 2 b 1.9bl Percentage of exports 34.9 35.9 29.6 22.0 33.2 49.6 40.6 Percentage of GDP* 14.6 14.0 14.0 13.5 14.6 15.0 14.6 Total Petroleum Revenues 1.329bl 1.574bl 1.269bl 912.9m 1,048bl 1.460bl 1.347bl Revenues from crude exports (millions) 683.2 939.4 625.5 249.5 745.6 1.286bl 990.1 Revenues from sale of derivatives (millions) 645.8 635.1 644.4 663.4 303.1 173.1 357.2 Percentage oc public revenues 29.0 33.8 26.9 22.7 29.8 35.4 27.4 Includes mining, which makes an insignificant contribution to the petroleum sector. Source: Central Bank Statistical Information and PetroEcuador Statistics. PETROLEUM POLICY 117 panies for 44 percent. When comparing reserves to production, one observes that private companies own 25 percent of reserves, and yet currently contribute nearly half of total production. The majority of private investment in exploration and development of new reserves is carried out through participation contracts. This modality, which was incorporated in the Law on Hydrocarbons in 1993, has allowed contracts in which private companies assume all risks, investments and costs, and share production with the state at a proportion of approximately 75 percent and 25 percent, respec- tively. In 1993, the modality of Contracts for Marginal Fields was also adopted which utilizes the participation model, while allowing private companies access to reserves discovered in small fields (which make up less than 1 percent of national production). In 1998 the former administration tried to incorporate the Joint Ven- tures modality into the law, in order to allow private companies to partner with Petroproducci6n to operate large fields. Although the National Congress supported this initiative, its initial economic conditions were modified and it was later declared partially unconstitutional-and became null and void. During recent years there have been few initiatives to seek new private invest- ment. The Operational Alliances was one such initiative, and was utilized to develop two Petroproducci6n fields in which private enterprise provided a variety of services and financing in return for payment-making the viability of the alliance depend- ent on increased production. The most recent attempt at contracting the manage- ment of producing fields is the proposal to Chile's National Petroleum Enterprise (ENAP-Empresa Nacional del Petrdleo). There was no call for tenders, based on the privilege of state companies to sign specific service contracts directly. The govern- ment sent a reform bill to Congress to try to incorporate this privilege into the law, but apart from a specific contract with ENAP, the reform was rejected. For 10 years petroleum production has been limited by transport capabilities. With the exception of the small AGIP pipeline, PetroEcuador and the private com- panies are using the TransEcuadoran Pipeline System (SOTE-Sistema de Oleoducto Transecuatoriano), with a capacity of 390,000 BPD of petroleum with a graviry of 23.70 API.2 In addition, PetroEcuador can transport a volume of nearly 50,000 BPD in agreement with the Colombian Petroleum Company (ECOPETROL- Empresa Colombiana de Petrdleo), to Tumaco via the TransAndean Pipeline. The crude transported via this pipeline is 290 API, the quality level required by the La Libertad refinery. Transport from Tumaco to la Libertad is by ship. Limitations on pipeline capabilities have made it necessary to mix light and heavy crudes. In order to end these limitations, in February 2001 the government authorized the construction of a heavy oil pipeline (OCP) through a consortium composed of 2. The API grades are an American Petroleum Institute measurement used to define the spe- cific gravity of oil. The greater the API, the lighter the product, meaning the higher the content in gasoline, diesel, and white products, the higher the price. 118 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM the main private companies operating in the country. The OCP will be able to trans- port up to 518,000 BPD of 18 to 240 API. It mainly follows the SOTE route and flows into a new sea terminal as in Balao Esmeraldas. In contractual terms, OCP construction should wrap up in June 2003, but owing to work stoppages caused by environmental groups and local communities, it is expected to begin operating in September 2003. Available transport capacity will increase to approximately 960,000 BPD with the OCP. The state monopoly and lack of investments have also seriously affected activi- ties. Primary refining capacity is currendy 175,000 BPD. Refining production in the hands of Petroindustrial does not completely meet domestic demand (135,000 BPD), meaning the state must import gasoline, diesel, and LPG. The Amazon and La Libertad refineries only have atmospheric distilling units, and even though the Esmeraldas refinery has some conversion capacity, production of residuals in the three refineries exceeds local demand. These residuals are exported at a low price. Petroindustrial derivatives and imports are distributed through the internal mar- ket by Petrocomercial, the owner of the network of ducts and terminals for storage and distribution. Petrocomercial provides products to vendors at the same price fixed by the President of the Republic in all terminals. As regards sale price to the consumer, the presidential decree establishes a maximum margin of 18 percent on the sale price in the terminal, applied by nearly all distributors, without price or margin competition. In terms of environmental and social management, industry activities are regu- lated by the environmental standards for hydrocarbon operations approved in Feb- ruary 2001. The main modification to this code was to raise environmental stan- dards to international standards, with special emphasis on re-injection of formation water, emissions monitoring, flaring of associated gas, and permanent environmen- tal auditing. The Department of Environmental Protection in the Ministry of Energy and Mining (Direccidn de Proteccidn Ambiental del Ministerio de Energia y Minas-MEA%) is the entity that supervises compliance with these standards. The law establishes the right of indigenous peoples and communities to partici- pate in consultations. The legal dispositions to support application of this right have just recently been promulgated. To date, companies have been managing social issues through direct negotiations with communities. The lack of a code of standards compounded by the enormous socioeconomic needs in petroleum zones that have not been met by the government, has forced firms to carry out public works and dis- tribute resources in order to be able to operate and avoid suffering costly delays in their work. And this is despite the fact that companies already pay an Ecodevelop- ment tax to benefit these regions. The tax amounts to $US0.35/bbl and will reach $US0.50/bbl by 2005 in the eastern fields. There is no evidence that the taxes paid or the support provided by companies has significandy contributed to development in the oil-producing region. In 2002, oil profits amounted to more than $US 1.5 billion, and this sector's con- tribution to the state budget averaged 28 percent. Revenues distribution has become PETROLEUM POUCY 119 more complicated because of the series of preallocations established for each revenue segment: exemptions, forner consortium production, service contracts, and so on. The lack of transparency in resource management, which takes place outside the framework of the state budget, is a serious problem. Starting in 2003, however, the large preallocation to the Armed Forces from oil royalties will be eliminated. The Fund for Petroleum Stabilization was one effort to develop a contingencies fund, and it accumulated resources when the price of crude exceeded $US20 per bbl. However, these resources have also been subject to preallocations. Finally, given the expected increase in production when the OCP begins operations, a Fund for Stabi- lization, Social and Productive Investment, and Reduction of Public Debt (FEIREP- Fondo de Estabilizacidn, Inversidn Socialy Productiva, y Reduccidn del Endeudamiento Publico) has been established. FEIREP's goal is to repurchase external public debt at market value, and stabilize revenues earmarked for health and education. B. The Main Problems of the Petroleum Industry in Ecuador The petroleum sector in Ecuador suffers from inefficiencies and distortions that limit the country's economic growth. The first series of problems are related to the need to increase investments in exploration and production. These increases should come primarily from the private sector, given public sector limitations and in par- ticular limitations on the state-owned company. The following measures are required in order to develop the production of proven reserves and to capitalize on the existence of increased transport capabilities by the end of 2003: * Ensure legal and economic stability of contracts, beginning with the resolu- tion of the VAT problem for oil companies operating in the country. * Find a contractual formula within the framework of current laws that allows PetroEcuador to partner with private companies to develop reserves in the most important oil fields. * Develop new reserves, as well as those already proven and those resulting from the exploration of new areas. In commercialization and other activities, price and tax distortions should be eliminated, as should PetroEcuador's defacto monopoly, thus favoring competition both in refining (as opposed to importing products) and in product distribution and marketing. Without these improvements the state will lose tax revenues, and con- sumers will continue to pay high prices for low quality products. Some of these measures are as follows: * Eliminate the LPG subsidy. * Redefine the price and tax policy on consumption of fuels in a way that facil- itates the entry of new companies. 120 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM 0 Seek private investments for refining activities. Many of these measures are complementary and some can be taken without changing laws. In addition to these measures, other sectoral actions include: o Revising the current petroleum revenues management scheme to ensure trans- parency, and eliminate corruption and the inefficient use of petroleum rev- enues. • Revising the industry's legal and institutional framework, separating the role of the state-acting as guardian of the public interest by administrating rev- enues and as guarantor of a petroleum industry that is committed to sustain- able development-from PetroEcuador's role, that should remain focused on maximizing the profitability of state assets in the sector. o Improving the management of social and environmental impact. Ecuador is a country with very sensitive environments in petroleum zones, where a highly costly environmental liabiliry has accumulated. Indigenous culture should be supported and the quality of life of indigenous peoples should be improved. These groups have been affected particularly negatively by indus- try activities. The Problem of VAT Reimbursement and Contractual Stability The VAT exemption on imports enjoyed by oil companies is contained in the Law on Hydrocarbons, while the exemption for petroleum services is in the Law on the Internal Tax Regime. In 1998, an interpretation of the Law on Hydrocarbons at the customs level resulted in companies being forced to pay sales tax on their imports. In 1999, the Tax Regime Law was reformed, with the elimination of the sales tax exemption for petroleum services, and the rate was increased from 10 to 12 percent. Until August 2001, companies received reimbursement of the value-added tax paid on crude exports, like any other exporter in the country. In that month, the Inter- nal Revenue Service (SRI) introduced a reinterpretation of the tax law, differentiat- ing, in terms of treatment, between the hydrocarbon industry and all other export industries. This meant that private oil companies stopped receiving the VAT reim- bursement. The economic impact of this measure, according to the companies, will reach over $US200 million by the end of the year. PetroEcuador has ignored the companies' complaints regarding this situation, even though it has a contractual obligation regarding retribution to the contractor in the event that the tax regime was changed. This should have been applied at least in order to compensate for the rise in the VAT rate from 10 to 12 percent. With respect to the change in interpretation by the IRS, companies have presented administrative and legal complaints. They believe that the reimbursement of VAT should apply to all exporters because this tax should not be exported. The companies PETROLEUM POLICY 121 also oppose the revoked exemption on the fundamental basis that these contracts were established based on economies that did not take such a change into account. At one time, the outgoing administration decided to let the SRI resolve the con- flict. The SRI argues that the oil companies have been reporting costs illegally in some cases. There have been three judicial verdicts that have only taken into account the recognition of the 2 percent increase in the tax rate. In other words, the verdicts have ratified the nonreimbursement position, considering a rate increase, and not the entire revoked VAT exemption, as the only factor that affects the economic sta- bility of contracts. As the conflict continues, positions have lost clarity, mixing arguments such as the illegality of re-interpretation with accusations of tax evasion. With the goal of seeking a solution, the option of international arbitration has been proposed. The state has accepted the principle of arbitration with reservations, and still does not agree with Occidental Petroleum on how to proceed. Encana, a company that was negatively affected by the court ruling, has indicated its intention to seek interna- tional arbitration. The negative impact of these tax measures on the country's economy, and specif- ically on the petroleum sector, is significant. The companies are downsizing their investment plans, which will directly