Report No. 27443 Ecuador Development Policy Review Growth, Inclusion and Governance: The Road Ahead May 31, 2004 Ecuador Country Management Unit Poverty Reduction and Economic Management Department Latin America and the Caribbean Region Document of the World Bank Table of Contents PREFACE FOREWORD EXECUTIVESUMMARY................................................................................................................... i MATRIX OFREFORMS............................................................................................................ vi-viii I ThePoliticalEconomy............................................................................................................ . Historical and Structural Failures of Ecuadorian Society ......................................................... 1 1 The Twin-Currency and Banking-Crises ............................................................................. 3 The November 2002 Elections.................................................................................................. 5 The Challenges Ahead .............................................................................................................. 7 I1 . Long-Term Growth Trends ....................................................................................................... An Overview of Major Development Outcomes................................................................... 9 9 12 FiscalPolicy and Public Debt Sustainability .......................................................................... MixedMacroeconomic Performance ...................................................................................... 18 Deteriorating Competitiveness................................................................................................ 22 Lack of Governance and Broad Corruption............................................................................ The Social Gap andVulnerable ~ o u p.................................................................................. s 24 26 I11 . The Development Agenda..................................................................................................... 29 Preserving Stability with Fiscal Discipline andAccelerating Growth with Competitiveness................................................................................................. 30 A. B. PromotingMacrofiscal Stability ................................................................................ 30 TakingControl of the Wage Bill................................................................................ 33 34 D. C. Strengthening the Banking System............................................................................ Improving the Investment Climate andLabor Markets Flexibility............................ 36 E. DevelopingTrade Facilitation Reform...................................................................... 36 Boosting Sustainable andEquitable Development ................................................................. F. Improvingthe Oil and Infrastructure Sectors............................................................. 38 41 A. 41 Addressing Social Sector-Specific Challenges.......................................................... Social Outcomes ........................................................................................................ B. 42 45 Providing Quality Government Services and PromotingFlexible Labor Markets .................46 D. CompletingPensionModernization........................................................................... C. Improvingthe Safety Net........................................................................................... A. 47 47 B. Upgrading Decentralization....................................................................................... Addressing Governance and Corruption.................................................................... 48 C. 49 D. ConsolidatingJudicial Reform................................................................................... Strengthening Oil Environment Management ........................................................... 49 IV. Medium-TermOutlook and Risks....................................................................................... 51 A. 51 B. The Outlook for Growth: A Base Case Scenario....................................................... Risks:What ifOilProspectsDeteriorate? ................................................................. 52 C. Other Risks................................................................................................................. 54 D. Alternatives to the Existing Development Framework.............................................. 58 APPENDIX A Statistical Appendix.......................................................................................... . .59-74 APPENDIX B The EcuadorianInvestment Climate: Preliminary Findings............................... . 75 REFERENCES.................................................................................................................................. 87 Tables Table I1 . Ecuador Governments. 1979-2003 ............................................................................. 1 Table 1.2 Ecuador: ExclusionandEducation............................................................................. Table 1.3 SpontaneousDollarization(foreign currency/total banking deposits 2000) ............... 2 5 Table 11.1 Sectoral Structure and Dutch Disease....................................................................... 12 Table 11.2 14 23 Ecuador's Social Indicators inInternational Perspective.......................................... The Costs of DoingBusinessare HighinEcuador................................................... SelectedEconomic Indicators................................................................................... Table II.3 Table 11.4 25 Table 111.1 Ecuador: Financing Gap Needs................................................................................. 32 Table 111.2 Effective Taxes or Subsidies on Petroleum Products, 2003...................................... 39 Table 111.3 Government of Ecuador's Key Poverty ReductionGoals ........................................ Table I11.4 Incidence of SocialExpenditure by MainPrograms and Income Quintiles .............42 45 Figures Figure 11.1 Ecuador Real GDPper Capita..................................................................................... 9 Figure 11.2 10 L A C GDP Growth Rate Changes Between 1980sand 1990s................................... Total Factor Productivity vs.Real GrowthRates. 1991-2000 ................................. Figure 11.3 Figure 11.4 Projected Growth Assuming Progressto Top 25 Percent of L A C and The World...10 11 Figure 11.5 11 Microeconomics Indicators....................................................................................... GrowthRates inNationalAccounts.......................................................................... Figure II.6 13 Figure 11.7 Ecuador's FinancialRisk(inbasis points) ............................................................... 16 Figure 11.8 RealExchange Rate Appreciation and Productivity ................................................. 17 Figure 11.9 Total Public Sector Net Worth (index basedon 2001U.S. dollars) ......................... 18 Figure 11.10 Tax Collection Efficiency ......................................................................................... 19 Figure 11.11 20 Ecuador: Poverty Rate, 1988-2002........................................................................... D o You Believe that the Government Spends the Tax Money Well?....................... Figure II.12 24 Figure 11.13 27 L A C Index of Budget Transparency, 2003 (9% of Respondents) .............................. Trends inGovernance Indicators, 1997-98 and 2000-01......................................... Figure 111.1 31 Figure III.2 Financial System Indicators...................................................................................... 35 Figure 111.3 38 Base Case Oil Production(million barrels) .............................................................. Total Crude Oil Output............................................................................................. Figure IV.1 53 Figure IV.2 Low Case Oil Production (million barrels) ............................................................... 53 Figure IV.3 Comparison of Base andLow Case Scenarios.......................................................... 54 Figure IV.4 Co-movement inEcuador EMBI+spreadand LACEMBI+Spreads...................... 56 Figure IV.5 Ecuador: Changes inRealGDP and RealEffective Exchange Rate (REER) (percent) ............................................................................. 55 Boxes Box 1.1 The Economic TransformationLaw-The Trole Law ............................................... 4 Box 1.2 The NationalDialogue Process................................................................................... 6 Box 11.1 22 The Customs ReformLaw ........................................................................................ The Law on Responsibility. Stabilization. and FiscalTransparency ........................ Box 111.1 30 Box 111.2 The Civil Service andWage UnificationLaw: A Stepinthe RightDirection.................................................................................... 33 Box 111.3 InitialMeasuresfor the Restructuringof the FinancialSector under the IMF-SBA .................................................................................................. 34 Box IV.l The Base Case Scenario............................................................................................ 52 Preface This report was prepared by a team led by Jose' R. Ldpez-Cdlix (Task Manager) with inputs by Eduardo Siandra (consultant, macro and fiscal topics), Pablo Fajnzylber (Investment Climate Survey), Elaine Tinsley (Relativeprices trends, debt sustainability analysis, macro outlook, and statistical analysis), Horacio Ye'pez (consultant, oil sector) and Eleodoro Mayorga Alba (oil outlook), JefSreyRinne (labor markets), Enrique Fanta (consultant, Customs),Norbert Fiess and Conrado Garcia-Corado (contagionanalysis),Daniel Dulitzky and Rafael RoJinan (social issues) and Jorge Shepherd (consultant,fiscal volatility). Edgardo Favaro and John Panzer provided precious guidance as peer reviewers. Valuable inputs and suggestions from Vicente Fretes- Cibils, McDonald Benjamin, Marcel0 Giugale, Luis Serve'n, Sara Calvo, Mauricio Carrizosa, Emesto May, Giovanni Majnoni, Gautam Datta, Patricia McKenzie, August0 de la Torre, Guillermo Perry, Bob Traa (IMF), Mayra Zermeiio (IMF), Esteban Vesperoni (IMF) and David Yuravlivker (IMF) are gratefully acknowledged. Editorial assistance was provided by Diane Stamm. Valuable production support at various stages was provided by Michael Geller. Complementary efforts were brought by Patricia Chacdn-Holt, Jose' Francisco Irias, Maria Antonieta Gonzrilez, and Rosalia Rushton. Alexandra Castillo, Ana Maria Vicuiia, Lucy Vargas, Cynthia Gizmrin, Vinicio Valdivieso, and Ana Maria Villaquirdn provided excellent operational support tofield research in Quito. Theteam wouldfinally like to express its sincere gratitudefor the excellent cooperationand commentsprovided by Ecuadorian ofJicials,inparticular Mauricio Pozo, Gilbert0 Pazmiiio, Diego Mancheno, GaEo Viteri, Jenny Guerrero, Fernando Sucirez, Fausto Herrera, Roberto Salazar, Hugo Muiioz, Fabidn Carrillo, Mauricio Ye'pez, Leopoldo Bdez, Ramiro Galarza, Lenin Parreno, Ivonne Baki, Javier Game, Roberto Yturralde, Christian Espinosa and Diego Martinez. Although thepresent versionof the report reflects, to the extentfeasible, most comments received, it does not necessarily represent the ofJicial views of the Governmentof Ecuador. Foreword This report i s part of a program that was initiated in October 2002, at the request of the Government of Ecuador. The program involved producing a formal Bank report, so-called a Development Policy review (DPR), and providing technical assistance to the transition to the incoming Govemment of Ecuador. In preparation of the DPR and the Bank's Country Assistance Strategy, the task team realized that essential background papers required for producing a DPR were missing. Bank Economic and Sector Work had been scarce in the previous years, and there were important knowledge gaps about Ecuador. Thus, per the request of the country team, the region decided to prepare the DPR intwo stages. First, an informal set of Policy Notes would be prepared for the incoming new administration. Second, a fonnal DPR would be prepared as a follow-up to the Policy Notes. Both documents would also have different, but complementary focuses. Where the Policy Notes would be short-term oriented and focused on immediate priorities in part defined from the perspective of Ecuadorian authorities, the ensuing DPR would be medium-term oriented, focused on strategic priorities as perceived from the Bank`s own vision of Ecuador. Thus, the Policy Notes became a long and comprehensive document, whereas the DPR became a short and crisp one. Notwithstanding the diagnostic tone preserved inthe Policy Notes, the DPR adds a thorough assessment of the implementationof the economic, social, andgovernance agendaduringthe first year of current administration and makes proposals for its fine-tuning. The Policy Notes were prepared inrecord time with their first draft widely disseminated in a Quito seminar early on January 2003. This seminar collected the authorities' and civil society's views to improve the final draft. This meeting with the incoming authorities took place one week well before their arrival to office, and included the participationof President GutiCrrez and his full Cabinet. As a follow-up exercise, the Policy Notes were presented by mid-2003 in workshops and seminars in three major Ecuadorian cities-Quito, Guayaquil, and Cuenca. The Policy Notes constituted a major input in the preparation of Ecuador CAS as well as in two adjustment operations-one on fiscal consolidation and competitive growth and another on human development. Their translation to Spanish expanded their outreach and ensured a good, localunderstanding of the report. As a follow up to the Policy Notes, the DPR dissemination both inthe GOE and within the World Bank has been more selective. However, throughout the process of its preparation and dissemination, its impact on the Bank`s on-going operational work has become increasingly relevant. Most lending operations and sector work have now benefitted directly or indirectly from inputs collected from early versions of the document. The DPR has also been actively used by Authorities inthe refinement to the GOE's agenda, one year later. Insummary, both documents have made deep inroads to building an open and friendly working relationship with the GutiCrrez administration. They should be seen as two sides of the same coin. This reportreflects policy developments through May 31,2004. Executive Summary 1. Reviewing development issues in Ecuador requires a long-term and comprehensive perspective, that goes beyond purely economic indicators. Although GDP per capita is usually used for assessing improvements inthe quality of life over several decades, it hardly measures welfare beyond material gain-barely one aspect of life that enhance economic well-being. Instead, a more accurate and comprehensive indicator of economic welfare, that measures both the quantity and quality of life, i s the gain in life expectancy (Becker, Philipson and Soares, 2003). Comparing both indicators reveal interesting trade-offs. On the one hand, whereas Ecuador underachieved in GDP per-capita terms between 1965 and 1995-by reaching about a quarter of the average GDP per-capita growth attained by developing economies-it was a good performer in terms of life expectancy gains, rising from 60 to 71 years and placing itself in the top range of countries showing major improvements in the world. On the other hand, whereas Ecuador GDP per capita essentially stagnated after 1980, life expectancy improved due to attributable reductions in mortality, thus making a case for targeted spending. Infant mortality declined from 87 per thousand in 1970 to 30 per thousand in 2000. Indeed, social, political, environmental, and not only economic factors contribute to welfare improvements. The combination of those factors however, has not always been favorable to Ecuador's development. 2. Ecuador is not only a natural-resource-rich country, but also one featuring deep exclusion and rooted poverty. Indeed, its balance sheet exhibits high oil reserves, a very rich biodiversity, a potential for tourism, steady inflows of remittances from abroad, and a strategic international market location close to its main commercial partner, the US, among its assets, but also a long-termbias for the development of non-tradable rent-seeking activities, high public debt, severe social gaps and exclusion and a long history of poor governance, misuse of oil resources and problems of corruption among its liabilities. As a result, heavy government intervention and rents have not been adequate to encourage business growth. Instead, regulation of private sector activity and state intervention in direct production of goods and services have been excessive and biased toward certain groups. All public enterprises remain inthe hands of the state. State intervention has also failed to solve income distribution and long- standing indigenous marginalization issues. 