Document of The World Bank

Report No: 25786-EC

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

PROGRAM DOCUMENT

FOR A PROPOSED

FISCAL CONSOLIDATION AND COMPETITIVE GROWTH

ADJUSTMENT LOAN

IN THE AMOUNT OF US$50.0 MILLION

TO THE

REPUBLIC OF ECUADOR

28 April, 2003

COUNTRY DEPARTMENT V I BOLIVIA, ECUADOR, PERU AND VENEZUELA LATIN AMERTCA AND THE CARIBBEAN REGION

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AGD ALCA BCE BEDE CAE CAF CAN CAS CEDEGE CFAA CFN CG CGE

CODELORO CODERECH CODERECO COMEXI CONADES CONAM

CON ATEL CONELEC CORSICEN CORSINOR CPAR CPIA CREA CRM cso ECORAE ECV FCCGL

FEIREP

FSL FTAA FTSRL

GDP GEF GLP GOE IBRD

ICE IDB IESS IMF

REPUBLIC OF ECUADOR - FISCAL YEAR January 1 - December 31

(Exchange Rate Effective as of 03/21/2003) CURRENCY EOUIVALENTS

Currency Unit = Sucre, US dollar US$l.OO = 25,000 Sucres

WEIGHTS AND MEASURES Metric System

ABBREVIATIONS AND ACRONYMS Deposit Guarantee Agency Free Trade of the Americas (FTAA) Central Bank of Ecuador Development State Bank Country Assistance Evaluation Andean Corporation Andean Community Country Assistance Strategy Guayas River Studies Commission Country Financial Accountability Assessment National Finance Corporation Central Government General Controllers Office, Contralorfa General del Estado Oro Regional Development Corporation Chimborazo Regional Corporation Cotopaxi Regional Corporation Foreign Trade and Investment Council National Council on Salaries National Council for Modernization of the State Telecom National Council Power Regulatory Council Sierra Regional Corporation North Sierra Regional Corporation Country Procurement Assessment Report Country Policy and Institutional Assessment Center for Azuay Economic Development Manabi Rehabilitation Center Civil society organization Amazon Development Fund Living Standards Measurement Survey Fiscal Consolidation and Competitive Growth Loan Fund for Stabilization, Investment, and Public Debt Reduction Fixed-spread loan Free Trade Agreement of the Americas Fiscal Transparency, Stabilization and Responsibility Law Gross Domestic Product Global Environment Fund Natural Gas Liquid Government of Ecuador International Bank for Reconstruction and Development Special Consumption Tax Inter-American Development Bank Ecuadorian Social Security Institute International Monetary Fund

INEC IRS/SRI ISR ISSFA ISSPOL LAC MDGs MEF MEM MICIP

MIDUVI ML MOSTA NFC NFPS NGO NTB OCP OED OMC OSCIDI

PCM PERHD

PetroEcuador

National Statistics Institute Internal Revenue Services Income tax Armed Forces Social Security Institute Police Social Security Institute Latin America and the Caribbean Millennium Development Goals Ministry of Economy and Finance Ministry of Energy and Mines Ministry of External Trade, Industry, Fishing and Competitiveness Ministry of Urban Development and Housing Ministry of Labor State Modernization Project National Finance Corporation Non Financial Public Sector Nongovemmental organization Nontariff barriers Heavy Crude Oil Pipeline Operational Evaluation Department

Civil Service and Institutional Development Office President’s Council of Ministers Program for Economic Restructuring and Human Development State-owned Petroleum Company

PIB Gross Domestic Product (GDP) PREDESUR South Ecuador Regional Corporation PROMEC

RDO SAL SAPYSB

SBA SCL SIGEF

SIISE

SOE SSEP STR TAME TROLE VAT WTO/OMC

Power and Telecom Modernization and Rural Services Project Regional Development Organizations Structural Adjustment Loan Subsecretariat of Drinking Water and Basic Sanitation Stand-By Arrangement Single Currency Loan Integrated Govemment Financial Management System Integrated System of Ecuadorian Social Indicators State-owned enterprise Social Sectors Expenditure Program Simplified Tax Regime Military Air Transport of Ecuador Economic Transformation Law Value-Added Tax (VAT) World Trade Organization

Vice President: David de Ferranti Country Director: Marcel0 Giugale Sector Director: Emesto May Lead Economist: Vicente Fretes Cibils r Task-Team Leader: JosC R. L6 ez-C&lix

ADJUSTMENT LOAN FOR FISCAL CONSOLIDATION AND COMPETITIVE GROWTH

TO THE REPUBLIC OF ECUADOR

TABLE OF CONTENTS

ABBR~EVUTIONS AND ACRONYMS

LOAN AND PROGRAM SUMMARY

PROJECT DOCUMENT

I . I1 . I11 . IV .

BACKGROUND AND RATIONALE ............................................................................................. 1 RECENT ECONOMIC DEVELOPMENTS ..................................................................................... 3 THE GOVERNMENT'S PROGRAM AND REFORM AGENDA ....................................................... 8 THE PROPOSED LOAN ........................................................................................................... 21

ANNEXES

Annex 1 . Annex 2 . Annex 3 . Annex 4 .

Annex 5 . Annex 6 . Annex 7 . Annex 8 . Annex 9 . Annex 10 . Annex 11 . Annex 12 . FIGURES Figure 1 . Figure 2 . Figure 3 . Figure 4 . Figure A.6.1 Figure A.6.2 Figure A.6.3

Key Economic Indicators ......................................................................................... 33-35 Overall Multiyear Government Program o f Policy Reforms ................................... 36-44 Letter of Development policy ................................................................................. .4 5.56 The Program for Economic Restructuring and Human Development (PERHD) of the Government o f Ecuador. 2003-2007 ............................................................................. 57 A Public Debt Sustainability Analysis o f Ecuador ........................................................ 64 A Poverty Profile for Ecuador ........................................................................................ 68 Labor Markets in Ecuador .............................................................................................. 71

Ecuador at a Glance ................................................................................................. 78-79 Status of Bank Group Operations .................................................................................. 80 Statement of IFC' s Held and Disbursed Portfolio ......................................................... 81 IMF-World Bank-IDB Review of structural Reform ..................................................... 83

Public Wage Bill Control in Ecuador ............................................................................. 74

Macroeconomic Indicators ............................................................................................... 4

Financial System Indicators ............................................................................................. 7 Debt Scenarios ............................................................................................................... 13 Urban Poverty Measured by Income (annual), 1988-2001 ........................................... 69 Urban Poverty Measured by Income in the Main Cities (monthly) ............................... 69 Poverty Measured by Income in Urban and Rural Areas, 2000-01 ............................... 69

Ecuador: Urban Poverty. 1988-2001 ............................................................................... 4

TABLES Table 1 . Table 2 . Table 3 . Table 4 . Table A.4.1 Table AS . 1 Table A.6.1 Table A.6.2 Table A.8.1 Table A.8.2 Table A.8.3

Ecuador: Non-Financial Public Sector Financing Requirements and Sources ................ 6 Fiscal Impact o f Proposed Measures in the Short and Medium Term ........................... 14

Multiyear Government Program: Key Prior Actions and Future Benchmarks ....... .2 2-23 Selected Economic Indicators for Ekuador. 1998-2005 ................................................ 20

Poverty-Reduction Goals for 2003-07 ........................................................................... 60 Base Case Scenario for Debt Sustainability ................................................................... 67 Poverty Measured by Consumption ............................................................................... 68 Projected Social Indicators Based on Alternative Economic Growth Rates .................. 70 Public Employment in Ecuador and Selected Countries ................................................ 74

Personnel Expenditures by Type for Five Ministries and Departments, 2002 ............. 77 Number o f Central Government Posts (by Public Employment Regime, 2002) ........... 75

=PUBLIC OF ECUADOR FISCAL CONSOLIDATION AND COMPETITIVE GROWTH

ADJUSTMENT LOAN (FCCGL)’

LOAN AND PROGRAM SUMMARY

Borrower:

Amount:

Terms:

C o d tment Fee :

Implementing Aeencv:

Obiectives and Description:

I

Republic of Ecuador.

This i s a single-tranche operation of US$50 million.

Fixed spread loan in U.S. dollars with 22 years maturity, including a 6-year grace period with repayment dates of April 15 and October 15.

0.85% per annum on undisbursed loan amounts for the f i rst 4 years and 0.75% thereafter.

Ministry o f Economy and Finance.

This operation i s part of the Banks response to the new Government of Ecuador’s urgent request for asistance to correct an unsustainable fiscal position and achieve high growth for poverty reduction. The comprehensive Multiyear Government’s Program to be supported by the FCCGL has two pillars: (a) fiscal consolidation with social expenditure protection, and (b) faster growth with improved competitiveness. Specific objectives of the loan are to (a) improve tax policy and administration, (b) reverse expansionary spending and improve budget transparency, (c) regain control of the public payroll, (d) clear arrears and improve public debt management, (e) support trade reform, (f) promote competitive pricing and regulatory

The Bank’s core task team included JosC R. L6pez-Cfilix (Task Team Leader, LCSPE), Vicente Fretes Cibils (Lead Economist, LCC6C), Elaine Tinsley (Debt Sustainability and Macro Outlook, LCC6C), Osvaldo Schenone (Tax Policy and Administration, Consultant), James Hanna (Competitiveness, FPSI), Andrea Silverman (Competitiveness, LCC6C), Dominique Hachette and Enrique Sierra (Trade Policy, Consultant), Franz Drees (Water, LCSFW), Philippe Durand (Electricity, LCSFE), Eloy Vidal (Telecom, CITPO), Eleodoro Mayorga (Oil, COCPO), Carolina Sfinchez-Ptiramo (Labor Market, LCSPP), Jeffrey Rinne (Civil Service, Consultant), Roby Senderovith (Civil Society Consultation, LCSPR), Gisela Durand (Fiduciary Procedures, Consultant); Isabella Micali Drossos (Legal Advisor, LEGLA), Patricia McKenzie (Senior Financial Management Specialist, LCOAA), Xiomara Morel (Senior Financial Officer, LOAG3). Important contributions were received from McDonald Benjamin (Quito, LCC6C), Marcel0 Giugale (LCC6C), Guillermo Perry (LCRCE), Gautam Datta (FINCR), Bruce Fitzgerald (OPCFG), David Rosenblatt DECVP, Jaime Pichon (LCSER), Maria Donoso-Clark (LCC6C), Ernest0 May (LCSPR), Mauricio Carrizosa (LCSPR), George Ledec (LCSEN), Keisgner Alfaro (LCOPR), John Redwood (LCSES), Odin K. Knudsen (ESDVP), Ulrich Zachau (LCRW), Kundhavi Kadiresan (LCOQE), Ricardo Tejada (LCC2C), and Katherine Bain (LCSPR). Peer reviewers were Fernando Rojas (LCSPS), and David Rosenblatt (DECVP). Diane Stamm, Chris Hale, Alexandra Castillo, Ana Maria Villaquiran, Maria Antonieta GonzBlez, and Rosalia Rushton (LCC6C) provided excellent editorial and processing assistance. Finally, only the GOE’s close collaboration with the Bank’s team made this operation possible.

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Benefits and Risks:

policies, and (g) increase labor flexibility. These objectives are complemented by a parallel programmatic operation in the social sectors.

The overall main benefit o f the loan i s to contribute to poverty reduction in Ecuador through two complementary ways. First, the reform program supported by the FCCGL w i l l put fiscal accounts on a more sustainable path. Most o f the proposed measures carry fiscal implications, which are estimated to produce initial net fiscal savings o f about 2 percent o f GDP. Fiscal reforms w i l l also strengthen countercyclical fiscal institutions and rules; improve the efficiency o f tax collection by the IRS and Customs; contribute to reducing country risk, which should induce a fal l in domestic interest rates and have a lasting impact on economic recovery; and free resources for financing priority poverty-reduction programs. Second, the reform program w i l l accelerate economic growth through structural change aiming to increase productivity and deepen markets, especially labor. As a result, the loan w i l l contribute to increased private participation and investment in basic infrastructure-water, power, telecommunications and oil- sectors, attracted by a more competitive framework, a more open economy, sound pricing and regulatory policies, and more flexible markets.

The main specific results o f the reform program are next. On revenue management, Customs modernization and tax reform should lead to increased tax revenue collected by the IRS no less than 7.5 percent per year. On expenditure management, sustained implementation o f austerity measures through 2003 and 2004 should lead to 5 percent o f GDP primary surpluses, and compliance with the 3.5 percent cap on real primary spending o f the Fiscal Law. On c iv i l service reform, the unification o f public sector wages and further measures taken to rationalize public employment should lead to negative growth o f the wage payroll in real terms. On transparency measures, the implementation o f the Transparency Plan should produce virtual access to timely and reliable reports on executed NFPS consolidated expenditure and the establishment o f an e-public procurement and national investment systems. On debt management, Ecuador should clear a l l domestic and external arrears, and allocate no less than 50 percent o f FEIREP accumulated annual proceedings to debt reduction. On trade reform, al l import licenses should be unified and about 20 percent o f them, considered as ineffective, should be eliminated in a process o f effective simplification o f import licensing procedures. On power sector reform, electricity tar i f fs should continue adjusting, reaching no less than 90 percent o f average costs by March 2005. On telecom reform, the strategy to improve the efficiency o f ANDINATEL and PACIFICTEL should lead to award a third mobile telephony license, effective investments by a private investor and the signing o f management

11

contracts o f both companies with a private firm. Finally, on labor market reform, the concertation strategy o f the Government should lead to effective salary adjustments below the inflation rate.

All prior actions for this single-tranche operation have been met satisfactorily. Successful prevention o f policy reversal and swift implementation o f further stages o f the Multiyear Government's Program are, however, uncertain. The country faces a number o f domestic and external r isks that may pose a threat to fiscal stability and economic recovery. In particular: (a) political opposition in Congress remains strong and coalitions are fragile; (b) social unrest could prevent the government from implementing adjustment and structural reform measures; (c) given dollarization and the absence o f any meaningful lender o f last resort for the banking sector, external economic shocks- especially a severe decline in the price o f oil, competitive depreciations by neighbouring countries, or sudden stops in capital flows to the region-might make a deflationary fiscal adjustment socially unbearable and put the fragile banking recovery at r isk ; (d) the debt overhang could affect fiscal sustainability and impede Ecuador from clearing arrears, or could lead to new ones; and (e) there might be a low local capacity on the part o f officials to develop and implement an ambitious program. All these risks might lead Ecuador to fail to comply not only with i t s arrangement agreed with the International Monetary Fund (IMF) or with the program o f reforms agreed under this operation, but to abandon dollarization.

To mitigate political risks, and in coordination with other donors, the Bank, with the support o f the Government, i s developing a continuing dialogue with members o f Congress and political forces on the bills submitted as part o f the agenda o f reforms. To mitigate social risks, the GOE i s committed to developing a national dialogue with union and indigenous leaders. B y increasing social spending and enhancing the coverage and delivery effectiveness o f basic public services, the government hopes to limit the impact o f i t s policy actions. These efforts are complemented by the Bank's dialogue with representatives o f the c iv i l society and assistance to the government in reformulating and implementing social protection programs aimed at protecting the poor and the most vulnerable groups. To mitigate external risks, the government i s strengthening i t s capacity to respond to shocks countercyclically by replenishing the o i l stabilization fund, repaying debt, increasing the share o f non-oil fiscal revenues, diversifying non-oil exports, strengthening prudential regulations and creating a liquidity fund for commercial banks, increasing labor market flexibility, and encouraging competitiveness and private participation in key investment sectors. To mitigate i t s debt-overhang risk, the Bank

... 111

i s assisting Ecuador in (a) resuming bilateral debt rescheduling agreements with the Paris Club, (b) defining a comprehensive debt-reduction strategy, and (c) strengthening debt management. To mitigate the capacitv risk, the Bank i s planning to combine several instruments: for example, technical assistance, grants for building capacity, increased supervision, joint missions with the IMF, and analytical and advisory activities and training.

Schedule of Disbursement: US$50 mil l ion to be disbursed immediately after loan effectiveness.

Poverty CaterJorv: The proposed loan creates fiscal room for social spending.

Rate of Return: Not applicable.

Pro.iect ID Number: EC-P082739.

M a w IBRD No. 28022

i v

I N T E R N A T I O N A L BANK FOR RECONSTRUCTION A N D DEVELOPMENT

FOR A N ADJUSTMENT LOAN FOR FISCAL CONSOLIDATION A N D COMPETITIVE GROWTH

TO THE REPUBLIC OF ECUADOR

PROJECT DOCUMENT

1. This program document proposes an adjustment loan for Fiscal Consolidation and Competitive Growth to the Republic o f Ecuador for US$50 million. This operation w i l l provide initial World Bank support to the country’s fiscal adjustment and structural reform agenda. This i s a single-tranche operation, within a multiyear framework, reflecting the overall Government’s Program. The loan w i l l be a fixed-spread loan (FSL) in U.S. dollars with 22 years’ maturity including 6 years o f grace, with pre-set repayment dates. This operation i s part o f the Bank’s response to the new Government o f Ecuador’s (GOE’s) urgent request for assistance. A parallel Programmatic operation i s also being proposed to protect the most vulnerable groups, as the economy engages in an austerity plan to correct fiscal imbalances, and to support design and implementation o f structural reforms in the social sectors.

I. BACKGROUND AND R A T I O N A L E

2. Since i t s return to democracy in 1979, Ecuador has been characterized by high external vulnerability, weak macroeconomic performance, and poor governance. Successive external shocks-tied to reductions in petroleum prices or wide fluctuations in the country’s capital flows as in 1998-and natural disasters have been combined with poor macroeconomic management reflected in high fiscal deficits and public accumulation o f external debt. These developments have often been accompanied by very high rates o f inflation and foreign exchange instability, leading the country to four severe recessions-1982-83, 1987, 1989, and 1998-99; three hyperinflationary periods-1983, 1988- 1993, and 1999-2000; various episodes o f payment moratoriums; and recent twin exchange rate and banking crises that led to dollarization and destroyed 20 banks holding 50 percent o f bank deposits. Misguided policies were also the result o f unstable government administrations and poor governance. For instance, in 23 years, Ecuador had 29 finance ministers who remained in office an average o f less than 10 months, and it was perceived as the Latin American country with the least control over corruption.

3. The twin crises of 1998-99 had a devastating effect on the poor. During 1995-99, the number of poor people grew by more than 2 mil l ion and the headcount poverty index nearly doubled from 34 to 56 percent o f the population. Similarly, the number o f people l iving in extreme poverty (income insufficient to cover a basic basket) increased from 12 to 21 percent (Annex 6). The crises hit rural areas most severely, especially those in the highlands, where the poverty rate increased by 7 percentage points during 1998-99 alone. These indicators reveal the depth o f the crises and the greater vulnerability o f the rural-mostly indigenous-poor in dealing with their income losses. The crises also led to emigration o f more than 300,000 people-3 percent o f the labor force-since 1997, making the country a significant recipient o f family remittances, although at the price o f eroding the country’s human capital, and i t s rural social capital.

4. Ecuador dollarized not by choice but as a last resort for dealing with i t s twin crises that occurred in 1999. The country did not meet the preconditions for successful dollarization, including a solid fiscal position, a sustainable public debt, a diversified export structure to accommodate trade shocks, a sufficient level o f international reserves to accommodate capital outflows, a sound and competitive

1

banking system, flexible factor markets-particularly labor and real estate-to preserve the competitiveness of the nontradable goods sector, and a climate to attract investment. Despite these impediments, dollarization allowed Ecuador to achieve critical objectives in the short term: it unveiled the serious fiscal, real, and financial imbalances that plagued i t s economy in the late 1990s; i t brought down hyperinflation; and it helped to restore confidence in the banking system.

5. Ecuador i s at a turning point. I t s stability and economic recovery are promising, but i t s fiscal and external positions remain vulnerable. These vulnerabilities are due to i t s rigid response to real or financial external shocks-typical o f dollarized economies with only fiscal policy as an instrument-in a context of highly volatile and oil-dependent fiscal revenues, expansionary spending policies, and heavy external indebtedness that have resulted in declining fiscal surpluses and high balance-of-payments deficits. For their part, the structural reforms that should accompany dollarization are either absent or inconclusive. Fiscal adjustment i s among those inconclusive ones, as i s the strengthening o f the financial system, while the promotion o f private investment in the petroleum sector remains absent. Other reforms that have not been carried out include trade reform, and deepening competitiveness and private infrastructure.

6. The proposed operation i s a Fiscal Consolidation and Competitive Growth Loan. I t builds upon the progress achieved from the previous Structural Adjustment Loan ( S A L ) approved by the Board on 22 June 2000. It responds to the Government’s Program for Economic Restructuring and Human Development (PERHD) aimed at solving immediate liquidity problems, deepening fiscal solvency and strengthening fiscal institutions; and supporting structural reforms-by introducing flexibility in goods and services markets and increasing the productivity o f the factors o f production, al l essential conditions for sustaining dollarization in the medium term (Annex 4). In parallel to a Programmatic operation aimed at strengthening human development and social policies, the FCCGL w i l l provide critical support to the country’s fiscal and structural reform programs.

7. The SAL made initial progress in supporting recovery and advancing structural adjustment. Specifically, the S A L supported (a) public sector reforms, including an o i l stabilization fund, the modernization of public sector financial management, and the design o f the legal and regulatory framework to facilitate privatization in telecommunications and electricity; (b) financial sector reforms, the regulatory framework for intervention, restructuring, and resolution o f banks, restructuring o f private sector debts to banks, and a medium-term strategy for development the banking system; and (c) social sector measures, including protection o f key programs and selected projects that employ unskilled labor, and development o f a social expenditure targeting mechanism. Reforms on these fronts are incomplete. The proposed FCCGL assures the continued progress, building on Ecuador’ s previous attempts to reach fiscal consolidation and deepen the structural reforms. I t i s expected that future reforms along that path w i l l be supported through subsequent Programmatic operations.

8. The proposed FCCGL of US$50 million has been prepared in the context of strong international support and in close collaboration with the IMF. It has benefited from an active engagement across institutional boundaries within the Ecuadorian government and at the local level. The proposed adjustment operation has been designed in parallel to and in close collaboration with the IMF negotiations leading to the signing o f a Stand-By Arrangement (SBA). The 13-month SBA for SDR151 mil l ion was approved on 21 March 2003 with the goal o f fiscally stabilizing the economy and generating high-quality growth with key structural reforms under a framework that i s consistent with dollarization.

9. The loan i s crucial and timely. Ecuador faces not only a difficult sociopolitical situation, which l i m i t s the space for reforms, but also severe budget illiquidity and pressing external arrears that the country s t i l l has to clear. Barely three days after taking office, the government announced i ts program, thus showing strong commitment for making significant progress quickly (Annex 6). Supported by this

2

operation, officials should be able to implement significant components o f the PERHD, leading fiscal accounts to a sustainable path, structural reforms to solid ground, and protecting key social spending. The overall Multiyear Program o f policy reforms agreed under th i s operation (and the parallel Human Development operation) should also deal with complementary aspects o f this development agenda. Officials are aware that the credibility o f their economic program does not depend merely on dollarization, but on the implementation o f a sound policy framework that w i l l provide an appropriate management o f the economy in the event o f future internal and/or external shocks, l ike the waning o f the current petroleum boom.

10. This initial single-tranche approach, under a multiyear framework, i s well suited to Ecuador’s situation and needs. The Country Assistance Strategy (CAS) Progress Report discussed by the Board on 22 June 2000 foresaw a fast-disbursing adjustment operation in fiscal 2002 to support restoration o f macrofinancial stability and growth for poverty reduction if strong macroeconomic performance, including an IMF-supported program, and accelerated structural reforms in the public, financial, and/or social sectors, took place. Because o f cancellation o f two agreed-telecom and tax- reforms, and delays in remaining conditions o f disbursement o f all tranches under the S A L , by mid-2002, it became clear that pending policy reforms would not be implemented under the previous Administration. In addition, the Ecuador Country Assistance Evaluation, submitted to the Board on 25 January 2001, found that, historically, adjustment lending has not been a successful instrument in Ecuador and suggested that, at a minimum, further fast-disbursing lending should be extended only when major reforms have reached the “sticky hard-to-reverse stage” that are typically featured in operations, with clearly accomplished milestones, policy requirements, and monitoring indicators. Finally, the Bank‘s Policy Notes presented to the incoming officials in a workshop in Quito on 11 January 2003 also suggested that in order to bring credibility to the Government’s program, officials needed to swiftly take actions on the fiscal front, or the financing o f the program would not be sustainable. The lessons drawn and the need for a blueprint o f key reforms for Ecuador make most suitable an initial single-tranche approach, but in a multiyear framework, in t h i s operation.

11. The short- and medium-term reforms supported by the FCCGL are laid out in the Government’s Letter of Development Policy (Annex %to be included). They are also reflected in the multiyear matrix o f policy and institutional reforms (Annex 2).

11. RECENT ECONOMIC DEVELOPMENTS

12. Ecuador’s macroeconomic conditions are recovering from the twin crises, but continue to be fragile. Benefiting h m a positive external environment characterized by high petroleum prices, low intemational interest rates, and sigmficant flows o f family 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 reached single digits by late 2002 (Figure 1). The recovery i s explained by the increase in domestic demand (particularly private demand), stimulated in turn by high petroleum prices, growing remittances, the increase in nominal ”urn. and average salaries in dollars, which practically doubled between April 2000 and October 2000, and a gradual reactivation o f private credit, consistent with recovery o f the banking system Construction o f the new pipeline for heavy cmde oils (OCP) has attracted significant foreign investment. The initial inflationary impulse, followed by a slow deceleration o f inflation, fits into the pattern observed in most dollatized economies: in the medium term, domestic inflation tends to be determined by international inflation, but in the short-term, lags occur in relative price adjustment due to the control o f certain managed prices belonging to the basic basket, and to the postcrises reactivation o f domestic demand.

