Report No. 20313-BR Brazil Financing Municipal Investment Issues and Options April 20, 2001 Brazil Country Management Unit Finance, Private Sector and Infrastructure Management Unit Latin America and the Caribbean Region u Document of the World Bank CURRENCY EQUIVALENTS Currency Unit - Real (Rs$) EXCHANGE RATE March 2000 Rs$1.74 = US$1 WEIGHTS AND MEASURES: Metric System FISCAL YEAR: January I - December 31 ABBREVIATIONS AND ACRONYMS ARO Adiantamento de Receita Ordinaria Advances of Current Revenue BCIE The Banco Centroamericano de Integraci6n Central American Bank for Econornic Econ6mica Integration BNDES Banco Nacional de Desenvolvimento National Development Bank Econ6mico e Social BOT Build-Operate-Transfer CEF Caixa Economica Federal Savings Bank CLF Credit Local de France CMN Conselho Monetario Nacional National Monetary Council ESAF Escola de Administra ao Fiscal School of Fiscal Administration FDM Fundo de Desenvolvimento Municipal Municipal Development Fund FGTS Fundo de Garantia de Tempo de Serviqo Unemployment Fund FJP Fundacao JoAo Pinheiro Joao Pinheiro Foundation FPM Fundo de Participa,ao Municipal Municipal Participation Fund IBAM Instituto Brasileiro de Administra,ao Institute for Municipal Administration Municipal IBGE Instituto Brasileiro de Geografia e Estatistica Institute of Geography and Statistics ICMS Imposto Sobre Circula,co de Mercadorias e Tax on Goods and Services Servi,os IDB Inter-American Development Bank INCA Infrastructure Finance Corporation Limited IPEA Instituto de Pesquisa Econ6mica Aplicada Institute of Applied Economic Research IPTU Imposto Predial e Territorio e Urbano Urban Property Tax ISS Imposto Sobre Servigos Service Tax LAC Latin America and the Caribbean MDF Municipal Development Fund NGO Non-Governmental Organization PARANACIDADE Parana State Urban Development Fund PIMES Municipal Development Project in the State of Rio Grande do Sul PMAT Programa de Modernizacao das Adminstra- Municipal Tax Administration ,ces Tributarias Municipais Modernization Program PNAFM Programa Nacional de Apoio a Administrac,o Program to Support Fiscal Administration of Fiscal para os Municipios Brasileiros the Brazilian Municipalities PROMUNI Municipal Development Program (Colombia) Vice President, LCR: David de Ferranti Country Director: Gobind T. Nankani Sector Director: Danny Leipziger Lead Economist: Joachim von Amsberg Task Leader: Mila Freire PROMUNI Municipal Development Program (Colombia) PSP Private Sector Participation RLR Receita Liquida Real Real Net Revenues SFI Special Financial Intermediary SNG Subnational Governments SOMMA Programa de Saneamento Ambiental, Program for Environmental Management, Organizacao e Modernizacao dos Municipios Organization, and Modernization of Municipalities, State of Minas Gerais STN Secretaria de Tesouro Nacional National Treasury Secretary SWM Solid Waste Management PREFACE AND ACKNOWLEDGEMENTS The report is based on the findings of a mission to Brazil in November 1999. The report was prepared by a team comprising Mila Freire (Task Manager), Benjamin Darche, William Dillinger, Cristina MacDowell, George Peterson, David Sislen, and David Vetter. A background paper on international experiences on municipal special financial intermediaries was prepared by Eleoterio Codato. The report draws on contributions from several World Bank Reports, including the 1999 publication, Brazil: Private Participation in Brazil 's Water Sector - Lessons of Experience and Options for the Future. Peer reviewers for this report were Vincent Gouarne, Fernando Rojas, and Hiroaki Suzuki. Alice Gibbons and Solange Van Veldhuizen provided assistance in preparing report documents. This report was produced in collaboration with the Brazilian government, notably IPEA, Caixa Economica Federal (CEF), Banco Nacional de Desenvolvimento Econ6mico e Social (BNDES), and PARANACIDADE. In particular the authors are grateful for the useful thoughts provided by Ricardo Lima, coordinator of Urban Policy in IPEA, as well as Cristina MacDowell and Katia Calmon (IPEA), Andrea Fernandez, Sergio Ferreira and Fernando Vivaqua (BNDES), Jose Renato de Souza and Alexandre Melillo (CEF), Lubomir Ficinski Dunin and Roberto Santouro (PARNACIDADE). A draft report was discussed at technical level in August 2000 in a meeting hosted by IPEA and chaired by Dr. Fernando Resende with representatives of IPEA, BNDES, CEF, ESAF, IBAM, Ministry of Planning, Central Bank, Bradesco, PARANCIDADE, and State of Rio Grande do Sul. The comments were included in the final report which was submitted to the government in September 2000. During the finalization of the report, the Government of Brazil enacted important legislation which affects the municipal finance sector. The Lei de Responsibilidade Fiscal (see pars. 4.17 - 4.27) and the recently adopted initiative to enable the creation of State Development Agencies which may take on the functions of the Municipal Development Funds will influence the development of the sector in the near- and medium-term. The implications of these changes, which will be significant, will be studied in greater detail in future analytical pieces prepared by the Bank in the sector. Brazil FINANCING MUNICIPAL INVESTMENT ISSUES AND OPTIONS Table of Contents Page Preface and Acknowledgments Executive Summary i 1. Introduction 1 A. Purpose of the Report, Major Issues, Nature of the Problem 1 B. Content and Methodology 6 C. Analytical Framework 7 2. Institutional Context and Recent Evolution 11 A. Constitutional Framework 11 B. Recent Evolution of Municipal Finance 13 C. Sources of Municipal Investment Financing 15 3. Municipal Capital Finance: Improving Current Savings 17 A. Increasing Tax Revenues 17 B. Fiscal Transfers 19 C. Level and Composition of Municipal Revenues 20 D. Managing Recurrent Expenditures: Legal Constraints 22 E. Interest Obligations 24 F. User Charges 28 G. The Need for Capacity-Building 31 H. Summing Up 32 4. Municipal Credit Market Development 33 A. Overview of Brazil's Present Municipal Credit Market 36 B. Federal Controls on Municipal Borrowing 37 C. Controls on Municipal Borrowers 40 D. Reflections on Brazil's Municipal Credit Limits 42 E. Municipal Lending Rates and Sources of Financing 46 F. Principles of a Market-Oriented Municipal Credit System 49 G. Credit Risk and Intercepts 52 H. Conclusions and Next Steps 54 5. Private Sector Participation in Municipal Infrastructure Investment and Service Delivery 56 A. Current Private Sector Activities in Municipal Infrastructure 56 B. Legal Risks 5 7 C. Regulatory Obstacles 5 3 D. Financial Obstacles 5 ) E. The Operating and Capital Expenditure Balance 6 ) F. Financing Mechanisms 6 1 G. Activities to Reduce Creditor Risks and Accelerate Approval of Concessionaire Loans 62 H. Investments and Financing Options 64 6. Financial Intermediaries for Municipalities: Lessons from International Experience 68 A. The Rationale of "Debt Instruments for Capital Investment 68 B. International Experience 63 Europe 7) North America 7) Developing Countries 72 India: The Tamil Nadu Municipal Development Fund 73 South Africa: A Private Municipal Development Fund 73 C. The Brazilian Experience with Municipal Development Funds 75 D. How to Deal with Moral Hazard: Issues and Examples 73 E. Credit-Enhancement Programs 8 1 F. Conclusions 8 1 References 8.3 Annexes 85 Annex A: Institutional and Political Context Annex B: Decentralization and the Municipal Situation in Brazil Annex C: PARANACIDADE and Betterment Fees Annex D: Credit-Enhancement Programs Annex E: Statistical Appendix Executive Summary 1. Municipalities in Brazil will face significant near- and medium-term challenges in financing needed infrastructure and municipal services. This report aims to create a framework for analyzing the critical issues facing the municipal sector in order to build a foundation upon which a consensus for the direction of municipal finance in Brazil can be developed. The audience of the report includes central government, municipal and state officials dealing with municipal financing, financial institutions and policy makers dealing with city management and finance. The message of the report is that there should be no "one-size-fits-all" approach to financing municipal investments, and that the future of the sector should be discussed within the context of (a) moving toward greater transparency and accountability, (b) increasing municipal revenues, (c) developing a continuum of financing options based on the type of capital investment and municipal characteristics, (d) insuring a future financial landscape that reflects international experience and successful cases, and (e) where appropriate, increasing the role of the private sector in the financing and provision of municipal infrastructure and services. Underlying these conclusions is the pressing need to continue capacity-building efforts at all levels of municipal and urban management and to ensure continuing macroeconomic and fiscal discipline. 2. The municipal sector in Brazil is a mixture of 5,500 municipalities (both rural and urban) encompassing a broad range of units with extreme differences in size, economic structure, and fiscal outlook. The sector is dominated by small municipalities, 75% of which have fewer than 20,000 inhabitants; most of them are fiscally weak and overly dependent on transfers from upper levels of government. At the other extreme, two mega- metropolises, Rio de Janeiro and Sao Paulo, dominate the fiscal and economic landscape, accounting for almost 10% of Brazil's population as well as two-thirds of overall outstanding municipal debt in the country. 3. Unlike many countries, Brazilian municipalities are not creatures of state governments, but are federal entities in their own right. The national Constitution defines their revenue authority as well as the system of revenue sharing. Functional responsibilities are however defined in fairly general terms, sometimes leading to confusion and allowing state and municipal responsibilities to overlap. 4. Municipalities have responsibility for the provision of usual "household" services - solid waste, police, water and sanitation, and some public transit. They also share responsibility for education and health with the states and, in recent years, have progressively gained more responsibility for investing in the infrastructure required for economic and social growth of local communities. Government estimates indicate that the investment needs in municipal infrastructure - water, sanitation and housing - for the next seven years will be around R$50 billion (see Chapter 1).' In annual terms, this is equivalent to about three times what municipalities are currently investing in these sectors. This value will be larger if municipalities receive fuller responsibilities in the delivery of services like education and health as a result of better definition of responsibilities between states and municipalities. ii Brazil: Financing Municipal Investment: Issues and Options 5. Can municipalities handle it? Available data through 19972 show that while the municipal sector, on average, is relatively fiscally balanced - current surpluses are declining but there is no generalized current deficit among Brazilian municipalities - the needed finance for infrastructure is beyond what even the largest municipalities can afford today. The situation is worsened by the fact that 20% of the municipalities failed to generate even a small current surplus, and that future pension obligations will add further need for financing in the medium term. The challenge for Brazilian municipalities is to examine all possible avenues to increase revenues, strengthen fiscal management and utilize various sources of capital financing: current savings, credit markets, and the privale sector. This report examines each of these elements. 6. The main conclusion of the report is that there is considerable potential to be tapped in terms of financing municipal investment while keeping rigid controls on macroeconomic and fiscal balance. This will require a multi-faceted approach. On the revenue side, the report stresses the critical importance of predictable cash flows as the primary means for direct financing, as well as the need and the potential for improved local tax management, better pricing of municipal services and improvement of the regulatory environment of public utilities. On the debt financing side, the report identifies important opportunities for a stable municipal credit system to develop in the near future with the participation of the private sector and more reliance on market interest rates. The success of this process will depend on the capacity of municipal governments to make sound investment decisions, adopt transparent financial management procedures, and improve their managerial ability. It also depends on the support they receive from the central government in terms of technical assistance, the establishment of transparent rules and enforcing accountability. A. Sector Background 7. The sector. Brazil's public sector is highly decentralized: states and municipalities account for almost half of all public sector revenues and expenditures. Municipalities represent 19% of total public revenues (5.4% of GDP), 13% of public spending, and 240Y6 of gross investment (Bremacker 1997). A large part of social expenditures are financed by municipalities: 31% of primary and secondary education, 20% of health, and 82% of housing and urban expenditures. 8. Continuing Concerns: Despite important improvements since the last report the Bank prepared on the Brazilian municipal sector in 1991, some concerns persist: many Brazilian municipalities have little managerial or financial capacity to invest, the demand for public services in infrastructure has not been adequately addressed, and most of the financing for municipal infrastructure is being funded by a few public sector banks, with little participation of the private sector. Almost one fourth of the municipalities continue to show poor fiscal performance, current deficits hampering their capacity to finance investment needs. 2 Data on municipal finance is no longer collected by STN as the "delegacias da Secretaria Nacional de Controle" have been closed. The only data available for municipal finance is collected by CEF which does not cover the universe of Brazilian municipalities. Brazil: Financing Municipal Investment: Issues and Options iii 9. Persisting infrastructure needs. In the last 10 years there has been a significant improvement in the delivery of urban infrastructure services. Nevertheless, there are still important gaps, with the poor faring considerably worse than the average Brazilian. While access to electricity is almost universal, and 91% of the population has piped water, only 72% has adequate sewerage (for the poor, the percentage is even smaller, 37%). Regional disparities are striking: in the Southeast, piped water and sewerage are available to 94% and to 81% or the population, respectively. In the Northeast, the coverage rates are only 58% for water and 37% for sewerage. Among the poor in the Northeast, coverage rates fall to 37% and 17% respectively. 10. Striking differences. As expected, the differences in the provision of services are related to the level of investment municipal governments can afford. In 1997, the level of per capita investment in Northeast municipalities was less than half of what Brazilian municipalities invest on the whole. In the case of the large metropolitan areas - Recife, Bahia, Fortaleza - the differences were even greater: R$ 10 (about US$6) per capita in the Northeast metropolises, compared with R$74 (about US$44) in the Southeast. In general, very small municipalities (below 50,000 people) and megacities invest more in per capita terms. The Northeast's major metropolitan areas are the exception -per capita investment in large cities in the Northeast is one-fourth of what the small cities spend (See Table 1.4). 11. Role of the World Bank. For many years, the World Bank (the Bank) has been involved in lending and non-lending work in the Brazilian municipal sector. After the first generation of urban projects in the 1970s and 1980s, which focused on sites and services, slum upgrading, and metropolitan citywide infrastructure, Bank programs were refocused in the 1990s toward strengthening local technical capacity, institutional development, fiscal and financial management, and cost recovery. This was in line with what the new Constitution demanded from municipal governments - that is, more responsibility for the delivery of social services and environmental management, and wider fiscal responsibilities. Bank projects supported the creation of state urban development funds that aimed at making municipal governments more self-reliant in terms of fiscal resources and project implementation responsibilities. Municipal Development Funds (MDFs) were financed in the states of Parana, Rio Grande do Sul, Santa Catarina, Ceara, and Minas Gerais. 12. Municipal DevelopmentFunds3. Since the early 1980s, 35 World Bank-financed municipal development funds (MDF) have been implemented in 26 countries. The programs in Brazil have been among the most successful. MDFs represent 10% of the total credit available to the municipal sector -- outstanding credit to MDFs is around R$900 million compared with total outstanding municipal credit - R$14 billion (distributed among the federal government, CEF, and BNDES). The impact of MDFs has been felt in the financing of municipal improvements, but their effects have been most visible in capacity-strengthening. Working with medium and small municipalities, MDFs 3 The functioning of the Brazilian MDFs has been affected by the Lei de Responsibilidade Fiscal, approved in 2000. Recent legislation allows for the creation of State Development Agencies which may take over the functions of the MDFs. iv Brazil: Financing Municipal Investment: Issues and Options have contributed to an increased awareness of the tax capacity of municipalities and the available ways to tap of resources of the community in order to boost the provision of services. They have encouraged the formation of association of municipalities and strengthen the capacity of municipal governments to prepare sound urban projects. Examples of Parand (PARANACIDADE), Minas Gerais (SOMMA), and Rio Grande do Sul (PIMES) are encouraging, and their experience in municipal finance can play a key role in preparing the transition to increased private sector financing (para. 50.). 13. Brazil's municipal sector is poised for significant changes. The autonomy that the Constitution has given to municipalities has been used by mayors and city managers to develop innovative approaches in dealing with city finances, private sector investment, ard increased participation form the public. The examples of participatory budgeting in Portc Alegre and Belo Horizonte have been replicated in 24 cities in Brazil, and in many ways represent international best practice. Increasingly, one sees municipal governments requesting small loans from BNDES to finance improvements in fiscal management and tax administration. New experiments have been tried in Natal, Fortaleza and Vit6ria. The large cities with a relatively wider pool of good managers are ready to innovate and improve their fiscal responsibility. 14. Smaller municipalities represent the real challenge, for they do not have the size to benefit from economies of scale but have the largest percentage of urban poor, resist forming associations with other municipalities for fear of losing autonomy, and often are reluctant to levy taxes, as anti-tax platforms were often integral to the political carnpaigns for the creation of new municipalities. In the last 10 years, 1,700 municipalities have beer created in Brazil, 90% of which have fewer than 5,000 inhabitants. They survive almost exclusively on transfers from the central government. 15. Developing a solution to the challenges faced by the municipal sector requires a mix of political management and fiscal policies. The next paragraphs concentrate on the technical aspects rather than the political ones, though political concerns are also very important. Annex A contains an analysis of the political and institutional context of the municipal challenge in Brazil. B. Expanding Current Savings 16. To improve investment capacity, municipalities need to improve their savings and strengthen their cash flows. This depends on four factors: (a) the yields of municipal taxes, especially the taxes on services (ISS) and urban property (IPTU); (b) growth in current transfers from the federal and state governments; (c) cost recovery and pricing of municipal services; and (d) reductions in variable current expenditures, particularly personnel and pensions and levels of interest obligations. 17. Revenues. Municipal revenues consist of own revenues and transfers. On average. own-source fiscal revenues account for 35% of total municipal revenues, with transfers accounting for 65%. The situation changes drastically in smaller municipalities: Those with fewer than 20,000 inhabitants depend almost exclusively on grants from the federal and Brazil: Financing Municipal Investment: Issues and Options v state governments. Per capita revenues increase with the size of the municipality; municipalities with populations between 200,000 and 3 million have per capita revenues 45% higher than smaller municipalities. While there has been a considerable effort to increase revenues, the municipal share of tax revenues in Brazil is 5.4%, which is low compared with Spain (8.7%), the United States (16.3%), and Japan (37.7%). The past record, however, is interesting: between 1989 and 1996, municipal tax revenues increased 195%, though during the same period, transfers increased only 88%, less than half of the tax revenue increase (Fundacao Getulio Vargas 2000). There is evidence in Brazil, as in many other countries, that resource mobilization can respond to incentives. When municipal managers are committed to improve services and the public can see the impact that increased tax revenue can have, the resistance against taxes is substantially reduced. For example, in Natal, the city's own-source revenues increased from 15% to 40% of total revenues in less than 10 years. This was possible due to a voluntary effort to collect taxes in parallel with a visible improvement in the services offered to the community. 18. Increasing tax revenues. Brazil's main municipal taxes are the taxes on personal and professional services (ISS), urban property (IPTU), and real estate transfers (Imposto sobre Transmissdo, or ITBI). The ISS is the highest yielding of these three taxes, contributing, on average, 40% of municipal tax revenues. IPTU and ITBI contribute 32% and 7%, respectively, while fees and betterment taxes account for the remaining 20%. The ISS is imposed on all services (except communications) as a fixed percentage of the retail price of the service provided. Tax rates are set by individual municipalities, subject to ceilings (5%) set by the federal government. As an ad valorem tax, the ISS is relatively buoyant with respect to economic activity and inflation. The future of this tax is uncertain, because under the tax reform plans currently being discussed, the base of the ISS would be combined with that of the federal industrial products tax and the state VAT to create a single value added tax, imposed by both federal and state governments. Municipios would then be assigned a retail sales tax to substitute for the ISS. As the details of the proposal have yet to be worked out, the fiscal implications for municipios remain unclear. However, even without an increase in rates, most municipalities could gain substantially by simply collecting the taxes. 19. IPTU, the urban property tax, is imposed on the capital value of all land and buildings within the officially designated urban area (or areas) of each municipio. Property valuations are based on the physical characteristics of each property and adjusted each year on the basis of an inflation index. Property taxes have failed to capture the sharp increases in urban property values and waves of new construction that periodically sweep Brazil as a result of delays in updating data on property characteristics, inaccurate systems used to index property valuations, infrequent revisions of land value data, and inefficient tax collection. The remedies are well-known and include more frequent surveys to capture new construction and changes in use, updating changes in land prices, and improving collection by aggressively pursuing major delinquents in the courts. The chief obstacle to increasing property tax revenues is often the political cost associated with this tax as well as the high cost of updating the tax base. In addition to these, it is important that the property tax assessment methods are transparent and well-known to the citizens. Some countries have introduced self-declaration schemes, simplified the assessment method, and vi Brazil: Financing Municipal Investment: Issues and Options improved the way citizens can pay the property tax. These effort have lead to considerable increases in the collection of property tax. 20. Tax capacitv pro-grams. The main problems that affect the level of municipal revenues include the high level of tax evasion, the political reluctance to increase taxes anid often the lack of knowledge about how to do it. However, it is encouraging to note that most of the Brazilian municipalities collect some or all of the taxes under their control. A recent study by BNDES4 indicates that among 4,622 municipalities surveyed in 1996, 99% collected taxes. The average tax burden was 1.6% of GDP of those municipalities. To encourage municipalities to improve tax collection and financial management, several programs have been launched with the support of the World Bank, Inter-American Development Bank (IDB), the Ministries of Finance, Planning, and Budget, and the two largest public banks, CEF and BNDES: * The Programa Nacional de Apoio a Administra,co Fiscal para os Municipios Brasileiros (PNAFM) is supported by an IDB credit of US$450 million. The goal of the program to be launched in early 2001 -- following the municipal elections -- is to help 1,800 municipalities to improve their tax-management capacity. PNAFM finances the purchase of solutions (or basic kits that can be adapted) available for municipalities with fewer than 50,000 inhabitants and the development of custom-made software and accounting solutions in the case of municipalities with more than 50,000 people. The program is administered by the CEF banking network in conjunction with ESAF which assists in the training component. * The Programa de Modernizaqdo das Adminstracoes Tributdrias Municipais (PMAT), created in 1997, opens lines of credit for the financing of equipment and training to improve tax collection and administration. The loans are small -- five years, up to R$12 million, less than $R18 per inhabitant, and less than 7% of the receita liquida real (real net revenue) -- and finance up to 80% of the investments. BNDES is the project manager. By the end of 1999 the portfolio of PMAT projects totaled R$150 million; 42 municipalities had applied and received support. These municipalities represent 55% of all tax collection and one-fourth of the population. The increases in tax collection were considerable. They varied between 23% in Vit6ria (the capital of Espirito Santo) and 97% in Cuiaba (capital of Mato Grosso). These results are similar to those obtained under the Minas Gerais MDF. SOMMA municipalities have reported that overaLl tax revenues increased 150% in five years. * The program Farol (Lighthouse) of the Banco do Nordeste covers the 1,900 municipalities of the Northeast Region, part of Minas Gerais and Espirito Santo and focuses on helping small municipalities to prepare their own development plans in line with their advantages and potential. The program is very intensive il 4 BNDES, Desigualdades na Carga Tributaria (1996), Inform SF-NO 15, July 2000. Brazil: Financing Municipal Investment: Issues and Options vii technical assistance and includes participatory methods to engage the community in the identification of their problems and available solutions.5 * The institutional components of the municipal development programs funded under PARANACIDADE, Somma (Minas Gerais), PIMES (Rio Grande do Sul), Bahia and Ceara have had a significant impact on the ability of the participating municipalities to improve their institutional capacity (e.g. in managing investment subprojects, using better procurement procedures) and state urban development agencies to plan, finance, and execute investment programs. PARANACIDADE has established associations of municipalities and use an integrated and on-line management system for municipal projects, and SOMMA has developed training materials for small municipalities, for instance. 21. All these programs could benefit from (and are ready for) increased integration and synergy, with identification of the specific contributions that each institution makes, regional coverage, focus, training method, etc. The proposed scale-up of learning and training activities currently under preparation by SEDU, IPEA, ESAF, and the World Bank in Brazil would use this network of professionals to deliver training programs adapted to different groups of municipalities. Areas of possible collaboration also include the definition and preparation of urban management indicators (an area in which the Bank is working in connection with the Urban Observatory6), training in tax policy, and financial management. Box 1 Participatory Budget and Tramparency Brazil's use of participatory budgetng and participatory meethodologies to include the comnunity and the poor in the choice and design of their own programs is unique and probably the best in the world The experience of allocatig a share of the capital budget to be spent with the input olocaf neighborhoods started 10 yeass ago in Porto Alegre. It is used today in several cities, including Belo Horizonte. Participatory budgeting and management is also today a widely accepted way to improve tansparey at the local level and to miniize the effects of corruption in the hani of pubi fnance. Gradually, the notion of preventing corruption and pronotuing "cleane local govenanents is permeating the agenda of local leaders and will help determine the outcome of upooming elections. Participatory budgeting should be evaluated in terms of its fial impact on the efficiency and equity of the final investment allocation and financing 22. Transfers. The main federal transfer is the municipal participation fund (FPM), fixed at 22.5% of the federal government's two largest taxes: the income tax and the S BNB has a group of "development managers" who help communities get organized in search for their economic vocation and potential. Sometimes communities try to bring back traditional activities - e.g. honey or cotton production - tracing the reasons for their decline and putting together programs to bring them back. 6 The Urban Indicators Program of UNCHS (Habitat) is currently developing an integrated network of Local Urban Observatories (LUOs) that will be test beds for data-gathering and management tools and for the development of appropriate methods for the application and analysis of indicators. viii Brazil: Financing Municipal Investment: Issues and Options industrial products tax. The second most important transfer is the ICMS, received frorr the state. Twelve percent of the FPM is allocated to state capitals - a proportion well below their share of Brazil's total population. The remainder is distributed among all other municipalities on the basis of population, using a weighting factor that favors the least populous jurisdictions. Due to its distribution formula, per capita FPM funds are largely concentrated in small municipalities. From the state level, municipalities receive 25% of the state value added tax; 75% of this amount must be distributed among municipalities on the basis of the origin of tax receipts. Small municipalities receive mostly FPM; for medium municipalities, the ICMS is the most important transfer. 23. There is little scope for municipalities to improve the level of transfers they receive from the upper levels of government as these depend on general economic performance. The only issue is the redistributive aspect of the FPM, which seems to penalize the population of the largest cities in favor of micro-jurisdictions. This is a genuine concern of the Brazilian authorities, because this FPM allocation encourages the formation of small municipalities, independent of their economic justification and basis (see Annex B), a serious disincentive to the formation of associations of municipalities. Actually, the incentives for the creation of new municipalities may have to do with the opportunity given to the population to participate in the management of their municipality. In low density municipalities, people away from the center may feel excluded from the political life of their cities, hence the incentive to create their own municipality. A political reform that could provide wider and more effective ways of participating in the management of the municipality could contribute to reducing the impetus to create new municipalities in Brazil.7 This is one of the issues that needs to be addressed in the wider context of the sustainability of Brazil's fiscal federalism system. 24. User charges. Brazilian municipalities impose six main municipal fees or taxas: street cleaning, street lighting, fire fighting, conservation and advertising. These fees account for about 20% of municipal own revenues. Betterment fees, a concept that is closer to the cost recovery objective, have been introduced by less than 10% of Brazilian municipalities but their successful experience may encourage other municipalities to follow. As mentioned before, this is a key aspect in municipal management, as predictable cash flows are essential for municipal financial management and private sector financing. The introduction of full-cost recovery mechanisms, though, faces several constraints, including an arnbiguous regulatory framework, a persisting culture of non-payment for services, and a pattern of political behavior that often undermines progress toward financially responsible municipal service provision. The prinary impediment, though, may be lack of political will. A new generation of city managers is assuming power soon and may well be the champions of a new approach to dealing with cost recovery at the municipal level. C. Expenditures: Legal Constraints ' In 1996, a constitutional ammendment made it more difficult for the creation of new municipalities. Nevertheless, about 40 new municipios will be created in 2000. Brazil: Financing Municipal Investment: Issues and Options ix 25. Controlling personnel costs. Personnel is the largest single item of current spending - 45% on average. While this value is lower than at the state level, personnel is the most obvious target if one wants to improve savings. There are, however, large and costly constraints imposed by the 1988 Constitution. Pension benefits were improved (municipalities had to adopt a single regime for their employees, with pensions being paid directly by the municipal treasury); pension benefits are fixed at 100% of exit salaries and indexed to increases in salaries in the position vacated; and there is liberal eligibility for retirement. Moreover, the Constitution prohibits the reduction of nominal wages. 26. Recent amendments promise to increase municipal discretion over personnel costs. The 19th Amendment (1998) abolishes the single employment regime and grants municipalities temporary authority to dismiss civil servants. The 20th Amendment (December 1998) toughens retirement criteria, notably in terms of years of service and minimum age for eligibility. However, the full impact of these amendments is not likely to be felt for decades. In the short term their effect is likely to be limited, because the new provisions apply only to staff hired after the two amendments went into effect. In addition, some municipalities have been able to "finesse" some of these limitations and have delayed the adoption of the lei de regime unico. 27. Interest oblizations are small and do not affect municipios' ability to generate savings. They represent only 2% of current expenditures. Municipal debt (regulated by the Senate) totaled R$28 billion in 1999, but two-thirds of that is owned by two municipios: Rio de Janeiro and Sao Paulo. Municipal debt stock includes (i) municipal bonds owed by Rio and Sao Paulo alone and limited to rollover; (ii) public bank loans from CEF, BNDES, BDN (62% of total municipal debt); and (iii) loans from the federal government (24%). This last is concentrated in the large cities, the result of debt rescheduling over the last 10 years. Private domestic banks hold 2% of outstanding debt, mostly short-term revenue- anticipation loans (AROs). Direct external borrowing by municipal govermments is also relatively limited and is concentrated again in Rio de Janeiro and Silo Paulo. 28. In sum, the potential for a dramatic increase in municipal revenue for the whole sector might be small, as municipalities depend primarily on transfers as main revenue sources. Nonetheless, small and medium municipalities have a high potential to increase own revenue (as well as their capacity for investment). The results of capacity-building programs sponsored by national and external institutions have shown that these programs need to be scaled up and consolidated if municipal savings are to be increased. x Brazil: Financing Municipal Investment: Issues and Options Stock of Municipal Debt (R$ Million, September 1999) Total 9600 9796 7203 214 1190 28003 737 28739 WithoutRJ&SP 412 2895 6,528 171 117 10122 456 10,467 Structure Across Lenders (%) Total 33.4 34.1 25.1 0.7 4.1 97.4 2.6 100.0 W/o RJ & SP 3.9 27.7 62.4 1.6 1.1 96.7 3.3 100.0 Capitals 42.6 39.4 9.4 1.0 5.5 97.9 2.1 100.0 RJ&SP 50.3 37.8 3.7 0.2 5.9 97.9 2.1 100.0 Structure Across Borrowers (%) Capitals 95.7 86.7 28.2 100.0 100.0 75.4 61.9 75.1 RJ& SP 95.7 70.0 9.4 20.1 90.2 63.9 53.1 63.6 Non-capitals 4.3 13.3 71.8 0.0 0.0 24.6 38.1 24.9 Without RJ & SP 4.3 29.6 90.6 79.9 9.8 36.1 46.9 36.4 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 * Includes federal development banks ** Revenue Anticipation Loans (with maturities less than I year) Source: Government of Brazil 29. In terms of expenditures, personnel is the single largest item for municipalities, but the Constitution limits what can be done in this area. However, cities have tried creative solutions such as contracting out for the provision of services or creating public enterprises. In those municipalities that have large numbers of statutory employees, looming pension obligations appear to be the principal rival to current savings, at least until the impact of recent constitutional reforms is felt. D. Municipal Capital Financing: The Role of Municipal Credit 30. Characteristics. Brazil's municipal credit system has some distinctive features: * Low outstanding debt (12% of public sector debt) and low exposure of municipalities in terms of debt obligations (interest represents 2% of recurrent revenues). * A long experience of municipal borrowing. Five states have been borrowing from MDFs, some for as long as 19 years. * A good record of creditworthiness. Although the largest municipalities, especially Sao Paulo and Rio de Janeiro, have shared in the loan repayment problems and restructuring of subnational debt, especially to state banks, municipalities' loan repayment record to federal lending institutions and to MDFs is very good. There have been no defaults on MDF loans, and no loan restructurings at lower interest rates. In the Parana and Minas Gerais MDFs, less than 0.5% of loans have ever had a late payment. Brazil: Financing Municipal Investment: Issues and Options xi * A developed private banking sector and domestic credit market. * A large backlog of urgently needed municipal infrastructure investment. * Availability of funds in the hands of well-run private sector banks, although there is very little intermediate- or longer-term lending of domestic private sector funds to municipal governments to help finance their investments. * The nonexistence of a credit market linking domestic, private sector suppliers of capital to municipal borrowers. * Heavy administrative regulations on demand and supply of municipal credit. * A concentration of municipal lending from a few public banks. * Very little reliance on market mechanisms. 31. In spite of demand for credit and good lending records, the municipal credit market is controlled by public banks with little or no participation of the private banking sector. Private credit represents less than 2% of total municipal borrowing and is mostly short-term. This is unusually low, both compared with other countries at Brazil's stage of economic and financial-sector development, and compared with the volume of lending to private sector corporate borrowers. This discrepancy is explained at least in part by Brazil's strong tradition of public sector lending to municipalities at "subsidized"/below- market interest rates (see Box 4.8), which has largely eliminated potential private sector competition. Unlike most other countries at Brazil's level of development, where public policy has forced large cities with strong local tax bases to borrow from the private sector at market rates, while providing smaller cities access to parastatal funds supplying subsidized credit, in Brazil the capital cities actually make less use of private sector bank credit than do smaller municipalities and have been able to exercise their political leverage to obtain subsidized credit from public sources 32. In addition, municipalities have suffered from the poor credit reputation of state governments, resulting from the poor record of loan repayment by states to state banks. Most of the continuing crisis in subnational debt has involved state government borrowers, whose loans have had to be taken over the by the national Treasury and repeatedly refinanced at lower interest rates as part of work-out agreements. A few state capital cities have fallen into this same cycle of actual or threatened non-payment of debt service owed to banks, followed by federal assumption of the loan obligation at below-market interest rates. 33. A new vision. Brazil has now announced a national policy priority to break with its history of having the "public sector lend to itself' to finance municipal and other public sector investment. The federal government has imposed tight controls both on municipal borrowing and on lending by public financial institutions to public entities, including municipal governments. The Law of Fiscal Responsibility (LRF, Lei de Responsibilidade Fiscal) approved in May 2000, has prohibited any lending among government levels, xii Brazil: Financing Municipal Investment: Issues and Options banning any direct and indirect lending between federal, states and municipal governmenm. The main objective of these regulations is to limit the federal government's financial exposure to bailouts resulting from undisciplined or politicized borrowing by subnationalk. Over the longer run, the policy change is intended to support more productive capital investment at the local level by limiting the possibility that politically favored local public capital projects can be financed by politically arranged low-cost borrowing from other public institutions. tv0000"000 ~ ~ ~ Si Nub' innuicipa 0;f: 000!0 debt :X 00; i00;: Although few RraA muiipaliti 0hvehil of debt, Sto Paulo is an exception. As of JanWa* 2000, its debt stock totaleightlov $0bi, or ,5 pr cita, compared with 70 X6r the avage Brazilian mnmentad in principle to refince this debt, .~erapproximately the samt e tersasthograntedtothestatesThIs agreement was in jeprdr a while, owing to a cr ttin involing th at thetime The scandal itselfwasptlyai producf pst byd o saof city bos whi n as; nanc ei, gsthatas discnttoa st gr of inves andpticiptn e rsltig profitswhe thebondswnth n ma. In M h 2M000 an ijunctio aissed revigthmayorfrom ce.Thereentlyeected ew m ayor Ahas takenoneo he 34. From vision to action. The closed system wherein the "public sector lends to itself' could be broken in one or both of two ways: (i) private lenders could replace public lenders as the primary suppliers of credit to municipal governments; or (ii) public sector financial institutions could continue to be the principal suppliers of credit, but lend to private sector firms, like privatized water and wastewater companies, which would replace municipal governments as the primary investors in local infrastructure facilities. Up to now, national policy has focused on the second possibility - privatizing local infrastructure companies, while continuing to supply credit for local investment from public institutions at below-market interest rates. Chapter 4 examines the first option - developing a municipal credit market where private institutions lend at market rates of interest. 35. Federal controls on municipal borrowing are designed to (i) reduce credit risk and potential bailouts from the central government, (ii) help the macroeconornic fiscal prograTm, and (iii) accelerate privatization of municipal infrastructure. The controls now in place limit both municipalities' ability to borrow and public financing institutions' ability to lend to public entities. They aim to centralize the management of municipal debt in response to the macroeconomic crisis though which Brazil has passed - and the contribution that state governments in particular made to that crisis. While there is justification for this, these measures may overreact in the case of municipalities by exaggerating the contribution of municipal indebtedness to consolidated public sector deficits and by opting to restrict municipal borrowing through a highly complex set of centralized administrative controls rather than market discipline. 36. Controls on demand for credit consist of administrative controls monitored and exercised by federal institutions. There are no measures that would raise toward market Brazil: Financing Municipal Investment: Issues and Options xiii rates the interest rates charged by federal institutions for loans to finance local infrastructure investment, or expand the participation of private sector lenders in the municipal credit market, thereby increasing the role of the market in disciplining municipal borrowing. The administrative controls take the form of separate borrowing restrictions on (i) the annual volume of new borrowing, (ii) the stock of total debt outstanding, (iii) annual debt service payments, (iv) the primary surplus, and (v) the instruments used to obtain credit (bond issues are prohibited through the year 2010). Most of the restrictions spelled out below are contained in Senate Resolution 78 of July 1998 (see Box 4.4) and its various subsequent amendments. The borrowing limits included in the Law of Fiscal Responsibility will be defined by the Senate in the upcoming months. (See Box.4.6) 37. Controls on the supplv of credit by the public sector to the public sector have been imposed by the Central Bank (Resolution of the Monetary Council, No. 2653, 99). Public sector banks cannot have more than 45% of their equity in the form of loans to or investments in public sector entities. Both CEF and BNDES are subject to this limitation. The state MDFs have been judged to be direct agents of their respective states, rather than financial institutions, and are subject to the prohibition of lending among public sector non- financial entities. This threatens MDFs' existence as major vehicles to help the municipalities improve their management and fiscal capacity. Alternatives are being studied by the central and local governments to permit that MDFs functions will not come to a halt. 8Loans that CEF and BNDES make to private financial institutions, which in turn lend to municipalities or municipal enterprises, are not subject to the public sector lending limit. 38. As a result of the limits on lending to municipalities, both CEF and BNDES have shifted their attention to preparing local infrastructure companies (like municipal or state- owned water enterprises) for privatization. Financing provided to privatized enterprises, or to public enterprises preparatory to a privatization, is not counted against the lending ceiling, as long as the privatization plans are actually implemented. It is not clear at this stage what will happen to the MDFs operations with municipalities, whether they will be transformed into state-development agencies (with financial characteristics), privatized or subject to some other solution. 9 39. Issues. While the reasons for the limits on municipal borrowing are well- understood, the system has some "wrinkles". The most important is the requirement that a municipality have a primary surplus. This limit is a not an effective measure of creditworthiness, as it implies that municipalities could never use net borrowing to finance investment."' If a municipality financed any fraction of its investment budget with net borrowing, it would violate the requirement of a primary surplus. Utilizing the primary surplus alone places a municipio with little debt and a large current account surplus in the 8 Recently passed legislation (April 2001) allows for the creation of State Development Agencies which will be able to take on some of the financing and capacity building functions of the MDFs. 9 According to the Constitution, borrowing from municipalities is prohibited 6 months before and 6 months after the municipal elections. In this context, municipal lending has stopped and will not resume before March 2001. '°The primary balance, defined as total revenue (excluding receipts from borrowing) minus total expenditures (excluding debt service) can be positive only if the entire "real" budget, including current and capital expenditures, is financed with municipal revenues excluding debt receipts. xiv Brazil: Financing Municipal Investment: Issues and Options same category as a municipality with large debt and no current surplus. The objective of municipal debt limitations should not be to suppress borrowing, and therefore to reduce municipal investment, but to ensure that borrowing is used only to finance capital investment that meets reasonable standards of economic returns and can be repaid. 