3. Since 1979, when the country returned to democracy, Ecuador has suffered from high external vulnerability, poor macroeconomic and socialperformance, and deteriorating governance, and this pattern aggravated with the twin crises that led to dollarization in 2000. A succession of external adversities-linked to the volatility of oil prices and sharp variations in capital flows-and natural calamities, all in combination with poor economic and social management, resulted in macroeconomic imbalances, negative gains in productivity, low growth, and declining social development. Duringthis period, the country suffered four severe recessions: 1982-83, 1987, 1989, and 1998-99; and three periods of hyperinflation: 1983, 1988-93, and 1999-2000. Ensuing high and unsustainable external debt led to various moratoriums on payments, and to the most recent twin- currency and banking--crises in 1999, which destroyed 20 banks that accounted for over 50 percent of banking deposits. The crises had a devastating effect on employment levels, poverty, and income distribution. While the rate of formal unemployment grew from 10 to nearly 15 percent, poverty incidence increased from 34 to 56 percent between 1995 and 1999, and the Gini coefficient increased from 0.52 to 0.54 during the same period. These indicators imply that the number of poor Ecuadorians grew by over 2 million during the crisis. The crises severely affected the poor and the indigenous population, particularly those living in the rural sierra, where the poverty rate increased by 7 percentjust between 1998 and 1999, and those living in the coast, who suffered at least $2 billion in damages and doubling urban unemployment rates incities like Guayaquil. Half a million people have immigratedand another half million moved into marginal urban areas. Other human and social development indicators, such as infant mortality, malnutrition, and the school desertion rate, also worsened in this period. Partial reforms and bad economic and social policies were partly caused by weak, fragmented and too-often- changing public management, and the governance problems that traditionally characterize oil-producing countries. Inthe last 23 years, Ecuador has had 29 finance ministers, meaning each spent an average of less than 10 months in the post. In addition, Ecuador remains at the bottom of rankings of Latin American countries interms of perceived control over corruption. 4. The twin crises revealed important gaps in the competitiveness, social and governance areas. Economic stagnation has been caused by low productivity of investment in physical and human (especially secondary and tertiary) capital. Among L A C countries Ecuador has had some of the lowest growth intotal factor productivity. This i s due not only to external shocks, but to unevenly implemented structural reforms in the 1980s and 1990s. Nearly all global indicators show indisputable and consistent evidence that the country's competitiveness gaps are significant and growing: in2003: the country ranked 86thamong 102 countries in terms of global competitiveness evaluated by the World Economic Forum. In social terms, the country has a lead in primary school enrollment rate, measles immunization and mortality indicators, but significant lags in terms of social spending levels, educational attainment (secondary enrollment), access to safe water and female life expectancy. The country i s also perceived as havingthe lowest budget transparencyinLAC, as well as among the lowest control of corruption. 5. The GutiCrrez administration that took office in January 2003 has proposed an ambitious pro-poor development agenda to fill these gaps, while sustaining dollarization. Since 2000, dollarization has brought price stability, positive growth, a restored confidence in the financial system, and last, but not least, has lifted the monetary veil that prevented the country from seeing the serious fiscal, real, and financial imbalances that plagued its economy. Ensuing real salary levels and unemployment rates are back to 1998 levels. More fundamentally, the dollarization regime set up a framework for clearly identifying and dealing with the interlinked problems of lack of stabilization, stagnant per capita growth, heavy debt burden, severe social gaps, and poor governance. Four years after dollarization, Ecuador i s at an importantjuncture inwhich it can reap the benefits of a monetary system that entails low rates of inflation and predictability for medium-term planning and investment, but requires considerable commitment to fiscal discipline and structural reforms. The GutiCrrez administration i s committed to advancing such reforms. Its economic program has been supported by a Stand-By Agreement (SBA) and a multiyear structural reform agenda agreed with multilaterals, dealing with macroeconomic sustainability and competitive growth, social development and inclusion, and governance and anti-corruptionreforms. 6. Economic performance in the first year of government was broadly positive and encouraging, but results are fragile. Ecuador has benefited from an exceptional three years of an oil price windfall and steady family remittances flows, and this has allowed it to overcome difficulties achieving high rates of growth and bringing inflation rates down to international levels. In 2003, the economy continued to expand gradually by 2.6 percent and inflation declined to 6 percent. Country risk declined by about 1,000 basis points to pre-dollarization levels with a significant reversion inthe upward trend prevailing at the end of the previous administration. Fiscalbalance almost doubled at a 1.7 percent of GDP: a 4.7 percent fiscal primary surplus brought public debt ratios down from 58 percent in 2002 to 53 percent in2003, closer to sustainable levels estimated at 40 percent of GDP. However, wage spending remained expansive and revenues slightly declined-with highoil revenues partly offsetting a declining tax revenue ratio. Due to a weak dollar, the real exchange rate slightly reversed its appreciation trend inherited since 2002, and returned to 1998 levels. Domestic interest rates remained highfor a dollarized economy; but domestic private investment and credit continued reactivating, but at a slow pace. The required level of internationalreserves, which i s lower than for a non-dollarized economy, but important in a country deprived of a lender of last resort, slightly increased to 1.7 percent of GDP, thus preserving its low potentialto act as precautionary buffer to shocks. 7. However, implementation of key structural reforms, including those in the social and governance areas is lagging. Delays were perceived in the implementation of fundamental medium- term economic reforms-tax, financial, labor market, trade and basic infrastructure sectors-which might 11 led to a fall in the tax revenue ratio, upward fiscal pressures on the real exchange rate, an incomplete regulatory framework in the financial system, weak external competitiveness, oil export volumes far below the resources potential, and successive operational deficits in state-owned electricity and telecommunications companies. Lagging reforms in the social and governance areas might also lead to persistent low coverage and quality of education (secondary) and healthservices, regressive incidence and inefficiency of public--especially social-spending, continuous corruption in Customs, poor institutional indicators and a weak rule of law for attracting foreign investment. 8. This Development Policy Review (DPR) examines, from the World Bank's perspective, the design and implementation of Ecuador's development agenda during the first year of the present government. Such agenda i s summarized in 30 key policy proposals (see Matrix of Proposed Reforms in Table ES1). The Matrix of Proposed Reforms provides a comprehensive framework to analyze progress in policy implementation accomplished during the first year of the new government. It is organized around the three pillars originally identified by the GutiCrrez's administrationas key to sustained growth, social inclusion andenhancedgovernance. The Development Agenda 9. At the outset, the Development Agenda of Ecuador has 4 top priorities. First, it needs to preserve price stability, which i s equivalent to fiscal discipline and debt sustainability. Second, it needs faster and equitable growth, and for this it requires to dismantle most of the state interventionmechanisms it created in past decades. Third, it has to develop its human capital, by improving the quality of education and expanding its educational attainment inprimary and secondary education and the coverage of health services through decentralized services. Fourth, it has to make a major effort to improve transparency in government accounts and debt management, including those of provincial and municipal governments, so as to promote governance and consensus building, based on social auditing and civil society participation inthe budget cycle. 10. Macroeconomic stability and growth. Both international experience and the experience of Ecuador itself show that the best tool to combat poverty and protect the most vulnerable citizens is to maintain price stability and accelerate economic growth. It i s estimated that on average, with each 1 percent increaseof the gross domestic product (GDP) per capita, poverty i s reducedby approximately 0.7 percent. Given moderate growth rates of the past decade, it will not be easy to upgrade the Ecuadorian economy on a prolongedtrack of rapid growth inthe mediumterm, but it i s feasible and can be achieved through the following key actions. 9 First, preserve a balanced macroeconomic framework, particularly with reference to public accounts, that fosters stability and private investment, and that allows the process of debt reduction to continue. This means obtaining primary surpluses between 4-5 percent of GDP, preventing any temptation to divert the Fund for Stabilization, Investment & Debt Reduction (FEIREP) resources allocated to debt reductionto expansionary spending, addressing pressing fiscal liquidity problems in the short term, and preventing the buildup of further arrears. Ecuador made significant progress on all fronts in2003: it obtained a NFPS primary surplus of 4.7, cleared all external arrears, created andputFEIREP into action and started repurchasing debt. The implementation of Customs and budget reforms are, however, lagging. Inthe mediumterm, a tax simplification reform is also needed. 9 Second, regain control of the wage bill, both interms of its growth in real terms, and interms of control of its wage benefits and civil service policies. In2003, the Executive issued an austerity decree, whose impact on public salaries has been extended until 2005 and Congress approved the civil service and wage unification law. As a percentage to GDP, the wage bill of the Central Government remained constant in 2003, and non-interest current spending declined due to cuts in the budget for goods and ... 111 services. The coverage of the austerity decree and the new Law can however be expanded, and their effectiveness to reduce growth inthe wage bill and inpublic employment be strengthened. 9 m,promote economic expansion and competitiveness through induced lower interest rates to stimulate greater private investment in the economy, facilitated private sector expansion inthe provision of infrastructure services, the gradual elimination of non pro-poor subsidies (for propane, diesel, fuel oil, local telephone calls and electricity) and improvedtargeting of others (for propane gas), greater flexibility of input markets, especially labor, and opening of trade. In 2003, active lending interest rates fell by about 2 percent, but their levels remain highindollar terms. Financial sector reform, however, requires to finalize the process of banking sector restructuring. The Government also adjusted power tariffs and fuel prices, but failed to do it in local telephone calls and did not eliminate the subsidy to propane gas. Attempts to pass management of telecom and power tariffs to private hands were unsuccessful. Labor market and trade facilitation reforms are lagging, but should speed up in the context of the Free Trade negotiations with the U.S. 9 Fourth, accelerate the expansion of the petroleum sector through the promotion of private sector investment with legal and regulatory changes. Sector reforms are critical to bring about legal and fiscal stability to foreign private investment in the oil fields with the greatest reserves, and to materialize expected duplication of oil exports by private companies through the new pipeline. Unfortunately, no progress in attracting new foreign investment for PetroEcuador fields occurred in2003 and its production fell by about 8 percent in2003. A new contract of Asociacidn Petrolera i s expected to be approved under aproposed Hydrocarbons Law could be approved by Congress in 2004. 11. Sustained and equitable social development. Numerous Cabinet changes had a major impact indelayingthe implementationof a comprehensive social agendaduring2003. This is a critical concern becausewith no sustainedand effective implementation of the social agenda, economic growth and fiscal adjustment alone cannot achieve their ultimate objective of improving the living standards of the over 7 million Ecuadorians living in poverty. Ecuador i s committed to the Millennium Development Goals (MDGs). These goals were adopted by the international community within the framework of the United Nations to be achieved between 1990 and 2015. They cover the areas of poverty, malnutrition, mother- infant health, education, gender equity, and environmental sustainability. According to World Bank estimates, it is "very improbable" that the GOE's will meet its mid-term goals of reducing poverty and extreme poverty by 13 percent and 15 percent, respectively, set for 2007. Ecuador shouldrather achieve a more modest reduction of 5 percent inboth rates. However, it i s "probable" that Ecuador will reach goals for primary education (100 percent coverage) and malnutrition (50 percent reduction); it i s "possible" that Ecuador will meet goals for lowering infant mortality and mortality of children under age 5 (66 percent reduction), and to a lesser extent the goals for sanitation (cut by 50 percent the number of people without access to potable water). The high sensitivity of the MDGs-particularly for poverty-to the rate of economic growth and to fiscal spending demonstrateswhy Ecuador critically needs to reach highrates of growth in an accelerated and sustained manner, with rates higher than historical levels, and improve the quality of its social spending. Obviously, this will be possible only with the implementation of an integrateddevelopment agenda, as follows. 9 First, promote higher educational attainment of human capital (especially in secondary levels), improve the quality of teachers' educational skills through the institutionalization of the Aprendo system for measuring results, strengthen the social protection network by guaranteeing the assignment of public resources to priority, efficient and pro-poor education and health programs, and reverse declining levels of social spending. In2003, authorities did budget higher resources for education and health sectors, but this ratio stagnatedin2004. Executioninpriority programs was close to 80percent of budgeted amounts. The Bono was also restructured, and its results are being evaluated. No progress registered in the institutionalizationof the Aprendo system, iv > Second, guarantee the population access to a basic package of essential health services that i s financially sustainable and would be gradually introduced, Expand the coverage of the Free Maternity Care (LMC) program and the Seguro Social Campesino (SSC) using a targeted universe of beneficiaries of the previous Bono Solidario, and modernize the role of the Ministry of Public Health, shifting from direct supplier to regulator of services. In2003, an agreementwas signed between the SSC and the L M C to design a strategy to share resources and increase coverage, but its implementation remains pending. Noprogress i s reportedinother areas. 9 Third, improve the efficacy and efficiency of the social safety network in protecting vulnerable groups. The number of programs in the current social assistance system should be significantly reduced, and coordination among surviving ones should improve to enhance quality and coverage. This requires a review of the benefits, targeting criteria, objectives, and administration of all programs. A positive step in 2003 has been the transformation of the Bono de Solidaridad into the Bono de Desarrollo Humano, with increased benefits, and prospects for revised targeting, coverage, and evaluation. The new administration should focus its efforts on ways to take advantage of the Bono program's structure to serve as the backbone of an overhauled social protection system, but noting that changes demand a major political consensus, which i s not easy to obtain, and a proper evaluationof alternative targeting mechanisms before their selection and implementation. Moreover, the social protection network i s missing an anticyclical social assistance program to ensure that unemployment levels do not increase significantly in times of crisis, when the number of people demanding social assistancegrows. > Fourth, in the formal sector, reform of the social security system with a clear separation of different services provided, such as pensions and health, modernizing their legal and institutional framework and financial management, and broadening coverage took place in 2003. E S S auditing of 2003 accounts i s on-going. The contingent liability embedded in the acknowledgement of the debt that the State has with the Ecuadorian Social Security Institute (IESS) has been valued and accounted, as IvlEF authorities have reportedly offered US$540 million to be paid in equal installment in 10 years. No progress is reported regardingthe status of Law reforming the social security system. 12. Governance. Progress inthis area was slow in 2003. Ecuador did not improve its international low ranking in governance during 2003, and the national dialogue about the Governance Pact was postponed indefinitely. This i s a concern, since public perceptions of lack of progress inthe fight against corruption have arisen from 2002, together with public concerns regarding low performing institutions, affect the Administration's credibility as it designs and tries to implement public policies. This also influences the government's ability to provide public services. The government could gain momentum with a series of initiatives depicted below. > First, carry out urgent reforms in promoting total transparency in functions such as budgeting, regulation and provision of public services, acquisition of goods, and contracting of services. By separating the economic from the political links, and rendering virtual budget information to the public, it will promote social auditing and avoid, wherever possible, capture of the State by economic interest groups or political parties. This i s not an easy task both from a technical and political perspective. SIGEF, the financial management tool for budget transparency i s being overhauled and major results are only expected by end-2004. The design of a highly performing Contratanet system by an independent Anticorruption Civil Committee in 2003 i s a major outcome, but its full success will depend of the approval of an amended procurement bill allowing public contracts, included those from subnational governments, to be offered in the website and its migration toward a fully transactional system. A related achievement i s the development of an integrated payroll system for Central Government employees by the Central Bank. Such a system will allow transparency of the public payroll and, inthe future, integrate with other systems inthe public sector under development. 