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Figure 1. Macroeconomic Indicators

Economlc Growth (annual percentage) Inflation and Reserves

5%

0%

-5%

.inn/. I 1997 1998 1999 2000 2001 2002 I 1 1997 1998 1999 2000 2001 2002 I

100% 1000 80% 60% 40% 20%

500

0

0% -500

Non Flnanclal Public Sector (%GDP) 8.0

3.0

-2.0

a7.0

10

5

0

-5

Balance of Payments (%of GDP)

/.in 1 I 1-12.0 J

Real Efectlve Exchange Rate (2001=100) Wages & Emplolment 1125 I b5 1 1995=100

15

10

5 75

50 50 0 1997 1998 1999 2000 2001 2002 1997 1998 1999 2000 2001 2002

IC Rate index (+ aprec.)

13. Economic recovery has contributed to partly improved social conditions. The beginning o f economic recovery made possible a decline in urban poverty levels during 2000-01. Following the sharp increase of nearly 17 percentage points during 1998-99 as the result of the crises, there has been a significant recovery o f about 12 points starting in 2000, but s t i l l not reaching the rates seen in 1997 (Figure 2). The same survey estimates how the decline in poverty, measured on the basis o f income during 2000- 01, affected both rural areas and cities to an almost identical degree (Annex 6). Coupled with intemational migration, economic recovery has also contributed to bringing employment and unemployment rates practically back to their January 1998 levels, but underemployment continues to be three times higher, reflecting more profound changes in labor markets.

Figure 2. Ecuador: Urban Poverty, 1988-2001 - __ -- _ _ -. - ._ - __ - - - - -

60.0% 1-- 40.0% 50*0% i ::::: ___ 10.0%

0.0%

Source: Le6n (2002), based on Surveys o f Employment, Unemployment, and Underemployment.

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14. The fiscal stance remains vulnerable. Expansionary spending policies have partly been offset by increased and volatile revenues, making it difficult to achieve medium-term fiscal sustainability. As a result, the primary surpluses of the Non-Financial Public Sector (NFPS) have decreased from 7.7 percent of GDP in 2000, to 4.5 percent of GDP in 2002. Primary surpluses have been almost exclusively the result of an increase in both petroleum and tax revenues, which have fluctuated irregularly between 2 percent and nearly 5 percent of GDP compared to 1999. Unfortunately, they have covered a heavy burden of interest on public debt, which has left negative or meager positive global balances during these two years, exclusive of transfers to recapitalize commercial banks, floating debt, or external debt arrears. The primary surpluses would have been higher if not for the expansive behavior of current primary spending. Spending on salaries and on goods and services has almost doubled compared to predollarization levels-from about US$l billion and US$0.5 billion, respectively, in 1999, to about US$2 billion and US$O.9 billion, respectively, in 2002-and capital spending remained high at 6.4 percent of GDP in 2002.

15. Ecuador’s external debt i s principally to official lenders. In 2003, Ecuador has total net financial requirements of about US$2 billion, which after including already scheduled financing, leaves a gap in financing o f US$0.7 billion (Table 1). The largest share comes from multilateral and bilateral debts, which together represent more than 90 percent o f total external debt amortization and two-thirds of total public debt amortization over the next three years. Scheduled external payments include repayment of arrears to the Paris Club in 2003. Given the composition of the debt, Ecuadorian officials expect to fill the financing gap through a combination of (a) fiscal surpluses originating from expenditure cuts and additional income from oi l and non-oil earnings; along with (b) a program of structural reforms that wi l l allow the country to obtain rapidly disbursing and freely disposable external funds from the multilateral agencies; and (c) rollover of most of i t s domestic debt, with some repurchase coming from proceeds of i t s Fond0 de Estabilizacidn, Inversidn Social y Reduccidn del Endeudamiento Pliblico (FEIREP).

16. Ecuador’s external position i s fragile. Following El Niiio and the strong capital outflow o f 1999 that affected the Latin America and the Caribbean (LAC) Region and was a major factor in the origin of the crises, some relief of the external position took place in 2000. That improvement followed the successful negotiations of the IMF SBA in March; the approval of financing by multilaterals, including the Bank, in June; the repurchasing of the old Brady Bonds and Eurobonds at a discounted value o f 60 cents on the dollar in August; and the rescheduling of debt owed to the Paris Club in September. As a result, “excess freely disposable international reserves” went from negative-US$254 million in 1999-to positive US$776 million in 2000, but then declined two years in a row, halving to about US$400 million in 2002. This result conceals very important changes in the components of the balance of payments.

17. The fall in excess international reserves can largely be attributed to the sharp and sudden reversion of the current account surplus in the last two years. I t went from a surplus of 6.3 percent in 2000 to a high deficit of 5.0 percent for 2002. About 80 percent of the current account imbalance corresponds to a rising deficit in the trade balance. Several factors explaining the trade deficit are the “boom” in domestic demand (and imports) that often accompanies countries with an oi l windfall and rapidly rising family remittances; diseases and difficulties in accessing European markets that have affected the exportable supply of Ecuadorian shrimp and bananas, respectively; some appreciation in the real exchange rate to precrisis levels; and the temporary surge in imports accompanying construction of the heavy crude oil pipeline (OCP), which i s fully financed by foreign investment inflows in the capital account for about 3 percent of the 2002 GDP. The current account reversal hides, however, some positive developments, like the decline in net interest payments on external debt (nearly US$500 million), and the growth in family remittances, which became the second-most-important source of foreign currency and represented about 6.5 percent of GDP in 2002.

5

Table 1. Ecuador: Non-Financial Public Sector Financing Requirements and Sources 2001 2002 2003 2004

Prelim Projection --------> Gross Financing Need 1,885 2,233 1,986 NFPS deficit Deposit buildup Scheduled amortization External Domestic

Others Arrears clearance Accounts payable carried in Banking sector assistance Other*

Identified Financing

Domestic bond issues Loan disbursements Others

NFPS surplus

Arrears accumulation Accounts payable carried out Other

Gap Reschedulingldebt relief IDB WB CAF IMF

0 33

1,117 73 1 386 735 304 79 330 22

1,547 0

333 5 84 63 1 563 68 0

338 94 61 71 173 0

Unidentified -6 1 .~ _ _ _ _ * Includes debt reduction, and payment to the ESS. Sources: BCE, IMF, and World Bank estimates.

0 20

1,113 710 403 1100 832 68

200 0

1,983 245 138 412 1188 798 78 312

250 73 0 0 81 96 0

0 26

1,150 726 424 1882 606 78 69 29

1,316 508 398 339 72 4 68 0

671 150 100 130 100 160 31

1,566 0

283 1,174 776 398 95 12 68 0 15

953 544 0

338 71 0 71 0

613 100 100 100 150 40

123

18. The financial system has recovered but remains vulnerable. Deposits in the banking system are stable, and credit to the private sector shows positive growth rates since the negative levels o f 1999. However, there are s t i l l areas that need improvement (Figure 3): (a) real active interest rates are slightly positive, while passive rates remain negative and do not strengthen financial intermediation; (b) the expected decline in nominal interest rates following the elimination o f exchange risk after dollarization has been late in coming and limited-barely 3 to 4 percent, and less than the nearly 5 percent decline in international interest rates-and has not provided sufficient stimulus for economic recovery; (c) the liquidity of commercial banks remains high-above 30 percent-and continues to fluctuate, which reflects the Banks' concerns about having enough provisions that would allow them to meet their obligations in the event o f a run on deposits; and (d) a significant percentage-10 percent-of the portfolio i s delinquent and the highest proportion o f credit continues to be concentrated in commercial credit, the segment with the most delinquency, a trend that reflects the difficulty that economic agents encounter in meeting their debts and not seeking rollovers, and the banking system's limited t rust in granting medium-term credit for housing or microenterprises, despite dollarization.

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Figure 3. Financial System Indicators

Tasas de lnteres Activas en Ecuadorll Tasas de lntereses

Coeficiente de Liquidez Neta de 10s Bancos Privados Domesticos

(Diciembre 99-Setiembre 02) 100% 80% 60%

Morosidad de la Banca (cartera venciddcartera total)

Fuente: Banco Central del Ecuador; Superintendencia de Bancos del Ecuador & Fondo Monetario Internacional 1/ Tasas activas nominales y reales provienen de la Superintendencia de Bancos del Ecuador.

19. The IMF and the Bank are providing technical and financial support in the banking sector. Key challenges are to complete audit and restructuring o f private sector debt portfolios o f eight closed banks held in the Deposit Guarantee Agency (AGD) and achieve the sale o f Banco del Pacifico; strengthen banking supervision (including in the area of anti-money-laundering vigilance); approve effective bank resolution mechanisms; improve the interbank payments system, clearance, and settlement mechanisms including real time gross settlements for large value transactions; and create an effective central registry that can facilitate scripless trading and ensure delivery versus payment. Finally, a functional liquidity support mechanism and credible deposit insurance scheme should be created. Whereas the SBA deals with the short-term commitments to liquidate pending portfolios held in the AGD and the liquidation o f Banco del Pacifico, the Bank i s supporting financial restructuring through i t s ongoing Financial Sector Technical Assistance Loan and additional financial sector advisory services. A joint Bank-Fund Financial Sector Assessment Program (FSAP) evaluation i s scheduled for fiscal year 2004.

20. Public debt remains high. The stock o f public external debt was estimated at about 60 percent of GDP in 2002, more than twice the level o f exports and among the highest in Latin America. About four-fifths o f total public debt i s external. Of this, about 65 percent i s official d e b t 4 0 percent multilateral and 25 percent bilateral-making it somewhat less vulnerable to changes in emerging markets and offsetting the country's lack o f access to international markets. Nearly two-thirds o f domestic debt consists o f bonds issued by AGD and the National Finance Corporation (CFN) to cover the costs o f interventions during the banking crisis. The burden o f debt service i s excessive, creating continuous problems o f ill iquidity and making it very difficult to eliminate arrears. Approximately one of every three dollars entering the Treasury i s used to pay debt service. At the end o f 2002, Ecuador also

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had problems wi th arrears to the Paris Club estimated at about US$l80 million, and a scheduled amount of debt service o f about 8.1 percent o f GDP (4.7 percent in amortizations and 3.4 percent in interest for 2003-04). At the same time, the spread of Ecuadorian bonds (above 1,850 basis points) was the second highest in the region (Figure 2). The outlook of the three major risk-rating agencies i s that the country’s ability and desire to pay have improved with the new Government, but with a CCC+ (Standard & Poor’s) or Caa2 (Moody’s) rating, Ecuador i s s t i l l not eligible for a level o f investment that would allow it to issue new sovereign bonds on international capital markets in the near future. However, the signing o f the SBA, the clearance o f most external arrears to Paris Club members, and the multilaterals’ init ial public endorsements o f the Government’s program have led Ecuadorian bonds spread to fal l by about 400 basis points between end-December 2002 and April 2003.

111. THE GOVERNMENT’S PROGRAM AND REFORM AGENDA

A. The Government’s Strategic Vision

21. The Government’s strategy is to bring Ecuadorian citizens together to launch a concerted fight against poverty, through coordinated advances on the economic, social, and governance fronts. On the economic front, the GOE’s strategy i s anchored on fiscal consolidation and comprises reforms to stimulate production and commerce, improve basic infrastructure, strengthen financial markets, and create more flexible and competitive input, especially labor, markets. On the social front, the GOE’s strategy i s to reform social assistance, education, health, and social security to better fight poverty. On governance, the GOE’s commitment i s to fight corruption, improve public service delivery and transparency, and increase overall security, which i s broadly defined also to include judicial and environmental aspects.

22. The new Administration announced i t s Program for Economic Restructuring and Human Development upon taking office on 15 January 2003. The PERHD has two main pillars: economic policies and redistributive policies. It defines 11 social indicators for 2003-07: poverty, extreme poverty, illiteracy, schooling, infant mortality rate, general mortality rate, population without access to health care, safe water coverage, sewerage coverage, degree o f household overcrowding, and social spending (Annex 4). It recognizes the precarious fiscal situation and declares a temporary “state o f war” economy with respect to public finances. Short-term economic policies mainly encompass (a) an austerity Presidential Decree, “Norms for Patriotic Savings,” that severely restrains public expenditure to attack the immediate liquidity problem; a 2003 budget consistent with such austerity norms; an increase in fuel prices by an average o f 20 percent; (b) a tax reform; (c) a restructuring o f the corruption-prone Ecuadorian Customs Corporation; (d) the setting-up o f FEIREP for active debt reduction and countercyclical fiscal policy; and (e) an active public debt repurchasing program. The PERHD also ratifies the GOE’s intention to comply with the Fiscal Transparency and Responsibility Law approved end-2002, and reinforces the importance of a SBA with the IMF, to strengthen the credibility o f i t s overall macroeconomic framework and support i t s structural reforms (see Annex 4).

23. The PERHD also defines structural reforms to sustain economic recovery in the medium term. These include c iv i l service reform; completion o f the financial sector reform; creation o f a Banking Liquidity Fund; full liquidation o f closed banks; and new incentives to attract foreign investment, in particular in telecommunications, electricity, and the o i l industry, starting with a transparent adjustment o f tariffs to reflect the cost and quality o f the service and the modernization o f i t s regulatory framework. Institutional reforms also include anticorruption policies, modernization o f the state, and pro-transparency and citizen participation programs. T o do so, the GOE has organized Mesas

de Didogo and announced i ts intention to revise the decentralization framework, while engaging c iv i l society in the design and monitoring o f the public budget, but has not yet been very explicit about the strategy to accomplish such goals.

24. Because some policies could have negative impacts, the PERHD includes redistributive social policies. Several recent measures w i l l affect purchasing power, particularly o f the poor. Examples are fuel price increases, gradual adjustment o f utility services, elimination o f the gas subsidy and i ts replacement by a well-targeted mechanism, and freezing o f wages o f public servants. To offset these measures, the PERHD has approved measures o f limited fiscal impact. The Bono Solidurio (cash subsidy) was raised from US$11.5 to US$15 per month; the pension o f retirees was increased by US$5 per month; and a minimum pension o f US$15 per month was approved for people over 68 years o f age who are not receiving the Bono SoZidurio. Officials are also proposing to replace the regressive gas subsidy by one targeted toward the poorest and most vulnerable groups, and, supported by the Programmatic Human Development Loan, to protect social spending and implement reforms in the social sectors and the social security system. Additionally, there i s new emphasis being placed on developing active policies to generate economic opportunities (incomes) for the poor, especially indigenous and rural populations, though detailed proposals are s t i l l being developed.

B. The Reform Agenda

1. Why Are Adjustment and Structural Reform Still Needed?

25. Adjustment policies and structural reforms are critical for correcting internal and external imbalances, creating room for pro-poor social policies, and supporting a solid economic recovery. Ecuador has limited policy choices in the face o f the possible medium-term collapse o f dollarization. The country must counteract the rigidity involved in adopting the dollar as legal currency for circulation, savings, and domestic transactions. With no control over monetary or exchange rate policy, and no ability to “hide” fiscal imbalances and alter relative prices by depreciating the domestic currency, Ecuador needs to simultaneously ensure macroeconomic stability exclusively through solvency and fiscal stability, and introduce flexibility in goods and services markets to maintain the competitiveness o f i t s products on domestic and foreign markets.

26. A debt sustainability analysis indicates that Ecuador needs sizable primary fiscal surpluses to lead i t s debt along a sustainable path. From a fiscal sustainability perspective, given the init ial situation o f financing constraints and high public debt (60 percent of GDP in 2002), th i s requires making adjustments in order to obtain primary surpluses in the fiscal accounts estimated at an average o f 4 to 5 percent of GDP over the next years. This would bring debt below 40 percent o f GDP at the end o f the decade, while ensuring short-term liquidity and guaranteeing the country’s solvency for i t s public debt service obligations in the medium term (see Annex 5). The fiscal adjustment would take into account the volatility o f tax revenues as a result o f the variability in petroleum prices. T o offset it, particularly during a foreseeable scenario o f price reductions, the application o f automatic stabilizers and better use o f the extraordinary receipts during the current boom are projected.

27. Increasing the flexibility of the market of factors of production, especially labor, i s critical. Without exchange rate policy, there are limited instruments to respond to adverse shocks or to cushion public policy weaknesses in the real sector. Market rigidities, with high costs not only for production but for goods and services, might lead to negative effects on competitiveness, growth, and job creation, which could threaten dollarization’s sustainability. The risk lies in the fact that, given inflexible markets-such as the formal labor market-adjustments to shocks occur primarily through reductions in amounts produced (and sold), with the contraction in demand based on inputs, particularly labor. This would not only create pressure to “abandon” the model, in view o f increased unemployment, but would also increase

9

commercial banks’ arrears as economic activity fell. This would threaten fiscal adjustment goals and recovery o f the banking system. Two external shocks would require particular attention: frrst, devaluations or depreciations (discrete or continuous) o f the currencies o f Ecuador’s trade partners; or second, appreciation of the dollar against other “strong” currencies. In both cases, the “appreciation” o f the dollar would have to be offset by increases in productivity and/or by deflationary adjustments in production and transaction costs to maintain competitiveness and avoid the loss o f markets.

28. In summary, the essential conditions for sustaining dollarization are to consolidate the fiscal stance and foster competitive growth based on more flexible markets, and rising productivity.

2. The Challenge of Consolidating the Fiscal Stance 29. The GOE has demonstrated an early commitment to fiscal adjustment, despite the difficult economic, political, and social conditions. Important issues have been identified, and the Government has embraced a comprehensive development agenda.

30. Strengthening the Fiscal Framework. Procyclical and discretionary policies have resulted in volatile revenue, expansionary spending, declining primary surpluses, and little credibility in fiscal management. In late January 2003, the Government published an Executive Decree containing the norms (Reglamento) o f key components o f the Fiscal Tranparency, Stability and Responsibility Law: (a) multiannual budgeting, (b) quantitative targets for fiscal variables, (c) a Public Debt Reduction Plan, (d) management o f the resources saved in the o i l stabilization fund, and (e) budget transparency and citizen control. These norms should bring a medium-term strategic approach into budgeting, increase predictability o f critical fiscal variables, design a comprehensive debt management strategy, make sure that o i l revenues saved in the o i l fund are used for debt reduction, and comply with the government’s main goal o f eradicating corruption by increased disclosure and c iv i l society empowerment in the social auditing o f fiscal accounts.

3 1. Enhancing Revenue Management. Fiscal revenues are vulnerable to the variability o f o i l prices, which gives fiscal receipts a procyclical nature; the excessive number o f preassigned taxes; and low collections o f nonpetroleum taxes, which i s a consequence o f the low value-added tax (VAT) and the excessive number o f exemptions, particularly on the VAT and the income tax (ISR). Each dollar drop in the price o f a barrel o f o i l means a reduction o f receipts o f about 0.2 to 0.3 percent o f GDP. The excessive use of distortions, such as exemptions and earmarkings, i s a result o f “fine-tuning” to the demands o f special interest group^.^ The large number o f taxes (more than SO) reduces tax efficiency because it makes it impossible for officials to focus on the taxes that are a priority. The deeply rooted practice o f providing tax exemptions robs the tax system o f transparency, equity, and efficiency. Failure i s particularly acute in terms o f meeting redistributive goals in the case o f the VAT, and in promoting socially profitable processes in the case o f low and corruption-prone tax collection by Customs. The excessive earmarking of taxes (over 50) also impedes more efficient use o f about 1.7 percent o f the GDP of fiscal resources, and discourages tax collection by provincial or municipal governments, as they become accustomed to transfers from the Central Government. Under th is operation, the Government i s committed to reducing the volatility o f fiscal revenues by increasing non-oil revenues, broadening the tax base, simplifying the tax structure, and promoting a more efficient allocation o f fiscal revenue. To achieve this, the multiyear reform program supports tax measures mainly encompassing, among others things, (a) a gradual elimination o f most VAT and ISR tax exemptions, (b) simplification o f the tax system with the elimination o f most nuisance taxes, and (c) a gradual elimination o f most unconstitutional

2. In view of i t s impact on environmental protection, and the small size of the amounts involved, the principle o f earmarking revenue is, however, appropriate for keeping an adequate portion of the protected areas revenue for their maintenance.

10

earmarked taxes. And in tax administration, i t mainly addresses (a) the setting o f quantitative benchmarks to tax collection administered by the IRS, thus consolidating i t s positive performance o f the last two years; and (b) it supports an improved tax collection by Customs. Under this operation, the Executive has submitted a draft bill to Congress aimed at improving tax collection by Customs through (a) a strengthened IRS role on the Customs board, (b) a complete restructuring o f Customs, (c) rationalization of Customs personnel, (d) full and timely access to import bills by the IRS, (e) virtual crosschecking information wi th taxpayer files, (f) severe penalties for underinvoicing import bills, and (g) improved border control.

32. Improving Public Expenditure Management. There are three related problems with public expenditure: i t i s inflexible (particularly on salaries), i t i s inertial, and it i s not transparent. Budget rigidity i s a serious threat to fiscal discipline, since it captures most projected increases in earmarked tax revenues and thus will require further squeezing o f discretionary spending-including counterpart funds for investment financed by external sources-to comply with the 3.5 percent cap on real primary expenditure growth. Derived from it, inertial expenditure i s perhaps the most serious obstacle to price stability. The lack of transparency prevents adequate control and public auditing, and encourages tax evasion. Expenditure rigidity i s very severe and increasing. The discretionary (unallocated) portion o f the budget was about 5 percent of GDP in 2002 and declined to 4 percent o f GDP in 2003. For i t s part, primary spending grew from 19.4 percent o f GDP in 1999 to 21.7 percent o f GDP in 2002, a period of presumed adjustment. Budget rigidity i s mainly due to the fixed public payroll, and tax earmarking-oil- and non-oil related-written into over 50 current legal regulations and mainly benefiting nonaccountable spending by sectional (subnational) governments. The wage bill doubled in U.S. dollar terms between 2000 and 2002 and, even after applying the 2003 austerity measures, s t i l l must absorb a carryover o f about 1 percent o f GDP from the wage increases and benefits approved by the previous government in 2002. The budget lacks transparency because some fundamental modern tools are missing: there i s no centralized public payroll, there i s limited coverage and information registering o f public expenditure by the Integrated Government Financial Management System (SIGEF), and there i s an absence o f controls on preassigned spending and resources assigned to public enterprises and subnational governments. To halt expansionary spending in the short term, the Government has issued an Executive Decree that freezes wages for regular c iv i l servants, suspends overtime allowances, reduces the President’s salary by 20 percent, reduces the salary o f government appointees by 10 percent, reduces the number o f new positions to be filled, and restrains spending on goods and services. In the medium term, fiscal retrenchment requires complying with the cap in real primary spending set up in the FI’SFU,. Measures to increase transparency under th is operation w i l l be addressed in a Transparency Plan with three components: (a) a SIGEF-based system to produce monthly, timely, and reliable reports on executed expenditure beginning in mid-2003, and consolidated NFPS financial statements through the Government’s website (Portal) beginning in 2004; (b) an e-government system to develop public procurement; and (c) a national public investment system.

33. Taking Control of the Wage Bill. The wage bill accounts for about half o f Central Government primary spending in 2003. Ecuador’s current wage and personnel management systems generate three main problems (see Annex 7). First, the proliferation o f salary components has undermined the government’s control over the wage bill. The result i s a payroll system wi th a myriad o f separate components that make up the monthly salary, and no coherent control over pay policy. Second, there i s no government office with a reliable and comprehensive picture o f the number o f public employees by ministry, department, agency, post, and grade, and with the capacity to track which employees have been removed from public service (with the payment o f an indemnity) and to ensure that they do not return to the state’s employ. Third, there i s no comprehensive human resources policy, since salary inequities and hiring discretion discourage staff that believe they are unfairly compensated relative to s imi la r professionals employed in another part o f government, particularly those in autonomous agencies.

11

34. Implementing civil service reform. Under th is operation, the Government i s committed to c iv i l service reform, and it has completed a final draft o f public salary unification. This bill w i l l seek Congressional approval o f a law collapsing nearly al l salary components into a single base wage. I t i s an essential f i r s t step to reestablish government control over the wage bill, make wage policy more transparent, and facilitate registration o f public employees. The outgoing Administration submitted a draft law to Congress, but i t was rejected in committee. Implementation o f the law would be easiest in ministries that have already reduced salary categories from a 21-grade to a 14-grade pay scale. As a critical complementary step, the Government i s committed to submitting a bill on c iv i l service and administrative career reform. The rationalization o f public employment implies staffing reviews. However, the largest ministries (agriculture, social protection, education, health, and public works) remain under the 21-grade system and with no staffing reviews. Under i t s Program, by December 2003 the GOE i s expected to complete a staffing review for these ministries so that implementation o f the Unification Law may proceed swiftly. In the course o f those reviews, certain staff may be identified as redundant. A lack o f resources to pay indemnities would limit the government’s ability to dismiss redundant employees. Therefore, a study would assess the cost and sources o f funding to pay these indemnities, and their impact on the payroll. Last, to control the wage bill, the government would manage not only pay scales, but the number o f personnel, as well. At present, information i s woefully inadequate to this task. Thus, as a key complement to the salary unification, the Program calls for the establishment o f a consolidated database for registering al l public employees and their salary benefits.

35. Achieving a Sustainable Public Debt. The liquidity and solvency o f Ecuador’s public external debt are delicate. On one hand, Ecuador has immediate problems to resolve over arrears with the Paris Club, estimated at approximately US$lSO mil l ion in 2002, and debt service o f 9.5 percent o f GDP for 2003 and 2004. On the other hand, (a) to reduce the debt to sustainable levels, Ecuador needs primary surpluses o f 5 percent o f GDP; and (b) to close the financial gap in the next two years, i t wil l require additional resources o f around 4 percent o f GDP (Annex 5). Given i t s dollarized status, under the fiscal rule the GOE aims to (a) reduce the public debt-to-GDP ratio by 16 percent o f GDP before 2006 under the fiscal rule, and (b) reduce the public debt-to-GDP ratio below a benchmark 40 percent. Moreover, when compared to other deeply indebted Latin American countries, Ecuador has limited institutional capacity for debt management: i t i s strictly operational and not analytical, lacks transparency, i s fragmented, and i s poorly coordinated between the Finance Ministry and the Central Bank. Under this operation, the GOE has cleared 100 percent o f al l external public debt arrears accumulated up to February 2003, and 100 percent of al l domestic bonded public debt arrears accumulated up to March 2003. The Government has also set a Paris Club meeting to reach an agreement next June on a l l March 2003-04 external arrears. Under the Program supported by this operation, and also in agreement with the fiscal law, the Government i s committed to preparing a Debt Reduction Plan that would set policies to clear i t s remaining arrears for 2003, repay i t s debt with the Ecuadorian Social Security Institute (IESS), gradually repay expensive debt in Global bonds, as well as strengthen i t s institutional capacity, and make debt management transparent, with regular publication o f commitments and payments on debt service, including floating debt as stipulated in the fiscal law.