40. To limit bad political behavior and unwise investment decisions, the Law on Fiscal Responsibility appears to be more effective than the primary surplus requirement. Along with the precise limits on outstanding debt decided upon by the Senate (see Box 4.6), some main pillars have been defined. The LRF (a) divides municipal budgets into an operating budget and a capital budget, (b) prohibits multi-year borrowing to finance operating deficits (all cash-flow borrowing to finance operating expenditures must be repaid in the same fiscal year), and (c) requires other borrowing to be used solely to finance investment and limits the growth of net debt to the amount of municipal investment, while (d) imposing separate limits on a municipality's stock of outstanding debt. This latter limit is expressed as a percentage of municipal disposable revenue. A system of debt controls of this type is consistent with good practice elsewhere in the world - it limits debt accumulation, while ensuring that municipalities can borrow prudently to finance investment. 41. The current system creates an unnecessary bottleneck at the Central Bank, because all requests from the 5,500 municipalities require prior approval by the Central Bank before borrowing. This, in turn, implies that the Central Bank must review and verify municipal accounts to confirm that each of the separate borrowing limitations has been met. The review system has not collapsed to date, but only because the vast majority of municipalit es realize that they do not meet the stringent borrowing standards and have not applied for Central Bank approval. 42. The limitations placed on municipal borrowing rely solely on administrative controls. Even under the Law on Fiscal Responsibility - a major improvement in the regulatory framework of municipal borrowing in Brazil as it introduces a much more transparent system of credit allocation - below-market financing is likely to remnain the principal source of credit for municipalities. Nothing in the current or proposed control mechanisms would shift municipal lending toward market rates. Excess demand for municipal borrowing, therefore, will persist - in the sense that more municipalities will want to borrow larger sums than they would if credit carried a market rate of interest. Administrative controls will limit demand but will do nothing to increase the probability that the municipal capital projects that get financed have high economic returns. The controls merely limit the size of the flow and stock of debt, without addressing the productivity of capital. While one understands the present limitations in the context of the fiscal adjustment program, a medium-term vision is required to guide the discussion for a more efficient municipal credit system. 43. Municipal lending rates and sources of financing. Most municipal lending in Brazil is controlled by two state banks, CEF and BNDES, both of which have access to low-cost federal funds collected from social welfare system contributions. These low-cost funds are passed on to municipal and other authorized borrowers with a margin to cover Brazil: Financing Municipal Investment: Issues and Options xv the institutions' operating expenses. In both cases the resulting municipal loans are made at less than half the market interest rate. While subsidizing such loans for social infrastructure can be justified - although as a second best compared with direct transfers to beneficiaries -- there should be debate as to what extent and for how long such subsidies should exist and, more importantly, whether explicit interest-rate subsidies are the most efficient way to finance social infrastructure. As discussed in Chapter 4, capital grants to help finance municipal investments - especially those with externalities or public- good characteristics - could be an alternative more compatible with the goal to encourage the private sector to lend to municipalities. Indeed, despite a worldwide pressure on publicly operated municipal lending institutions to move toward market pricing of municipal loans, none of the recent municipal loans financed by the Bank or the IDB contains provisions that would move MDFs toward market rates of interest in their municipal loans or support a transition from public sector to private sector lending to municipalities. 44. BNDES has examined the possibility of on-lending some of its low-cost funds to private institutions, which would in turn lend to municipalities to help finance infrastructure investment. It would do so at a combined spread of 2.5% over BNDES' cost of funds. The spread would be divided 1% for BNDES and 1.5% for the private banks. Not surprisingly, private commercial banks have expressed no interest in absorbing their administrative costs and the entire credit risk from municipal loans within the remaining 1.5 percentage point margin. 45. Private sector participation in the municipal credit market will become feasible only if public sector lenders are required to adopt market rates of interest in municipal lending, or if the public sector institutions' low cost of capital is passed on to private financial institutions, along with allowance of much greater spreads to cover the combined costs of credit risk and private sector administration of the credit program. Without these market inducements, private lending will emerge only slowly if publicly supplied credit dries up as Resolution 2653 becomes binding and squeezes out additional lending to municipalities by public financial institutions. 46. Credit risk is considerably larger for state and private banks than it is for CEF and BNDES. CEF and BNDES report a fantastic record of loan payment. The banks have had many more municipal problem loans that have had to be taken over and refinanced by the federal Treasury. The inherent credit risk in municipal loans, unsupported by credit enhancements, is high, especially for small municipalities. According to CEF, about 60% of 1,000 municipalities which have requested CEF credit reach a CCC rating or better. Of these, about 10% are rated B and 5% BB. None reaches the BBB threshold of "investment quality." The nearly universal usage of intercepts as a credit enhancement tool, however, would reduce actual payment risk to the very low levels observed at federal lending institutions and state MDFs (Constitutional transfers and tax-sharing payments to municipal borrowers that are not current in debt-service payment can be "intercepted" and transferred directly to the lender). At the federal level, CEF and BNDES use federal law to intercept federal transfers. At the state level, state law authorizes the intercept of state xvi Brazil: Financing Municipal Investment: Issues and Options transfers to municipal borrowers as well as taxes collected by the state and shared with municipalities. 47. The intercept mechanism appears to fully resolve the issue of credit risk for most borrowers and most current lenders. However, the system has broken down in the largest states' capital cities. These cities have successfully argued that intercepting the full amotnt of debt service from transfers and tax-sharing due the cities would strangle the local budget, forcing waves of public employee layoffs, service cuts, and other high-profile consequences. The politicization of debt has proved a successful ploy only for the largest cities, which can grab media headlines and exert pressure on large numbers of political representatives. However, the experience of threatened non-payment of debt service (which was taken to much greater heights of political drama at the state level) has caused private banks to turn away from all types of municipal lending. 48. It is not clear whether the intercept mechanism can be used by the private sector. Presently, the intercept laws in effect in most states authorize payment of intercepts only to other agents of the state government, like MDFs. It would be desirable for any legislation dealing with intercept authority for late payments to also trigger the same set )f prohibitions on further state grants or state transfers to municipalities that are not current in debt service, as is done in Minas Gerais. In addition, lenders would need to calculate the maximum magnitude of intercept that could be needed, and to ensure that loan size does not escalate to the point where intercepts of this magnitude truly jeopardize local budget management and service capacity. As in most countries, giant cities like Sao Paulo and Rio de Janeiro remain special cases. Their high profile and political leverage make standard creditworthiness assessments methods largely irrelevant. Qualitative judgment of willingness to pay plays a correspondingly large role in credit judgments. 49. Governance, moral hazard, and the "politics of governors." In the long term, the government should aim to reduce its efforts to control subnational debt through regulation and to rely more on private capital markets to discipline uncreditworthy borrowers and imprudent banks. The long history of subnational bailouts has created the expectation - among both subnational governments and lenders - that loans to subnational goverumeni s bear an implicit federal guarantee. As long as the federal government continues to reinforce this expectation, subnational governments and their suppliers of credit are likely to continue to behave imprudently. The federal government, therefore, needs to change the perceptions of the market. To some extent, Resolutions 78 and 2653 and the LRF may be useful as transitional measures in this regard, by removing the need for federal bailout 3, but they must be accompanied by a willingness to let local governments that have found a way around the regulations to suffer the consequences. 50. Where to go next? It is unrealistic to expect a swift replacement of subsidized, public sector lending to municipalities by private sector lending at market interest rates. On the one hand, real interest rates in Brazil remain very high due partly to the crowding- out effect of the high public sector debt. On the other hand, there is a supply constraint to long-term financing and long-term loans are rarely made by private-sector lenders, even to highly creditworthy borrowers. As a consequence, most municipalities for some period Brazil: Financing Municipal Investment: Issues and Options xvii will be unable to afford, and unable to obtain, market-priced long-term credit, and private lenders have little incentive to engage in lending to the municipal sector given the high returns to low risk domestic government debt. In addition, municipal governments and private sector lenders, such as commercial banks, have very limited understanding of each other's financial operations. A gulf of stereotyped misconceptions stands between the two. 51. Moving from public sector lending to private sector credit markets for municipalities must be thought of as a gradual and systematic program extended over five to eight years. Such an initiative should include: * Introduction of private sector lenders and municipalities to each other (possibly under World Bank sponsorship), so that the foundation for a domestic credit market can be laid. * Design of a pilot program in which BNDES or another institution with access to below-market funds provides one or more private banks access to these funds for on-lending to municipal governments. Such a program would begin to accumulate actual experience with longer-term municipal lending in Brazil's private sector. The private lending institutions would assume all of the credit risk in such an arrangement. * Simultaneously, discussions should begin on the type of credit enhancements that private banks will require to expand into municipal lending. For example, the intercept arrangements used by state MDFs have proved highly effective in reducing municipal credit risk, and the legal possibilities of extending intercept arrangements as at least partial guarantees for private-sector lending to municipalities should be explored. 52. Over a five- to eight-year period, it is reasonable to expect that macroeconomic policy and financial sector restructuring can succeed in lowering real interest rates in Brazil and opening the way for long-term lending to creditworthy borrowers. It is also a reasonable period over which to move all municipal lending "toward" market rates. The discipline of paying the market cost of capital holds promise both as the most efficient way to restrain municipal demand for credit and raising the productivity of local capital investments financed by credit. The "convergence" of declining real market interest rates coupled with municipal lending that gradually replaces public sector lenders with private sector lenders, while moving toward market rates of interest in municipal credit operations, forms a realistic and desirable policy agenda. A five- to eight-year transition period may seem lengthy, but in fact it will require immediate initiation and energetic implementation. E. Private Sector Participation in the Provision of Municipal Finance 53. While there is room for and need for private sector investment in municipal capital investment, direct involvement of the private sector in the delivery of municipal services is limited by the size of the Brazilian municipalities, legal and financial risks, and the limited xviii Brazil: Financing Municipal Investment: Issues and Options options for such participation. The report examines the situation in the water sector as an example of the constraints faced by private sector participants. 54. The types of projects that have the highest potential for the largest volume of private investment in municipal infrastructure and serve the largest population are water and sanitation concessions, BOTs, and asset sales. The 5,500 municipalities in Brazil thai serve 150 million people offer an enormous market for private sector investment. However, as we have said, of the 5,500 municipalities, 75% have fewer than 20,000 people. Private sector participation (PSP) for these smaller municipalities may not be possible primarily because of the high cost of expanding networks that results in high tariffs required to operate the systems, amortize capital investments, and provide acceptable returns to private investment. The lower income levels of the populations in thie smaller communities would most likely not support the tariff levels required for the private sector to invest in these projects without additional government financial support. Pooling municipalities into larger service areas that achieve population sizes greater than 1 00,00( is one way to overcome the small scale issue. Two recent concessions in the state of Rio de Janeiro have successfully combined several municipalities into larger service areas to attract private investment. 55. The Bank study, Brazil - Private Participation in Brazil's Water Sector: Lessons of Experience and Options for the Future, identified 10 full water distribution and wastewater collection concessions in operation serving a population of 1.4 million people. Three other full concessions that have been signed but are not yet operating because of lack of financing (serving a population of 660,000), and one full concession that was terminated were also identified. There are seven bulk water supply and wastewater treatment BOTs (primarily in the state of Sao Paulo) either in operation or construction serving almost 1 million people, and five BOT concession contracts that have been awarded but not signed to serve 720,000 people. The total population served for operating and proposed concessions and BOTs is fewer than 3 million people. 56. Private sector participation is hindered by (a) Legal risks: While municipalities have the constitutional responsibility to deliver water services, most have delegated this responsibility to state water companies. These companies have generally invested in expansion and bulk water supply. When the state company enters into a concession contract or sale with the private sector, it is not clear how municipalities and the state company share the existing asset ownership or how the distribution of privatization benefits will take place. This problem first emerged in the partial sale of the state of Rio de Janeiro's water company. (b) Regulatory obstacles: There is no standardized national law for water and sewer concessions, and no clear legislation on ownership of existing assets or tariff adjustment. Concession contracts are generally poorly drafted and clauses on tariff adjustment are left unclear. Brazil: Financing Municipal Investment: Issues and Options xix (c) Financial obstacles: Most water companies are in poor financial condition due to a mixture of water losses, redundant labor, and the high cost of borrowing capital combined with low tariffs. PSP in the sector will improve efficiency and financial conditions as demonstrated by PROLAGOS concession (see Chapter 5). However, the main financial problem PSP faces is the risk that politics will interfere with sensible decision-making regarding tariff adjustment. 57. BNDES is the most important source of debt financing for water and sewer privatization. However, water and sewer concessions represent only 3.5% of BNDES lending. This may reflect the systemic risks associated with water and sewer concessions, notably lack of clarity in the ownership of network assets, the political risk that a mayor will refuse to upwardly adjust the tariff, and the potential for a court ruling on a concession in one state to affect another concession in a different state. In this context it is unlikely that BNDES (or any other creditor) will provide sufficient funding to accelerate the depth of privatizations in the sector. 58. The cited Bank report includes a detailed menu of the measures that need to be implemented. These recommendations could be promoted by CEF and BNDES in their current technical assistance program to municipalities, and be included as conditionalities in the loans to be extended by the BNDES. 59. In other services, such as street paving, drainage, and lighting, MDFs (with and without possible private participation) provide substantial financing, using municipal revenues as collateral for the loan. An alternative would be to organize the beneficiaries of the street improvements - e.g., the owners who have frontage property along an improved road - into a non-profit or for-profit entity to manage the street paving. This organization becomes responsible for repaying the MDF loan. This is the approach used by some Brazilian municipalities that have implemented "Betterment Districts" (contribuicao de melhoria) mostly in street paving but also in urban transport, public markets, and street lighting1 as well as by the PROMUNI project for implementing infrastructure improvements in small municipalities in Central America. The Banco Centroamericano de Integraci6n Econ6mica (BCIE) funds the PROMUNI program with contributions from the U.S. Agency for International Development. BCIE acts as a second-tier bank that lends funds to private commercial banks or non-profit organizations. In the smaller municipalities, non-profit organizations organize and assist the community in applying for the PROMUNI loans and manage the construction of the municipal infrastructure improvement. 60. Another approach for MDF financing of municipal infrastructure in smaller municipalities is to establish a pooled financing program. This could be done through a revolving fund and a "loan bank" (a variation of a bond bank). The revolving fund is a II Betterment levies can be highly effective in financing local (tertiary) street improvement and drainage works, where benefits can be easily allocated and beneficiary "ownership" is strong. However, they have not worked at all when applied to trunk streets or traffic engineering investments that have citywide benefits. For these (in large metro areas) a local gasoline surtax has been used successfully in Colombia. xx Brazil: Financing Municipal Investment: Issues and Options variation of a state revolving fund bond financing mechanism common in the United States. Its basic characteristic is that the central government provides a grant to state governments for given infrastructure projects. The grant, with a required state matching grant, is used to provide additional security for a bond issue or for a loan to be made by the fund. The MDF in collaboration with BNDES/CEF would help the municipalities prepare for PSP in municipal infrastructure programs. The revolving fund would lend to the municipal concessionaires if the municipality complies with the procedures and institutional criteria. An alternative is the loan bank, similar to the revolving fund but without the credit enhancement scheme. 61. Other sectors where PSP could be promoted with the help of the existing MDFs or other financing mechanisms are solid waste management and public transit. PSP in solid waste collection and disposal is limited to the large metropolitan areas (Salvador, Belo Horizonte, Manaus, Recife, Rio, Sao Paulo, and Curitiba), although many medium-size cities use some type of third-party private contract to collect garbage. (An ongoing IBAM4 service will bring some additional clarity in the area.) PSP participation in the larger cities is primarily in the form of operating contracts to collect garbage, provide street-sweeping services, and operate transfer stations, composting plants, and incinerators. Usually the private contractor is responsible for financing the collection trucks for these operations, but there is limited involvement in major investment items such as sanitary landfills, treatment plants, and transfer stations.'2 62. Solid waste management has limited economies of scale (especially in collection), and the assets (being "on wheels") can be generally be financed through truck-leasing rather than municipal credit. Final disposal - with clear economies of scale - would call for regional schemes and BOT-type financing, with the revenue stream coming from local taxes in participating municipalities (or tipping fees paid by collection contractors, which does not change the final revenue source but discourages illegal dumping). Given the nature of the service - a non-excludable service - financing through general tax revenue is consistent with the analytical framework adopted in this report and compatible with the participation of the private sector in the provision of these services. The potential for solid waste management projects is worth exploring. F. Alternative Mechanisms for Municipal Financial Intermediation 63. International experience. Brazil's municipal credit systems are poised for significant evolution, and international experience can guide us toward alternatives that have worked elsewhere to develop robust municipal credit systems. Two of the most common instrunents are municipal bonds and specialized financial intermediaries (SFIs). These are not mutually exclusive and, in fact, complement each other insofar as they serve the needs of different segments of the municipal credit market. SFIs tend to be a better alternative for small or specialized borrowers, whereas municipal bonds are a more attractive choice for large and frequent borrowers. Although it is true that in Europe SF] s 12 There are some notable exceptions to this general observation, such as the proposed Sao Paulo incinerator BOT. Brazil: Financing Municipal Investment: Issues and Options xxi tend to dominate the market and in North America municipal bonds are more popular,'3 both places, in fact, operate with both instruments. There are municipal bond issues in Europe, and there are SFIs in North America. Municipal bond banks (in both Canada and the United States) and state revolving funds (in the United States) are typical examples of SFIs in North America. 64. The European experience. Financial intermediaries for local governments in Europe were set up by national governments in the early 1 900s. European countries that have financial intermediaries specializing in local governments are Austria, Belgium, Finland, France, Germany, Italy, Netherlands, Spain, and Sweden. In Finland and Sweden, SFIs were created and are wholly owned by municipalities. In the Netherlands, BNG (Bank Nederlandse Gemeenten) is owned jointly by the national and municipal governments. With the exception of these cases, which have remained in the public sector, all other SFIs have been privatized. 65. Without exception, the European SFIs operate according to capital market rules; they fund themselves in that market. Having to compete for business with other financial institutions as well as with the bond market, these SFIs have to operate very efficiently in order to offer a cost-effective alternative for municipalities seeking to fund capital investments. This implies having a good rating in order to raise capital at the lowest cost possible. 66. The North American experience. Many of the approximately 40,000 local governnent issuers in the U.S. bond market are small and unsophisticated. However, the well-established legal and regulatory processes, the availability of skilled advisers, and competition among potential lenders greatly improve the access of smaller units to the markets. To achieve this objective, as many as 17 states have set up municipal bond banks. Most of these have been created in largely rural states in which there were no strong regional financial markets. Combined with the availability of private bond insurance and preferential federal tax policy, municipal bond banks keep competitive pressure on dealers and private lenders in providing services to small issuers. Their primary function consists of pooling smaller loans into larger offerings, thus providing economies of scale and giving the opportunity for greater liquidity in the secondary market. More recently, the interest at the national level in creating revolving loan funds (see Chapter 5) as a means of replacing recurring capital grants from the federal government has reactivated interest in state-based financial intermnediaries, including traditional bond banks. 67. In Canada, provinces use the bond bank vehicle expansively to borrow on behalf of their municipalities, which only have access to the markets with the permission of the provincial government. This basically amounts to a requirement to use bond banks instead of having the freedom of choice experienced in the United States. The municipal bond market in the United States and Canada is larger than the corporate bond market. '3 By the end of 1999, there was about US$1.5 trillion in outstanding municipal bonds in the U.S. market, representing about 10% of total outstanding public and private debt. xxii Brazil: Financing Municipal Investment: Issues and Options 68. The experience in developing countries is mostly confined to the Municipal Development Funds supported by the Bank and other donors. In many countries of Latir America, notably Argentina, Bolivia, Brazil, Colombia, and Ecuador, the Bank and the Inter-American Development Bank have financed municipal development projects that helped capitalize Municipal Development Funds. Similar initiatives have been supported in India, Jordan, Morocco, and the Philippines. MDFs have made long-term capital available to local governnents for capital investments that otherwise may have never been carried out, given the unavailability of long-term financing in almost all of those countries. They have also encouraged better local government financial management and procurement practices while introducing a credit finance culture to a government level that once had to rely almost exclusively on grants not always allocated according to transparent criteria. 69. The Brazilian experience with the five MDFs has been positive and has offered a number of interesting lessons, not only in ternis of institutional strengthening but also because they have dealt with municipal finance in innovative ways. While small in relatio n to the overall municipal finance market, MDFs have: (a) contributed to a change in mind set, treating municipalities as responsible for their own financing and investment decisions; (b) financed projects according to their feasibility; (c) used intercept and guarantee systems to ensure the repayment of the loans; and (d) charged differentiated interest rates. This experience would be valuable when opening the municipal sector to the private sector banks. MDFs have to be part of this natural evolution, as the markets develop and the new Law of Fiscal Responsibility bans lending between government layers. One alternative is to open the MDFs to the private sector, either by full privatization, securitization or other forms of involvement with private sector. For some of the more developed funds, opportunities for greater private sector participation in the short run might include for- profit MDFs able to finance larger municipal projects. It is crucial that the experience of existing MDFs in Brazil is captured and leveraged through capacity building and technical assistance initiatives. 70. The Indian experience . The Tamil Nadu Municipal Development Fund evolved from a municipal trust fund, like those mentioned before, and is today funded and managed by public and private sectors. It is currently planing to issue bonds in the local market to mobilize additional finance. The initial fund was entirely financed by the public sector, and while it was financially viable, it was too small for the demnand for urban infrastructure investment. In order improve the impact of the fund, the initial fund was converted into an autonomous financial intermediary - the Tamil Nadu Urban Development Fund (TNUDF)/Tamil Nadu Urban Infrastructure Financial Service Ltd. (TNUIFS). The new fund has participation of the private sector - which holds 30% of the capital - and is managed by TNUIFS, a private management company. The scope of operations has been widened to include urban infrastructure projects sponsored by privale investors. 14 In addition, the participating financial institutions have committed to contribute to the fund an amount that corresponds to 44% of the government of Tamil Nadu's initial contribution. The ultimate objective of the TNUDF is to provide self- sustainable financing while mobilizing private savings for urban infrastructure investment. 14 To further pursue the project's objective of poverty alleviation, a new grant fund was established to finance poverty alleviation projects for specific low-income populations. Brazil: Financing Municipal Investment: Issues and Options xxiii The administration of the TNUDF is entrusted to a board of trustees nominated by the government of Tanill Nadu and the participating financial institutions. Participating financial institutions include (i) ICICI Limited Credit and Investment Corporation of India, Ltd., as the leading managing partner of the TNUIFS; and (ii) Infrastructure Leasing and Financial Services and the Housing Development Finance Corporation, a leader in the development and financing of private infrastructure projects in India on a limited recourse basis and a leading finance corporation in the field of housing and regional development. The strong reputation of these institutions in India's business and financial community will help the TNUDF to raise additional resources from other private investors. G. Conclusions and Next Steps 71. From the above, we derive some observations and recommendations: (a) Fiscal federalism. The present constitutional arrangements are very clear in terms of tax responsibilities and revenue sharing arrangements, but assigning expenditures is often unclear, leading to overlaps between municipal and state governments. This is often the case in the education and health sectors, in water and sanitation, and, to a certain degree, in urban transport. A clearer definition of common responsibilities is required. Given the lack of hierarchy between states and municipalities, any changes in the status quo will require consensus. This should be pursued with the support of the central government, especially when there are issues of national concerns, as is the case with education policy. (b) The worrisome small size of municipalities. Despite the 1996 constitutional amendment that prevents the proliferation of small municipalities, Brazil's municipal sector is dominated by small municipalities many of them the result of municipal subdivision. This has increased the unit cost of providing services, increased the administrative costs of the govermnent, and does not allow the minimum size of investments that could be attractive to private investors. In a large percentage of small municipalities, their own source revenues are not sufficient to pay the members of the municipal council. At present, there is a project law to limit the payment of municipal councilors to municipalities with more than 5,000 inhabitants. (c) The possibilitv and necessity of an increase in municipal revenues. Any improvement in municipal financing calls for financially strong municipalities with predictable cash flows. This requires improved tax management and pricing of municipal services as well as an improved regulatory framework for public utilities. Assuming that municipalities have the political will to increase their own revenues, targeted programs for capacity strengthening can be very effective - especially in the case of small municipalities -- as demonstrated by the large number of positive experiences in Brazil, such as SOMMA, PARANACIDADE, PNAFM, PMAT. Given the large number of these xxiv Brazil: Financing Municipal Investment: Issues and Options initiatives, the central government could be the champion of a nationwide initiative to encourage the exchange of programs and to identify the relative advantages brought to the table by each partner. In the case of the Bank, the scale-up of its partnerships with IPEA, ESAF, IBAM, FJP and others should be a priority. Such activities target city managers at the level of large cities, with standardized models that can be replicated by the local partners, adapted to specific local conditions, and designed for distance learning. (d) Better management of personnel costs. The experience of Recife and Curitibax indicates that municipalities are able to decrease personnel expenditures by contracting out or hiring personnel under the regime of the private sector. New experiences with state pension funds with some capitalization should be reviewed and shared. Pension obligations are probably the largest unknown cost to municipalities. (e) Municipal credit markets. The gradual use of market instruments rather than administrative controls, and a progressive overture to private sector financing, can improve the efficiency of municipal credit markets. As the process will take time to be accepted and implemented, immediate steps to be taken include facilitating the knowledge that municipalities and private lenders have of each other and experimenting with private lending for municipal infrastructure projects using at first subsidized funds and particular enhanced mechanisms. (f) Borrowing limits and data. New borrowing limits that apply under the LRF have been submitted to the Senate. These limits apply to the ratio of total debt outstanding to net current revenues and are in line with the principles of transparency and accountability. However, one recommends that the primary surplus requirement should be replaced by more meaningful limitations, for it hurts the best municipalities and hinders long-term investment. In addition, it is urgent to reinforce the national capacity to collect and examine municipal financial data. The delegacias of the Secretaria Nacional de Controle, which had the responsibility to collect municipal date have been closed in 1998 and a major effort is necessary to restore that capability. (g) Interest rates. There should be a gradual but steady move of municipal interest rates toward market levels by all public and parastatal lenders to make room for private lending. In the short term, smaller municipalities would continue to have access to subsidized credit. Larger and wealthier municipalities would face market interest rates. A system of capital grants could be considered to gradually replace the subsidized interest rate system. (h) Joint public-private lending experiments. Private financial institutions could combine with state MDFs or federal lending institutions as joint lenders to municipalities or municipal enterprises, or to finance freestanding revenue- generating projects. The parties would combine their sources of funds in a blended cost of borrowing to the municipality and would share credit risk. Experience of this kind would introduce private banks to the municipal market Brazil: Financing Municipal Investment: Issues and Options xxv and teach them the kind of budgeting and other information that is needed to appraise a municipal loan. (i) Intercepts. Institutional and legal obstacles should be cleared away so that the intercept mechanism can be used to secure private sector as well as public sector loans to municipal governments. To limnit the moral hazard that often associates with the existence of intercept mechanisms, the intercept should be limited to 50 percent of the loan. This would share the risk between the lender and the subnational borrower. Lenders would have incentives to evaluate the profitability of the project and the local government's payback capacity. (j) Moral hazard will remain with the Brazilian subnational credit systems until the mind-set of the public sector, politicians, and the private sector changes. Several mechanisms are described in the main report, notably the steps taken in the United States with state credit boards to ensure that minimum credit ratings and financial conditions are in place before any subnational borrowing takes place. This, however, will never solve the problems coming from political interference and clout, though one hopes that time and the deepening of a democratic tradition will have positive effects on political behavior. Eventually, moral hazard is a question of perception on the lender's side that the central government will not let a subnational entity to default on its debt payment. Such perception will not change unless the central government actually allow a subnational entity to go bankrupt. A less draconian measure will obligate the private banks to make reserves in line with the quality of their portfolio of sub- national debt"5 -- the avenue followed by Mexico and Brazil. (k) Improving private sector participation. To improve private sector participation in the provision of municipal services, a wide-ranging program is required. The program must (i) address the systemic risks that currently affect the water and sewerage system; (ii) implement national standardized legislation regarding private sector concessions; (iii) address or agree on how to solve problems of common ownership between state companies and municipalities; (iv) promote associations of municipalities to provide the minimum amount of business that would attract PDP; and (v) develop financial mechanisms that cater to PSP entities, notably revolving funds or loan pools. (1) No single "right" way. In the way of thinking about how to open the municipal system to competition with the private sector and to market rules, international experience with specialized financial institutions shows that there is no single rule or avenue, and that bond banks can complement SFIs (as in Europe, Latin America, or South Africa). The message is that all the European and North America models are fully privatized, highly scrutinized by the 15 Subnationals undergo a systematic credit rating assessment by credit rating agencies and the percentage of reservices required from the Banks is based on the quality of the sub-national portfolio held by each particular bank. xxvi Brazil: Financing Municipal Investment: Issues and Options market, particularly strict in lending conditions, and often owned by the municipalities themselves. (m) Different approaches for large and small municipalities. Lending to small municipalities would be kept differentiated from credit to larger municipalities, which have a better capacity to go into credit operations "by themselves." The two-tier municipal credit system will need to be maintained. Criteria to separate the mature municipalities from the immature ones would need to be constructed, and the rules must be simple and clear to avoid political manipulation. (n) Only the first step. Continuing analysis is necessary to better understand the structure of expenditures at the municipal level and how this relates to the quality of services provided. In sectors where municipalities and states share the responsibility for the provision of services, this analysis needs to be comprehensive to shed light on the different actors. (o) Institutional Capacitv Building. There is an urgent need to strengthen the capacity of municipalities not only in financial management but also in other sector for which they are responsible. This is particularly important in the case of small and poor municipalities which represent three fourths of the Brazilian municipalities. A cohesive approach to scale up technical assistance will requil e (i) protecting and expanding the successful experience of the municipal development funds throughout Brazil; (ii) coordinating and exploring the synergies of the new programs being implemented under PNAFM, PMAT, Banco do Nordeste, ESAF, WBI; (iii) progressing towards a comprehensive approach to municipal capacity building based on partnerships among government levels and development partners. (p) Transpareny: Brazil has an extremely good record in terms of participatory budgeting at the local level. A committed effort to disseminate this experience to larger numbers of municipalities will contribute to better municipal management, grounded on well identified priorities and less susceptible to reni seeking and corruption. (q) Helping the poor. The real losers in terms of needed infrastructure and improved municipal service provision are the poor. Simply put, the status quo most negatively affects poor municipalities, who are left with few options to finance key investments. Improving the ability of municipalities to finance and undertake infrastructure improvements will have a dramatic and lasting effeci on Brazil's poor. 1. Introduction A. Purpose of the Report, Major Issues, Nature of the Problem 1.1 This report explores alternative ways to finance municipal capital expenditures while maintaining macroeconomic stability and fiscal discipline. It tries to estimate the financing effort that municipalities will need to make in order to meet the demand for infrastructure services over the next five to 10 years, taking into account the municipalities' expected resources from local taxes, user charges, and intergovernmental transfers. The report - aimed at policy makers, municipal officials, and financial managers -- provides a conceptual framework to address these issues in the context of urban management and urban poverty programs supported by the national and subnational governments, external donors, and other development partners. 1.2 The provision of basic services to the poor - water and sanitation services, health care, and so on - is a major focus of Bank assistance to Brazil. At present there are substantial gaps in the coverage of these services, and municipalities play a key role in addressing them. For many Brazilian municipalities this challenge may seem overwhelming, so there needs to be a consistent attempt to improve local capacity as well as making an effort to use infrastructure finance to support increasing private sector participation and reduce fiscal drain from the municipal sectors. 1.3 Brazil's public sector is highly decentralized: States and municipalities account for almost half of public sector revenues and expenditures. Municipalities represent 19% of total public revenues (5.4% of GDP), 13% of public spending, and 24% of gross investment (Bremacker 1997). A large proportion of social expenditures are financed by the municipalities: 31% of primary and secondary education, 20% of health, and 82% of housing and urban expenditures. Unlike municipalities in many other Latin American countries, Brazilian municipalities have a special status in the federal system; rather than being "creatures" of the states, which is the most common institutional setup in Latin America, Brazilian municipalities are recognized as the third tier of government under the 1988 national Constitution. 1.4 The municipal sector. Brazil has 5,500 municipalities, most of which are very small. Seventy-five percent have fewer than 20,000 residents. Revenues come from two main taxes - on urban property (IPTU) and professional services (ISS) - and from transfers from the states and the federal government. On the average, a municipality's own revenues account for about 35% of its total revenues, and transfers account for 65%. But for small municipalities - below 20,000 inhabitants - the level of dependency reaches 90% (see Table 3.1) 1.5 The Constitution is not very explicit in how it allocates responsibilities to municipalities. Municipalities are supposed to provide services of local interest - housing, urban development, street cleaning, waste management, security, etc. They are also co- responsible with the state governments for the provision of major social services such as 2 Brazil: Financing Municipal Investment: Issues and Options education, health, social assistance, water, and urban transport. 16 Given the fact that municipalities are constitutional entities and not subject to states' control, there is no way to disentangle cases of blurred responsibilities. This is particularly serious in education and water management, and it muddles accountability for performance. Table 1.1: The Relative Importance of Brazilian Municipalities (In Percentage) As Percentage of Total Public Sector Revenue 10.0 9.9 14.5 17.1 18.9 Expenditure 10.2 10.5 11.3 13.0 Of which: Wages and Salaries 10.1 15.7 16.6 17.5 Social Transfers 2.2 51 5.1 5.0 Gross Investment 22.2 30.8 22.9 24.3 As Percentage of GDP Revenue 2.7 2.4 3.8 5.2 5.4 Expenditure 2.6 2.5 3.7 4.3 Of which: Wages and Salaries 8.3 5.6 7.1 10.2 Social Transfers 0.2 0.8 0.5 0.5 Gross Investment 1.0 0.7 0.6 0.7 Sources: World Bank (1992); Bremacker (1997). 1.6 Previous Bank work. The Bank's last analysis of the municipal sector (World Bank 1992) focused on the impact of the 1988 constitutional reforms on the ability of municipalities to manage their new responsibilities and their new resources. The report identified several concerns. First, for many sectors that required a municipal role in service delivery, such as pollution control or health, the municipalities' expertise was limited. Second, the performance of some traditional municipal services, such as primary education and solid waste management, was deteriorating, and there was a concern that municipalities would not be able to expand service unless they reduced quality. Finally, there was a concern that imbalances between revenue sources and expenditure responsibilities could lead to a fiscal crisis in some municipalities. 1.7 The report concluded by emphasizing the need to ensure efficient provision of municipal services as well as the fiscal discipline at the municipal level. It insisted on the need to (i) improve the data basis; (ii) make sure that intergovermnental transfers were clear, predictable, and formula-driven to avoid room for negotiation; (iii) use cost recovery in pricing policy; (iv) reform municipal expenditure management; and (v) increase the private sector role in the delivery of public services. 16 States build and operate water utilities, but municipalities can pay for the extension of water lines into favelas (slums). Both state and municipal governments finance and construct primary schools in the state system. While the federal and state governments play the predominant role in highways, municipalities can build highways, too. Even urban transport (the metros and suburban railway systems) can be state or municipal. Brazil: Financing Municipal Investment: Issues and Options 3 1.8 Some of the above matters are still valid. There is a perception that Brazilian municipalities have little capacity (both financial and managerial) to invest, that the demands for public services in infrastructure have not been adequately provided for, and that most of the financing for municipal infrastructure is being funded by a few public sector banks, while special grants (convenios) obtained in a discretionary fashion from upper levels of government are still widely used. This perception is supported by this report. In addition, a study of CEF (1998)17 shows that municipal investment has declined in the last five years, that short-term credit is on the rise (mainly supplier credits and arrears), and that a large number of municipalities may not be creditworthy. 