9 Second, sign aGovernance Pactbetweenthe Stateand civil society, which is amore difficult task to achieve. Such Pact should bring stability to the Congress agenda and to the policy reform initiatives V agreed with civil society. No major progress, however, was reported in 2003; which reflects the difficulties that Authorities face inbuildingdomestic consensus around reforms. 9 w,design of a comprehensive decentralization framework i s missingfrom the GOE's agenda of reforms. This is an important gap, since provincial and sectional (municipal) govemments are believed to spend about 15 percent of budget resources, with virtually zero accountability to the Central Govemment and, of equal concern, generally little accountability to their local populations. Restructuring decentralization in Ecuador will face at least three main challenges in its attemp to improve public services delivery: assign new functional roles and spending responsibilities to subnational govemments; revise the intergovernmental formula for the transfer of resources; and issue and enforce compliance of fiscal responsibility rules by subnational governments, including limits onpublic debt stock and service. 9 Fourth, reactivatejudicial reformis essentialto strengthenthe rule of law. The 1996reformof the judicial system is incomplete. Efforts to support judicial independence, improve judges, lawyers and clerks training, improve access to justice-especially women and indigenous people-introduce dispute resolution mechanisms, and encourage the public's participation are needed. Despite the Government's contention that judicial reform i s a priority, its implementationis lagging. Table ES1. Matrix of ProposedReforms Ecuador: Key Actions of the Develop lent Agenda and Progressduring2003 PolicyProposals I status ProgressAccomplished toDate PreservingStability with FiscalDiscipline 1. Sustained and sound Done IMF approved a Stand-by Agreement with the Government, macroeconomicprogram. but the end-year second review was not concluded due to delays in compliance with most structural benchmarks. Macro and fiscal indicators were sound. In2003, growth was about 3 percent, inflation fell to 6 percent; the open unemployment rate fell to 9.3 percent; the current account deficit more than halved to 1.7 percent of GDP; the NFPS primary fiscal surplus was 4.7 percent of GDP and the overall fiscal surplus was 1.7 percent of GDP, slightly below quantitative criteria of the Stand-by. A new Agreement with the IMFi s expectedto bereachedinthe nearterm. 2. Passage of austere budgets and Partly Budgeted growth in real primary spending and reduction in compliance with the fiscal rule. implemented non-oil deficit met the fiscal rule in 2003 and 2004. The austerity decree has been extended to 2004, and the salary freezing has been extended to 2005. However, the government still need to agree with the IMF those measures bringing the 2004 primary surplus to 4.5-5 percentof GDP. 3. Budget reform with passage of a Pending Ifagreedunder thenew arrangementwith the IMF,the GOE bill eliminating tax exemptions, would submit a draft bill to Congressinmid-to-late 2004. nuisance taxes and non- constitutional tax earmarkings. 4. Customs reform with passage of a Partly The Customs Reform Law was passed-establishing stricter bill modernizing Customs and implemented requirements for valuation and documentation, SRI merging SRI and CAE, thus participation in the CAE Board, cross-checking information supporting an enhanced service systems, and tightening surveillance in the ports-but it did delivery, an increase in Customs not provide SRI with sufficient authority over personnel revenue and a reduction in its removal in CAE. Yet, Customs reform did not bring positive corruption levels. revenue effects in 2003: collection fell and corruption levels reportedly remain high. 5. Regained control of the wage bill, Done The Austerity decreefroze public salariesfor 2004 and 2005. by freezing overall salary payroll (zero growth in real terms for the Central Govemment). v i 6. Wage unification and Civil Service Done Congress approved the Civil Service Reform Bill in reforrn with passage of a bill September, and its amendments in January. It unifies an unifying multiple benefits, excessivenumber of salarybenefits, reduces categories from designing a single agency for 21 to 14, caps the highest-paid salary at $8,00O/month human resources management and (President'ssalary),createsa Secretariatfor human resources, passing from 21- to 14-grade pay and prevents re-entry to the public sector. Its coverage is scales limited (45 percent of public servants),and its fiscal impact is neutral in the short term. 7. Public debt-to-GDP gradually Done ThePlan was prepared andis being implemented. Public debt approaches sustainable levels (40 to GDP fell from 58 percent in 2002 to 53 percent in 2003. percent) with acomprehensive Debt All external arrears are cleared, and agreements with Paris Reduction Plan. Club members are being agreedwith. FEIREP resources are flowing and it started repurchasingdebt in early 2004. And Competitive Growth 8. Approved new forms of contracts Pending The GOE announced it would allow joint private ventures, but with oil companies to allow mixed strikes by PetroEcuador workers led the government to investment. backtrack and agreeonly to allow servicecontracts. Issuing a new Hydrocarbons Law is pending. 9. Labor An assessmentof the labor market was completed in 2003, automaticmarket wage reform of the Pending indexing and consensus-building roundtables between all actors have mechanisms and mandatory been scheduledfor mid-May 2004 application of sectoraltables. 10. Power sector reform by restarting Partly The GOE adjusted tariffs to 89 percent of economic costs, but electricity rates adjustment and implemented froze them in November 2003 and reducedthem to 85 percent reducing the operational deficit of in April. Authorities plan to passmanagementof distribution distribution companies. companies to international private administrators in 2004. 11. Telecom sector reform by allowing Partly A Swedish company manages TELECSA, a cell phone Andinatel, Pacifictel and Telecsa to implemented company owned by Andinatel andPaciflctel. Authorities plan be managedby private companies. to pass management of Andinatel and Pacifictel to international private companiesin 2004. 12. Approval of an amended Pending The GOE will introduce an amendedLaw in 2004, in the form Competition bill. of urgent economic legislation. 13. Trade facilitation reform centeredin Partly The GOE unified import licenses,and by doing so eliminated the elimination of Non-Tariff implemented 8 percent. Further reductions will take place in mid-2004. It Barriers (NTBs)-administrative also eliminated about 30 percent of non-WTO compatible simplification of imports licences, technical norms in 2003, and further eliminations are unification and elimination of projected for end-2004. An electronic systemthat will reduce duplicative import licenses, and time to approve import licenses has been developed. elimination of technical norms Negotiations for a FIA with the U.S have started and are WTO-non compatible, and signing scheduled to be concluded in 2005. 14. Banking of aITAgreement with restructuring the U.S. sector Partly Audits have been done of 9 closed banks by the AGD, but completed through liquidation of implemented only 5 were taken into liquidation, and the remaining 3 were all closed banks and sell state- about to start . An international firm was hired to bring state- owned banks. owned Bunco de1Pacific0 to the point of sale, but its sale is pending. Boosting Sustainable and Equitable DeveloDment 15. Increased education and health Ptly Budget allocations for education and health rose in real terms spending, as well as on priority implemented in 2003, but not in 2004. Budget allocations for priority social programs-at least similar to social programs rose in real terms in 2003, but executed 2002 levels,coupled with enhanced spending showed about 20 percent under-compliance in 2003. participation, evaluation and The GOE has not taken any leadership role in implementing targeting of thesePrograms. evaluations of the targeting of the PSPs. Required consultations with civil society have also not been implemented. 16. Upgraded quality of education Pending The Minister of Education was changed three times in 2003. through the institutionalization of The sector lacks a medium-term strategy. Reported strong ProgressAccomplishedto Date resistance from teachers to the application of the Aprendo program. The Government singled out education as the social priority for 2004 and a new Education Law i s being prepared. Teachers continue to be paid late, and not remunerated in relation to results, and almost no progress has been made in documenting which paidteachers are actually working intheir assignedareas. 17. Replaced gas subsidy with a pro- Pending The GOE has postponed such decision indefinitely, until a poor targetedmechanism. proper and effective targeted mechanism i s designed, and proper politicalconditios appear. 18. Improved Bono de Desarrollo Partly A conditional cash transfer program, the Bono de Desarrollo Humano benefits and targeting, implemented Humano, was created, progressively replacing (and merging) merging the Beca Escolar and the the databaseof beneficiariesstill needto bebetter targeted. . the Bono Solidario and the Beca Escolar. On the other hand, Bono Solidario. 19. Improved targeting of the Partly A poverty map has been designed, but the targeting Programa de Alimentacih Escolar implemented mechanismstill i s underreview. with the adoption of apoverty map. 20. Combined coverage of the the Free Partly The Minister of Health was changed three times in 2003. Maternity Care and the Rural Social implemented The sector lacks a medium-term strategy. An agreement was Insurance (SSC) programs, and signed betweenthe Ministry of Health and the SSC to design expandedIESS coverage to spouses a strategy to share resources in order to increase access to and children under 6 years and a basic health care for population not previously beingcovered, minimumpackageoffered. also including a process identifying non-affiliated beneficiaries. The status of the minimum package for relatives of IESS affiliates i s underreview. 21. Separated IESS funds for pensions Partly The separationof funds was completedand validated, but the and for social security, thus making implemented auditing of 2003 balances is underreview. transparent cross subsidies between bothprograms. 22. Providedinsurancefor the elderly, a Pending A working group has beencreatedto define a strategy for the health care program for the retired old age income protection system, including the extension of and disabled through the Bono coverage and to make the initial assessments of the other Solidario, and a countercyclical programs. employment program. 23. Clearedup State's debt to the IESS, Pending h4EF made a proposal defining the amount owed to IESS in while the status of the law US$540M. IESS has reportedly acceptedit, in exchange of reforming the social security system additional compensations over its actuarial balance. The i s clarified. status of the law reformingthe social security systemremains uncertain. And Quality Government 24. Signed GovernancePact. Pending The Government did not achievea GovernancePact. 25. Implemented Transparency, and Partly h4EFdesigneda TransparencyPlanincluding the overhaul of Anti-Corruption Plans. implemented the SIGEF-based information system, an e-government system focused on public procurement, and a single national investment database. Transparency plans are only being started, as the GOE's Portal does not provide accuratedata on executed spending. The Govemment has drafted a Customs Anti-Corruption Plan. 26. Unified public payroll in a single Done The Central Bank has developedan Integrated Payroll System database and made transparent to for the Central Governmentsector. The systemis running. the public scrutiny. 27. Procurement reform supported by Partly A pilot Contratanet, e-procurement,systemhas been set up by an E-procurement website system, implemented the Anti-corruption Committee, but its full adoption requires allowing the publication of all an evaluation of its performance, before becoming a public procurement bids and transactional system, the designation of an institutional quarterly reports, and a new champion and the issuanceof anew ProcurementLaw. procurementbill. viii PolicyProposals I Status ProgressAccomplishedtoDate 28. During a fiscal emergency period I - - Pending - The Government has not defined its decentralization strategy (2003-and 2004), frozen transfers to yet, and has rather increasedtransfers unconditionally to local sectional governments above 10 to governmentsto 15 percent of revenues. Some improvements 11 percent of revenues, only to transparency and accountability of financial data increased once they assume new information by provincial and sectional govemments have responsibilities and accountabilities. occurred. 29. New municipal fiscal rules issued Pending The Govemment has not defined its decentralization strategy with enhanced accountability and and does not want to amendthe fiscal rule in its early years of transparencyrequirements. application 30. Completed design of the reform of Pending The GOE and the Judicial authorities are defining a strategy thejudicial system. to reactivethe institutional reform inthe Judicial System. 13. Risks. Given high oil prices, steady ramily remittances, positive external outlook and encouraging macroeconomic perforhance, the probability of a currency cksis inthe near term i s low, but the vulnerabilities and risks of the development framework in the medium term warrant their close attention. 9 The risks that appear more likely are external. Ecuador has limitedtools-fiscal policy in the short term and enhanced factor productivity in the medium term-to offset adverse asymmetric shocks, especially due to an unfavorable external environment arising from contagion of a sudden stop in capital inflows to the region, falling terms of trade (especially oil prices), exchange rate depreciations by neighboring countries, or rising international interest rates. To mitigate deflation and unemployment that often accompany external shocks indollarized economies, Ecuador needsbuffers. These are (a) a sound fiscal policy and solid institutions, like FEIREP, that allow it to steadily comply with its debt reduction program and, eventually, develop countercyclical policy (with the use of its projectedresources to be cushioned ina recently created oil facility fund for 2.5 percent of GDP); (b) increased flexibility in its labor market, so that real exchange rate adjustments are made by wage adjustments, rather than by sharp variations in employment; (c) updated prudential regulations and strengthening of a liquidity fund to protect the financial system from rising private debt defaults in a recession; (d) elimination of barriers to the domestic market in order to attract technology and promote human resources training and development; and, of course, (e) in the context of free trade negotiations with the U.S., a comprehensive reformof its trade policy to correct the many and chronic distortions that still "protect" a few rent-seekerproducers to the detriment of Ecuadorianconsumers. 9 Domestic risks are equally important: (a) the extension of the oil windfall might tempt government officials to postpone the difficult fiscal and structural reforms to which they have committed themselves; (b) the social environment might deteriorate due to popular mistrust of structural reform programs, thus leading to street demonstrations that could derail the social program; (c) the government may not be able to maintain a coalition within Congress that i s able to pass critical legislation; and (d) an external shock might increase domestic pressureson the government to change the currency regime, notwithstanding the enormous political, economic and social costs of doing so. Ultimately, there i s not any economic solution, including de-dollarization, in which the very same essential structural reforms and fiscal prudence could be set aside. 14. Conclusion. The proposed reforms are far from being a magic formula of success and observing their full impact will require time to materialize. They will have success if the country stays the course for a prolonged period of time and that will only be possible if there i s a critical mass of the population that agrees with the core elements of the reform program. The GOE's reform agenda embodies a courageous attempt to address long-standing structural shortcomings of Ecuador, and creates the foundations for sustained and inclusive per capita growth, competitiveness, and social development. The DPR assesses the core lines of action for keeping the GOE's agenda on course, while providing a delicate i x and needed rebalancing between' on-going sustainable fiscal and debt policies already under successful implementation, with medium-term policies needed to consolidate fiscal and competitiveness gains, prepare for free trade gains, gradually improve targeting of quality social spending, and enhance democracy and governance efforts needed to gradually eliminate the rent-seeking and corruption-prone activities of the past. Inthe future, as the country sets the ground to access the internationalbondmarkets and completes fiscal, financial, and structural reforms, a swift implementation of critical components of the lagging social and governance agendas would mitigate risks and strengthen credibility in the Government's development program. X I. THEPOLITICALECONOMY Historicaland StructuralWeaknesses of theEcuadorianState 1.1 Since its independence, the social and economic difficulties of Ecuador have led to political andgovernance failures, and vice versa. Historically, the emergence of Ecuador as a state independent from the Confederationof Gran Colombia in 1830 created a country with two main competing regions; a coastal area centered around the city of Guayaquil, and the Sierra highlands around the capital city of Quito. Regional disputes have been a permanent source of social and political instability inEcuador, with political parties formed along regional lines, and ensuing policymaking environment in which resources, taxes, trade restrictions, and quotas of political power are allocated in an effort to maintain regional balance. Socially, Ecuador also remains a highly stratified country. In spite of the country's natural (especially oil) cultural and biodiversity richness, and geo-strategic location on the equator in the eastern Pacific, wealthy people, elite landowners, and financial and industrial entrepreneurs coexist with a large, poor, and marginalized, but increasingly politically active, indigenous population. Realincomeper capita has not grown during the past 20 years in Ecuador, and 45 percent of the population (58 percent of the rural population) remains poor (The World Bank, 2004). 