36. The debt sustainability analysis i s robust, even if the country faces a significant external shock. If o i l prices fall significantly for several years, the Government could s t i l l reach i t s public debt-to- GDP benchmark, but two to three years later (Figure 4 and Annex 5).

12

Figure 4: Debt Scenarios

60 1

O t 1 2003 2004 2005 2006 2007 2008 2009 2010

Low - -Base

37. The overall net impact of the fiscal measures considered by the Multiyear Government’s Program i s projected to raise revenues of about US$0.5 billion, equivalent to 2 percent of GDP (Table 2). The change in the domestic price o f fuels w i l l raise revenue by about 1 percent o f GDP. Tax measures would raise revenue by another 1 percent o f GDP. The reversal o f external tariff rates by the Consejo de Comercio Exterior e Znversiones ( C O m X I ) w i l l recover revenue for about 0.3 percent o f GDP. There i s an inframarginal gain associated to the elimination o f nuisance taxes, but this action would facilitate tax collection. Since tax administration and collection by the Internal Revenue Service (SRI) has markedly improved over the past two years, there are good reasons to expect that tax collection administered by the S R I w i l l continue to increase slightly. However, social compensation measures represent a fiscal cost o f about 0.4 percent o f GDP, whereas the carryover o f last year’s wage increases, despite austerity measures, represents a fiscal cost o f 1.0 percent o f GDP in 2003. In sum, the increase in the wage bill due to the inertial growth o f the public payroll in 2003 w i l l phase out about one-third o f the additional revenue obtained from the adjustment measures.

3. Fostering Growth through Competitiveness

38. Developing a Competitiveness Agenda. Competitiveness i s instrumental to sustaining dollarization. However, competitiveness abroad and the investment climate at home require adjustments. Nearly al l global indicators show indisputable and consistent evidence that the competitiveness gaps are significant and growing. In 2001, Ecuador ranked 54’h out o f 62 countries evaluated in terms o f global competitiveness during the World Economic Forum. In 2002, Ecuador’s ranking deteriorated even further when it was classified as 73rd among 80 countries, with the highest relative percentage for innovation and the lowest in terms o f business climate and respect for countries and for laws. One o f the first steps o f the new Administration i s to design a simplified agenda o f policies and laws to strengthen competitiveness: revision o f the Law o f Competitiveness; trade reform; pricing policies; a framework conducive to private participation in basic infrastructure; and strengthening the petroleum industry.

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Table 2. Fiscal Impact of Proposed Measures in the Short and Medium Term

Estimate in

MillionUS$ % GDP

I.

II.

TAX POLICY A. Fuel Excises Increase price of fuels Gas price increase from gas subsidy substituted for targeted mechanism on hold (gross revenue)

B. Taxes Include in VAT list of medicines and other products Zero VAT on electricity and prepaid medicine Include ICE on products or increase the tax Tax on business capital (one-time)

Land tax on property >200m2 (one-time) Vehicle

TAX ADMINISTRATION A. Customs Tariffs and Administration Administrative measures COMEXI reverses tariff exemptions

Widen tax base Tier 1 contributors. Exemption on base income ~$5,000

STR Tax System on the informal sector

Regulations to the tourism law eliminating tax loopholes

B. Expanding Tax Base

C. Other

111. EXPENDITURE MEASURES Increase in wage bill from 2002 measures 20% reduction in government salaries for salaries >$1,000 10% reduction in ministry budgets Reduction of budgetary allowance to PetroEcuador Revision of Purridus system in education

IV. COMPENSATION MEASURES Increase bono solidurio from $1 1.50 to $15 (new bono solidurio program) * Increase retirement benefits to $15

V. CIVIL SERVICE REFORM.

603.2 345.8 270.0 75.8 257.4 20.0

57.0 40.0

90.0 50.4

160.0 120.0 40.0 80.0 40.0 20.0 20.0

0.0

-158.0 -260.0

2.0 0.0

100.0 0.0

-95.0 -50.0 -45.0

20.0

2 3 1.3 1 .o 0.3 1 .o 0.1 0.0 0.2 0.1

0.3 0.2

0.6 0.4 0.1 0.3 0.1 0.1 0.1

0.0

-0.6 -1.0 0.0 0.0 0.4 0.0

-0.4 -0.2 -0.2

0.1

ESTIMATED NET SAVINGS FROM FISCAL REFORMS 530.2 2.0 * In some cases, no significant change in expenditures i s expected, but an improved targeting will lead to more efficient use of existing funds. This i s particularly true for the nutrition program and the merging of the Bono Solidurio and Becu Escolar programs into the new Bono de Desurrollo Humuno. Sources: MEF, IMF, and World Bank estimates.

39. Accelerating Trade Reform. Trade reform to correct an anti-export bias i s fundamental to promoting nontraditional exports. This bias i s preventing modernization and competition based on profitability. Ecuador has seven import tariff rates ranging from 0 to 35 percent, with a simple average tariff o f 11.3 percent. The external tariff approved by CAN covers about 62 percent o f tariff items. The combination o f high Ecuadorian tar i f fs for final products and tariff dispersion leads to a wide range o f effective protection rates that force consumers, including the poor, to subsidize uncompetitive, high-cost

14

local producers. The anti-export bias i s reinforced by the discriminatory application o f nontariff barriers (NTBs). Import licenses and technical norms are the most important NTBs. On one hand, licenses are distributed in a discretionary manner. They are s t i l l applied to about 1,600 out o f 6,707 tariff items, and about 8 percent o f those are duplicated and concentrated in the health and agricultural sectors. Import licenses cover about 25 percent o f al l tariff positions, which account for about 10 percent o f total imports into Ecuador. The majority o f these licenses contradict the norms o f the World Trade Organization (WTO). On the other hand, there are 757 obligatory technical norms and 1,339 optional norms used as obstacles against imports. About half o f them are concentrated in five categories: food, construction materials, chemicals, mechanical components, and o i l products. Upon i t s accession to the WTO in 1996, Ecuador signed the WTO Normalization Code, but has not applied it. The Government’s trade reform agenda intends to work on three fronts. First, it intends to simplify the Customs tariff to five rates o f 0, 5, 10, 15, and 20 percent as agreed with other Andean countries. This i s only an init ial effort, since the recent Latin American tendency i s toward tar i f fs below 10 percent, to slightly diminish tariff dispersion and reduce the effective protection rates. I t would represent a positive step toward preparation of the future Free Trade Agreement o f the Americas. More important, supported by this operation, the Government has unified 100 percent o f duplicative import licenses. The Government i s also committed to eliminating most o f those import licenses that did not register commercial activity from 1991 through 2000 (about 919 tariff positions), and to setting up a simplified regime for import licensing, to reduce processing time from 40 to 60 days to 24 hours by December 2003. Finally, the GOE w i l l dismantle about 10 percent o f existing technical norms per year previously evaluated, which do not comply with WTO regulations.

40. Promoting Market-Pricing Policies and a New Regulatory Framework for Private Participation. The sectors o f water and sanitation, electricity, and telecommunications confront problems such as low coverage (particularly in rural areas), low efficiency, and poor quality o f services, in part derived from pricing policies setting tar i f fs below real economic costs and incomplete institutional and regulatory frameworks. The national government would confront these challenges by seeking greater local, national, and international private sector participation, which can be achieved only with market tariffs, and by consolidating the regulatory framework. In addition to these problems, the water and sanitation sector i s characterized by the low recovery of costs through charges, the high dependency on transfers from the Central Government to cover the deficit, and the lack o f an integral national system o f water resources. All water and sanitation services come from decentralized providers that depend on municipal governments, and the Central Government intends to use three main instruments to improve quality and efficiency and to extend coverage: (a) perfect the legal and institutional framework by restructuring the Subsecretariat o f Drinking Water and Basic Sanitation (Subsecretada de Agua Potable y Saneamiento Bdsico, SAPYSB), and submitting to Congress a new Water and Sanitation Law; (b) reform the use o f central transferences to introduce incentives for profitability among service providers; and (c) create a Water Fund inside MIDUVI to link transfer to the sector to performance-based criteria by local water companies. The preparation o f the Water Law should ensure consistency with existing environmental laws and regulations (para. 45).

41. The most urgent problems of the electricity sector are tariff adjustments and the financial unsustainability of the wholesale market. The electricity sector has gone through an incomplete reform process since 1996 and i s not financially sustainable. Reforms to separate electricity generation, transmission and distribution functions, and put in place a wholesale energy market regulated by the National Electricity Council (CONELEC) and efficiently administered and monitored by the National Center o f Energy Control (CENACE) are incomplete. The Solidarity Fund (FS) and local government owners o f power distribution companies have failed to upgrade their management, permitting average losses o f one-third o f energy generated, as a combination o f distribution losses and insufficient bill collection. Genuine reforms in the sector to mobilize badly needed private investment and achieve sustainable efficiency improvements require political commitment. The Government Program i s

15

committed to the preparation o f a strategy to reduce the financial deficit and improve the efficiency in the electricity sector, which would entail the main following elements: efficient functioning o f mechanisms for effective payments to generators (fideicomisos); a strategy to resolve the situation o f Emelec, the Guayaquil distribution utility; debt restructuring for al l government-owned companies in the sector; and a medium-term strategy for sustainable efficiency improvements in distribution and private investment in the sector. The Bank‘s PROMEC approved in 2001 to modernize electricity and telecommunications services in rural areas, i s assisting with the regulatory framework, particularly in the wholesale market, and with electrification for poor rural households, as well as energy conservation through GEF support. The PROMEC’s project has a major social outreach component to build public support for further tariff adjustment toward reaching the estimated economic cost o f U S 10.4 cents/kWh in average. These adjustments were initiated by the previous Administration and average tar i f fs reached about 75-80 percent o f economic cost in 2002. All customer categories are now charged a tariff that fully covers economic cost, except residential customers with consumption lower than 300 kWh/month. Supported by this operation, the new Administration has decided to resume tariff adjustment for this category o f customers, with a gradual adjustment o f 1.64 percent per month, so that economic costs are reached for al l customers over a three-year period. This gradual increase would represent only about 2 to 3 percent o f total expenditure even for the poorest households. I t should also be noted that the poorest households (about 40 percent o f the rural population) s t i l l do not have access to electricity. In sum, to confront these challenges, the multiyear Program supported by this operation supports continuous progress in the tariff adjustment-with the appropriate “lifeline”-type protection for poorer households-until they fully cover their economic cost, and the design and implementation o f a strategy to eliminate the financial deficit o f the electricity sector.

42. The telecommunications sector i s challenged by low, undustainable local rates and a deficient regulatory framework. CONATEL signed with ANDINATEL and PACIFICTEL concession contracts that authorized tariff increases to the price cap l i m i t s in December 2001. However, the previous Government decided not to raise all tari f fs to these l imi ts . All commercial tar i f fs were adjusted to levels that eliminated cross-subsidies. However, the prices for residential local calls are s t i l l subsidized by long- distance calls. The new Government recognizes that these rates need to be adjusted, to eliminate cross- subsidies and to promote competitive long-distance rates that will, in tum, increase Ecuador’s international competitiveness. Supported by th is operation, the Government has devised a strategy to eliminate cross-subsidies in one year. All rates wil l be adjusted to the price cap l i m i t s set by CONATEL by the end o f 2003. In addition, ANDINATEL and PACIFICTEL have recently created a new company, TELECSA, to provide mobile services in Ecuador. Recognizing that their operational indicators compare unfavorably against regional benchmarks, and that this new venture w i l l require resources and expertise beyond the Companies’ capacities, the Government has prepared a strategy for attracting a private operator to invest in this new venture under th is operation. The Government must act quickly to stop subsidies, especially to PACIFICTEL. Finally, the current Telecommunications Law i s obsolete and has many contradictions, due to i t s multiple revisions. This gloomy regulatory framework i s a disincentive for investors, because it gives the regulatory entities (CONATEL and SUPTEL) excessive discretion with respect to key decisions. Under i t s Multiyear Program, the GOE has already awarded a third mobile phone telephony license and approved a telecom sector strategy. Under such strategy, i t i s committed to (a) prepare a attract a private investor to Telecsa, the new cellular phone company created by ANDINATEL and PACIFITEL; (b) find a private administrator o f these two companies; and (c) draft a new Telecommunications Law, to have a single sector authority, simplify entry into the Sector, and eliminate the regulator discretional faculties.

16

43. Promoting Environmentally Sound Private Sector Investment in the Oil Sector. The strength of the oi l sector i s key for accelerating economic growth in Ecuador. To achieve this, however, the government must address a set of distortions constraining the sector. First, the sector has been hindered by (a) low production of the oi l fields with the greatest reserves; (b) price and tax distortions on combustible fuels which in turn have caused investment in exploratory activity to flatten or decline; (c) judicial and fiscal instability under the sector’s outdated legal and institutional framework and (d) inadequate planning and management by PetroEcuador. Under PetroEcuador’ s monopoly, nondiscriminatory treatment-that would normally facilitate foreign companies’ access to markets-has discouraged foreign investment flows and refinery modernization, has depreciated product quality, and has elevated commercialization and marketing costs. New private investment and transport capabilities could easily enhance PetroEcuador’s production, especially in the fields operated by them where important oi l reserves have been found. Since the current Law of Hydrocarbons already contains provisions that would allow private enterprises to participate with PetroEcuador, complementary legislation i s recommended so as to end PetroEcuador’s monopoly, to promote greater competition, and to provide incentives to invest in refineries and new distribution and marketing installations. Second, weak environmental management within the oi l sector continues to constrain sustainable development activities: New o i l exploration and production must incorporate state-of-the-art technologies developed by private companies, consultations with local communities, and the best available environmental practices in order to prevent serious adverse environmental impacts.

44. Developing the Oil Sector. Support under this operation complements a set of ongoing Bank efforts in supporting sound development o f the oi l sector. The Bank i s already providing technical assistance through an Energy Sector Monitoring and Assistance Program (ESMAP) Grant training of indigenous populations to negotiate on an informed basis with prospective oi l investors. Also, jointly with the CAF and IDB, the Bank i s preparing an economic and financial analysis o f the sustainability of the Petroindustrial oi l refinery. An Institutional Development Grant approved last year supports a tripartite (government-community-oil industry) process of dialogue for development of regulations governing consultation processes on hydrocarbon investments in indigenous and environmentally sensitive areas. In addition to these, through i t s Multiyear Program the Government i s committed to reducing oi l subsidies, making them more transparent, and enforcing environmentally friendly regulations to promote private sector participation. As a fus t step, budget transfers to PetroEcuador have been reduced in 2003 and the Government i s committed to further reduce them in 2004, but with assurances that these cuts wi l l not result in any decline in PetroEcuador’s funding to address environmental issues. Increased transparency about PetroEcuador management wi l l be supported through publicly available external audits committed by the Government under this operation. In addition, the Government has already adjusted fuel prices as a f i rst step toward a sustainable financial development of the sector. This action i s providing greater fiscal income, eliminating contraband, and minimizing the government’s need to perform the onerous task o f managing the price of combustible fuels.

45. Enforcing Environmental Regulations in the Oil Sector. The previous measures would be complemented by a proper enforcement of recent environment regulations. The Law on Environmental Management was approved in July 1999 regulating the execution of industrial projects. Moreover, the Environmental Regulations on Hydrocarbon Operations were approved in February 2001 to regulate the development of petroleum industry activities involving environmental and social management. I t s main modification was the raising of environmental standards to international levels, with special emphasis on the injection of formation waters, emissions monitoring, and environmental auditing procedures. Finally, the Regulations for the Consultation and Participation o f the Indigenous Populations in Hydrocarbon Activities were approved last December 2002. These clarify the rights o f local communities, particularly indigenous peoples, to be consulted prior to the bidding process for new oi l exploration and exploitation contracts, and prior to the start o f the oi l contract execution. The Consultations intend to (a) collect the affected populations’ concerns about environment damage prevention, mitigation, control, compensation,

17

and rehabilitation, as well as positive impacts that the project might bring to their area; and (b) assess the social and environment implications o f new o i l projects through the preparation o f an Environmental Impact Study and Environment Management Plan in a tripartite dialogue among government, industry, and communities. These regulations cover all new contracts to be developed by PetroEcuador andor private-foreign or domestic--enterprises established in the o i l industry and are to be enforced by the Ministry o f Energy and Mines and the Ministry o f Environment. Under the FCCGL, the Government w i l l prepare and publish the environmental studies and management plans required by such regulations under a consultative and participatory framework. Expected follow-up measures under the Multiyear Government’s Program include:

0 Up to March 2004: The Ministry o f Energy and Mines (MEM) i s expected to approve and publish the required environmental impact studies and environmental management plans prepared by PetroEcuador andor contractors for new o i l sector investments, according to (a) the Law o f Environmental Management (1999); (b) Environmental Regulations on Hydrocarbon Operations (2001); and (c) Regulations for the Consultation and Participation o f the Indigenous Populations in Hydrocarbon Activities (2002). Up to March 2005: The Ministry o f Energy and Mines (MEM) i s expected to verify that the recommendations o f the environmental management plans for new o i l sector investments required by Ecuadorian environmental regulations have been properly implemented.

0

46. Increasing Labor Market Flexibility. Employment indicators show there has been some recovery from the impact o f the end-of-century crises. Formal employment declined until 2000, then gradually rose to around the 1998 level. This recovery i s partial, however, and does not reflect migration. Hal f a mil l ion Ecuadorians (the most economically active population) have immigrated to other countries and there i s continual internal migration from the country to the cities. The Underemployment rate remains three times higher than in 1998, which reflects that a growing number o f workers work less than 40 hours a week (visible underemployment), or are paid less than their stipulated wages (invisible underemployment). Such outcomes are partly a result o f the Economic Transformation Law, because it simplified wage policy in the private sector and introduced new and more flexible forms o f hiring through hourly and temporary contracts. However, the system continues to be rigid. On one hand, the Sectoral Tables, based on the minimum wage established by the National Wages Council (Consejo NacionaZ de Salarios, CONADES), involve compulsory 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 are hardly a reasonable basis for additional increases negotiated within each sector or as part o f collective agreements. This indexing mechanism could help control inflation, but it i s a serious obstacle to competitiveness when inflation stabilizes near international levels.

47. Dollarization requires special attention to wage levels and market flexibility. Under the Multiyear Government’s Program supported by this operation, a consultative process--called Mesas de Trabajo- has already been announced by the Ministry o f Labor (ML) for 2003. I t w i l l include authorities, entrepreneurs, and worker organizations. There are 10 topics to be covered by such Mesas: labor policy, labor productivity, labor law enforcement, training, international labor law, retirement and pensions, a new Labor Code, a new Labor Procedures Code, terciarization, and bargaining methods. In 2004, future wage increases would be brought in line with the inflation rate. This would imply simplifying the wage negotiation process by no longer revising wages according to predicted inflation only, but to productivity; and minimizing the role o f the Tablas Sectorides as reference indicators, in establishing a single minimum wage. In support of these activities, the GOE has also requested further analysis on the labor markets from the Bank. Three analytical instruments are planned for fiscal 2004: a Poverty Assessment, an Investment

18

Climate Survey, and a Labor Market Study. conditions in the private sector

All o f them would provide detailed insights on labor

C. The Medium-Term Macroeconomic Outlook

48. Macroeconomic stability and faster growth are necessary conditions for poverty reduction. Sustained recovery over the next four years w i l l consolidate economic, fiscal, and financial stability; attract foreign investment; reduce the country’s r i s k ; reduce poverty; and prevent deterioration o f l iv ing standards during a difficult adjustment period. I t can only be based on a multidimensional agenda. The medium-term outlook i s based on the assumption that the economic program wil l be successful, and on sustained dollarization (that is, no major exogenous shocks to the present regime). Under the base case scenario the government would (a) slow expansionary spending and increase non-oil tax revenues, to obtain sizable primary surpluses, repay i t s debt, and lower inflation; (b) induce a reduction in interest rates to slowly improve external competitiveness to foster private-foreign and domestic-investment and exports as the main sources o f growth; (c) finish the new o i l pipeline by end-2003, to increase o i l exports starting in 2004; (d) have a marginal growth o f o i l production in 2003-barely 2 mil l ion barrels (lower than the official forecast o f 10 mil l ion barre lsbas a result o f the low investment by PetroProducci6n; (e) gradually restructure the banking system; (f) clear al l i t s arrears in 2003 and avoid default over the next three years; and (g) provide full financing o f the social expenditure identified by the PREN to bring adequate protection to the poorest, while minimizing the potentially negative short-term impact of adjustment measures, thus achieving minimum social and political consensus over the difficult measures to be adopted.

49. The base case scenario assumes moderate growth with low inflation (Table 3). In 2003-05, key assumptions are (a) growth averaging 4 percent, with single-digit inflation rates, converging to international levels; (b) a slow recovery o f the U.S. economy beginning in the second semester o f 2003; and (c) a short-lived o i l boom in 2003, disappearing fully in 2005 with falling prices partly offset by new o i l exports (Table 3). As a result, on the internal balances, the NFPS primary surplus should average 5 percent of GDP (for an NFPS overall balance surplus o f 1 to 2 percent o f GDP) arising from the approval of several tax measures in 2003, temporarily increased o i l revenues, and declining public spending- especially capital investment-in real terms. Compliance with al l fiscal rules contained in the Fiscal Transparency, Stabilization and Responsibility Law (Ley de Transparencia, Estubilizacidn y Responsabilidud Fiscal, FTSRL) i s also assumed. On the external balances, the current account should fall to about 2 to 3 percent o f GDP, as temporary booming imports related to the construction o f the OCP disappear in 2004, and the growth o f family remittances, despite some loss o f dynamism, remains positive. The period ends with a gradual decline o f the public debt-to-GDP ratio to the minimum sustainable ratio o f 40 percent o f GDP in 2005, the benchmark set up in the fiscal rule, as a result o f the active repayment o f expensive domestic debt with the primary surpluses. Such ratio should continue declining over subsequent years.

50. There are high risks associated with the base case economic projections. Ecuador remains vulnerable to internal and external shocks that, should they materialize, could derail the economic program. First, the economy i s vulnerable to terms-of-trade shocks, especially on oil, bananas, and shrimp. Second, remittance flows might fal l faster if migration policies in labor-recipient countries l ike the United States and Spain get tougher. Third, global economic recovery could take longer than projected. Fourth, and turning to domestic shocks, the projected increase in o i l production and exports may not materialize if PetroEcuador performs poorly. Fifth, the schedule o f fiscal and structural measures implied by the base case could take longer than planned. This would put the SBA at risk and would require renegotiating the program, with obvious implications for the loans. Sixth, if the projected external multilateral financing does not materialize, the Government would turn to domestic debt, thus raising interest rates and crowding out private investment. Seventh, until there i s a final decision on the

19

amount and modality of payment o f the government’s debt with the Social Security Institute, it remains a potential source of fiscal pressure. (Other r isks of the loan are described in Section IV.)

Table 3. Selected Economic Indicators for Ecuador, 1998-2005

I. National Accounts Gross Investment Gross Domestic Savings Gross Financial Gap

Public Investment Public Savings Public Savings Gap Private Investment Private Savings Private Savings Gap

II.Non-Financial Public Sector Current Revenues

o/w Tax Revenues o/w Oil Revenues

Current Expenditures o/w Interest Expenditures

Capital Expenditures Primary Balance Overall NFPS Balance

o/w Non-oil revenue NFPS balance

III. Balance of Payments Exports of GNFS Imports o f GNFS Trade Balance Worker‘s Remittances

Current Account Balance Foreign Direct Investment Change in Reserves ( -ve implies increase)

IV.Creditwortbiness Indicators Public Debt/GDP Public Debt/ Exports o f GNFS Public External Debt Service/ Revenue I/

V. Banking System Indicators Total Deposits (US$ mln) Non-Performing Loans (as 90 of total loans) Liquidity / Short-term. liabilities (%) R e m s over Equity (%) Private credit growth

Memorandum items: GDP growth GDP in US$ Real exchange rate, 1995=100, apprec = +

25.3 15.9 9.3 3.6 0.2 3.4

21.7 15.8 5.9

19.1 9.9 3.9

18.9 4.2 5.2

-0.9 -5.1 -9.0

21.5 27.3 -4.3 3.4

-9.3 3.6 2.1

67 309 33

4310 8.9

24.5 5.4 2.2

2.1

14.7 20.5 -5.7 3.8 1.3 2.4

11.0 19.1 -8.2

22.5 9.5 6.2

21.2 8.1 6.0 3.4

-4.6 -10.9

31.6 22.1 10.0 6.5 5.7 3.8

-1.0

98 311 31

1953 28.8 26.5 0.8

-29.4

-6.3 k 23,255 $ 16,674

107.7 80.3

20.1 26.4 -6.3 2.9 6.6

-3.7 17.2 19.8 -2.6

27.6 11.7 9.2

21.0 6.6 5.5 7.7 1.0

-8.1

37.1 28.2 9.2 8.3 6.3 4.5 1 .o

87 234 181

2808 34.7 28.2

-25.6 7.6

2.8

25.7 23.2 2.4 3.5 6.3

-2.7 22.1 17.0 5.1

24.3 12.3 6.4

18.0 4.7 6.7 4.3

-0.4 -6.9

27.1 29.0

6.7 -2.4 6.3 0.8

-1.4

67 248 49

3474 13.4 28.5 -5.5 28.1

5.1 k 15,934 $ 21,024

73.3 102.3

25.7 20.7 5.0 4.4 7.4

-3.0 21.3 13.3 8.0

25.9 12.5 5.7

18.6 3.5 6.4 4.5 1.0

-4.7

25.0 29.8 -4.0 5.6

-5.0 5.0 0.2

58 232 22

4256 9.8

24.7 26.5

3.0

25.4 20.2 5.3 3.7 7.3

-3.6 21.7 12.9 8.8

26.7 12.6 6.5

19.4 3.3 5.4 5.2 1.9

-4.6

22.8 28.0 -5.6 5.3

-5.3 4.6

-0.8

50 220 22

3.5 $ 24,347 $ 26,807

112.7 117.7

25.0 21.4 3.6 3.9 7.5

-3.6 21.1 14.0 7.2

26.8 13.0 5.5

19.3 3.4 5.6 5.3 1.9

-3.7

23.8 27.7 -4.5 5.1

-3.6 4.1

-0.6

44 187 21

4.0

24.8 22.0 2.8 3.9 7.4

-3.5 20.9 14.6 6.3

26.5 12.9 4.7

19.1 3.4 5.7 5.1 1.7

-3.0

25.2 27.8 -3.6 5.0

-2.8 3.7

-0.5

40 159 21

4.0 $ 29,080 $ 30,860

121.0 122.1 Term of trade 58.1 75.6 100.0 87.7 86.7 89.3 86.7 84.8 Sources:Central Bank of Ecuador, MEF, IMF, and Bank staff estimates. I / Public external debt service grew substantially in 2000 due to increased amortizations resulting from $5.6 billion in refinancing. Excluding this amount. scheduled Dublic external debt servicdrevenue would have been 47.5%.