affect production in both the short and medium terms. If the VAT problem is not resolved, this will also block revenues from new investment and will even affect company participation in the reactivation of Petroproducci6n's current oil fields. Increasing Petroleum Production Private Companies At present, private firms maintain field operations that represent 26 percent of the countrys reserves. The prospects of production by private companies has been affected by VAT problems, which is reflected in greater idle OCP capacity, at least in the short term. The following scenarios can be foreseen in the medium term: * The first scenario corresponds to a low rate of growth of production that would increase from 180,000 BPD in 2002 to 240,000 BPD in 2004, reach- ing a level of 295,000 BPD in 2007. This scenario is based on a voluntary reduction of company investment because of the lack of stability in the judi- cial system in general, and particularly on a lack of resolution of the legal con- flict over VAT. * The second scenario-which assumes that the new government will resolve the VAT problem quickly during the first weeks of its mandate-would allow companies to accelerate the investment process, and production could jump from 180,000 BPD in 2002 to 290,000 BPD in 2004, and hit 420,000 BPD in 2007. 122 EcUADOR: AN ECONOMIC AND SocALp AGENDA IN THiE NEW MILLENNIUM Considering that on average, 30 percent3 of private production belongs to the state, the difference in the fiscal terms between these two scenarios is more than $US500 million-which translates to more than 45 million barrels that the state would no longer receive as part of its participation. This is sufficient reason for the government to urgently seek a solution to the VAT problem. Petroproducci&n During the last four years, the national company has been operating under restric- tions that have caused a drop in production averaging 6.1 percent annually, costing the country over 45,000 BPD of petroleum, which represents nearly $US700 mil- lion in fiscal terms. If these limitations on PetroEcuador's financial and technologi- cal resources continue, based on the current 10 percent decline in production, only one-third of remaining proven reserves will be recovered in the next 20 years. The drop in Petroproducci6n's production is not due to the geology of the oil fields (which have sufficient reserves), but due to the state's deficient management of an industry that is extremely technical. Political interference has been the norm, with emphasis on meeting short-term objectives and permitting different economic and social interest groups, as well as unions, to pressure the company. The com- pany's maintenance of its facilities is very poor. It has lost key technical personnel over the years and has not gained access to new technologies. There is very little planning, and serious deficiencies exist in administration and operational capacity caused partly by the loss of financial autonomy because the entity is bound by the Public Budget Law. The collective contract, which covers all employees and estab- lishes significant compensation in the case of either termination or resignation, is another factor that has diminished the efficiency of this state enterprise. At the present time, PetroEcuador does not have the necessary technological know- how to execute, evaluate, and interpret the results of the perforation of horizontal wells, improved recovery, and 3D seismnic campaigns. Investments in these activities have been only partially successful. However, no significant participation on the part of private companies, which have the capital and technology required, has been per- mitted. This is because political and labor union actor s have waved the flags of nation- alism and identified this sector as "strategic," in order to block opening initiatives. The little private participation in production development efforts is centered in five marginal oil fields and two medium-sized fields that are part of the Operative Alliance system. Meanwhile, the joint ventures option in large fields was thrown out following the distortions introduced in the National Congress during the approval of the Trolley Laws of 2001. If Petroproducci6n continues to operate the most important reserves in the coun- try with the same financial and technological restrictions, it probably will not be 3. This is over 30 percent even if state participation represents 25 percent in participation contracts, when participation in marginal oil fields and the equivalent of the AGIP con- tract is consolidated. PETROLEUM POLICY 123 Figure 1. National PetroleLum Production and Consumption Millions of bbl. 60 - 40 - 20 1998 1999 2000 2001 2002 R Private UI Perroecuador - Consumer Source: PetroEcuador. able to increase production. However, this scenario could change significantly if the private sector actively participates. If conditions are provided to attract private investment both in PetroEcuador's areas and the areas contracted out-that is, sce- nario 2 in Table 2-and restrictions on transport are lifted by the end of 2003, national production could double in the next four years. Petroproduccion's exploration activities have not achieved significant results in recent years. Reserves of fields nor yet in production are not very promising (180 million bbl), and possible reserves are not substantial (75 million bbl). These fields contain many areas that are governed by environmental restrictions on exploration, with Imuya's prospects standing out. Table 2. Projections for National Petroleum Production (Mlns of bbl) 2002 2003 2004 2005 2006 2007 NATIONAL TOTAL Scenario 1 148 150 173 179 183 191 Scenario 2 148 150 192 226 254 280 PETROPRODUCCION Scenario 1 82 84 85 86 84 83 Scenario 2 82 84 86 93 106 127 PRIVATE COMPANIES Scenario 1 65 66 88 93 99 108 Scenario 2 66 66 106 133 148 153 124 ECuADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM The Case of the ITT Fields In 1993, Petroproducci6n discovered heavy crude reserves in several fields called Ishpingo-Tambococha-Tiputini (ITT), in the central-eastern part of the Amazon. The last perforations and studies indicate the existence of a significant volume of reserves (1.4 billion bbl.). The geographic and environmental situation of ITT and the quality of crude oil with a high sulfur content means it is necessary to budget high levels of investment and to keep in mind that production cannot begin until seven years of investment have been completed. The interest of Petro- producci6n in becoming an active partner in the project, and determining the form of execution and deciding phases ofproduction, have delayed the project's definition. Both for this project and others, private investment requires opera- tional autonomy. Reserves It is the state's responsibility to ensure that the flow of oil revenues in the long term equally benefits current and future generations of Ecuadorans. For this reason, it is necessary to begin new exploration, particularly when one considers that it takes from 5 to 10 years for reserves to reach