1.2 The combination of sensitive regional divisions and fragile political coalitions has, in turn, severely hampered the capacity of the Central Government to ensure stable policies that garner national consensus. A series of repeated constitutionalr e f o m (19 Constitutions since independence- the most recent was enacted in 1998), presidential crises, and cycles of military governments followed by civilianrule have reflectedunsuccessful attempts to ensure stable governments. Inthe past 24 years, only half of elected presidents have concluded their term under normal circumstances (see Table 1.1). Misguided policies have also been the result of poor governance. In the last 23 years, Ecuador had 29 Finance Ministers who remained inoffice an average of less than 10months. This was accompanied by a frequent rotation of technocrats working for the govemment and a highmigration of professionals abroad. Congress has also been characterized by an unusually large number of political parties for a country of Ecuador's size. Table 1.1: Ecuador Governments, 1979-2003 Period President Acceded to Ofice by Reasonof Departure Aug 79-May 81 Jaime Rold6s Election Accidental death May 8l-Aug 84 OsvaldoHurtado VP assumedoffice Term concluded Aug 84-Aug 88 Le6nFebresCorder0 Election Termconcluded Aug 88-Aug 92 Rodrigo Borja Election Term concluded Aug 92-Aug 96 Sixto DurtinBall& Election Term concluded Aug 96-Feb 97 Abdalti Bucaram Election Removedby Congress Feb 97-Aug 98 Fabitin Alarc6n Congress designated Termconcluded Aug 98-Jan 00 Jamil Mahuad Election Resigned Jan OO-Jan 03 Gustavo Noboa VP assumedoffice Termconcluded Jan 03- LucioGutiBrrez Election Source:BeckermanandSolimano (2002). 1.3 The main legacy of the colonial period has been a history of exclusion, state paternalism, and corruption. Ecuador has among the highest (and rising) Gini coefficients of income inequality (54 percent) inthe world (World Bank 2003). The wealthiest 10percent of the population, with 42 percent of GDP, earn70times more than the poorest 10percent, with only 0.6 percent of GDP (ibid.). Wide gaps in income translate to unmet basic needs (like education). Unlike for the majority white-mestizo population, Ecuador's indigenous or Afro populations are highly marginalized (indeed the latter remain largely invisible), and the differences are particularly striking in education (Table 1.2). For instance, adult self- reported literacy (78 percent) in the lowest quintile i s much below 98 percent reached by the richest quintile (ibid.). There are also large gaps inaccess to resources betweenurban and rural populations, and 1 I Table 1.2: Ecuador: Exclusion I between men and women. The gender wage gap for urban salaried workers i s 0.8, well below the LatinAmerica and the Caribbean (LAC) average of 0.9 ibid.). Exclusion and serfdom arose from a history Definition Attendance based on large haciendas or landholdings and a colonial legacy of (years) Indigenous 3.3 long-standing injustices only began to give way with land reform and Black 5.8 voting rights changes in the 1960s and 1970s, and major indigenous Mestizo 7.3 uprisings in the 1990s. In addition, state paternalism favored Mulato 6.5 entrepreneurial rent-seeking through barriers to trade and explicit White 9.2 barriers to diversification, tax exemptions, imperfect property rights, import licenses, and real wages containment, which constrained productivity-based growth that mostly affected the lowest income quintiles. Located at the middle range of the income distribution, public sector employees also acquired privileged positions and significant political clout, which in a context of limited accountability and rare public disclosure, often led to allegations of corruption. More generally, Ecuador has in recent years ranked among the countries in Latin America with the highest perceived incidence and weakest control of corruption, which i s a regressive tax whose heaviest burden i s concentrated on lowest-income households. On average, the poorest households spend up to 4 percent of their annual income on bribes, whereas the richest spend less that 1.5 percent (Seligson and Recanatini 2003). In sum, the colonial period left poor foundations for technological progress, ranging from an unequal distribution of wealth and income, weak property rights, political instability and corruption, and weak fiscal finances derived from state interventions to support inefficient manufacturing sectors, to the detriment of resource-exporting sectors inthe post-World-War-II period (De Ferranti and others 2001). 1.4 Ecuador discoveredexceptional oil resourcesinthe early 1970s, but their management has not fulfilled its potentiaL The discovery and exploitation of oil and gas, and the sharp rise in oil prices in the 1970s, provided the country with huge exceptional resources. The value of production of petroleum and natural gas, which was virtually zero in 1971, grew 23 percent in 1974, reflecting boththe start-upof large-scale productionandthe fourfold increaseinworld oil prices. This newfoundwealth that could have been used as the basis for the expansion of its capital base and a sustainable improvement in its living standard, has rather been used to finance an increase in the size of the State, and to subsidize private consumption (through low prices of domestic petroleum, under-pricing of public services and sizable credits to the private sector from state banks). This strategy proved unsustainable when external or domestic circumstances changed in the early 1980s. The sudden cessation of external credit from commercial sources, the high rise in international interest rates and the sharp decline in Ecuador's terms of trade in 1982 showed the fragility of Ecuador's previous development pattern. 1.5 Since its return to democracy in 1979, Ecuador has been characterized by high external vulnerability, mostly associated with its dependence on exports of a few commodities such as oil, bananas, cacao and shrimp, and weak macroeconomic management. In 1999, after Venezuela and Trinidad and Tobago (also oil-exporting countries), Ecuador had the third-highest concentration (in excess of 60 percent) of exports in four products of the LAC region. This dependence has made the economy prone to the volatility associated with the booms and busts in the international prices of commodities, especially oil, and to climatic changes, like El NiAo. Ecuador has benefited from four oil booms-in 1974, 1980, 1990, and 2000. Although such episodes featured highrates of growth initially, these in turn have resulted in high fiscal deficits (except in 2000), which were financed either by externally borrowing against oil revenues or by printing local currency (formerly the sucre). When preceded or accompanied by severe external shocks or natural disasters, these recurrent episodes of excessive fiscal deficits and excessive external borrowing led to disruptive economic and/or financial crises, which were barely addressed by structural reforms that were never completed. As a result, inthe last two decades, the country suffered four severe recessions-1982-83, 1987, 1989, and 1998-99; three hyperinflationary periods-1983, 1988-1993, and 1999-2000; and various debt payment defaults or 2 moratoriums. Overall, the national debt quadrupled between 1980 and 2000, while real GDP per capita remained unchanged. The Twin-Currency andBanking-Crises 1.6 The late 1990s witnessedEcuador's worst economic crisis inmore than a century. In 1999, as the recession got deeper, the country entered hyperinflation. GDP growth fell 6.3 percent, and the annualized inflation rate reached 60 percent that December. The high rates of inflation in turn drove additional pressureto devalue the sucre, which between mid-1998 andJanuary 2000 lost three-quarters of its value (moving from S.6,OOO to S.25,OOO per U.S. dollar before the Government decided to dollarize on January 9,2000). An accompanying financial crisis destroyed 20 banks holding about 50 percent of bank deposits. 1.7 The twin-currency and bankingdrises resulted from a combination of external and internal shocks. On the external front, El NiAo hit first with over US$2.6 billion indamages-including crops and agricultural export losses, and the destruction of 2,500 kilometers of roads and 19 bridges- (equivalent to 13 percent of GDP) due to flooding in coastal regions in 1997. Then, in 1998, a severe decline in oil and banana prices, and diseases that ravaged shrimp production, contributed to the collapse of about 20 percent in Ecuador's exports. Contagion from the Asian crisis also reached Ecuador, featuring a sharp capital outflow provoked by the Russian crisis in the fall of 1998, thus drying the external credit lines for the Ecuadorian banking system. On the internal front, weak fiscal management and low oil prices ledto large fiscal deficits, hyperinflation, and default on external debt inAugust 1999; external shocks, combined with mismanagement and deficient supervision ledto a collapse inthe banking sector in 1999 that resulted inthe freezing of bank deposits and the disappearance of 20 banks holding about 50 percent of bank deposits. 1.8 Among pre-dollarization shocks, Ecuador's sudden stop in capital flows in 1998 was perhaps the most striking by any standard. Net inflows of about US$2.2 billion in 1998 changed into net outflows of US$1.3 billion in 1999, that is, a reversal of US$3.5 billion, equivalent to 20 percent of GDP, or 56 percent of credit to the private sector prevailingin 1998. Moreover, about 85 percent of this fall was explained by the behavior of non-foreign direct investment (FDI) flows (Izquierdo 2002). Capital outflows contributed to high volatility of the nominal (and real effective) exchange rate and to inflation. Exchange rate mismatches in commercial banks' balances, in an environment of a rapidly depreciating exchange rate, led to the collapse of the banking system, with estimated fiscal losses of at least 15 percent of GDP (Naranjo 2003). Contagion, nevertheless, hit Ecuador harder nor only because it encompassed traditional sources of vulnerabilities and other shocks, but because other sources of structural vulnerabilities embedded inEcuador's policy framework-such as wage and price rigidities and above mentioned pervasive mismatches in the portfolios of bank`s borrowers-multiplied the impact of the shocks. 1.9 The crisis of 1998-99 hada devastating effect on already high poverty levels. The incidence of poverty (the headcount) doubled from 34 to 56 percent of the population between 1995 and 1999. This means that the number of poor people grew by more than 2 million during the crisis. Similarly, the number of people living in extreme poverty (income insufficient to cover a basic basket) increased from 12 to 21 percent during the same period. The percentages of population living in slums in Quito (30 percent) and Guayaquil (60 percent) are significantly higher than those found in other Latin American cities of a similar size. The crisis hit Guayaquil, medium-sized cities, and rural areas with indigenous populations most severely, especially those located in the highlands. In2000, poverty levels rose to 77 percent of the rural population and to over 90 percent among indigenous rural communities. The degree of deterioration inthese indicators reveals the depth of the crisis and the greater vulnerability of the rural poor in dealing with their income losses. The subsequent international emigration of about 200,000 3 people-about 7 percent of the labor force-since 1997 has transformed the country into a highreceiver of family remittances.' 1.10 Formal dollarization was adopted on January 9,2000, despite the mixed degree of political support. By end-1999, it was clear that the economy could not make further progress without a radical change. Ecuador was devastated by a severe economic crisis and rapid hyperinflation, rising poverty, default on public debt, frozen bank deposits, and a collapsing banking system, production systems in disarray, and a major indigenous uprising, supported by members of the military, that led to President Mahuad' s resignation in January 2000. These groups, and left-wing political parties, opposed dollarization, in part on nationalistic grounds. In contrast, the middle class, industrialists (especially importers), and bankers supported dollarization both in Guayaquil and Quito. This support was critical for obtainingthe approval of dollarization lawsby CongressinMarch2000. 1.11 The decision of the new Administration that assumed power in January 2000 to maintain dollarization made it clear that Ecuador could no longer look back With dollarization, fiscal discipline and a series of incomplete structural reforms became essential to stabilize the economy, reactivate economic growth, reduce inequality, and improve governance. The dollarization framework, however, was incomplete. It lacked important pieces of legislationregarding the new accounting system, the conversion of contracts from sucres to dollars, and labor laws and other complementary laws. That i s why, immediately after assuming office upon appointment by Congress, President Noboa took initial steps to implement these reforms, leadingto omnibus reformlegislation in 2000-the so-called Trole law (Box I. established the minimum basis for dollarization, brought some flexibility into labor 1)-that markets, and widened the scope for private participation in services long provided by public enterprises. Improvement in the fiscal position relative to the pre-dollarization period, the progressive unfreezing of deposits, another timely boominoil prices, together with a more predictable policy environment under Box 1.1: The Economic Transformation Law-The TroleLaw Approved by Congress in March 2000, the Trole Law contains measures for transitioning to dollarization and a program of structuralreforms, most of which are still incomplete: 0 Dollarizarion: Prohibits the issuance of new sucres, except coins; obligates the Central Bank to a fixed exchange rate (25,000 sucres per US$1) and to withdraw all sucre notes in circulation; and requires all companies to convert their accounting to dollars. 0 Interest Rates: Approves a debt conversion mechanismcalleddesagio to transfer all dollar loans anddepositsto lower interest rates, which i s also applicable to prior debt issuedin dollars for a short period; and approves a procedure for establishing maximumlegal interest rates in the banking system equal to the London Interbank Offer Rate (LIBOR) plus country risk (as determinedby the Central Bank),plus4 percentagepoints. Financial Reforms: Strengthens and introduces flexibility in financial supervision, placing legal limits on the immunity of senior officials, and giving greater autonomy to the Superintendencyto intervene in troubled banks and dispose of the assets of closed banks; establishes a limit of US$S,000 on the previously unlimited guarantee on deposits; and establishes provisions for restructuring private sector debt to the banking system. 0 Public Spending and Deficits: The fiscal deficit cannot exceed2.5 percent of GDP, andthe three-year movingaverage must be limited to zero; establishes a limit on increases in current spending; and establishes provisions to make governmentcontracting more transparent. Private Participation in Infrastructure: Allows the construction of a new petroleum pipeline (OCP) by a private consortium, the participation of private firms in the management of telephone companies, and the sale of 51 percent of the shares in state electricity companies. However, this law failed to establisha complementary legal-contractual framework to attract a greater private participationinthe oil sector. Labor Market: Approves both areform making it possible to hire hourly workers at a minimumsalary of US$0.50per hour, andprovisionsunifyingextrabenefits basedon base salary. 1. Remittances have acted as a macroeconomic and social buffer. They have improved national income; have had a positive effect on the balance of payments, financing the current account, and contributing to the accumulation of reserves; and have allowed for improvements in private consumption that partially offset the decline in real salaries. Emigration, though, has also reduced unemployment, although at the price of eroding the country's human capital (and its social capital in rural communities). Other adverse effects from remittances are explainedinChapter 11. 