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IV. THE PROPOSED LOAN

A. Rationale for Bank Involvement

5 1. The Bank has long supported Ecuador’s structural reforms. Political constraints and adverse circumstances have prevented several administrations from making Ecuador a good performer. The dollarization o f the economy has lef t officials with fewer options. Not only i s fiscal policy the single policy instrument available to deal with exogenous shocks, but structural reforms are the only tools to obtain and preserve gains in productivity, and bring flexibility to the factors o f production, especially labor, under an eventual slowdown of the economy.

52. Progress Under the Previous Structural Adjustment Loan. Ecuador signed a Structural Adjustment Loan ( S A L ) for US$151.2 million in August 2000. During 2000-01, it made progress in supporting efforts to stabilize the economy, create an oi l stabilization fund, modernize public financial management, protect priority social spending, and develop a targeting mechanism to improve the efficacy of social expenditure. The S A L had a mixed performance in financial sector reforms, including improvement of the regulatory framework for intervention, restructuring and resolution of banks, restoring of intervened banks to private ownership, full restructuring of private sector debts owed to banks, and phasing out of offshore banking activities booked in Ecuador. However, little or no progress was achieved in three critical areas: tax reform, expenditure control, and private participation in telecommunications and electricity. In the f i r s t semester of 2002, the agenda o f structural reform was suspended and severe policy slippages occurred. The approval of large increases in the wage bill and social security benefits, the granting o f new revenue earmarking and discretionary tax cuts, and the freezing o f electricity and telecom tar i f fs in April, prevented the signing o f a new Stand-By Agreement with the IMF and led to the cancellation of two floating tranches of the S A L geared to tax reform and public enterprise reform. Only upon arrival of the new Government did the country comply with the remaining conditions for disbursement, and the final tranche of the S A L was disbursed in early 2003.

B. Objectives and Sequencing

53. The proposed single tranche loan, under a multiyear framework, will support the Multiyear Government’s Program described previously (Table 4) and in the Letter of Development Policy (Annex 3). The main objectives are to bring fiscal sustainability, reinitiate structural reforms to provide a sustained recovery with enhanced competitiveness, and mitigate the impact of adjustment on priority social investment that protects vulnerable groups. This fiscal support would help solve the severe short- term liquidity problem, and create fiscal room for smoothing the social costs o f adjustment both in th is operation and in a parallel Human Development Sector Loan. The loan i s based on structural reform measures that have been implemented by the Government prior to Board presentation.

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KEY PRIOR ACTIONS BENCHMARKS BENCHMARKS

M A Y 2003 M A R C H 2004 M A R C H 2005

I. MACROECONOMIC FRAMEWORK AND OVERALI. PROGRAM

The macroeconomic framework is consistent The macroeconomic The macroeconomic with the objectives of the program e framework is consistent a framework i s

with the objectives of the program objectives of the

consistent with the

program

The Government agrees to implement an The Government The Government overall Multiyear Program of Policy Reforms maintains satisfactory e maintains satisfactory (Annex 2) progress in carrying out progress in carrying

the overall Multiyear Program of Policy Reforms (AMW 2)

out the overall Multiyear Program of Policy Reforms (Annex 2)

II. ACHIEVING F~SCAL CONSOLIDATION AND DEBT SUSTAINABILITY

MEF submits to Congress draft legislation to improve tax collection by Customs through (a) a strengthened I R S role on the Customs board, (b) a complete restructuring of Customs, (c) rationalization of Customs personnel, (d) full and timely access to import bills by the IRS, (e) virtual crosschecking information with taxpayer files, (f) severe penalties for underinvoicing import bffls, and (g) improved border control

Executive issues and implements an austerity Decree (Decree No. 44 “Norms for Patriotic Savings”) and the 2003 budget complies with the Decree and the Fiscal Transparency, Stabilization, and Responsibility Law (FTSRL). Key measures of the Decree include (a) freezing of wages for regular civil servants, (b) suspension of overtime allowances, and (c) 10% salary reduction of civil servants with monthly earnings above US$l,OOO. Key ceilings of the FTSRL are (a) a 3.5% cap on real primary spending growth of the Central Government per year, and (b) a reduction in non-oil deficit of the Central Government of 0.2% of GDP per year

MEF and the Ministry of Labor complete a satisfactory final draft of the Public Sector Wage Unification Law. Key components of the Law include (a) consolidation of all salary supplements of central government civil servants into the base wage, and (b) d e f ~ t i o n of the institutional mechanisms to follow up the implementation of the new wage policy

Tax revenue collected by IRS increases by at least 7.5% between 2002 and 2003 due to tax policy measures to broaden the tax base, IRS’s administrative strengthening and Customs modernization

a MEF complies with the austerity Decree in 2003 and the Executive extends i t to 2004

Tax revenue collected by I R S increases by at least 7.5 % between 2003and2004dueto tax policy measures to broaden the tax base, IRS’s administrative strengthening and Customs modernization

MEF complies with the 3.5 % ceiling on real primary spending growth of the Central Government in 2004, set in the F isca l Law

a

e

e MEF completes staffing reviews to register all civil servant positions, verify vacancies, and evaluate functions with responsibilities in the following ministries: Health, Education, Public Works, Agriculture, and Social Welfare

MEF controls the growth of the wage bffl in line with the inflation rate and public employment in 2004, as a result of the new wage policy and civil servants reviews

MEF satisfactorily MEF satisfactorily MEF completes a Transparency Plan with 3 components: e implements the e implements the

A SIGEF-based system to produce Transparency Plan Transparency Plan. monthly, timely, and reliable reports on executed expenditure beginning in mid- 2003, and consolidated NFPS P m u a l statements through the Government’s website (Portal) beginning in 2004 A n e-government system to develop public procurement

22

KEY PRIOR ACTIONS BENCHMARKS BENCHMARKS

MAY 2003 M A R C H 2004 MARCH 2005 A public investment system

MEF has cleared 100% of external public MEF allocates at least debt arrears accumulated up to February 28, e 50% of resources e 50% of resources 2003, and 100% of domestic bonded public accumulated in the debt arrears accumulated up to March 31, FEIREP during 2004 2003 debt reduction for debt reduction

MEF allocates at least

accumulated in the FEIREP during 2003 for

111. PROMOTING FASTER GROWTH THROUGH INCREASING COMPETITIVENESS AND MARKETS FLEXIBILITY

COMEXI issues resolutions to (a) reverse selective import tariff concessions adopted at e to eliminate at least 10% e resolution to eliminate the end of 2002, and (b) unify 100% of total number of import licenses. licenses and simplify number of import

COMEXI issues resolution COMEXI issues

of total number of import

import licensing licenses procedures

at least 10% of total

CONELEC issues a Ministerial Decree to The distribution The distribution adjust electricity tar i f fs for residential e companies adjust the e companies adjust consumers under JOOKwWmonth, starting from an average of about 80% of estimated economic costs reaching a minimum Decree, reaching a

electricity tariff as set in CONELEC’s Decree,

average of 85 % of economic costs for residential consumers for residential below 300KwWmonth consumers below

electricity tariffs as set in CONELEC’s

minimum average of 90% of economic costs

300KwWmonth

C O N A M and the Solidarity Fund

CONATEL awards a third mobile telephony license and C O N A M adopts a strategy to modernize the telecommunication sector. e satisfactorily implement e satisfactorily Key objectives of the strategy include the strategy. implement the designing the process to find a private strategy, including the administrator to manage ANDINATEL and signing of management PACJFICTEL, and define incentives to contract@) with a attract a private firm to invest in Telecsa private

administrator(s) of A N D I N A T E L and P A C I F I C T E L

The Ministry of Labor ML issues a Decree to (ML) completes an e de-link the automatic assessment of the labor salary indexation market under a mechanism from the consultative process with inflation rate workers and entrepreneurs

C O N A M and the Solidarity Fund

54. In support of the Multiyear Government’s Program, and as part of the CAS, the Bank also envisions two eventual Programmatic operations, to be prepared separately over the next two years. The Government’s Program i s built around FCCGL main goals: First, achieving fiscal consolidation through (a) a sound budget framework; (b) enhancing revenue management; (c) improving expenditure management with austerity, transparency, and accountability, and tight control of the wage bill; and (d) prudent debt management; and second, promoting faster growth with competitiveness based on (a) competition and trade reform policies; (b) solid pricing and regulatory policies to attract investment in key basic infrastructure sectors; and (c) increasing labor market flexibility. While the f i rst phase o f the Government’s Program-supported by this operation-will focus on short-term adjustment aspects required to put the economy on a fiscal sustainability and debt solvency path, the second and third phases w i l l consolidate and deepen the structural reforms-labor, trade, pricing, and regulatory policies needed to attract private sector participation-in the medium term. This operation has also provided technical assistance in the design o f sector policies and strategies, the adoption o f the legal and regulatory

23

framework that w i l l lay the ground for reforms, and the implementation o f consensus-building activities with c iv i l society; and the preparation of policy tools that w i l l facilitate achievement o f a transparent and participatory budget management.

C. The Proposed Loan Components

55. The proposed FCCGL covers the two areas discussed above: fiscal consolidation, and faster growth with competitiveness. Under the first area, the following components are considered: overall fiscal framework, revenue management, public expenditure management, public payroll control, and public debt. Under the second area, the following components are included: competition and trade policies, pricing and regulatory policies o f basic infrastructure services for growth, and labor market flexibility. Although the Program has specific measures assigned to al l areas, as indicated in the Letter o f Development Policy, there i s a reduced set o f key prior actions adopted for this operation, and benchmarks among an anticipated set o f actions under the second and third phases o f the Multiyear Government’s Program. Those actions are interrelated and represent the blueprint o f core policy actions o f the overall Multiyear Government’s Program. The l i s t o f future policy actions may be modified as the Government gains experience through further studying and implementing i ts reform agenda.

56. The first phase of the Government’s Program, supported by this operation, emphasizes the first two objectives because they are most urgent: stability and fiscal consolidation. I t defines an overall macroeconomic framework and a comprehensive program that are consistent with budget constraints. Specific policies on the revenue side focus on tax administration: the modernization of Customs administration with IRS support. These measures would raise tax collection and facilitate crosschecking o f taxpayer files with the IRS. Then, on expenditure management, i t begins with the liquidity fiscal problem by issuing an emergency austerity Executive Decree and obtaining from Congress a 2003 budget that i s consistent with i t s norms. As prior action, officials have implemented the Decree, in agreement with the Fiscal Law, which proved particularly helpful during Congress’s attempts to increase the 2003 budget. Because the austerity Decree i s insufficient to halt the main cause o f expansionary spending, the wage bill, officials have also submitted to Congress a Public Wage Unification Law. On public debt, the clearance o f external and domestic arrears accumulated up to February and March 2003, w i l l contribute to successful Paris Club negotiations next June. To complete fiscal measures, officials have prepared a Transparency Plan. The Transparency Plan should produce, in 2003, timely and reliable reporting o f executed expenditure, and from 2004 onward, the modernization and consolidation o f NFPS accounts. This operation also supports implementation o f structural changes in the areas o f trade reform, and electricity and telecommunications. With respect to trade reform, the Government intends to reverse distortionary decisions that raised tariff dispersion and effective protection by end-2002. It has unified all import licenses, and i s committed to eliminating those that have been unused for several decades, a critical measure for complying with WTO standards. With respect to electricity and telecommunications, the Government has adjusted power rates, awarded a third mobile phone license and prepared a strategy to increase the efficiency o f the public telephone companies, ANDINATEL and PACIFICTEL, while finding a private investor for Telecsa, the third mobile phone company recently created by ANDINATEL and PACIFICTEL. The phasing-in o f the program recognizes that fiscal adjustment can bring early credibility and achieve public savings needed to finance investments for poverty reduction, while structural changes in the basic infrastructure sectors should f i rs t adjust prices toward reaching real economic reforms, while preparing the studies needed to engage in more complex regulatory reforms.

57. The second phase of the Government’s Program, scheduled for March 2004, would preserve progress achieved in 2003 and set the stage for important medium-term structural reforms. On the revenue side, measures to broaden the tax base, improve tax administration, and modernize Customs would contribute to effectively raising i t s collections by no less than 7.5 percent in annual terms. On the expenditure side, austerity measures would be extended and broadened to 2004, to

24

comply wi th a critical benchmark in the Fiscal rule: compliance with the 3.5 percent ceiling in real primary spending growth in 2003 and 2004. In parallel, the Government would reach a major milestone in human resource management reform, by completing the staffing reviews o f ministries accounting for most o f the national government’s labor force. In the transparency and debt-reduction areas, officials are also committed to implementing two respective plans satisfactorily, and in particular to strengthening their fiscal rules by devoting no less than 50 percent o f resources transferred to FEIREP to debt reduction. On the growth and competitiveness front, a new Competition Law should be submitted to Congress by end-2003, and trade reform would continue, deepening the number o f import licenses eliminated. Power tariff adjustments would proceed in accordance with the schedule set by CONELEC’s Decree up to 85 percent o f economic costs. In addition, a private investor i s expected to have invested in Telecsa by March 2004. Finally, the Government i s committed to preparing a full assessment o f labor market conditions under a consultative process in the second operation. Additional anticipated actions in the second operation are included in the Government’s program in the following areas: fiscal framework; tax policy and administration; overall expenditure control; public wage bill control; public debt; competition and trade policies; pricing and regulatory policies in basic infrastructure-water, power, telecommunications, and oil; and labor markets reform.

58. The third phase of the Government’s Program would emphasize achieving outputs. B y March 2005, customs revenue would reach another 7.5 percent annual increase. Fiscal rules would be strengthened by devoting, again, no less than 50 percent o f resources transferred to FEIREP to debt reduction. MEF would have executed the budget in compliance with the ceilings o f the extended austerity Decree and would have retaken control o f the real growth o f the wage bill in 2004, in line with the inflation rate and public employment rationalization. On the structural front, further import licenses would be eliminated, and power tar i f fs for consumers under 300Kw would reach 90 percent o f their average economic cost, with the exception o f some low-income consumers, s t i l l benefiting temporarily from a reasonable social tariff. A private administrator would have been found to manage ANDINATEL and PACIFICTEL by March 2005. Following consultations, the Labor Ministry would have de-linked automatic salary adjustments from the inflation rate. All actions would have a renewed emphasis on accountability, transparency, and promotion o f c iv i l society participation.

D. Links to Country Assistance Strategy and Other Bank Operations

59. The Country Assistance Strategy for Ecuador has identified three pillars o f the Government’s agenda: (a) consolidating the macroeconomic framework to lay the foundation for diversified and sustainable growth and poverty reduction, (b) making needed structural reforms socially sustainable and mitigate their impacts on the poor and the vulnerable, and (c) strengthening governance and helping officials build an accountable and efficient government the services o f which are accessible to al l Ecuadorians. The present operation f i t s in the f i rs t pillar, the parallel Bank Programmatic operation on Human Development Sector Reform f i t s in the second pillar, and both operations propose measures to address institutional constraints (third pillar). These operations are scheduled jointly with the CAS for Board presentation on 27 May 2003.

60. The Programmatic loan on Human Development Sector Reform has complementary objectives to th is operation. I t aims to protect the most vulnerable during adjustment, and to support the design and implementation o f structural changes in the social sectors, to increase the effectiveness and efficiency o f basic social programs, and promote consultation, transparency, and accountability in the social sectors and priority programs. More specifically, i t assures minimum levels o f budgeted public spending in priority social sectors--education, health, and social welfare-and programs; extends coverage and improves targeting o f social services; and improves transparency in the administration o f resources, and facilitates access to information by managers and usersheneficiaries.

25

61. Coordination with other Bank activities in Ecuador, currently under preparation and implementation, will be assured. Policy-based credits would be complemented by other instruments, such as technical assistance and investment credits directed toward solving some o f the institutional problems or investment needs o f the areas affected by this loan. Two Bank operations are related to th i s operation. The Public Sector Financial Management Technical Assistance project would provide assistance in introducing improved budget monitoring and consolidation through the SIGEF-Institutional system in several key autonomous agencies, and integrating these more fully into the SIGEF-Global network. The Bank Project PROMEC in the electricity sector i s providing assistance to the institutional modernization o f the sector, and i s implemented in close collaboration with the Inter-American Development Bank (IDB). On analytical and advisory activities, the Bank has just completed a set o f Policy Notes, covering 18 topics and underlying the design o f the CAS and the two operations. A Public Expenditure Review, a Poverty Assessment, and a Labor Market Reform are also under preparation for fiscal 2004; which wil l provide the basis for advancing the reform agenda to further stages based on their analytical underpinnings.

62. This operation was prepared in parallel to and in close coordination with the IMF, which required an extraordinary amount o f bilateral technical dialogue and coordinated views with officials, who welcome such efforts. Topics o f common preparation have been Fiscal law, Custom reform, the austerity Decree, and a public sector wage unification law. Topics for further collaboration in the second and third phases o f the Government’s Program also involve tax and trade reform. Whereas the SBA mainly focuses on short-term measures to be adopted in the next 13 months, the GOE’s Multiyear Program agreed with the Bank also endorses and brings continuity to key adjustment efforts over a longer term, while deepening reforms such as budget transparency, debt management, and trade and o i l sector reform, and providing assistance to areas where the Bank has technical and financing expertise, such as Customs and budget modernization, c iv i l service and labor market reforms, and private participation in basic infrastructure sectors. Finally, close collaboration with the IMF in the area o f pension reform i s expected with the Bank’s Programmatic loan on Human Development, and continuous joint efforts in financial sector reform (see para. 19).

Collaboration with the IMF.

63. Coordination with other multilateral institutions. Two other multilateral institutions-the IDB and the Corporucidn Andina de Foment0 (CAFbhave also announced their intentions to contribute to financing a support package o f about US$500 mill ion in 2003 to fill the fiscal financing gap. The IDB i s preparing an operation in the social sectors, the matrix o f policy actions o f which has been prepared in parallel to one o f the Bank’s operations on human development. The IDB’s operation i s mostly focused on strengthening the social safety net, protecting public spending in the social sectors, and promoting some structural changes in education and in labor markets. The Bank‘s and the IDB’s teams have been working closely to assure the maximum coordination between the two operations, including joint missions and meetings with Government officials to discuss the contents o f the operations. The CAF has also offered fast-disbursing resources for fiscal adjustment and economic recovery.

E. Arrangements for Management, Implementation, and Supervision

64. The Government of Ecuador would be the Borrower of the proposed Adjustment Loan and the Ministry of Economy and Finance (MEF) will be the principal executing agency and would have overall responsibility for coordinating and overseeing al l aspects o f the Program. The Ministry o f External Trade, Industrialization, Competitiveness and Fishing (MICIP), the Ministry o f Urban Development and Housing (MIDUVI), the Ministry o f Labor (ML), the Development State Bank (BEDE), the Foreign Trade and Investment Council (COMEXI), the Power Regulatory Council (CONELEC), the Telecom National Council (CONATEL), the National Council for Modernization (CONAM), the Ministry o f Energy and Mines (MEM), and the Internal Revenue Service (IRS) would

26

also have key roles in executing the program, and would work closely with the MEF in executing Program components under their respective jurisdiction. The MEF would be responsible for providing periodic reports to the participant’s public agencies on overall Program progress, and for informing the Government and the Bank. The GOE and the Bank would consult on progress quarterly during implementation. The closing date of the loan would be December 31,2003.

65. Ecuador has a poor record in implementing adjustment operations with Bank and IMF programs. However, the single tranche approach to adjustment lending bases Bank support on actions the Government has already taken, rather than on conditions of future actions. This provides an opportunity for a new Government to build a track record by demonstrating i t s commitment to reforms, and for the Bank to provide financial support aligned to the strength and pace of the Government’s reform. This single-tranche approach incorporates lessons learned from previous adjustment operation, and from the Operation Evaluation Department’ s 1999 Country Assistance Evaluation. Implementation of the Multiyear Government’s Program would be monitored through frequent missions (every two months) and continuous supervision through videoconference technology facilities of the information system of the country office. Although supervision wi l l mainly focus on fulfillment of policy results and benchmarks, the presence of policy reversals and the implementation of other anticipated actions wi l l also be assessed. Moreover, reviews would be supported by technical assistance and advisory services to be carried out during supervision missions, previously requested by officials.

F. Consultations with Stakeholders

66. Consultations with civil society have taken place in stages. The preparation of the operation has opened extraordinary opportunities for an ongoing dialogue with civil society organizations (CSOs) on how best to involve the Bank‘s support in fiscal growth and poverty-reduction programs. Previous consultations took place at several stages. They accompanied implementation of the previous S A L during 2002. Then, in January 2003, a one-day workshop with the incoming officials, advisors, academia, the private sector, and selected civil society representatives on the presentation of the Policy Notes provided a unique opportunity to exchange views openly and candidly on the country’s development agenda. A week after the Government took office, the Bank’s representative in Ecuador participated in the National Dialogue that has examined some of the topics considered by this operation. In February, CAS consultations took place with civil society in several parts o f the country, providing valuable insights about the perception o f civil society about the Bank‘s work and role in Ecuador.

67. Outcomes of dialogue with civil society. Before setting definite loan policy priorities, on 25 March 2003 a one-day workshop, was held with NGOs, and indigenous and other CSOs in Quito. I t examined the two parallel operations and solicited reactions and suggestions on the contents, sequencing, and r isks of these operations. Results from the consultations revealed substantial common ground among participants, as well as some differences, and contributed to reshaping the loans in several ways, including (a) the importance of combining macroeconomic stability with fiscal responsibility, and of adopting measures to sustain economic recovery as the main vehicle for creating employment; (b) the validity of the Bank‘s approach to complement this operation with another addressing the social sector needs, but especially i t s structural programs; (c) the perception that decentralization i s not among the f i r s t priorities of the new Administration, and confmation that the GOE’s focus i s on immediate fiscal emergency needs; (d) the need to adopt measures strengthening budget transparency, because this i s the only tool that allows CSOs to actively participate in formulating the budget and to audit i t s implementation; (e) the disagreement o f some CSOs with the GOE’s decision to devote a large amount of oi l resources to repaying debt, instead of financing social programs; (f) the need for ex ante dialogue with CSOs on specific incoming reforms, such as civil service and tax reform; and (g) the suggestion that dialogue with CSOs be institutionalized, and that the Bank and other donors take some leadership in encouraging the

27

Government to organize consensus-building processes. Such consultations should be considered as the initial step in a continuous process o f dialogue leading to continuing reforms in the upcoming months.

G. Safeguard Arrangements

68. fiscal and regulatory changes that do not have environmental impacts. OD8.60 applies, and no environmental assessment i s required.

Environmental assessment. This operation i s a structural adjustment loan. The loan supports

69. Social assessment. The program has been supported by sector Policy Notes that have illustrated the major issues affecting beneficiaries and stakeholders. Therefore, with th is background and consultative process that i s envisioned, a specific social assessment i s not being considered. Further consultations and preparation o f the details o f measures to be undertaken in Phases 2 and 3 o f the Government’s Program might constitute social assessments for these phases. In addition, under the First Programmatic Human Development Sector Reform Loan program, social objectives are being addressed and a follow-up social assessment i s being scheduled in Phases 2 and 3.

70. A weak policy and institutional environment compromises the effectiveness o f lending and nonlending interventions. In weak environments adjustment lending can be a risky instrument. Notwithstanding recent progress, the Bank’s Country Policy and Institutional Assessments Rating (CPIA) for 2002 for Ecuador assigned a rating o f 2.5 out o f a possible 6 for the Quality o f Budgetary and Financial Management. Ecuador was ranked 26 out o f the 28 countries rated in the Latin America and the Caribbean Region. Progress includes recent approval o f two laws. As part o f the Public Financial Management Action Plan that supported the S A L o f June 2000, the Law o f Fiscal Control and Auditing was approved in May 2002. To improve the efficiency o f the public sector, the Law of Fiscal Transparency, Stabilization, and Responsibility and i t s enabling regulations received congressional approval by end-2002. Another important piece o f legislation, the Public Financial Management Law, i s awaiting approval by Congress. This law would apply the principle o f centralized standard setting and decentralized operations, enabling the various agencies to assume responsibility for their own financial management. Another important development has been the Integrated System o f Financial Management (SIGEF), because successive Governments have viewed the modernization of public financial management as crucial to aligning expenditure more closely with policy priorities. Through the State Modernization Project (MOSTA), which ended in March 2001, and the S A L referred to above, SIGEF was designed. I t also included a debt management tool supported by SIGADE. National budgets are now being formulated in consultation with spending ministries. SIGEF has been implemented in over 60 entities including l ine ministries and their provincial offices, autonomous entities, sectional governments, and affiliated entities. A database consolidation module has been completed and it has been used to prepare consolidated financial accounts and the last two national budgets.