1.9 Infrastructure needs. Despite significant improvement in the delivery of urban infrastructure services, there are still important gaps. While 99% of the urban population has access to electricity and 91% to piped water (Table 1.2), only 72% have adequate sewerage (and only 35% of the poor do so), and less than 20% of collected sewage is treated. Regional disparities are striking: 94% of the population in the Southeast has access to piped water; in the Northeast only 58% does, and among the poor only 37%. As for sewerage, 81% of the population in the Southeast have access; in the Northeast only 37%. The Northeast poor have even less access - only 17%. Urban services and infrastructure are concentrated in higher-income neighborhoods. Of the 18 million urban- poor households, more than 30% lack piped water, 64% have inadequate sewerage, and 54% live in areas where there is no garbage collection. When low-income households have access to services, service quality is low. Lack of urban transport facilities and inadequate connection to public transport only aggravates the lack of access to working places. Transport subsidies are granted to formal workers, but informal workers and poor residents are further limited in their connectivity with the formal economy. The problems are compounded by lack of access to housing opportunities. Table 1.2: Access to Services by Region, 1997 (In Percentage of Population) Access to Services (%) Neorht North Sotheast SOth ALL West Water All 58.4 69.3 84.2 94.2 93.4 91.0 Poor 37.0 43.1 56.4 70.5 71.0 67.6 Sanitation All 36.5 43.6 39.0 81.4 65.0 71.6 Poor 17.3 16.6 15.2 41.7 25.4 35.7 Electricity All 81.0 93.9 93.0 97.4 96.6 98.7 Poor 69.6 84.8 74.1 83.5 82.1 94.3 Garbage All 48.3 60.0 75.4 83.9 77.4 85.9 Poor 27.2 31.5 43.4 39.6 42.7 56.4 % Urban Population 64.0 95.0 81.0 89.0 78.0 78.0 Sources: Secretaria de Desenvolvimento Urbano and IPEA. 1.10 In terms of municipality size, metropolitan areas are better covered than small urban centers. The most striking case is sanitation, where coverage rates in the metropolitan areas (88%) are twice the coverage of the small centers. The gap, in terms of 17 The study covers 3,800 municipalities that have approached CEF with financing requests. 4 Brazil: Financing Municipal Investment: Issues and Options the poor, is also the most striking, as less than one-fourth of the population in small urban areas has access to sanitation services compared with 58% in the large center (see Table 1.3). Table 1.3: Access to Services by Poor in Urban Areas by Size of Settlement (%) 4e;Metro MtrO Large Medium Snmal ALL LLL Access;; t . 1Services ; Cw i Peihery Urban Urban Urban Urba* Water All 96.6 93.1 93.9 89.8 81.7 91.0 Poor 83.0 72.0 72.6 68.0 59.7 67.6 Sanitation All 88.2 77.4 77.8 66.7 47.9 71.6 Poor 58.1 51.1 43.1 32.5 24.2 35.7 Electricity All 99.6 99.6 99.4 98.5 96.3 98.7 Poor 98.9 97.9 96.9 93.9 91.2 94.3 Garbage All 96.4 85.1 91.7 83.5 69.5 85.9 Poor 81.3 59.0 66.6 55.1 45.2 56.4 Source: World Bank (2000b). 1.11 As expected, these differences in the provision of services are strongly related to the level of investment made by the municipal governments. As illustrated in Table 1.4, the Northeast municipalities invest in per capita terms less than half the national municipal average; the large metropolitan areas - Recife, Bahia, Ceara - invest even less. In 1997. per capita investment in the largest Northeast cities was less than R$ 10 (about US$6). In the largest cities in the Southeast, the corresponding value was seven times higher, R$74 per capita. Another interesting finding is the relation between per capita investment anc size. In most regions, very small municipalities invest more (in per capita terms) than larger ones (50 to 100 thousand people). Per capita investments are relatively high for the largest metropolitan cities, with the exception of the Northeast municipalities. Northeast metropolises invest, in per capita terms, only one-fourth of the per capita investment of the micro-municipalities (fewer than 5,000 inhabitants). Table 1.4: Investment Expenditures (Per capita) by Group of Municipalities, 1997 (R$ Current inhabitant/year) Less than 5,000 39.9 45.1 69.4 72.2 66.7 61.8 5,000- 10,000 25.5 32.6 70.1 30.6 36.6 34.8 10,000 - 20,000 16.7 31.4 58.7 26.5 32.9 26.9 20,000 - 50,000 16.9 27.8 50.4 21.5 34.2 26.1 50,000- 100,000 16.9 47.6 28.2 22.3 33.0 27.1 100,000 - 500,000 22.5 21.8 43.0 22.2 39.7 32.9 500,000- I million. 16.1 6.4 43.3 31.3 More than I million 9.8 45.2 37.4 54.3 73.7 56.2 Total 17.6 34.8 46.0 30.1 47.6 35.8 Source: Secretaria do Tesouro Nacional (1997). 1.12 The Multi-year Plan. At the end of 1999 the government announced a wide and comprehensive program to fill the gaps in infrastructure services within seven years (2000- Brazil: Financing Municipal Investment: Issues and Options 5 Chart 1.1 Expected Public and Private Infrastructure Investments 2000-2007 (R$ billion) Airports - R$ 9.6 Ports - R$ 1 3 Waterways /R$ 2.9 Educabon - R$ 31.4 Highways - R$ 22.4 Health - R$ 34.7 >+:Railways - R$ 18.9 Sanitation - R$ 25.4 NE Water Resources - ydroelecti - R$ 8.6 Housing - R$ 21.3 R$ 29.1 Paging & Trunking - R ~ ~ Termoelectricity - Paging & TrnlJngn Kt R$ . R$ 17.6 1.4R$16 Fiber Optcs -R$ 1.4 Telephone - R$ 67.7 Transmission Lines - Data Communication - R$ 3.3 $R 0.6 Source: Government of Brazil 2007) with public- and private-sector participation. For areas more relevant for the municipalities - water and sanitation and housing - the plan calls for R$21 billion and R$25.3 billion respectively. This is 10 times the overall investment made by the entire municipal sector in 1997 but only 12% of the overall investment program. The Secretary of Urban Development has prepared the principal outlines of an urban development strategy, but the global investment partners - and relative contribution of the global and municipal sectors and the contribution of the private sector - have not been spelled out. 1.13 The Bank's assistance. For many years, the Bank has been involved in lending and non-lending work in the Brazilian municipal sector. The first generation of urban projects in the 1970s and 1980s focused on the financing of sites and services, slum upgrading, and metropolitan citywide infrastructure and services projects. When the 1988 Constitution gave the municipal sector status as a full tier of the public sector, Bank programs began to focus on municipalities, specifically on strengthening local technical capacity, institutional development, fiscal and financial management, and cost recovery. Projects supported the creation of state urban development funds, which aimed at making municipal governments more self-reliant in terms of fiscal resources and project irnplementation responsibilities. 1.14 MDFs were financed in the states of Paranai, Rio Grande do Sul, and Santa Catarina. MDFs were financed by the state government (with help from the international donors) and helped selected municipalities to strengthen fiscal management and technical capacity on a competitive base. These projects had positive outcomes and high evaluation ratings'8 for sustainability and impact. Their emphasis was on municipal revenue generation/expenditure control and financial viability of municipal sub-projects. Most of the investments were oriented toward municipal solid waste, water and sanitation, and street paving. Given the situation as depicted in Tables 1.3 and 1.4, this orientation seemed widely justified. I' By the Operation Evaluation Departnent of the World Bank 6 Brazil: Financing Municipal Investment: Issues and Options 1.15 The MDFs still ongoing in the states of Parana (now financed by the IDB), Minas, Gerais, Ceara, and Bahia have increased the emphasis on poverty intervention and provicLe a range of institutional support for municipalities. 19 The Ceara MDF project is financing the upgrading of low-income areas and funding municipal strategic plans, very much in line with the concept of city development strategies being adopted by many cities around the world. The ParanA MDF requires full cost recovery for all investments; it also introduced important concepts such as the establishment of associations of municipalities, betterment fees, and independence of the MDF management from the state government. The Minas Gerais project has developed detailed training manuals on everything from municipal management to wholesale training to small municipalities. This work has become fundamental in the preparation of programs for capacity building in Brazil. B. Content and Methodology 1.16 The report is organized into six chapters. The introduction describes the overall problem, main issues, methodology and analytical framework. Chapter 2 explains the context under which municipalities operate, and it identifies the main financial trends in the sector. Chapters 3 through 6 focus on alternatives to improving municipal investment capacity: - How to increase municipal current savings to enable municipal governments to finance investment and leverage borrowing (Chapter 3). * How to ensure that the existing municipal credit systems operate efficiently, that municipalities with "good" projects find adequate long-term financing, and that credit is allocated more by market rules and less by political factors - that is, how to move from a segmented and subsidized system to an increasingly market-oriented system (Chapter 4). * How to support the involvement of the private sector in the financing of municipal infrastructure and in helping the transition toward less regulated credit systems. (Chapters 5 and 6) The report draws from previous work undertaken in the Bank - notably Private Participation in Brazil's Water Sector, Lessons of Experience and Options for the Future, Report No. 1999, as well as from research and analytical work developed for IPEA, BNDES and CEF in terms of economic analysis and experience with municipal capacity building. 1.17 The methodology combines the analysis of aggregate municipal financial needs (to understand the problems and issues) with the analysis of specific financing mechanisms used by public and private sector in borrowing and lending. The report uses two cases of municipalities that have adopted innovative ways of financing investment (Bahia and Curitiba), as well as MDFs whose performance can provide lessons to other municipalities 19 The functioning of the Brazilian MDFs has been affected by the Lei de Responsibilidade Fisca, approved in 2000. Recent legislation allows for the creation of State Development Agencies which may take over the functions of the MDFs Brazil: Financing Municipal Investment: Issues and Options 7 (Parana and Rio Grande do Sul) and public/private sector partnerships in solid waste management and water supply (Rio de Janeiro and Sao Paulo). C. Analytical Framework 1.18 Institutional arrangements. It is well known that political concerns are often important considerations that explain the ultimate decisions by policy-makers concerning investment in infrastructure. Many times such decision-making does not correspond to the best resource allocation in terms of needs and objectives. According to the professional literature (Kessides 1993), the choice of institutional arrangements that guides the provision and financing infrastructure should be based on three objectives: promoting efficiency, equity (fair access), and accountability (responsiveness to users and financiers). It is also generally accepted that for most goods and services, competitive markets - mainly involving private actors - are both the most efficient mode of supply and the most accountable to users' (consumers') needs. The most difficult task for all of us who work in this field is to assess whether the conditions of competitive markets apply to specific situations and to determine which functions the government needs to undertake and can implement effectively if such perfect markets do not exist. 1.19 Public versus private. Some guidelines are at hand. The first step is to clarify the rationale for public versus private involvement in infrastructure, which calls for an assessment of whether market conditions exist for each infrastructure activity (see Table 1.5). Some well-known criteria have been suggested: * The nature of the good/service - whether it is jointly or privately consumed (public versus private good). * Conditions of production - to what extent there are economies of scale that create natural monopolies; whether high sunk costs deter new suppliers from entering the market (if not, the activity is said to be contestable); and what degree of coordination in production (e.g., of technical standards) is needed for efficiency purposes. * Externalities and social objectives - to what extent there are benefits and costs associated with the production of the good or service that affect people other than those directly involved in the activity. * Characteristics of user demand - e.g., the degree of consumers' access to information about supply alternatives, and the existence of substitutes for particular kinds of services. 1.20 From the above criteria, we derive the following guidelines for policy: * For activities involving public or quasi-public goods, natural monopolies or projects with high sunk costs, there is a case for a public sector role in planning or financing, or for private sector ownership with regulation. This is the case for the provision of network, trunk-type facilities like power transmnission grids, major highways, and pipelines for water and sanitation, port installations, etc. 8 Brazil: Financing Municipal Investment: Issues and Options * The activities necessary to generate services from those facilities may best be carried out on the basis of competitive bidding for the right to operate the monopoly. The public sector would make sure the consumers are protected from possible abuses of the monopoly and to ensure that other providers of services using the network facilities face fair conditions of access. * For most activities involving capital with low sunk costs (e.g., road freight transport), entry by the private sector should be fully liberalized. * Additional characteristics for infrastructure activities such as externalities, social service objectives, and certain features of user demand may provide justification for public intervention through regulation or fiscal transfers and subsidies but rarely for public ownership. 1.21 Pricing and financing. Infrastructure is more likely to be economically efficient when it is subject to user charges. The absence of user charges has usually not promotec access to services by the poor, but has in fact reduced availability of the service to the very poor, worsening inequalities of access and eventually of well-being. User charges should be based on both costs of supply and considerations of demand (willingness to pay), as well as, to the extent possible, externalities - that is, positive or negative effects of the service on people other than the customer. 1.22 Social obiectives (for public service obligations), such as the supply of water and transport to low-income neighborhoods, should be financed by explicit budgetary subsidies to the provider for these purposes alone. An even better approach, where feasible, is to make payments to the needy population directly. Such transfer payments must be clearly specified at the outset in any contracting arrangement with private providers. Moreover, they should be auctioned off to bidders, who will minimize the costs of such services. Before any such subsidies are justified, the ability and willingness to pay for services should be fully assessed. 1.23 Benefit taxes. In activities where services cannot be priced according to individual consumption, financing through benefit taxes (i.e., taxes paid by the beneficiaries of the services) provides an instrument to manage demand and promote efficient resource allocation. Establishing an explicit link between such revenues and the activities they support can be an important element in transforming activities like road maintenance and municipal sanitation from a bureaucratic to a commercial orientation. Brazil: Financing Municipal Investment: Issues and Options 9 Table 1.5: Municipal Services: Main Characteristics and Pricing Guidelines for ._____________ _ ..Selected Services Natural Monopoly/ Public vs. Private Economies of ScaW SoCI Good Suukei Level of Costs Solid Waste Management: Low subtractability. High/medium Land/air pollution, public Disposal and land fill Medium excludability. health, drainage Solid Waste Management: Medium subtractability. Low Land/air pollution, public Collection, recycling Medium excludability. health, drainage Solid Waste Management: Medium subtractability. High Land/air pollution, public Disposal, Incineration High excludability. health, drainage Urban Transport: Low subtractability. Low Public safety, traffic Traffic signaling Medium excludability. congestion, accessibility Urban Transport: Medium subtractability. Medium economies of Urban congestion Metro/rapid transit: Track Medium excludability. scale/ and Rails High sunken costs Urban Transport: High Subtractability. Low Pollution, urban congestion, Van, bus, taxi, metro, High excludability. public safety, noise. railcars Affordable access Wastewater Management: Low subtractability. Medium Pollution, health effects Conventional sewerage and High excludability. street sewerage; pumping station; treatment plant Wastewater Management: High subtractability. Low/low Pollution, health and well- Low-cost sewerage, basic High excludability. being condition, affordable sanitation access Water Supply: High subtractability. Low (home faucet) Affordable access Piped Low excludability. Water Supply: High subtractability. High (trunk system), Affordable access Non-piped trunk system High excludability. distribution system Source: Kessides (1993) 1.24 Debt instruments. Once incentives for cost recovery and financial discipline are established, the prospects for access to financing improve. Debt instruments should be used in many areas of infrastructure, especially in the creation of long-lived assets to ease the cash flow and promote fair burden-sharing between generations. Instruments such as revenue bonds, as well as equity issues, can provide a good feedstock for emerging capital markets and an attraction to institutional investors. Specialized institutions created to provide credit to municipal government should operate on solely financial criteria. In many cases, local governments need to improve their creditworthiness. This may require effective tax mobilization, as well as changes in the sharing of revenues and expenditures among levels of government. In all cases, subnational debt ought to be regulated by national conditions to ensure that it is compatible with the macroeconomic and fiscal stability. 10 Brazil: Financing Municipal Investment: Issues and Options 1.25 From the above, the following principles underline the analysis in this report: (a) Municipal financing should be available to fund high-rate-of-return projects, and it should be compatible with macroeconomic stability and should minimize moral hazard - i.e., it should avoid federal or state bailouts. (b) Institutional arrangements that guide the provision and financing of infrastructure should be based on the objectives of promoting efficiency, equity (fair access), and accountability in the supply of infrastructure services. (c) The private sector is generally more efficient than the public sector in providing infrastructure services, as long as the conditions of a competitive market apply. (d) Cases of market failures (public goods, economies of scale/sunk costs, externalities) need public sector intervention but rarely public ownership. (e) Infrastructure is more likely to be economically efficient when it is subject to user charges. User charges should reflect both supply costs and demand considerations (willingness to pay), as well as, to the extent possible, externalities. (f) Social objectives such as supplying water and transport to low-income neighborhoods should be financed by explicit budgetary subsidies to the providei for these purposes alone, if this is easier than the preferred method of transferring money directly to the poor people. (g) In activities where services cannot be priced according to individual consumption, financing through benefit taxes provides an instrument to manage demand and promote efficient resource allocation. (h) Debt instruments should be used in many areas of infrastructure, especially in the creation of long-lived assets to ease cash flow and promote fair burden-sharing between generations. (i) Specialized institutions created to provide credit to municipal governments should operate only on financial criteria. This may require effective tax mobilization, as well as changes in the sharing of revenues and expenditures among levels of government. 2. Institutional Context and Recent Developments A. Constitutional Framework 2.1 Under the 1988 Constitution, Brazil is a federal system comprising 26 states and a federal district. Municipios are territorial subdivisions of the states, but they are not creatures of the states. They are federal entities with much autonomy and considerable political clout. In addition, there are liberal incentives for their creation, so more than 1,400 municipalities were created in the last decade. Half of them have fewer than 5,000 inhabitants. The consequences of this proliferation in terms of fiscal policy are discussed in Annex B. 2.2 Brazilian municipalities vary widely in ternis of population, land area, income, degree of urbanization, and other characteristics. The sector is dominated by small jurisdictions: In 1996, 75% of Brazil's municipalities had fewer than 20,000 inhabitants but accounted for only 19% of the country's population (See table 1 in the Statistical Annex). Half of Brazilians live in municipios with populations over 100,000. The poor tend to live in smaller cities, especially the Northeast, where around 50% of the poor live in municipalities with fewer than 20,000 inhabitants. (Table 2.2) Table 2.1 Percent of Population Residing in Municipios of Various Sizes *-e ;''of-; Ue.'N* ' 'utr ' Less than 20,000 24.3 21.0 24.9 27.6 12.5 19.6 20,000 to 100,000 40.2 40.1 24.4 32.4 23.0 30.6 100,000 to 500,000 14.5 18.5 18.1 28.3 29.2 23.4 500,000 to 1,000,000 8.7 0.0 5.7 0.0 9.2 6.8 More than 1,000,000 12.3 20.3 26.9 11.8 26.1 19.7 Percent of Poor Population Residing in Municipios of Various Sizes ,~~~o 4o---_st 2No-'h 8' ' i 'r-. Less than 20,000 45.2 41.5 43.0 32.1 30.7 39.0 20,000 to 100,000 22.1 30.0 23.0 33.6 18.9 23.3 100,000 to 500,000 16.0 18.5 26.0 14.9 13.5 16.3 500,000 to 1,000,000 8.1 2.0 0.0 11.9 4.6 10.3 More than 1,000,000 12.0 7.0 9.0 6.7 2.6 11.1 Source: IBGE - Contagem da Populagao 1996. Gomes and MacDowell (2000). 2.3 Fiscal federalism over time. The legal status, powers, and responsibilities of municipios have varied widely over time. Before independence, municipalities were established only in urban areas. Large rural areas under plantation agriculture operated as semiautonomous fiefdoms beyond the control of local government. The establishment of the republic in 1889 brought a federal structure to Brazil, but local political bosses 12 Brazil: Financing Municipal Investment: Issues and Options (coroneles) continued exercising a substantial control over the local votes, which gave them considerable bargaining power in their dealings with the state governments. 2.4 The 1934 Constitution introduced a more transparent system of intergovernmenial financial relations that strengthened municipal autonomy in relation to state government;. Revenue-sharing was introduced, and municipalities were granted the right to levy their own taxes, organize their own services, and elect all office holders. This was eliminated during the Vargas dictatorship (1937-1945), when municipal councils and executives were appointed by state interveners. With the return of democracy in 1946, the powers granted to municipios by the 1934 Constitution were restored. 2.5 The military government of 1964-1985 retained the municipal autonomy with some limitations. Mayors continued to be elected - except in state capitals, security zoncs, and mineral-producing areas, where they were appointed by the military - but effective autonomy was reduced. As part of its modernization drive, the military federalized the provision of water and sewerage, low-cost housing, and urban rail transit. In the water sector, state governments were required to form state-level water companies as a condition of receiving federal financing. These companies absorbed the functions formerly performed by municipal governments (either directly or through private concessions) in large cities. Urban rail transit, similarly, was federalized through the creation of a federal company responsible for suburban rail systems, and later, the subway systems of Rio de Janeiro and Sao Paulo. 2.6 The 1988 Constitution. With the political liberalization initiated in 1975, municipd powers were gradually restored, mayoral elections in capital municipios having been restored in the mid-1980s. It was the post-mnilitary constitution of 1988 that established the framework under which municipalities currently operate. It also provided for the dire,t election of mayors, vice mayors, and council members for terms of four years. Mayors are elected under a simple plurality system except in municipalities with more than 200,000 inhabitants, where they must achieve 51% of the votes cast through a two-stage voting process if necessary. Mayors may stand for immediate re-election only once (but may rur for non-sequential terms as many times as they wish.) Council members are elected by a party-list system of proportional representation on a citywide basis. There no term limits for council members. 2.7 As mentioned earlier, this Constitution not only defines the federal structure - a federal government, 26 states, and an undefined number of municipalities - but also defines the powers of the federal government. It grants the states "all powers not otherwise prohibited to them by this Constitution."20 The federal government has control over national defense and social security, the issuance of currency and public debt, foreign trade, and the "general norms of public employment." There are some concurrent responsibilities of the federal government and the states, including tax legislation, education, and social assistance; the Constitution specifies that federal law will be limited to "general norms" but will prevail in case of conflict with state legislation. 20 Article 25, Section 1. Brazil: Financing Municipal Investment: Issues and Options 13 2.8 The third tier of the federal structure. Unlike most other federal constitutions, which typically define municipal governments as subjects of their respective states, the 1988 Constitution establishes municipal government as a third tier of government with the same constitutional status as the states. Municipios can adopt their own organic laws, and states cannot compel or prohibit actions by the municipalities within their jurisdictions. In this context and without a clear functional boundary between states and municipalities, the division of responsibilities tends to reflect an accumulation of historical precedents and the relative availability of resources at each level. 2.9 The Constitution has some general prescriptions for municipal responsibilities. They are granted the power to legislate over matters of "local interest" and provide - directly or through concessions - essential public services "of local interest." They also have the responsibility for primary education and health care, but these services are to "be provided with the financial and technical assistance of the federal and state governments." In fact, there is no fixed pattern in the functions performed by municipal governments, and in general municipalities tend to predominate in urban housekeeping services (solid waste collection and disposal, street maintenance, land use planning) while sharing responsibility with state governments for social services (education and health) and the delivery of capital-intensive infrastructure such as water supply, sewerage, highways, and urban rail transport. The degree of such division, however, is arbitrary. In the municipality of Rio de Janeiro, for example, most primary education is provided by the municipal government, a legacy of the city's former status as the national capital. But in the municipality of Sao Paulo, primary education is largely provided by the state. B. Recent Evolution of Municipal Finance 2.10 Until 1997, data on municipal finance were collected by STN through the Delegacias Estaduais da Secretaria Federal de Controls. In 1998 these agencies were closed, and CEF is now collecting this information based on a sample of large municipalities (700,000). Beginning in 2000, all municipalities are required to send quarterly information to the CEF regional offices, the final analysis and publication being the responsibility of STN. In 1997, there was information for 5,000 municipalities or 91% of the total. Best coverage was for the South and Southern Regions. The worst coverage was for the Northern region where information was available for only 70% of the municipalities (see Statistical Appendix). 2.11 Table 2.2 illustrates the evolution of the overall municipal sector. Some interesting features are worth noting. First, both current revenues and current expenditures show a similar evolution - sudden increases in 1990 and 1996, and relatively low growth during the remaining years. The first jump is due to the new Constitution, whose effect on municipal revenues was fully felt in 1990. The second jump follows the implementation of the Plano Real, the stabilization program successfully introduced in 1995. Second, municipal investment, which averaged R$10 billion during most of the 1990s, dropped in 1997 to R$6 billion. This is probably the result of a significant decline in capital transfers, itself related to the implementation of fiscal measures to improve the macroeconomic situation of the country. 14 Brazil: Financing Municipal Investment: Issues and Options 2.12 Contrary to the common idea that the sector is financially bankrupt, Table 2.2 indicates that as a whole the municipal sector in Brazil obtained a reasonable current account balance (e.g .savings) during the last decade, financing between 50% and 600/i, of annual investment. Capital transfers have financed around 20% of capital expenditures - having declined to 18% in 1997 - and credit financed 38% in the last part of the decade. Table 2.2: Municipal Fiscal Performance, 1989-1997 (Billions of Reals) ~Zmwp10 i -Y1991 - 1993 1995oo 1996 7 1977i i, Current Revenues 39.3 44.7 45.9 45.1 48.7 56.4 58.1 Current Expenditures 34.2 38.1 39.4 40.5 43.3 52.9 55.0 O/w/ Interest 1.2 Current Balance 5.1 6.6 6.5 4.6 5.4 3.5 4.6 Investment 7.2 10.6 10.7 8.3 10.1 11.8 6.6 Other capital expend 3.6 1.3 Capital Transfers 2.6 2.7 2.2 1.5 0.9 2.1 1.1 Total Balance 0.5 (1.3) (2.1) (2.2) (3.7) (9.8) (3.7) Financed by 1. Credit Operations 1.3 0.8 1.9 1.9 3.2 2.4 2.5 2. Sale of Assets 0.2 0.1 0.1 0.3 0.1 0.4 0.3 2. Amortization -2.9 3. Other -1.0 0.4 0.1 0.0 0.4 7.0 3.7 Source: Secretaria Nacional Tesouro. 2.13 A closer look, however, reveals large disparities in fiscal performance among regions and size of municipalities. It also shows that about 25% of the Brazilian municipalities showed current deficits in 1997. This means that not only they had no means to finance capital investment but also that they had to borrow (or accumulate arrears) to finance their operating expenditures. The situation is particularly difficult in the Northeast and in the group of municipalities between 100,000 and one million inhabitants. These cases need to have priority in programs of rehabilitation and financial management. Table 2.3: Number of Municipalities which have Current Surplus Popl ation of r tCet Sot Sothi Braiil: Munici aUtes West ___ Ate 5 mil 85.8 76.0 75.9 89.4 81.9 83.8 5 a 10 mil 73.8 68.0 72.7 74.8 79.1 75.3 10 a 20 mil 63.7 80.8 76.5 77.7 75.7 71.6 20 a 50 mil 65.6 84.1 78.3 76.4 66.9 70.0 50 a 100 mil 68.8 78.9 66.7 80.4 75.8 74.2 100,000 to 500,000 67.9 70.0 62.5 62.5 66.7 66.1 500,000 to 1,000,000 66.7 * 100.0 * 50.0 60.0 More than 1,000,000 100.0 100.0 100.0 100.0 66.7 90.9 Total 70.2 76.9 75.1 80.6 76.1 75.3 Source: MacDowell (2000), Secretaria de Tesouro Nacional; IBGE Contagem da Populacao, 1996 2.14 In terms of resource allocation, the patterns vary substantially. For example, in Bahia and Goias (see Brazil: State Social Expenditures, June 1999), the municipalities Brazil: Financing Municipal Investment: Issues and Options 1 5 invest in health between 11% and 16%. In Ceara and Minas the shares are 31.6% and 26.8% respectively. Data are less reliable for this desegregation. On the average, education, health and sanitation represent 52% of municipal spending (table 2.4). Table 2.4: Structure of Municipal Spending, 1997 (as % of total) North Nortbeast Southeast South Center West Jrzil Transport 11.46 5.11 15.39 17.10 15.73 13.88 Housing/Urban 23.93 20.75 19.85 15.42 15.71 19.22 Education 29.94 35.47 25.87 34.86 31.24 29.24 Health, Sanitation 19.67 21.17 24.71 16.76 23.00 22.64 Assistance 7.57 9.65 9.72 10.64 6.80 9.61 Legislature 7.42 7.86 4.47 5.21 7.52 5.40 Total 100.00 100.00 100.00 100.00 100.00 100.00 Source: MacDowell (2000), Secretaria de Tesouro Nacional; IBGE Contagem da Populagao, 1996 C. Sources of Municipal Investment Financing 2.15 Based on the analysis carried out by IPEA, Table 2.5 indicates the relative importance of different sources of municipal financing according to the size of municipality and region. Some conclusions seem apparent: * Capital spending is concentrated in the Southeast municipalities. In 1997, they accounted for around 60% of total municipal capital expenditures. This value has been more or less constant in the last eight years. The metropolitan areas of the Southeast account for one-fourth of total municipal capital expenditures. This is compatible with the fact that the Southeast municipalities have the largest per capita capital expenditure (see Chapter 1). * Small municipalities (fewer than 50,000 inhabitants) and the group of large metropolises (above 1 million) each account for 30% of municipal capital spending. * On the financing of the municipal investment, we isolated three sources: savings, credit, and capital transfers. Savings is by far the most important financing source - 64% on average - having the greatest role in the Northeast (80% of the municipal capital expenditures) and the lowest in the Southeast (50%). • Capital transfers finance 13% of all municipal investment. The Northeast municipalities depend on capital transfers for around 28% of total capital expenditures, while the Southern municipalities receive only 8%. For municipalities above 1 million people, the importance of capital transfers is minimal - 3.7%. * As for access to credit, 39% of municipal capital expenditures seem to be financed by credit, at least in the year 1997. Credit is especially important in the Southeast, where more than half of the capital spending is financed with credit, and much less in the Northeast, where credit represented less than 5% of total municipal investment. 16 Brazil: Financing Municipal Investment: Issues and Options Table 2.5: Municipal Indicators by Region and Population, 1997 Stru 1i0w~stuie$ eudi ure by 1egonand Cit Siz e1 Less than 50,000 2.3 7.2 11.4 6.2 4.8 31.9 50,000 to 100,000 1.2 1.7 4.4 1.5 0.5 9.3 100,000 to 500,000 0.8 2.3 14.3 2.7 1.3 21.5 500,000 to 1,000,000 1.2 5.1 0.1 6.3 More than 1,000,000 2.0 1.0 24.4 2.8 0.7 30.9 Total 6.3 13.4 59.6 13.3 7.5 100.0 Less than 50,000 0.8 2.0 7.9 17.9 4.3 7.5 50,000 to 100,000 12.8 3.3 15.2 24.2 17.4 14.3 100,000 to 500,000 - 3.6 9.7 24.1 0.6 9.9 500,000 to 1,000,000 19.0 3.8 _ 6.6 More than 1,000,000 4.2 87.1 123.8 21.0 5.2 102.8 Less than 50,000 5.9 9.8 |15.5 9.6 6.9 47.8 S0,000 to I100,000 1.7 2.7 6.5 2.2 1.2 14.2 100,000 to 500,000 3.5 4.3 13.6 3.3 1.8 26.5 500,000 to 1,000,000 1.4 1.3 0.6 2.6 More than 1,000,000 3.0 1.3 1.9 0.9 331.9 8.9 Total J4.1 19.6 38.0 16.0 12.4 10.0 Less than 50,000 32.9 17.2 17.1 19.5 18.0 18.9 50,000 to 100,000 17.3 20.5 18.7 18.4 27.5 19.3 100,000 to 500,000 54.1 23.3 12.0 15.2 17.2 15.3 500,000 to 1,000,000 15.3 1.3 101.2 4.1 More than 1,000,000 19.4 16.5 0.9 4.1 33.6 3.7 Total 2.8 1884 9 57. 15.2 20.8 12.6 Less than 50,000 55.0 45.2 63.4 82.9 47.1 60.0 50,000 to 100,000 31.7 50.0 54.0 88.3 54.3 55.8 100,000 to 500,000 178.2 71.8 54.6 48.8 21.7 58.3 500,000 to 1,000,000 105.7 26.5 47.6 41.6 More than I ,OOO,OOO 107.2 478.3 62.8 65.4 86.4 80.1 ITotal E:82.8 88.9 57.2t 72.8 146.7 164.3 Source: MacDowell (2000), Secretaria de Tesouro Nacional; IBGE Contagem da Populac,ao, 1996 Brazil: Financing Municipal Investment: Issues and Options 17 3. Municipal Capital Financing: Improving Current Savings 3.1 As shown before, the main source of financing municipal investment has been current savings of the municipalities themselves. This result is encouraging because it is contrary to the generalized view that all subnational governments in Brazil tend to lack fiscal discipline. This chapter addresses the question of how current savings can actually increase so as to finance additional capital works or to service additional debt. 3.2 The capacity to generate current savings (a surplus of revenues over current expenditures) depends on four elements: (a) yields of the municipal taxes, notably the most important ones on services (ISS) and urban property (IPTU) and cost recovery; (b) growth in current transfers from the federal and state governments; (c) reductions in current expenditures, particularly personnel and pensions; and (d) levels of interest obligations. In practice, only the municipal taxes and reduction in current expenditures are of immediate policy relevance to municipal governments. Revenue sharing, while a key part of the financing of most municipios, lies outside municipal policy control. Interest obligations, except in a handful of very large municipios, does not have a major effect on municipal resources. A. Increasing Tax Revenues 3.3 Brazilian municipalities have exclusive power to impose taxes on personal and professional services (ISS), urban property (IPTU), and real estate transfers (excluding estate taxes). The ISS is the highest-yielding of these three taxes, contributing 40% of the overall tax revenue and 17% of the revenues of the largest municipalities. The tax is imposed on all services (except communications and interjurisdictional public transportation) as a percentage of the retail price of the service provided. Tax legislation is designed to avoid overlap with federal corporate income and state value added taxes." Tax rates are set by individual municipalities, subject to ceilings set by the federal government. Rates vary considerably across sectors. In Sao Paulo, for example, private schools are subject to a tax rate of 2%. Hotels and restaurants, banking services, and security services are taxed at 5%. Nightclubs pay 10%. 3.4 As an ad valorem tax, the ISS is a good local tax, relatively buoyant with respect to economic activity and inflation. Its future, however, is uncertain. Under the tax reform plans being discussed in Congress, the base of the ISS would be combined with that of the federal industrial products tax and the state value added tax to create a single value added tax, imposed by both federal and state governments. Municipios would then be assigned a retail sales tax to substitute for the ISS. As the details of the proposal have yet to be worked out, its fiscal implications for municipios remain unclear. 21 In the banking sector, for example, the ISS is imposed on non-lending services such annual credit card fees, ATM fees, and check issuing, but not on the interest charged on loans. In the case of bus transportation, the tax is imposed on intra-municipal buses, but not on intercity or interstate bus transport, which are subject to the state value added tax. 18 Brazil: Financing Municipal Investment: Issues and Options Chart 3.1 Trends in Municipal Revenues con ° 50,000 o 40,000 [I other revenue 6 30,000 0 other transfers 0) _ 20,000 - FPM 10,000 13j taxes 1989 1991 1993 1995 1997 Source: Secretaria Nacional do Tesouro. 3.5 The IPTU, or urban property tax, is the second most important tax for the municipalities as a whole but the only tax instrument for many small Brazilian municipalities. It represents 31% of what the average municipality collects in tax revenues. The IPTU is imposed on the capital value of all land and buildings within the urban area (of each municipio. Property valuations are based on the physical characteristics of each property, converted to an estimate of market value using construction cost data and surveys of neighborhood land values. These valuations are adjusted each year on the basis of an inflation index. 3.6 Issues. While the property tax is by definition a good local tax - as it benefits from an immobile base - there are some problems with the IPTU as it is presently administered by the municipalities in Brazil. The most important problems are lack of updating and poor and inefficient collection. The lack of updating explains the failure of this tax to capture the sharp increases in urban property values and waves of new construction that periodically sweep Brazil. This is due to several factors, but notably (i) long delays in updating data on property characteristics; years can pass before new construction or changes in property use are reflected on property tax rolls;22 (ii) the system to index property valuations does not capture increases in local real estate prices; and (iii) the high political cost of the tax.. Land-value data are rarely revised, and the indexes used to adjust property valuations for inflation capture general increases in consumer prices, not local changes in land values. An alternative worth considering would be to introduce "self- declaration options" as a means to avoid losing track of real estate values between assessments. "A uto-avaluo" was successful in boosting property tax revenues in BogotA, as the city had a deadbeat cadastre. 3.7 Collection inefficiencv is the other problem. Delinquent accounts are subject to fines and interest penalties. Municipalities can impose a variety of administrative tools to enforce payment, including liens on title, and can send delinquent accounts to the courts, which have the authority to order the sale of delinquent properties for back taxes. However, this last remedy is rarely used, and the incentives for owners to pay property taxes are weak. 22 Changes in property use have an important impact on tax revenues, because rates are much higher on commercial and industrial property than on residential uses. Brazil: Financing Municipal Investment: Issues and Options 19 3.8 The solutions to these problems are well-known. Municipalities can (i) survey properties more frequently to capture new construction and changes in use; (ii) revise the tables used to convert physical characteristics into market values in order to capture relative changes in land prices; and (iii) improve collection by aggressively pursuing major delinquents in the courts. However, the property tax often raises strong political opposition. But recent experiences undertaken by several municipalities with assistance from international agencies, BNDES, and CEF do indicate that many municipalities, especially smaller ones, are awakening to the benefits of using the IPTU as an instrument to levy taxes and finance investments for their communities. The link between taxpayers and satisfied consumers seems to be starting to take hold in Brazil. Table 3.1: Own Recurrent Revenue as Percentage of Total Recurrent Revenue, by Groups of Municipalities, 1996 (%) Population Northeast Nortb Center-West South Soutbeast ftal Less than 5,000 2.9 4.4 7.5 9.9 10.1 8.9 5,000 to 10,000 4.0 3.4 7.8 12.9 12.6 10.1 I0,000to20,000 4.0 4.2 9.7 16.3 17.7 12.3 20,000to50,000 5.8 9.1 15.4 23.1 23.0 17.5 50,000 to 100,000 10.6 15.0 19.4 27.1 30.8 25.3 100,000 to 500,000 21.3 18.8 25.0 37.7 36.3 34.2 500,000 to 1,000,000 28.1 * 47.7 * 41.4 38.1 More than 1,000,000 43.6 32.2 43.4 52.5 60.2 55.9 Total 17.9 20.3 20.9 29.2 41.0 33.5 Source: Gomes and MacDowell (2000). B. Fiscal Transfers 3.9 Fiscal transfers represent more than 60% of municipal revenues (on average) and can account for more than 90% of the smaller municipalities' current revenue (Table 3.1). Brazil's transfer system consists of formula-driven tax-sharing arrangements with the federal and state governments. From the federal government the largest transfer is the Fundo de Participacdo Municipal (FPM). It is funded from a fixed share (currently 22.5%) of the two most important federal taxes, the income tax and the industrial products tax. The FPM is distributed_as follows: 12% is allocated to state capitals, with 88% going to all other municipios on the basis of population, using a weighting factor that favors the least populous jurisdictions. Because of this distribution formula, the FPM funds are concentrated in small municipios,23 and one may argue that sometimes the existing system may provoke a forced redistribution of tax income from the largest - and not necessarily richest - municipalities (see Table 3.2). 23 The distribution formula for the FPM was revised several times during the 1990s. The most recent revision, under Lei Complementar 91 of 1997, essentially reinstates the distribution formula established in 1981. 20 Brazil: Financing Municipal Investment: Issues and Options Table 3.2: NET FPM Received By Group of Municipalities, 1996 ($R million) Population Northeast North Center- Soutt Southeast Brsal West ___ Less than 5,000 83 40 99 219 297 740 5,000 to 10,000 258 44 82 220 295 901 10,000 to 20,000 663 50 113 264 375 1.465 20,000 to 50,000 679 50 100 169 392 1.462 50,000 to 100,000 248 45 27 38 103 41 100,000 to 500,000 151 95 34 -101 -785 -603 500,000 to 1,000,000 70 * * * -458 -387 More than 1,000,000 -63 -80 -23 -340 -3.495 -4.003 Total 2.091 280 433 469 -3.274 33,5 Source: Gomes and MacDowell (1999). 3.10 From the state level, municipalities receive 25% of the state value added tax; 75% of this amount is distributed among municipios on the basis of the origin of tax receipts. The remainder is distributed on the basis of formulas devised by each state legislature. Since the VAT is the largest single source of tax revenue in Brazil (excluding social security contributions), this transfer is an important source of municipal revenues, particularly in the larger, more industrialized municipios. 3.11 Convenios. Historically, there has been a widespread use of discretionary federal grants (convenios) as a means of building political support for presidential initiatives. Convenios were therefore a principal element in the financing of municipal capital investment. Fiscal constraints at the federal level have reduced the scale of such grants. C. Level and Composition of Municipal Revenues 3.12 The 1988 Constitution increased the volume of transfers to municipal governments in several ways. On the one hand, it increased the share of federal income tax and industrial products taxes from 17% to its current 22.5%. On the other hand, it increased state VAT transfers by (i) expanding the base of the VAT by abolishing federal taxes on fuel, electric power, and transport, and incorporating their bases into the VAT; and (ii) by increasing the share of the state VAT to be shared with municipios from 20% to 25%. 3.13 As a consequence, municipal revenues increased, reaching an all-time high in 1991. The effect of the new Constitution, however, was offset by macroeconomic developments, as high rates of inflation eroded the real value of municipal tax revenues, as well as the federal and state taxes on which revenue sharing was based.24 After the introduction of thev stabilization plan in 1994, municipal revenues failed to recover immediately. There was a sudden decline in interest income,25 and part of the increase in the FPM was cut back.26 24 "Other revenue" - mainly interest earned on municipal deposits - remained high during this period. 25 The abrupt fall in inflation and nominal interest rates that followed the Plano Real reduced the return on municipal cash. Brazil: Financing Municipal Investnent: Issues and Options 21 However, municipal tax revenue increased. Lower inflation rates led to higher IPTU and ISS taxes in real terms. Transfers from the state VAT have increased for the same reason, but total revenues in 1997 nevertheless remained substantially below the peak year of 1991, and are scarcely higher than the levels of 1989. 3.14 The level of revenues varies considerably among municipalities. Per capita revenues tend to increase with population size (excluding the smallest class of municipios, which are favored by the FPM). Per capita revenues among municipios in the 200,000- 3,000,000 size class are 45% higher than in municipios with populations between 20,000 and 50,000. Per capita revenues in Sao Paulo are 2.5 times higher than those in the 20,000-50,000 size class. 3.15 The composition of revenues also varies. Very small municipios (under 20,000 people) rely largely on federal revenue sharing (FPM) and, to a lesser degree, shares of the state VAT. Tax revenues in the smallest class of municipios are virtually nil. As population increases, the role of Table 3.3: Evolution of Tax Sharing transfers in total revenues falls, ?.*cmt R'Ai_et by Each Level and the importance of taxes , fovern_met rises. Own-source revenues - - - 197 .. 