4 1.12 Unilateral dollarization took place under very fragile initial conditionsand as a lastresortfor stopping highinflation and dealing with Ecuador's twin crises. In the late 1990s, Ta:Ei$ ~ ~ ~ spontaneous dollarization ratios were rather low, but rapidly increasing in Ecuador (Table 1.3). The share of dollar deposits in total banking deposits rose from 36.9 percent in 1998 to 53.7 percent in 1999 (De Nicol6, Honohan, and h e 2003). The country was far from meeting most standard preconditions for successful unilateral dollarization, too, including stable prices, a solid fiscal position, sustainable public debt, a diversified export structure to accommodate unfavorable shocks to its terms of trade, and a sufficiently high level of intemational reserves (at least to cover the monetary base) as a mechanism for absorbing capital outflows; a sound and competitive banking system under strong supervision to prevent the formation of contingent liabilities; flexible markets for nontradable production factors-particularly labor and real Source:Berg, Borenstein,andMauro (2003) on estate-to accommodate the price adjustments requiredto preserve IMFdata; andDe Nicola andOthers (2003). the competitiveness of the nontradable goods sector or adjust them The November 2002 Elections 1.13 The November 2002 elections resulted in a major shift in power toward nontraditional politics. President Lucio Gutihez, an outsider from the Amazonas region, was elected with support from a wide coalition of indigenous, peasant, labor, and business organizations on a mandate to fight corruption, promote economic recovery, and reduce poverty. The election of President Gutierrez's newcomer party, called Sociedud Putrio'tica (SP), reflected widespread rejection of the traditional political parties. These were made responsible for two previous decades of weak economic performance and rising poverty. The coalition of political forces behind SP was, however, fragile, and represented very diverse views. On the one hand, SP was initially supported by the Pachakutik Movement, the political arm of the Confederation of Indigenous Nationalities, CONAIE, and by the Democratic Popular Movement, MPD. Coalition members supported large-scale pro-poor spending measures, staunchly defended public sector administrationof public services and utilities, opposed free trade policies, favored a freeze on servicing foreign debt. Inthe second half of 2003, they withdrew from the coalition mainly due to differences with SP on economic policy. On the other hand, SP also includes a number of reformist military or middle-class technocrats and entrepreneurs not affiliated with traditional parties. The new Administration also obtained a minority representation in Congress, which required it to obtain the support of traditional parties to secure passage of its reform proposals inCongress. To this end, it has formed a fragile coalition with center-right parties. 5 Box I.2. The NationalDialogueProcess The National Dialogue was launched around five pillars of the govemment's national agenda: fighting corruption, promoting economic growth, reducing poverty and exclusion, promoting a sovereign international policy, and increasing security. The processbrings together a broadrange of govemment, private sector, and civil society actors who would normally not have the inclination or opportunity to communicate with each other. It began with working groups of civil society representatives in November 2002, who debatedarange of political, economic, and social issues, andconcludedits first phaseof activities ina first meetingheldin Quito in January 2003. A second Dialoguewas held in Guayaquilin March 2003 and a third one in Cuenca in July 2003. The process built on similar initiatives at the local govemment level. Considerable demands had arisen that the President keep this process open and make it increasingly inclusive and binding on the National Govemment, however the process was suspended when Pachakutik left the Coalition in August 2003. The Dialogue process served as a vehicle for building consensus for reforms, identifying areas of disagreement,andfor beginningto establishmechanismsfor monitoringthe implementationof agreedpolicies and actions, and it is hopedthat this processcan be resumed with a view to orienting public andprivateresources moreeffectivelytowards long-termpovertyreduction. . 1.14 President's Gutidrrez first steps inoffice were to launch a NationalDialogue, and announce the Program for Economic Restructuring and Human Development (PERHD). Through the National Dialogue (Box 1.2), the government hoped to achieve broad participation inand popular support of the Government's economic, social, and anticorruption agendas. The PERHD originally had three main pillars: economic, redistributive, and institutional policies. It recognized the precarious fiscal situation and the urgent need for short- and medium-term structural reforms to sustain economic recovery and reduce poverty. Ittargeted 11social indicators for 2003-07. Short-term economic policies encompass (a) an austerity Presidential Decree, "Norms for Patriotic Savings," which restrains public expenditure to attack the immediate liquidity problem; a 2003 budget consistent with such austerity norms; and an increase in fuel prices; (b) a tax reform; (c) a restructuring of the corruption-prone Ecuadorian Customs Corporation; and (d) the setting up of FEIREPfor debt reductionand countercyclicalfiscal policy. 0 Medium-term structural economic policies include (a) civil service reform; (b) completion of the financial sector reform; (c) strengthening of a Banking Liquidity Fund; (d) full liquidation of closed banks; and (e) new incentives to attract foreign investment, in particular in telecommunications, electricity, and the oil industry,startingwith tariff adjustments. Social policies include (a) the raising of the Bono Solidurio (cash subsidy) from US$11.5 to US$15 per month; (b) the increaseof pensions of retirees by US$5 per month; (c) the approval of a minimum transfer of US$15 per month for people over 68 years of age who were not receiving the Bono Solidurio; and (d) actions in the social sectors and the social security system, especially benefiting indigenous andruralpopulations. Institutional reforms contain (a) anticorruption policies, (b) modernization of the state, and (c) pro- transparency and citizen participation programs. To do so, the GOE organized Mesas de Didlogo and also announced its intention to revise the decentralization framework, while engaging civil society in the design and monitoring of the public budget. 1.15 One year later, the GOEhas refined the PERHDwith a clear view to implementinglagging reforms on the economic (structural), social, and governance fronts. In January 2004 President GutiCrrez made a review of the PERHD's first year. Main achievements in price stability, short-term fiscal consolidation and redistributive policies were underscored. However, President GutiCrrez recognized delays in approving measures to attract foreign investment-especially in the oil sector, in completing the financial sector reformagenda, inpassing telecommunications and power state companies to a private manager, in filling the structural social gap-especially education-and inimplementing an effective governance and anticorruption agenda. The PERHD has also had limited civil society support and faced important political constraints. Hence, while deepening its previous efforts on economic, social, and governance policies, the GOE added two new pillars to its poverty reduction agenda on productive and environment and security policies. Consequently, on the productive front, it announced 6 new policies for the oil sector; and in the telecommunications and power sector, new policies to reduce operational costs, while making further attempts to find a private manager, and preserving the trend toward market-determined tariffs; in the education sector, policies to improve quality at the primary and secondary level; and in the social security system, policies to broaden its coverage and improve its efficiency. Similarly, new emphasis was placed on developing active securitv policies to strengthen the safety net against naturaldisasters and economic shocks, and to preserve safe environment practices while enforcing existing regulations. These refinements, though, will build upon multiple progress achieved last year. The ChallengesAhead 1.16 Four years after dollarization, Ecuador is at an important juncture. The dollarization Trole Law explicitly indicated the minimumreforms under which it can be sustainable inthe medium term. If pursued, the country can reap the benefits of a monetary system that entails low rates of inflation and considerable predictability for longer-termplanning and investment, but which at the same time urgently requires the structural reforms that were neededbut not implementedbefore dollarization, to compensate for lost nominal exchange rate flexibility in responding to adverse external shocks. Implementing these long-overdue reforms, however, will require substantial commitment from Ecuador's population, together with solid Congressional support. That notwithstanding, domestic consensus i s hard to achieve when the country suffers a fragile fiscal position, severe rigidities in the economy, and external vulnerability to oil and commodity shocks. A heavy debt burden and high service payments also imply strong efforts to contain public expenditures and make them more flexible and efficient, which goes against populist expansionary policies and the regressive fiscal earmarking and subsidies that have resulted from ideological and regionalrivalries. 1.17 There is a unique opportunity to reform Ecuador toward a more participatory and transparent society, in which the fruits of growth are shared more broadly. The new Administration's commitment to reducing poverty, the scope for resuming a dialogue with civil society oriented towards poverty reduction, proposed measures in various public programs to strengthen public oversight so as to promote transparency and fight corruption, and the benefits of greater economic stabilization and early recovery that have so far come with dollarization, all represent opportunities that point to a significant break fromthe past. 1.18 President GutiCrrez faces a difficult political landscape in building consensus to overcome two principal sources of political risk: a possible reluctance on the part of some members of the ruling Congress coalition or the indigenous organizations to support reforms that affect vested interests or may be perceived as externally imposed. Political opposition in Congress remains strong and the Government's coalitions are fragile. Similarly, social movements have been more vociferous in their opposition to structural reform policies. Reforms, such as controlling the growth of the public payroll, improving the efficiency of public services, improving,the targeting of subsidies toward the poor, strengthening tax collections, signing a Free Trade Agreement with the U.S. and eliminating trade protections that favor a limited few, if undertaken, are expected to benefit a large share of the population, but hurt entrenched interests that could put up significant resistance either in Congress or in public demonstrations. Such outlook suggests that fiscal and structural reforms should pay more attention to the long-standing social inclusion and regional dimensions. In any case, the development path of Ecuador has no choice, but to find a concerted solution. Otherwise, ifconsensus-building and political will to carry through reforms falters, Ecuador i s likely to face the same fiscal and debt problems, concentration of resources, and poverty-enhancing inequality, and political gridlock that have held up progress for the past 30 years. 7 8 11. AN OVERVIEW OFMAJORDEVELOPMENTOUTCOMES 2.1 The recovery of the Ecuadorian economy remains fragile. Adequate ex ante fiscal and financial conditions, and accounting practices, were not presentwhen Ecuador announced dollarization in January 2000, and these have only started to be built ex post. As shown above, the adoption of the dollar as the local currency was a rather desperate move to address a massive capital flight from domestic currency and the banking system, and to reversehighinflation after a long period of monetary and sizable fiscal imbalances. Against this background, the outcomes of dollarization have been remarkable. Inthis chapter, we assess how the oil windfall and dollarization have combined with family remittances to bolster an otherwise mixed macroeconomic performance that has certainly contributed to eliminating hyperinflation, reaching moderate growth levels, beginningto restore and reestablish the banking system, and partially reversing the decrease in real salaries and increase in unemployment, poverty and, to a certain extent, social exclusion. However, it has left severalconcerns about fiscal balances, real exchange rate appreciation, the downside implications of family remittances, and the level of liquid international reserves. Then, we complete our review by exploring the central development outcomes that guide our design of Ecuador's development agenda. These reveal that although price stability and moderate growth are necessary conditions to combat poverty, they will be insufficient unless they focus on the strengthening of the dollarization regime under a participatory and inclusive approach, thus reaching broad sectors of the most vulnerable population (such as the marginalized indigenous, peasant and Afro- Ecuadorianpopulations). Long-Term Growth Trends 2.2 Ecuador grew strongly from 1975 until1980, andduringthis period realGDP Figure 11.1: EcuadorReal GDP per Capita per capita increased by 20 percent. Since 2000 US$ then, however, it has remained stagnant- 1400 first declining in the early to mid-l980s, then 1350 growing slowly until the late-l990s, only to 1300 fall significantly during the twin crises, until recovering after dollarization. Twenty-three 1250 years later GDP per capita still remains below 1200 its 1980 levels (Figure 11.1). In2002, Ecuador had a GNIper capita of US$1,450. 150 1100 2.3 Stagnation of per capita GDP has 75 80 85 90 95 00 been the direct consequence of economic 2. TFP is a broad measureof the flexibility of the economy and thus its ability to allocate a stock of productive resources to its most efficient use. It i s the "residual" factor, beyond factors accumulation, accounting for differences in economic growth across countries, regions, and time. All figures and estimates referring to TFP are taken from Loayza, Fajnzylber, and Calderon (2002). TFP typically accounts for up to 60 percent of total growth. TFP growth rates were negative in the 1980s for Ecuador. 9 growth was large and steady with respect to the 198Os, varying between 2.5 and 4 times the capital contribution, which declined sharply (Loayza, Fajzylber, and Calderon 2002). Figure IL2:TotalFactorProductivity vs. RealGrowth Rates, 1991-2000 3 - + / 2 - Chile + Honduras -4 1 Growth 2.4 Ecuador found itself at the bottom of policy performers in the LAC region (Figure 11.3). Figure11.3: LAC GDP Growth Rate Changes Structural reforms played a positive role despite their Between 1980sand1990s delayed and limited implementation, uneven stabilization policies played a neutral role, and external factors played a negative role. Evidence points out that in the 199Os, structural reforms accounted for about half (0.8 percent) of average GDP per capita growth achieved. Unevenly implemented stabilization policies had no impact, whereas external factors accounted for -0.4 percent of GDP per capita growth. 2.5 A simulation exercise suggests that Ecuador's greatest challengesand opportunities for achieving higher growth are related to the avoidance of a financial crisis, and to the areas of -1.5 -0.5 0.5 1.5 2.5 3.5 education and infrastructure. Inorder to assess the policy areas in which Ecuador has greatest challenges Stabilization UStructural ti! External ahead but also has the potential to achieve greatest benefits in terms of higher economic growth, Fajnzylber (2003) estimates potential increases in growth rates that could be achieved if, for each determinant of growth, Ecuador were to move to the 75 percent percentile of the LAC region, or to the 75 percent percentile of the world. Inthe f r s t scenario, Ecuador would achieve an annual rate of per capita growth of 2.7 percent, while in the second more optimistic scenario the expected rate of growth would be 4.53 percent. Indeed, just by avoiding a financial crisis over the next decade, Ecuador could grow at a rate 1.5 percent higher than during the 1990s. As for education and infrastructure, the payoff from reaching the regional best practices in each of them i s an additional 0.5 percent inper capita GDP growth, while achieving world best practices would provide 0.85 10 percent and 1.07 percent, respectively, of additional annual growth. To illustrate the relative importance of the above potential gains, it suffices to compare them with the ones associatedwith other reformareas. If, for instance, Ecuador were to reach sound international levels ininflation, volatility, trade openness, and financial development, its total growth gains would be 0.6 percent and 1.6 percent, respectively, for achievingLatinAmerican and world standards (Figure 11.4). Figure II.4: ProjectedGrowthAssuming Progressto Top25 PercentofLACandtheWorld FigureIIJ:GrowthRatesin NationalAccounts FinancialCrisis 30.0 Overvaluation 20.0 Volatility 10.0 Inflation Infrastructure 0.0 GovernmentBurden -10.0 Trade Openness financial Depth Mucation RojectedChange RojectedGrowth 000 100 200 300 400 500 1 I75thDercentileof LAC 0 75th Dercentileof the w orld1600 2.6 Domestic Factors: Demand Trends. A different way to look at growth decomposition i s by looking at the demand side of the economy. On one hand, there i s a declining contribution to growth from the tradable sector, especially the petroleum sector-related to both, low oil prices in 1992-95 and 1998-99 and a secular fall in maintenance expenditures on existing oil installations by PetroEcuador resulting in declining oil volumes-manufacturing and, to some extent, agriculture (Table A.2). On the other hand, there is a slightly increasing contribution to growth from nontradables sectors, especially constructionand services. If services and constructionare the main forces behindmodest rates of growth, then one would also expect steady modest growth rates inconsumption. Consumption indeedwas steady: it grew slower at the beginning of the decade, but then reversed only to grow faster than GDP infour of the six final years (Figure 11.5). For its part, during the 1990s, investment grew faster than GDP at the beginning of the decade, then markedly reversed in the year of the crises, and rapidly recovered its positive trend following dollarization. Such results are consistent with a patternof growth driven by high consumptionand public investment demand on nontradable goods in an inward-looking economy (Ronci, Sanchez, and Offerdal 2000).3 The average investment-to-GDP ratio, which was about 20 percent inthe two decades and close to L A C average, has risen above 22 percent in the 2000s, driven by public investment. Coupled with poor-quality spending, this would suggest low efficiency arising from protectionismand an overextended public sector, certainly not supportive of private sector-led growth. 