Financial management.

71. The risk of reversing reforms in financial management i s high. On one hand, a follow-up operation for SIGEF approved by the Bank in February 2002 to consolidate financial management and control, expand i t s coverage, upgrade the technological base, develop the Contraloria General del Estado (CGE) audit capacity, and establish organizational functional support to ensure medium-term sustainability o f the reform i s s t i l l not effective. Failure to implement it, or implementation of a reduced scope, poses substantial r isks to effective and reliable financial management and control by officials. On the other hand, several Bank-financed projects have experienced delays in implementation, due to lack o f counterpart funds or untimely allocations. Moreover, most Project Implementing Units possess financial management arrangements that meet minimum Bank requirements and have received unqualified opinions on their annual financial statements. During fiscal 2002, most projects did not comply with loan covenants regarding the submission o f audit reports. Delays in the submission were attributed to lack o f coordination between the projects and the CGE, and procedural delays in contracting o f auditors and in

28

the review o f f inal audit reports by the CGE (prior to delivery to the Bank). To mitigate financial management risk, officials have agreed to prepare a Transparency Plan in this operation, based on a revamped SIGEF,3 which w i l l adopt new measures and a chronogram. Key objectives o f the plan are to produce monthly, timely, and reliable reports on executed expenditure; to consolidate fiscal accounts; to facilitate virtual access to fiscal accounts; and to support production o f financial reports by public enterprises and Regional Development Organizations (RDOs). In addition, a Country Financial Accountability Assessment (CFAA) i s planned for fiscal 2004. The results o f th i s assessment are expected to contribute to Ecuador’s economic development by identifying weaknesses in Public Financial Management Systems and Practices, and making recommendations for improving efficiency, transparency, and accountability. Upon completion o f the diagnostic work, additional specific actions could be built into the Program Policy Matrix. Regarding audit arrangements, during 2002, a Memorandum o f Understanding was reformulated and approved by the Bank and the Controller General of the State (CGE), which enhances oversight o f the independent audits o f projects and aims at improving the timeliness and quality o f audit reports. Also, during fiscal 2003 a Pilot Capacity Assessment o f Private Audit Firms in Ecuador was conducted. The assessment revealed that there i s unevenness in the institutional capacity, audit methodology, and engagement practices o f f m s , when benchmarked against international standards on auditing. As a result o f th is assessment, recommendations have been made to the CGE on the acceptability o f f m s to conduct audits o f Bank-financed projects. I t i s expected, therefore, that the r isks to Bank funds posed by uneven quality o f audits w i l l be reduced.

72. Procurement. The overall procurement risk o f Ecuador’s portfolio i s rated High in the Country Procurement Assessment Report (CPAR). Consequently, the GOE and the Bank have agreed on specific issues and necessary reforms that are essential to achieve transparency, competition, economy, and efficiency in managing the public contracting system. These are included in the CPAR’s Action Plan that was accepted by the GOE in 2000. The new Government has confirmed i t s commitment to achieving these objectives. A key reform included as a benchmark for the second stage o f the Government’s Program concerns a new procurement law. Key principles o f the bill wil l include (a) streamlining procedures for the procurement o f works and goods, (b) incorporating revised consulting standards, (c) facilitating the use o f electronic technologies in public procurement, and (d) creating and implementing a national regulatory body to enforce the procurement laws and regulations. In addition, the GOE i s interested in developing an E-Government system for the procurement o f goods, works, and services at al l levels of government and, as part o f the third phase o f i t s Program, it has agreed to complete the establishment o f a COMPRA.NET system for electronic public bidding. Finally, a measure that w i l l contribute to mitigating procurement risk under the program itself would be improved budgetary control through an improved SIGEF, and strengthened capacity o f the Comptroller General’s Office to audit ministry and agency accounts. Individual projects have generally made their own provisions for procurement to minimize procurement risk. In the present Program, there i s no specific procurement against a “positive list,” with the exception o f some goods and services that may be procured as part o f the support for the eventual preparation o f future operations. Procurement in this operation w i l l simply follow the Bank’s guidelines.

73. Eventual preparation of future Programmatic loans. Immediately following disbursement o f this loan, the GOE would initiate work on the actions contained in the second and third phases o f i t s Program. A detailed schedule o f these activities and budget would be prepared with the Bank‘s support at

~

3. A revamped SIGEF should include the following minimum modifications: (a) a consolidated budget for the Non- Financial Public Sector; (b) disaggregated reporting o f actual revenues and executed expenditure by financing source and budgetary item, and in conformity with the IMF Manual o f Public Finance; (c) disaggregated and unified reporting of executed expenditure between Treasury and Budget at the MEF, to reflect floating debt; (d) an interface between the budget and public credit modules to have a common database; (e) a module for human resource management; and ( f ) a module for subnational governments.

29

that time. Financing o f these activities may be sought through the Project Preparation Facility o f future Programmatic operations or, if possible, through PHRD grants.

H. Loan Disbursement

74. The single-tranche adjustment loan amounts to US$50 million. The entire amount w i l l be disbursed upon effectiveness, soon after approval. The preparation o f future Programmatic operations and the definition o f their specific amounts, would be decided as a function o f the country’s performance under the Bank‘s country strategy and under the Multiyear Government’s Program. The basis for the preparation o f these loans w i l l be the fulfil lment o f benchmarks described in the Policy Matrix o f Reforms (Annex 2). Disbursement arrangements for the present operation would follow the simplified procedures for SALs/SECALs approved by the Board on 1 February 1996. The Borrower w i l l open an account in Ecuador’s Central Bank (Banco Central del Ecuador). Once the Bank formally notifies the borrower that a tranche i s available for withdrawal, the borrower may submit a simplified withdrawal application so that the proceeds o f the tranche are deposited by the Bank in this account, for use in accordance wi th the Loan Agreement. Disbursements w i l l not be linked to specific purchases, and supporting evidence for disbursements i s therefore not required. The proceeds o f the loan may not be used to finance expenditures typically excluded under the Loan Agreement. Although a routine audit o f the deposit account would not be required, the Bank reserves the right to request that an audit be conducted in accordance with International Standards on Auditing, by an independent firm acceptable to the Bank. If requested, the audit w i l l be performed in accordance with terms o f reference approved by the Bank.

I. Benefits and Risks

75. The main overall benefit of the loan i s to contribute to poverty reduction in Ecuador through two complementary ways. First, the reform program w i l l bring fiscal accounts to a more sustainable path. Most o f the proposed measures carry fiscal implications, which are estimated to produce init ial net fiscal savings o f about 2 percent o f GDP. Fiscal reforms w i l l also strengthen countercyclical fiscal institutions and rules; improve the efficiency o f tax collection by the I R S and Customs; contribute to reducing country risk, which should induce a fal l in domestic interest rates and have a lasting impact on economic recovery; and free resources for financing priority social programs. Second, the reform program w i l l accelerate economic growth through structural change aiming to increase productivity and flexibilize markets, especially labor. As a result, the loan w i l l contribute to increased private sector participation and investment in basic infrastructure-water, power, telecommunications, and oil-sectors, attracted by a more competitive framework, a more open economy, sound pricing and regulatory policies, and more flexible markets.

76. Results and Monitoring Indicators. The main specific outcomes expected from the Multiyear Government’s Program are derived from prior actions and benchmarks agreed in the matrix o f policy reforms (Annex 2). On revenue management, Customs modernization and tax reform should lead to increased tax revenue collected by the IRS n o less than 7.5 percent per year. On expenditure management, sustained implementation o f austerity measures through 2003 and 2004 should lead to to 5 percent o f GDP primary surpluses, and compliance with the 3.5 percent cap on real primary spending o f the Fiscal Law. On civi l service reform, the unification o f public sector wages and further measures taken to rationalize public employment should lead to negative growth o f the wage payroll in real terms. On transuarencv measures, the implementation o f the Transparency Plan should produce virtual access to timely and reliable reports on executed NFPS consolidated expenditure and the establishment o f an e- public procurement and national investment systems. On debt management, Ecuador has cleared most domestic and external arrears, and should allocate no less than 50 percent o f FEIREP accumulated annual proceedings to debt reduction. On trade reform, al l import licenses are unified and about 20 percent o f

30

them, considered as ineffective, should be eliminated in a process o f effective simplification o f import licensing procedures. On power sector reform, electricity tari f fs should continue adjusting, reaching no less than 90 percent of average costs by March 2005. On telecom reform, the strategy to improve the efficiency of ANDINATEL and PACIFICTEL should lead to effective investments by a private investor and the signing o f management contracts o f both companies with a private fm. Finally, on labor market reform, the concertation strategy o f the Government should lead to effective salary adjustments below the inflation rate. The matrix also includes a full set o f monitoring indicators. The social impact o f the key measures adopted in this operation-tariff increases, reduction o f subsidies, and so forth- w i l l be evaluated in the poverty assessment work planned for fiscal 2004.

77. All prior actions under this operation have already been achieved, but the risks of policy reversals or weak implementation of the Multiyear Government's Program are high. Indeed, the Program faces a number o f domestic and external r isks that may pose a threat to fiscal stability and economic recovery. All r isks mentioned below might lead Ecuador not only to fail to maintain a proper macroeconomic framework and to depart f rom the Program o f reforms agreed under th is operation, but also to abandon dollarization. In particular:

0 Political risk. Political opposition in Congress remains strong and coalitions are fragile. To mitigate this risk, the new Administration i s developing a continuous dialogue wi th members o f Congress and political forces on a commonly agreed agenda. The Bank i s assisting such conversations on an ad hoc basis and, in coordination with other donors, i s supporting the approval o f key Government bills submitted as part o f the agenda o f reforms, minimizing the need for new laws and contributing to creating consensus on reforms. As coalitions develop, though, the reform agenda, priorities, and timing can depart from those outlined in Annex 2. I t i s impossible to predict whether the actual program w i l l be more or less robust in any given element than the one the Government has outlined here, but World Bank policy dialogue should help the Government to mitigate the r isks o f weaker program Outcomes.

0 Social risk. The fragile coalition that supported President GutiCrrez could break up, and ensuing political unrest could prevent the government from implementing key adjustment or structural reform measures. To mitigate social risk, the GOE i s committed to developing a national dialogue with union and indigenous leaders. B y increasing social spending and enhancing the coverage and delivery effectiveness o f basic public services, the government also hopes to limit the impact o f i t s policy actions. These efforts are complemented by the Bank's continuous dialogue with representatives o f civi l society and assistance to the Government in formulating and implementing social programs aimed at protecting the poor and the most vulnerable groups, particularly with the financial support o f the Programmatic Social Loan.

0 External risks. Given dollarization and the absence o f any meaningful lender o f last resort for the banking sector, external economic shocks-especially a severe decline in the price o f oil, competitive depreciations by neighbouring countries, or partial sudden stops in capital flows to the region-might make a deflationary fiscal adjustment socially unbearable and put the fragile banking recovery at risk. To mitigate these external risks, the government i s strengthening i t s capacity to respond to shocks countercyclically by improving its institutions to develop a countercyclical policy and replenishing the o i l stabilization fund (FEIREP), clearing arrears and repaying debt, increasing the share o f non-oil fiscal revenues, diversifying non-oil exports, strengthening prudential regulations and creating a liquidity fund for commercial banks, increasing labor market flexibility, and encouraging competitiveness and private participation in key investment sectors.

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0 Debt overhung risk. High debt service could affect fiscal sustainability and impede Ecuador from fully clearing past arrears, or could engender the accumulation o f new arrears in the near term. To mitigate i t s debt-overburden risk, the Bank i s assisting Ecuador in resuming bilateral debt rescheduling agreements with the Paris Club, defining a comprehensive debt-reduction strategy, and strengthening debt management.

0 Zmplementution risk. Given Ecuador’s past performance, there might be a strong need to support limited local capacity o f officials in developing such a comprehensive program rapidly and successfully. To deal with such risk, the Bank intends to strengthen field supervision, develop joint supervision missions with the MI?, and combine several additional instruments including, for example, technical assistance, advisory services, and grants for building capacity and training.

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Annex 1. Key Economic Indicators

Prelim. Projection _______________________ Indicator 1998 1999 2000 2001 2002 2003 2004 2005

National accounts (as % of GDP) Gross domestic producta

Agriculture Industry Services

Total Consumption Gross domestic fixed investment

Government investment Private investment

Exports (GNFS)b Imports (GNFS)

Gross domestic savings Gross national savings'

100 100 100 14 12 11 23 29 35 63 60 55

82 79 74 20 17 20 4 4 3

16 13 18

21 32 37 28 25 31

18 21 26 15 18 24

Memorandum items Gross domestic product 23266 16682 15942 (US$ million at current prices) GNI per capita (US$, Atlas method) 1750 1420 1270

Real annual growth rates (%, calculated from 2000 prices) Gross domestic product at market prices 2.1 -6.3 2.8 Gross Domestic Income -2.6 -4.3 6.8

Real annual per capita growth rates (%, calculated from 2000 prices) Gross domestic product at market prices Total consumption Private consumption

Exports (GNFS)b Merchandise FOB

Imports (GNFS)~ Merchandise FOB

Resource balance Net current transfers Current account balance

Net private foreign direct investment Long-term loans (net)

Balance of Payments (US$ millions)

Official Private

Other capital (net, incl. errors & ommissions)

Change in reservesd

Memorandum items Current account balance (% of GDP) Real annual growth rates

Merchandise exports (FOB)

Merchandise imports (CIF) Manufactures

0.1 1.6 2.5

5007 4203 6337 5198

776 -1330

-2 169

83 1 815 188 627 63

460

-9.3

-5.3 -2.3 25.2

-8.1 0.9 -8.6 2.0 -8.8 1.9

5263 5912 4451 4927 3687 4499 2786 3469 1576 1413 1101 1360 955 1004

636 720

17 1 171 -645 -371

-816 -542 -1438 -1188

492 -165

5.7 6.3

-4.0 8.0 0.3 8.0

-42.4 4.5

100 9

29 62

79 22 4

18

27 31

21 20

21024

1300

5.1 -0.6

3.2 2.9 3.5

5697 4678 6100 4981

1665 -403

-510

1330 859

1179 -320

-1832 153

-2.4

0.8 0.8

24.5

100 9

29 62

81 23 4

18

25 31

19 19

24347

1490

3.0 6.8

1.2 6.0 2.2

608 1 4953 7264 5928

1590 -1183

-1215

1216 1893

49 1844

-207 1 177

-5.0

0.5 0.5

15.5

100 9

29 62

80 25 4

22

23 28

20 26

26807

1770

3.5 6.3

1.7 3.2 0.9

6125 4958 7494 6452

-1369 1639

-1410

1246 256 139 117

48

-5.3

-1.8 -9.6 2.4

-140

100 9

30 62

79 25 4

21

24 28

21 27

29080

1960

4.0 3.2

2.2 -0.6 -0.7

6912 5625 8050 6920

1731 -1139

-1039

1200 34

-398 432

28 -223

-3.6

14.6

5.2 -2.7

100 8

30 61

78 25 4

21

25 28

22 27

30860

2080

4.0 3.4

2.3 -0.9 -0.9

7785 6268 8580 7381

1745 -796

-865

1150 -197 -49 1 294 96

-184

-2.8

11.6 0.4 4.6

(Continued)

33

Annex 1. Key Economic Indicators, continued

Public finance (as % of GDP at market prices)e Current revenues 19.1 Current expenditures 18.9

0.2 Capital expenditure 5.2 Primary Balance -0.9 Overall Balance -5.1

Current account surplus (+) or deficit (-)

Monetary indicators M2lGDP Growth o f M2 (%)

22.3 -14.9

Price indices (1987-100) Merchandise export price index 119.2 Merchandise import price index 150.3 Merchandise terms o f trade index 79.3 Real exchange rate (US$LCUf 107.7

Consumer price index (% change) 36.1 GDP deflator (% change) -3.7

22.5 21.2

1.3 6.0 3.4

-4.6

21.7 -30.1

131.4 141.2 93.1 80.3

52.3 -23.5

27.6 21.0 6.6 5.5 7.7 1 .o

25.3 11.1

134.7 166.7 80.8 73.3

96.1 -7.0

24.3 18.0 6.3 6.7 4.3

-0.4

24.1 26.1

126.8 192.9 65.7

102.3

37.7 25.5

25.9 18.6 7.4 6.4 4.5 1.0

24.5 17.4

134.9 200.4 67.3

112.7

12.5 12.4

26.7 19.4 7.3 5.4 5.2 1.9

27.8 25.0

136.2 196.4 69.4

117.7

7.9 6.4

26.8 26.5 19.3 19.1 7.5 7.4 5.6 5.7 5.3 5.1 1.9 1.7

29.4 29.4 14.9 6.1

134.8 134.6 200.3 204.3 67.3 65.9

121.0 122.1

4.5 2.1 4.3 2.0

a. GDP at market prices b. "GNFS" denotes "goods and nonfactor services." c. Includes net unrequited transfers excluding official capital grants. d. Includes use of IMF resources. Negative implies increase in reserves. e. Non-financial public sector. f. "LCU' denotes "local currency units." An increase in US$/LCU denotes appreciation. Base year = 1995 g. Period average

34

Annex 1. Key Economic Indicators, continued

Kev Emosure Indicators I . Prelim. Projection . . . . . . . . . . . . . . . . . . . . . . .

Indicator 1998 1999 2000 2001 2002 2003 2004 2005 Total External Debt

Total debt stock (TDO) (US$m)a 16331 16282 13416 14221 16083 14714 14646 14394

Total debt service (TDS) (US$m)" 7576 6581 11964 6756 6901 7172 7167 7267 Net disbursements (US$m)" 1080 -297 -2536 1297 1643 210 -68 -252

Debt and Debt Service Indicators (%) TDOXGS~ 275.9 253.5 183.8 198.6 214.7 193.7 173.5 153.6 TDOlGDP 70.2 97.6 84.2 67.6 66.1 54.9 50.4 46.6 TDSRGS 128.0 102.5 163.9 94.4 92.2 94.4 84.9 77.6 ConcessionaVTDO 11.8 12.6 15.1 13.5

Public External Debt External debt stock (US$mIa 13171 13752 11187 11183 11183 11034 10584 9997

Debt service (US$m)a 1384 1078 7947 2492 1418 1531 1530 1637 Net disbursements (US$m)a 507 392 -2230 490 -213 116 -450 -587

Public Debt and Debt Service Indicators (%) Total Public Debt/GDP 66.6 98.3 86.7 67.3 57.9 50.3 44.5 40.2

o/w external 56.6 82.5 70.2 53.2 45.9 41.2 36.4 32.4 Public Interest Paymenmevenue 22.1 35.9 24.1 19.4 13.3 12.3 12.8 12.7 Public Ext. Debt Service/ Revenue 31.2 28.7 181.0 48.8 22.4 21.4 19.7 20.0 Public Ext. Debt Service/ XGS 23.4 16.8 108.9 34.8 18.9 20.2 18.1 17.5

IBRD exposure indicators (%) IBRD DS/public DS 9.1 10.8 10.8 8.2 8.6 8.8 7.4 6.8 Preferred creditor DS/public DS (%) 33.0 38.1 33.9 30.1 34.5 44.9 49.0 46.6 IBRD DS/XGS 2.2 2.2 2.2 1.9 1.9 1.8 1.4 1.2 IBRD TDO (Us$mId 854 861 862 898 835 869 891 928 Share of IBRD portfolio (%) 1 1 1 1 1 1 1 1 IDA TDO (us$mld 23 22 21 20 19 18 17 16

a. Includes public and publicly guaranteed debt, private nonguaranteed, use of IMF credits, net short-

b. "XGS" denotes exports of goods and services, including workers' remittances. c. Preferred creditors are defined as IBRD, IDA, the regional multilateral development banks, the IMF, and the

Bank for International Settlements. d. Includes present value of guarantees. e. Includes equity and quasi-equity types of both loan and equity instruments.

term capital, and refinancing and condonation. Debt service in 2000 includes refinancing of $3.5 bln of Brady bonds.

35

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m d

REPUBLICA DEL ECUADOR

MINISTERIO DE ECONOMIA Y

FINANZAS

Quito, Ecuador April 28,2003

Mr. James D. Wolfensohn President The World Bank Group Washington, D.C. 20433

Dear Mr. Wolfensohn:

1. This letter outlines the Government's program of reforms to revert the deterioration in Ecuador' s social, economic, and financial conditions experienced in recent years,.and place the economy in a sustainable growth path with greater equity and opportunities for the poor. T h i s multiyear program i s supported by the World Bank through an Adjustment Loan for Fiscal Consolidation and Competitive Growth and i t s posible follow up operations, and the Programmatic Loan for Human Development Sector. I t also has the support from an IMF Stand By Arrangement, as well as from IDB and CAI; through related operations. The Annex to this letter summarizes the detailed key measures already implemented by the Govemment under th i s operation, and those that it plans to adopt in the future.

The Inherited Economic and Social Situation

2. When the Govemment o f President Gutierrez took office last January, i t encountered a very difficult economic and social situation. Ecuador experienced a difficult period in the last decade owing to the o i l price slump in late 199Os, damage from the El Niiio, and disease in the shrimp industry which compounded structural weaknesses and led to economic stagnation, hyperinflation, and banking crisis. Ecuador became one o f the countries in the world with the most poverty and inequity. Poverty increased substantially to 56 percent of the population in 1999, with 21 percent of the population in extreme poverty. The rural areas, where most of the indigenous population live, were the most affected. About half a million Ecuadorians were forced to emigrante to other countries. On the other hand, forty percent o f Ecuador's national income i s concentrated in the hands o f ten percent of the population; an unacceptable situation that must be gradually corrected.

3. The dollarization o f the economy in January 2000 gradually reversed the accelerated growth o f inflation that took place since 1998 and helped restore confidence on the banking system. The recovery in oi l prices, the rapid growth in domestic demand, new private investment in the o i l pipeline (Oleoducto de

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FINANZAS

Crudos Pesados, OCP), and higher public sector spending helped raise GDP growth to 5.1% in 2001. However, in 2002 the GDP growth slowed again to 3 percent, and the current account o f the balance-of-payment registered a deficit equivalent to -5% of GDP, owing in part to weakened fiscal discipline (especially large increases in the wage bill ), and suspension of structural reforms. At the end o f 2002, the country was facing a public external debt equivalent to 60% of GDP and more than twice the level o f exports of goods and services, and a serious liquidity problem: a US$2 billion financing shortfall for 2003, arising from: i) US$750 million in arrears on wages and salaries agreed to by the previous administration (approximately US$400 million of which would be illegal to disavow, plus US$350 million with respect to which a political commitment has been made, which w i l l be withdrawn); ii) an unfinanced 46% increase in public sector remunerations for 2003; and iii) amortizations and interest on the internal and external debt contracted in previous years.

The Government’s Program

4. Upon taking office on January 15,2003, the new administration announced i t s Program for Economic Restructuring and Human Development (PERHD). The key objectives of the Program are: promoting growth with stability, reducing poverty, and eradicating corruption. I t aims to solve immediate liquidity problems and deepen fiscal solvency; support competitive production policies by introducing flexibility in goods and services markets and increase the productivity of the factors of production; and promote social development and reduce poverty. The PERHD establishes key targets to be achieved during 2003-07. Specifically, the Government’s program seeks inter alia to reduce poverty from 51 percent to 38 percent by 2007; reduce the illiteracy rate from 10 percent to 8 percent; reduce the percentage o f the population without access to healthcare from 23 percent to 17 percent; generate an economic growth rate averaging more than 5 percent annually during 2003-07; and succeed in rapidly reducing inflation rates to international levels. In the social areas, among the different measures being contemplated, the Government plans to finance the Frente Social’s poverty- reduction program, strengthen the provision o f basic services and the social protection system, and target subsidies on the poorest and most vulnerable sectors.

5. On the economic front, the most urgent task i s addressing the liquidity crisis, reestablishing fiscal discipline, and strengthening fiscal and debt management, all preconditions for the resumption o f growth. In addition, the PERHD includes comprehensive structural reforms to ensure that economic recovery can be sustained in the medium-term. The areas that wi l l receive priority are: tax reform; civi l service reform; public enterprise reform (water, electricity, telecommunications), the oi l industry, and labor markets. All these areas are covered in the multiyear program supported under this operation.

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6. The Government i s also completing financial sector reform. Under the program recently signed with the IMF, i t i s committed to: liquidate 8 closed banks administrated by AGD; contract international f i r m s to administer Filanbanco and AGD liquidation t rusts funds; bring Banco del Pacifico to the point of sale; conduct an assessment o f the operating procedures and actuarial balances o f the social security system (IESS, ISSFA, and ISSPOL); and return to depositors al l blocked deposits in Filanbanco and AGD.

7. The Government i s firm in i ts intention to eradicate corruption, modernize the state and make rapid progress in promoting transparency and citizen participation. Some specific measures in this direction have been included in our economic program detailed below; other actions are s t i l l being developed in close consultation with the civi l society.

Austerity and Poverty Alleviation

8. The Government has declared the economy in a temporary “state of war” to mobilize an all-out austerity effort to address the serious liquidity problems, redress the fiscal imbalances, and lay the foundations for renewed economic growth. Concurrently, i t i s taking measures to protect the most vulnerable groups from the negative impact of the stabilization measures adopted.

9. Austeritv. Immediately upon taking office, a set o f corrective measures were put in place, namely: a) an austerity program that severely restrains public expenditure including: i) freezing o f wages for regular c iv i l servants; ii) suspension o f overtime allowances; and iii) 10 percent salary reduction o f civi l servants with monthly earnings above US$l,OOO; b) a 2003 budget consistent with the austerity program and the Fiscal Transparency, Stability and Responsibility Law (FTSRL,); c) an increase in fuel prices by an average o f 20 percent; d) the setting-up of Fond0 de Estabilizacibn, Znversibn Social y Reduccibn del Endeudamiento Pliblico (EIREP) for active debt reduction and counter-cyclical fiscal policy; and e) an active repurchasing public debt policy.