1"7 W93 account for less than 30% of Income, Federal 88% 67% 53% industrial State 10 14 22.5 municipal revenues, even In products taxes Municipal 10 17 22.5 municipios in the 200,000- Special fund 2 2 3 3,000,000 size bracket. It is only VAT State 80 80 75 in the two mega-cities, Sao Municipal 20 20 25 Paulo and Rio de Janeiro, that Fuel, electric Federal 40 40 * locally administered taxes and power State, municipal 60 60 charges account for a majority Transport Federal 30 * of revenues. State 50 Municipal 20 3.16 These variations have Real estate State 50 important implications for transfers Municipal 50 100 municipal fiscal policy. They Motor vehicle State 50 suggest that even in medium- Municipal 50 sized municipalities, trends in * incorporated in VAT federal and state revenue sharing Source: Nogueira (1995). will have an overriding impact on municipal revenues. A doubling of property tax revenues in a municipality in the 50,000-100,000 size bracket would increase its total revenues by only 7%. It is only in the largest jurisdictions that local tax effort is likely to have a significant effect on aggregate revenues. However, increasing own-tax revenue allows for the financing of some additional investment or program that may represent a new way of doing business for the local municipal manager. 26 Constitutional Amendment 4 of 1994 authorized the federal government to reduce the amount of income and industrial products subject to sharing by 20%. While the provision was intended to be temporary (January 1, 1994 to June 30, 1996), it was later extended. 22 Brazil: Financing Municipal Investment: Issues and Options C hart 3.2 Composition of Municipal Revenues by Population Group 4 500 ffiu 4 5 0 M*other current 350-_ _ elother transfers 'Z 30 0 4) ~~~~~~~~~~mic MS t 250 -- - -_IM 0) 2 0 0 - E _ N FPM *8 1 5 0 - * 1lil i _ ; -i lDother tax o 15 - 100 o MIPYU _ 50 L.ss than 20,000- 50,000- More Rio de S o 20,000 50.000 200 000 than J-nero P.aulo 200,000 Source: Government of Brazil Chart 3 Conmpaion of nidpal Bqletidih ~700- o 600 4l-00 *lacthiuTnwt Fe 300 * Oinit toY s _ atraclEri 0, 9100 .2 Lessthan 20,000- 50,OOD- MDrethan Riode S5oPaulo 2D,000 50000 2D,000 200,000 Jaeiro Source: Goverrnent of Brazil D. Managing Recurrent Expenditures: Legal Constraints 3.17 Controlling personnel costs. Reducing current expenditures is another way to increase current savings. Personnel is the largest single item of current spending and the most obvious target; municipios spend, on average, about 45% of current revenues on personnel (Chart 3.3). It is interesting to note that this value is lower than what both states and municipalities spend on personnel. The ability of municipios to control personnel casts is constrained by the 1988 Constitution. Prior to 1988, municipal staff could be employed under either of two legal regimes. The statutory regime conferred a wide range of civil service benefits and rights, including a protection against dismissal (except for cause) and pension benefits paid directly from the municipal treasury. The consolidated labor law (CLT) regime allowed for dismissal without cause (although it established compensation requirements). Staff employed under the CLT participated in the national pension systern, with benefits considerably below those offered to statutory employees. Brazil: Financing Municipal Investment: Issues and Options 23 3.18 The 1988 Constitution altered the picture in two respects. First, it required municipios to adopt a single regime for their employees. Municipios were required to absorb former CLTistas into the statutory regime, with all the benefits and rights pertaining to them. Second, it expanded civil service benefits. It prohibited municipios from lowering salaries in nominal terms. It required pension benefits to be fixed at 100% of exit salaries, indexed to increases in the position vacated by the retiree. And it established very liberal eligibility for retirement. Under the 1988 constitution, male non- teaching staff were allowed to retire after 35 years of service. Female non-teaching staff could retire after 30 years. Teachers were given an additional five years' dispensation. Service, in this case, meant employment of any kind. Thus staff could join a municipality after many years of employment elsewhere and expect to be fully vested in their pension rights. 3.19 These conditions have proved to be extremely onerous for municipios, particularly those that employ a large number of teachers. Some municipios appear to have avoided the full impact of the 1988 Constitution by delaying the unification of employment regimes, organizing services as state enterprises (which can continue to employ staff under the CLT), or contracting out. As described below, Recife's trash collection service is organized as a parastatal, with its staff employed under the CLT. In Curitiba, trash collection is contracted out to private firms, thus severing the tie to public sector labor law altogether. Box 3.1 The Burden of Retirement Benefits in the Municipality of Rio de Janeiro The municipality of Rio de Janeiro may be facing the prospect of increasing retirement costs. The generous benefits provided to civil servants prior to the recent amendinents, notably fmnalteahers - they can retire after 25 years of experiene - proed to be vey costly to the municipality. Ib 1997, payments to retirees constituted one-third of the municipality's wage bill. Because Rio's retiement obligations are unfimded, pension costs must be paid out of geeral revenues. In principle, Rio de Janeiro may be confronting an abrupt increase in these costs. Between 1993 and 1997, while the active staff declined from 85,0O to 75,000, the number of retirees increased from 29,600 to 41,600. The shae of retirees in the payroll increased from n26 percent in 1993 to 35 percent in 1997. This may be the result of a bureaucracy that has ceased to expand (in an expanding bureaucracy, the proportional nwnber of retirees is likely to be small, because the majority of staff have a relatively short tenure in the government). The proportion of retirees would be expected to continue to grow until the number of new retirees reached the point at which the death rate among existing retirees was sufficient to offset the number of new retirees added each year. Source: World Bank (1999a). 3.20 The Constitution nevertheless continues to represent an important constraint on municipal efforts to control recurrent costs. Recent amendments to the federal Constitution promise to increase municipal discretion over personnel costs. The 19th Amendment (April 1998) abolishes the requirement of a single employment regime, opening the door for an eventual return to a mix of private sector and public sector staff. It also grants municipalities (as well as other governunent bodies) temporary authority to 24 Brazil: Financing Municipal Investment: Issues and Options dismiss civil servants, provided certain conditions are met: (a) personnel costs must exceed a threshold established in complementary legislation (the Lei Camata); (b) at least 20% of positions filled by political appointment (cargos de confianza) must have been eliminated; and (c) non-confirmed civil servants must have been dismissed. The Law of Fiscal Responsibility reiterates the limits defined by the Lei Camata : personnel costs ought not to be larger that 60% of the net current revenues -- 6% for the Legislative and 54% for the Executive. 3.21 The 20th Amendment (December 1998) toughens retirement criteria. To be eligible for retirement, a staff member must (a) have 10 years of service in the public sector; (b) have five years in the position from which he or she is retiring; (c) meet minimum age criteria (60 years of age for men, 55 for women); and (d) meet a years-of- contribution criteria (35 for men, 30 for women). The guarantee of a pension starting at 100% of exit salary (now defined as "total remuneration") and the indexation of retirement benefits remain in place. 3.22 In the short term, the impact of these amendments is likely to be limited. Existing benefits have been grandfathered - existing statutory employees cannot be involuntarily converted into CLTistas. Existing employees can retire under the terms specified in the original draft of the 1988 Constitution. The new provisions apply only to staff hired aftei the two amendments went into effect. Their full impact is therefore not likely to be felt for decades. In this context, additional provisions to reduce the retirement costs may be needed if the limits imposed by the LRF are to be realistically implemented. E. Interest Obligations 3.23 Interest obligations on existing debt are not a major constraint on municipios' ability to generate savings. While the amount of municipal debt registered with the central bank is about R$28 billion (as of September 1999), nearly two-thirds of that belongs to two municipios: Rio de Janeiro and Sao Paulo, withper capita debt of R$790 and R$1,550 respectively. The average level of debt in all other municipios combined is only about R$76 per capita. Debt service is less than 2% of municipalities' current revenue. (Table 1 Statistical Annex). Table 3.4: Stock of Municipal Debt (R$ Million, S etember 1999) Bo;lds Federal BaM*S domffhc External Subtotal AROs Total Treasury msi State capitals 9188 8492 2028 214 1190 21113 456 2156 Other municipios 412 1304 5174 0 0 6890 280 7171 Total, of which 9600 9796 7203 214 1190 28003 737 28734 Sao Paulo 9188 3428 219 43 578 13456 391 13847 Rio de Janeiro 3473 458 495 4425 0 442: * Includes federal development banks ** Revenue-anticipation loans (with maturities less than I year) Source: Government of Brazil Brazil: Financing Municipal Investment: Issues and Options 25 3.24 Municipal governments have borrowed from a variety of sources using a variety of instruments. The most common form is probably "informal" borrowing, notably arrears on payments to suppliers and public employees. Of formal sources of credit, bonds constitute the largest single form of municipal debt (see Table 3.4), but these are almost totally owned by the municipio of Sao Paulo. Actually, bond issues are now prohibited - except to roil over existing bonds - and all municipios are prohibited from using this source of financing until the year 2010. 3.25 Debt to the federal Treasurv represents half of the debt other than bonds. It is especially important in the case of the large cities and capitals, representing 71% of their outstanding debt. This is not recent. It is instead the result of a series of debt rescheduling over the last 10 years, which in turn arose from foreign borrowing and borrowing from federal financial intermediaries during the 1 980s. The foreign debt was rescheduled in 1989, with 30-year maturities and interest rates based on the original terms of each loan. (Rescheduled foreign debt continues to be denominated in foreign currency.) Debt to federal banks was rescheduled in 1993, on the same terms. 3.26 Bank debt accounts for one-fourth of the total stock. Most of this consists of loans from federal development banks contracted since the last general rescheduling. The federal housing and savings bank, in its capacity as agent of the national unemployment insurance scheme (FGTS), offers long-term financing to state or municipal housing companies and state water companies. CEF also operates as an agent of multilateral donors (IDB and World Bank). 3.27 Municipalities also borrow from private domestic banks, although this form of lending is mostly lirnited to short-term revenue-anticipation loans (AROs). Direct external borrowing by municipal governments is also relatively limited (although municipalities may bear the foreign-exchange risk of donor-financed loans intermediated through the Caixa). More recently, Rio successfully floated a Eurobond. 3.28 Overall, the level of debt is low, and it does not Table 3.5: Municipal make a significant claim on municipal resources, except Spending on Interest in Sao Paulo and Rio de Janeiro. Actual expenditures on Population ger9ent interest averaged less than 2% of current expenditures in Less than 20,000 0.5% municipalities with populations under 200,000, and only 20,000 to 50,000 0.8% 2.7% of current expenditures in municipios in the 50,000 a 200,000 1.4% 200,000-3,000,000 size class (Table 3.5). More than 200,000 2.7% Rio de Janeiro 2.2% Sao Paulo 2.7% 3.29 Case Studies. Municipal finances in Brazil are Total 1.8% idiosyncratic. Fiscal performance varies over time and Source: Government of Brazil among municipios. The cases of two similarly sized cities, Recife and Curitiba (Boxes 3.2 and 3.3), give a sense of the fiscal constraints each one confronts and its efforts to overcome them. 26 Brazil: Financing Municipal Investment: Issues and Options Box 3.2: Recife Recfe (population 1.346 million) is the 0capitalof the northeastern state of Pernambuco. While relativel poor, it is fiscally conservative, with small debt (26% of revenues) and a relatively low personnel burden. Its principal finctions - other than primary education - are carried out by city enterprises. A consistent cuwrent account surplus - together with a modest flow of capital grants- finances a respectably siied capital investment program. Its largest single source of revenue is the state value added transfer (ICMS), which amounts to 30% of total revenues. Taxes on services and property also make significant contributions -:with 18% and 10% respectively. The trends in revenues reflect the irpact of inflation (1992-93) and the introduction of the Plano Real in 1994. The latter led to substntial real increases in revenue sharing and ISS revenues. Property tax revenues also increased, due to the'revision of theplanta de valores (the table used to convert physical characteristics to values), and the resurveying of the city's principal shopping mall. RvamvDine the proertv Tax. To firther increase its property tax revenues, the city in 1997 undertook a comprehensiveiresurvey of the tax base to discover new construction and changes in prop*ty use. Since 1999 it has stepped up efforts against delinquent accounts. Property tax evasion in Recife is high - about 30% of the potential tax. Of the R$S 15 million billed fbr 1999, the city expect- to collect only $85 million, even after allowing for late payments to be received in 2000. R$4 million of the remainder is unbillable due to a lack of information on the billing addresses of property owners (a common problem in illegally occupied land.) The remaining R$25 million is owed by what the city considers its permanent tax evaders - cases that are registered in the city's debt registry (divida ativ) and are referred ti the courts for resolution. The state court says that it lacks the staff to execute them. The city has agreed to provide bonuses ( ratficabes) to staiff of the judiciary to overcome this obstacle. Expendit Recife's largest expenditure item is personnel. Spending on civil servants in nevertheless relatively small. The wage bill with active staff was only 27% of revenues in 1998 (the average fo rBrazil is above 50%). Adding the cost of retirees paid by the Treasury raises that percentage anoter10 p 0rent to 37%. Reeife keeps its direct personnel costs low by organizing a variet of municipal services as indirect administration. These include trash collection, public markets, and security services. (The state government is responsible for police; the city's security service is responsible only fo pro i public buildings.) Most of these services' workers are remployed under private sector law(). Pensions. Because the numbe of civil servants is low, Recife's pension obligations are not yet insurmountable. Recife participated in the state pension system, which took a 15% payroll contribution and assumed responsibit for retirement benefits. The city has now dropped out of the state system and assumed the payment of retirement benefits. The city has established a pension find. but it lacks the resources to capitalize it. As a result, payme to retirees are expected to consume an increasing portio o current revenues. Recifi's debt service obliatios are very small - less than 2% of current revenues. Debt is very low, with a stock of R$ 157 million, or:28% ofrevenues.Nearly 90%/o of this consists of rescheduled debt arising from borrowing prior to 1993; 77% consists of debt to federal financial intermediaries rescheduled in 1993. As a result, interest obligations are minor, averaging less than 2% of revenue. Investment sneidino has averaged 15%-20o of revenue since 1991 (except in the 1997 and 1998, whenit shrank to 5% and 8%, respectively.) With the exception of a loan contracted in 1991, this has largely been financed from current account surpluses and capital grants. The net result has been a consistently healthy set of fiscal indicators throughout the 190s. The current account balance has 0.r emained positive throghout the period. Te overall deficit has averaged about 4% of revenues since the debt rescheduling of 1993. Although the debt stock has risen in nominal terms, due to the indexation of principal), it has remained roughly constant as a percent of revenues. Brazil: Financing Municipal Investment: Issues and Options 27 Box 3.3: Curitiba Curitiba is the capital of southern state of Parani. Its population, 1.48 million, is approximately that of Recife's, but it is a much richer city in terms of revenue per capita. In 1998, Curitiba generated R$525 per capita; Recife generated only R$380 per capita. Curiously, the city's financial situation is more precarious. Revenues. Curitiba's revenue structure is similar to Recife's, but with a higher proportion of revenues from taxes. The ISS, IPTU, and related charges account for 45% of revenue in Curitiba, as opposed to 34% in Recif. Owing to the high per capita income of the state of ParanM, Curitiba receives virtually nothing from the federal transfer fund (FPM). Curitiba's revenues have grown in real terms since the Piano Re-al went into effect. Revenues in 1998 were 37%/o above their 1995 levels. Most of this growth is attributable to rising transfer income. As shown in Table 3.6, tax revenue increased by only 190% over the three-year interval. Table 3.6: Cur Wba Receipts and Expenditure (ootan Reals of 1S95> ' '-''-- ' t9s 19i 1997 -194 Curffe Reveue 442 4S4 507 07 Tax Renue 228 242 245 271 Cufrent Expenditue 395 444 454 484 Capitai Expndiwe 88 137 108 IS Capiw Revenue S 64 26 49 Cash Flow -33 -33 -29 S3 . Source Govement of Brazil EIW_nditures. As in Recife, personnel is the largest single expenditure item in Curitib acowunting for about 400%o of the total. Like Recife, Curitiba restrains the number of statutory employees by separating many public services from direct administration. Recife does so by organizing sevices as public enterprises. Curitiba simply contracs these services from private sector providers. Trash collection, for example, is provided by private firms under contract to the city. Curitiba has very little debt. The outstanding stock - RS177 million - is equivalet to 23% of revenue. Unlike Recife's debt, most of this is rect The largest debt consists of a RS106 million urban transport loan from the IDB, contracted in 1995. The rest consists of domestic project financing, including loans for the Caixa Econ6mica for low-cost housing and sanitation (PROMORAR). The city has no rescheduled debt. Curitiba's recent fiscal history has not been without problems, however. The city ran up large cash- flow deficits in the mid-1990s, which were financed by accumulating arrears to personnel and suppliers. In 1997 it enacted a hiring feeze and dismissed many of its recently hired staff (who were not yet qualified for civil service protection). As a result, the number of acive civil servants has declined slightly. This measures were sufficient to produce a overall surplus (2% of revenues) in 1998. An immediate pension crisis is looming, however. In 1991, when Curitiba unified its employment regimes (as required by the new Constitution), it required its CLTistas to work for 10 years as statutory employees before permitting them to retire with statutory employee benefits. That 10 years expires in 2001. The city expects a wave of new retirees in the year ahead. Because the retirement system is unfunded, these will have to be paid out of general Treasury revenues. 28 Brazil: Financing Municipal Investment: Issues and Options F. User Charges 3.30 Many Brazilian municipalities have resorted to the participation of the private sector in the delivery of municipal services (see Box 3.4). The participation of the private sector in water and sewage, power, and transportation infrastructure - whether as concessionaires, in BOTs, or as shareholders in public infrastructure enterprises - has raised the possibility for sustainable financing of municipal infrastructure through (a) efficiency gains in service provision; (b) increased coverage of often marginal communities; and (c) improved collection of revenues through the implementation of cost recovery, including tariffs, user charges, and betterment fees. Traditionally, cost recovery in Brazil takes place through the collection of fees or taxas (e.g. street cleaning, street maintenance, fire fighting, public lightening, advertising, etc.). The idea of pricing the public service is now taking hold. o3. Private Sector Tiivoe In Brazilian M iciplite WAM has undertaken a svy to beter undersandthe role of the private secor in the provisio andfinai o mnicipalsies Brazil.. The tetpopulation were municipalities between r2,00and1 million i i 0-- about 1,400 mniipalities.1Te goal was to undra th financing mechanism, the the recuperationof oS stsuse in thXe provision of publics . Mai din Private sector participation is mofequet inlarger municipalitielloes hhio tranpor andstret avin, slidwaste and pulclgtn.I ae n eea rvt etrpriiainIS verylimited r ree, p clighti' markesea e frite setor providers. Traditionall these servicwere outorwdtstate companieswhich have e prvzd % Mnnlcipali*is ;thaVat use private sector in thedelvery of the lowing servcs 2000 Public Transportation: 31.9 Street Paving ~19.5 Solid 00C waste nollection 0 22.7 ' ti0; L;20 0Solidwatedisposal 20.0 treatment, distribution) 4.4 Public Ligh 28.8 Slaughter Houses 18.1 t;0 000 000t0 00 ;Cemeteries 0 9.3 The f ontrt mis the concession (60-70 muusethis contract engaging the Pri iheof srvic). Perits is e sed most imporant frm. finacing, 6% of the surveed municipalities declared that tthey are the main ianciers of their sanitaion services; 634% s the same frrbaequipment.Finacingromthe privat to mo r apparentirantanrod35% of the case0).As for cost recovery, 43% of the municiies areproiingfee servicesin t 28% inisniation and solid waste collection; 30% in urban equipment. Betterment fees occur in some transt and rsyss, 12% in street paving; 6% in m arkand public lighting. 3.31 Financing for public infrastructure at the municipal level is currently taking place through MDFs and with financing from domestic development banks (i.e., CEF and Brazil: Financing Municipal Investment: Issues and Options 29 BNDES). Financing of the private sector is currently being undertaken exclusively by BNDES. User charges are generally not being applied to recover costs for social investments (including health facilities and industrial parks). As in most countries, user charges provide far less than 100% of costs for major public urban transportation infrastructure (such as subways). The Parana MDF assesses betterment fees for road paving and street lighting (which account for 98% of loans), the latter with a guaranteed financial rate of return (FRR) of 25% (see Annex C). Water, sewage, solid waste, and some transport infrastructure are being provided by the private sector with varying levels of cost recovery, though considerable difficulties remain in making private sector participation more widespread and financially viable. Box 3.5: Parani Betterment Fees While betterment fees are contemplated in the 1934 and 1988 Constitutions as a way for the public sector to recover the costs of public investment, Brazilian municipalities have rarely used this instrument, which represents less than 1% of municipal own-source revenues. There is little knowledge. In 1988 the state of Parana began helping the state's 390 municipalities to use betterment fees as part of their revenue apparatus. As part of a sizable program to help municipalities finance infrastructure, the condition of the small loans was full repayment using betterment fees. These are levied on the direct beneficiaries of the public work and have legal protection. By December 1998, 217 betterment fee directives had been issued, making feasible the collection of R$44. 1 million in a period of approximately five years. A total of 1 22,431 fee-payers benefited from the public works relative to these directives. From the financial point of view, the incoming flow of resources from this source - which was extremely low until recently - had increased to R$7.5 million by the end of 1998. 3.32 Constraints on further use of user charges. Despite the increasing role of the private sector in the delivery of municipal services, cost recovery mechanisms are hindered by several problems. Some of these relate to an ambiguous regulatory framework, a persisting culture of non-payment for services, and political resistance. The ambiguity in the regulatory framework within which municipal service providers operate is illustrated by a recent court ruling in the state of Parana, in which SANEPAR, the state water company with exclusive water distribution rights, was prohibited from interrupting service to non-paying customers. The ruling was based on the argument that interrupting service would be a violation of Article 42 of the Constitution, which prohibits consumers from "being exposed to ridicule." There is also little recourse to service providers who find themselves victim of Brazil's patronage-based political system. For example, after constituents complained about a toll on a state highway, the governor of one Brazilian state declared that the tolls would be halved. 3.33 It is particularly difficult to begin charging consumers for services that have traditionally been provided at no charge, including water provision. Rates of non-payment are high - PROLAGOS, which serves five municipalities north of Rio de Janeiro, has non- payment rates of approximately 60%. Non-payment is not necessarily caused by a lack of resources. To the contrary, the distribution of non-paying users is often skewed away from the poorer communities. PROLAGOS is not currently charging consumers for sewage, 30 Brazil: Financing Municipal Investment: Issues and Options though the company does plan to do so after upcoming investments in treatment facilities are completed; as a result, consumers will face an overnight doubling in their monthly water bills. There is a considerable problem with theft of water by so-called 'jatos" (water jets or sprinklers), and in many cases intermediaries provide stolen water from the municipal water supply directly to water delivery trucks that serve communities without piped water (see below). Chart 3.4 3.34 Evidence from an IBAM Municipal Service Cost Recovery survey financed by the World Bank on the financing and delivery of Adm,inistrative _ # q . q, qa municipal services in Brazil has services J|| 0 ;1 0i:; lt0X000000 Q; i; ltl00fig0 . highlighted both the importance of the Urban Services role of the municipality as an administrative unit in providing publi: Water, Se-age, erS n W'teS-Sn'lt9tatiogn' andF _ services, and the opportunities for TranspDt/Road -T= -improved municipal revenues througl _ S service cost recovery. As shown in D 20n 4ow 6osi to% 1o0 Charts 3.4 and 3.5, less than 30% of DMunicipal Budget * Fees 0Tariffs rilBetterment Fees the surveyed municipalities rely solely the municipal budget to finance urban services. The remaining acknowledge the importance of tariffs and other cost recovery mechanisms. 3.35 Steps taken by private sector service providers to increase revenues include (a) increasing tariff rates without changing nominal tariffs by changing incremental tariffs; (b1' adjusting the minimum tariff according to consumption;27 (c) marketing, outreach, and education of consumers; (d) a Chart 3.5 "lottery" for consumers who pay Municipal Services their bills promptly; (e) Financing by Level of Government _==DS_~ _ significant internal Administrative reorganizations, including Services _~~ X _devolution of internal Urban Services i_ has made it exaggerating the contribution of difficult to enforce federal restrictions on subnational muncipal ndebtedniess to borrowing, even when it involves loans from the federal consolidated public sector deficits govemment's own banks. The magnitude of the recent and by opting to restrict municipal bond crisis may harden the federal govemment's borrowing through a highly complex resolve. Senate Resolution 78 and CMN Resolution set of centralized administrative 2653 are both indicative of the new firmer stance toward controls rather than market subnational borrowing. As mernory of the debt crisis fades, it remains to be seen whether these restrictions discipline. will continue to be universally applied. 4.16 The limitations on municipzal borrowing can be divided into (a) restrictions imposed on municipal borrowers, the potential demanders of credit, and (b) restrictions imposed upon public financial institutions that are the traditional suppliers of credit for municipalities. It is interesting 1o note that all of the limitations consist of administrative controls monitored and exercised by federal institutions. No initiatives have been proposed that would raise toward market rates the interest rates charged by federal institutions for loans to finance local infrastructure investment, or expand the participation of private sector lenders in the municipal credit market, thereby increasing the role of the market in limiting municipal borrowing. Brazil: Financing Municipal Investment: Issues and Options 39 Box 4.3 Controls on Subnational Borrowing Constitutionally, the cotrol of subuational borrowing is a prerogative of the federal Senate, which exercises this role by adopting resolutions that establish ceilings on subnational debt, based on ratios of debt service or debt stock to revenues. Each loan application is separately evaluated by the Senate, which is free to ignore its own resolutions. Demand Side Controls: In 1998, the Senate adopted the most demanding set of controls on subnational borrowing yet observed. Resolution 78 (Box 4.4) consists of a broad set of controls on subnational demand for credit. It imposes a ceiling on new borrowing, debt service, and debt stock, it imposes conditions to the jtwisdictions that want to borrow, and prohibits specific kinds of borrowing. For example, it forbids the issuance of bonds by states or municipalities until the end of 2010, except to finance rollovers of existing bonds. The resolution requires that at least 5% of any bond issue must be retired at maturity and that any state or municipality whose debt service obligations are less than 13% of RLR (Receita Liquida Real, or Real Net Revenues) must retire up to 10% of bonds at maturity or spend 13% of RLR, whichever is less. Resolution 78 also singtes out and prohibits certain practioes that have been used to evade federal regulations in the past. borrowing from decentralized entities and assuming obligations to suppliers in the fomr of promissory notes, credit card debt, etc. Finally, it forbids borrowing by subnational governments that are in default on existing bank debts, or debts to the federal social security system, or ones that are in violation of debt reduction schedules imposed under Lei 9496. Federal legislation is also used to control subnational borrowing. After the wave of defaults on loans from federal financial institutions, further controls were enacted. Under Lei 8727/93, the feeral government and its agencies were forbidden to concede any loans to states or municipalities that are in default on debt service obligations to the federal government. The law also authorized the fieeral government to use intercepts on intergovernmental transfers to recover debt service. The most recent round of debt rescheduling fiurher restricts subnational borrowing, specifaing a schedule fbr reductions in the debt: revenue ratio of each jurisdiction. The federal government is prohibited from guaranteeing external borrowing in any jurisdiction that is in violation of its schedule. (Lei 9496/97) Supply-de Controls. In September of 1999 a resolution of the National Monetary Council was issued imposing a complementary set of restrictions. The council's Resolution 2653 has two major components. It authorizes the Central Bank to control the supply of credit to subnational governments by domestic banks. Second, it authorizes the Central Bank to enforce Senate Resolution 78's controls on subnational borrowing. To control the supply of credit, Resolution 2653 authorizes the Central Bank to impose restrictions on domestic bank's lending to states and municipalities. The most important ofthese is a limitation on lending to the public sector. Under the resolution, outstanding loans to the public sector may not exceed 45% of a bank's equity. "Public sector' in this case includes the federal government, states, and municipios; and the autarchias,fiundaqoes, and public enterprises controlled by them. "Bank" means both private and public banks, including the Caixa Econ6mica and the federal industial developmnent bank, BNDES. Resolution 2653 also sets a ceiling of R$600 million on the total exposure of the banking system to the public sector. The resolution requires banks to observe the demand-side limitation imposed under Senate Resolution 78. It prohibits any bank from lending to any state or municipio in violation of Resolution 78 restrictions and to any public sector entity that (1) is in default to any other bank or (2) has disputes with the public sector debt registry (CADIP). Finally, it prohibits banks from refinancing any form of arrears to suppliers or contractors. The Central Bank is also authorized to enforce the terms of Senate Resolution 78 in its advisoy role to the Senate, All petitions for Senate approval must be submittd, first, to the Central Bank, which has 30 days to analyze them and forward its recommendations to the Senate. The resolution specifically authorizes the Central Bank to refuse to forward loan requests to the Senate from entities that (1) have a negative primary blance in the relevant fiscal period or (2) are in default to any bank. 40 Brazil Financing Municipal Investment: Issues and Options C. Controls on Box 4.4 Municipal Borrowers Summary of Resolution 78 Essential Conditions 4.17 In August, * Article 3 prohibits borrowing fron own enterprises or suppliers. 2000 the governmen. * Article S requires borrowing to equal or exceed capital budget. has sent to the Senate * Article 6 limits new debt to less than 18% of RLR (Receita Liquida a proposal for new Real); debt service to less than 13% of RLR; debt stock to less than borrowing limits under 2 times RLR X the new Lei de * Article 7 requires primary surplus, prohibits borrowing by Responsibilidade i defaulters. R nX . Article 8 limits guarantees to less than 25% RRL. Fiscal. They are * Article 9 liunits new AROs to less than 8% of RLR. slightly different from * Article 10 prohibits new bond issues except for rollovers. those established in the i Article 17 requires AROs to be liquidated less than 10 days before Resolution 78 and will end of budget year. be mentioned in due * Article 18 prohibits cotracting debt less than 180 days before of place. For most of ii., end of term. this section refers to Non-Essential Conditions the controls in place as * Article 19 requires that state/municipal guarantees that the of July 2000. borrower (a) offer counter-guarantees and (b) be current (not in default) to the state/municipality offering the guarantee. 4.18 Potential ^ Article 20 requires that new bonds issued to refinance old bonds municipal borrowers have equivalent terms and that they be usable for payment of taxes are subject to separate and that maturity be less than 60 days. • Article 13 requires that the prospective borrower is current with borrowig restrictions social contributions and is in compliance with Amendment 19, on (i) the annual Article 212 and with lei complementar 82. volume of new ____________________________________________________ iborrowing, (ii) the stock of total debt outstanding, (iii) annual debt service payments, (iv) the primary surp.us, and (v) the instruments used to obtain credit. A municipality must demonstrate that all conditions have been satisfied (for the 12-month period ending with the month preceding application for credit approval) and must obtainprior approval from the Central Bank for any domestic credit operation. The Senate retains final approval for international loans Io subnational governments, and may in certain cases override the domestic loan-approval authority it has delegated to the Central Bank. Most of the restrictions spelled out below are contained in Senate Resolution 78 of July 1998 (Box 4.4) and its subsequent amendments. The proposed controls included in the Lei de Responsibilidade Fiscal are also mentioned. 4.19 Annual volume of new borrowing Per Resolution 78, the volume of annual new% borrowing by a municipality is limited 18% of the Receita Liquida Real, which is defined as the municipality's total receipts for the previous 12 months minus the following: receipts from credit operations, receipts from property sales, and receipts from transfers earmarked for specific purposes such as the 25% of constitutional transfers earmarked for education spending, targeted transfers earmarked for local health spending, and project- specific grants that must be spent on targeted investment projects. Brazil: Financing Municipal Investment: Issues and Options 41 4.20 Stock of Debt Outstanding. Resolution 78 establishes limits for total debt, including both new debt to be issued and existing debt. New borrowing can be authorized only if, and to the extent that, total debt outstanding remains within these limits. The outstanding debt limit is stated as a proportion of Receita Liquida Real. The proportion of permitted debt to Receita Liquida Real was set at 2.0 for 1998. The limit declines by 0.1 annually for the next 10 years, until in 2008 it reaches the limit of 1.0. That is, by 2008 a municipality will not be able to enter into credit operations unless its total stock of outstanding debt, including the debt to be issued, does not exceed the municipality's annual net revenue flow after excluding income from capital operations and revenues dedicated to specific expenditure purposes. 4.21 The proposed limits under the Lei de Responsibilidade Fiscal differ across government levels. For the central governnent, the ratio of total debt to Receita Corrente Liquida is set at t at 3.5; the limit is set at 2 for the state governments and 1.2 for the municipalities. The present level of indebtedness is 1.565 and 0.96 for states and municipalities giving some room for adjustment. In the case state and municipalities are above the proposed limits, they would have 15 years to adjust. The annual debt stock would need to go down in line with the adjustment trajectory. Failure to comply with this would make municipalities unable to borrow. 4.22 Annual debt service. According to Resolution no 78, annual debt service is limited to 13% of Receita Liquida Real. Debt service includes both interest payments and amortization. The limit applies to all future years in which there are debt servicing obligations. A municipality, therefore, must prepare a debt service schedule for as far into the future as any loan payments are due, and ensure that interest and amortization payments in each of those future years falls within the limit of 13% of the municipality's net receipts (defined as above) for the previous 12 months. No formal guidelines have been provided as to how the municipality should deal with variable-rate loans. The new proposed limits under the Lei de Responsibilidade Fiscal (LRF) state that debt service cannot exceed 11.5% of the net current revenues. Since Resolution 78 and the LRF used different concepts of municipal revenues, it is not clear whether the proposed limits would limit further the debt capacity of the municipalities. 4.23 Primary surplus. In order to borrow, a municipality must demonstrate that it generated a primary surplus for the previous year. The concept of "primary surplus" is borrowed from Brazil's macroeconomic targets set in agreement with the IMF, and is defined in exactly the same manner as the IMF defines the primary surplus for national budget accounts. In effect, the primary balance is defined as total municipal receipts minus total municipal expenditures, after eliminating the effects of credit operations from both the revenue and expenditure side of the balance. That is, receipts from borrowing are excluded from revenue, while payments of debt service are excluded from expenditures. The resulting balance must be positive (for the previous 12 months) for a municipality to be eligible to borrow. Note that this definition heavily penalizes municipalities that had investments financed by borrowing in the previous year, however creditworthy the municipality may be. Any municipality whose total expenditures over the past 12 months (on both current and capital account) exceeded revenues net of borrowing is automatically 42 Brazil Financing Municipal Investment: Issues and Options prohibited from borrowing in the current year. This limitation unambiguously prohibits the routine use of long-term credits to finance local capital investment, regardless of the municipality's ability to service its debt or to meet the other limitations specified by law (see Box 4.5). 4.24 Municipal bond issuance. Municipalities are prohibited through the year 2010 from obtaining new credit by the issuance of municipal bonds on the domestic market. The issuance of municipal bonds is permitted only to refinance existing debt. Direct, prior approval by the Senate is required for international bond issues. The Senate has indicated that it will maintain strict control over international issues. 4.25 Limitations on lending by public financial institutions. In addition to the limits placed on municipal borrowing, public sector banks and financial institutions are subject to Central Bank limits on lending to public sector entities. Any financial institution subject lo Central Bank regulation that proposes to lend to a municipality must first inform the Certral Bank and obtain its approval. The Central Bank has set a ceiling on lending by public banks and financial institutions. These institutions cannot have more than 45% of their equity in the form of loans to or investments in public sector entities. The Central Bank will not approve new loans from these institutions to public sector entities, including municipalities, if they would cause the 45% ceiling to be breached. Both the CEF and BNDES are subject to this limitation. Both are reported to be very near the maximum ceiling on public lending. The state Municipal Development Funds have been judged to be direct agents of their respective states, rather than financial institutions, and hence are not subject to the public sector lending limitation. However, under the Lei de Responsabilidade Fiscal all lending among government levels has been prohibited. 4.26 Loans that CEF and BNDES make to private financial institutions, which in turn lend to municipalities or municipal enterprises, are not subject to the public sector lending limit. However, the private institutions must be exposed to the full credit risk of the final borrower, and the public institution must be exposed to the full credit risk of the private Jn- lender. The arrangement cannot be backed by a federal or other public sector guarantee if it is to avoid the public sector lending ceiling. 4.27 As a result of the limits on lending to public municipalities, both CEF and BNDES have shifted their attention to preparing local infrastructure companies (like municipal or state-owned water enterprises) for privatization. Financing provided to privatized enterprises, or to public enterprises in preparation for privatization, is not counted against the lending ceiling, as long as the privatization plans are actually implemented. D. Reflections on Brazil's Municipal Credit Limits 4.28 The municipal credit limits now in effect were put together hastily in 1998. They were installed as a means of limiting the rapid growth of subnational debt, which had become an important contributor to macroeconomic instability. The rules now in effect almost certainly will be modified before assuming a more permanent form. The Law on Brazil: Financing Municipal Investment: Issues and Options 43 Fiscal Responsibility, for exarnple, replaces the interim limits with different types of credit ceilings still to be defined. Box 4.5 Is the Primary Surplus an Appropriate Tool to Use to Limit Municipal Borrowing? The "primary surpluse is normally a tool of macroeconomic management. It assumes that, to a first approximation, future debt service obligations from existing debt are fixed and beyond the national government's ability to control. The rernaining, non-financial portion of government budgets then has to be managed in such a way as to generate a surplus that can be used to pay debt service and, if this is part of the national economic objective, reduce the debt/GDP ratio. This non-financial surplus in the aggregated public sector accounts is called the primary surplus. Brazil's agreement with the IMF sets targets for the public sector primary surplus. The target was 3.1% of GDP in 1999. This target was met. The target in 2000 rises to 3.25% of GDP. These targets are projected to be sufficient to lower Brazil's public sector debt ratio from more than 50% of GDP in August 1999 to 47.0%o in 2000 (average for the year) and 44.4% in 2001. Brazil's adjustment program sets separate primary surplus targets for the federal government, states, and municipalities. In 1999 these targets were for states to increase their primary surplus from -0.4% of GDP 1998 to +0.2%o, for the federal government to increase its primary surplus from +0.6% of GDP to +2.6%, for state enterprises to increase from -0.4% to +0.1%, and for municipalities to remain constant at 0.2% of GDP (World Bank 1999b). Use of the "primary surplus' to limit municipal borrowing appears to be an effort to push municipalities toward budget management that is consistent with national macroeconomic goals. The requirement that municipalities generate a primary surplus as a condition of borrowing provides an incentive for municipalities to produce a primary surplus. The other controls on municipal debt ensure that the primary surplus will be used largely to pay down net debt at the municipal level. As a tool to limit municipal borrowing, the primary surplus suffers from two important defects. First, as shwn in Tables 4.1 and 4.2 and in the primary surplus target figures above, municipalities account for only a small fraction of subnational debt. They already generate an aggregate primary surplus. and the targets in the IMF agreement contemplate municipalities' continuing to generate primary surpluses at the same rate, 0.2% of GDP per year. Frorn the perspective of macroeconomic management, municipal behavior does not require major modification. More importantly, under the primary surplus lirnitation, municipalities cannot put together a consistent, multi-year capital investment plan that is financed in part by prudent levels of borrowing. Any municipality that needs and uses credit to help finance its capital budget in Year A breaches the primary surplus condition and cannot borrow in Year A+1. This situation would compel the municipality to move forward with capital investment in fits and starts (partially credit-financed investment in Year A, followed by a drop-off in investment in Year A+ 1 to levels that can be financed with internal revenues alone in order to meet the primary surplus requirement, followed by resumption of borrowing and greater investment in Year A+2, etc.). Alternatively, the municipality could try to borrow more than is needed in Year A, subject to the other borrowing limits, in order to carry forward fiunds to help pay for invesunent in Year A+ I. Both of these "solutions" are inefficient. 4.29 Three features of the current regime deserve emphasis in considering future development of Brazil's municipal credit market. First, the most restrictive limit on municipal borrowing - the requirement that a municipality have a primary surplus - also is the most unreasonable and inefficient. If the requirement were imposed on the current 44 Brazil Financing Municipal Investment: Issues and Options budget year, it would imply that municipalities could never use net borrowing to finance investment. The primary balance can be positive only if the entire "real" budget, including current and capital expenditures, is financed with municipal revenues excluding debt receipts. If a municipality financed any fraction of its investment budget with net borrowing, it would violate the requirement of a primary surplus. 