2.7 The shift in relative prices toward non-tradable goods remains high and rising during the post-dollarization period. The declining price ratio between tradablehontradables goods renders the non-oil economy less competitive and shifts growth contribution toward production in nontradable sectors. The resulting bias in output composition toward non-tradable goods i s known as Dutch Disease (DD). To measure it, we follow the methodology derived by Chenery and Syrquin (1989). Norms for shares in GDP (SNi)are estimated for each sector (i). Changes inthese norms are owed to increased real 3. Disentanglingservices confirms this finding. Among all components of the services sector (construction, trade, transport, financial, public administration, and others), all except public administration had a negativecontribution to non-oil growth duringthe 1990s (TableA.12) 11 income per capita, which i s representedby non-oil GDP per ~ a p i t a .These shares are compared with the ~ constant price shares (Si). The DDIndex i s then defined as: 2.8 With agriculture and manufacturing considered to be non-oil tradable components and construction and services the non-tradable components, the DD index measures the shortfall inthe share of tradables in the non-oil (so-called `non-mining' in the Table) economy relative to standard norms coming from an internationalcomparison. Changes inthe DDindicate the direction inwhich the constant- price composition of GDP i s evolving relative to a "normal" ratio (Table II. 1). Table 11.1 SectoralStructure and Dutch Disease Index Sectoral Shares inNon-Mining Average Annual Change inConstant Norms Real Norms Real Norms Real 1993-99 1999- 1993 1993 1999 1999 2003 2003 2003 Amiculture 18.3 10.1 18.8 12.6 17.8 12.0 4.0% -1.2% Minufactwing 22.1 16.4 21.9 17.3 22.3 14.7 0.9% -3.9% Construction 6.5 10.4 6.4 8.3 6.5 10.1 -3.5% 5.2% Service 53.2 63.1 52.9 61.8 53.4 63.2 -0.3% 0.6% Dutch Disease 13.8 10.8 13.3 Change -3.0 +2.5 GDPicapita 1980 1799 1727 1858 Note: A negativevalue for the change inDDindicates a strengtheningof non-oil tradables relative to their expectedshare. DD= N o 2share of agriculture + Norm shareof manufacturing -constant price share of agriculture -constkt price share of manufacturing. 2.9 Higher shares of construction and services than their "normal" levels already suggests the presenceof a bias toward production innon-tradable goods in Ecuador. Between 1993 and 1999, a negative value for the change in DD indicates a strengthening of the non-oil tradables relative to their expected share, which reflects some improvement of the DD index during this period. This was partly due to the decline in oil prices and depreciating nominal exchange rate. This trend, however, reverses post-dollarization. Between 1999 and 2003, the positive value for the change in DD, which reflects a deterioration of the index, suggests a strengthening of the nontradable sector. The DD index practically reverses to its 1993 levels, possibly explained by the oil windfall, increased flows of family remittances, recovery in consumption, and appreciating real exchange rate until 2002. In the future, mitigating its potential multiple effects-the inflationary pressures, decline inthe export sector, and worsening of the trade deficit-is critical inthe era of dollarization. Mixed Macroeconomic Performance 2.10 The record of both economic performance and policy implementation has recently beenmixed. This was due, to an important extent, to fiscal slippages that occurredat the end of the previousadministration. Theseslippageshavebeenpartially offsetby risingoil prices andlow internationalinterestrates, andbymeasures to pay off arrearsandtightenfiscalpolicy underthe presentadministration. 2.11 Dollarizationoftheeconomyhasgeneratedfavorableresults(Figure II.6 andTable II.2). 4. Normswere derived from Chenery and Syrquin (1989,Table 4). 12 NonRnaeidM i csedor (%dcioq edmcedFaymb (%dGOP) 107 10.0j 5 50 0 0.0 -5 -5.0 J-01 A-01 J-010-01 J-02 A-02 J-02 0-0: J-02 A-02 J-Oh 0-02 -m(+dqrec) -TmdTrade o The periodof highinflationendedin2001and consumer pricehilation continuedto decline in2003. In 2000, dollarkation did not prevent the domestic price level from continuing to rise rapidly, following a sharp depreciation of the currency from 8,000 to 25,000 sucres per dollar, fueled by the turmoil in the financial markets.5 However, the end-year annual inflation fell to 22 percent in2001, reached single digits in2002, and fell to 6 percentin2003. This rather slow decelerationof inflationcorresponds to the behaviorexpected from a recentlydollarized economy, where the domestic inflationratetends to be determinedby intemational inflation, the lag in relative price adjustments: control of certain managed prices that belong to the basic basket, and expansionof domesticdemand. 5. There were two factors that contributed to the large depreciation rate of the sucre: the intent to avoid a real appreciation after dollarization on account of "residual inflation," and the need to increase the purchasing power of a limited level of intemationalreserves (dollars) to buy (cheaply) the monetary base in sucres at a more depreciatedexchange rate (Beckerman and Solimano 2002). This slow price-adjustment mechanismhas also been observedinEstonia, when adopting a Currency Board. 6. The initialand significant increasein prices in 2000, after dollarization, and the slow and gradualdecline afterward is not an experience unique to Ecuador, and i s associatedto the domestic price adjustment following a large depreciation of the official exchange rate. Many former Soviet Republics experiencedthe same phenomenonwhen establishing their Currency Boards. Assessing the "equilibrium" real exchange rate, innominal terms, is difficult. On one hand, there is an undervaluationrisk of the domestic currency at the rate selected, especially if the currency has depreciatedsignificantly during the months preceding dollarization (Beckerman and CortCs 2002). On the other hand, there is an overvaluation risk to the point that the "conversion" exchange rate might not be credible to economic agents. Ecuador chose to guarantee credibility by running the risk of undervaluation. 13 Table 11.2: Ecuador: Selected Economic Indicators (As a share of GDP, unless otherwise indicated) 1999 2000 2001 2002 2003(p) 2004(e) I.NationalAccounts Gross Investment 14.7 20.1 25.7 27.7 25.2 23.5 Gross Domestic Savings 19.4 25.4 22.4 22.8 23.5 24.1 Foreign Savings 4.6 5.3 -3.3 -4.9 -1.7 0.6 Public Investment 3.8 2.9 3.5 4.4 3.1 3.3 Public Savings 0.9 6.9 7.1 7.2 6.6 7.3 Public Savings Gap 2.9 -4.0 -3.6 -2.8 -3.5 -4.0 Private Investment 11.0 17.2 22.1 23.3 22.1 20.2 Private Savings 18.5 18.5 15.3 15.6 16.9 16.7 Private Savings Gap -7.5 -1.2 6.8 7.7 5.2 3.5 1I.Non-Financial Public Sector* Total Revenues 22.5 27.6 24.7 26.0 25.7 26.1 Petroleumrevenues 6.2 9.2 6.4 5.7 6.2 6.3 Non-Petroleumrevenues 15.5 17.5 17.7 19.4 18.9 18.9 olw Tax Revenues 9.1 11.7 12.3 12.5 11.8 11.8 olw Social security contributions 1.4 1.3 2.2 3.2 3.3 3.2 Public enterprisesurplus 0.8 0.9 0.5 0.9 0.6 0.9 Current Expenditures 21.2 21.0 17.6 18.8 18.6 18.8 olw Interest Expenditures 8.1 6.6 4.7 3.5 3.0 2.8 olw Wages andSalaries 7.1 5.7 6.9 8.2 8.5 8.4 olw Goods and Services 3.1 3.3 3.2 3.6 3.5 3.3 Capital Expenditures 6.0 5.5 6.7 6.4 5.4 5.1 Primary Balance 3.4 7.7 4.3 4.5 4.7 5.0 Overall NFPS Balance -4.6 1.o -0.5 1.0 1.7 2.2 olw Non-oilNFPS balance -10.9 -8.1 -6.9 -4.7 -4.5 -4.1 III.BalanceofPayments Exportsof GNFS 31.6 37.2 27.2 25.4 26.2 28.7 Imports of GNFS 23.1 29.3 29.8 30.4 27.8 27.8 Trade Balance 9.0 8.2 -2.2 -4.6 -0.8 1.6 Worker's Remittances 7.9 9.6 6.7 5.4 5.8 5.4 Current Account Balance (-deficit) 4.6 5.3 -3.3 -4.9 -1.7 0.6 Capital Account Balance -9.6 1.4 2.5 3.9 2.5 -0.6 ForeignDirect Investment 3.9 4.5 6.3 5.2 5.8 4.6 Reserves (MlnUS$) -254.0 775.7 595.2 396.2 453.0 553.0 IV.CreditworthinessIndicators** Public Debt/GDP 101.2 91.4 70.2 58.3 53.2 48.6 Public Extemal Debt Service1Exports of GNFS 27.7 28.7 26.5 22.0 19.5 17.6 EMBI+ (bp, eop) 2650 2866 1233 1801 799 Memorandum items: Consumerprice (% eop) 60.7 91.0 22.4 9.4 6.1 3.0 GDP growth -6.3 2.8 5.1 3.3 2.6 4.5 GDP inUS$ 16,674 15,934 21,024 24,311 26,913 28,968 Notes: ~~ * This table containsminor differences with the Statistical Annex because it contains IMFinformationthat uses a different ** methodology with respect to the BCE. The Statistical Annex i s only basedon the BCE. Includes arrears and adjustment for exchangerate variation anddiffers from records inbalanceof paymentsinthat the latter does not include earlier payments or refinancing. Therefore the debt numbersdiffer with respect to Table A.8. Source: Central Bankof Ecuador, MEF, and IMF. Information updatedas of April 2004. 14 o Economicrecoveryiswell under way, althoughgrowth slowedin2003. Inthe samevein, benefitingfrom a positive extemal environment characterized by highpetroleumprices and low intemational interest rates, GDP grew 5.1 percent in200L3.5 percentin2002, and endedat 2.6 percent in2003. This recovery is alsoexplained by the increase indomestic demand (particularly private demand), stimulated intum by highpetroleumprices, growing remittances representing 5.8 percent of GDP in 2003, increases in nominal mini"and average salaries in dollars-which practically doubled between Apnl 2000 and October 2002-and dynamic private investment. The modest, but positive inpercapita terms, growth rate of 2003 was affectedby a decline inthe volume of oil exports, especially a fall of 8 percent of production by PetroEcuador. However, prospects for recoveryin2004areoptimistic, withprojectedgrowthratesabove4.5 percent. o Domestic private investment and credit have reactivated, although they also slowed in 2003. Private investment has recovered(and surpassed) its 1998 level at about 22 percent of GDP. Private credit reached an average 15 percent annual growth during2001-02, but slowed down to 5 percentin2003. Suchpattem is also consistent withthe gradualrecoveryofthe bankingsystemandtrends indomestic demand. o Domestic interest rates have declinedinline with international interestrates, but with some lag. With dollarization, the elimination of exchange risk should have allowed for a rapid and significant decline in nominal interest rates, but this did not happen immediately, due to high domestic inflation. Between April 2000 and late 2002, the decline was rather slight, barely 3 to 4 percentage points, and less than the nearly 5-percentage-point decline in intemational interest rates.7 However, as inflation fell into single digits and the financial system recovered, domestic interest rates have continued to fall. InDecember 2003, with a lending rate of about 11percent and inflation at 6.1 percent, Ecuador's real active rates were close to the prime rate inthe United States. Real passiverates, however, were stillnegative, which does not contribute to increasing financial intermediation. Interest rates in Ecuador, however, remain high when comparedto those fromother countriesinLatinAmerica, indollar or dollar-equivalent terms. o Realsalary levelsandunemploymentratesare practicallyback to their 1998levels. Inpart, this is due to economicrecovery and extemal migration. Openunemploymentwas 9.8 percent in 2003. Underemployment, however, continues tobe25 percenthigher, reflecting deeperchangesinlabormarkets(TheWorldBank,2004).8 o Externalbalances are sound. Supportedby favorable terms of trade, total exports have had positive rates of growth and reached 19.3 percent in 2003. This export dynamism is the combined result of the windfall inoil exports, which rose 26.4 percent, and non-oil exports, which rose 14.3 percent.' Nonetheless, and despite significant family remittances, the extemal current account deficit increased to 4.9 percent of GDP in2002, as imports associatedto the constructionof the new pipeline for heavy crude oils (OCP) rose sharply, representing about 3 percent of GDP. In2003, however, this deficit morethanhalvedto 1.7 percentof GDPas the OCP was completed. Forits part, thecapitalaccount benefitedfromthe modestreversalincapital outflows since 2001, and the constructionof the OCP that has attracted steady flows of foreign direct investment (FDI) averaging 5.7 percent of GDPinthe lastthree years. FDIfigures are consistent with foreign private investors' preferences for channeling funds to a sector with a tradable output in a country with a history of defaults and with downgraded internationalpublic credit. o Country risk has significantly declined with respect to pre-dollarization levels, with a significant reversion in the upward trend prevailing at the end of the previous administration. In December 2002, the spread of Ecuadorian bonds was the second highest in Latin America with an upward trend: about 1,801 basis points-above Brazil and the average for Latin American bonds-and increasing since 7. At the end of an inflationary episode, commercial banks tend to raise real interest rates in order to adjust to new prices, generate greater revenuesandrecover part of the losses from decapitalization, inreal terms, that occurredduring the episode. This happensbecause interestrates never increase as much as prices during crises. 8 The World Banki s concluding a Poverty Assessment that will deal with employment and labor issues. 9. A puzzling developmenthas beenthe evolution of nontraditional exports, which reachedan annualgrowth rate of 20 percent in 2001, then at a rate close to zero in 2002, and double digits in 2003. Nonetheless, it should be noted that the tax authorities indicated that the 2002 figure reflects a significant underassessment of exports, which i s explainedby tax evasion. 15 April 2002 when no agreement was reached with the IMF (Figure 11.7).1° Since then, this trend has reversed with a marked decline of over 1000 basis points up to January 2004. Indeed it i s part of a regional trend, but worth noting that Ecuador andLatin American EmergingMarkets BondIndex (EMBI) differences have also narrowed, with a significant absolutedrop for the former. Even thoughthe January 2004 level-720 basis points-was the lowest since dollarization, the country still has difficulties to tap from the intemational capital markets with new debt issues. In February 2004, Moody upgraded the rating of Ecuadorian debt to Caal from Caa2, citing a stable environment with improved fiscal management and a future lower debt level, mostly due to revenue generated from private sector oil production, Figure11.7. Ecuador'sFinancialRisk (inbasis points) 5 0 0 0I 4000 3000 2000 1000 0 Jan- A p r - Jul- Oct- Jan- Apr- Jul- Oct- Jan- Apr- Jul- Oct-Jan- Apr- JuI- Oct- Jan- Apr- Jut- Oct- Jan- A p r - 9 9 9 9 9 9 9 9 00 00 00 00 01 01 01 01 02 02 02 02 03 03 03 03 04 04 Source: JP MorganEMBI+ 2.12 At the same the, there are developments inthe fwal, real exchange rate, remittances, and financial policyareasthat warrant closeattention. o Post-dollarization fiscal performance has been mixed, expansive in terms of current spending and steady interms of revenues, making it hard to achievehigher primary surpluses. To service high debt levels, Ecuadorrequiressizableprimary surpluses of around4-5 percent of GDP (see below). Decliningfrom a peak 7.7 percent of GDP in2000, primary surpluses of the Non-Financial Public Sector (NFPS) fell to 4.3- 4.5 percent of GDP during 2001-02, but increased to 4.7 percent of GDP in 2003. Obviously, primary surpluses would havebeenhigher ifnot for the expansivebehavior of current primary spending." Inaddition, the composition of primary surpluses sufferedtwo important modifications between2000and2003. First,part of the savings obtained in interest payments-3.6 percent of GDP-was used to cover salary increases inherited from the Noboa administration of about 2.8 percent of GDP. Spendingon salaries and on goods and services almost doubled comparedto predollarization levels-from US$1.181billion and US$511million in 10. Notethat the spread has decreasedsignificantly sincedollarization,butremainssensitive to intemalandextemalshocks. 11. Itshouldbenotedthat fiscal surpluses inthe NFPS do not includeextraordinaryoutlaysto support the recapitalizationof the banks, equal to an estimated 1.5 percent of GDP in2001and 1.0 percent in2002, with which they would become adeficit. The 2002 surplus includesthe floating debt estimatedto be US$722million in late 2002, (US$181 million in arrears to the Paris Club andUS$541million inaccountspayable, the breakdownof which is unknown), accordingto top officials. 16 until 2000, propelled by an increase in prices for Figure 11.8:Real Exchange Rate Appreciation and Productivity tradable goods that were affected by the sharp depreciation in the Sucre; but it subsequently fell due Real Bilateral Exchange Rate with the us to larger increases in prices for nontradable goods Based on CPI and Unitary Labor Costs after dollari~ation.'~The combination of both trends 180 - reflects an appreciation in the real exchange rate until 180 - 140 - 2002 (Figure 11.8). Note that estimated real 120 - appreciation is much lower when calculated on the basis of unit labor costs (8.1 percent) than when calculated on the basis of consumer price indexes (62 -Labor Costs - 2 ' CPI percent), in the case, for example, of its principal trading partner-the United States-between 2000 and Relationship between Productivity and Relative 2002. This trend has however reversed in 2003, since Prices of Tradable/ Nontradable Goods a weak dollar helped Ecuadorian exports not to lose competitiveness o Family remittances are a mixed blessing leading to a positive transformation in the __--- Ecuadorian economy, but containing some adverse effects that should be corrected. Ecuador has become, inper capita terms, the country with the third- >car w*<%"Id Ramk h r dunJlr Imm JU BLE "IU d ~ n Fl2plyllunt highest remittances in Latin America. Ecuadorian \ Y W C ~ L remittances have four distinct characteristics in comparison with the trend in Latin America: they are 12. Goods whose prices are determined by intemational markets are known as "tradable" goods, and goods whose prices are determinedby the domestic market are known as "nontradable" goods. 