10. With the measures adopted and the expected support from multilateral organizations, the Government wi l l be able to close the financing gap in 2003. O f total financial requirements of about US$2 billion, after including already scheduled financing, about US$0.7 billion remained unfinanced. I tw i l l fill the financing gap through a combination o f a) fiscal surpluses originating from expenditure cuts and additional income from oi l and non-oil earnings; b) rollover of most of the domestic debt, with some repurchase coming from proceeds o f i t s FEXREP; c) support from multilateral agencies, including the World Bank, and d) prompt payment on external arrears accumulated up to February 28, 2003, and an agreement with Paris Club member countries scheduled for June 2003.

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11. Protecting the Poor. Some measures taken by the Government to address the liquidity problem wi l l have a negative impact on the most vulnerable groups. Among these are the utility services and fuel prices increases and the freezing o f wages of public servants. Therefore, the Government has introduced a set o f compensatory measures to protect the income o f poor, namely: a) an increase in the Bono Solidurio (cash subsidy) from US$11.5 to US$15; and b) an increase in pension of retirees by US$5 per month. In addition, the Government plans to substitute the regressive gas subsidy by one targeted on the poorest and most vulnerable groups; protect social spending from budget cuts, and implement a number of reforms in the social sectors. The World Bank Programmatic Loan for the Social Sectors wi l l support some of these measures. Additionally, the Government i s developing policies to generate economic opportunities for the poor, especially the indigenous and rural population, who were the most adversely affected by the crisis.

Fiscal Consolidation and Debt Sustainability

12. The Government i s committed to dollarization, and i s fully aware that for th is regime to work in favor o f Ecuador's development, i t i s necessary, among other things, to maintain a strong fiscal stance and bring the external debt to manageable levels. Therefore, improved public sector and debt management areamong i t s top priorities.

13. Fiscal Discidine and Transuarencv. The Government i s also committed to comply with the Fiscal Transparency, Stability and Responsibility Law (FI'SRL) approved in 2002 and to improve transparency. The FTSRL establishes a 3.5% cap on annual real primary spending growth o f the Central Government and calls for an annual reduction in non-oil deficit o f the Central Government of 0.2% o f GDP per year. In late January, the Government issued the regulations for the FI'SRL (Executive Decree No. 1221) with respect to: a) pluri-annual budgeting; b) quantitative benchmarking of fiscal management; c) public debt reduction plan; d) investment by public enterprises; e) management of the o i l stabilization fund; and f) fiscal transparency and citizen's control. The Government plans to adhere closely to the Fiscal Transparency Law and i t s regulations. In this context, i t wi l l issue an Executive Decree defining the technical norms to determine the exact amount of revenues to be transferred to the Fondo de Estubilizucibn, Znversibn Social y Reduccibn del Endeudumiento Pliblico, EIREP. In addition, beginning in 2004, i t plans to prepare and publish i t s first pluri-annual budget for 2004-07.

14. The Government i s developing a Transparency Plan that includes the modernization of the integrated financial management (SIGEF), the public procurement, and the public investment systems. Regarding the SIGEF, the objective i s to be able to count with more timely, detailed information on fiscal,

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debt and human resources developments to improve decision-making and transparency. Based on the information collected by SIGEF, the Government plans to produce monthly reports and make this information available on the internet. Before March 2004, i t also expects to have published the financial statements of Petro-Ecuador, the electricity and telecom public enterprises, and the Regional Development Organizations on the internet. To this end, the Ministry o f Economy and Finance (MEF) wi l l issue a technical directive defining the norms and chronogram of the annual reports to be submitted by these public entities.

15. To increase transparency and efficiency, prevent corruption, and facilitate social auditing, the Government intends to modernize the procurement system. Accordingly, i t wi l l submit to Congress a new draft Procurement Law before March 2004 that wi l l streamline current procurement procedures; incorporate revised consulting standards; use electronic technologies in public procurement; and create a national regulatory body to ensure a proper enforcement o f the legal framework. In this context, MEF plans to establish a system to facilitate electronic procurement.

16. On the public investment system, the Government plans to develop a web- supported system to manage pre-investment analysis, monitoring and evaluation of investment projects, and procedures for facilitating citizen's participation and social auditing.

17. Improved Fiscal Performance. Fiscal revenue i s characterized by high volatility, mainly due to continuous changes in oi l prices and tax laws, an excessive number of earmarked revenues; and increasing, albeit s t i l l low when compared to their potential, tax revenues from non-petroleum taxes owing in part to the excessive number o f exemptions, particularly on the VAT and the income tax (ISR). The large number of taxes (more than 80), most of which yield little revenue, has a negative impact on the efficiency of tax administration.

18. To correct these problems the Government wi l l implement a comprehensive tax reform by mid 2003. Specific measures to be adopted are s t i l l under consideration, but reform should include a mix o f the elimination o f some tax exemptions, the elimination of most nuisance taxes-without affecting those earmarked for maintenance o f environment protected areas; and other tax policy measures, like the introduction of a tax on luxury vehicles.

19. The Government i s committed to strengthening tax administration. I t i s further improving the tax system and addressing the serious inefficiency and mismanagement affecting the Customs Service. Measures to be implemented in the short-run include: a) introduction o f a Simplified Tax Regime (STR-Rdgimen

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FINANZAS

Impositivo Simplificado Ecuatoriano or RISE) that wi l l allow expansion o f the tax base by collecting a minimum tax on the informal sector, especially small producers and retailers, and creating an enlarged registry o f taxpayers that would allow enhanced cross-checking for tax purposes; and b) a thorough reform to Customs including strengthening SRI role on Customs Board, rationalizing Customs personnel, and introducing severe penalties for under-invoicing import bills, and improving border control. The Government also plan to give in concession to the private sector certain Customs services, de-concentrate SRI administration, and eliminate loopholes affecting tax collection by Customs.

20. Exuenditure Rationalization. In addition to the austerity measures already implemented, which the Government w i l l be extended to 2004, the Government intends to reduce growth of the wage bill, bringing wage expenditures in line with fiscal constraints. The wage bill accounts for about half o f primary spending of the Central Government in 2003. The public sector wage system i s fragmented and lacking adequate information to enable a rational public wage policy. To correct these problems, the Government intends to introduce a comprehensive civi l service reform in consultation with al l interested parties. In this context, i t wi l l submit to Congress a Public Sector Wage Unification Law that w i l l include the consolidation of all salary supplements o f Central Government c iv i l servants. During 2003, and in parallel to the preparation of a new draft Civ i l Service Law and Administrative Career, the Government plans to complete staffing reviews to register all civi l servants positions, starting with the Ministries o f Health, Education, Public Works, Agriculture and Social Welfare; verify vacancies and evaluate functions with responsibilities in Central Government entities already having 14 salary steps.

21. With the revenue enhancing and expenditure reducing measures outlined, the Government expects to be able to increase tax revenues in the next two years by at least 7.5% and comulv with the 3.5% ceiling: on real mimaw wending: o f the Central Government in 2004 set in the fiscal law.

22.Debt Management. The burden o f public debt i s a major impediment for sustained growth and poverty alleviation. The Government gives priority to the reduction in the debt burden in accordance with the Fiscal Law because it w i l l ameliorate the liquidity problems, improve the country’ s standing in international markets, reduce the country’s financing cost, and w i l l make possible diverting resources to the fight against poverty. The Government has cleared all existing external debt arrears accumulated up to February 28, 2003, and domestic bonded debt arrears accumulated up to March 31, 2003. Before March 2004, and in agreement with the Fiscal Law, i t w i l l prepare a Debt Reduction Plan and gradually reduce public debt through repurchases with the proceeds o f FEIREP. In this context, the Government plans to allocate 70% o f the resources

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FINANZAS

accumulated in the FEIREP for debt reduction in 2003 and 2004. As called for by the Fiscal Law, the Government i s also committed to strengthen i t s debt management capacity and make debt management transparent.

Structural Sector Reforms

23. The country’s capacity to improve competitiveness and enhance productivity w i l l determine whether Ecuador can achieve sustained economic growth and poverty reduction. Moreover, productivity growth i s critical for the sustainability o f the dollarization regime. In recent years, Ecuador’s competitiveness has deteriorated significantly. Therefore, the Government i s committed to reverse th i s trend and implement an ambitious structural reform agenda in the areas o f competition and trade reform, basic infrastructure (water, electricity, telecommunications), o i l industry, and labor markets.

24. Competition and Trade Reform. The Government believes that promoting sound competition through clearly defined, and enforceable “rules o f the game”, without discrimination or favoritism, w i l l help modernize our productive infrastructure and enhance i ts competitiveness, with benefits accruing to all Ecuadorian consumers. Ecuador’s competitiveness gap i s significant. In 2002, Ecuador ranked 73rd among 80 countries evaluated in terms of global competitiveness by World Economic Forum, with the highest relative percentage for innovation and the lowest in terms o f business climate and respect for the rule o f law. To begin addressing these problems, the Government plans to introduce a new draft Law o f Competition in order to create a single regulatory entity, clarify the role o f the Advisory Council (Consejo Consultivo), and stipulate anti- monopolistic regulations. To further promote the country’s competitiveness on the basis o f quality and reduce the cost o f doing business in Ecuador, the Government i s also committed to submit to Congress two new initiatives: a draft Law of Administrative Simplification before March 2004, and a draft Law of Production Quality before March 2005..

25. On trade, the Government i s committed to reduce the existing anti-export bias that i s hampering the development o f nontraditional exports. T h i s anti-export bias has been generated by the discriminatory support given to certain nonproductive sectors that have been especially favored by nontariff barriers (NTBs). The discriminatory use o f nontariff barriers, the most important o f which are the import licenses and technical norms, reinforces the anti-export bias. Import licenses s t i l l apply to about 25 percent of tariff positions affecting Ecuadorian imports and are distributed in a nontransparent manner. There are 23 18 technical norms and o f those, 885 are obligatory and infringe WTO regulations.

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26. COMEXI has already issued a resolution reverting selective import tariff concessions adopted last year and unified all import licenses. Then, i t wi l l eliminate at least 10% of the number o f licenses in 2003 and 2004. COMEXI and MEIF w i l l prepare a comprehensive Trade Policy Strategy compatible with WTO, A L C A and free trade arrangements, which wi l l encompass: a) tariff reductions with a view of unifying the majority tar i f fs in five categories (0, 5, 10, 15 and 20 percent); b) non-tariff barriers; c) norms o f origin and anticompetitive practices; and d) agricultural products, services and investment.

27. Water Sector. Ecuador s t i l l lacks a comprehensive water resource management policy framework. The sector confronts several problem including low coverage (particularly in rural areas), low efficiency, and poor quality o f services. These problems are derived in part from the low user charges and high dependency on transfers from the Central Government. Since water and sanitation services are provided by decentralized entities that depend on municipal governments, to improve the quality and efficiency o f services and assuring increased coverage, the Government intends to restructure SAPYSB, changing i ts role from an implementing agency to the sector’s policy-setting body, and submit to Congress a new Water and Sanitation Law which w i l l include the creation of a new independent regulatory entity. The Government also plans to set up a Water Fund inside MIDUVI and assigns the budget allocations needed to provide water sector financing according to uniform, performance-based criteria.

28. Electricitv sector. The key challenge the Government face in the electricity sector i s to ensure i t s financial viability. Therefore, the Government i s adjusting electricity tariffs until they reach their economic cost. The adjustment wi l l be gradual to minimize their impact on lower income consumers. CONELEC has issued a Ministerial Decree to adjust electricity tariffs for residential consumers under 300Kwh/month, and i s committed to cover at least 90% o f estimated economic costs by March 2005. In addition, CONAM, CONELEC, and the Solidarity Fund wi l l prepare a strategy to improve sector efficiency.

29. Telecommunication sector. The challenges facing this sector include low local rates for fixed telephone service and institutional fragmentation owing to a deficient regulatory framework. To address these problems, the Government awarded a third mobile telephone license band and prepared a Strategy for the telecommunications Sector. Before March 2004, it i s also committed to prepare a new draft Telecommunications law to strengthen the regulatory framework, create a single sector authority, encourage greater private sector participation in the sector, including Telecsa, the third mobile license company. Before March 2005, the Government wi l l have signed management contracts with private administrators of Andinatel and Pacifictel and select a private investor for the third mobile license.

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MINISTERIO DE ECONOMIA Y

FINANZAS

30. O i l Sector. The oi l sector i s crucial for the country’s economic growth but i t s recent contribution has been well below potential because it suffers from several weaknesses. Among these are price subsidies, which together with the lack o f judicial and fiscal stability and outdated legal and institutional framework have deterred foreign investment. T h i s has contributed to the low production of fields with the greatest reserves and a low level of exploratory activity. O i l resources by PetroEcuador should also be managed with transparency. . To begin addressing these problems, the Government has increased the price of fuels and has a commitment to keep adjusting fuel prices according to market conditions. To promote austerity, accountability and efficiency, and reduce subsidies, i t has reduced the budgetary allowance to PetroEcuador by US$lOO million in 2003- while the public enterprise preserves the budget allocated to comply with environmental regulations-and plans to conduct an external audit o f PetroEcuador, the result o f which wi l l be made public before March 2004. Before March 2005, the Government wi l l further reduce the budget to PetroEcuador and verify that the recommendations of the environmental management plans required by environmental regulations are properly implemented.

31. Labor Market. The Government i s fully aware that the dollarization of the economy requires a flexible labor market. The existing wage setting mechanism, the so-called Sectoral Tables, which are based on the minimum wage established by the National Wages Council (Consejo Nacional de Salarios, CONADES), involves compulsory 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 are not related to productivity but are the basis for additional increases negotiated within each sector. T h i s system not only undermines the country’s competitiveness, but also rest flexibility to the formal labor market, that has to comply with such compulsory adjustments Accordingly, the Government plans to make a detailed assessment of the labor market problems in consultation with workers and employers, and establish a new salary adjustment mechanism before March 2005.

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Fighting Corruption and Transparency 32. Corruption i s an enemy that undermines the possibilities for human development in Ecuador. The Government of President Gutierrez i s firm in i t s intention to eradicate corruption and make rapid progress in promoting transparency and citizen participation. I t i s calling on all Ecuadorians to mobilize and work together against instability, stagnation, poverty, unemployment, hunger, and corruption. The Mesas de Didogo (Dialogue Meetings) are engaging civi l society in the design and monitoring of public policies.

Concluding Considerations

The multiyear reform agenda outlined above i s ambitious, but it i s what Ecuador requires in order to revert the recent deterioration in economic and social conditions. The Government i s determined to seek the political consensus and to mobilize the support o f all groups o f society to execute i t successfully. I t i s developing a permanent dialogue with members of Congress and political forces on the legislation submitted to support the reforms. At the same time, the national dialogue wi l l take into account the opinion of union and indigenous leaders. Compensatory measures introduced together with increased coverage and delivery effectiveness o f basic public services w i l l help minimize the negative impact of some policy actions on the most vulnerable groups. Without underestimating the challenges, the Government i s determined to place Ecuador on a path of sustained growth and redress i ts long-standing inequities.

Sincerely yours,

Mauricio Pozo Crespo Minister of Economy and Finance

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ECONOMIA Y F’INANZAS

Annex: Multiyear Government ‘s Program: Prior Actions and Benchmarks I. MACROECONOMIC FRAMEWORK AND OVERALL PROGRAM

Prior Actions (May 2003) The macroeconomic framework i s consistent with the objectives of the program

The Government agrees to implement an overall Multiyear Program of Policy Reforms

Benchmarks (March 2004)

The macroeconomic framework i s consistent with the objectives of the program

The Government maintains satisfactory progress in carrying out the overall Multiyear Program of Policy Reforms

Benchmarks (March 2005)

The macroeconomic framework i s consistent with the objectives of the program

The Government maintains satisfactory progress in carrying out the overall Multiyear Program of Policy Reforms

11. ACHIEVING FISCAL CONSOLIDATION AND DEBT SUSTAINABILITY

Prior Actions (May 2003) MEF submits to Congress draft legislation to improve tax collection by Customs through (a) a strengthened IRS role on the Customs board, (b) a complete restructuring of Customs, (c) rationalization of Customs personnel, (d) full and timely access to import bills by the IRS, (e) virtual crosschecking information with taxpayer files, (f) severe penalties for underinvoicing import bills, and (g) improved border control

Executive issues and implements an austerity Decree (Decree No. 44 “Norms for Patriotic Savings”) and the 2003 budget complies with the Decree and the Fiscal Transparency, Stabilization, and Responsibility Law (FTSRL). Key measures of the Decree include (a) freezing of wages for regular civil servants, (b) suspension of overtime allowances, and (c) 10% salary reduction of civi l servants with monthly earnings above US$l,OOO. Key ceilings of the FTSRL are (a) a 3.5% cap on real primary spending growth o f the Central Government per year, and (b) a reduction in non-oil deficit of the Central Government o f 0.2% o f GDP per year

MEF and the Ministry of Labor complete a satisfactory final draft of the Public Sector Wage Unification Law. The key component of the Law include a consolidation of all salary supplements of central Government civil servants into the base wage. MEF completes a Transparency Plan with 3 components:

a SIGEF-based system to produce monthly, timely, and reliable reports on executed expenditure beginning in mid-2003, and consolidated NFPS financial statements through the Government’s website (Portal) beginning in 2004 ; an e-government system to develop public procurement: and a public investment system

MEF has cleared 100 percent of all external arrears accumulated up to February 2003, and above 80 percent of domestic arrears accumulated up to March 2003 Benchmarks (March 2004) Tax revenue collected by IRS increases by at least 7.5percent between 2002 and 2003 due to tax policy measures to broaden the tax base, IRS’s administrative strengthening and Customs modernization

MEF complies with the austerity Decree in 2003 and the Executive extends it to 2004

MEF completes staffing reviews to register all civil servant positions, verify vacancies, and evaluate functions with responsibilities in the following ministries: Health, Education, Public Works, Agriculture, and Social Welfare

55

REPUBLICA DEL ECUADOR MINISTERIO DE

ECONOMIA Y FINANZAS

MEF satisfactorily implements the Transparency Plan

MEF allocates at least 50% of resources accumulated in the FEIREP during 2003 for debt reduction

Benchmarks (March 2005) ~~ ~

Tax revenue collected by I R S increases by at least 7.5 percent between 2003 and 2004 due to tax policy measures to broaden the tax base, IRS’s administrative strengthening and Customs modernization

MEF complies with the 3.5% ceiling on real primary spending growth of the Central Government in 2004, set in the Fiscal Law

~~

MEF controls the growth of the wage bill in line with the inflation rate and public employment in 2004, as a result of the new wage policy and civil servants reviews

~

MEF satisfactorily implements the Transparency Plan.

MEF allocates at least 50% of resources accumulated in the FEIREP during 2004 for debt reduction.

HI. PROMOTING FASTER GROWTH THROUGH INCREASING COMPETITIVENESS

AND MARKETS FLEXIBILITY

Prior Actions (May 2003) COMEXI issues resolutions to (a) reverse selective import tariff concessions adopted at the end of 2002, and (b) unify 100 percent of total number of import licenses.

CONELEC issues a Ministerial Decree to adjust electricity tariffs for residential consumers under 300Kwh/month, starting from an average of about 80% of estimated economic costs

CONATEL awards a third mobile telephone licence and CONAM completes a Telecom Strategy.

Benchmarks (March 2004) COMEXI issues resolution to eliminate at least 10 percent of total number of import licenses and simplify import licensing procedures

The distribution companies adjust the electricity tariff as set in CONELEC’s Decree, reaching a minimum average of 85% of economic costs for residential consumers below 300KwWm

CONAM and the Solidarity Fund satisfactorily implement the plan, including effective investment by a private investor in Telecsa

The Ministry of Labor (ML) completes an assessment of the labor market under a consultative process with workers and entrepreneurs

Benchmarks (March 2005) COMEXI issues resolution to eliminate at least 10 percent o f total number of import licenses

The distribution companies adjust electricity tariffs as set in CONELEC’s Decree, reaching a minimum average of 90% of economic costs for residential consumers below 3OOKwh/m

CONAM and the Solidarity Fund satisfactorily implement the plan, including the signing of management contract(s) with a private administrator(s) of Andinatel and Pacifictel ML issues a Decree to de-link the automatic salary indexation mechanism from the inflation rate

56

Annex 4. The Program for Economic Restructuring and Human Development (PERHD) of the Government of Ecuador, 2003-07

Background

Ecuador’s situation in the world context: 0

0

0

0

Only 20 percent o f the world’s countries have more poverty and inequity than Ecuador. Seventy percent o f the world’s countries are developing more rapidly than Ecuador. Corruption i s an enemy that undermines the possibilities for human development in Ecuador. This situation could change if Ecuadorians agree to work together against instability, stagnation, poverty, unemployment, hunger, and corruption.

Key social statistics that call us to action.

0 Poverty. We define poverty as the lack o f money to purchase food and basic commodities, and i t affects more than half o f the Ecuadorian population. Measures to effectively combat poverty and corruption have been formulated and w i l l be immediately executed. Inequity. Forty percent o f Ecuador’s national income i s concentrated in the hands o f 10 percent o f the population. Strong action aimed at distributing wealth must be immediately taken. Social spending stagnation. Urgent actions and decisive reforms are needed so that Ecuador can consolidate i t s economy and finance a 10-percent reduction in the illiteracy rate and a 25- percent reduction in the percentage o f the population without access to healthcare.

0

0

What are we trying to do? The promam’s main objective i s to involve the citizenry in the fight against poverty in a coordinated fashion, and to reduce poverty through a joint social and economic effort. I t s main goals are to:

0

0

0

0

0

Reduce poverty from 5 1 percent to 38 percent by 2007 Reduce the illiteracy rate from 10 percent to 8 percent by 2007 Reduce the percentage o f the population without access to healthcare from 23 percent to 17 percent by 2007 Generate an economic growth rate averaging more than 5 percent annually during 2003-07 Succeed in rapidly reducing inflation rates to international levels.

The PERHD’s Three Main Policies

The PERHD’s program has three main policies: economic, supply side, and redistributive. Their goals are outlined below.

Economic Policv

0

0

0

Solve the immediate problem o f liquidity Solve the 2003 budgetary problem through a coherent, fully financed plan Submit key economic legislation to Congress in support o f the economic and social program.

Supply-side Policv 0

0

Reformulate an efficient o i l policy Reduce inefficient, unnecessary tax levies on investment

57

0 Make lines o f credit viable, with conditions that meet the needs o f the productive sector.

Redistributive Policy

0

0 Modernize the State 0

0

0

Include the Ministry o f the Economy and Finance in the Cabinet o f the Frente Social (Social Front)

Finance the Frente Social’s poverty-reduction program Target the poorest and most vulnerable sectors for subsidies Submit legislation to Congress for the Reform o f the Social Security system and for the creation o f systems that w i l l provide education, healthcare, and other basic social services.

Most Urgent Priorities

The serious liauiditv problem inherited from the former Administration: a US$2 bil l ion financing shortage for 2003, arising from:

0 US$750 mil l ion in arrears on wages and salaries agreed to by the previous Administration (approximately US$400 mil l ion o f which would be illegal to disavow, plus US$350 mil l ion with respect to which a political commitment has been made, which wil l be withdrawn) An average increase o f 46 percent, without financing, in remunerations for the public sector for 2003 Amortizations and interest on the internal and external debt contracted in previous years A fiscal deficit projected at the time that the previous Administration left office, which must be reverted in order to consolidate the economic base o f the new Administration.

0

0

0

What i s the Government doing to correct it? I t has declared a “war economy” with respect to public finances by issuing an austerity decree, effective in February 2003, which provides for the following:

0 A 20-percent reduction in the remunerations o f the President o f the Republic and o f any other public officials who serve in positions that are freely revocable, and whose overall incomes are more than US$l,OOO per month. This provision also covers officials serving abroad. Fill only 90 percent o f the freely revocable vacant positions in the public sector. Prohibit all increases in remunerations o f public servants during 2003. Gradually reduce the number o f public servants until an optimal size o f the public labor force i s reached. The Austerity Decree also includes about a 20-percent increase in fuel prices, which w i l l affect the population.

0

0

0

The following fiscal policies are also being applied in the “war economy”:

0 A comprehensive tax reform, along with the strengthening and restructuring o f the Ecuadorian Customs Corporation

0 The consolidation o f the o i l stabilization fund, making it possible to mitigate the impacts o f adverse shocks on the economy

0 An active repurchasing public debt policy that w i l l help reduce the burden o f i t s service and generate savings to be reoriented to the social sector

58

0

0

0

0

Submission o f two additional bills to Congress: a Wage Benefits Unification bill and a Customs Reform bill The adoption o f efficiency and productivity indicators for institutions that handle public funds A review of the tax framework that attracts and ensures foreign direct investment An efficient redistribution o f public spending, favoring targeted mechanisms that provide direct benefits. Benefits should be focused, for example, on the social protection network and poverty reduction.

The Tax Reform should provide for:

0

0

0

0

Taxation on indemnifications in excess o f what i s permitted under the Labor Code and the Law on Remunerations A decrease to US$5,000 in the tax-exempt base for the income tax Elimination o f profit sharing (15 percent) for workers in public companies where the State i s the sole owner Creation o f a zero-rate VAT for electrical energy, prepaid medicine, and medication manufacturing services. In addition, the Internal Revenue Service must approve the l i s t o f VAT-exempt medications Introduction o f a tax on luxury vehicles with depreciation o f the vehicle’s value at up to 10 percent annually, with a residual value o f 10 percent Reform o f the Vehicle Tax for high-priced vehicles.

0

0

To support the macroeconomic framework, the Government has a Stand-By Agreement with the IMF that makes it possible to finance up to US$500 mil l ion through the multilateral entities, under the following assumptions: (a) an inflation rate between 6 and 8 percent (as o f December 2003), (b) growth o f GDP between 3.5 and 4 percent (as o f December 2003), (c) o i l prices o f US$18 per barrel (annual average, 2003), and (d) volume o f crude o i l exports (105 mill ion barrels per year).