the production stage. In the most favorable investment scenario, we can foresee significant production increases by 2007, based only on reserves already proven. After that date, there could be a reduction in pro- duction if the ITT fields are not being worked, and if there are no discoveries in other areas. After the eighth round of bidding, carried out in 1998, no new blocks have been contracted. There are three blocks in the east that were adjudicated in the seventh and eighth rounds to the Burlington, CGC, and Tripetrol companies. These planned explorations have not begun because the first two companies have had problems with the communities, and because of legal problems in the case of the third company. Apart from the direct contracting carried out by Petroproducci6n with ENAP for the exploration and exploitation of the three medium-sized fields currently in production, it does not seem feasible or appropriate to carry out new direct contracts with state enterprises when this option has been expressly rejected by the National Congress. The outgoing administration has delayed the ninth round, and modified its scope several times. The blocks up for bidding in the eastern region have been taken off the list, with the round being limited to blocks in the offshore region. In addi- tion to the political waffling, the lack of specific regulations has made it impossible to carry out a consultation process with communities living in the blocks of the east- ern region-a necessary prerequisite to begin the project. However, it is worth not- ing that thanks to the efforts to build consensus, the outgoing government has promulgated a regulation for community consultations that will facilitate initiating these processes in the new exploration and production zones. PETROLEUM POLICY 125 General Subsidy for Liquid Petroleum With the recent increase in oil prices and the prices of derivatives, the net effect of taxes paid by consumers and hidden subsidies that currently govern the sale of fuels has an estimated fiscal cost of more than $US300 million annually. This number includes the general subsidy for gas, as well as minor subsidies for diesel and fuel oil. Gasolines are the only products that are being taxed effectively. A detailed estimate of the prices of current economic efficiency is presented in annex 2, along with a comparison with current prices. These calculations are based on crude prices in the West Texas Intermediate (WTI) of $US27,515/bbl, which are relatively high owing to the problems caused in the international market by the cur- rent situation in Venezuela. LPG requires a karge percentile price increase to reach its price of economic effi- ciency4 (347 percent). In addition to fiscal cost, the way the subsidy is currently applied to both LPG and other products means that the total value earmarked under this subsidy indiscriminately benefits the rich as well as the poor, without targeting to improve the quality of life of the most needy, which should be the pri- ority objective. Various governments have tried unsuccessfully to eliminate the gas subsidy, but they have not been able to implement compensatory measures that would convince the population to accept price increases. On some occasions, after deciding to increase the price of the product, governments have had to back down and reduce them in order to quell popular protest. There are various alternatives for targeting this subsidy. The outgoing administration has left a plan in place that would permit selling LPG at an economic price of import parity, while introducing a special coupon for the poor simultaneously. This way those in need of financial assistance can continue to buy the cylinder of LPG and pay the current subsidized price. Price and Tax Policy, and Lack of Competition in the Derivatives Market The state monopoly and the fixing of fuel prices by decree are the main characteris- tics of the petroleum derivative market in Ecuador. The elimination of the LPG sub- sidy opens the doors to efficiently organizing the tax system for fuels. This can be done without substantially changing the prices for the public, since the correction needed on diesel prices (16 percent) and fuel oil (13 percent) could be staggered while waiting for the international market to stabilize. The fundamental objective is to eliminate price fixing by the state, and basically letting prices respond to interna- 4. The economic efficiency price corresponds to the cost of opportunity. In this case the price is calculated taking into account the cost of importing each combustible fuel, plus the local costs of services until they are sent to the Petrocomercial terminal. 126 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM Figure 2. Price of Products in Terminal (ind. VAT) Cents $US/gallon 140 - 120- 100 80 60 40 20 Super Extra Diesel Fuel Oil GLP O Terminal price + VAT, without O Economic price + VAT distribution and marketing profit margins Source: PetroEcuador. tional market variations. There are experiences with price adjustment mechanisms that allow the state to withdraw, and that absorb the inopportune price fluctuations on the international market, without affecting consumers. Decisionmaking on taxes and profit margins of commercialization are closely linked to decisionmaking on prices. In Ecuador it is important to revise the value of the Special Consumption Tax (ICE) and liberalize the profit margins for product distribution and marketing in a way that permits the entry of private companies in a competitive manner. Commercialization activities of derivatives are carried out by Petrocomercial, with the private sector exclusively handling retail commercialization of derivatives at a fixed price established by the government. This is reflected in the absence of a competitive market, which forces the final user to accept rigid price and quality options. Investments in Refining In Ecuador, the consumption of derivatives is 135,000 BPD, compared with a refin- ing capacity of 175,000 BPD. However, there is a national production deficit in PETROLEUM POLICY 127 gasoline, diesel, and LPG, and imports are needed to meet internal demand. At the same time, the excess procluction of residuals needs be exported. It is estimated that imports this year will hit $US360 million, a number that will continue to grow in future years. Petroindustrial's refineries generate a high volume of residue to the detriment of production of white products, owing to its configuration and the crudes it processes. The quality of fuels is very low. Both gasoline and diesel have a high sulfur content, and gasolines are low in octane. In Ecuador, a diesel is sold containing up to 7,000 ppm of sulfur, while the Latin American average is approximately 400 ppm, and in western European and U.S. markets the goal is to have a ceiling of 30 ppm by 2005. The refineries want to modernize their equipment to cut production costs and reduce the negative environmental impacts they are causing. In short, they should increase productivity. These actions have not been undertaken