4.30 At best, the primary surplus in isolation is an indicator of intentions. If it is assumed that municipalities have control over current revenues and non-debt-service expenditures - i.e., that debt service is the only financial element outside municipal control - then the primary surplus may indicate the extent to which a municipality is doing its best to manage its finances. A large primary surplus would indicate that a municipality is restraining all the expenditures under its control - both current and capital - to match its recurrent revenues. But it would not indicate whether this effort was sufficient to render the municipio capable of taking on additional debt. As Brazil's limit is actually drafted, it requires a primary surplus over the previous 12 months, making it technically possible (though obviously unstable and undesirable) for a municipality to borrow in alternate years, subject to the other limiting conditions, while compiling a primary surplus for 12-month periods between the borrowing episodes. Box 4.: The La of isa Responsibility Thei L ;of Fal i (he pblic manager to manag pbi sector rerceswithin a frameworkof clear rul1es imposedonall managers and all spheres iof government The :l law;edorsesth principle of transparecyas ato vl s nolan uirsthw p tioif Ial acounting instrumtsused atg all govermentleve Soe ofthe basic oncpts ar te following l ; Letf 00 Xde ietrze Onet 4ia (DO,a w of budgietay iAdeinesA alt 0 is00 pulihe annually establishing the rle frthe &nextyea ug It cotaistagsfr reenes expeditres de*t a -asse for the nets 3 peiod *Let Graenra nna W) h nulbugtr a needstocfrmwh e140adih theLREtco taenyar unexpe ted events. ls;ot t i measures that ma rtt ndcine of r A ane t increase in n a :needs to bt aomaed inteofmaso inrearevenues by the sam aon * Personnel costs aient and temporary prsonel,pe nd oter cot 0 00 are limited to 60%0 or0%Q of Nt CuretReene, n h case of muipaities and tatesor00 the0 fesderal government respectively. Specific adjustment measures are defined to hel ubntinail * Public D Limits for theDebt stcl~arestabis;hed gas ao of ~ Let (outstandingdtotal et db et of ~ s an fiancal balance)oe ie retrvne.T olwn iisapy . o h cent a oenen;2trsttsrn o uial l o0 umns.Tis i ofral bv h Prese nt debt situation3.54frthetr grnt, 1.56 fr stes andl 097fo muncipalities. ; *; Ses rnd municipalities with a de}t stock above the lit will have 15 years to . * For t ites and municipalities, confractinu of inew debtis authorized only when debt servi6ne et cur00aSrentreene sfr isealolessS*n;ll.N000000000000000 than 11d.5%.;00000t l * Forthe central governmenthe . Borrowing:olden Rule awlies: annual borTowing cannot the va lue of te capital epnditures. 0 k0 0 0Xf 0t0t!fA t0000 Brrowing among levs rntsfoien t* AOR 0(Advances of Ordn ay Rev s i d to take place within the budget year. * Repts on budg y implemenn and flman nt ill be prepared and published every two ad four months,resetvely Brazil: Financing Municipal Investment: Issues and Options 45 4.31 The difficulty with the primary surplus limitation is that it tries to put into operation a macroeconomic concept on a municipality-by-municipality basis. The objective of municipal debt limitations should not be to suppress borrowing, and therefore to reduce municipal investment, but to ensure that borrowing is used only to finance capital investment that meets reasonable standards of economic returns and can be repaid. The draft Law on Fiscal Responsibility addresses this issue in a far more efficient manner. It (a) divides municipal budgets into an operating budget and a capital budget; (b) prohibits multi-year borrowing to finance operating deficits (all cash-flow borrowing to finance operating expenditures must be repaid in the same fiscal year); and (c) requires other borrowing to be used solely to finance investment and limits the growth of net debt to the amount of municipal investment while (d) imposing separate limits on a municipality's stock of outstanding debt. This last limnit is expressed as a percentage of municipal personal income. A system of debt controls of this type is consistent with good practice elsewhere in the world. It limits debt accumulation, while ensuring that municipalities can borrow prudently to finance investment. 4.32 Second, a system of municipal borrowing limits that is administered like the present system will create an intolerable bottleneck at the Central Bank that jeopardizes its implementation. There are more than 5,500 municipalities in Brazil. All of them now require prior approval by the Central Bank before borrowing, which in turn implies that the Central Bank must review and verify municipal accounts to confirm that each of the separate borrowing limitations has been met. Such a system implies a drastic degree of centralization as well as a burdensome work load for Central Bank staff. The review system has not collapsed to date largely because the vast majority of municipalities realize that they do not meet the stringent borrowing standards and have not applied for Central Bank approval. If the system is relaxed to permiit a reasonable degree of municipal borrowing for investment purposes, the current trickle of complaints about delays in the Central Bank review process will grow into a torrent of municipal frustration. 4.33 Third, even under the draft Law on Fiscal Responsibility the limitations placed on municipal borrowing rely solely on administrative controls. In fact, there is a substantial paradox built into the system. Below-market financing is likely to remain the principal source of credit for municipalities. Nothing in the current or proposed control mechanisms would shift municipal lending toward market rates. Excess demand for municipal borrowing, therefore, will persist - in the sense that more municipalities will want to borrow larger sums than they would if credit carried a market rate of interest. The excess demand will be limited only by the series of administrative controls and borrowing lirnits that a municipality must pass through. Even if this system could function satisfactorily in administrative terms, it will do nothing to increase the probability that the municipal capital projects that get financed have high economic returns. The controls merely limit the size of the flow and stock of debt, without investigating the productivity of capital. Only the limits placed on public sector lending by the Caixa and BNDES may affect the productivity of local investment, by placing a greater percentage of subsidized capital in the hands of private firms that will want to cover at least this cost of capital in their investments. This initiative is likely to yield modest gains in efficiency, however, because privatized firms will have incentives to borrow as 46 Brazil Financing Municipal Investment: Issues and Options much subsidized capital as possible, as long as their returns exceed their actual interest cost, whether or not returns reach the level of the true market cost of capital. Box 4.7 Brazil, Low-lntermoediion State Brazil is trapped in a low-intermediation state, exhibiting both a low level and low efficiency of financial intemediation, Given, the importance that a well-developed financial sector has for economic growth, refoms that can increase the level and improve the efficiency of financial internediation should be higa on policy makers' agendas. At present, the Brazilian domestic federal securities market can be characterized as being a sizable market, the largest in the region before Mexico, Argentina, and Chile, focused on short-term and floating- rate instruments, illiquid for its size, and concentrated in two types of participants: bank treasuries and mutual iunds. According to BIS fres, the Brlian g securities market is by far the largest in Latin America, with an outstanding amount of US$379 billion in June 1999. Mexico follows with US$38.6 billion, and Argentina with US$24 billion . In a more interational comparison, the Brazilian market is bigger than the Spanish government bond market (US$279.9 billion) and only somewhat smaller than the Canadian government securities :market (US$416.6 billion). Domnestically, the Brazilian government securities marke amounts to more than 80% of the total fixed-income securities outstanding, the next issuer in terrns of size being the baking sector, with only 17% and the corporate sector 1 %. The stock market capitalization was roughly US$1SO billion in June 1999. As of the end of February 2000, the total domestic federal debt in Brazil amounted to R$458.3 billion, or 531% of GDP. Clearl. Biazil's outstandg debt and resuant interest rates on domestic ovrmt r,cuitesis the Prima cs o he lk oprivate investment in public infrastiiructur r s and should be seen as the main conistraint to oe level of priate credit and stock market capitalization, the average miturity of loans is low in Brazil. Anecdotal evide suggests that most small- and medium-size companies in Brazil only obtin short- term bank credit, with maturities of at most 90 days. Sources of long-term finance are very limit and may from stateownd development banks, such as BNDES. International evidence suggests that the legal and regulatory environment in which financial institutios operate are an important detminant of financial development, and economic growth. The rights of secued and unsecurle creditors, the enforcement of contracts and the sharing of cedit iformation between intermediaries are important cmponlents of this legal and regulatory environment. Compared hother countries, Bzil shows a low level of contract enforcement and limited information sharing Teeaknesses in these components of the legal and regulatory frmlework can partly explain the low- intermediation trap in Brazil and ite feble growth. Reforms that will significantly increse the level and efficiency of financial intermediation and have a positive impact on economic growth include improved efficiency of the judicial sector and greater enfrceabilty of contracts; stronger rights of secured and unsecured creditors; improving the quality of information by strengtheing accounting standards and pracices; andi the development of a legal and rulatory framework to 1iuilitate the sharing of negative as well as positive in fonnation about borrowTrs betwee financial institutions. Authorities are aware of the need to lower the costs of financial intemediation and have been moving ative. Measures have been adopted (a) to assure the legality for compound interest in operations (preiously an inteted4Y in a contract argued against such procedure based on an outdated law that forbad chargBing compoundin0terestin loans lasting less than one year); (b) to include the extension of alienatdoflduciaria (foreclosure) to housing and mobilegoodHs, and the legal separation of principal and interest; and(c) to lower the costsbyreducing taxes an reserve requirements. A ftirher lowering the level of financial intermediton taation is planned. A ad reform of Brazilian payments system will increase its reliability and reduce the costs of financial intermediation. Information availability has also Brazil: Financing Municipal Investment: Issues and Options 47 Box 4.7 (coat.) increased The Credit RLsk Data Center, operated by the Central Bank, now makes available standardized infomation on credit operations and financial institutions will report monthly their classification of credit operaions above R$20,00. The early evidence of the degree to which these benefits will be passed on to banks' customers is favorable, and lending rates are cretly near a five-year low. But spreads remain high, at about 30 percentage points, and fiurther reform wiU be necessary to lower the costs of financial intermediation. This will require further improvements in the efficiency of the legal system. Reforms could include a limitation on the availability or the levels of appeal, the creation of special courts, increasing the precedent value of higher court decisions and educating judges in economic and financial areas. While these arepotaly sensitive issues and can only be addressed over the long run, improvements in the enforeability of contracts have high payoffs for increasing financial intennediation and growth in Brazil and shold have high priority. Thejudicial changes should be complemented by changes in the creditor rights. While, as in other Latin American countries, bankruptcy reform has been on the agenda for much of the past decade, little progress has been made. Tlhis contrasts with the progress made by other Latin American countries, notable in Argentina (1995) and in Mexico. Refrms in creditor rights need to adopt international best-practice- ranking secured creditors first and automatic replacement of management - and a more flexible bankruptcy law, Changes in the banlruptcy law should allow for more flexibility in restucturing and reorganization, while protecting the rihs of creditors. To date, advocates for bankruptcy reform - creditors (largely state-owned) andpotenS boowers - have not been successful. reform wIl require greater public education about the link between certainty of ntatment of creditors in bankruptcy and the availability (and cost) of finance in order to reverse the tendency in Brazil to fvor debtors.. Efforts in this direction are underway in Argentina and in Mexio Tis need for reform applies equally to Brazil's laws on security interests, which are fagmented among the civil code, the commercial laws, financial sector legislation and special laws for cerain kinds of (e.g. mortgage suritization). Brazil needs to move to a uniform code govemning the ation, perfon and enforcement of securities interests. A "Secured Transactions Code," as is beg considred in Argentina and in Mexio, can facilitate the creation, and enforcement of security interess in financial transactions. An appropriate legal and regulatory framework has to be developed to fcilitate the sharing of information an borrowers between finani institutions, private credit infomation agencies, and possibly the Central Bank. Source: World Bank (2000) E. Municipal Lending Rates and Sources of Financing 4.34 As pointed out earlier, Brazil is unusual among countries at its stage of development in that it has very little private commercial bank lending or other private domestic lending to local governments. There are two primary reasons for this state of affairs: Most domestic municipal credit is delivered through public or parastatal authorities at below-market interest rates, and private banks have been "burned" in the past by bad loans that had to be bailed out by the federal governmnent. 48 Brazil Financing Municipal Investment: Issues and Options 4.35 The institutional structure of municipal lending in Brazil is outlined in Table 4.3, along with the institutions' most recent interest rates for municipal loans, their source of capital, and other features of municipal credit. Two federal institutions - the Caixa Economica Federal and BNDES - dominate the municipal credit landscape. Both institutions have access to low-cost federal funds collected from social welfare system contributions. These low-cost funds are passed on to municipal and other authorized borrowers with a margin to cover the institutions' operating expenses. In both cases, the resulting municipal loans are made at less than one-half the interest rate of the most nearly comparable market-rate loans to private borrowers. The loans are for longer periods than are available on the commercial market, and they contain other favorable provisions, like grace periods on amortization payments, that are generally unavailable commercially. 4.36 At the state level, the Municipal Development Funds established with World Bank support operate on similar below-market terms. Under these programs the state governments absorb the cost of external debt service of the World Bank of IADB loans. rhe Municipal Development Funds use the external cost of capital (denominated in dollars) simply as a reference rate for their pricing of municipal loans, to which they add an authorized margin to cover administrative costs. The actual cost of capital to the funds is zero, since they are not expected to bear any part of the cost of servicing the international donor financing.29 4.37 In spite of the incentives for publicly operated municipal lending institutions from both international donors and national governments to move toward market pricing of municipal loans, no proposals of this kind have surfaced in Brazil, especially in view of the 1998-99 fiscal crisis. In fact, in all programs financed to five state MDFs (Parana, Minas Gerais, Rio Grande do Sul, Ceara, and the dormant Santa Catarina program), neither the Bank's nor the IDB's programs have provisions that would move the MDFs toward market rates of interest in their municipal loans or support a transition from public sector to private sector lending to municipalities. 4.38 BNDES has examined the possibility of on-lending some of its low-cost funds to private institutions, which would in turn lend to municipalities to help finance infrastructure investment. An on-lending mechanism of this kind would not be subject to the 45% of equity limitation on loans to public sector institutions, as long as the private sector on-lender accepted all of the credit risk. BNDES has sought to maintain the present cost structure of its lending, however, including a ceiling of 2.5% on the combined spread between BNDES' cost of funds and the municipal borrowing rate. BNDES estimates that it would require 1 percentage point of this margin to cover its own administrative costs. Unsurprisingly, prilvate commercial banks have expressed no interest in absorbing their administrative costs and the entire credit risk from municipal loans within the remaining 1.5 percentage point margin. 4.39 Private sector participation in the municipal credit market will become feasible only if public sector lenders are required to adopt market rates of interest in municipal lending, or 29 Most Brazilian states operate other specialized loan funds that also make loans to municipalities. Minas Gerais, for example, has a state environmental fund and an urbanization fund that make loans to municipalities or municipal enterprises. Brazil: Financing Municipal Investment: Issues and Options 49 if the public sector institutions' low cost of capital is passed on to private financial institutions, along with allowance of much greater spreads to cover the combined costs of credit risk and private sector administration of the credit program. Without these market inducements, private lending will emerge only slowly, should publicly supplied credit dry up as Resolution 2653 becomes binding and squeezes out additional lending to municipalities by public financial institutions. Table 4.3 Municipal Lending Rates, Sources of Funds, by Lender Program 'Principal Lending Rate Volume of Financing to Municipality How Rate is Municipal Program Source of Funds Purpose of or Municipal Calculated Credit Municipal Enterprise' Outstnding ____ ___ ____ ___ L oans_ _ _ _ _ _ _ _ Caixa Econ6mica FGTS mandatory Housing and 8%-12%, Margin over - R$7 billion Federal worker water depending on cost of funds contributions, systems program IADB credit BNDES PIS-PASEP and Wastewater 5%-8% for 2.5% margin. - R$2.billion FAT employer systems, subsidized FAT funds social insurance transport regions & carry rate of contributions activities, TJLP+2.5%, up to 16% for although only a standard loans portion has to be paid in cash. Remainder is capitalized ___________ _ indefinitely. Federal Treasury Federal Budget Refinancing 6%-9% Political - R$5 billion Bailout of stressed negotiation loans _ Parand Municipal Now IADB, Various 10.14% 3.5% margin US$ 415 Development Fund formerly World over IADB million Bank reference loan rate Minas Gerais World Bank Various 9.04% 3% margin over R$ 328 mullion Municipal World Bank Development Fund reference loan rate Ceara Development World Bank and Various 9% Spread over Bank and BNDES base rate Municipal Development Fund _ Private Sector Market rate Private 34.5% rate for Market N/A Commercial Loans sector 2-year commercial loan to prime clients a Fall of 1999. Source: Govermnent of Brazil 50 Brazil Financing Municipal Investment: Issues and Options F. Principles of a Market-Oriented Municipal Credit System 4.40 The following principles should guide the discussion of how to move from the present system to a more market-oriented municipal credit system. (a) All municipal lending should take place at market rates. No private sector lender is likely to even experiment with this market as long as the market is dominated by public agencies authorized to lend at rates well below private financial institutions' cost of capital. (b) Subsidies for municipal investment should be delivered through capital grants. To avoid perverse incentives (for example, by providing capital grants to municipalities that are in a weak budget position), capital grants should be tied to independent circumstances that make sense economically and are beyond a local government's power to manipulate through bad management. Appropriate criteria for capital grant subsidies include the following: • Type of investment. The national government or state government have investment priorities spelled out in their development plans. Municipal investments that are high on this priority list, and involve externalities (benefits that extend beyond the municipality itself) are appropriate candidates for grant support. Cost-effective investments for handling waste water and solid waste disposal, for example, can be subsidized. * Local poverty. Capital subsidies from both national and state institutions can be steered to especially poor municipalities - as measured by average household income, poverty rates, or some other generally available, approximate measure. * Type offinancing to be encouraged Finally, grants can be steered to municipalities that adopt fee charging and cost recovery from users (or other direct beneficiaries) of selected types of investments. A matching capital grant could be supplied to municipalities using fee mechanisms to pay for the costs of road construction, for example. (c) Matching capital grants should be equally available regardless of the source of credit financing. Capital grants should not be tied to borrowing from a particular source, such as BNDES, but should be equally available regardless of whether the municipality finances its own part of the investment by borrowing from a private bank, from a public agency, or uses its own surplus funds. 4.41 This capital financing system would make it possible for private suppliers of capital to compete for municipal lending. Extra incentives probably will be needed to draw private lenders into the municipal market initially. Nonetheless, there are advantages to this market-oriented system of credit supply, even if the lending system does not get privatized quickly. It relies more on the market cost of capital to allocate funds. It establishes a Brazil: Financing Municipal Investment: Issues and Options 51 framework in which privatized investment for municipal purposes can compete equitably with municipal investment in the same field. It can target subsidies for developmentally desirable purposes more effectively than universally subsidized interest rates. The criteria for capital subsidies should be announced publicly and be fully transparent. Once such a system is in place, municipalities can look for the best way to raise the credit portion of a financing package. Box 4.7- Is Municipal Lending by Federal Development Institutions Subsidized Public funds, raised through employer and employee mandatory contributions to the social insurance system (FGTS) are allocated to public banks and, in turn, partly used to finance municipal loans for infrastructure investment. Since these funds are remunerated at less than market rates, one mentions that there is a "subsidy" for municipal lending by public banks. Is this correct? Some ficts: the Brazilian system: ^ Allocates employer and employee contributions to FGTS to federal development institutions without going through the market. * The cost of these funds is below the cost of capital raised through the market; * The cost savings are passed on to municipalities in the form of below-market interest rates. At end 1999, standard, long-term municipal loans carried an interest rate of 16%, compared with 34.5% for two year commercial bank loans to prime private-sector borrowers.; * Ongoing saving accont rates may not represent the correct "market rate" as individual small savers do not have many investment choices in the Brazilian system and banks do not value these small- scale, unpredictable, individual savings. A better indicator of the alternative market rate for individuals' long-term savings probably is given by the volumtary complementary private pension plans that were first established in 1977 and operate side by side with the governmnt's pay-as- you-go system. While is fair to characterize the Brazilian system as involving a public -subsidy" fDr municipal lending, almost every country in the world provides a subsidy of some kind to municipalities for credit used to finance long-term investment. The existence of such a subsidy does not by itselfmean that the credit system should be changed. Integrating Municipal Lending into the National Credit Market It will be desirable, however, to gradually integre municipal lending into the national credit market rather than keep it as a largely separated, publicly financed sub-market. Progress in this direction could be made on two fronts. First, private pension glans cld be encoumged to enter the municigal lending market on an experimental basis. Closed pension funds already are permitted to invest a portion of their assets in state and municipal debt, but have been very slow to actually make loans. A clearer specification of what constitutes prudential lending to sub-national governments (e.g., a minimwn cedt rating by an independent credit-rating agency) could generate a small level of pension fund lending to municipalities. Second, private banks and other private - Eor e ital mark institutions could _ f oa oton of national oial inurance funds subject to the condition that the funds be used for municipal lending. It is far from certain that private banks would wish to enter the municipal lending field under current conditions. Nonetheless, the potential availability of social insurance fund flows could focus greater private sector interest in the municipal credit market. If private institutions do not express an interest in bidding for such funds, this would provide a stronger market justification for continuing to channel funds for municipal investment through public development agencies, until such a time as the municipal market becomes more appealing to private intermediaries. 52 Brazil Financing Municipal Investment: Issues and Options 4.42 Some experimentation would be necessary with credit financing through local branches of banks (assuming the current restrictions are relaxed). The transformation to private sector lending to municipalities needs to be gradual and based on success cases. While one wants a system that accommodates the private sector, a sudden, complete turnabout in the way municipalities get credit would be disastrous to all partners. G. Credit Risk and Intercepts 4.43 Two divergent municipal credit histories lie side by side in Brazil. The Caixa Econ6mica Federal, BNDES, and the state-level Municipal Development Funds all report impressive credit histories, with less than 0.5% of loans having had any late payments and with even fewer problem loans. State and private banks, however, have had far larger volumes of municipal problem loans that have had to be taken over and refinanced by the federal Treasury. 4.44 The inherent credit risk in municipal loans, unsupported by credit enhancements, i; high. The Caixa Economica Federal is completing its internal credit rating of municipalities, attempting to use rating standards comparable to those of independent credit rating agencies. On its scale, about 60% of municipalities reach a CCC rating or better. Of these, about 10% are rated B and 5% BB. None reaches the BBB threshold of "investment quality." (CEF's internal minimum credit standard for lending is CCC.) 4.45 The nearly universal usage of intercepts as a credit enhancement, however, reduces actual payment risk to the very low levels observed at federal lending institutions and state MDFs. Constitutional transfers and tax-sharing payments to municipal borrowers who are not current in debt service payment can be "intercepted" and transferred directly to the lender. At the federal level, the Caixa and BNDES use federal law to intercept federal transfers. The entire process is automated. Intercepted funds are deposited in the Caixa's account, normally within 24 hours of the automatic triggering of a late payment notice to the Central Bank. At the state level, state law authorizes intercept of state transfers to municipal borrowers as well as taxes collected by the state and shared with municipalities. In Minas Gerais, state law further provides that no state agency can make a grant, loan, or transfer payment to a municipality that has debt service arrears until the arrearage is cured. Again, the notification and intercept procedure is fully automated. 4.46 As the process is actually implemented at the state level, the term "intercept" ofter. is a misnomer. More accurately, it is an automatic payment mechanism. Municipalities typically authorize the bank handling its accounts to deduct at source the payments needed to meet its monthly debt service obligations, before the money ever is sent to the municipality. No action then is required of the MDF in order to stay current in debt servico. payments. A municipality can express a preference for a pure intercept if it wishes, but few do it. 4.47 In terms of economic efficiency, this arrangement has two problems: Brazil: Financing Municipal Investment: Issues and Options 53 (a) On the lending side, the lender has no credit-risk motivation to investigate the economics and feasibility of the underlying investment project. A rational private sector lender would look almost exclusively at the strength of the "intercept" guarantee. A public sector lender will look at other things, like the economic value or internal rate of return of the project, only to the extent that it is specifically charged with this responsibility in addition to its lending role. (b) On the borrowing side, the municipality never sees the transfer or tax-sharing funds and so has only a dim sense of the opportunity costs of the revenue stream it is signing away. In other words, neither the lender nor the borrower has much reason, from the structure of the loan and repayment arrangement, to investigate the economics of the project itself. 4.48 To overcome these problems, given the need of the private sector to have some "guarantee" about repayment, one can suggest two options: (a) One option is to make intercepts equally available for private and public lenders, but to limit their coverage to a maximum of 50% (say) of annual repayment amounts. That is, the intercept would cover only half the payment risk. The lender would enjoy partial protection, but would be obliged to fully investigate the project in order to cover its entire risk. (b) Local governments could be encouraged (through the targeted capital grants described above) to set up the functional equivalent of intercept systems from their own funds at the local level to cover the remainder of the payment obligation. Revenues from a project, generated by user fees or dedicated taxes, would go directly into a "lockbox" or trustee-administered fund, which could be used only for loan repayment. (Excess funds beyond some agreed-upon coverage rate could be released for general budgetary use.) Many countries use this kind of system. It is the basis for the revenue bond financing in Ahmedabad. It has been used with success in South Africa, Colombia, and Eastern Europe, as well as in the United States and other countries. 4.49 A lender wants to know where the money for loan repayment is coming from, and that the funds are protected from political manipulation. For a municipality to be able to set up a secure, revenue-financing system at the local level is far more consistent with decentralization objectives than having an automatic payment deduction at source. Once in place and functioning, these mechanisms make it possible to borrow from any source, public or private, through a loan or a revenue bond. Both lender and borrower have a strong incentive to concentrate on the adequacy and predictability of the revenue flow and the adequacy of the institutional arrangements that protect the revenue stream from general governmental predation. 4.50 Avoiding moral hazard. The above system works on the principle of risk-sharing. A lender's financial risk is first reduced by a partial intercept, then further reduced by a well-defined repayment system at the local level. There is no full guarantee, however. 54 Brazil Financing Municipal Investment: Issues and Options Both the lender and borrower have a strong incentive to investigate the economic/financ ial feasibility of the underlying project and its revenue generation, and (equally important for developmental purposes) to investigate the strength of the institutional arrangements that set and adjust fees, dedicate revenue for loan repayment, etc. 4.51 Two final matters have to be considered in relation to the role of the intercept mechanism to lower the credit risk for most borrowers and most current lenders. The fir st is the fact that the system has broken down in the use of the largest state capital cities. These cities have successfully argued that intercepting the full amount of debt service from transfers and tax-sharing due the cities would strangle the local budget, forcing waves ol public employee layoffs, service cuts, and other high-profile consequences. The politicization of debt has proved a successful ploy only for the largest cities that can grab media headlines and exert pressure on large numbers of political representatives. However, the experience of threatened non-payment of debt service (which was taken to much greater heights of political drama at the state level) has caused private banks to turn away from all types of municipal lending. 4.52 A related issue that requires clarification if the intercept mechanism is used to secure private-sector lending to municipalities is its legal status. Apparently, each state must pass its own legislation authorizing the use of intercepts for specified classes of lenders. Presently, the intercept laws in effect in some (perhaps most) states authorize payment of intercepts only to other agents of the state government, like MDFs. It is unclear how serious the political and legal hurdles would be to extend intercept authority in all states to private sector lenders. It would be desirable for any legislation dealing wilh intercept authority for late payments to also trigger the same set of prohibitions on furthor state grants or state transfers to municipalities that are not current in debt service, as is done in Minas Gerais. 4.53 In summnary, the problem of municipal creditworthiness seems fully soluble in Brazil with the tools already at hand. Lenders of all types need only to keep in mind that they should calculate the maximum magnitude of intercept that could be needed, and to ensure that loan size does not escalate to the point where intercepts of this magnitude trAly jeopardize local budget management and service capacity. As in most countries, giant cities like Sao Paulo and Rio de Janeiro remain special cases. Their high profile and political leverage make standard creditworthiness-assessment methods largely irrelevant Qualitative judgment of willingness to pay plays a correspondingly large role in credit judgments. H. Conclusions and Next Steps 4.54 A program to build a stable and efficient municipal credit market relying significantly on private lending should include * Reform of the present system of municipal borrowing limits. Brazil: Financing Municipal Investment: Issues and Options 55 * A gradual but steady move of municipal interest rates toward market levels by all public and parastatal lenders to open room for private lending. * Experimentation with joint public-private lending to municipalities by having private financial institutions combine with state MDFs or federal lending institutions as joint lenders to municipalities or municipal enterprises, or to finance freestanding projects generating revenue returns. The parties would combine their sources of funds in a blended cost of borrowing to the municipality. They would share credit risk. Experience of this kind would introduce private banks to the municipal market and the kind of budget and other information that is needed to appraise a municipal loan. Joint lending of this kind has proved successful elsewhere in inducing private banks to provide credit to the municipal sector Private banks will require substantialiy higher margins than have been discussed up to now to find the municipal market attractive. * Institutional and legal obstacles should be cleared away so that the intercept mechanism can be used to secure private sector as well as public sector loans to muunicipal governments. 4.55 The following chapter details some of the institutional formats that would enable the private sector to occupy a more relevant position in the provision of the services, complementing the analysis of the role of the private sector as co-financier of public investment. 5. Private Sector Participation in Municipal Infrastructure Investment and Service Delivery 5.1 The future of municipal service provision in Brazil will no doubt involve a growing role for the private sector. Experience with private sector participation (PSP) in the delivery of municipal services, both in Brazil and internationally, has led to improved service quality and reduced costs and, in particular, can be used to relieve the financing burden on local governments for needed investment. This chapter addresses opportunities to increase PSP in municipal service delivery and infrastructure finance in Brazil with a focus on water, sewer, and solid waste services, a sector in which ample opportunity remains to boost the private sector's role. Though some issues are specific to the water, sewage, and sanitation sectors, the majority of the issues raised in a discussion of these sectors are valid across the spectrum of municipal services. 5.2 The legal, regulatory, political, institutional, and financial obstacles that inhibit further private sector participation in these sectors are particularly important. This chapti r will discuss them and also will address the financing mechanisms of the official lenders, BNDES and CEF, and present options for policy-driven modifications to their lending practices to accelerate the pace of private sector involvement in the sector. 5.3 Though private sources of credit for municipal infrastructure in Brazil are likely to remain limited in the short term, the growing involvement of private sector actors in municipal service delivery has created a need for a comprehensive policy dialogue aimed at establishing the proper incentives and institutional framework to ensure that the initiatives currently underway can be sustained and replicated. While a long-term vision for increasing PSP is contingent on macroeconomic stability, legal and regulatory reform, ar d capital markets development, especially as regards the supply of long-term savings, medium-term efforts should be focused on improving accountability and transparency, leveraging government-supplied credit in a more effective manner, and exploring optiomn for new financing mechanisms based on international experience. A. Current Private Sector Activities in Municipal Infrastructure 5.4 The types of projects that have the highest potential for the largest volume of private investment in municipal infrastructure and serve the largest population are water and sanitation concessions, BOTs, and asset sales. The 5,500 municipalities in Brazil that serve 150 million people offer an enormous market for private sector investment. However, of the 5,500 municipalities, 75% have fewer than 20,000 people. PSP for these smaller municipalities may not be possible primarily because of the high cost of expandirg networks that results in a high tariff required to operate the system, amortize capital investments, and provide an acceptable return to private investment. The lower income levels of the populations in the smaller communities would most likely not support the tariff levels required for the private sector to invest in these projects without additional government financial support. Pooling municipalities into larger service areas that achieve population sizes greater than 100,000 is one way to overcome the small scale issue, though political obstacles often prohibit such initiatives. Two recent concessions in the Brazil: Financing Municipal Investment: Issues and Options 57 State of Rio de Janeiro have successfully combined several municipalities into larger service areas to attract private investment. 5.5 PSP in the water and sanitation sector in Brazil has been active recently. The types of projects that have attracted private investment include: (a) bulk water supply and water treatment (BOT); (b) expansion of the water distribution and wastewater collection networks; (c) wastewater collection and treatment (BOT); and (d) partial asset sales (e.g. the Parana State Water Company, Sanepar). 5.6 A recent World Bank report (World Bank 1999c) that reviews PSP in the sector identified 10 full water distribution and wastewater collection concessions in operation serving a population of 1.4 million people. The report mentions three other full concessions that have been signed but are not yet operating because of lack of financing, or for other institutional or regulatory reasons (serving a population of 660,000), and one full concession that was terminated. There are seven bulk water supply and wastewater treatment BOTs (primarily in the state of Sao Paulo), either in operation or construction serving almost 1 million people, and five BOT concession contracts that have been awarded but not signed to serve 720,000 people. 5.7 The total population served for operating and proposed concessions and BOTs is fewer than 3 million people. This number would have substantially increased to over 15 million if the sale of the Rio de Janeiro State Water Company, CEDAE, were successful. However, even with the sale of CEDAE, the relatively small number of concessions from the large potential market demonstrates the significant constraints that inhibit further privatization. As the Bank report shows, there are major legal, regulatory, institutional/political, and financial obstacles to greater PSP in the water and sanitation sector. B. Legal Risks 5.8 Although municipalities have the constitutional responsibility to deliver water services, most have delegated this responsibility to state water companies, either through a concession granted to the state company, through convenios for water services, or through historical practice. State water companies claim they have invested in water and sewer network expansion, bulk water supply, etc., within the municipal service areas. In most cases the water companies built these facilities with financing from the state or central government. When the state water company enters into a concession contract or sale of the company with the private sector, existing asset ownership between the state water company and municipality is unclear. The distribution of privatization benefits (concession outorga, or asset sale payments) between the state water company and the municipalities is also unclear. This problem first emerged in the partial sale of the state of Rio de Janeiro's water company, CEDAE. 5.9 When the Rio de Janeiro state government decided to sell a controlling share in CEDAE, the Rio metropolitan area municipalities claimed that the water and sewer networks were owned by them and that they should receive a significant amount of the 58 Brazil Financing Municipal Investment: Issues and Options sale proceeds to compensate them for these assets. CEDAE, on the other hand, claimed that it should be compensated for the non-depreciated value of the assets and that it had the rights to the proceeds of an asset sale equivalent to this value. In addition to the disputes with the municipalities, the privatization became embroiled in the gubernatorial election battle. After much negotiation with the municipalities, an agreement was reached between the Rio metropolitan municipalities and the state government regarding the allocation of the CEDAE sale proceeds. However, the State Assembly nullified this agreement when it vetoed a law sponsored by the governor to allow the state to privatize the delivery of water services in the Rio metropolitan area. In spite of the failed effort to sell CEDAE, several other states are considering partial assets sales, and the state of Parana was successful in selling 40% of its ownership in the state water company, SANEPAR to a private consortium. It is considering the sale of the remaining shares to this group.30 5.10 Many concessions have been hurt by inconsistent local court decisions on the interpretation of environmental protection and basic sanitation laws and on concession contracts, which have sent mixed signals to the private sector (World Bank 1999c, p. 56>. For example, in Petropolis, in the state of Rio de Janeiro, the court ruled that sewer tarifls could not be imposed unless the sewage were treated, not just collected. In Parana the lower court ruled that SANEPAR could not shut off water delivery service on constitutional grounds. Also in Parana, a municipality whose concession will expire with SANEPAR in the near future has passed a law that will not allow SANEPAR to disconnect a home's water service. These issues create significant legal and financial risk for prospective owners considering a purchase of the remaining SANEPAR shares. This legal uncertainty is also a considerable risk for creditors, including BNDES and CEF. C. Regulatory Obstacles 5.11 The regulatory obstacles to PSP in the water and sanitation sector in Brazil are significant. On the one hand, there is no standardized national law for water and sewer concessions that establishes institutional arrangements to regulate water and sewer concessions. Other regulatory risks include (a) overlapping jurisdictional battles over the award of concession contracts and the ownership of existing network assets; (b) monitoring responsibilities for water and wastewater quality; (c) oversight of raw water extraction; and (d) managing the relationship between the concessionaire's rights to a fair market return as provided under Brazilian law ("economic-financial equilibrium") and tariff adjustment and revision procedures. 5.12 Poorly drafted concession contracts exacerbate the regulatory problems (World Bank 1 999a). Contracts are designed more like civil works public procurement contracts that focus on technical issues rather than a document that clearly defines in detail the allocation of critical risks between the government and concessionaire. In addition, many critical concession contract clauses such as tariff adjustments and revisions are very vague, which inevitably leads to disputes between the concessionaire and the municipality. The 30 See World Bank (1999c), pp. 16-26, for a detailed case study of the attempt to sell a portion of CEDAE. Brazil: Financing Municipal Investment: Issues and Options 59 vague language also leaves room for substantial political interference and interpretation of events that suit the political exigencies of the moment. D. Financial Obstacles 5.13 Most water companies in Brazil are in poor financial condition, based on the general rating criteria used by CEF.3' Physical and commercial water losses, redundant labor, high pension costs, and the high cost of borrowing for capital investments combined with low tariffs have created financially weak water companies. PSP in the sector will improve operating efficiency and financial conditions of these companies, as demonstrated by the PROLAGOS concession described Box 5.1. However, there are still many financial hurdles to overcome for concessionaires and public water companies before they dramatically improve their financial condition. 5.14 The main financial obstacle to PSP in the water sector is the political difficulty of enacting the tariff hikes required to finance investments. In most concession agreements, private contractors rely upon the regulated tariff adjustment mechanism incorporated in the contract to generate surplus revenues for investments, to act as security to creditors to raise capital, and to achieve acceptable investment returns. There is some anecdotal evidence of great ambiguity of the regulatory framework and its negative impact on incentives to attract private investment to municipal service delivery. For example, in one instance a newly elected governor refused to honor the tariff adjustment formula to increase rates by inflation, a critical consideration for private investors in inflation-prone Brazil. In other cases the refusal to adjust the tariff according to the terms of the contract has led to reductions in investment and the inability of the concessionaire to secure loans from BNDES. Related to this issue is the culture of non-payment for water by users. 5.15 Even with substantial operating improvements, as shown by the PROLAGOS example below, concessionaires will still have financial obstacles to overcome to obtain funding for investments, especially from private funding sources. The political risks associated with repudiation of tariff adjustments and revisions by newly elected mayors, combined with the inherent risks associated with the asset conditions of the network, make water operations a risky business. In the short and medium term, private concessionaires will continue to rely on federal direct and indirect BNDES lending programs to fund their water improvements. These programs provide longer-term financing (up to eight years) than private commercial banks, if such loans were even available, and they do so at the subsidized cost of BNDES funds. The challenge for BNDES is to encourage a transition to the private commercial market when macro economic conditions and the financial risks associated with water and sewer concessions improve. 