Together with the objective o f price stabilization, the Government has adopted the following policies regarding the real sector:

0

0

Lines of credit to reactivate the productive sector, with special emphasis on microenterprise and the agricultural sector Deductions o f contributions made by financial institutions to the Superintendency o f Banks and to the Deposit Guaranty Agency (Agenciu de Guruntiu de Depdsitos, AGD) to the extent that they grant loans for investments in production Incentives for foreign direct investment in telecommunications, electricity, and the o i l industry Safeguards against contraband and unfair competition Modernization o f utilities that service the productive sector Aggressive policies for promoting nonpetroleum and nontraditional exports.

0

0

0

0

To strengthen the banking; system the GOE will:

0

0

Eliminate the Deposit Guaranty Agency (Agenciu de Guruntiu de Depdsitos, AGD) Liquidate closed banks that were under the AGD

59

0 Create a t rust with an intemational administration that w i l l channel funds from the sale o f the AGD’s assets (net o f the settlement o f liabilities) to a fund that finances educational reform and healthcare Establish a strengthened Banking Liquidity fund, overseen by the private banking sector Reengineer public banking with the aim o f channeling funds toward the productive and crafts sectors Apply policies aimed at fomenting the securities market Use the public debt as a payment vehicle for the sale o f assets through public, transparent bidding competitions.

0

0

0

0

In addition, the GOE w i l l support the sustainable reactivation o f uroduction through:

Creation o f conditions under which financial institutions wil l channel their funds toward the productive sector and reduce interest rates. This w i l l generate the confidence o f foreign investors in the country and improve Ecuador’s country-risk rating. Reform o f Social Security and o f human resources training and educational loans, in order to elevate human capital and national productivity. Comprehensive reform o f the labor system (by restructuring pay scales and hiring processes). Development o f technical capacities and transparency in the adjustment o f public transportation fares to reflect the costs and quality o f service. Review o f the long-term impact o f decisions made in recent months by the Foreign Trade and Investment Council (Consejo de Comercio Exterior e Znversiones, COMEXI) Application o f a technical mechanism that, under suitable financial conditions, allows for the return o f funds that the financial system maintains abroad, and their investment in production.

Table A.4.1. Poverty-Reduction Goals for 2003-07

The GOE’s commitment to a redistributive social uolicv w i l l be implemented through:

60

0

0

An increase in the Bono Solidurio (Cash Subsidy) from US$11.5 to US$15 per month With support from Congress, enactment o f laws that allow for the financing o f (a) an increase of US$5 per month in the pensions o f retirees from the Ecuadorian Social Security Institute (IESS); (b) a minimum pension o f US$15 per month to people over 68 years o f age who are not receiving the Bono Solidurio and are not retired from the IESS; (c) a tax levy in the form o f a property tax on real property construction in excess o f 200 square meters; (d) reforms in the educational, healthcare, and social protection systems; and (e) the participation o f the Ministry o f Economy and Finance in the Frente Social (Social Front) Cabinet.

These actions are evidence that the GOE i s committed to poverty reduction. Table A.4.1 outlines these ambitious but realistic goals for 2003-07.

THE MACROECONOMIC FRAMEWORK FOR 2003 (SUPPORTED BY THE IMF STAND-BY ARRANGEMENT)

In 2003, there w i l l be moderate growth in economic activity, the current account deficit, and consumption. Growth o f 3.5 percent i s forecast (due mainly to the increase in o i l exports through the OCP), and 6 percent inflation i s forecast.

Austerity i s required o f the public administration to maintain a high primary fiscal surplus starting in 2004. Meanwhile, additional income from o i l exports w i l l be used to reduce public debt, which w i l l create confidence in financial markets, reducing the risk-spread index.

Fiscal Policy Fiscal policy w i l l be aimed at (a) relieving immediate pressure on liquidity and dealing wi th the debts left unpaid by the previous government, (b) strengthening the fiscal position, (c) stabilizing the income o f the poor and strengthening social programs, and (d) flexibilizing fiscal policy and establishing spending priorities.

P r i m surplus: The primary balance o f the Non-Financial Public Sector (NFPS) wi l l rise from 4.5 percent o f GDP in 2002 to 5.2 percent in 2003. An overall NFPS balance o f $509 mil l ion i s projected, leading to a reduction in the public sector debt coefficient equivalent to 59 percent o f GDP in 2002, and 52 percent in 2003.

NFPS income: This i s expected to increase by 0.9 percent o f GDP (26.9 percent o f GDP in 2003), due to reorganizational measures taken by the government, such as raising the price o f fuels by 25 percent ($400 million) and eliminating the selective cuts to import tar i f fs ($30 million) made by the previous Administration. Subsidies, including the prices o f public services, wil l be reduced and approval w i l l be sought in August for laws on public sector wage unification ($20 mil l ion more for the social security system in 2003).

Stabilization o f NFPS unman, expenditure at 21.7 percent o f GDP i s projected for 2003, through the 22 January decree on fiscal austerity, freezing wages for the rest o f the year, eliminating overtime provisions, a 10 percent reduction in remunerations o f more than $1,000 to freely transferable public employees, and a 10 percent reduction in the number o f posts to be covered by the new government. Spending on NFPS remuneration w i l l come to $2.251 bi l l ion (a $260

61

mil l ion rise) due to increases in 2002. Expenditure allocated to PetroEcuador has been reduced to $100 million. Spending on the social safety net w i l l increase. The Bono Solidurio wi l l be $15 per month and social assistance to the elderly poor w i l l rise $5 per month per person, starting in January 2003, at a total cost o f $60 million. To cover the 25 percent increase in IESS pensions in 2003, this institution w i l l suspend loans for surgery, reducing operations from $158 mill ion in repayable loans to $40 mill ion in 2003.

Strengthening the social security system: With technical aid, the state of the social security funds wi l l be assessed (IESS, ISSFA, ISSPOL) to determine a strategy for reforming them.

Focusing the gas subsidy: With IDB assistance, the Bono Solidurio database w i l l be improved, focusing aid and eliminating the domestic gas subsidy ($40 mil l ion in 2003).

The NFPS reauires $2 bil l ion in financing in 2003: This consists mainly o f debt payments ($1.2 billion, including the repurchase of $29 mil l ion in debt through the FEIREP); and unreschedulable late foreign and domestic debt payments ($100 mill ion and $400 million, respectively). Financing w i l l be based on fiscal surplus ($500 million); rollover o f domestic debt that comes due during the year ($400 million); financing for projects ($300 million); and $600 mil l ion in extraordinary financing ($130 mill ion from the World Bank; $100 mil l ion from the IDB and the CAS, respectively; $160 mill ion from the IMF; and $150 mill ion in debt rescheduled with the Paris Club and other official creditors). Oil w i l l not be provided as a guarantee for any loans.

The 2003 budget i s consistent with the economic program, based on a wage freeze and crude o i l at $18 per barrel. If o i l income falls below th i s estimate, spending cuts wil l compensate for the deficit. If, on the contrary, i t i s greater, it w i l l go to the FEIREP or w i l l be used to reduce public debt. Extra funds contributed to the social security system w i l l be saved and used to capitalize assets. To protect income, the government w i l l pass the new Tourism Act.

Structural Reforms

Three structural reforms that w i l l lead to a healthy fiscal situation in the medium term are:

Law on Customs Reform: Aimed at restructuring Customs Office administration and personnel, enabling the IRS to update the customs information system and administer customs. Law on Wage Unification and Civi l Service Reform: This wil l enable the different remunerative components to become part o f a single wages account. Implementation w i l l require four years. The Law on the Civ i l Service and Administrative Careers wil l be reformed to reduce the number o f public sector employees and the nominal wage mass in 2004. Law on Tax Reform: Aimed at better allocation o f public spending and an increase in the tax base. This wil l be based on (a) eliminating any preallocation o f income not stated in the Constitution, (b) eliminating fiscal exemptions, (c) eliminating s m a l l taxes that provide little income but have a high administrative cost, (d) increasing collection o f the vehicle tax, (e) reducing the base income tax rate, and (f) eliminating “fiscal shields.”

These reforms are aimed at creating a sustainable fiscal surplus to reduce public debt. The OCP, which w i l l begin operations in the last quarter o f 2003, has the capacity to double petroleum exports, which supports higher medium-term projections o f growth and exports. New income wi l l be administrated in accordance with the provisions o f Organic Law on Responsibility,

62

Stabilization, and Fiscal Transparency (September 2002), w i l l become part o f the Fondo de Estabilizacidn, Znversidn Social y Reduccidn del Endeudamiento Ptiblico (FEIREP), and wil l be distributed as follows: 10 percent for social spending, 20 percent to deal with contingencies, and 70 percent to repurchase debt. The debt coefficient w i l l drop from 59 percent o f GDP at end- 2002 to 40 percent in 2006.

Measures for the Financial System Filanbanco and eight other closed banks now under AGD administration w i l l be liquidated. At the end o f February contracts w i l l be signed to administer the Filanbanco t rus t and to recover or sell i t s loans portfolio. The assets and liabilities o f the banks will be part o f another t rust that w i l l distribute them among the creditors. The return o f deposits and other liabilities w i l l begin in March and end in December 2003 for all banks. The government w i l l eliminate al l legal obstacles to the liquidation of the other 10 banks in the AGD. At the same time, the restructured portfolio o f these banks wi l l be auctioned, generating resources to be used to return frozen deposits and to cancel obligations. State Banco del Pacific0 w i l l be privatized.

Other Structural Measures T o improve productivity, the efficiency o f the telephone and electric distribution companies w i l l be increased. These companies w i l l be administered by private international companies at the end o f June. The regulatory officials have decided to adjust rates on a monthly basis to match production costs. With the technical aid o f the IDB and the World Bank, the rate structure wil l be standardized at the end o f June 2003.

An economic and environmental study wi l l be prepared for an action plan and schedule to improve the efficiency of the production, distribution, and sale o f petroleum and i t s derivatives, before the end o f June 2003.

The government w i l l promote fiscal transparency by publishing information (monthly fiscal statistics) that w i l l make it possible to monitor implementation o f the economic program through the webpages o f the Ministry o f the Economy and the Banco Central del Ecuador. Financial reports, profit and loss sheets, cash flows, and the general balance o f PetroEcuador, Transporte Aereo Militar del Ecuador (TAME), and companies in the Fondo de Solidaridad w i l l be published on the websites o f each, upon approval by their respective boards o f administration.

63

Annex 5. A Public Debt Sustainability Analysis of Ecuador

Despite the economic turnaround in recent years, since Ecuador’s default in 1998 the government’s credibility has yet to recover to i t s precrisis levels. While dollarization has brought stability and a return in confidence to the country, spread levels s t i l l remain high. Within Latin America, Ecuador spread levels are close to politically volatile Venezuela, and below Argentina. In an effort to demonstrate i t s commitment to addressing i t s debt situation, in June 2002, the government passed a Fiscal Law that requires the public debt-to-GDP ratio to fal l 16 percent in the next four years, then to below 40 percent o f GDP afterward, and to remain at this level. This step marked the first time that the government had made such a strong commitment to reducing i t s debt burden.

In this annex, we examine Ecuador debt sustainability based on the reform program outlined in the report. Overall, Ecuador’s critical debt situation i s expected to improve and i t s 40 percent target should be reached well in advance o f 2010. However, to maximize fiscal resources in the medium term, this wi l l require tight fiscal discipline and initial high fiscal surpluses o f 5 percent of GDP. The high surpluses serve two purposes: first, they reduce the additional financing burden caused by new debt creation, and second, by demonstrating the government’ s commitment to address i t s debt, regain credibility and reduce the country’s risk premium and interest rates. B y obtaining early high init ial surpluses, the government w i l l in the longer run free up more resources for additional social spending. Although the outlook i s positive, several r isks remain high because the debt profile i s vulnerable to o i l price changes and fiscal slippages.

THE MODEL

The model begins with the government’s amortization schedule and init ial assumptions on the overall fiscal balance. Interest payments are calculated based on the current debt levels and projected new debt. A primary surplus i s estimated. Revenues and primary expenditures up to 2005 are taken from the Base Case projections. Beyond 2005, a trajectory o f government expenditure (based on the fiscal laws) and non-oil revenues (fixed at 22 percent o f GDP) i s assumed. To reach the primary surplus, the difference between the trajectory and the primary balance i s identified as extra fiscal effort, and th is can take place as either decreased expenditure or increased revenue collections. From the overall fiscal balance, amortizations are subtracted and the remainder i s the needed additional financing. Hence the total fiscal burden on the government i s the amount o f extra fiscal effort needed plus the additional financing. The model also examines how funds from the FEIREP w i l l be used to pay back debt.

Main assumptions. GDP growth o f 4 percent during 2004-05, and thereafter 3.5 percent. Inflation rates follow the trend of the Organization for Economic Cooperation and Development country levels by 2005. The average o i l price assumption i s $18 per barrel during 2003-10.

Base Case. In the f i rs t few years the government faces a high amortization schedule during which, even with primary surpluses, w i l l also require additional financing. If the Government produces high initial primary surpluses, th is would allow it in later years to produce a lower level of primary surpluses than it i s currently projected to produce, that is, i t s fiscal effort might become negative. In other words, starting in 2006 the government w i l l have more resources freed for increased social expenditures.

64

However, maintaining high primary surpluses wi l l not be an easy task. The next three years wi l l be critical in terms of finding financing to cover amortizations and increases in public wage expenditures in 2002, which wil l add pressure to fiscal accounts from 2003 forward. Because capacity to absorb new domestic debt i s limited, and weak congressional backing hampers government credibility, i t wi l l have to rely on i t s own performance for obtaining primary surpluses.

MAIN RESULTS OF THE BASE CASE

Into the medium term, mainly due to a heavy amortization schedule, Ecuador’s debt levels should achieve i t s debt objective of 40 percent of GDP. I t could reach th i s amount by 2005-06. However, doing so wi l l require primary balances of around 5 percent of GDP in 2003-04. As amortization levels decline, financing needs wil l fall from 2.5 percent of GDP in 2003 to 0.7 percent in 2010, at which time they can be readily absorbed domestically.

Although the Fiscal Law cap on expenditure growth does little to reduce debt, it helps prevent debt creation by restraining expansionary spending. Real GDP growth i s expected to be in line with the maximum increase in expenditure growth. This would prevent any further erosion of the fiscal accounts, to which the debt analysis i s highly sensitive.

Finally, i t also appears that FEIREP would have limited impact on reducing debt. First, the government has revised what it believes wi l l be peak pipeline usage to 600,000 barrels per day, which i s 200,000 barrels below original projections. This inevitably wi l l reduce the expected windfall in government oi l revenues. Second, funds entering into the FEIREP wi l l depend on the marginal o i l production increases incurred. If the OCP reaches full capacity within a short time, a potential $178 million annually wi l l be available for external debt repurchase. However, problems in resolving the VAT tax dispute between the government and the oi l companies have delayed investment in the oi l fields. As a result, a lower marginal increase in productions makes external debt repurchase more modest at just $250 million during 2004-07, compared to a potential $712 million.

Sensitivity to a Fall in Oil Prices in a Low Case Scenario

In a low case scenario for 2004 to 2010, we assume a $6 drop in average oi l prices (from US$18 per barrel), which lowers average GDP growth by about 0.5 percent per year from the base case. As a result of the poorer oi l revenues, fiscal balances and debt sustainability worsen. The overall surplus falls into deficit and the primary surplus declines. Without a high primary surplus to cover amortization, t h i s results in higher annual financing needs of about of 1.5 percent of GDP over the base case. High financing needs would increase the country’s risk, which would lead to higher interest rates and make new debt more costly. Increased financing needs would also raise the debt stock. Although the government would s t i l l achieve i t s 40 percent debt-to-GDP target, this would be delayed by two to three years. Moreover, under th i s low oi l price-lower growth scenario, the debt ratio would fail to decline by 16 percentage points by 2006, another benchmark of the Fiscal Law. Lower oi l prices (assuming production remains the same) would put less money into the FEIREP and by 2010 the cumulative FEIREP debt buyback would be about 44 percent less than in the base case. In addition, if a key fiscal constraint introduced by the Law of

65

Fiscal responsibility i s relaxed, and expenditures grew a real 3.5 percent per year, this would result in an additional financing need o f US$600 mil l ion during 2004-10.

CONCLUSIONS

By tightening the fiscal stance now, Ecuador stands to achieve considerable gains in the medium term. Furthermore, given the volatility o f o i l prices, the more fiscal space the government can create, the better i t w i l l be able to deal with external shocks. Moreover, the private sector would also benefit from the spillover effects o f a more credible and fiscally prudent fiscal management. Interest rates, currently very high for a dollarized economy, would come down and help boost investment and improve competitiveness.

Although Ecuador’s debt targets set up in the Fiscal Law are achievable, they are insufficient given the vulnerability o f a dollarized economy. While the law caps the debt ratio at 40 percent o f GDP, the government should strive to bring down t h i s ratio even further, lowering the country’s risk premia and interest rates, which w i l l be key to keeping the country competitive. From our analysis, lowering the debt ratio would be feasible, and Ecuador could bring i ts ratio down to 30 percent o f GDP by 2008. Moreover, beyond reducing i t s debt ratio, the country also has to develop the institutional capacity to better manage and direct i t s debt portfolio, rather than just responding to financing needs, thereby making the debt work for the country.

66

Table A.5.1. Base Case Scenario for Debt Sustainability BASE CASE 2002 2003 2004 2005 2006 2007 2008 2009 2010

Est. Proj. Proj. Proj. Proj. Proj. Proj. Proj. Proj.

24347

4.5

3.5 1 .o

Total debt as '3'0 of GDP

DSA MODEL Primary balance Interest payments

Scheduled interest payments Interest payments on new debt

Overall fiscal balance Net amortization of existing debt Financing need (new debt) Net fiscal burden Implicit average interest rate

Debt Details Total debt

Stock of new commercial debt Total existing debt

Domestic External

Cumulative debt buyback Reduced Interest Payments

Fiscal Details PRIMARY BALANCE

Extra fiscal effort Core primary balance projection

Oil revenues Non-oil revenues Primary Expenditures

Oil Revenues Oil Revenues -To budget Oil Revenues - Diverted to fund = >20% to stabilization fund = >70% to debt reduction

To IESS Debt buyback

26807 3.5

6.38

5.2 0.0 3.3 1.9 2.5 2.5

57.9

1087 842 842

245 44

5.97

14103

14103 2920

11183

1087

1393 4925 5231

1393 1393

29080 4.0

4.31

5.3 0.1 3.4 1.9 1.2 1.2

50.3

1386 878 869

9 508

1166 658 660 6.51

13477 540

12937 2289

10648

1386 1

1385 1666 5492 5774

1666 1666

30860 4.0

2.00

5.1 0.1 3.4 1.7 1.8 1.9

44.5

1538 994 973 78

544 879 335 361 7.69

12933 876

12057 2339 971 8

26 3

1538 25

1513 1568 6247 6302

1383 1340

43 9

30 5

26 A

32579 3.5

2.00

4.4 -0.5 2.9 1.5 1.4 1 .o

40.2

1560 1034 1013 157 526

1095 569 597 8.33

12407 1445

10962 2161 8802

77 9

1560 28

1532 1373 6771 661 2

1459 1373

85 17 60 9

51 Q

34393 3.5

2.00

4.3 -0.6 2.8 1.5 1.3 0.7

36.6

1448 959 825 134 489 959 470 31 2 8.05

11918 1915

10004 2052 7951

153 18

1448

1606 1419 71 67 6980

1547 1419 128 26 90 13 76

-1 58

36309 3.5

2.00

3.5 -1.1 2.5 1 .o 1.2 0.1

33.2

1464 949 777 171 516 97 1 455 257 8.32

11402 2369 9033 1953 7081 250 30

1464

1662 1465 7567 7369

1628 1465 164 33

115 17 97

-1 97

38332 3.5

2.00

3.2 -1.1 2.2 1 .o 0.9

-0.2 30.4

1264 90 1 695 207 363 795 432 24

8.17

1 1039 280 1 8238 1913 6325 348 42

1264

1673 1465 7988 7780

1628 1465 164 33

115 17 97

-408

40586 3.5

2.30

3.0 -1.1 2.0 1 .o 0.7

-0.4 27.8

1245 861 623 239 383 747 364 -76

8.08

10656 31 65 7491 1869 5621 445 53

1245

1684 1465 8433 821 3

1628 1465 164 33

115 17 97

-440

25.3

1231 825 560 265 406 691 285

8.05 -1 82

10250 3451 6800 1835 4964 543 65

1231

1697 1465 8929 8696

1628 1465 164

-467

I= >IO% to social spending I 13 16 16 16 1

67

Annex 6. A Poverty Profile for Ecuador

Trends in Poverty in Ecuador

Although the sources o f information are not always strictly comparable (especially in terms o f income and consumption), there appears to have been a continuous reduction in poverty between 1990 and 1997, serious increases in poverty rates during the 1998-99 crisis, and a partial recovery in the 2000s.

In Ecuador there are a number o f primary surveys that can be used to estimate the distribution o f poverty and how it has changed over time. First, calculations o f poverty measured in terms o f consumption can be based on the L iv ing Conditions Surveys (ECVs) of 1995, 1998, and 1999 (the next ECV i s planned for 2003). These surveys cover both rural and urban areas. Table A.6.1 shows clear increases in poverty and extreme poverty as measured by consumption during 1995-98, and again during 1998-99. During 1995-99 the number o f poor people increased by 65 percent, while the poverty gap and the severity o f poverty also increased significantly, in both rural and urban areas.

TABLE A.6.1. POVERTY MEASURED BY CONSUMPTION

Poverty Rate Gap Severity

1995 1998 1999 1995 1998 1999 1995 1998 1999 Total 34 46 56 11 18 NA 5 9 NA Urban 19 30 42 5 9 NA 2 4 NA Rural 56 69 77 20 29 NA 10 16 NA

- - - - - - - - -

Extreme Poverty Rate Gap Severity

1995 1998 1999 1995 1998 1999 1995 1998 1999 Total 12 17 21 3 5 NA 1 2 NA Urban 4 7 9 1 2 NA 0 1 NA Rural 23 30 38 6 9 NA 3 4 NA Sources: World Bank (ZOOO), and Ledn (2002).

- - - - - - - - -

As for poverty measured by income, calculations can be based on two sources, the f i r s t o f which i s the Urban Survey on Employment, Underemployment and Unemployment. This survey has been carried out annually since 1987. Until 1999 it covered only urban areas, but since 2000 it has covered both urban and rural areas. In addition, since March 1998, the Central Bank has been carrying out a monthly survey o f employment in the three main cities in the country (Cuenca, Guayaquil, and Quito). Measuring poverty by income has serious disadvantages compared to measuring it by consumption: in general, income fluctuates cyclically (especially in rural areas) and i s more subject to errors in measurement. In Ecuador, however, the measurement of poverty by income i s essential in order to trace trends in poverty since 1999.

To calculate poverty by income, the Sistema Integrado de Indicadores Sociales del Ecuador (Integrated System o f Ecuadorian Social Indicators, SIISE) has set the poverty line at US$2 per person per day. The advantage of t h i s i s that it facilitates comparisons with other countries. Figure A.6.1, based on the Urban Surveys on Employment, Underemployment and

68

Unemployment, shows a clear reduction in poverty during 1990-97, a sharp increase in 1998 and 1999, and a drop since then (though not to pre-1997 rates). Figure A.6.2, based on Central Bank surveys, shows a similar trend, with increases in poverty between July 1998 and July 2000, and falling since then. Finally, Figure A.7.3 shows that the drop in poverty measured by income between 2000 and 2001 has affected both the country and the cities.

Figure A.6.1. Urban Poverty Measured by Figure A.6.2. Urban Poverty Measured by

Income (annual), 1988-2001 Income in the Main Cities (monthly)

60’o% I I BO%

Source: Surveys on Employment, Unemployment and Underemployment.

Source: Surveys by the Central Bank of Ecuador.

Figure A.6.3. Poverty Measured by Income in Urban and Rural Areas, 2000-01

70%

60%

50%

40%

30%

20%

10%

0% Ciudad Total

Source: Urban Surveys on Employment, Unemployment and Underemployment.

Ecuador and the Millennium Development Goals

The Millennium Development Goals are a set o f goals adopted by the international community to be met by 2015. These goals cover poverty, malnutrition, mother-child health care, education, gender equality, and environmental sustainability. Although no information exists on which to base forecasts for all the Millennium Development Goals for Ecuador, estimates of econometric models based on reasonable suppositions can be made to predict some welfare indicators. A calculation based on 2.7 percent annual growth in GDP (the basic World Bank scenario) shows that Ecuador would “likely” reach i t s goals in primary education (100 percent coverage) and

69

malnutrition (50 percent reduction); would “possibly” reach i t s goals in mortality among infants and children under 5 years o f age (66 percent reduction), and sanitation (50 percent reduction in the population without access to potable water); and would “very unlikely” reach its poverty- reduction goals (50 percent reduction in poverty and extreme poverty).

The likelihood o f meeting the Millennium Development Goals i s very closely linked to the rate o f GDP growth. Table A.6.2 shows the predicted changes in two health indicators (infant mortality and mortality among children under 5 years of age), two education indicators (the illiteracy rate and the net rate o f secondary education), and an indicator of monetary poverty (the percentage o f people whose income i s below the poverty line) in three scenarios corresponding to GDP growth rates of 2,4, and 6 percent. The table shows that al l welfare indicators-particularly the poverty rate-are very sensitive to the rate o f economic growth. I t i s abundantly clear that Ecuador needs high rates of sustained growth to reduce poverty in i t s various manifestations.