because of the lack of political decisionmaking, poor administration, low levels of investment, and pres- sure from labor unions. The current price policy does not provide incentives for investing in private refineries as prices are discretional rather than fixed by competi- tion. This is compounded by limits on access to storage and transport infrastructure at reasonable rates for new wholesale companies. Without the possibility of inte- grating into the market, investors are not willing to participate in refining activities. The state monopoly on refining activities and commercialization has generated costs for the Treasury, not only because of the existence of subsidies but also because of PetroEcuador's inefficiencies. Between the years 2000, 2001, and 2002, the accu- mulated losses of the sector were over $US 1.7 billion. Administrative System for Petroleum Revenues From the beginning, the administration of the resources from the petroleum sector has been subject to inadequate and politicized management, converting collection and allocation of resources into a true labyrinth with each passing year. The govern- ment has found petroleum revenues to be a never-ending source of resources to meet all types of fiscal needs. In addition, revenues for the state budget are estimated based on high oil prices,5 and total debits are adjusted to this estimate. This situa- tion implies high risk during periods when oil prices are low because of the fiscal deficits produced. At the same time it does not permit rational management of ever- growing public expenditures. The breakdown of petroleum revenue allocation for the period 1995-2000 illus- trates that the management of profits from hydrocarbon activity is centralized (only 3.8 percent is directly allocated to sectional governments), and that preallocations 5. The price used in the state budget corresponds to the price of Eastern crude, which is the WTI price minus a quality differential. For the year 2003, an estimated price of between $US18 and 22/bbl. is being debated. 128 ECUADOR: AN ECONOMIC AND SoCIAL AGENDA IN THE NEW MILLENNIUM Table 3. Economic Results of Refining and Commerciaiation (thds $US) 1998 1999 2000 2001 2002 REVENUES 1,174,474 964,941 1,156,661 1,321,511 1,491,115 Internal sales (*) 1,025,173 782,696 838,002 1,116,664 1,280,379 Export of derivatives 149,301 182,245 318,659 204,847 210,735 Debits 1,177,685 1,305,570 2,051,815 1,728,076 1,920,171 Import of derivatives (**) 440,105 302,722 320,135 347,581 361,904 Cost of crude (***) 474,919 724,878 1,457,029 1,084,899 1,225,500 Commerciali- zation costs 106,216 112,406 111,064 116,375 131,456 Industrialization costs 156,446 165,563 163,587 179,221 201,311 NET -3,212 -340,629 -895,154 -406,565 -429,057 (*) Does not include value of VAT on products. (**) In 1998, the compensation value of crude was considered. (**) Refinery crude has been valued at international prices. Source: Elaborated by the author based on PerroEcuador's statistics. lack definition (a large quantity of resources allocated to various institutions is in the category "Others"). (See Table 4.) In comparison with other countries of the Andean region, the Ecuadoran system of revenues distribution shows less transparency, and leads to inefficient manage- ment of petroleum revenues. For example, allocations to institutions outside of budgetary control in other countries are 2 percent less on average, while in Ecuador it is greater. The resources allocated to social funds in Ecuador are also clearly insuf- ficient, at only 3.3 percent of total. Table 4. Petroleum Revenues Distribution Structure (Average 1995-2000) Central government 62.14% Provinces 1.42% Municipalities 2.40% Social support funds 3.30% Others 30.94% Source: Population, Environment, and Energy Program (EAP), 'Comparative Study of Distribution of Petroleum Revenues," Energy Sector Management Assistance Program (ESMAP), February 2002. PETROLEUM POLICY 129 One of the measures already taken is the elimination of preallocation of resources for the Armed Forces, which now receive resources through the state's regular budget. However, there is still much to be done in order to improve the current sys- tem's transparency. ECORAE, a fund created to help develop social programs and conserve the envi- ronment in the Amazon region, has not produced the expected results. Thirty per- cent of the revenues from this production-based fund is transferred to provincial councils of the region, 60 percent goes to municipalities, and 10 percent to the Insti- tute for Regional Ecodevelopment in the Amazon (Instituto para el Ecodesarrollo regionalAmazonico). The regional government has oriented its resources to maintain a bureaucratic system, and to develop urban areas, rather than specifically targeting zones affected by petroleum-related activities. The Fund for Petroleum Stabilization was created along with other initiatives allocating resources to specific funds. The goal is to take precautions against exter- nal shocks that could result from a fall in crude prices, accumulating resources when crude prices go over $US20/bbl. This fund has not met its goal because revenues generated have also been preallocated to the Amazon Highway (35 percent) and the Public Investment Fund (65 percent). Finally, the current administration has estab- lished a new preallocation for a fund called Stabilization, Social and Productive Investment, and Reduction of Public Debt. The resources for this fund come from PetroEcuador's crude exports which are transported by the OCP, as long as they are not derived from lesser utilization of the SOTE. The fund will be used to repurchase external debt, to stabilize petroleum revenues, and for education and health. In this case, even though the Law's goal is worthy of praise, the amounts needed to fully comply with objectives do not match realistic expectations for production. Legal and Institutional Framework The sectoral law, in effect since 1978 and reformed many times, was structured based on the premise that the petroleum sector is strategic and that exploitation is the sole duty of the state. The state carries this out directly, and only exceptionally delegates the task to private companies. This is why the development of the coun- try's petroleum sector depends on PetroEcuador's performance. In the case of Petroproducci6n, operational costs have been rising continuously, since production is dropping and since there is no oversight and no accounts pre- sented to the Ministry of Finance, which usually charges PetroEcuador on the basis of estimated costs. An even greater problem is that investments are not made in accordance with the approved budget, and projects are discretionally managed by the authorities of the day. (See Table 5.) With the external commercialization of crude, contracts are adjudicated on the basis of premium that companies offer under a pre-established differential between eastern crude and the WTI. This differential is frequently modified, which is rea- sonable considering the fluctuating market conditions, but does