13. The laborproductivity series (productllabor) i s constructedusingdataon urbanemployment rather thannational employment becausethe latter i s available for only 2000 and2001, whereas product is national in that there are no urbanproduct series. The price series uses the BCE's producer price index for tradable goods and the urbanconsumer price index, also produced by the BCE, for nontradablegoods. Thus, bothindexesare proxies of real values. 17 shocks, typical of a nondollarized economy, is ;; 4o Fierrc-Renoy nonexistent. Although the amount of intemational reserves required under dollarization i s less relevant -c 20 than under a flexible exchange rate system because FiscalPolicy and PublicDebt Sustainability 2.13 Estimates of Ecuador's net worth suggest a considerable decline that makes past fiscal policies unsustainable under a passive scenario." The erosion of net worth is equivalent to a country continuously living beyond its means for an extended period of time, supported by the depletion of a single resource. Oil revenues have been exhausted steadily in the last 3 decades (around 150 million barrels a year), and consumed instead of invested or used to lower public debt. Calculations of the decline in net worth vary between 32 and 48 percent between 1970 and 2002 (Figure 11.9).18 With oil 14. However, there are two key differences betweenthe remittances and the petroleum booms: their duration, inthat remittances tend to provide a more permanentpositive extemal shock-usually 7 to 10 years-than booms; and the productive use of resources, given that in comparison with petroleum earnings, higher shares of remittances tend to be consumed in investmentsin nontradable goods, rather than in imports. Both differences make remittances a welcome phenomenon, the use of which can be maximized. 15. Note that the role of lender of last resort was irrelevant to avoiding the banking crisis prior to dollarization. We speak of "minor" contingenciesthat do not include the possibility of a large number of depositors withdrawing their deposits from the banks. Should that happen, then in the absence of altemative liquidity mechanisms either interest rates would have to rise to extremelyhighrates in an attempt to recapturedeposits, or another banking crisis could occur. 16. "Excess" intemational reserves, a concept that is appropriate to a dollarized system, results from deducting from the total amount of freely disposable reserves the intemal liabilities of the Central Bank, which include the currency and paper it issues and the deposits of commercial banks in the Central Bank. Excess reserves increase particularly when the govemment makes deposits to the Single Treasury Account (including IESS and FEIREP ones), and thus these deposits become akey variable/goal of the macroeconomic program. 17. This sectionsummarizesfindings from Traa (2003) and Fierro-Renoy andNaranjo (2003). 18. Estimates vary becausethe lower ratio includes as liabilities the social debt, that is, the cost of nonprovision of certain basic social and infrastructure services by the State. Both estimates, however, include the actuarial deficit of the Ecuadorian Social Security Institute(IESS). 18 2 projected 6.2 percent of GDP in 2003 50 (Table 11.2). The efficiency of tax 0 0 0 0 0 collection has been low. According to a 40- 0 0 O O eoo WDI forsamplethe oflast150threecountriesdecades,trackingthe data 30- correlation between the logarithm of per 0 0 0 0 0 capita GDP and the tax-to-GDP ratio 8g 00 080 0 2o- o O m o 0 0 0 0 0% 0 was 12.4 percent, well below the ratio a 0 0 0 - 0 8:o 0" ooo O predicted by the regression of 19.8 0- 0 0 percent, a difference of 7.4 percent that 10- 9 oOQ &adso op reflects a sizable gap that has to be filled 0 0 8 with sustained improvements in tax 0 0 19 negligible and, given the seasonal nature of tax revenues and the unpredictability of extemal disbursements, it contributes to continuouscash problems andprevents quality spending with adequately plannedcash outlaysredirectedtowardpriority socialprograms. o Government spending is of poor quality and misallocated, due to its high fragmentation, Figure11.11: Do you believethat the weak controls, poor targeting and no governmentspendsthe tax money transparency. Barely 7 percent of Ecuadorians well? believe the governments spend their taxes (Country PercentageTotals, Latin Barometer 2003) wisely (Figure 11.11) (Latin Barometer 2003). - Six out of seven Ecuadorians a f f m that the Chile 27 - 22 -19 -1s - budget allocations by the Executive fail to Honduras 26 correspond to state policies oriented toward the ElSalvador Nicaragua well-being of Ecuadorians and according to a Brasil national development plan (LAC Index on Venezuela - 18 Budget Transparency 2003). Four reasons Argentina 17 - explain such perceptions. First, the Costa Rica 16 preallocation of some 30 percent of spending in Paraguay 14 more than 50 different agencies and 242 Paname -14 sectional governments (provinces and cantons) Uruguay -14 that are not subject to any regular coordination, Bolivia 12 Colombia - 11 targeting, monitoring, or evaluation mechanism Guatemala 10 leads to fragmented budget execution," to a Mexico -9 lack of control over spending, and to serious Peru -9 obstacles for allowing budgetary transparency Ecuador -7 and accountability. Second, financial management systems are decentralized by law A. Latina 15 I I to executing agencies, but are incomplete, 0 10 20 30 because these are carried out under an Integrated Financial Information System (SIGEF) that covers a nonconsolidated budget, encompasses only a portion of spending by the central administration, excluding the decentralized and sectional agencies,20 and reveals non virtual, lagged, and incomplete data on execution. Third, absence of controls i s well rooted. Budgets are closed out more than a year after the end of the fiscal year, with subsequent verification by the Office of the Comptroller even later, and public institutions, like the municipalities, do not even publishtheir financial statements. Fourth, poor targeting (especially for socialprograms) and lack of budget transparency are generalized (see Chapter 111). 2.15 During the last 30 years, Ecuador has been struggling to control the heavy burden of servicingits debt. Part of the problem lies inthe fiscal structure the country inherited from the military regime: a big bureaucracy coupled with dependence upon highly volatile oil revenues, subsidies, and earmarked expenditures. However, there are other reasons: persistent bad fiscal management practices, including sizable wage hikes in the public sector unrelated to productivity; inflation; and the distorted exchange policies of the past. All of these factors have conjoined to make fiscal accounts especially vulnerable to extemal crises, compelling the country to default and restructure its debt on two occasions inthe 1990s. The first was in 1994, after a seven-year suspensionofdebt service, withthe introductionof Brady bonds, and the second in 1998, when Ecuador became the first country to default on its Brady bonds, necessitating restructuring inthe form of global bonds. After the second default, Ecuador reached an agreement inJuly 2000 with private bondholders to swap its Brady bonds and Euro bonds for new 12- and 30-year bonds, at a rate of US$0.60 on the dollar (up from a value of less than US$0.30 on the dollar 19. The fragmentation of spending is understoodinthe broadsense, that is, basedon the preallocation of revenues and expenses. 20. SIGEF covers about 84 percent of CentralGovemment spending. 20 before the swap). The 30-year global bonds paid an initial coupon of 4 percent, increasing by 1 percentagepoint annually upto a maximumof 10percent in2006. Inexchangefor an additional discount on the value of the debt, 12-year bonds were offered at a 12 percent fixed coupon. As a result, external debt stock in private bonds dropped from US$6.5 billion to US$3.9 billion. When compared to other deeply indebted Latin American countries, Ecuador not only has a high debt but also a limited institutional capacity for debt management: it i s more operational than analytical, lacks transparency, i s fragmented, and i s poorly coordinated between the Finance Ministry and the Central Bank. Last year, however, the Government was able to complete a debt reduction plan, in agreement with the fiscal rule. Supported by the Plan, it cleared all 2003 external debt arrears, initiated bilateralrenegotiationwith Paris Club members, and issued guidelines for subnational debt. In2004, it expects to define debt reporting requirements in the MEF website, especially for the incoming use of FEIREP resources; complete bilateral debt renegotiations with Spain, Germany, France and Norway; and sets the ground for a US$500 millionbond issue inthe internationalmarkets. 2.16 Public debt ratios have improved, but these are still high and illiquid. The stock of public debt was estimated at 101.2 percent of GDP in 1999, more than twice the level of exports of goods and services, and the highest in Latin America after Argentina (before the crisis). Despite declining to 53.2 percent of GDP in2003, the debt level and service burden i s still excessive, creating continuous problems of illiquidity. About four-fifths of total debt i s external debt. Of this, some 65 percent i s official debt- 40 percent multilateral and 25 percent bilateral-making it somewhat less vulnerable to changes in emerging markets and offsetting the country's lack of access to international markets. Nearly two-thirds of domestic debt consists of bonds issued by the Deposit Guarantee Agency (AGD) and the National Finance Corporation(CFN) to cover the cost of bank interventions duringthe bankingcrisis. At the onset of the present administration, Ecuador also had immediate liquidity problems with arrears to the Paris Club estimated at US$181 million and a scheduled amount of debt service of about 8.1 percent of GDP (4.7 percent in amortizations and 3.4 percent in interest for 2003-04). The outlook of the three major risk-rating agencies i s that the country's ability and desire to pay have improved with dollarization, but with CCC+ (Standard & Poor's) or Caal (Moody's) ratings, Ecuador i s still not eligible for a level of investment that would allow it to issue new sovereign bonds on international capital markets in the near future.21 2.17 Complying with the Law on Responsibility, Stabilization, and Fiscal Transparency is essential for debt sustainability. The law determines that a ratio of 40 percent of debt to GDP i s consistent with a sustainable debt path, and it i s achievable by 2006 (Box El). Based on several assumptions, our debt sustainability analysis (DSA) determines that such goal can be met with sustained gradual efforts.22 For example, in 2004, bringingthe debt-to-GDP ratio down from 53.2 percent to 48.6 percent, the government needs a minimum estimated primary surplus of 4.5-5.0 percent of GDP and cover a financing for 4.2 percent of GDP. Neither the cost of fiscal adjustment nor the necessary amount of financing i s by any means figures to be taken lightly. The picture i s roughly similar for 2005-06. The country must then obtain successive primary surpluses of above 4.5-5 percent of GDP during 2005-06 (see Tinsley 2003).23 Incompliance with the fiscal law, the assumptions of the model include maximum noninterest expenditure real growth of 3.5 percent, an annual reduction of the non-oil-related fiscal 21. A risk rating of C means that the issuing institution has obvious deficiencies, probably relatedto the quality of its assets or the poor structuring of its accounts (fiscal in this case). This leads to a considerable degree of uncertainty and reasonable doubtsregardingits ability to confront additionalproblems inthe future. 22. Debt sustainability is achieved when the value of future streams of public sector primary surpluses matches the market value of public debt, that is, the long-term public sector budget constraint does not break down. Business cycles and long-term growth trends impinge in obvious ways on fiscal sustainability through the size of the tax base. A reverse feedback also holds: the size and quality of public spending, and the tax system burden and subsidies are bound to affect long-term economic performance. A subtler linkage is the tradable-nontradable price ratio. It is a widely accepted stylized fact that this ratio shows a secular decline as the economy grows. Inthe same vein, the ratio tends to be lower inbooms andhigher in recessions. 23. For afull presentationof the assumptionsof the model andthe calculations, see Tinsley (2003). 21 balance by an average 0.2 percent of GDP, and mandateddebt buyback with 70 percent of resources from the oil fund. Box 11.1: The Law onFiscalResponsibility,Stabilization, and Transparency The law was approved inJune 2002. Its objectives are: to reducepublic debt, contribute to stabilizationand fiscal sustainability, use the savings by directing it to investments that encourage economic and social development, and establish regulations on public finances and transparency for efficient management andeffective citizen oversight. The law approves the following commitments: Approval of a multiyear plan at the start of each government for a period of four years to guide spending and establish quarterly goals for each institution inthe NFPS that canbemonitored. Central primary spendingmay not grow by morethan a realrate of 3.5 percentper year. The total deficit, without petroleumexport revenues, will be reducedby 0.2 percent eachyear. The debt-to-GDP ratio will fall 16 percentage points during 2003-06, and a similar provision will be applied to subsequentyears untilthe ratio reaches 40 percent. The real value of the state's debt to the Ecuadorian Social Security Institute (IESS) will bepaid off. For sectional (provincial and municipal) governments: The ratio betweentotal annual liabilitieshevenues must not be greater than 100percent;andthe ratio betweendebt serviceltotal revenuesmustnotbe above 40 percent. Resources from the budget surplus and revenues from the OCP (incremental based on no lower utilization by SOTE of light petroleum) will be the principal source of the FEIREP. FEIREPresources will be distributed as follows: 70percentto repurchase external debt andpay off debt to the IESS, 20percent to stabilize petroleumrevenues untilreaching 2.5 percentof GDP andto cover emergencies, and 10percentto education andhealth. The MEFwill establish anofficial information and dissemination system, as will the sectional governments. The annual budget will include the quarterly projection of revenues, tax spending (and budget headings to offset it), the list of productive and unproductive assets; contingent liabilities and fiscal risks, and an estimate of profits from state companies and autonomoussystems. 2.18 The oil fund will have animpact on debt buyback, butlessthaninitially expected. Although the new oil pipeline will increases total daily capacity to over 900,000 barrels per day (bpd) from the previous 400,000 bpd, the government believes that the maximumuse of the pipeline will only be about 600,000 bpd, that is, 200,000 bpdfewer than its original projections. This inevitably reducesthe expected windfall in government oil revenues, since it will probably take until 2008 for production to reach such amount. Moreover, the oil fund's resources will depend on the marginal increases in oil production over those of the existing pipeline, and this in turn depends heavily on the government creating the right investment environment. However, the problems that have arisen in resolving the controversy surrounding the value-added tax (VAT) rebate dispute between the government and the oil companies have possibly delayed the attractiveness of new investments inthe oil fields. With production not coming online as quickly, funds for debt repurchasing couldnot accumulate as rapidly as expected. Our estimates indicate that debt repurchasing i s expected to amount to US$630 million between 2004 and 2006, equivalent to about 5 percent of current public debt stock. Deteriorating Competitiveness 2.19 Competitiveness is essential for faster and sustained growth. A rapid look at international trade figures suggests that the country's competitiveness i s losing ground inthe medium-term. Ecuador switched from predominant trade surpluses in the mid-to-late nineties to successive deficits afterward (- 4.6 percent in 2002), only to partly recover to -0.8 percent of GDP in 2003. This i s largely explained by four factors: oil exports below potential (in spite of high oil prices) due to reduced oil production by PetroEcuador; falling exports in the banana and shrimp industries due to market access problems in Europe and pest problems, respectively; loss of competitiveness relative to neighboring countries Perti and particularly Colombia, the currencies of which depreciated sharply against the dollar; and growing imports (20.6 percent in 2002) of consumer goods, and intermediate and capital goods (mostly for the OCP pipeline) as Ecuador's productive sectors recovered under dollarization. Improvements in five indicators are critical to show marked improvements in competitiveness: trends in tradable vs. 22 nontradable ratio (as a proxy for the real exchange rate), the competitiveness gap, the degree of economic integration with the United States, the degree of flexibility of the labor market and the technology gap. Findingsare consistent with declining growth due to negativetotal factor productivity, as indicatedabove. o Tradable versus nontradableratio. Evidence analyzed above (Figure 11.8) points to a negative trend up to 2002, only slightly reversed in2003, thus raisingjustified concerns over the losing competitiveness of the Ecuadorian economy. This finding i s consistent with severe institutional rigidities in labor markets, in which nonflexible hiring practices of Ecuador's civil service and tight credit rationing in the domestic banking systempost-dollarization play a significant role (see below). o Competitiveness gap. Internationalcapital mobility (andto a much lesserextent labor mobility) makes a country's ability to keep domestic investors and attract foreign investors a crucial competitiveness asset. Nearly all global indicators show indisputable and