Table A.6.2. Projected Social Indicators Based on Alternative Economic Growth Rates 2000 2001 2002 2003 2004 2005 2010 2015

Health Indicators

GDP Growth Rate

GDP Growth Rate

GDP Growth Rate

GDP Growth Rate

GDP Growth Rate

Infant Mortality 2% 30.8 30.1 29.5 28.8 28.2 4% 30.4 29.5 28.6 27.8 27 6% 29.9 28.9 27.8 26.8 25.9

Mortality Among Children Under 5 Years of Age

2% 35.5 34.8 34.1 33.5 4% 34.9 33.9 32.9 32 6% 34.3 33 31.8 30.6

Educational Indicators

Illiteracy Rate 2% 8.7 8.5 8.2 8

6% 8.7 8.4 8.1 7.9 4% 8.7 8.4 8.2 7.9

Net Rate of Secondary Education

2% 53.6 54.6 55.6 56.7 4% 54.3 55.6 57 58.4 6% 54.9 56.7 58.4 60.2

Indicators of Monetary Poverty

Poverty Rate Based on Consumption 2% 55.9 55.8 55.7 55.6 4% 53.9 52.8 51.8 50.7

32.8 31.1 29.5

7.7 7.7 7.6

57.7 59.9 62.1

55.4 49.7

27.6 26.3 25

32.2 30.2 28.4

7.5 7.4 7.4

58.8 61.4 64

55.3 48.7

24.7 22.7 20.8

29 26

23.4

6.5 6.4 6.3

64.5 69.5 74.7

54.2 43.5

22.2 19.6 17.4

26.1 22.4 19.6

5.6 5.5 5.3

70.7 78.6 85.8

52.6 38.5

6% 52 50.1 48.2 46.4 44.6 42.9 35.1 28.4 Sources: SimSIP, and Bank staff based on national statistics.

70

Annex 7. Labor Markets in Ecuador

Ecuador’s labor market was characterized by a tenuous creation o f employment in the formal sector as a result o f a notable deterioration in most o f the indicators during the 1998 crisis, followed by a very timid recovery after 1999. This i s nonnegligible given that emigration increased noticeably after 1998 (approximately 200,000 people have emigrated during the last three years, doubling the number o f Ecuadorians who live and work outside the country). This probably relieved the pressure on the labor market. In fact, official calculations submitted by the Sistema lntegrado de Indicadores Sociales del Ecuador (Integrated System o f Ecuadorian Social Indicators, SIISE) indicate that the rate o f unemployment might be between 0.5 and 2 points higher than the current percentage if al l these people had not emigrated.

The data on real earnings are more confusing in that they depend on assumptions regarding inflation. Calculations according to the latest revision submitted by the Central Bank o f Ecuador show that real labor income increased an average o f 20 percent during the 2000s. The increases were higher than average for the informal sector and among employers and independent workers, and lower than average for the formal sector and for salaried workers. Similarly, we can see deficient performance in terms o f employment and a significant recovery in terms o f real earnings since the 1998 crisis, with potential effects on competitiveness to the point that i t does not reflect true changes in the productivity o f the labor force.

Problems in the Private Market

In th is context o f limited creation o f employment in the formal sector and positive growth in real earnings, two aspects stand out that merit greater attention. First, salary negotiation i s a complex process for Ecuador, both because it involves many agents who negotiate at different levels and times and because, until recently, salaries represented only part, and sometimes a very small part, of what workers received because the rest consisted o f supplements and allowances. Second, formal employment has over the last 10 years been subject to what i s commonly called 6 6 outsourcing,” or the growing use o f so-called “temporary employment agencies” through which temporary employees are hired to do permanent work, thus avoiding the payment o f the contractual obligations that a permanent employee entails.

Congressional ratification o f Ecuador’s Economic Transformation Law (also known as TROLE I) in 2000 sought to deal with these matters by simplifying pay policy in the private sector (“salary unification”) and introducing more flexible and modern hiring methods, such as hourly and temporary contracts. The new Social Security Law also provided that al l workers, regardless o f the nature o f their contracts, must contribute to Social Security, thus equalizing to some extent the contractual obligations of “regular” workers and those hired through temporary agencies.

Setting Salaries, Salary Unification, and Incentives for Creating Formal Jobs

Salaries are set at three different levels: 0 The National Council on Salaries (CONADES) regulates the base salary and annual increases

to it. When no agreement i s reached between employers and workers’ representatives within the CONADES framework, the Ministry o f Labor establishes an annual increase in the base salary equal to expected inflation in the upcoming year. Minimum salaries specific to each occupation (and thus the relative minimum salaries for each occupation) are established in each sector though fixed-salary programs called “sectoral tables” that employers and workers’ representatives renegotiate periodically. In the past, the tables had to be updated annually, but th i s i s no longer the case. Except in the petroleum,

0

71

electricity, and telecommunications industries, the tables seem to be binding, that is, workers receive salaries according to the levels specified by the tables. Employers and workers’ representatives can agree on additional salary increases through “collective agreements” by sector or by company.

0

The interaction between the tables and decisions made through CONADES and the agreements has multiple effects: 0 The tables, by setting relative salaries, have the ability to automatically transmit the increase

in the minimum salary to the entire salary distribution. This situation may or may not be desirable. Although it may be considered reasonable to index the minimum salary according to inflation in order to preserve the buying power o f those less favored by the distribution, it i s not clear that th is i s the best method for al l salary levels. The tables do not reflect differences in productivity between companies in a single sector and thus create considerable salary rigidity at a time when dollarization has diminished the competitiveness o f Ecuadorian companies. In addition, renegotiation could create a tool for unfair competition between large and small companies in the same sector, given that the former are more productive than the latter, and have more decisionmaking power in the process. Increases in the minimum salary that are indexed to projected inflation are desirable in a period of rapidly declining inflation, but once prices stabilize they can cause inflationary pressures. This situation could be exacerbated by the fact that the agreement can propose additional salary increases and at the same time follow what i s stipulated by CONADES if the economic conditions o f the sector and o f the company so require.

0

0

In summary, the system seems too rigid, leaves little room for differences in productivity to be reflected in differences in salary, and makes it difficult to modify relative salaries between employees and companies. In this context, Congress approved salary unification in 2000 (TROLE I). The law establishes that, with the exception o f the 13” and 14” salaries, al l existing allowances should be incorporated in the minimum salary, the purpose being to try to expand the tax base for Social Security and other employment-related taxes that are traditionally paid exclusively on the basis of salaries. Given that in practice these changes w i l l increase the cost o f employment for employers, they w i l l be implemented over five years, so that in each year during that period the base salary w i l l incorporate 20 percent o f al l nonsalary components o f the workers’ pay.

The effective increase in labor costs, combined with a somewhat rigid salary-setting system (which w i l l be s t i l l more rigid once the discretionary element involved in the special allowances disappears), may partially explain why the creation o f formal employment has been limited since 2000 compared to the creation o f informal employment.

Outsourcing and Flexibility in the Labor Market

Since the emergence o f temporary employment agencies, employers have made extensive use o f them, far beyond their cyclical needs, as some companies are now operating exclusively with “temporary workers.” The result o f th is situation i s that the country now has some 2,000 temporary employment agencies employing approximately 10,000 workers, that is, between 5 and 10 percent o f formally employed worker^.^

5 Preliminary data obtained from Ecuador’s representative to the International Labour Office. To date, Ecuador has no reliable and systematic sources on information on outsourcing.

72

Termination costs in Ecuador are similar to those in Peru, Bolivia, and Colombia (approximately equal to 3.5 to 4 months o f average monthly salary), but much higher than termination costs in other countries in the region such as Argentina, Paraguay, and Uruguay (2 to 2.5 months o f average monthly salary), most European countries, and the United States. This suggests that these costs may be part o f the reason why temporary employment agencies are popular.

Another reason why companies use temporary employment agencies seems to be in order to avoid paying employees the profit sharing that i s due to them by law (employers are obligated by law to pay workers up to 15 percent o f all company profits). Although al l workers are entitled to this, regardless o f whether they are temporary or permanent, the threat o f losing work i s enough to keep the demands o f temporary workers to a minimum. This in turn explains why outsourcing did not decrease despite the introduction of hourly and temporary contracts in 2000 (although companies are allowed to hire temporary employees for up to 40 percent of their total work force, regardless o f the company’s type o f activity).

In addition, temporary employees often receive salaries below the legal minimum and are completely denied special allowances. This could partially justify the increase noted in invisible underemployment.

Finally, the fear i s that outsourcing has contributed to a general deterioration o f relations between employers and employees, and to the decrease in training plans and other types o f company investments in human capital, although once again the quantitative data are limited. The second situation could have serious consequences in an era when technology and sk i l ls complement each other and when growth in productivity seems to depend more on the simultaneous accumulation o f both factors rather than the replacement o f one by the other.

In sum, although outsourcing has prevented later increases in informal employment, at the same time it does not have had the principal characteristics o f formal employment: the right o f workers to a minimum salary and some type o f protection, and the right to jo in unions and receive appropriate training.

73

Annex 8. Public Wage Bill Control in Ecuador

Background

Employee Numbers and Public Employment Regimes. Disaggregated data on public employment and pay in Ecuador are dispersed, difficult to obtain, and sometimes unreliable. In the aggregate, the number o f Central Government posts-excluding the Znstituto Ecuatoriuno de Segun’dud Social (Ecuadorian Social Security Institute, IESS)-has grown slightly since 1998, reaching about 3 10,000 in 2002.6 Approximately 34,000 o f those were employees o f autonomous agencies. Data on state-owned enterprise (SOE) employment i s not generally available, but with effort, the MEF or Ministry o f Labor could extract this information from their files. At the subnational government level, consejos provinciales employed at least 8,300 people as o f January 2003. Officials in Quito claim the number o f municipal employees i s about 26,000. Current public employment figures for Ecuador, and recent data for several comparator countries, are shown in Table A.8.1.

Table A.8.1. Public Employment in Ecuador and Selected Countries Ecuador’ Bolivia2 Chile3 Honduras4 Nicaragua3

(2002) (1999) (1999) (2001) %Pop. %Pop. %Pop. % Pop. %

No. Pop. Total Public Employment ... 2.8 3.1 1.9 ...

... 0.1 0.2 ... 0.3 STATE

ENTERPRISES

Armed Forces 56,200 0.4 0.3 0.6 0.1 0.3 Civilian Central Govt. 270,000 2.2 2.3 ... 1.4 1.3

o/w Education 113,000 0.9 1.3 0.8 0.7 0.3 o/w Health 17,000 0.1 0.2 0.2 0.16 0.2 o/w Police 26,000 0.2 ... 0.23 ... ...

Subnational Govt. 34,000 0.3 0.2 ... 0.1 0.1 . . . = Data unavailable. o/w = of which. For a definition of these employment categories see http://wwwl .worldbank.org/publicsector/civilservice/cross.htm. Sources: 1. Calculated from Ministry of Economy and Finance data. The number for subnational government i s an estimate of actual employment. The remaining employment categories represent sanctioned posts, which likely exceed the actual number of public employees. An estimate for the health sector has been derived by determining the share of health care professionals among employees of the Ministry of Public Health in three provinces, then applying this ratio to the country as a whole. 2. The World Bank, Civil Service Reform: Strengthening World Bank and IMF Collaboration, Washington, D.C.: World Bank, 2002, p. 31. 3. World Bank dataset on government employment and wages - http://www I .worldbank.org/publicsector/civilservice/cross.htm. 4. Data gathered by the author, and World Bank dataset on government employment and wages.

The Ley de Sewicio Civil y Carrera Administrativa covers most o f Ecuador’s c iv i l servants (approximately 53,000). Schoolteachers, the largest group o f public employees, are roughly

6 The number of police, health, and education employees has increased over the past five years-by more than 13,000. But posts elsewhere in the Central Government have fallen b y nearly the same number. Employees of the IESS are not included in this figure, because IESS i s considered a “semipublic” institution. IESS employees numbered about 15,000 in 2002.

74

twice that number. They are regulated by the Ley de Carrera Docente y Escalafin del Magisterio. Doctors are one o f nine different Profesionales Escalafon~dos.~ Ecuador’s police and armed forces each have their own escalafones, as do judicial, legislative, and Foreign Service personnel. Another 20,000 state employees are covered by the same law that governs private sector employment, the Codigo de Trabajo. Contract employees, approximately 2,500 in 2002, are covered by the Ley de Sewicio Profesionales por Contrato (see Table A.8.2.)

Table A.8.2. Number of Central Government Posts (by Public Employment Regime, 2002)

Employment Regime No. Yo Total Ley de Servicio Civil y Carrera Administrativa 53,330 16.3

23,865 CODIGO DE TRABAJO

7.3

Ley de Personal Fuerzas Armadas 57,440 17.6 Policia Nacional 26,000 8.0 Profesionales Escalafonados (excl. MCdicos) 3,075 0.9 MCdicos 6,940 2.1 Funci6n Judicial 4,900 1.5 Funcicin Legislativa 320 0.1 Ley de Servicio Exterior 610 0.2

Magisterio Nacional 112,790 34.5

Ley de Servicio Profesionales por Contrato 2,540 0.8 Others 35,120 10.7

326,930 100% TOTAL

Source: Compiled with data from the Ministry o f Economy and Finance.

The Wage Bill. Although public employment increased only modestly from 1998 to 2002, the government wage bill fluctuated dramatically over the same period. Rampant inflation produced a sharp decline (more than 70 percent!) in the real value o f base wages during 1997- 99.8 Following dollarization in 2000, the deterioration in real wages was halted, and was reversed through significant wage increases in March and May o f that year, plus a 50 percent increase at the start of 2002. These increases in base wages were not excessive considering the prior decline in real purchasing power.g However, base wages are merely a fraction o f the wage story in Ecuador. A multitude o f monetary allowances have been added over the years, such that an employee’s salary may include from 20 and 30 separate items. Table A.8.3 shows the relative importance o f base pay and allowances for a sample o f six government ministries/departments for which we have fairly reliable data. In each o f these, base wages account for less than one-quarter of the government’s personnel expenditures. The lion’s share of expenditures i s accounted for by

7 The other eight are lawyers, managers, architects, economists, civil engineers, chemical engineers, geological engineers, and journalists. While doctors enjoy their own pay scale, the remaining eight share a common pay and grading system. 8 Calculated using the Sucre/US$ exchange rates in the Central Bank’s Boletin Anuario No. 24, 2002, p. 154. Even as Ecuador’s GDP fell by more than 5 percent during 1998-2000, the Central Government’s personnel expenditures as a share of GDP shrank from 7.7 percent to 5.2 percent. (Banco Central del Ecuador, Boletin Anuario No. 24,2002, p. 104.) 9 Even after the 2000 increases, civil servants’ base salaries were equivalent to only one-half their 1997 value for those at the bottom on the salary scale, and just one-third for those at the top of the scale.

75

pagos complementarias (for example, decimotercer salario, various bonificaciones). And with the exception o f the Ministry o f Agriculture and Livestock, increases in the total ministry/department wage bill during 2001-02 far exceed the percent increase in base wages.

T h e Fiscal I m p a c t of the Proposed R e f o r m L a w

I t i s very diff icult to calculate the cost o f salary unification. The Ministry o f Labor estimated that i t would cost US$240 mill ion to bring al l public employees under the new pay scale. That i s twice the estimate produced by the Ministry o f Economy and Finance o f what i t would cost to bring al l public employees under the existing 14-grade pay scale." Three factors w i l l determine the final cost:

e The actual monthly wages received by employees in a ministry or department on the eve of salary unification. The real wage increase w i l l be considerably less than the difference between the present and future wage scales, because the state i s already paying salaries well above the current base wage due to accumulated allowances. If an employee already receives a higher monthly wage (including allowances) than he or she i s entitled to under the new pay scale, that individual w i l l not receive any wage increase whatsoever." Many employees wil l be reclassfled in the course of salary unflcation, but the question is how many and to what levels. Staff whose qualifications and job activities are not consistent with their current post w i l l be downgraded, or upgraded as the case may be. I t would be too painful politically and administratively to reduce their salaries, as well. But these employees would have their wages frozen until the job they are performing i s entitled to a wage increase above their current level. OSCIDI estimates that in the ministries and departments they have restructured, nearly half o f the employees in those institutions were reclassified. The number of employees who are not needed to perform the department's functions who can be dismissed with an indemnity payment. How many w i l l be entitled to the maximum indemnity o f US$lO,OOO? How many one-time indemnity payments can the state afford in the short term to reduce i t s long-term obligations?

e

e

The law should aim to be fiscally neutral in the short term, while holding out the prospect for modest but real reductions in the wage bill over the medium and long term. The potential for savings through staff reductions (to mitigate the fiscal impact o f the wage increase) and efficiency gains through reassignment are considerable. Conversely, the cost o f inaction i s likely to be high.

10. 11.

Memorando No. SIP-DM-2002-236. The precise estimate was US$119.9 million. The draft law recognizes that it wi l l not be possible legally or politically to reduce a current employee's salary. Thus, the new base wage wi l l be calculated by dividing all the payments an employee receives (except for the 13th salary, 14th salary, length o f service bonus, and a bonus for relevant academic degrees) by 12 to arrive at his or her new base wage.

76

$ 9 rl

I I

I I

Ecuador at a glance

income

3/5/03

Development :POVERTY and SOCIAL

107

2001 Population, mid-year (millions) GNI per capita (Atlas method, US$) GNI (Atlas method, US$ billions)

__ Lower-middleincome group

Average annual growth, 1995-01

Population ("6) Labor force (%)

Most recent estimate (latest year avallable, 1995-01) Poverty (56 of population below national poverty line) Urban population (% of total population) Life expectancy at birth (years) Infant mortality (per 1,000 live births) Child malnutrition (% of children under5) Access to an improved water source (% of population) Illiteracy (% ofpopulation age 154 Gross primary enrollment (% of school-age population)

Male Female

KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1981

GDP (US$ billions) 14.8 Gross domestic investmenVGDP 23.2 Exports of goods and servicedGDP 21.8 Gross domestic savings/GDP 22.8 Gross national savingdGDP 20.3

Current a c t " balance/GDP -5.8 Interest paymentdGDP 3.6 Total debVGDP 51.6 Total debt service/exports 53.7 Present value of debVGDP Present value of debVexports

1981 -91 1991 -01 (average annual growth) GDP 2.2 4.6 GDP per capita -0.3 2.5 Exports of goods and services 6.1 7.2

Ecuador

12.9 1,300 16.8

1.9 3.0

63 70 28 14 71 8

114 114 114

1991

11.8 22.2 31.4 23.8 15.3

-6.0 3.9

86.4 32.2

2000

2.8 0.9

-1.0

Latin Amerlca & Carib.

524 3,560 1,862

1.5 2.2

76 70 29 9

85 11

130 131 128

2000

15.9 20.1 37.1 26.2 23.6

6.3 3.4

84.2 17.5 82.4

180.0

2001

5.1 3.2

-1.3

2,164 1,240 2,677

1 .o 1.2

46 69 33 11 80 15

107

T

-Ecuador

2001

21.0 25.7 26.7 20.9 20.4

-2.4 3.3

67.6 21.6

2001-05

Economic

1

STRUCTURE of the ECONOMY

(56 of GDP) Agriculture Industry

Services

Private consumption General government consumption Imports of goods and services

Manufacturing

(average annual growth) Agriculture Industry

Services

Private consumption General government consumption Gross domestic investment Imports of goods and services

Manufacturing

1981

11.9 39.3 17.2 48.8

61.6 14.3 20.8

1981 -91

4.9 0.8

-0.3 2.3

1.9 -1.4 -2.0 0.1

1991

14.3 36.3 20.8 49.4

68.6 7.6

29.7

1991 -01

3.6 4.5 4.3 5.1

4.6 2.8 4.2 6.5

2000

10.6 34.7 13.6 54.6

64.0 9.8

31 .O

2000

-0.1 0.8

-6.8 4.7

3.8 4.7

29.0 15.8

2001

9.0 29.4 11.7 61.6

68.9 10.1 31.4

2001

0.7 5.1 2.9 6.0

5.4 0.5

36.8 17.2

3.7 1 -Ecuador - Lower-middleincome group 1.9

4.7

I l W T 40 20 0

-M -40 -ea

20 10 0

.10 2 0 -30

lJOL - Exports -0-lmports

Note: This is a CMU generated At-a-glance table. '*The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond will

* The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond will be incomplete.

be incomplete.

78

Ecuador

PRICES and GOVERNMENT FINANCE

Domestic prices (% change) Consumer prices Implicit GDP deflator

Government finance (% of GDP, includes current grants) Current revenue Current budget balance Overall surpluddeficit

TRADE

(US5 m///ions) Total exports (fob)

Oil Bananas Manufactures

Total imports (cif) Food Fuel and energy Capital goods

Export price index (1995=100) Import price index (1995=100) Terms of trade (1995=100)

BALANCE of PAYMENTS

(US5 millions) Exports of goods and services Imports of goods and services Resource balance

Net income Net current transfers

Current account balance

Financing items (net) Changes in net reserves

Memo: Reserves including gold (US5 millions) Conversion rate (DEC, /mWS$)

EXTERNAL DEBT and RESOURCE FLOWS

(US5 millions) Total debt outstanding and disbursed

IBRD IDA

Total debt service IBRD IDA

Official grants Official creditors Private creditors Foreign direct investment Portfolio equity

World Bank program Commitments Disbunements Principal repayments Net flows Interest payments Net transfers

Composition of net resource flows

1981

16.4 -1.5

1981

2,143 1,323

183

1,996

84 71 9

167 108 154

1981

2,542 2,830 -288

-589 21

-856

486 370

650 1 .o

1981

7,666 151 37

1,397 23

1

8 404 871 60 0

137 55 13 42 11 31

1991

48.7 6.6

1991

2,851 1,059

720 352

2,399

92 668

109 96

114

1991

3,407 3,108

299

-1,117 110

-708

866 -158

1,090 1 .o

1991

10,185 816 31

1,106 150

1

46 102 -78 160

0

247 60 79

-1 9 72

-9 1

2000

96.1 -7.0

27.6 6.6 1 .o

2000

4,927 2,144

82 1 1,229 3,721

298 942

131 83

159

2000

5,912 4,499 1,413

-1,769 1,360

1,004

-697 -307

1,179 1 .o

2000

13,416 862 21

1,276 164

1

68 171

-41 7 720

0

162 69 91

-22 74

-96

2001

37.7 25.5

24.7 6.2 0.5

2001

4,678 1,900

865 1,247 5,363

297 1,661

114 81

140

2001

5,697 6,100 -403

-1,772 1,665

-510

404 106

1,074 1 .o

2001

14,221 898 20

1,550 139

1

73 31

713 1,330

1

32 126 76 49 64

-14

lntlatlon

150 T I 100

50

0

-50

I -GDP deflator b C P I 1

6,000 T I

O1 I 95 96 97 98 99 W

Exports Imports

6 4 2 0 2 4

-6 -8

-10 -12

7118

.\* IBRD E ~ Bilateral B - IDA D - Other multilateral F ~ Private C ~ IMF G - Short-term

Development Economics 3/5/03

79

ANNEX 10. STATUS OF BANK GROUP OPERATIONS

Operations M i 0 (IBRWIDA and Grants) M u m t a m ”

-* TOW Disbursed (Ww)

TOW Disbursed (Closed)

TOW asbursed (active + a d )

of Mich ha5 been repaid

dMich has been repaid

dMich has besn repaid Total Undisbursed (Active) Total Undisbursed (Closed) TOM mdsbursed ( ~ c t i ~ e + aased)

171.57 0.03

2,m3.70 1,49414

2,1~,271,9292? 1 ,w,140.950.95

168.43 0. w

168,428,221.48

AetiveRolect. DmwencaBawssn laEi35 E X p e d e d d M

SupeCvlrlulFLatlng pdnal Amwm In USS Mlllla

n t l RoJedID ProjectName Zd-- “=” RscalYesr leRD IDA DRANT cancsl. UndisR orfg F m W d

wO7131 &RESEARCH S s 1997 210 120 772 376 389 pMn135 AGRlC CENSUS & INFO s s 1998 248 401 -079 w64w5 ECfinSectrTALn s s 2030 100 818 651 Po63644 EC pwrer&comnSect MxRmI.7 &Rural SeM s S 2 0 2 230 2059 262 W74218 EC FWK: Sector FinWlal Managemsnt U U 2oM 139 1386 479 w39084 E G HEALTH SERVICES M3DERNIZATION PRQl s s 1998 450 3013 2507 1163 w40086 EGINDIGENCUS PEOPLES s s 1998 250 0621 OM Po72527 EGPo\hRr&C” Wrs !kdmir&Fiural S m s s 2oM 2 % 3 w 003 m m 7 EGW s U 2030 1515 5ow 3003 mw mw

1821 1 M w40108 ImTRDEilNTEGPAnO s s 1998 210 w56390 W EGOZONE PROTECT II s s 2w1 3 41 279 125 Po39437 RUWIL WVERTY (PROLOCAL) s s 2oM 252 2369 -1 31 Fww24 Rural Water Supply & Sanitation s s 2w1 320 2761 1515 mrall Result a 4 625 5120 17421 13952 9551

Annex 11. Statement of IFC’s Held and Disbursed Portfolio

Ecuador Statement of IFC’s

Held and Disbursed Portfolio As of 313 112003

(In US Dollars Millions)

Held Disbursed

FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic 1997 Agrocapital 3.5 0 0 0.0 3.5 0 0 0.0

1969/1973/19751197711981119821987 COFIEC 0 0.3 0 0.0 0 0.3 0 0.0 199811999 Concessionaria 1 1.5 1.3 0 15.0 2.9 0.3 0 3.8

1999 FV Ecuacobre 3.8 0 4.0 0.0 3.8 0 4.0 0.0 199812003 FavoritaFruit 22.2 5.0 0 0.0 15.2 5.0 0 0.0 1999 La Universal 8.2 0 5.0 0.0 8.2 0 5.0 0.0 1993 REYBANPAC 2.5 0 0 0.0 2.5 0 0 0.0

Approvals Pending Commitment Loan Equity Quasi Partic

Total Pending Commitment: 0 0 0 0

81

d 2 2 d z z w

-3 A4

a 8 a 3 a

E

2 P E

LE

a

d c E &

m 8

m 2 4 m & m 8 2 m

h k2