not offer trans- 130 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILENNIUM Table 5. Indicators of the Petroproducci6n Affiliate 1998 1999 2000 2001 2002(C) Operational costs $US/bbl 1.41 1.09 1.31 1.97 2.44 Production MM bbl 101.4 89.5 85.0 82.9 82.2 Investments/budget 40% 77% 83% 55% 68% (*) Estimated. Source: Petroproducci6n's Economic Budget of expenditures and investment. parency since it is based on PetroEcuador's internal studies, which often involve a large dose of subjectivity. PetroEcuador's contracting system is slow and not very transparent. On average, six months are needed for contracting. Bidding processes are frequently canceled for lack of bidders, contracts are subscribed without a bidding process, and pressure is exerted on adjudicating bodies. The assignment of a state role to PetroEcuador, as counterpart and control entity for petroleum contracts, has had a negative impact on the company's relationship with private companies and on the success of new initiatives with private participa- tion. PetroEcuador, because it competes with the private sector for better projects, suffers from a conflict of interest and has tried to maintain the institutional status quo. In practice, this hurts the state's needs and plans. The frequent change of administration, political intervention in company man- agement, the lack of an auditing system for officials, and inefficient control mecha- nisms have all created a system where responsibility is low. All of these factors work against proper utilization of the country's hydrocarbon resources. Ecuador is competing at a disadvantage compared to other countries in the region that have reformed their laws and have separated the roles of (i) the Ministry as the definer of sectoral policy; (ii) the regulating entities and/or the entities charged with representing the state in the definition of incentives and contractual frameworks that attract foreign investment to explore and produce hydrocarbons; and (iii) the national petroleum industry acting within a framework of financial autonomy and competition during all phases. Environmental and Social Impact The petroleum industry in Ecuador carries out activities in a fragile environmental and social context. Very little attention was paid to these matters during certain operations, and as a result, large environmental liabilities have accumulated. Perhaps the most notorious problem is the treatment and elimination of formation water that is a by-product of the production of crude oil. Crude spills are frequent, and mud perforation pools and/or pools of formation water are visible on eastern oil fields, and should be eliminated. Radical measures must be taken to prevent this PETROLEUM POLICY 131 problem from growing. Lessons can be learned from the experience of PetroE- cuador's pilot project with rhe private company now charged with processing and re- injecting formation waters on the Shushufindi field. The flaring of associated gases is also a pernicious practice on the production fields of PetroEcuador. The gas plant at Shushufindi has a idle capacity of 60 percent, equivalent to 15 million cubic feet of associated gas per day. This contrasts with the volume of gas that continues to burn in the Amazon, easily more than 50 million cubic feet daily. The negative consequences of gas flaring are environmental as well as economic. The full utilization of the Shushufindi gas plant will allow an annual 20 percent (1.2 million barrels) reduction in imports of LPG. Projects that take advan- tage of the LPG of associated gas and that improve electricity generation on oil fields should also be made feasible; as in the case of the Sacha field and others in the east. Environmental regulations contemplate developing participatory-type monitor- ing of operations, but there is no capability to do this. It is important to evaluate the resources needed by the Sub-secretariat of Environmental Protection, and at the same time, seriously explore options for more participatory monitoring involving indigenous and local populations. Government support for regions affected by petroleum exploitation in terms of preallocations is limited and not very transparent. Companies, in return for com- pensation, exchange permits to operate, and then carry out public works that are defined by the communities according to their immediate needs. In practice this does not translate into support for real sustainable development that increases the standard of living and that allows implementation of feasible sustainable projects in these regions. C. Recommendations and Implementation A series of recommendations are presented below, as well as a framework indicating priority, the entity responsible, and compliance indicators for the recommended activities. A Solution to the VATProblem The VAT problem is in the hands of the new government and needs to be resolved as quickly as possible, whether by adopting international arbitration or another pro- cedure. Measures that are adopted should be implemented administratively in the short term, and which will require rulings by the SRI make them operative. If the government opts to return nonreimbursed amounts, we recommend nego- tiating a plan of financing with private firms, such as a payment linked to future production increases. We suggest taking advantage of this situation to clarify the tax regime applicable to companies, not only in the present but also in the future, in such a way that 132 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEw MILLENNIUM Ecuador provides transparency, clear rules, and security to current and new foreign investment. It would be useful to provide detailed information to the IRS in the case of new petroleum contracts, before they are signed. Increasing the Production of PetroEcuador's Oil Fields The new government should take immediate action to allow an increase in produc- tion. Private sector support is absolutely necessary given the business environment in Petroproducci6n. The Law on Hydrocarbons contains various legal provisions that can be applied in these cases, allowing the private sector to participate in petro- leum-related activities with PetroEcuador.6 The specific modality should satisfy the different sectors of public opinion and be attractive to investors. In order to ensure rapid implementation, this modality should be completed without the intervention of the National Congress. One scheme that fits the needs described above is the establishment of joint ven- ture companies, a form of contracting used by PetroEcuador when working with small firms (for example, Austrogas and Lojagas). This type of company acts as a limited liability company in which a state institution and a private company are stockholders. In each area of production (Sacha, Shushufindi, Aguarico, Auca, Lake Agrio, and Libertador-so of which cover several fields), a joint venture would be set up. Petroproducci6n would be the stockholder that capitalizes the firm with petroleum reserves, installations, and personnel, and obtains a percentage of shares. The search for a private stockholder could be done through international bidding, and would require at least three offers for each area thus guaranteeing transparency. The competing offers would be formulated as a single figure representing an annual bond fixed for several years. In calculations, the bond should include the cost of dealing with priority environmental liabilities. Increasing Reserves Once the problems affecting private investment are resolved, particularly those related to the legal security and stability of the tax regime, and once there is greater transport capacity combined with new regulations governing prior consultation with the local population, we recommend planning new tendering for blocks. Approximately 50 percent of the country with oil potential has not been explored, and there is a need to incorporate new reserves in coming years to make up for the decline in production. 