31 CEF uses a letter system, similar to international rating agencies, to evaluate the financial condition of water companies and municipalities. The majority of the water companies are rated in the CCC category, the lower end of the A-C ranking system. 60 Brazil Financing Municipal Investment: Issues and Options Box 5.1 PROLAGOS Concession, State of Rio De Janeiro Te rort area northof Rii has historically had a wter-supply problem. The pri watert lis a fresh water laik near the town of Cabo Frio that was dammed by a loal silica plant, manufacturer to provide water to its processing plant several decades ago. The manufacturer ial aiwt plt, wi a capacity of 500 liters per second, to serve the plant and the homesthilt the the area. Thearea grew as resort activities moved in and the pulaftion ineed, but motect to the water syster or connected ilaly. Water tankers supplidthdsome temporaresidences that spran up during the tourist season.hendvid h some ofthewater tan illegally connected to the main wter supply pipe leadingfm the lae The state water compy, CEDAE, operatd the system from 19until thess lon conrc was signed in 1997. e tecncessionaire, PROLAGOS l beganoperating the system, more tha 60% o.f the cu stmrs had delinquent water bills. MEDAE only eoectaboutR00,000 in ater tarifrevenues permonththrough30000 connetons ta tdwatercctof500 liters per secon. PRAOS disconnected up to 2,000 ersprt aincreaswater revenue collectio to $700,W peraonth, added 2 f0,000connections, doubled the water treatmn capac, and cut water service to custmers who did noit paytheii rw bills wihin 60 days. 5.16 One of the lessons learned from the failed CEDAE privatization concerns the municipalities' expectations about financial gains from privatization of a state water company. The CEDAE case clearly shows that the state water companies have a claim on the non-depreciated assets that they financed and built. As the courts sort through the asset disputes related to water and sewer concessions in several states, it will become increasingly clear that the municipalities may have to pay state governments for the residual value of the assets at the time they grant concessions to private companies. It is essential, as the World Bank (1999c) report indicates, for the municipality to properly assess the value of the asset to determine the required payment to the state water company upon transfer of the assets to the concessionaire. Another reason to value the existing assets is to reduce the uncertainty of the condition of the existing assets for bidders, thereby reducing their risks and leading to higher bids. E. The Operating and Capital Expenditure Balance 5.17 One of the risks associated with water and sewer concessions is the unknown condition of the network assets. Often, these assets are in very bad condition and require substantial investment to reduce leaks. The issue is whether these networks are considered maintenance costs or are completely replaced and viewed as a capital expenditure. If they are replaced, then the new asset is considered as a capital expenditure and incorporated into the capital base for upward tariff revision. 5.18 Establishing the condition of the assets and their value prior to the concession will help address the issue as to whether capital investments are required to improve existing service and reduce water losses. If the condition of the assets is known, the regulator can Brazil: Financing Municipal Investment: Issues and Options 61 make a determination as to whether expenditures should be considered as a capital expense and incorporated into the tariff revision formula, or a maintenance expense and only considered for annual tariff inflation adjustments. Determining the condition of the assets (and their value) prior to awarding a concession can be costly. However, this has not prevented deals from being financed in Manila, Bucharest, and other cities. An alternative would have the regulator, at the time of rate reviews, relying on independent engineering reports that audit the concessionaires' network information system and the resulting asset management plan. F. Financing Mechanisms 5.19 BNDES is the most important source of debt financing for water and sewer privatization. However, water and sewer concessions represent only a small portion of BNDES lending. Infrastructure accounted for 43.7% of BNDES' direct and indirect lending portfolio in 1998,32 but only a small percentage were loans to water and sanitation projects (including solid waste disposal) and other urban development activities. Electricity/gas (21.1%), and transportation, mostly rail and port facilities (14.4%), are the primnary recipients of BNDES loans. This reflects BNDES' strategic national development focus. The small amount of lending to the water and sanitation sector may be the result of large-project strategic portfolio investment, risk aversion to the sector, or a combination of both. 5.20 When it lends to private concessionaires, BNDES undertakes a credit analysis of the concessionaire, its shareholders, the project, and the municipality/state that granted the concession along the line that a commercial bank evaluates a project financing. It assesses the financial, legal, economic, political, regulatory, and institutional elements of the project to determine its viability and to identify the critical risks that affect the ability of the concessionaire to repay the debt. The basic element of this evaluation is the tariff level required to support operations, amortize debt, and provide a return to the private investor. The factors that affect the annual tariff revenues are then considered and BNDS may require an additional security (other than the tariff revenue) to provide a loan. Other elements considered in the decision-making process are the experience and financial strength of the concessionaire and the shareholder parent companies, and the political and economic environment of the project's service area. BNDES then decides whether it will require the concessionaire to provide additional security for its loan. This security may consist of additional equity, additional shareholder loans, collateral from the shareholder parent company, personal collateral from the shareholders, municipal guarantees, or some other pledged security that reduces the systemic and specific concession risks briefly mentioned above. 5.21 Until the national government curbs some systemic risks associated with water and sewer concessions, it is unlikely that BNDES (or any other creditor) will provide sufficient 32 Direct loans go from BNDES to the final borrower, both public and private. Indirect loans are provided to financial intermediaries who on-lend to the final borrower. The 43.1 % of BNDES' total loan portfolio for infrastructure lending represent both direct and indirect loans. Statistics provided in this section are from the BNDES 1999 Bond Offering Circular. 62 Brazil Financing Municipal Investment: Issues and Options funding to accelerate the depth of privatization in the sector. The lack of regulatory laws and institutional structures increases the political risk that a mayor will refuse to adjust thz tariff upward even though the formula in the concession contract for adjusting the tariff iŽ well-defined and unambiguous. Other obstacles indicated above, e.g., lack of clarity in tht ownership of network assets, also illustrate the system-wide nature of the risks and the potential for a court ruling in one state to affect another concession in a different state. This system-wide risk is a real concern for BNDES and will continue to inhibit its lending for water and sewer concessions until these risks are mitigated by national legislation and action. 5.22 Until some of those systemic issues are resolved, it is difficult to see how BNDES can expand its financial participation without increasing the risk profile of its portfolio. However, there may be some activities that it can encourage, along with its partner, CEF that will accelerate the financial approval process. G. Activities to Reduce Creditor Risks and Accelerate Approval of Concessionaire Loans 5.23 The fist step the large public banks may consider is to support the recommendations provided in the World Bank report (1 999c) - and widely discussed in Brazil - to standardize the privatization process, reduce creditor and concessionaire risk, and accelerate the loan-approval process. For example, BNDES should encourage local governments and water companies to act in a way that reduces the credit risk for loans to concessionaires. This effort can begin immediately with improvements in the concession bidding process, concession contracts, legal changes related to tariff adjustments and revisions, and regulation (including water quality standards and levels of service), as described in Box 5.2. 5.24 Regulatory commissions may be created at the state level to implement a national regulatory law. The national law should establish the principles of regulation (see Article~ 86 through 96 of Colombia's Ley 142), the institutional structure of the state regulators, the method of appointing, substituting, and terminating regulators, the authority of the regulatory commission, voting procedures, responsibilities, etc. The national law would include a procedure for enforcing regulation by the state regulatory commission. The national law would also include principles to guide the development of the model concession contracts and some of the critical clauses in these contracts such as dispute- resolution, clarification of the "economic-financial equilibrium concept," and contract revision procedures. Brazil: Financing Municipal Investment: Issues and Options 63 Box 5.2 World Bank Recommended Changes to the Concession Bidding Proces, Concession Contraet Developmnent, and Concession Legal Framework for PSP in Water and Sanitation Projects * Award of concessions should be based on economic and financial criteria rather than the technical proposal. Confirmation of the technical ability of the concessionaire to operate the water and sewer system is the most iuportant technical requirement. * Biddg documents should be based on one or more stndard models prepared for diffent types of privatization (BOT, conession, asset sale) which will provide clear options for modifications reflecting local circumstances and priorities. * The federal govement should propose (in an ordinary law or by the National Basic Sanitation Agency, through regultion) a single tarff readjustment formula for the entire basic sanitation sector that would be valid for the entire country. An example of this approach is Colombia's Ley 142, Regulaci6n de los Servicios Puiblicos Domiciliarios. * SEDU, CEF, and BNDES should hie COMpetent legal, financial and technic consulans to determine the most appropriate PSP methd, prepare the water company for privaizatko, and prepare, evaluate, and recmmend the bid award. Consultant costs are compensated by the bidder to SEDU, CEF, or BNDES at the time of signing the concession contract.* * Draft bidding documents and concession contract should be approved by the state acounting tribunal (an agency of the legislative branch that oversees executive acts) prior to biginnigthe bidding process. * Uniform national water quality and level of service standards should be established, bt te states and municipalities should be allowed to modify these national standards based on local conditions. * A regulatory framework should be created to transfer tariff adjustment and revision approvals from the local political body to an indepenent regulator. For a good example, see Ley 142 from Colombia, whicb establishes a national regulatory commission and a regulatory superintendent to implement the commission's decisions. * The Water Sector Modenization program in Colombia, administered by the Ministry of Economic Development is an example of this approach. Source: Summarized from World Bank (1999c). 5.25 The activities indicated above would help to standardize the concession bidding process and create a "level playing field" for potential concession bidders across the country. Establishing standard procedures, rules, and regulations for the water and sanitation sector should mitigate many of the current political, financial, technical, and regulatory risks currently associated with water and sewer concessions in Brazil. In this way BNDES and CEF will establish the foundation for the integration of the commercial banking sector into project lending in the future. 33 This law provides for the national regulator to establish the tariff calculation methodology that applies through the nation. However, if a water concession is competitively bid, the specific tariff adjustment and revision formula in the concession contract applies, but only if its method follows the general rules established in Ley 142. See Articles 86 through 96 that deal with tariff setting, adjustment and revisions. 64 Brazil Financing Municipal Investment: Issues and Options 5.26 CEF and BNDES can promote the recommendations cited above and adopt these practices in their technical assistance programs to municipalities for water and sewer concessions. These efforts will send signals to the private sector that the federal government is concerned about the risks associated with concessions, especially as they affect creditors. States and municipalities that do not follow the program recommendations should be informed that the concessionaire will not receive a loan. These institutions should publish, a "tool kit" or manual that lists the procedures a concession grantor must follow for the concessionaire to receive BNDES or CEF funding. H. Investments and Financing Options 5.27 Future PSP in municipal services in Brazil, as elsewhere, will depend on the development of the domestic capital market to supply debt finance with tenors that matc i the financial requirements of infrastructure investments and the need for interest-rate stability. In the absence of a domestic capital market with the depth needed to meet the demand for infrastructure investment, the current landscape is dominated by the two major public development banks, and, at the margin, by internationally sponsored MDFs. In thc short term and medium term, options for expanding the role of MDFs to lend for PSP ard development of mechanisms for financing infrastructure with the involvement of the private sector should be examined. The intention of this paper is not to articulate specific solutions for financing municipal investment in Brazil, but instead to highlight options fo r the development of financing mechanisms in the context of the existing capital market situation. 5.28 Currently, Municipal Development Funds provide loans to municipalities for water, sewerage, street paving, street lighting, solid waste disposal, public markets (fairs, open stands, etc.), and general economic development (construction of buildings, offices, warehouses, etc.). In the context of administrative restrictions on borrowing by subnational governments, MDFs could consider loans to private sponsors of municipal infrastructure. This would require new credit analysis and loan administrative skills for MDF staff. These skills could be developed with support of the large public banks in Brazil, notably BNDES, based on its experience with private concessionaires. 5.29 However, in the case of some more developed or mature funds, it seems that there are substantial opportunities for greater private sector participation in the near-term.34 Such PSP might include the following options: * Privatization of the MDF. This could be politically difficult, because the fund provides long-term loans to smaller municipalities that might have difficulty getting credit from other sources. * Establishment of a new, privately owned, for-profit MDF that could finance larger municipal projects not eligible under the non-profit MDF, such as the private 34 The implications of the recent decision to transform existing MDFs into State Development Agencies in this regard are unclear, and opportunities for directly involving the private sector in the ownership of the MDFs may be limited in the immediate future. Brazil: Financing Municipal Investment: Issues and Options 65 sector providers of municipal services and infrastructure. Municipalities also could move to the for-profit PCID. This might occur over time, with the non-profit PCID's financing a diminishing share of the total cost, so that the total interest rates would rise gradually. Private sector participation in the funds could help assure that lending does not become politically oriented. Cofinancing and advisory services for lending to private sector providers of municipal infrastructure and services. A private sector partner could help evaluate the risk of lending to private sector providers. 5.30 One alternative is to set up a new private or more "privatizable" entity that can gradually take over the business of the older public entity. This is what was done in France with Credit Local de France (CLF), as mentioned earlier.35 Other alternatives include (a) cofinancing by the private sector; (b) syndication of loans by the public banks; (c) securitization of the loan portfolios of public banks for sale in the private capital markets (see Brad Johnson (1999) for an interesting feasibility study of securitization and also pooled financing for PARANACIDADE); and (d) provision of guarantees or insurance by the public sector banks against different kinds of risks for the private sector (Standard and Poor 's Credit Week 1999). In the World Bank program, the guarantee may be either for specified risks (partial risk guarantee) or for all credit risks to occur during a specified part of the contract of the financing term (partial credit guarantee) (World Bank website). Rather than lending directly to states and municipalities, the World Bank might provide guarantees via an apex bank such as the BNDES or the Caixa, or the IFC could help to channel guarantees via the private sector. 5.31 For water and sewer concessions, the MDFs could collaborate with BNDES/CEF on specific projects. Similar to commercial banks' syndicated loans in project finance, BNDES/CEF would act as the "arranger" of a syndicated loan for the private concessionaire. The MDF would be a participant in the loan syndication until it has sufficient experience to arrange loans on its own accord. The critical factor for this approach is the standardization of the concession process. This will permit BNDES/CEF to more easily transfer credit evaluation technology to the MDF and to allocate project risks between the concessionaire and the grantor for projects in different states/municipalities. 5.32 MDF financing for small investments. For street paving, drainage, and lighting, MDFs provide financing using municipal revenues to secure the loans. An alternative for the collateral would be for the MDFs to organize the beneficiaries of the street improvements - i.e., the property owners who have frontage property along the improved road - into a non-profit or for-profit entity to manage the street paving construction. This organization becomes responsible for repaying the MDF loan. An example of this approach is the PROMUNI project for implementing infrastructure improvements in small municipalities in Central America. The Banco Centroamericano de Integracion Econ6mica (BCIE) funds the PROMUNI program with contributions from the U.S. 35 The Spanish experience is also interesting to consider. 66 Brazil Financing Municipal Investment: Issues and Options Agency for International Development. BCIE acts as a second-tier bank that lends fund:. to private commercial banks or non-profit organizations. In the smaller municipalities, non-profit organizations organize and assist the community in applying for the PROMUNI loans and manage the construction of the municipal infrastructure improvement. The MDFs in Brazil could use a similar approach. They would organize an autarchy or a foundation that would be responsible for the construction and operation of the infrastructure. The MDF would assist the NGC) to enter into a BOT contract arrangement with a firm that builds and operates the infrastructure, paves the street, collects the garbage, or constructs a drain. The work with the community would have two advantages: i) the beneficiaries would have a vested interest in insuring that the facility is built and operated efficiently, as they are responsible for paying and maintaining the facility, and ii) it could be very difficult to implement a transparent bidding process with a small municipality; it would be better to go directly to the beneficiaries for organizing the worc because they have to repay the loan. 5.33 Solid waste management and other infrastructure projects. PSP in solid waste collection and disposal is limited, to the most part, to the large metropolitan areas (Salvador, Belo Horizonte, Manaus, Recife, Rio, Sao Paolo, and Curitiba), although many medium-size cities have some type of third-party private contract to collect garbage. PS? participation in the larger cities is primarily in operating contracts to collect garbage, sweep streets, and operate transfer stations, composting plants, and incinerators. Usually the private contractor is responsible for financing the collection trucks for these operations, but there is limited involvement in major investment items like sanitary landfills, treatment plants, and transfer stations.36 5.34 PSP in solid waste management (SWM) in small and medium municipalities faces a number of problems. First, because PSP participation requires economies of scale, smaller municipalities would need to associate among them and create functional SWM areas. This is especially true of landfill operations. Since there are no statewide companies on SWM and no association experience, this could be difficult to put in motion. In addition, many smaller municipalities do not have separate SWM companies or departments; SWM4 costs and revenues are consolidated with general municipal revenues and expenditures, making it difficult to determine the actual cost of the service and to asses the feasibility c f PSP investment in the operation and management of garbage collection and disposal. 5.35 Cost recovery for SWM services faces legal issues, because Brazilian court rulings have designated SWM as an essential service that the municipality is obliged to offer. Tariffs for SWM services cannot be based on the cost of service, but can be levied only through a "user charge" or "benefit tax" that in general does not relate to the service delivery costs. Although this prevents the concessionaire from charging users directly, this is compatible with the fact that solid waste collection from households (large-scale industry waste is different) is a non-excludable "public good" service, best funded from local taxes, rather than direct charges levied by contractors from each household. (A par: 36 There are some notable exceptions to this general observation, such as the proposed Sao Paulo incinerator BOT. Brazil: Financing Municipal Investment: Issues and Options 67 of the local taxes can be earmarked to ensure sustained funding the service; the garbage will be produced anyway, so budget discretion here is not useful.) 5.36 There are limited economies of scale in solid waste collections, and the assets (being "on wheels") can generally be financed through truck leasing rather than municipal credit. What is more difficult is final disposal, where regional schemes and BOT-type finance could be envisaged, with the revenue stream coming from local taxes in participating municipalities (or tipping fees paid by collection contractors, which doesn't change the final revenue source but discourages illegal dumping). MDFs can promote the participation of the private sector in solid waste management services. They can begin to organize groups of smaller municipalities into SWM districts and to encourage the larger metropolitan areas to become more active in capital intensive investments such as sanitary landfill operations. If SWM projects are viewed as a means to create jobs and provide environmental benefits to the community, it might be possible to influence residents to comply with user charges that can support private sector investment. 5.37 Urban bus transportation is another potential PSP area. Indeed, most metropolitan areas and some medium-size cities offer concessions to bus operators. However, like solid waste, bus concessions are more like operating contracts. Concessionaires may, on occasion, be required to purchase rolling stock, but often the cost of the rolling stock is included in a lease payment to the municipality that purchased the equipment (financed by BNDES). 68 Brazil Financing Municipal Investment: Issues and Options 6. Financial Intermediaries For Municipalities Lessons from International Experience 6.1 International experience and the dynamics of the municipal sector in Brazil indicate that municipal credit markets are set for a rapid expansion in the near future. While macroeconomic considerations call for all precautions to avoid credit crisis and a negative impact on fiscal stability, one can only wonder what will those markets look like. Will the emphasis be on bonds, as in the U.S. market? Or will it be on privately owned banks, especially banks specializing in subnational lending, as in Europe? Or will it be a mixture of both systems? 6.2 Convergence of banks and capital markets is actually happening (Standard and Poor 's Credit Week 2000). Many European banks have successfully developed credit- enhancement products for U.S. subnational bonds in the form of letters of credit and liquidity facilities. Many subnational governments in Western Europe have issued bonds with the help of investment banks. In response, the specialized European banks have formed subsidiaries to underwrite bonds (e.g., Dexia Capital Markets).37 As mentioned above, in all cases some fundamental conditions were present: (i) the fiscal federal systemn was stable and transparent; (ii) moral hazard was controlled; (iii) financial information v- as available and reliable; (iv) investors were legally protected, as there were procedures for dealing with solvency problems (e.g., bankruptcy code); and (v) the capital market was sufficiently developed to ensure the liquidity of the applications and protection of the snal investors. 6.3 This chapter deals with several aspects of financial intermediation for municipalities. One starts with a brief review of the rationale for debt instruments supporting capital investment. The case of the Brazil development funds comes next. This is an important portion of municipal lending to Brazil supported by the Bank and the ID13 and an approach that needs to be reviewed and assessed. The case of Parana is analyzed in greater detail, looking for examples and lessons. We end the chapter with a discussion o iF how to deal with moral hazard at the municipal level and what lessons to extract from the industrialized world. A. The Rationale of Debt Instruments for Capital Investment 6.4 As mentioned earlier, municipalities finance their capital investments with net operating savings, grants from higher levels of government and borrowings. Even though borrowings represent a relatively small portion of resources allocated for financing municipal capital investments, they are a desirable and important source of financing where market conditions permit. 37 In a recent speech, Alan Greenspan, chairman of the U.S. Federal Reserve, argued that the presence of both bank and capital market financing partially explained the resilience of the U.S. economy, compared with economies dependent on bank financing, such as Japan. Brazil: Financing Municipal Investment: Issues and Options 69 6.5 There are three major justifications for the use of borrowings for financing capital investments, especially in growing economies: * First, the amounts needed for the investments are too large to raise from current resources, and, because of their nature, the entire investment must be expended before benefits start to accrue. In the absence of borrowing, municipalities would be unable to make certain investments or would be forced to finance capital investments on a "pay- as-you-go" basis, thus imposing the full burden of financing such investments on taxpayers who happen to live in a particular location when these investments are made. * Second, the investments required to accommodate future growth are needed today. To delay them will slow the growth that will improve conditions, including the ability to repay debt. * Third, because of the extended useful life of most capital investments, it is more equitable and economically efficient to have those inhabitants who over time get the benefits of the investments to contribute to the costs. In addition, borrowing for long- maturing assets is important, because they offer a good match to long-term liabilities that some investors - such as pension funds and insurance companies - carry on their balance sheets, thus contributing to capital market development. B. International Experience 6.6 Countries around the world have developed different instruments to allow local governments or municipalities to finance their capital investments. Two of the most predominant instruments are municipal bonds and specialized financial intermediaries (SFIs). These are not mutually exclusive and, in fact, complement each other insofar as they serve the needs of different segments of the municipal credit market. SFIs tend to be a better alternative for small or specialized borrowers, whereas municipal bonds are a more attractive choice for large and frequent borrowers. While it is true that in Europe SFIs tend to dominate the market, while municipal bonds are more popular in North America,38 both markets operate with both instruments.39 6.7 Historical and economic reasons shaped the development of these two "models." The highly decentralized system of government in North America and the lack of strong national banks, especially in the United States, has favored the issuance of bonds and the use of syndicated loans as a means of financing local governments. Also, the fact that interest on municipal bonds in the United States is exempt from federal income taxes (and some state and local taxes) gives this instrument a tremendous advantage in the municipal credit market. By contrast, the "European model," which developed in the context of unitary forms of government and strong national banks (e.g., France), favors borrowing through SFIs. 38 It is estimated that by the end of 1999 there was about US$1.5 trillion in outstanding municipal bonds in the U.S. market, representing about 10% of total outstanding level of public and private debt. 39 Municipal bond banks in both Canada and the United States and state revolving funds in the United States are typical examples of SFIs in North America 70 Brazil Financing Municipal Investment: Issues and Options Europe 6.8 Alnost invariably, financial internediaries for local govermnents in Europe were set up by national governments in the early 1 900s. European countries that have fmnancial intermediaries that specialize in local governments are Austria, Belgium, Finland, France, Germany, Italy, Netherlands, Spain, and Sweden. In the case of Finland and Sweden, the SFIs were created and are wholly owned by municipalities. In the case of the Netherlands, BNG (Bank Nederlandse Gemeenten) is owned jointly by the national and municipal governments. With the exception of these cases, which have remained in the public sector, all other SFIs have been privatized. 6.9 After privatization, the leading SFIs in Belgium and France, namely Credit Communal de Belgique and Credit Local de France, merged together to form the Dexia Group. Together under the Dexia Group these two SFIs own the Banque Internationale a Luxembourg and Dexia Public and Project Finance International Bank. Since its creation in October 1996, the Dexia Group has opened offices in Germany, Sweden, and the United Kingdom, and has bought shares of SFIs in Austria, Italy, and Spain, thus acquiring a lead position in the municipal credit market in Europe. For example, in France alone, Credit Local de France has a share of about 42% of the municipal credit market. 6.10 Without exception, the European SFIs operate according to capital market rules, inasmuch as they fund themselves in that market. Having to compete for business with other financial institutions as well as with the bond market, these SFIs have to operate very efficiently in order to offer a cost-effective alternative for municipalities seeking to fund capital investments. This implies having a good rating in order to raise capital at the lowest cost possible. North America 6.11 The United States is often perceived as having a highly sophisticated financial market, with knowledgeable and skilled investors and issuers. But that is not necessarily true for the estimnated 40,000 local government issuers in the U.S. bond market. Many are small and unsophisticated. However, the well-established legal and regulatory processes, the availability of skilled advisers, and competition among potential lenders greatly improves the access of smaller units to the markets. To achieve this objective, as many as 17 states have set up municipal bond banks. Petersen (2000) notes that most U.S. bond banks have been created in largely rural states in which there were no strong regional financial markets. He also notes that the creation of the bond banks in New Hampshire, Vermont, and Maine, for example, was to an extent a reaction to those states being in the backwater of the New England regional financial markets that were dominated by large Boston banks. Combined with the availability of private bond insurance and preferential tax policy, municipal bond banks keep competitive pressure on dealers and private lenders in providing services to small issuers. Brazil: Financing Municipal Investment: Issues and Options 71 Box 6.1 Credit Local de France (CLF): A Subnational Development Fund That Successflly Privatized Itself CLF evolved from a public subnational development fimn into a fully private, profitable, financial institution dring the postwar period. It is an interestmg exmple for how public financing institutions can naturally mature into private institutions. CLF evolved as follows: • From the end of the war in 1945 through the 1960s, the Casio de D4ts et Consignatiow (CDC) extended subsidzed loans to the local governments using tax-free saving dpsits as the main funding. * In 1966 Caisse DaideA L 'quipement des Collectivititis Locales (CAECL) obtained funds in the international fmancial markets to complement fte ones granted by CDC. Its loans were not necessarily subsidized. * Decentralization (1982) and deregulation of fmancial markets (1987) led to the transformation of CAECL into Cridit Local de France (CLF) in 1987. CLF's main shareholders were the French govrnmen and its public owned enterprises, such as CDC. However, CLF priatized itself in two main steps: In 1991 it first sold shares on the Paris stock exchange, and in 1993 it sold a majority of voting shares. CLF is currently a private joint stock company, classified as a specialized financial insitution (SFI). As such, it cannot accept depits; it funds itself in domestic and iernatio ea caI markets. The Ministry of Finance has a representative on the board of CLF who has veto pwer. CLF has been for many years been one of Europe's largest bond issuers, raising the equivaen of 8 billion Euros in 1998. CLF's mission is to be the reliable, permant and long-term partner to local governments, whatever their size. Its main focus is to seek long-term partnerships with subnational governments, not limited to its lending activity. It advises its clients thrughout te decision- making process and works with them on a daily basis, especially on ways of improving tansparency and management efficiency. In this, it cotributes to national efforts to foster loca development, environental protecion, and economic renewal. The Dexia Group was created by the economic merger, in 1996, of CLF with Credit Commua de Belgique (CCB), a public fiance institution with 90%0 market share in Belgium. 6.12 Municipal bond banks are state-backed financial intermediaries with a variety of administrative and program structures and financing experience. Their primary function is to pool smaller loans into larger offerings, thus providing economies of scale and giving the opportunity for greater liquidity in the secondary market. The earliest bond banks were seen as general extensions of state government creditworthiness to help close the marketing gap for small, isolated, general-purpose municipal issuers. Over the years, the bond banks frequently have taken on specialized areas of activity, such as financing environmental activities, local schools, short-term borrowing, and equipment leasing. They have also moved to take up limited obligations, participating in structured transactions and providing enhancements. 72 Brazil Financing Municipal Investment: Issues and Options 6.13 Because they are competitive with private lenders and dealers, and many times can finance at lower costs or on better terms than are otherwise available in the market, the creation of bond banks has been resisted by both commercial banks and securities dealer 3 in many states.40 After early adoptions in several states, the bond bank movement in the United States slowed down as opposition from competing interests and concerns about stretching state credit enhancements too thin began to crystallize. More recently, the interest at the national level in creating revolving loan funds as a means of replacing recurring capital grants from the federal government has reactivated interest in state-based financial intermediaries, including the traditional bond banks. 6.14 In Canada, provinces use the bond bank vehicle expansively to borrow on behalf of their municipalities, which only have access to the markets with the permission of the provincial government. This basically amounts to a requirement to use bond banks, unlilie the freedom of choice experienced in the U.S. municipal bond market. Developing Countries 6.15 The experience of developing countries with financial intermediaries that specialize in local governments is largely confined to that of initiatives supported by the Bank and other donors. Municipal Development Funds are an example of such entities. In many countries of Latin America - notably Argentina, Bolivia, Brazil, Colombia, and Ecuador - the Bank and the Inter-American Development Bank have financed municipal development projects that in many cases have helped capitalize Municipal Development Funds. Similar initiatives have been supported in other parts of the world, such as India, Jordan, Morocco, and the Philippines. 6.16 Municipal Development Funds have made long-term capital available to local governments for capital investments that otherwise may have never been carried out, given the unavailability of long-term financing in almost all of those countries.4' They have also encouraged better local government financial management and procurement practices while introducing a credit finance culture to a government level that once had to rely almost exclusively on grants not always allocated according to transparent criteria. 6.17 FINDETER, Colombia's SFI, has a unique design in that it operates as a second. tier financial institution. As such, it rediscounts loans made by commercial banks to loca governments for investments that conform to certain criteria. By rediscounting up to 85%,o of the loan amount, FINDETER requires commercial banks to mobilize 15% from their 40 Because bond banks aggregate small issues into a large one, they can provide economies of scale. But that process reduces the amount of business available to regional dealers and banks. On the other hand, large money-center dealers may support their creation if they think they will get the underwriting business. The latter, however, have little political influence in the state compared with investment firms that are situated there. 41 In many emerging and immature financial systems that characterize the developing world, existing credit markets are febrile and dominated by the central government's own financing needs. Potential lenders are often unfamiliar with local governments and are concerned about their financial integrity. And banking practices and government regulations may restrict or even preclude interest in private sector lending to local governments (Petersen 2000). Brazil: Financing Municipal Investment: Issues and Options 73 own capital, thus leveraging additional finance from the local market. It is important to note that the 100% of the risk associated with loans to local governments are borne by the commercial banks. India: The Tamil Nadu Municipal Development Fund 6.18 The Tamil Nadu Municipal Development Fund - a very active institution in the financing of municipal capital investment in the state of Tamil Nadu - is today funded and managed by public and private sectors. It evolved from a municipal trust fund, like those mentioned before, and is currently planing to issue bonds in the local market to mobilize additional finance, complementing the seed capital from a Bank loan. The initial fund was entirely financed by the public sector, and while it was financially viable, it soon became evident that the fund was too small for the demand for urban infrastructure investment. In addition, its administrative structure as part of the state government and limited funding did not allow much room for growth. 6.19 In order to improve the impact of the fund, the project was restructured in 1996, and the initial fund was converted into an autonomous financial intermediary - the Tamil Nadu Urban Development Fund (TNUDF)/Tamil Nadu Urban Infrastructure Financial Service Ltd. (TNUIFS). The new fund has participation of the private sector - which holds 30% of the capital - and is managed by TNUIFS, a private management company. The scope of operations has been widened to include urban infrastructure projects sponsored by private investors.42 In addition, the participating financial institutions have committed to contribute to the fund an amount that corresponds to 44% of the government of Tamil Nadu's initial contribution. The ultimate objective of the TNUDF is to provide self-sustainable financing while mobilizing private savings for urban infrastructure investment. 6.20 The administration of the TNUDF is entrusted to a board of trustees nominated by the government of Tamil Nadu and the participating financial institutions. Participating financial institutions include (i) ICICI Limited Credit and Investment Corporation of India, Ltd., as the leading managing partner of the TNUIFS; and (ii) Infrastructure Leasing and Financial Services and the Housing Development Finance Corporation, a leader in the development and financing of private infrastructure projects in India on a limited recourse basis and a leading finance corporation in the field of housing and regional development. The strong reputation of these institutions in India's business and financial community will help the TNUDF to raise additional resources from other private investors. South Africa: A Private Municipal Development Fund'3 6.21 INCA (Infrastructure Finance Corporation Limited ), is a private sector financial institution in South Africa that specializes in the infrastructure and municipal sectors. It 42 To fiurther pursue the project's objective of poverty alleviation, a new grant fund was established to finance poverty alleviation projects for specific low-income populations. 43 From the World Bank's subnational capital market development website. 74 Brazil Financing Municipal Investment: Issues and Options makes long-term loans to municipalities, and it is thus an alternative to the nonexistent municipal bond market. INCA was created in 1996 with the following objectives: * to apply consistent and expert credit evaluation techniques for the evaluation of potential borrowers so that credit risk can be accurately priced; * to utilize, where possible, primary and/or secondary credit enhancement to provide security for the borrower; * to issue INCA Bonds, which are independently rated by IBCA as an investment opportunity for medium- and long-term investors; * to provide a liquid market for INCA Bonds by listing them on the Bonds Exchange and through the use of market-making abilities of the First National Bank; and * to operate with a capital structure designed to further reduce the risk for investoi s, of which a key feature will be subordinated "junior debt." 6.22 Capital. INCA was created in 1996. Its main shareholders are public-oriented but mostly privately owned and privately managed institutions. These include a major South African financial institution (First National Bank), two important insurance companies (Old Mutual and Southern Life), a semi-public financial institution (Msele Financial Holdings), a women's development institution (Women's Investment Portfolio), and four international partners - Dexia International (of France), Proparco (a subsidiary of Caisse Francaise de Developpement, also from France), Deutsche Investitions und Entwicklungsgesellchafts (DEG, of Germany), and Commonwealth Development Corporation (of the United Kingdom). These international partners are instrumental to the company, bringing expertise as well as credibility. Their representatives sit on the board of INCA. 6.23 Bonds. INCA's business is to borrow on the capital market (through bond issues) and to lend the proceeds to local governments. One such bond issue has been arranged ir 1997, the second private bond issue in South Africa in recent years. The amount issued was 1.2 billion rand (US$240 million). INCA had prestigious advisers (Deloitte & Touche and First National City Bank), issue managers (First National Bank of Southern Africa, and Msele Corporation, and Merchant Bank), as well as a placing adviser, a legal adviser, and auditors. More imnportantly, First National Bank was ready to buy what the market would not buy at the time of issuance, and to sell it afterward. It did buy about half of the issue; part of these bonds were auctioned in the following year. Brazil: Financing Municipal Investment: Issues and Options 75 Box 6.2 INCA Bond Issue, 1997 Amount: 1.2 billion rand (US§ 240 m) Maturior:: 6 years (for 200m 2003 bonds), 9 years (for 800m 2006 bonds) and 14 years (for 200m 2011 bonds) Interest rate: 13,5% (for 2003 and 2006 bonds) and L4% (for 2011 bonds) Redemption value: 100% of par value Interest payable: semi-annually Transferability: by registration Credit raling:; by IBCA South Africa (Ply) Limited: AA- 6.24 In addition to the bond market, INCA also obtained several international loans: a FFRI50 million (about US$25 million) 10-year loan from Agence Fran,aise de Developpement, and a 275 million rand (about US$55 million) loan from the European Investment Bank. In addition, arrangements have been made with the U.S. Agency for International Development and Dexia to guarantee or underwrite bond issues on the U.S. and Eurorand markets, to be actually made when conditions are appropriate. 6.25 INCA lends to municipal governments for general purposes rather for projects. Conditions to access the loans are rigorous: sound economic and tax bases and good management. It has developed a sophisticated computerized risk assessment model to help select the municipalities that eligible for credit. 6.26 Relationshi banks. Specialized SNG banks in Western Europe engage in "relationship banking" (Peterson 1997) in that they specialize in building long-term relationships with their clients. For example, Credit Local de France (CLF) explicitly tries to be a "reliable, permanent and long-term partner to local governments, independently of their size."44 Its main business to help develop its clients' activities are not limited to lending, but include other services, such as providing decision-making tools, budget analysis, financial information, and assistance for special problems, general information, and financial data. Relationship banking plays an important role in preparing local governments, especially small ones, to enter the bond markets, as they can act as private consulting firms or financiers. It can obtain resources, assess the viability of the subnational credit markets for public and project financing, develop a strategy for market development, assess creditworthiness, evaluate the project's technical, financial, and environmental viability, price the loans based on funding costs, prepare the term sheets and present bids to borrowers, negotiate the loan agreement, and monitor subnational governments' compliance with loan-agreement covenants. 44 Another type of relationship bank is a private bank that stresses building strong relationships with their well-to-do clients by helping them to meet their needs. For a private bank, the clients are rich customers. For CLF, the clients are the SNGs. 76 Brazil Financing Municipal Investment: Issues and Options C. The Brazilian Experience with Municipal Development Funds 6.27 As mentioned before, there have been five experiences of Bank/IDB supported MDFs in Brazil: Santa Catarina, Parana, Rio Grande do Sul, Ceara, and Minas Gerais. Parana is probably one of the earliest ones we know much about, due to fact that the manager of the fund went beyond the financial funds and created an exemplary support system for all the municipalities in the state. Overall, although the size and coverage of MDFs has been small relative to the size of the Brazilian municipal market (less than R$] billion compared with R$14 billion provided by the federal government, BNDES, and CEF), MDFs have demonstrated an impressive record of prudent lending to municipal governments and have laid the foundation for a larger program of capacity-building aimed improving local managerial capacity. 