6. It is estimated that investments potentially attracted by the optimization of current fields within the proposed framework could amount to more than $US1 billion, which would increase current production from 225,000 BPD to 347,000 BPD for the year 2007, or 60 percent more than current levels (see annex 3). PETROLEUM POLICY 133 The launching of a new oil round requires the adoption of an appropriate con- tract model, and proceeding to the necessary consultation and environmental stud- ies. We recommend the participatory contract model for bidding, because its appli- cation is immediate (it does not require legal modifications), the companies have accepted it, and it has not been questioned. It is significant that criticisms received have had to do with modified contracts. This framework would allow the government to launch a broad round that includes the blocks identified in the east and on the coast, as well as a specific project to develop the ITT fields. This recommendation requires immediately initiating con- sultations with the communities in the area of influence of the blocks to be bid on, establishing principles for participation and concrete benefits for communities. These principles should be laid out in the terms of reference. In order to avoid questions about the validity of modified contracts, the new contracts should be standard and their final version should be the product of a consensus among the different actors- the Ministry of Energy, companies, the General Accounting Office, and the SRI. Elimination of Indiscriminate Subsidies for Gas An increase in the price of a cylinder of 15 kilos of LPG from its current value of $US 1.60 to the estimated economic price of $US7.157 is recommended; at the same time a targeted direct subsidy should be established to compensate the poorest. No law is required for this adjustment since the fixing of fuel prices is the responsibiliry of the President of the Republic. There are two alternatives for the proposed compensation. The first consists in the creation of a gas cash payment that would be paid along with a social cash pay- ment currently in existence and that approximately 1,200,000 families are already receiving. This payment would be worth $US10 monthly, which would cover the increase in cost for gas usage equivalent to 21 cylinders annually per family. The sec- ond possibility is to hand out 21 coupons annually to these same families receiving the social cash payment, which would allow them to purchase a cylinder at the for- mer price of $US1.60. In consolidated fiscal terms, the elimination of the subsidy would save $US245 million, assuming that the benefit is received by the nearly 50 percent of the popu- lation that currently receives the Solidarity cash payment. After subtracting the cost of the gas cash payment of $US144 million annually; the state would reduce fiscal costs by $USIO1 million a year. The increase in the LPG price to its efficiency price would considerably reduce the utilization of this fuel for purposes other than cooking, such as running motors 7. The economic price of $US5 per GLP cylinder mentioned frequently in the press is the average of the price of real opportunity ($US7.16/cylinder) for the volume of imported LPG (that is, two-thirds of the market), and an accounting cost price for national LPG production (that is, one-third of the market) 134 ECUADOR: AN ECONOMIC AND SOCiAL AGENDA IN THE NEw MILLENNIUM or heating water, for which other types of energy can be used (for instance, fire- wood). At the same time, contraband to neighboring countries would be eliminated making it highly probable that benefits would be greater. New Price and Tax Policy As in the case of subsidies, we recommend that the government make hidden taxes on products more transparent. This will require sending a legal reform to the National Congress to create a new tax on special consumption (ICE) in cents per gallon of the product. Table 6 presents the suggested ICE values by product and prices for the public. With the exception of LPG, which will lose its indiscriminate subsidy, one advan- tage of the proposed scheme is that it does not imply a substantial modification of the price of gasolines, but simply adjustments in the prices of diesel and fuel oil that could be adjusted according to price fluctuations in the international market. After adjustments in prices and the tax regime, we suggest continuing with the liberalization of the market. Tariffs on imports should be eliminated, which means opening the market to private imports of derivatives, with the possibility that pri- vate companies have access to transport infrastructure and storage facilities. In the short term they would utilize installations owned by Petrocomercial, and later their own installations resulting from new investment. In order to make this proposal feasible, Petrocomercial must be forced to offer transport services via ducts, storage, and other means needed by firms interested in commercializing products. The Ministry of Energy and Mining would publish the transport and storage tariffs that Petrocomercial8 would charge, and these should be competitive. Given the size of the Ecuadoran market, in order to avoid the estab- lishment of private monopolies on distribution and commercialization, the qualifi- Table 6. Suggested and Current Prices for the Public ICE Price suggested suggested-current* $USIgaL $US/gaL Commentary Super 25.0 140.8-141.6 No change Extra 7.0 111.7-112.1 No change Diesel 0.0 97.0-83.6 Slight increase Fuel Oil 0.0 61.5-54.6 Slight increase LPG 0.0 97.5-21.8 Important increase Price for the Public = Terminal price + (VAT + ICE) + Margin for distribution and marketing. 8. According to the study, "An Analysis of Fuel Products Pipeline Tariff Structure for Trans- portation, Storage, and Maritime Terminal Usage," by Booner and Moore, 1999, prepared by CONAM. PETROLEUM POLICY 135 cation of firms interested in activities should not be too rigorous in terms of size. On the other hand, in no way should this easing of requirements mean noncompliance with operational and environmental standards. These must be followed and super- vised by the National Directorates of Hydrocarbons and Environmental Protection, respectively. Producers and commercial agents would increase with the reduction of entry bar- riers and opening to imports. In the medium term this would surely result in improvements in the quality of products and services offered, as well as a reduction in profit margins for distribution and marketing that are currently too high-oscil- lating between 10 and 18 percent. Investment in Refining The establishment of joint venture companies is both politically and economically viable as an option to modernize refineries. The proposed scheme requires that the state cede a percentage of its property to qualified private companies, and in exchange these companies would make needed investments and cover operational costs, labor costs, and environmental measures. The private company would be selected through international bidding managed by the Special Bidding Committee (CEL), with a minimum of at least three offers. The company that offers the great- est economic value for the stocks offered would win the contract. In terms of economic efficiency, it is more advantageous to build new refineries rather than increase imports to meet local demand. A local refinery can acquire raw material at lower prices and does not have to pay transport costs. Since refining is a competitive industry, the new refineries would require detailed economic feasibility studies, and these should only be done through private initiatives. In order to achieve this, the need for special authorization from the executive branch to imple- ment these projects should be eliminated. Improvements in the Administration of Petroleum Revenues The incoming government should prepare a Law on Transparency of Petroleum Revenues that eliminates preallocations and classifies revenues in accordance with industry reality. The list of participants in preallocations should be submitted to the General State Budget and the resources to be allocated should respond to real needs. However, during a first stage, the amounts for preallocation would remain within the state budget until an evaluation is completed. This would reduce opposition to a project of this nature. Distribution of petroleum revenues should respond to the following criteria, among others: * Decentralization, which means part of the revenues goes toregional and local governments, with those affected by hydrocarbon activity having the greatest 136 ECUADOR: AN ECONOMIC AND SOCIAL AGENDA IN THE NEW MILLENNIUM weight. The parochial councils would be the first benefited by this, followed by municipalities and prefectures, thus modifying the current scheme. 0 Development of indigenous communities. In the medium term, in order to be applied this case requires training and strengthening of indigenous organiza- tions so that they can develop sustainable projects in which they invest the resources that they are administering. o Stabilization Funds. With respect to having a real Fund for Petroleum Stabilization, the government should adopt the policy of fixing a conservative price for the state budget, backed up by a legal reform.9 All surpluses derived from a higher price should be used to cap- italize this fund, which would help to mitigate the negative cyclical effects of the world petroleum market. The same reform should stipulate that this fund must be used to compensate for diminished revenues in periods of low prices and perhaps to lower the pressure of the foreign debt. Legal dispositions should be established to ensure rigorous fiscal management that eliminates extrabudgetary spending, and to bind all state institutions to rev- enues calculated exclusively based on realistic prices and production during the period. All debt based on anticipated payments from crude sales should be prohib- ited. Finally, the law should contemplate the creation of a permanent information bank on revenues management that is universally accessible, in order to guarantee transparency. New Legal and Institutional Framework A structural reform for this sector is a priority in order to comply with the mandates of the constitution, which establishes that the state should exploit this natural resource through companies (public or private, national or foreign) that are efficient and competitive. Conditions should be created that spur competition, free enter- prise, cooperation, and that penalize monopoly-type practices and any that distort or impede the market's free functioning. This means that state enterprises in the hydrocarbon sector cannot constitute monopolies. Their presence should not impede the participation of other companies in the sector under the same condi- tions. The decision to carry out such a reform also means the elaboration of a new Law on Hydrocarbons and a new Law on PetroEcuador. The first law should make MEM the exclusive representative of the state, and provide continuity to the institutional strengthening of operational and environmental entities, while seeking to totally reduce political interference and promoting the execution of state plans and invest- ments in the long term. On the other hand, the new law should assign PetroEcuador 9. It is suggested that the price remain under $US17/barrel. PETROLEUM POLICY 137 the specific role of "oil company," with the same rights and obligations as any other private firm. Structural reform of the sector should be widely debated and implemented in the medium term, without losing sight of the fact that the reform must comply with goals to increase national and foreign investment in the sector, increase fiscal rev- enues, generate employment in the industry, improve environmental and security conditions, and improve international competitiveness of all productive sectors either directly or indirectly linked with the hydrocarbon industry. Management of Environmental and Social Impact The new government should take actions that allow reparation of environmental lia- bilities. This opportunity could be used to introduce specific clauses in contracts with private firms to increase production. These clauses could fix a minimum amount of investment to be deducted from production bonds fixed for mixed enter- prises. They should take into account the execution of priority environmental repa- rations. This recommendation is also applicable to refineries. The MEM should establish a procedure that permits adequate utilization of gas and limitations on flaring, in accordance with the new regulations. In social terms, it is important that the state develop an integral program to ben- efit communities, making them economic participants that would benefit from the operations. The channeling of economic resources should guarantee sustainability of development proposed in the long term, especially in the postpetroleum era. This implies a process of support for strengthening communiry organizations such as business entities capable of administering and generating their own resources, in addition to other actions. Policy Matrix 00 Policy measures Short term Medium term Problems (by June