6.28 The purpose of an MDF is mainly to enhance the fiscal and financial management capacity of municipalities, while providing some infrastructure in urban areas, and to improve targeting of urban programs to lower-income populations. A wholesale approaci encourages as many municipalities as possible to participate in the fiscal reform program financing technically simple projects such as street paving. These goals are achieved through the creation of an Urban Development Fund - providing long-term credit to municipalities, as well as technical capacity to prepare loans and appraise projects, and or.- lending to municipalities. To apply for a subloan, a municipal governrnent has to submit a financial action plan and a comprehensive reform package. Reforms have to include plans for training and technical assistance to aid institutional development. In Parana the responsibility of the MDF is under the Secretariat of Urban Development (SEDU) and now PARANACIDADE, an independent agent that manages the project. In Rio Grande do Sul the project was managed by the RGS State Bank (BADESUL); in Minas Gerais it was managed by the State Development Bank. Box 6.3 Bui g Local Governmest Capacity According to the rs in Rio Grande do Sul (surveyed in 1998) who participated in the MtD VI Rio Grande do Sul, municipalities valued most highly the institutional development interventions designe to increase the efTiciency of resource manent and to improve the managenent Of investmet subprjects, includi tprocu procedures. Professionaltraini information technology, ano it i were also highly valued. The survey identified several areas inr which lcl r ent cpatywas by the MDP process: * fiscal adjustment inproved and municipal ownrevenuesincrea * contacts among municipalities, private compan, the on became more intene * municipal administrations became more efficientt0 renrial * municipal emnploees became more highy valued as staff Source: World Bank Operats Evluation DtmetSpring 1999 6.29 The evaluation the Bank conducted in 1999 on the Brazilian MDPs shows that the most important results have been obtained in the areas of capacity level and fiscal Brazil: Financing Municipal Investment: Issues and Options 77 management. The share of own revenues of participants rose as a share of total revenues, property tax collection improve significantly and direct cost recovery was implement through levying and collecting betterment charges. At the state level, the initial implementation agencies established themselves as statewide urban development agencies with the necessary institutional capacity. Their impact on teaching smaller municipalities to improve fiscal policies and collect taxes is visible in all programs. In the Belo Horizonte case, local taxes grew from R$42 million in 1993 to R$107 million in 1997. In the smaller municipalities, fiscal revenue more than doubled during the 1993-97 period. Important material was developed and distributed, and plans to exist to continue the effort. 6.30 The Parana MDF was probably the one that grew most in terms of managerial capacity and vision. The program is managed by an independent private agency (PARANACIDADE), which is staffed by the most skilled people in the state and is promoting an active policy of training to all 120 employees. Some of its achievements include: * The development of a management system, a computerized network linked to participating municipalities with extensive data management and an operations- simulation system. The system allows constant monitoring of the financial position of participating municipalities, as well as the profitability of the fund and daily monitoring of disbursements and repayments. It is a powerful instrument for the management of the overall program as well as to identify anticipated cash-flow problems. * Betterment fees - helping municipalities applying for loans for street paving in small markets to implement betterment fees that must recover more than 90% of the loan. * Advisory services to municipalities in several areas, including legal aspects of the betterment fees, loan applications, and conditions to be eligible for the loan. * Advisory services to municipal associations. The 18 municipal associations are decentralized agencies that not only represent the interests of their members, but carry credit analysis up to R$200,000. They are staffed by technical people. The board of each association is composed of the mayors in the region. The president is elected for one year. PARANACIDADE provides technical support to all these associations and carries out analysis of projects above R$200,000. * Helping municipalities to devise their own strategies and get financing with a longer- term strategy by applying for Central Bank clearance for borrowing. * Technical assistance in subproject preparation, tracking project execution, reviewing the procurement process, monitoring project implementation, doing performance audits on each subproject, not releasing resources until the performance audit is satisfactorily completed, and monitoring overall municipal financial performance on an ongoing basis. 78 Brazil Financing Municipal Investment: Issues and Options Promoting consistent capacity-building efforts: PARANACIDADE and SEDU havc recently created the University of the City. It is an excellent initiative for training no n- elected municipal officials in such basic disciplines as procurement, project analysis, transport, etc. 6.31 What is the future of the Municipal Development Funds? MDFs have been key players in developing technical capacity and improving management in Brazilian municipalities. They have associated the rigor of project preparation and selection, to investment in priority areas encouraging cost recovery and sustainability. This function needs to be continued and strengthened, encouraging collaboration with the actors who offer complementary services: -- BNDES is offering its PMAT, CEF is supporting PNAFM using IBAM and ESAF, Bando do Nordeste focus on helping small rural and urban municipalities draw up their own economic and fiscal strategy. The needs are colossal - especially among the 3,500 small municipalities, and a wholesale effort is amply justified. The experience of MDFs for more than one decade is of enormous value. Theil impact in promoting the associations of municipalities and the choice of urban investments by their economic merit rather than by political factors is a fantastic contribution that needs to be preserved. . 6.32 The MDFs fnancial intermediation role could evolve toward more market-oriented mechanisms, including private sector capital (as it happen with Tamil Nadu Funds) and to the association of municipalities (as the Finish case). Many of the MDFs already do many of the things that specialized subnational banks do with regard to capturing and lending funds and progressive opening would increase competition in the municipal market while preserving the extraordinary experience accumulated during years of dealing with underskilled municipal governments. D. How to Deal with Moral Hazard: Issues and Examples 6.33 In subnational credit markets, a potential moral hazard exists when lenders can lend to uncreditworthy borrowers without facing the associated default risk due to an irnplicit or explicit guarantee from the national government or the collateralization of national government transfers. The greater the guarantee's protection, the greater the risk that the lender will lend to the uncreditworthy subnational governments, and, therefore, the greater the moral hazard. How can we reduce the moral hazard of lending to uncreditworthy subnational governments without unduly inhibiting credit enhancement of creditworthy ones? How have more developed subnational credit markets managed to accomplish this? Could these solutions be transported to Brazil? 6.34 Moral hazard varies with the coverage of the national government's pledge to make full and timely payment of a subnational government's debt in the case of default. The full or open-ended pledge of the national government to pay in the case of subnatioral government default offers the greatest protection for the lender and thus the greatest moral hazard. Such a guarantee is usually implicit rather than explicit. In Brazil, lenders believed that the national government would bail out the state and municipal governments, because this is what had always happened in the past. The national government in Brazil Brazil: Financing Municipal Investment: Issues and Options 79 cannot really let its larger states default, as this would have a very negative impact on its standing in the international credit markets, as the recent experience with Minas Gerais has shown. Box 6.4 World Bank Guarantees Partial risk 2uarantees cover specified risks arising from nonperformance of sovereign contractual obligations or certain political three majeure events. They are appropriate for private projects, especilly "limited-recourse financing,' as in build-ow-operaw and similar concession projects. A partial credit guarantee typically extends matuities bqyond what private ceditors could otherwie provide - for example, by guaranteeing late-dat repayments or providing incentives for lenrs to roll over short-term loans. Partial risk guarantees are particularly relevant in the context of the major worldwide shift toward privatization and private finaning of infrastructure. Such guarntees can be provided only in IR and IDA countries and cover specific government obligations spelled out in agreements with the priect entity. Partial risk guarantees ensure payment in the case of debt service default resulting fr*x the nonpeformanoe of contactual obligations undertaken by governmetnts or their agencies in private sector projects. Sovereign contractual obligations vary depending on the project, sector, and country. Typical govemment contractual obligatons include e manig the agreed regulatoy frmework, mcluding tariff formulas; * delivering inputs, such as fuel supplied to a private power ompany, * paying for outputs, such as power purchased by a government utility from a private power company or bu water purchased by a local public distribution company, * compensating for project delays or interruptions caused by government actions or political events, Transfer risks may also arise for investors and lenders becuse of constrints in the availability of foreig exchange. Sources oftranfer risk include procedural delays and adverse changes in exchaW control laws or regions A partial risk guarantee can cover such risks of foreign-xhane transfr. A partial risk guarantee is tiggered by debt service defult resulting from government nonomiance with one or more of its obligations as stipulated in agreements with the project company. 6.41 Lenders often assume that there is an implicit national guarantee until the national government refuses to bail out a subnational government. This occurred in France in the early 1 990s - in the case of Angouleme, for instance. After this, lenders began to hone their capacity to analyze creditworthiness. 6.42 Subnational governments can use their automatic transfers from the national government as collateral in borrowing. The pledge is, of course, limited by the amount of the total national transfers to the SNG. For example, many of the provinces in Argentina's Northwestern region now find borrowing more difficult because they have pledged all or nearly all of their coparticipaci6n transfers. Furthermore, the SNGs may develop ways of techniques of limiting the timeliness of payments. For example, in Argentina, the provinces pledge only a cupo, or percentage, of the total daily coparticipaci6n transfer. Obviously, 80 Brazil Financing Municipal Investment: Issues and Options this may mean that the lender will have to wait a long time to recoup the full debt. Limits on loan acceleration could also increase the risk of delayed payments. 6.43 Reducing moral hazard while allowing credit enhancement. There are a number of ways to reduce the moral hazard: (a) Eliminate the use of guarantees. This would make it difficult for the fiscally "righteous" subnational governments to use resources such as revenue sharing for credit enhancement to obtain favorable terms in the market. Denying the right to pledge revenue sharing punishes both the good and bad performers. (b) Prohibit lending to uncreditworthv SNGs. If effective, only creditworthy SNGs could use these guarantees to enhance their credit. The problem is that government regulation is often not effective in preventing the uncreditworthy from borrowing. (c) Force the lenders to bear part of the risk. For example, the revenue sharing may co, er only part of the amount owed (say, 70% of the debt service). This, however, may be illegal where the resources being transferred to the SNGs either are considered to be subnational initially (e.g., in Argentine provinces) or become subnational on transfer (e.g., in Mexico). So national laws or even a country's constitution may prohibit the national government from telling subnational governments how to allocate their resources. (d) Build incentives for responsible subnational lending into financial-market regulation. For example, in Mexico, the new banking regulation links risk weighting and provision requirements to credit ratings of SNGs from two internationally recognized entities. (e) Reduce "implicit" guarantees by allowing poorly performing municipalities to default. Mustering the political will to do so will take a colossal effort, but refusing to bail out bankrupt municipalities would be the most effective mechanism for reducing moral hazard and building incentives for creditworthiness. Brazil: Financing Municipal Investment: Issues and Options 81 E. Credit-Enhancement Programs 6.44 In the short term and medium term, municipalities in Brazil will be faced with a need to access capital in an illiquid and imperfect market. A variety of options for credit enhancement exist, and Brazilian policy-makers should adapt international experience with credit-enhancement programs. In the United States, for example, a number of states have developed credit-enhancement mechanisms: * The state of North Carolina established a Local Government Commission whose proactive supervision of local governments pays off in terms of better credit ratings and thus more favorable borrowing terms. * Other U.S. state programs enhance the credit of school districts by granting guarantees to districts that meet eligibility criteria. * The state of Texas set up such a guarantee fund that can guarantee school district bonds up to twice their market value. The fund applies strict creditworthiness criteria in granting the guarantees. Greater detail can be found in Annex D to this report. 6.45 In addition to specific programs for credit enhancement, options for development of alternative financing mechanisms should be considered. Such approaches may include the creation of pooled financing programs, such as revolving funds or "loan banks," described in greater detail in Annex D. In the United States, State Revolving Funds are created around a central government grant to state governments, with a required state matching grant, used to provide additional security for a bond issued by the state authority. A similar mechanism could be developed by leveraging the success of Brazil's MDFs. Alternatively, a loan pool could be developed, a variation of the "Bond Bank" created in the U.S. municipal capital market to assist small cities in raising capital for infrastructure projects. Regardless of the specific mechanism utilized, credit enhancement programs can be designed and implemented to both alleviate the "credit crunch" faced by municipalities in raising capital in imperfect markets and to encourage rational investment choice and private sector participation in service provision. F. Conclusions 6.46 International experience seems to indicate that SFIs play an important role in mobilizing credit finance for local governments. SFIs are particularly relevant for addressing the financing requirements of a large number of small and unsophisticated local governments that do not have large capital investment programs and lack market savvy, thus making it uneconomical to go directly to the capital markets. This is true even in the case of the United States, which enjoys one of the deepest municipal credit markets in the world. 82 Brazil Financing Municipal Investment: Issues and Options 6.47 The challenge for SFIs in the developing world remains one of integrating them with the local capital markets, as these become deeper. In encouraging a market-driven process for the development of SFIs, a good deal of attention will be needed in deepening local capital markets and upgrading local government financial practices and reporting. Where SFIs operate according to market rules, local governments are required to report their financial condition on a regular basis along the lines of generally accepted accounting principles. This, along with the widespread use of credit ratings and securities-related reporting requirements, have also worked to standardize and regularize financial reports. Brazil: Financing Municipal Investment: Issues and Options 83 References Bremacker, Francois (1997). Evoluqao das Financas dos Municipios no Periodo 1989/1995, IBAM. Banco Central (1999). Boletin das Finanqas Estaduais e Municipios, May. Bird, Richard (1999). User Charges in Local Government Finance. Mimeo prepared for the First Urban and City Management Course, January. Published in The Challenge of City Government, M. Freire and Richard Stren (eds.), forthcoming, World Bank. Caixa Economica Federal (CEF) (1998). Comportamentos dos Municipios Avaliados pela Caixa em 1998, Referente aos Exercicios de 1994 a 1997, Brasilia. Gomes, Gustavo, and Cristina MacDowell (1999). Evolucao de Financas municipais e tamanho dos municipios. IPEA mimeo. Fundacao Getulio Vargas (2000). Manual de Orientaqdo para Crescimento da Receita Pr6pria Municipal, Sao Paulo. Johnson, Brad (1999). Report to PARANA CIDADE on Pooled Financing Programs and Securitization of Loan Portfolios. Hawkins, Delafield and Wood, Washington, D.C. Kessides, C. (1993). Institutional Options for the Provision of Infrastructure. Washington, D.C.: World Bank Discussion Paper No. 212. MacDowell, Cristina (2000). IPEA mimeograph, April. Nogueira, Julio Cesar (1995). Ofinanciamento publico e decentralizaado fiscal no Brazil, CEPP #34. Peterson, George (1997). Building Local Credit Systems. Urban Management Program Discussion Paper. The Urban Institute, Washington, D.C., May. Petersen, John (2000). "Credit Assistance to Subnational Governments and Credit Market Development: Seeking the Goldilocks Solution." Paper at the course on Financial Intermediation at the Local Government Level, World Bank, Washington, D.C., March 27. Saad, Paulo, and Jorge Goelzer (1999). Performance of the Bettermemt Fee in the Parana Urbano Program. Parana Cidade, Technical Series, No. 20. Secretaria do Tesouro Nacional - STN e IBGE - Contagem da Popula,co (1997). preparation by IPEA (Institute of Politica Economica Aplicada). SOMMA (1999). Relat6rio de Atividades Programa SOMMA, 1993-1998. 84 Brazil Financing Municipal Investment: Issues and Options Standard and Poor's Creditweek (1999). "Political Risk Insurance May Enhance Emerging Market Structured Transactions," December 1, pp. 22-27. Standard and Poor's Creditweek (2000). "Trends in Public-Sector Lending in Western Europe," January 5. World Bank (1992). The Challenge of Municipal Sector Development in the 1990s. Report No 1 0161-BR. World Bank (1999a). Rio de Janeiro, A City Study. Report 19747-BR, June 19. World Bank (1 999b). Brazil: Structural Reform for Fiscal Sustainability, Vol. 1. World Bank (1999c). BRAZIL - Private Participation in Brazil's Water Sector, Lessons of Experience and Options for the Future. Draft. LAC/FPSI. World Bank (2000). Brazilian Capital Markets, Reform Issues. Draft. World Bank (2000b). Elements for an Urban Strategy in Brazil. Draft. World Bank website. www.worldbank.org/rmc/rmcguar.htm. Brazil: Financing Municipal Investment: Issues and Options: Annexes 85 ANNEX A: INSTITUTIONAL CONTEXT A. 1 Brazil is a federal countrv. The national territory is divided into 26 states and a federal district. States are in turn divided into 5,500 municipalities. As territorial subdivisions of the states, municipalities include both rural and urban areas. Thus they are analogous to U.S. counties, rather than to urban govermnents. There is a wide variation among jurisdictions at both levels. In terms of population, the states run the gamut from Sao Paulo (34 million) to Tocantins (250,000). Variations among municipalities are even wider. At the top of the scale are the megacities of Sao Paulo and Rio de Janeiro (10 million and 8 million inhabitants respectively). At the opposite end are thousands of largely rural municipalities with populations under 5,000. Despite this variation, common legislation applies to all the jurisdictions within each tier of government. A.2 Constitutional Framework. The relationship between the three tiers of government is regulated by the federal Constitution. In general, the Constitution provides for a high degree of subnational autonomy. Each state has its own constitution and its own directly elected legislature. Governors are also directly elected. The federal government's power to intervene at the subnational level-i.e., to dismiss elected officials - is severely restricted. Like the states, the municipalities have directly elected councils and mayors. The constitution gives municipalities an unusual degree of independence. Unlike most federal constitutions - which define municipal governments as creatures of their respective states - the Brazilian Constitution recognizes municipalities as a third tier of government. States therefore cannot compel or prohibit actions by the municipalities within their jurisdictions. A.3 The autonomy of subnational governments is reinforced by the Constitution's allocation of revenue sources. State governments have exclusive authority to impose the value added tax (VAT). The VAT is the highest-yielding non-social security tax in the country. As such, it gives the states an independent power base, particularly in the wealthy southeast where it is the principal source of state revenues. Poorer states benefit from federal revenue sharing. Sharing arrangements are explicitly defined in the Constitution. States therefore regard these transfers as theirs by right, rather than as funds that can be granted or withdrawn at the discretion of the federal government. A.4 The municipalities are assigned exclusive power to impose taxes on urban property and personal and professional services (ISS). It is revenue sharing, rather than taxes, that provides the fiscal basis for municipal autonomy, however. Like the states, the municipalities are Constitutionally assigned fixed shares of federal revenues, distributed according to formula and exempt from earmarking. In addition, states are constitutionally required to transfer fixed shares of their VAT revenues to municipalities. Except in the largest, most urbanized, municipalities, such revenue sharing account for the vast majority of municipal revenues. A.5 In contrast to its explicit division of revenues, the Constitution is deliberately vague in assigning functions to each tier of government. While it explicitly defines the powers of the federal government, it grants the states "all powers not otherwise prohibited to them by this Constitution. Municipalities, in turn, are granted 'the power to 86 Brazil: Financing Municipal Investment: Issues and Options: Annexes provide services of local interest.' Among the exclusive responsibilities assigned to th' federal government are national defense, social security, emission of currency, control of public debt, regulation of interstate and foreign trade, and the power to establish the "general norms of public employment." The Constitution also delineates certain concurrent responsibilities of the federal government and the states, including tax legislation, education, and social assistance. A.6 Within this general framework, individual jurisdictions are free to define their own scope of activities. Until recently for example, the federal government owned and operated the suburban railway systems in all of Brazil's major metropolitan areas. These have now been transferred to the states. Variability in the division of responsibilities is particularly marked between the state and municipal levels. Because municipalities are Constitutionally recognized as an independent tier of government, state governments cannot impose a division of functions between themselves and their municipalities. As a result, the dividing line between state and municipal responsibilities tends to reflect an accumulation of historical precedents and the relative availability of resources at each level. In the municipality of Rio, for example, most primary education is provided by the municipal government. In the municipality of Sao Paulo, it is largely provided by the state. A.7 The net result is a situation in which municipal governments, in particular, enjoy a relatively robust revenue base with few clearly corresponding mandates. This has two important implications for the analysis of municipal capital investment: First, it suggests that municipalities might be capable of generating a significant level of current account savings to finance investment. Second, it suggests that a municipal government's demand for capital investment financing will depend on the peculiarities of the division of responsibilities between itself and its state government. A.8 Political Economy The high degree of autonomy granted to subnational governments by the Constitution is reinforced by the political strength of subnational interests in national government. Brazil's political system is characterized by a high degree of party fragmentation and weak party discipline at the national level. Brazil ha; fifteen political parties represented in the national Congress. Except in the parties of the left, party discipline is weak. Strong state loyalties lead politicians to coalesce in support of projects that will benefit their own state, regardless of their party. Sitting state governors command the loyalty of federal deputies, since the support of the governor is more useful in their campaigns than the support of the president. Because of their influence over deputies and senators of their party, governors can thwart or facilitate presidential designs. To implement their programs, presidents must construct coalitions that not only involve several parties, but also satisfy regional demands. A.9 Historically, this has lead to the widespread use of discretionary federal grants (convenios) as a means of building political support for presidential initiatives. Convenios were therefore a principal element in the financing of municipal capital investment. Fiscal constraints at the federal level have reduced the scale of such grants. The strength of regional interests in national politics nevertheless remains an important factor in the analysis of municipal capital finance. As discussed below, regional politics has complicated past government efforts to resolve a series of state-level debt crises. if Brazil: Financing Municipal Investment: Issues and Options: Annexes 87 municipalities also take up borrowing on a large scale. it will also be a factor in determining whether such borrowing represents a vet again a risk to the federal government 's financial Dosition. Municipal Revenue Basis A.10 One of the hallmarks of Evolution of Tax Sharing the 1998 Constitution was an Tax Percent retained by each level of increase in the volume of 19 -t transfers to municipal 1967 11987 1993 goemetAshwniTal Income, industrial Federal 88% 67% 53% governent. As shown in Table products taxes State 80 14 21.5 4.2, the new Constitution Municipal 10 17 22.5 increased the share of federal ___ ____ __ Special fund 2 2 3 income tax and industrial VAT State 80 80 75 products taxes from 17% (in Municipal 20 20 25 1987) to its current 22.5%. The Fuel, electric power Federal 40 40 *Constitution also increased state states, 60 60 VAT transfers, in two ways. municipalities. Transport Federal 30 First, it expanded the base of State 50 the VAT (at the expense of the Municipal 20 = federal government), by Real estate State 50 abolishing federal taxes on fuel, transfers Municipal 50 100 electric power and transport and Motor vehicle State 50 incorporating their bases into Municipal 50 mcroam hrbsemt * incororate incVA the VAT. At the same time, it incorporated in VAT source: Julio Cesar Nogueira: 0 financiamento publico e increased the share of the state decentralizaIo fiscal no brazil CEPP #34, 1995 VAT to be shared with municipios from 20% to 25%. A. 11 ImPact of the new Constitutional Arrangements. This reallocation of revenues appeared to be a windfall for the municipios. Experience was to prove otherwise, however. As shown in Chart 4.1, municipal revenues did increase in the first years following the new Constitution, as new revenue sharing arrangements were phased in. The impact of the new constitution was soon overwhelmed by macroeconomic developments, however. High rates of inflation eroded the real value of municipal tax revenues, as well as the federal and state taxes on which revenue sharing was based ("other revenue", which consisted largely of interest earned on municipal deposits, remained high during this period). After the introduction of the federal government's stabilization plan in 1994, municipal revenues failed to immediately recover. In part this was due to a sudden decline in interest income.' It also reflected a federal decision to claw back some of the increase in the FPM: Constitutional Amendment 4 of 1994 authorized the federal government to reduce the amount of income and industrial products subject to sharing by 20%. While the provision was intended to be temporary (January 1, 1994 - June 30, 1996) it was later extended. 1 The abrupt fall in inflation and nominal interest rates that followed the Piano Real reduced the return on municipal cash. 88 Brazil: Financing Municipal Investment: Issues and Options: Annexes A. 12 Municipal tax revenue, however, increased. This is largely attributable to revel se- Tanzi effects: as inflation has fallen, the real value of IPTU and ISS taxes has increased in real terms. Transfers from the state VAT have increased for the same reason. Total in 1997 nevertheless remain substantially below the peak year of 1991, and are scarcely higher than the levels of 1989. Trends in Federal and Subnational Shares of Tax Revenues, Gross and Net of Transfers Share before transfers Share after transfers Year Federal State Municip Federal State Municip alities. I alities. 1987 70% 27% 3% 61% 28% 12% 1988 70 27 3 61 27 1 1 1989 65 32 3 57 30 13 1990 65 32 4 54 30 16 1991 62 32 6 51 30 18 1992 62 32 6 52 31 17 Source: from Jose Roberto Afonso "Decentraliza0o: Um Estudo de Caso Sobre 0 LBrasil" Jan 1994. Note that taxes include federal social security contributions A. 13 The result was the dramatic reallocation of net tax revenues shown in the table below. As shown, between the last pre-Constitution year (1987) and the year in which the majority of tax sharing was fully implemented (1992) the federal share of tax revenues, net of transfers, dropped from 61% to 52%. The state share increased, due to the growth of federal transfers and the broadening of the VAT tax base. This was partly offset, however, by the state's obligation to increase their own transfers to the municipalities. It is at the municipal level that the effect is most striking. The municipal share of net after- transfer revenues increased by roughly 40% over the six year period, from 12% in 198 7 to 17% in 1992. A. 14 Federal efforts to offload a corresponding amount of expenditure obligations failed. Under the rubric of Operacao Desmonte, then-President Collor proposed a program of expenditure decentralization intended to match the new division of revenue s. This was rejected by Congress. Thus it would appear that municipalities have received a windfall increase in revenues with no explicit increase in expenditure responsibilities. A. 15 It is not clear that this has resulted in an increase in current savings. There are two alternative hypothesis. The first is that the increase in revenues has been consumed by .he costs of absorbing functions abandoned ad hoc by the federal government. Having failed to decentralize federal functions formally, the federal government did succeed in offloading certain expenditure responsibilities onto subnational governments on a case by case basis. In Rio de Janeiro, for example, the majority of federal hospitals were transferred the municipal government. The federal government also managed to offload some health care costs onto subnational governments by reducing the amounts of federal compensation payments. A. 16 Another hypothesis is that municipalities responded to the increase in revenue E y expanding their payrolls. Once expanded, municipal payrolls are difficult to reduce. The federal Constitution defines the "rights" of public sector employees at all three levels of Brazil: Financing Municipal Investment: Issues and Options: Annexes 89 government. Under the Constitution, governments cannot dismiss redundant civil servants nor can they reduce salaries in nominal terms. Public employees have the right to retire after only 35 years of employment (with five years less for women and another five years less for teachers of either sex.) On retiring, public employees have the right to a pension equal to their exit salary, plus any subsequent increases granted to their previous position. Historically, governments have used inflation to control personnel costs. While the Constitution prohibits nominal reductions in salaries, it does not require salary levels to be maintained in real terms. In the triple-digit inflationary environment of pre-Plano Real Brazil, personnel costs were therefore easy to control. With the sharp decline in inflation following the introduction Plano Real, this tool is no longer effective. Personnel costs may therefore be consuming the windfall revenue increase conferred on the municipalities in 1988. A. 17 Borrowing Municipal governments can borrow from a variety of sources using a variety of instruments. From the domestic private sector, they can borrow from private banks, both for short term cash management purposes and for medium term financing. Two municipalities now float bonds on the domestic capital market. Municipalities also borrow from federal financial institutions. Long term financing is provided through a variety of forced saving schemes established in the mid-1960's - most importantly FGTS and PIS/PASEP - whose resources are passed through federal intermediaries-the housing and savings bank (Caixa Econ6mica) and the industrial development bank (BNDES) - and on-lent to municipal governments. A.18 From the external private sector, municipal borrowing has traditionally taken the form of medium term contractual debt. More recently, several municipalities have successfully floated Eurobonds. Municipalities also borrow indirectly from multilateral and bilateral donor agencies. The World Bank, for example, has several municipal development loans to state governments in Brazil. While the loans are made to state THE STATE BOND CRISIS The most recent subnational debt crisis took the form of defaults on state domestic bonds. These were originally sold to private investors. As state finances became increasingly precarious in the mid-1990s, private investors declined to hold state debt. In response the federal government permitted states to exchange their bonds for more readily marketable federal bonds. State bonds were held in the portfolio of the Central Bank, which floated a corresponding amount of Central Bank bonds, transferring them to the states. Due to the prevailing tight monetary policy, the real rate on the bonds was high: 22% in 1994 and 25% in 1995. As a result, the stock of bond debt grew explosively. At the end of 1996, the total stock of state (and municipal) bond debt stood at R$ 52 billion. The heavy interest obligations on this growing stock of debt, combined with the states' inability to reduce personnel costs or raise revenues, resulted in deficits that were large enough to have macroeconomic consequences. From an surplus of 0.8% of GDP in 1992, the overall balance of state and municipal government fell to 2.3% of GDP in 1997, 1.5 times the size of the overall deficit of the federal government. The bond debt crisis was not resolved until 1998-99. As in the previous crisis, debt was rescheduled (rather than written off) and a debt service ceiling was imposed allowing debt service above the threshold to be capitalized into the stock of debt. The principal innovation of the new debt agreements was a large interest rate subsidy. Rather than bearing the existing rate on federal bonds, the federal government agreed to charge the states a fixed real interest rate of six percent. While this will reduce the interest costs to the states, it will require an ongoing interest rate subsidy by the federal treasury. 90 Brazil: Financing Municipal Investment: Issues and Options: Annexes governments, fands are on-lent to municipalities. A. 19 Municipalities, finally, borrow through a variety of informal mechanisms. Arrears on payments to suppliers and salary payments to employees are commonly used to finance deficits, particularly in the last months of an outgoing administration. In additicn, municipalities can "borrow" by taking measures - expropriating land, for example - that are likely to be subsequently overturned by the courts. Until a judgment is issued, payment can be legally deferred. Given the time required to resolve legal disputes, this can represent a de facto loan of several year's maturity. (Under some conditions, court judgments, when finally issued, can be financed through special bonds, termed precatorios. In 1997, the municipality of Sao Paulo was rocked by scandal involving such instruments.) A.20 The Federal government is concerned about subnational borrowing. Within the past decade, Brazil has experienced three separate subnational debt crises, each of which was resolved at some cost to the federal treasury. The first was a legacy of the international debt crisis of the 1980's, when states - along with the federal government - ceased servicing their debt to foreign creditors. Once an agreement was reached between the government and the creditors at the national level, the Federal Government attempted to induce the states to resume servicing their debt. To do so, the federal government was forced to transform the accumulated state arrears and remaining principal into a single debt to the Federal Treasury. US$ 19 billion was rescheduled under these terms. The second crisis involved debt owed by the states to federal financial institutions. This was resolved in 1993 through a rescheduling of roughly US$ 28 billion of such debt. The third involved state bonds. (See box) A.21 In light of this succession of crises, the federal government is justifiably skeptical of subnational borrowing. To forestall repetition of these crises, each of the bond debt rescheduling agreements establishes a schedule for a gradual reduction in the debt: revenue ratio and prohibits federal guarantees on external borrowing for any state that is in violation of its schedule. The most recent debt agreements also require the states to pledge their revenue sharing as collateral for payment of debt service. A.22 No municipality has signed a bond rescheduling agreement. (Only two have outstanding domestic bonds.) These restrictions therefore do not apply to municipalities. The federal government nevertheless has an impressive array of other controls on debt, that apply to both states and municipal governments. The Lei de Responsibilidade Fiscal approved last May establishes the most relevant limits as well as the sanctions for those government units which fail to comply with them. Most recent available information shows the following: * Senate guidelines on aggregate borrowing Under the Brazilian Constitution, the Senate has the authority to regulate all state borrowing; i.e., any contractual arrangement involving repayment at a future date. The current resolution restr:lcts new borrowing on the basis of two factors: debt service coverage, and growth in the total stock of debt. . Brazil: Financing Municipal Investment: Issues and Options: Annexes 91 * Prohibitions on new bond issues The issuance of domestic bonds is controlled by the Federal Constitution, which prohibits new bond issues, other than to finance precatorios. The Constitution does not, however, prohibit subnational government from rolling over the principal and capitalized interest on their existing bonds. The proportion of such debt that may be rolled over is determined on a jurisdiction-by-jurisdiction basis by the Senate. . Central bank control on bank lending Borrowing from the domestic banking sector falls under the purview of the Central Bank. Under CB resolution 2008, private banks are prohibited from increasing their holdings of state debt, other than bonds. They may, however, shift the composition of their state debt portfolio, as existing loans mature. A.23 The lending policies of federal financial institutions vary according to the institution and the source of funding. Thus the CEF imposes one set of lending criteria in its capacity as agent for FGTS-funded infrastructure lending, and a different set as an agent for treasury debt refinancing program. In principle, all federal lending is subject to federal legislation prohibiting any loan or guarantee by any federal institution to any state that is in arrears on any loan from the Federal Government. In the past, such coordination among different agencies of the federal government has been difficult to achieve 92 Brazil: Financing Municipal Investment: Issues and Options: Annexes ANNEX B: Decentralization and the Municipal Situation in Brazil2 B. I This annex is a summary of the article recently prepared by Gomes and Mac Dowell (2000) from IPEA. The paper shows two important results of decentralization in Brazil, notably that decentralization led to a very rapid creation of new municipalities and to the increase of revenues made available to municipalities. Specifically, decentralization: (1) increased the number of the transfers of revenues which originatec. from large municipalities (from the relatively wealthier SW) and which were transferred to small municipalities; (2) benefited a small part of the Brazilian population (and not necessarily the poorest) which live in the small municipalities, as these municipalities allocate relatively more resources to the legislative body; and (3) increased the resources allocated to the wage bill since new municipalities bring new overheads. B.2 As a result of the decentralization process endorsed by the 1988 Constitution, tlle Brazilian municipalities not only receive more resources but they are upgraded to members of the Brazilian Federation ("A Repuiblica Federativa do Brasil [e]formada pela Unido indissolfvel dos estados e municipios e do Distrito Federal..."). The federation has an interesting characteristic: Municipalities can be created at the will of . group of population, willing to share with those who can form a new municipality, resources and political power. B.3 Intense Creation of Municipalities. Table DI shows that between 1984 and 1997, 1,405 new municipalities were created, raising the total number from 4,102 in 1985 to 5,508 or 34 percent.3 Table Bi: Number of Municipalities Created after 1984 by Size of Municipality (1997) Groups of Municipalities Northeast North Center- South Southeast Brazil (Population) West Up to 5.000 146 97 80 296 116 735 5.000 to 10.000 107 49 30 87 87 360 10.000to20.000 125 42 19 19 29 234 20.000toS0.000 21 18 6 2 14 6 50.000 to 100.000 2 3 3 1 2 1 100.000 to 500.000 I * * * 3 4 Total 77777T 402 7 209 138 405 251 1.4,35 Source:: Gomes and Mac Dowell (2000). (Dados Brutos): IBGE - Organizacao do Territ6rio e Contagem da Populacao 1996. 2 Descentralizacao Politica, Federalismo Fiscal e Criacao de Municipios:O que e Mau para o Econdmicc nem Sempre e Bom para o Social, Gustavo Maia Gomes, Maria Cristina MacDowell (2000). Texto para Discussao n. 706, Instituto de Pesquisa Econ6mica Aplicada - IPEA.2 3 0 processo de criacao de municipios parece ter sofrido uma paralisacao a partir da promulgacao da Emenda Constitucional n. 15, de 12 de setembro de 1996, que modificou o Art. 18 da Constituicao Federal. Nao existe certeza quanto a isso, entretanto, pois municipios podem ter sido criados sem que 6rg§os como o IBGE e o Tribunal de Contas da Uniao tenham sido informados. Brazil: Financing Municipal Investment: Issues and Options: Annexes 93 B.4 Proliferation of small municipalities. Table D4 shows that out of the 1,400 municipalities, 94.5% have less than 20,000 residents; of these, half have less than 5,000 residents (hence they are called micro-municipalities). Today, one fourth of the Brazilian municipalities have less than 5,000 inhabitants; half have less than 10,000; and 75 percent less than 20,000 (IBGE). In 1940, the proportion of small municipalities (defined as those with less than 20,000 people) was only 55 percent. Even more interesting is the growth in the number of micro-municipalities from 2 percent of the total in 1940 to 25.6 percent today. B.5 A result of decentralization and of municipal federalism is the growth of the fiscal resources that became available to municipalities, especially relative to the resources of the states and the central government. It is clear from the figure extracted from Gomes and MacDowell that municipal revenue in relation to the state and federal government almost tripled. B.6 Extreme dependence of small municipalities on transfers. Table D2 shows that out of the recurrent revenues of micro-municipalities (with up to 5,000 inhabitants) only 9 percent was from own revenues (1996). For the small municipalities with between 10,000 and 20,000 residents, the proportion of own revenues to the total recurrent revenues was 12 percent. In the large municipalities with more than one million inhabitants, the proportion was 56 percent. 13.7 This indicates that, to finance their expenditures, the small municipalities are highly dependent on transfers, mainly federal transfers through the Fundo de Participaqdo dos Municipios (FPM). Since most of the tax revenues are generated in the larger municipalities, this is tantamount to large municipalities ending up by financing smaller municipalities, regardless of their level of income or needs. Table B2: Own Recurrent Revenue as Percentage of Total Recurrent Revenue, by Groups of Municipalities (1996, %) Groups of Municipalities Northeast North Center-West South Southeast Brazil (Population) Up to 5,000 2.9 4.4 7.5 9.9 10.1 8.9 5,000 to 10,000 4.0 3.4 7.8 12.9 12.6 10.1 10,000 to 20,000 4.0 4.2 9.7 16.3 17.7 12.3 20,000 to 50,000 5.8 9.1 15.4 23.1 23.0 17.5 50,000 to 100,000 10.6 15.0 19.4 27.1 30.8 25.3 100,000 to 500,000 21.3 18.8 25.0 37.7 36.3 34.2 500.000 to 1.000.000 28.1 * 47.7 * 41.4 38.1 More than 1.000.000 43.6 32.2 43.4 52.5 60.2 55.9 Total 17.9 20.3 20.9 29.2 41.0 33.5 Source:: Gomes and Mac Dowell (2000). (Dados Brutos): Secretary do Tesouro Nacional - STN e IBGE - Contagem da Populacao 1996. Authors estimates. B.8 While there are large asymmetries between generation and distribution of the ICMS, the asymmetries favor the small municipalities through the rules of the FPM. Table B3 shows the net flow of transfers received by municipalities according to their 94 Brazil: Financing Municipal Investment: Issues and Options: Annexes size. The authors took the actually received amount of FPM and subtracted the contribution made by each group (which was estimated under the assumption that it is proportional to the federal taxes collected in each group of municipalities). (FPM is composed of IPU (Imposto Sobre Produtos Industrializados, 22.5%) and IR (Imposto Sobre Renda e Proventos de Qualquer Natureza). Table B3: NET FMP Received By Group of Municipalities (1996) ($R millioa) Groups .f Mmarndp~litI#s Northeas Nrh CteWstSouth Southeast Brazl (Popu ation ) Up to 5.000 83 40 99 219 297 74') 5.000 to 10.000 258 44 82 220 295 90 E 10.000 to 20.000 663 50 113 264 375 1.4(15 20.000 to 50.000 679 50 100 169 392 1.4(12 50.000to 100.000 248 45 27 38 103 4 100.000 to 500.000 151 95 34 -101 -785 -603 500.000 to 1.000.000 70 * * * -458 -387 More than 1.000.000 -63 -80 -23 -340 -3.495 -4.0)3 Total 2.091 280 433 469 -3.274 33,5 Source:: Gomes and Mac Dowell (2000). (Dados Brutos): Secretary do Tesouro Nacional - STN e IBGE - Contagem da Populacao 1996. Authors estimates. B9. It is interesting to note that the large municipalities (with more than half a millicn residents) are the net financiers of the smaller one. The same is true in the municipalit es of the South and Southeast. Table B4: Total Current Revenue, Per Capita, 1996 (R$/Inhabit/year) Groups of Municipalities Northeast North Center South Southeast Brazil (Population) West ______ Up to 5.000 295,0 288,6 429,9 468,2 470,7 431,3 5.000 to 10.000 199,3 187,5 311,6 303,4 303,1 2('9,4 10.000 to 20.000 153,0 135,9 269,4 274,0 282,4 220,2 20.000 to 50.000 139,0 123,2 211,8 246,5 290,4 2(.8,3 50.000 to 100.000 124,3 204,1 203,8 247,8 298,7 22.5,0 100.000to500.000 158,2 152,4 184,2 253,6 333,1 221,4 500.000 to 1.000.000 224,1 * 264,4 * 365,1 3(:7,9 More than 1.000.000 232,9 262,5 271,9 387,1 489,9 4(5,8 Total 167,5 190,7 244,6 283,9 366,1 B2 1,4 Source:: Gomes and Mac Dowell (2000). (Dados Brutos): Secretary do Tesouro Nacional - STN e IBCE - Contagem da Populagao 1996. Authors estimates. B. I0 Higher per capita recurrent revenues of small municipalities. Table D4 shows how the smaller municipalities (with up to 5,000 residents) have access to larger financial resources (on a per capita basis) than other municipalities as a result of higher transfei s, notably the FPM. The distribution across municipalities actually indicates that both the smaller and the larger municipalities have access to the largest per capita revenues. In the Brazil: Financing Municipal Investment: Issues and Options: Annexes 95 case of the larger municipalities, this is because their own revenues are larger; in the case of the micro-municipalities, the transfers are much larger. In sum, the average municipalities are the ones in a more complicated, less favorable position B. 11 Table B6 shows than only 2% of the Brazilian population live in micro municipalities (less than 5,000); 7.5%, in cities with more than 10,000 and 20% below 20,000. If one considers that these are the beneficiary of the municipal federalism, one concludes that these are hurting 80% of the population which does not live in the small cities Table B5: Distribution of Population by Municipalities by Size and Region, 1996 (%) Groupst #MunicWitif _e Nortbhast Nokrh tCeter-West South Southeast Bri. Up to 5.000 0.33 0.17 0.28 0.66 0.80 2.24 5.000 to 10.000 1.50 0.39 0.49 1.26 1.63 5.27 10.000 to 20.000 5.10 0.95 0.89 2.21 2.91 12.07 20.000 to 50.000 7.50 1.68 1.08 2.54 5.17 17.97 50.000 to 100.000 3.96 1.20 0.55 2.31 4.63 12.65 l00.000 to 500.000 4.12 1.33 1.21 4.23 12.46 23.36 500.000 to 1.000.000 2.48 * 0.38 * 3.92 6.79 Morethan 1.000.000 3.52 1.46 1.80 1.76 11.13 19.67 Total 28.50 7,19 6,68 14,97 42,65 100,00 Source:: Gomes and Mac Dowell (2000). (Dados Brutos): IBGE - Contagem da Popula§o 1996. Authors estimates. B.12 The small municipalities are not necessarily the poorest. Table C6 shows that in 1991, municipalities up to 5,000 residents were distributed by all decibels of income, the majority (around 70%) being above the 40% poorest. The municipalities between 10 and 50 thousand were the ones with concentration of poorer population. That is, the system of transfer is actually hurting the middle size municipalities where the poorest are more prevalent by comparison with the larger and smaller municipalities. The situation is even more complicated if one analyses the fact that smaller municipalities spend much more in paying the legislative body. Table B6: Distribution Of Groups of Municipalities By The Income Groups 1991 Grouips of Munidpaliies 10%- 10% X 10%s 10%s s% 10% , 10%. 1 O%s 10%s 1*%+ Tota (population)- Up to 5.000 8,4 5,6 7,6 8,5 14,8 17,2 14,8 11,9 6,9 4,3 100 5.000 to 10.000 13,8 10,9 9,2 9,0 9,9 11,2 11,2 11,7 7,8 5,3 100 10.000 to 20.000 11,7 13,5 12,8 10,1 8,2 9,7 9,1 8.4 10,7 5,8 100 20.000 to 50.000 8,5 12,1 12,0 14,7 8,2 4,1 7,7 8,3 11,2 13,3 100 50.000 to 100.000 2,2 1,1 5,9 9,2 13,5 8,1 3,8 9,2 21,1 25,9 100 100.000 to S00.000 0 0 1,8 0,9 6,4 3,6 7,3 11,8 13,6 54,5 100 500.000 to 1.000.000 0 0 0 0 0 0 0 16,7 25,0 58,3 100 More than 1.000.000 0 0 0 0 0 0 0 0 0 100 100 Source:: Gomes and Mac Dowell (2000). (Dados Brutos): IBGE, Census Demographic de 1991 96 Brazil: Financing Municipal Investment: Issues and Options: Annexes Table B7: Per Capita Expenditure with Municipal Legislative 1996 (R$/year) Gr ( fMunaaie o~h~s t ~ etr Sth'Suhat Bai Up to 5,000 18,0 22,5 26,4 19,3 20,2 20,6 5.000 to 10.000 13,4 13,5 21,4 12,2 12,8 13,7 10.000 to 20.000 9,2 10,4 15,7 10,4 13,1 11,0 20.000 to 50.000 8,6 8,6 12,7 9,7 13,3 10,5 50.000 to 100.000 7,2 16,1 9,6 10,9 15,3 11,6 100.000 to 500.000 11,5 9,7 15,4 11,4 17,2 14,7 500.000 to 1.000.000 17,4 * 21,4 * 16,2 16,9 More than 1.000.000 13,5 14,8 24,5 17,9 15,5 15,6 Total 0,8 12, 16,^94o 12,1 15,6 1 13,5 Source:: Gomes and Mac Dowell (2000). (Dados Brutos): Secretary do Tes:iuro Nacional - STN e IBGE - Contagem da Populacao 1996. Authors estimates. Brazil: Financing Municipal Investment: Issues and Options: Annexes 97 ANNEX C: PARANACIDADE AND BETTERMENT FEES Population: 9 million people, of which 78% are urban Capital: Curitiba (1.5 million inhabitants); 10 additional cities over 100,000 inhabitants Municipalities: 399 with 18 municipal associations Av. per capita income: US$ 5,605 Cl. Municipal development in Parana is the responsibility of the State Secretariat for Urban Development The state created and autonomous entity PARANACIDADE, to which it gave a management contract for the Urban Development Fund and the Parand Urbano Program. Financing is provided by the Urban Development Fund (UDF) a revolving fund financed from its own revenues and from external sources (mainly IDB and UNDP). C2. PARANACIDADE4 is a non-profit autonomous social service entity, which, by law, adheres to private sector laws; it is an integral part of the Parana State Secretariat for Urban Development and it manages public funds. Its mission is to obtain and disburse appropriately and efficiently financial resources for urban and regional development, and to provide technical assistance and institutional capacity building to municipalities in the State of Parana. C3. Urban Development Fund (UDF) is a revolving fund. It finances urban-related activities and projects. The UDF has many financial resources including the repayment by municipalities of loans made by previous programs and by the Parana Urbano program. C4. Parana Urbano is a four-year project financed by the Inter-American Development Bank and comprises two main components: a) Institutional Development and Strengthening, and b) Investment. Betterment Fee5 C5. The Brazilian constitution states that the investment value in public works6 belongs to the Government, making public administrations competent to levy taxes and fees to recover such investments. It also defines that the instrument for that is the Betterment Fee. This fee is an end-user fee to be paid by those who directly benefited by the public work, and not to the entire society, unlike taxes. Despite its positive characteristics and its potential for revenue generation, the municipal administrators have historically avoided applying this fee. This comes from lack of knowledge by local govermnents regarding the purpose of the fee, on the relevance of political interests7 to the detriment of municipal institutional and financial strengthening 4 The concept of PARANACIDADE is innovative. Further information on the institution may be provided upon request to PARANACIDADE or by consulting its web site. 5 Saad, Paulo and Jorge Goelzer (1999) 6 Public works include the construction, repair, enlargement or maintenance of public property. 7 Omission of the executive power (fiscal renunciation) in its responsibilities conferred by the election mandate, with the purpose of obtaining undue advantages for oneself or for others (electoral interest). 98 Brazil: Financing Municipal Investment: Issues and Options: Annexes C.6 Under the PARANA URBANO Program (PPU) managed by PARANACIDADE the betterment fee became a key instrument for cost recovery. Actually, the financing of public works through the program is contingent on the municipalities' commitment to recover the investment made ; i.e. in applying and collecting the above fee. C7. To help the municipalities design and use betterment fees, the program focused on reducing technical and legal problems associated with betterment fees edits and provide assistance in administrative transparency and legality of procedures9. the betterment fee directives have proven to be, in general, easily defendable in court. C8. By December 1998, 217 betterment fee directives had been issued, making feasible the collection of R$44,1 million in a period of approximately five years. A total number of 122,431 fee-payers benefited from the public works relative to these directives. Frc m the financial point of view, the incoming flow of resources from this source - which was extremely low until recently - had increased to R$7.5 million by the end of 1998. g The Agreement Term between the State of Parana and the municipalities for the imnplementation of PARANA URBANO program establishes in its Third Clause (From the Obligations of Municipalities) XIV - to reach the fixed targets of increasing the independent fiscal effort and collecting at least 80%/o of the resources billed annually by means of taxes and betterment fees, as established in the financial appraisal of the project; XV - to adopt adequate means relative to tariffs, taxes, betterment fees, etc., in order to reach the parameters of operational efficiency agreed. Together with the dissemination of the new directives for elaborating and publishing the betterment fee's provisions, PARANACIDADE elaborated and made available to the municipalities a model of specific law, necessary to obtain credit when there is going to be a betterment fee. This document presents a complete view of the levy and was elaborated according to principles derived from both the Federal Constitution and the National Tax Code. Brazil: Financing Municipal Investment: Issues and Options: Annexes 99 Annex D: Credit Enhancement and Pool Finance D. 1 Local Government Commissions: State governments in the US have developed some types credit enhancement of their local governments while controlling moral hazard. One of the programs is used by the State of North Carolina Local Government Commission (LGC). LGC has a strict and proactive supervision of local governments. This has led to strong fiscal and debt management and superior disclosure by issuers, which have resulted in above-average debt ratings for local general obligation and revenue bond issuers in North Carolina." 10 D.2 There is no equivalent institution in Brazil at this stage. To a certain extent, Brazil's Central Bank plays a similar role, but it focus more on preventing borrowing rather than enhancing creditworthiness. The current approach doesn't build political or financial support by the creditworthy SNGs, as it virtually prohibits borrowing for good and bad performers alike. D.3 Guarantee systems: Other state programs enhance the credit of school districts, by granting guarantees to districts that meet eligibility criteria. l l These are four main types of guarantee mechanisms: school aid intercept mechanisms; state general obligation guarantees; other direct state payment commitments; and permanent fund programs. Nevada, Oklahoma, Texas, and Wyoming use permanent fund programs. Their credit ratings are AAA ratings (by several credit rating agencies), at least one or two levels above the state's general obligation rating. D.4 The State of Texas set up such a guarantee fund that can guarantee school district bonds up to two times its market value. The state auditor tracks this ratio of outstanding guaranteed bonds to assure that the 2:1 statutory limit is maintained. Moody's considers this ratio conservative as compared with other guarantors of municipal debt. As of March 1999, the total market value of the fund was US$19.5 billion. 12 Currently about US$14 billion in bonds have been guaranteed by the fund. The program must follow detailed investment guidelines that will assure that the portfolio's solid performance will continue. The State Board of Education develops investment objectives and then is required by law to contract outside investment advisors to attain them. The fund also applies strict creditworthiness criteria in granting the guarantees. D.5 Pool Financing: In terms of financing alternatives, one approach for financing of municipal infrastructure in smaller municipalities is to establish a pooled financing program through a revolving fund or/and a "loan bank" (a variation of a bond bank). Existing MDFs could use these instruments. D.6 Revolving Fund The Revolving Fund is variation of a State Revolving Fund bond financing mechanism common in the United States. In most of these schemes, the '° Fitch-IBCA, State of North Carolina Local Government Commission: Credit Enhancement Program Review, March 29, 1999. " Fitch-IBCA, The ABCs of State School Credit Enhancement Programs, April 9, 1999. 12 Moody's Investor Service, PSF Continues to provide Strong Aaa Support for Texas school Districts Despite Ragid Growth of Guaranteed Portfolio, June 1999. 100 Brazil: Financing Municipal Investment: Issues and Options: Annexes central government provides a grant to state governments, for example for water and sanitation projects (through a federal agency like EPA). This grant, with a required state- matching grant, is used to provide additional security for a bond issued by the State authority. This state authority loans the proceeds from the sale of these bonds to municipal water companies for water and sewer projects. The tariff paid by the users is the security for the loan repayments to the State Authority. The State Water Company passes these payments through to the bond investors. However, the grant funding provides a security-enhancing feature. D.7 The grant or seed capital provided by the central government and state-matching grant are placed in an escrow or Reserve Fund account that generates interest earnings. The capital in the Reserve Fund account and the interest earnings are used as collateral to further enhance the credit quality of the State Water Authority bonds. The additional security improves the credit rating of the bonds and reduces bondholder risk. D.8 In the case of the Brazilian MDFs, a Revolving Fund could be imagined as follows. The MDF would receive a grant from the Federal Government or the State government or, in the case of existing funds, the MDFs could use their own capital and would leverage it to guarantee borrowing (bond issuing is banned currently in Brazil) from the private sector. As noted above, the State of Texas' constitution allows the find to guarantee up to twice its market value. To avoid moral hazard, the guarantee provided by the revolving fund should be partial. This will assure that private lenders adequate ly evaluate the credit risk. D.9 In addition, the MDF, in cooperation with the BNDES/CEF private municipal infrastructure financing programs, can provide technical assistance to the municipalities as they prepare their private sector participation in municipal infrastructure programs. A Revolving Fund Program created with the support of an international institution coulc tailor the terms and conditions to mitigate some of the risks associated with private concessions in municipal infrastructure. However, in order to avoid moral hazard, the private sector lenders to the concessionaires should assume some of the risks that they can evaluate and manage. D. 10 Alternatively, the MDF may incorporate a subsidiary as a private, for profit company to borrow from the IFC or from the domestic private investment banks. This approach would usually be preferable, as the private company has an incentive to increase the value of its shares and manage the program as a profit venture. In additio n, the State government may contribute a matching grant for the Reserve Fund that it recovers at the future sale of shares in the Revolving Fund subsidiary. D. 11 The Revolving Fund Subsidiary makes loans to municipal infrastructure concessionaires if the municipality complies with the procedures for preparing, awarding and managing private municipal infrastructure projects'3 The concessionaire also has to '3 See the recommendations proposed by the LAC/FPSI paper and summarized above for the water and sewer sector. Brazil: Financing Municipal Investment: Issues and Options: Annexes 101 pass an MDF credit evaluation to receive the loan. The MDF prepares loans using commercial bank and capital market standards. This will give them financial flexibility in the future and allow private commercial banks and other capital market providers to participate in PSP municipal infrastructure financing in the future. This participation can take the form of the BNDES indirect lending program'4; securitization of the MDF portfolio (collateralized loan obligation securities); or the sale of MDF shares (if it is a private company). D. 12 The concessionaire loans are secured by the tariffs generated by the project. But, the MDF may also require additional security. Syndicated commercial bank loans for infrastructure projects often require recourse to the concessionaire's parent company. Loans and bonds for private company activities in most countries have been secured with personal guarantees, liens on personal property and the other items listed above. BNDES sometimes requires this type of additional security for its loans. D. 13 Another option to consider is additional loan security provided by the municipality. In the case that there is not possible to charge sufficiently high tariffs for a particular service, the municipality may consider providing a loan payment guarantee for the concessionaire loan. The additional security may be in the form of a full or partial loan principal and interest payment guarantee; first loss coverage or liquidity guarantee, contractual risk coverage, or some other type of either credit enhancement, insurance, or risk guarantee. Whether the municipality offers any financial support should be evaluated during the financial feasibility analysis for the private infrastructure program. If the feasibility analysis requires municipal support for a concessionaire loan to attract the private sector, the details of this support are included in the Edital and concession agreement. 14 The MDF functions like FINDETER, a second tier or wholesale bank which on-lends fimds to commercial banks which provides direct loans to the concessionaire. 102 Brazil: Financing Municipal Investment: Issues and Options: Annexes D.14 In developing the Revolving Fund program and as part of the Federal Government's grant condition to the MDF, there would be a need to help the MDF to develop loan underwriting and credit review criteria (CEF/BNDES could help on this ). It would also assist the MDF in loan portfolio management during the initial stages of the loan repayment period. The cost of these services would be included in the loan interest rate. D. 15 To determine the size of the Reserve Fund required for the Revolving Fund, the MDF carries out a quantitative analysis based on the loan default probabilities of the concessionaires participating in the program. The actual amount of capital required will depend on the MDF's credit rating threshold. The lower the repayment risk (i.e. the higher the credit rating), the smaller the required Reserve Fund. D.16 Capital Recycling Nature of the Revolving Fund. Another characteristic of the Revolving Fund is the release of Reserve Fund capital as PSP loans are amortized. The GraDh 5.1 MDF Revolving Fund for Investment in Private Municipal Infrastructure Loan Repayent Feea _oem j D Federal Govemmen Grant to th D t ~~~Loan Proceeds frRvlm ud* Seed Capital )os Lon Loan Repayme :RetsereF 3 . !~~~ MDF for on-lending _ \ Lo~~~an Proceeds to Concessionaires \ Reserve Fund that Local and \\ Loan . accumulates intel est International BNDESICEF or Repayment Reserve earnings that are used Investors international Loan ~~~~~~~~to Secure MDF Loan Investors creditors ProceedX from the World Bank Contrile Contribute loan \ Capital and § proceeds and receive \\ MDF functions a; receive s 4 debt service payments \\ MDF Revolving a Second Tier Bank Divided Lending to Privaic Pago de Fund Subsidiary - Sector & Repays Constructs and Usuarios A Public or Private World Bank Loani Operates Projec W Venture with Concessionsiire Da Servicio Loan Payments Loan Proceeds Loan Repayment amount of Reserves required for the potential default of the loans is proportionately reduced as loans are amortized. This can only be done if the concessionaire's loan default rate is maintained with the reduced size of the Reserve Fund. The released Reserve Ftnds can be used to over-collateralize the remaining concessionaire loans that have not been amortized or they can be recycled for another loan issue. Retaining the reserves as Brazil: Financing Municipal Investment: Issues and Options: Annexes 103 collateral limits the recycling of the seed capital, but it does provide additional security for the MDF. D. 17 A Loan Pool is a variation of the "Bond Bank" created in the US municipal capital market to assist small cities raise capital for infrastructure projects. Similar to the Revolving Fund, a State Bond Bank Authority issues a single bond in the US tax-exempt municipal market. The proceeds from the bond issue are then on-loaned to individual municipalities. The municipalities secure the loan payments to the state authority with their revenues. D. 18 Often Bond Banks have special contingent reserve features such as a debt service reserve (one years debt service payments) and other supplemental or special reserve funds. The extent of the reserve funds depends on the credit quality of the borrowing municipalities and the desired credit rating for the bonds. In some cases, the states also support these bonds with a pledge to replenish the debt service reserve fund or in some other fashion which allows the bonds to receive a higher credit rating and therefore lower interest cost on the bonds. This lower interest cost is then passed through to the municipal loans. In other cases the state may withhold a municipal revenue transfer payment if the municipality is delinquent on its Bond Pool loan. The state government can also provide a direct payment guarantee. Other factors that effect the credit quality and interest rate of the bonds include the diversity and credit condition of the municipalities in the bond pool; the types of projects the municipal loans will fund and the financial support (other than Bond Bank loan proceeds) used for the projects; the pace of municipal loan amortization; and the quality of the State Bond Pool Authority management. D. 19 The MDFs can organize a "Loan Poorl facility similar to the Bond Bank concept strictly for private sector companies investing in municipal infrastructure. This is currently the practice for some Brazil's MDF programs. However, the current MDFs only lend to public agencies. The proposed facility would be limited to private concessionaires. D.20 The basic principles, repayment security and operating procedures of the Loan Pool program are similar to the Revolving Fund. The private concessionaire loans should reflect commercial bank and bond market standards that facilitate the integration of private financing vehicles into the Loan Pool program in the future. The terms and conditions of the loan to the MDF would also be similar to the Revolving Fund program: the municipality that grants the concession has to follow the concession bidding and award procedures indicated in the loan. Other terms and conditions would be similar to the Revolving Fund. D.21 The Revolving Fund and Loan Pool are very similar concepts: the fund has an additional security feature in the Reserve Fund financing mechanisms, whereas the latter has no additional security. The credit enhancement feature in the Revolving Fund program could be used in poorer Brazilian states, such as the Northeast, with lower income residents that have a lower ability to pay for services (as reflected in the tariff rate) than higher income residents in the Southeast. The Loan Pool without the Reserve Fund would not require a government grant to the MDF, but only the government guarantee in the case the loan came from external sources. 104 Brazil: Financing Municipal Investment: Issues and Options: Annexes D.22 Whether the Revolving Fund or the Loan Pool mechanisms are used to encourage PSP in municipal services, the critical element of any financing program is the technical assistance to remove the obstacles that today hinder private investment in municipal infrastructure. The regulatory and legal frameworks in water, sewer and solid waste services discourage PSP. Inadequate concession contracts, PSP project feasibility analysis, concession bidding documents, and other systemic problems increase commercial project risks for private investors and creditors. BNDES/ CEF can expand their current technical assistance programs for water and sewer PSP projects into other municipal service areas such as solid waste management, urban transport, and street paving and assist the MDFs prepare their PSP lending program. By providing a solid foundation for MDF loans to concessionaires, the MDF will have greater financial flexibility in the future to integrate private creditors into its PSP financing program when improved municipal creditworthiness, and Brazil's financial system can expand the domestic capital markets to accommodate longer term municipal borrowing for PSP infrastructure projects. Brazil: Financing Municipal Investment: Issues and Options: Annexes 105 E: STATISTICAL APPENIIX Table El: Number of Municipalities in Brazil by Size and Region, 1997 Pop0ulation lNorhb Noreast Sotheast South Center-West Brazil Up to 5.000 inhab. 117 284 456 401 149 1407 5.000 a 10.000 inhab. 100 404 404 302 110 1320 10.000 a 20.000 inhab. 107 593 345 246 101 1392 20.000 a 50.000 inhab. 89 377 258 124 60 908 50.000 a 100.000 inhab. 24 88 101 51 15 279 100.000 a 500.000 iinhab. 10 32 91 33 8 174 500.000 a 1.000.000 inhab. 6 8 1 15 Mais 1.000.000 hab. 2 3 3 2 2 12 Total 449 1787 1666 1159 446 5507 Source:: Mac Dowell, Maria Cristina (2000). (Dados Brutos): IBGE - Contagem da Populaco 1996. Table E2. Municipalities with Data on Fiscal Situation, 1997 Population North Northeast Southeast South Center-West Brazil Upto5.000inhab. 100 246 420 397 145 1308 5.000 a 10.000 inhab. 75 328 382 298 110 1193 10.000a20.000inhab. 73 514 334 242 98 1261 20.000 a 50.000 inhab. 63 327 251 123 60 824 50.000al00.O00inhab. 19 80 99 51 15 264 i 00.000 a 500.000 iinhab. 10 28 90 32 8 168 500.000 a 1.000.000 inhab. 6 8 1 15 Mais 1.000.000 hab. 2 3 3 2 1 1 I Total 342 1532 1587 1145 438 5044 Source:: Mac Dowell, Maria Cristina (2000). (Dados Brutos): Secretary do Tesouro Nacional - STN - FIMBRA, 1997 e IBGE - Contagem da Populacao 1996. Table E3. Percentage of municipalities with data by Size and Region, 1997 Populatioa Nortb Northeast Southeast South Center-West Brazil Up to 5.000 inhab. 85.5 86.6 92.1 99.0 97.3 93.0 5.000 a 10.O00inhab. 75.0 81.2 94.6 98.7 100.0 90.4 10.000 a 20.000 inhab. 68.2 86.7 96.8 98.4 97.0 90.6 20.000 a 50.000 inhab. 70.8 86.7 97.3 99.2 100.0 90.7 50.000 a 100.000 inhab. 79.2 90.9 98.0 100.0 100.0 94.6 100.000 a 500.000 iinhab. 100.0 87.5 98.9 97.0 100.0 96.6 500.000 a 1.000.000 inhab. * 100.0 100.0 * 100.0 100.0 More than lOOO.O00inhab. 100.0 100.0 100.0 100.0 50.0 91.7 Total 76.2 85.7 95.3 98.8 98.2 91.6 Source:: Mac Dowell, Maria Cristina (2000). (Dados Brutos): Secretary do Tesouro Nacional-STN - FIMBRA, 1997 e IBGE - Contagem da Populacao 1996. 106 Brazil: Financing Municipal Investment: Issues and Options: Annexes Table E4.: Municipal Fiscal Performance by Regions, 1997 (Billions of Reals at 1999 prices) Regions North Northeast Southeast South Center- BraAl West Current Revenue 2,510 9,772 33,527 9,470 2,787 58,066 Current Expenditure 2,185 9,133 32,056 9,006 2,592 54,972 o/w interest payment 19 150 787 175 38 1,169 Current Balance 325 639 1,471 464 195 3,094 Investment 415 888 3,948 878 498 6,627 Financial Investment 27 158 955 115 72 1,326 Other capital expenditures - 421 0 - - Capital transfers 118 164 317 133 104 836 Other Capital Revenues 24 53 157 13 4 252 Balance 25 (190) (2,957) (383) (267) (3,772) Financing Borrowing 17 93 2,208 180 23 2,521 Sale of Assets 5 34 209 52 8 309 Amortization 24 179 2,384 238 51 2,877 Other financing (23) 242 2,924 388 287 3,819 Per memoire Debt service/Current revenue 1.7 3.4 9.5 4.4 3.2 7.0 interest/Current revenue 0.8 1.5 2.3 1.9 1.4 2.0 Table E5: Municipal Fiscal Performance, By Regions1996 (Billions of Reals at 1999 prices ) Regions North Northeast Southeast South Center- Brazil West Current Revenue 1,994 9,365 33,141 9,029 2,844 56,373 Current Expenditure 1,753 9,029 30,814 8,589 2,690 52,875 Current Balance 240 336 2,328 439 154 3,498 Investment 541 1,243 7,984 1,419 615 11,802 Financial Investment 8 39 291 74 8 421 Other capital expenditures 34 306 2,910 284 101 3,635 Capital transfers 170 371 476 289 147 1,454 Other Capital expenditures 25 19 412 13 7 475 Balance (148) (862) (7,969) (1,036) (416) (10,431) Financing Borrowing 9 36 2,116 257 20 2,439 Sale of Assets 2 21 283 44 11 360 Other Financing 1 1 57 2,399 301 31 2,799 Brazil: Financing Municipal Investment: Issues and Options: Annexes 107 Table E6: Municipal Fiscal Performance, 1995 by Regions (Billions of Reals at 1999 prices) Regions North Northeast Southeast South Center- Brazil West Current Revenue 1,974 7,742 28,989 7,564 2,444 48,713 Current Expenditure 1,725 7,363 24,985 6,936 2,288 43,297 Current Balance 249 379 4,004 628 156 5,417 Investment 432 983 6,901 1,272 469 10,056 Financial Investment 9 24 371 51 14 468 Other capital expenditures 38 242 2,539 237 75 3,131 Capital transfers 104 286 301 183 67 941 Other Capital revenues 9 18 96 12 1 136 Balance (116) (565) (5,410) (738) (333) (7,161) Financing - - - - - Borrowing 7 47 2,992 149 16 3,211 SaleofAssets 18 17 49 23 5 112 Other Financing 91 501 2,369 565 312 3,838 Table E7: Municipal Fiscal Performance by Regions, 1993 (Billions of Reals at 1999 prices) Regions North Nortbeast Southeast South Center- Brazil West Current Revenue 1,568 13,163 12,419 10,807 7,173 45,130 Current Expenditure 1,406 11,067 10,671 10,068 7,329 40,541 Current Balance 162 2,095 1,748 739 (156) 4,588 Investment 516 2,296 1,603 1,837 2,003 8,255 Financial Investment 2 33 56 50 96 237 Other capital expenditures 12 410 675 188 433 1,718 Capital transfers 84 517 465 323 68 1,457 Other Capital expenditures 5 52 86 10 936 1,088 Balance (280) (75) (35) (1,003) (1,684) (3,076) Financing 280 75 35 1,003 1,684 3,076 Borrowing 73 365 348 218 902 1,906 Sale of Assets 2 36 108 88 28 261 Other Financing 205 (326) (422) 697 754 909 108 Brazil: Financing Municipal Investment: Issues and Options: Annexes Table E8: Municipal Fiscal Performance, 1991 by Regions (Billions of Reals at 1999 prices) Regions North Northeast Southeast South Center- Brazil West Current Revenue 1,383 6,146 26,250 6,894 5,215 45,889 Current Expenditure 1,319 5,622 21,923 5,618 4,902 39,385 Current Balance 64 525 4,327 1,276 312 6,504 Investment 509 1,383 6,412 1,517 926 10,747 Financial Investment 4 13 91 45 12 164 Other capital expenditures 17 476 2,164 131 199 2,988 Capital transfers 198 891 645 282 136 2,152 Other Capital expenditures 3 34 77 6 7 127 Balance (265) (423) (3,617) (130) (681) (5,116) Financing 265 423 3,617 130 681 5,116 Borrowing I 1 306 1,245 100 227 1,889 Sale of Assets 2 8 27 19 3 60 Other Financing 252 109 2,345 11 451 3,167 Table E9: Municipal Fiscal Performance, 1989-1997 (Billions of Reals at 1999 prices) 1989 1990 1991 1993 1995 1996 1997 Current Revenues 39.3 44.7 45.9 45.1 48.7 56.4 58 1 Current Expenditures 34.2 38.1 39.4 40.5 43.3 52.9 55.0 o/w interest payment 1.! Current Balance 5.1 6.6 6.5 4.6 5.4 3.5 3.1 Investment 7.2 10.6 10.7 8.3 10.1 11.8 6.6 Other capital expenditures 3.2 1.9 4.1 3.6 1.3 Capital Transfers 2.6 2.7 2.2 1.7 0.1 1.5 1.. Total Balance 0.5 -1.3 -5.3 -3.8 -8.6 -10.5 -3.7 Financed by 1. Credit Operations 1.3 0.8 1.9 1.9 3.2 2.4 2.; 2. SaleofAssets 0.2 0.1 0.1 0.3 0.1 0.4 0.1 3. Amortization 2.9 3. Other -1 2.2 3.3 1.7 5.3 7.6 3.-r Debt service/rec 7.0 Interest /rev 2.0 Source: Mac Dowell (2000). (Dados Brutos): Secretary do Tesouro Nacional - STN e IBGE. Brazil: Financing Municipal Investment: Issues and Options: Annexes 109 Table E10 Percentage Municipalities with Current Surplus in 1997 PopdWo Northeast North C-West South Southeast Brazil Atd 5 mil 85.8 76.0 75.9 89.4 81.9 83.8 5 a 10 mil 73.8 68.0 72.7 74.8 79.1 75.3 10 a 20 mil 63.7 80.8 76.5 77.7 75.7 71.6 20 a 50 mil 65.6 84.1 78.3 76.4 66.9 70.0 50 a 100 mil 68.8 78.9 66.7 80.4 75.8 74.2 100 a 500 mil 67.9 70.0 62.5 62.5 66.7 66.1 500 a I milhao 66.7 * 100.0 * 50.0 60.0 Mais I milhao 100.0 100.0 100.0 100.0 66.7 90.9 Total 70.2 76.9 75.1 80.6 76.1 75.3 Source: Mac Dowell (2000). (Dados Brutos): Secretary do Tesouro Nacional - STN e IBGE - Contagem da Populagao 1996. Table Ell: Municipal Expenditures by Function, 1996 (Constant Prices of December 1999) North Northeast Southeast South Center West Brazil Transport 182.7 389.8 4322.7 1247.1 409.3 6551.6 Housing/Urban 381.5 1583.9 5577.9 1125.2 408.9 9077.5 Education 477.2 2707.3 7267.1 2543.3 812.9 13807.8 Health, Sanitation 313.6 1615.5 6940.8 1222.7 598.5 10691.0 Assistance 120.7 736.3 2729.6 776.4 176.8 4539.9 Legislature 118.2 599.8 1255.9 380.0 195.8 2549.7 Total 1,593.9 7,632.6 28,094.0 7,294.7 2,602.3 47,217.6 As % of Total Expenditure Transport 11.46 5.11 15.39 17.10 15.73 13.88 Housing/Urban 23.93 20.75 19.85 15.42 15.71 19.22 Education 29.94 35.47 25.87 34.86 31.24 29.24 Health, Sanitation 19.67 21.17 24.71 16.76 23.00 22.64 Assistance 7.57 9.65 9.72 10.64 6.80 9.61 Legislature 7.42 7.86 4.47 5.21 7.52 5.40 Total 100.00 100.00 100.00 100.00 100.00 100.00 Source: Mac Dowell (2000). (Dados Brutos): Secretary do Tesouro Nacional - STN e IBGE - Contagem da Populagao 1996. 110 Brazil: Financing Municipal Investment: Issues and Options: Annexes Table E12: Expenditure of States and Capitals, Constant Prices 1995 States and Capitals ($R Billions) 1986=100 1986 1990 1991 1992 1993 1994 1995 1986 1990 1995 Total 74.0 84.0 74.0 77.0 78.8 91.2 103.0 100 114 139 Transport 8.2 9.7 5.8 7.2 7.9 8.8 6.0 100 118 73 Housing and Urbanism 2.2 3.1 3.6 3.8 2.7 3.3 3.7 100 141 169 Regional Development 4.8 5.2 5.1 4.9 4.6 6.3 7.2 100 110 152 Education 14.5 15.0 13.0 13.0 13.0 14.8 17.0 100 103 117 Health 5.9 8.6 7.7 7.6 7.2 8.7 9.7 100 146 164 Total 100 100 100 100 100 100 100 Transport 11.1 11.5 7.8 9.4 10.0 9.6 5.8 Housing and Urbanism 3.0 3.7 4.9 4.9 3.4 3.6 3.6 Regional Development 6.4 6.2 6.9 6.4 5.9 6.9 7.0 Education 19.6 17.9 17.6 16.9 16.5 16.2 16.5 Health 8.0 10.2 10.4 9.9 9.1 9.5 9.4 Capitals Total 7.7 9.6 10.9 10.8 9.1 11.4 14.7 100 125 191 Transport 0.8 1.3 1.2 1.5 1.4 1.3 2.0 100 159 238 Housing and Urbanism 1.4 1.8 2.5 2.5 1.7 2.0 2.6 100 128 186 Regional Development 0.0 Education 1.6 1.7 1.9 1.8 1.6 2.0 2.5 100 108 156 Health 0.9 1.3 1.4 1.6 1.3 1.7 2.1 100 145 247 PlanningandAdminist 1.7 1.9 2.1 1.7 1.5 2.6 3.2 100 110 182 Brazil: Financing Municipal Investment: Issues and Options: Annexes 111 Table E13: Financing Of States And Capitals, Constant Prices 1995 1986 1990 1991 1992 1993 1994 1995 1986 1990 1995 States and Capitals ($R Billions) 1986=100 Total Revenues 51.7 64.0 61.0 58.0 56.0 67.0 85.0 100 124 118 Total Revenues (-credit) 44.8 57.9 56.1 51.0 50.0 60.2 75.5 100 129 125 Current Revenues (-credit) 49.1 57.9 56.1 51.0 50.0 60.2 75.5 100 118 114 Own Taxes 43.0 44.0 41.0 37.0 35.0 47.0 57.0 100 102 95 Transfers 10.0 15.0 12.0 11.0 12.0 15.0 22.0 100 150 120 Capital Revenues 10.0 7.7 6.9 9.4 12.5 9.7 10.5 100 77 69 Credit 6.9 6.1 4.9 7.0 6.0 6.8 9.5 100 88 71 Capital Transfers 2.6 1.0 0.6 0.5 100 38 23 Currnt Revenues (w/credit) 56.0 64.0 61.0 58.0 56.0 67.0 85.0 100 114 109 Current Rev. (net) 25.5 31.5 31.1 26.0 23.2 28.3 34.5 100 124 122 Total Expenditure 71.9 81.6 71.3 74.6 76.8 89.0 103.8 100 113 99 Current Expenditures 52.0 60.0 54.0 54.0 57.0 66.0 83.0 100 115 104 Personal 23.0 25.0 21.0 20.0 20.0 23.0 31.0 100 109 91 Transfers 23.6 26.4 25.0 25.0 26.8 31.9 41.0 100 112 106 Capital Expenditures 19.9 21.6 17.3 20.6 19.8 23.0 20.8 100 109 87 Investment 6.0 6.6 5.6 6.1 6.8 6.3 5.0 100 110 93 Capital Transfer out 8.5 7.0 4.4 6.5 5.7 6.6 4.1 100 82 52 Amortization 1986 1990 1991 1992 1993 1994 1995 1986 1990 1995 Capitals (SR Billions) 1986=100 Total Revenue 6.3 8.3 9.7 8.7 8.0 9.5 12.0 100 132 154 Total Rev. less credit 6.0 7.9 9.0 8.3 7.3 8.7 9.8 100 132 149 Current Revenues 5.5 7.7 8.6 7.6 6.5 8.5 9.6 100 140 157 Own Taxes 2.3 2.8 3.6 3.0 2.2 3.4 5.0 100 122 157 Transfers 3.1 3.8 3.7 3.2 3.1 4.1 5.5 100 123 119 Capital Revenues 0.8 0.6 1.1 1.1 1.5 1.0 2.4 100 75 138 Credit 0.3 0.4 0.8 0.4 0.7 0.7 2.2 100 127 257 Capital Transfers 0.4 0.1 0.1 0.2 0.1 0.1 100 20 0 Current Rev. (incl. credit) 5.8 8.1 9.4 8.0 7.2 9.2 11.8 100 140 162 Current Rev. (net) 3.7 5.7 6.1 5.0 4.2 5.8 6.4 100 153 164 Total Expenditure 7.7 9.6 11.0 10.8 9.1 11.4 14.6 100 125 143 Current Expenditures 5.9 7.0 7.8 7.7 6.9 8.3 10.0 100 119 133 Personal 2.8 3.0 3.2 2.8 2.6 3.1 3.8 100 107 114 Transfers out 1.8 2.1 2.6 2.6 2.3 2.7 3.2 100 114 143 Capital Expenditures 1.9 2.6 3.3 3.1 2.2 3.1 4.6 100 142 177 Investment 1.1 1.4 1.8 2.0 1.5 1.8 2.7 100 133 167 Capital Transfer out 0.8 0.8 1.4 1.0 0.7 1.2 1.8 100 99 184 Amortization Per Memoir: Wage BillNet Revenue 75.7 53.0 52.7 57.1 63.0 53.1 58.9 112 Brazil: Financing Municipal Investment: Issues and Options: Annexes Table E14: Own Revenues as % of Total Current Revenue, by Municipality by Size, 1997 (%) -,miipaitis grups Norheat North Center- South S.uthe ~~ ulation ~~~~~West ___ Less than 5.000 2.6 4.4 6.8 11.0 9.5 8.6 5.000- 10.000 4.3 5.0 8.6 14.9 12.5 10.8 10.000-20.000 5.0 5.2 10.8 18.6 18.6 13.5 20.000 - 50.000 7.2 11.1 14.0 25.8 24.4 18.7 50.000 - 100.000 12.6 13.9 22.4 27.5 29.9 25.3 100.000 - 500.000 19.3 15.6 26.5 39.3 35.8 33.8 500.000- I million 33.9 * 37.9 * 41.2 39.1 More than I million 44.8 30.8 42.9 46.3 61.4 55.9 To 7jtal 1 19.7 17.8 19.1 29.9 41.1 33.6 Source: Mac Dowell (2000). (Dados Brutos): Secretary do Tesouro Nacional - STN e IBGE - Contageri da Populacao 1996. Note: The table includes 5.045 municipalities for which there are available data. Own Revenues as Percentage of Total Revenues; Municipalities by Size 70 60 0 E_ Brazil 50 - _ Northeast 40 - 0 NORTEE 30 - 0 C. E; 20 -EN SUL 1 0 E3 Southeast 0 Size of Municipality P~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Brazil: Financing Municipal Investment: Issues and Options: Annexes 113 Table E15: Own Current Revenue Per Capita by Group of Municipalities 1997 (R$ Current/inhabitant/year) Muz'ici:aIities group :I46th0ast North Center- .South Southeat Rra (Pop~~~uIation) ~West Less than 5.000 7.1 13.7 31.8 53.4 47.2 37.1 5.000- 10.000 8.8 10.2 30.3 48.4 41.4 31.0 10.000 - 20.000 8.3 8.2 32.2 56.8 59.2 32.7 20.000-50.000 11.1 17.8 32.7 70.4 81.9 43.8 50.000- 100.000 17.5 29.3 45.7 73.8 101.0 63.3 100.000 - 500.000 36.9 27.9 60.4 111.6 130.4 103.0 500.000- I million 92.6 * 11.0 * 172.3 134.1 More than I million 123.7 90.3 131.7 234.0 323.7 252.1 Total 38.0 37.5 49.2 96.9 166.3 1053 Source: Mac Dowell (2000). (Dados Brutos): Secretary do Tesouro Nacional - STN e IBGE - Contagem da Populacao 1996. Note: The table includes 5,045 municipalities for which there are available data. Own Current Revenues (Per capita) By Group of Municipality, 1997 (R$) 350 300 - 250 - Northeast * North 200 - . Cwest 150 - . .South r Southeast 100 - E,- *3 l11 - l 1 [ Brazil 50 1-r 0 0 IC\, e 09d ~~~~ 114 Brazil: Financing Municipal Investment: Issues and Options: Annexes Table E16. Total Current Revenue Per Capita by Group of Municipalities 1997 (R$ Current/inhabitant/year) uaico05 Less than 5.000 270.1 314.6 468.2 487.4 497.7 433.5 5.000- 10.000 201.7 203.8 352.8 325.7 332.1 287.7 10.000-20.000 167.1 159.6 298.9 304.7 318.8 242.7 20.000 - 50.000 155.4 160.5 233.0 272.5 335.8 234.2 50.000- 100.000 139.6 210.2 203.8 268.5 337.3 250.3 100.000 - 500.000 190.7 179.3 227.9 284.1 364.5 305.0 500.000- I million 273.1 8.0 28.9 8.0 418.1 343.2 More than I million 276.2 293.3 307.1 505.7 526.8 451.1 vtat 193.4 211 e0.O8t¢ *¢ 2573 324 .3z 404.6 /tj334 Source: Mac Dowell (2000). (Dados Brutos): Secretary do Tesouro Nacional - STN e IBGE - Contagem da PopulagAo 1996. Note: The table includes 5.045 municipalities for which there are available data. Table E. 5: Total Current Revenues (per capita) by group of Municipalities, 1997 600 500 400 300- 200 0 NORTHEFAST 100 U NORTH 0 0QC. WEST Less 5-10th. 10-20 20-50 50-100 100- 500th More Total 0 SOU[H than th. th th 500th to I than I U SE 5,000 million million E3 ERASIL Brazil: Financing Municipal Investment: Issues and Options: Annexes 115 Table E17 Investment Expenditures (Per Capita) by Group of Municipalities 1997 (R$ Current/inhabitant/year) Municipatisgroupst ot t- o (Population) W..t __,__.,. Less than 5.000 39.9 45.1 69.4 72.2 66.7 61.8 5.000- 10.000 25.5 32.6 70.1 30.6 36.6 34.8 10.000-20.000 16.7 31.4 58.7 26.5 32.9 26.9 20.000- 50.000 16.9 27.8 50.4 21.5 34.2 26.1 50.000- 100.000 16.9 47.6 28.2 22.3 33.0 27.1 100.000 - 500.000 22.5 21.8 43.0 22.2 39.7 32.9 500.000 - 1 million 16.1 6.4 43.3 31.3 More than I million 9.8 45.2 37.4 54.3 73.7 56.2 - - Total > . 17.6 34.8 46.0 30.1 47.6 -35.8 Source: Mac Dowell (2000). (Dados Brutos): Secretary do Tesouro Nacional - STN e IBGE - Contagem da Populagao 1996. Note: The table includes 5.045 municipalities for which there are available data. Table E18 Distribution of Population by Municipalities by Size and Region, 1996 (%) Municipalities groups Northeast North Center-West South Southeast Brazil (Population) Less than 5.000 0.33 0.17 0.28 0.66 0.80 2.24 5.000- 10.000 1.50 0.39 0.49 1.26 1.63 5.27 10.000-20.000 5.10 0.95 0.89 2.21 2.91 12.07 20.000 - 50.000 7.50 1.68 1.08 2.54 5.17 17.97 50.000- 100.000 3.96 1.20 0.55 2.31 4.63 12.65 100.000 - 500.000 4.12 1.33 1.21 4.23 12.46 23.36 500.000 - I million 2.48 * 0.38 * 3.92 6.79 More than I million 3.52 1.46 1.80 1.76 11.13 19.67 Total 28.50 7.19 6.68 14.97 42.65 100.00 Source: Mac Dowell (2000). (Dados Brutos): IBGE - Contagem da Populagao 1996. Table E19: Population Growth Rates in Metropolitan Regions Metropolitan Region 1980-1991 1991-1996 Belem 2.65 2.23 Fortaleza 4.49 2.32 Recife 1.85 1.14 Salvador 3.18 1.68 Belo Horizonte 2.52 2.09 Rio de Janeiro 1.01 0.77 Sio Paulo 1.86 1.46 Curitiba 3.64 3.40 Porto Alegre 2.15 1.43 116 Brazil: Financing Municipal Investment: Issues and Options: Annexes Picture E.6: Investment Expenditures per Municipality Group, per capita 1997 80 - 70 - 60 50 * North 40 ~~~~~~~~~~~~~~~~~~m40 Cwest 0 South 30 * Southeast 20 ~~~~~~~~~~~~~~~~~~~~~~~~~~~~ElBrazil 1 0 Less than 5-10 th. 10-20 th. 20-50th 50-100th 100-500 500th to More Total 5,000 th I million than I million Source: Martine 1994 and IBGE. Contagem da Populacao de 1996 Per capita Investment Expenditures by Municipality and Region, 1997 80 70 - V[ Less than 5,000 60 i 5-lth. 50 0~~~~~~~~~~~~~~~~~~~~~~C 10-20 th. 0 20-50 th 40 * 50-1 00 th Ci 100-500 th 30 *S~~~~~~~~~~~~~~~~~~~~0 00th to I million 20 O3More than I millior ETotal 10 0 Northeast North Cwest South Southeast Brazil Brazil: Financing Municipal Investment: Issues and Options: Annexes 117 Table E20 Population and Poverty Data for Metropolitan Regions Population Poverty rate % SAo Paulo Metro core 9,039,102 1.59 Metro periphery 7,392,054 4.03 Total 16,606,648 2.73 Rio de Janeiro Metro core 5,628,095 3.75 Metro periphery 4,547,560 8.52 Total 10,245,599 6.13 Belo Horizonte Metro core 2,001,355 4.91 Metro periphery 1,433,130 10.57 Total 3,751,727 8.56 Salvador Metro core 2,264,616 24.33 Metro periphery 441,217 34.78 Total 2,793,265 26.97 Recife Metro core 1,372,441 23.09 Metro periphery 1,557,369 28.78 Total 3,086,994 27.68 Fortaleza Metro core 1,948,334 20.06 Metro periphery 590,095 41.86 Total 2,598,690 26.26 Distrito Metro core 1,514,594 5.71 Federal Metro periphery 0 0.00 Total 1,776,490 9.11 Belem Metro core 854,196 16.69 Metro periphery 107,387 40.55 Total 961,583 19.35 Porto Alegre Metro core 1,321,845 5.10 Metro periphery 1,842,622 6.49 Total 3,306,749 6.43 Curitiba Metro core 1,261,993 2.00 Metro periphery 831,006 4.68 Total 2,211,392 3.69 OBS: The total population figure includes rural Table E21. Urban vs. Rural Poverty AREA Headcount % (Millions) Metropolitan Core 2.03 5.8 Metropolitan Periphery 1.89 5.4 Large Urban (100,000+) 2.98 8.5 Medium Urban (20,000- 100,000) 4.26 12.2 Small Urban (< 20,000) 7.15 20.5 Rural 16.57 47.5 TOTAL 34.88 100.0 118 Brazil: Financing Municipal Investment: Issues and Options: Annexes Table E.22: Number and Location of Urban Poor (millions) Area Nortbeast Center North Southeast Soutb Total % West Metropolitan Core 1.26 0.09 0.14 0.45 0.09 2.03 11 Metropolitan Periphery 0.85 - 0.04 0.84 0.16 1.89 10 Large Urban (100,000+) 1.68 0.26 0.37 0.47 0.20 2.98 16 Medium Urban (20,000- 100,000) 2.31 0.23 0.60 0.66 0.45 4.26 23 Small Urban (< 20,000) 4.37 0.43 0.83 1.07 0.43 7.15 40 TOTAL 10.47 1.01 2.00 3.49 1.34 18.31 100 % 57 6 11 19 7 100 NE = Northeast; CO = Center-west; NO = Northwest; SE = Southeast; SU = South Table E23 Urban Poverty Rate by Area (%) Region Northeast North Center Southeast South West Metropolitan Core 22.5 5.7 16.7 2.7 3.6 Metropolitan Periphery 32.8 0.0 40.5 6.3 5.9 Large Urban (100,000+) 24.5 7.8 15.2 3.8 4.8 Medium Urban (20,000- 100,000) 40.9 14.3 30.6 6.3 10.0 Small Urban (<20,000) 52.3 20.6 48.2 15.7 10.4 NE = Northeast; CO = Center-west; NO = Northwest; SE = Southeast; SU = South Table E24: Access To Urban Services By Region Access to Services (%) Northeast North Center Southeast South West Water All 58.4 69.3 84.2 94.2 93.4 Poor 37.0 43.1 56.4 70.5 71.0 Sanitation All 36.5 43.6 39.0 81.4 65.0 Poor 17.3 16.6 15.2 41.7 25.4 Electricity All 81.0 93.9 93.0 97.4 96.6 Poor 69.6 84.8 74.1 83.5 82.1 Garbage All 48.3 60.0 75.4 83.9 77.4 Poor 27.2 31.5 43.4 39.6 42.7 % Urban Population 64.0 95.0 81.0 89.0 78.0 NE = Northeast; CO = Center-west; NO = Northwest; SE = Southeast; SU = South Table E25: Access To Services By Poor In Urban Areas By Size Of Settlement Access to Services (%) Metro Core Metro Large Medium Small ALL Periphery Urban Urban Urban Urban Water All 96.6 93.1 93.9 89.8 81.7 91.0 Poor 83.0 72.0 72.6 68.0 59.7 67.6 Sanitation All 88.2 77.4 77.8 66.7 47.9 71.6 Poor 58.1 51.1 43.1 32.5 24.2 35.7 Electricity All 99.6 99.6 99.4 98.5 96.3 98.7 Poor 98.9 97.9 96.9 93.9 91.2 94.3 Garbage All 96.4 85.1 91.7 83.5 69.5 85.9 Poor 81.3 59.0 66.6 55.1 45.2 56.4 Brazil: Financing Municipal Investment: Issues and Options: Annexes 119 Per capita Investment Expenditures by Municipality and Region, 1997 80 70 - 60 Less than 5,000 60 - l_ 50 th. O3 10-20 th. 50 320-50 th 40 -50-l00 th 30 [3 100-500 th 30 *~~~~~~~~~~~~~~~~~~~~~0500 th to I million 20 [IMore than 1 million flTotal 1 0 0 Northeast North Cwest South Southeast Brazil Access to Services by Poor in Urban Areas by Size of Settlemient 120 100 03 Metro Core * Metro Periphery 0Medium Urban 40 E~~~~~~~~~~~~~~~~~~~~~~~~Small Urban 20- 0 All Poor All Poor All Poor All Poor Water Sanitation Electricity Garbage 120 Brazil: Financing Municipal Investment: Issues and Options: Annexes Table E26: Public Health Spending in Selected States, 1996 Bahia Ceara Minas Goiis State Health Spending as % State Revenues 12.2 10.4 13.6 8.2 As % of municipalities budget 11.2 31.6 26.8 16.1 Infant Mortality 50 40 31 29.7 Source: Government Data, Mission Estimates. Table E27: Estimates of Brazilian Health Care Expenditure, 1997 Sub-Sector Per D % Total RS capita, Public Total % GDP billion RS1 Public 27.9 179 100 64 3.29 Federal 19.8 124 71 45 2.33 State (a) 4.2 26 15 10 0.50 Municipal (a) 3.9 24 14 9 0.46 Private 16.1 95(b) --- 36 1.90 Total 44.0 274 --- I 00 5.19 (a) Own resources, excluding federal transfers (b) Calculated for the entire population, but private spending is concentrated in the sub-population with private health insurance Source: Ministerio da Saude (1997b) Table E28: Structure of Public Educational Expenditures, 1996 Total Federal State Munic. Total Federal State Munic. Total Bab Goiis Minas Pre- 0.0 0.4 11.8 3.8 0.0 5.2 94.8 100.0 0.4 6.0 1.1 primary Primary 10.0 48.7 45.9 40.0 5.1 59.7 35.3 100.0 37.8 43.1 61.3 Secondary 8.4 6.1 5.0 6.2 27.3 48.0 24.6 100.0 17.3 12.1 10.9 Higher 70.9 7.5 1.2 18.3 77.9 20.1 2.0 100.0 2.4 2.6 0.5 Other 10.6 37.3 36.2 31.6 6.8 57.9 35.3 100.0 42.0 25.6 25.6 Total 100.0 100.0 100.0 100.0 20.2 49.1 30.8 100.0 100.0 10).0 100.0 Source: Government Data, Mission Estimates. Brazil: Financing Municipal Investment: Issues and Options: Annexes 121 Table E29: Distribution of Primary and Secondary Students By Type of School, 1996 Federal State Municipal Private Total Primary Education Bahia 0.1 45.3 45.6 9.0 100.0 Ceara 0.0 32.1 49.2 18.7 100.0 Goias 0.0 61.4 29.1 9.5 100.0 Minas Gerais 0.1 70.7 23.4 5.8 100.0 Brazil 0.1 55.7 33.0 11.2 100.0 Secondary Education Bahia 1.2 65.8 14.9 18.1 100.0 Ceara 2.1 50.3 12.8 34.8 100.0 Goias 2.3 81.1 2.2 14.4 100.0 Minas Gerais 1.9 68.4 10.6 19.1 100.0 Brazil 2.0 72.1 5.4 20.5 100.0 Higher Education Brazil 21.9 14.0 5.7 58.4 100.0 Source: Government Data; Mission Estimates Table E30: Sub-national Governments in Public Expenditure, 1995 (as percentage of total) Federal States and Municipalities Government Total States Municip Total (1) (2) (3) (4) (1)+(2) Public Employment 3.0 (a) 35.6(a) 12.0 23.6 38.3 (a) Public Wage Bill 58.8 41.2 .. .. 100.0 Social Spending 54.4 45.6 26.8 18.8 100.0 Social Security 7W.2 20.8 16.5 4.2 100.0 Education and Culture 19.3 80.7 50.2 30.5 100.0 Health 28.2 71.8 39.0 32.9 100.0 Housing and Urbanism 7.8 92.2 14.2 78.0 100.0 (a) Does not include education, health, judicial and legislative Education and health public workers represent 51% of total public employrnent. Source: Governrment Data; Mission Estimates 122 Brazil Financing Municipal Investment: Issues and Options: Annexes Table 1: Number of Municipalities in Brazil by Size and Region, 1997 tPopulation No4th Northeast Sotxt1\South Cente-Wes SB. aSl Upto5.0OO