consistent evidence that the country's competitiveness gaps are significant and growing. In2001, Ecuador ranked 54" out of 62 countries evaluated in terms of global competitiveness duringthe World Economic Forum In2003, Ecuador's rankingdeteriorated even further when it was classified as 86" among 102 countries, due to impediments ranging from judicial unpredictability to bureaucracy to financial sector weaknesses and low adoption of technology. The costs of doing businessremainhighcompared to other LatinAmerican countries (Table 11.3). Table 11.3: The CostsofDoingBusinessare HighinEcuador LatinAmerica EastAsia Costs of DoingBusiness Ecuador Chile Colombia Peru Malaysia Thailand Number of procedures to legally 14 10 18 8 7 8 operate business Cost to legally operate business (% 65.1 13.6 15.3 22.5 26.6 6.7 of GNIper capita) Source: World Bankdatabases (WDI & DoingBusiness). o A declining degree of economic integration with the United States. Successful adoption of a foreign currency as a domestic one often requires close integration with the corresponding foreign currency area. Integration i s understood in a broad sense, but measured through trade openness and factor mobility. In the case of Ecuador, trade openness-measured as the sum of exports and imports to GDP ratios- increased compared with the pre-dollarization period, from 40.5 percent in 1998 to 44.8 percent in 2002 inGDP terms. Whereas the United States preserved its share as the major exuort receiver (39 percent) during 1998-2002, followed by Latin America and Europe, on the import side, the share of imports from the United States declined from 30 percent of total imports in 1998 to 23 percent in 2002, and this fall was offset by a significant increase of imports from Latin America. This trend i s consistent with the general nominal depreciation of neighboring countries' currencies relative to the dollar. Factor mobility refers to labor and capital mobility. Significant emigration flows have gone hand in handwith positive, but declining, growth of family remittances. Capital mobility has had reversing trends. The massive capital flights of 1999 and 2000- equivalent to -10.8 percent of GDP in 1999-were partly recovered by FDIinflows during2001-03, as manycommercialbanks still keep sizable amountsof deposits abroad. o Limitedflexibility of the labor market. Without an exchange rate policy, there are limited instruments to respond to adverse shocks. Private labor market rigidities, with highcosts not only for production but for goods and services, might leadto negative effects on competitiveness, growth, andjob creation, which could threaten dollarization's sustainability. The risk lies inthe fact that, given inflexible markets-such as the formal labor market-adjustments to shocks occur primarily through reductions in amounts produced (and sold), with the contraction in demand based on inputs, particularly labor. Modem labor market legislation i s also critical for the success of free trade negotiations and, by the same token, competitiveness. Whereas employment indicators show there has been some recovery fromthe impact of the end-of-century crises, the underemployment rate, however, remains 25 percent higher than in 1998, which reflects that a growing number of workers work less than 40 hours a week (visible 23 underemployment), or are paid less than their stipulated wages (invisible underemployment). Severance payments are also highest inLAC (average of 4 monthshalary), except for Bolivia. The minimumsalary- adjustment system still suffers from compulsory indexation to inflation, a heterodox mechanism that i s only adequatefor countries suffering for hyperinflation. Such outcomes reveal that despite the Economic TransformationLaw introduced a simplified wage policy inthe private sector and new and more flexible forms of hiring through hourly and temporary contracts, didnot fully remove labor market rigidities. o Technology gap. Technologicalinnovation i s a key source of economic, social andemployment growth. Ecuador i s a low performer in terms of information and communication technology, and ranks below L A C average in term of foreign investment barriers (2.0 versus a regional average of 2.2). It i s also lagging in terms of protection of property rights, with a property right index of 2.71, close to Peru, but well below countries like Paraguay, El Salvador, Brazil or Mexico (The World Bank, 2003~). Filling such gap through better regulations-especially for property rights-and enhanced use of resources to research and development, especially by improving the quality of highly regressive subsidies to tertiary education, hopefully with venture capital with privatefirms, i s needed. TheSocial GapandVulnerable Groups 2.20 Reductionof poverty and inequality and improvement of social indicatorsare central issues of any sustainable development policy agenda. This is due to at least three reasons: the welfare of the poor in itself; health and education as long-term determinants of sustainable growth; and glaring inequalities and lack of a safety net that undermine legitimacy neededto undertake structural reforms and underpin good governance across the public and private sectors. InEcuador, there i s a consistent policy bias against the poor reflected in the subsidies that proportionately benefit the richer half of the population, the low level of social expenditures compared to other countries in Latin America, and the low quality of those social expenditures. Bad quality i s reflected by the poor incidence of spending on the needs of low-income beneficiaries. There are also no anticyclical spending programs to protect the poor. 2.21 As stated earlier, the twin crises had FigureII.12: Ecuador Poverty Rate, 1988-2002 devastating effects on poverty and social indicators, but the beginningof economic recovery made possible an impressivedecline inurban poverty levels between 2000 and 2002. However, the employment survey shows a clear 20 percentdecline inpoverty, measuredby income levels, between 1990 and 1997, then a sharp increase of nearly 17 points in 1998 and 1999 as the result of the crises, and arapid recovery below 1997 levels of about 28 points starting in 1999 (Figure II.12). The same survey estimates how the decline in poverty, measured on the basis of incomes, affected bothrural areas and cities to an almost identicaldegree (Leh2002).24 IFuente: INEC, ENEMDU. Elaboracion:SllSE 24. With respect to measuringpoverty according to income, the calculations canbe done on the basis of two sources. First, the Urban Survey on Employment, Unemployment, and Underemployment has been conducted every year since 1987. Until 1999, it coveredonly urban areas, while as of 2000 it covers both urban and rural areas. Second, since March 1998, the Central Bank of Ecuadorhas been conducting anemployment survey eachmonthinthe country's three major cities (Quito, Guayaquil, and Cuenca). To calculate poverty according to income, the poverty line has been set at US$2 per personper day. This has the advantage of facilitating comparison with other countries. Poverty measured according to income has serious disadvantages compared with poverty measuredaccording to consumption. Income generally fluctuates cyclically (particularly in rural areas) and i s more subject to measurement errors. However, in Ecuador, measurements of poverty accordingto income are indispensableinthat they make it possible to track the evolutionofpoverty since 1999. 24 2.22 Although Ecuador has a lead in several areas, it still features significant social gaps in a regional and a worldwide perspective. Overall, the country lags behind more sharply inregional than in an international context, as measuredby the simple mean of all gaps of 4.8 percent and 3.3 percent, respectively. As usual, these averages hide important differences. On one hand, Ecuador has a definite lead in primary school enrollment rate, measles immunization, and mortality indicators. On the other hand, its major lags are in health spending (and to a lesser extent in education spending), secondary education, access to safe water, and female life expectancy (Table 11.4). Table 11.4: Ecuador's Social Indicators inInternationalPerspective SOCIAL INDICATORS Latin Lower International 1994-2000 Ecuador America gap Middle- Gap & Carib. (%) Income (%) Public expenditure Health(% of GDP)* 1.2 2.8 39.3 2.3 26.0 Education(% of GDP)* 2.5 3.3 3.0 4.6 30.4 Net primary school enrollment rate (%of age group) Total 97 97 0.0 91 -6.6 Male 96 99 3.0 91 -5.5 Female 97 98 1.o 91 -6.6 Access to an improvedwater source (%of population) Total 71 85 16.5 80 11.3 Urban 81 93 12.9 95 14.7 RlNal 51 62 17.7 69 26.0 Immunizationrate (% under 12months) Measles 99 93 -6.5 89 -11.2 DPT 80 87 8.0 89 10.1 Life expectancyat birth(years) Total 70 70 0.0 69 -1.4 Male 68 67 -1.5 67 -1.5 Female 71 74 4.0 72 1.4 ChildMortality Infant(per 1,000 livebirths) 28 29 3.4 33 -15.2 Under 5 (per 1,000live births) 34 37 -8.1 41 -17.1 Adult Mortality (15-59) Male (per 1,000 population) 185 208 -11.0 192 -3.6 Female(per 1,000 population) 123 121 1.7 125 -1.6 OVERALL GAP (*) 4.8 3.3 Notes: (*) Since some indicators are openedupby gender or region, there are only 14 independentindicators to take inthe simplemeanor overall gap. Datacorrespondto 2002. * Source: 2002 World Development Indicators, World Bank and World Bank (2004). 2.23 Tackling the needs of vulnerable groups is a critical challenge. These are poor children and preteens, pregnant women in conditions of poverty, and elderly people with no formal income. In fact, families with children under 2 years of age, and to a lesser extent families that include older children or elderly people, have a higher probability of being poor. Indigent families include, on average, a higher number of elderly people and children between zero and 2 years of age (Dulitzky 2003). o Chronic malnutrition among poor children is high. According to the Living Conditions Survey of 1998, the percentageof chronic malnutrition among children zero to 2 years of age and 3 to 5 years of age in the first income quintile was 32.5 percent and 44 percent, respectively, while the percentage of low weight-for-age was 24.3 percent and 29 percent, respectively. Both these figures are far above average for that age group. The National Children's and Family Institute (INNFA) reports that approximately 660,000 childrenbetween zero and 5 years of age show signs of acute, chronic malnutrition. 25 o School-age childreninthe poorestquintile are alsosubject to malnutritionandlimitedformation of human capital. Preschool education for this group is very low, with levels of attendance at 10percent (compared to 30 percent for the highest quintile). The disparity between levels of income i s particularly notablefor secondary schools, with net attendancerates of 44 percent for the country as a whole, but only 19 percent for the lowest quintile. According to data from the Integrated Social Indicators System of Ecuador (SistemaZntegrado de Zndicudores Sociales de Ecuador, SIISE), inEcuador there are 1,050,802 children who work, 32.5 percent of whom are between 5 and 9 years of age, and the rest of whom are between 10and 17 years of age. o More broadly, major challengesremainineducation. About 11percent of the populationover age 15 i s illiterate, and the net rate of primary school attendance i s close to 90 percent. This drops to 51 percent in secondary school and 14 percent in higher education. Educational attainment, 6.5 years, is slightly above the average for L A C countries, 5.8 years; whereas the deficit in secondaryeducation net enrollment i s significant, -8.4, which i s similar to MCxico, but higher than Pen?, Nicaragua and Uruguay (World Bank, 2003~). There are great differences in coverage between rural and urban areas and between indigenous and other groups. The system i s unbalanced: the poor and indigenous school-age population i s at a disadvantage compared to the rest of the population, and basic, diversified, and university education are aimed mainly at the urban populationwith above-averageincomes. About 15 percent of the rural population speaks languages other than Spanish, and schools with only one teacher are most often located in poor, rural areas. Increasing enrolment rates among children in these areas will necessarily require investments to improve bilingual education and the quality of education at multilevel schools. A bilingual education system, the Intercultural Bilingual Education system, has existed in Ecuador since 1998, and enrolments in bilingual schools have increased by more than 100 percent in a decade. However, despite these improvements the system covered barely 4.4 percent of all children enrolled in 2000. o Onthe health sector, anoveralldeterioration of healthcareconditionsas a consequenceof the crisis can be perceived inrural areas and infamilies where the mother has no schooling. When observing the percentages of children under 1 year of age who received complete vaccinations, a significant deterioration was seen between 1994 and 1999, especially inrural areas, and families with mothers with no schooling. In these families, the percentage that received complete vaccinations declined from 26 percent to 16percent. o The elderly are a particularly vulnerable group. Poverty statistics of the SIISE indicate that families with elderly people in their nuclear family unit have a 13 percent greater probability than the average population of being poor. In 1999, 5 out of every 100 poor were elderly, and illiteracy was seen in 34 percent of the elderly. Their coverageby the social security health systemi s minimal-as only 23 percent of Ecuadorians over age 60 are affiliated with the IESS-and barely 30 percent of Ecuadorians over age 65 are receiving the Bono Solidurio, a cash subsidy program targeted on this population. Currently, the subsidy i s approximately US$7 per month, representing between 15 and 30 percent of the value of the averagepension, andyet the cash subsidy to the aged compensatesfor poor coverage by social security. Weak Governance andHigh Perceptions of Corruption 2.24 Ecuador's problems with poor governance and corruption are widely recognized and contribute to the deficient delivery of public services. Compared with the rest of Latin America, most of Ecuador's recent indicators reflect deterioration, particularly in terms of the quality of its regulations, participation, the rule of law, and the responsibility and effectiveness of government. Specifically, Ecuador rates as the country with the least control over corruption in Latin America (Seligson and Recanatini, 2003)l. 26 2.25 The negative trend of the governance indicators presented above is a cause for concern. For various years, the World Bank Institute (WBI) has gathered indicators to measure the quality of g~vernance.'~As can be seen inFigure II.13, which compares the measures of governance for 1997-98 with those for 2000-01 and covers some 170 countries, the significant challenges that Ecuador's economic and political systemfaced during the 1990saffected all measures of governance.26 Inall cases, the most recent level i s lower than the preceding one. Recent data corroborate the persistence of such a negative trend for governance indicators in 2002 (Kaufmann, Kraay, and Mastruzzi 2003). It i s possible that some indicators might have improved in2003, but as yet there are no data to corroborate that. Figure11.13: TrendsinGovernanceIndicators,1997-98 and2000-01 controlofconuption Cauntrymtlny:inpewnth [o/lclo%j Cumparisanwithq ! S S Source: Kaufmann, Kraay, andZoido-Lobath (1999a; 2003). o GovernmentEffectiveness. This measuresthe quality of public service providedby the bureaucracy, the fitness of public employees, the independence of public administration from political pressures, and the credibility of the government's commitment to policies. Within the context of Latin America, it i s clear that the quality of government effectiveness in Ecuador does not earn a good rating. Inthe international context, the country falls slightly below the 20th percentile, unlike Chile, which has a rating higher than 90. Ineffect, only two other countries inLatin America are inthe "low" range inthis regard: Venezuela and Paraguay. o Rule of Law. One reason why governance i s so problematic in Ecuador is that the rule of law i s very weak. Although its ranking i s not as low as in the case of six other countries inthe region, World Bank data indicate that Ecuador i s again close to the 20" percentile inthe world distribution. o Level of corruption. The impact of limitations on the rule of law is, inturn, manifested quite concretely inhighlevels ofcorruption, a majorprobleminEcuador. WBIdata locateEcuador inthe lowestposition incontrollingcorruptionintheregion, close tothe 13'hpercentile. 25. The aggregate indicators constructed included data from 1997 and 1998. Assuming that institutional indicators do not change too much from year to year, these indicators provide a good measure of the 1990s. However, these indicators may not capture a true institutional improvement (or unfavorable evolution) in the same decade (Kaufmann, Kraay, and Zoido- Lobath 1999a; 1999b). 26. The thin lines associated with each bar in Figure 11.14 represent the margin of error in the calculations for a confidence interval of 95 percent. For more dataon measurement procedures, see Kaufmann, Kraay, andZoido-Lobath (1999b). 27 28 111. THEDEVELOPMENTAGENDA 3.1 Dollarization is a major historical break that puts Ecuador in a totally different scenario while pursuing its development path. Adopting unilateral dollarization by Ecuador was a discretionary decision that did not strictly comply with the often advisable previous process of building institutional capacity or reaching domestic consensus. However, as the country adopted the U.S. dollar and abandoned the possibility of setting its own monetary policy in response to domestic or foreign shocks, sustaining dollarization has become an endogenous-rather than an exogenous-outcome, and the probability risk o f its reversion inthe medium term, in the absence of fiscal discipline and timely policy reforms, should not be underestimated, since the economy has fewer buffers to offset potential shocks. 3.2 The adoption of a comprehensive medium-term agenda is an important condition for making the development framework sustainable. The Ecuadorian authorities in the Executive and Congress presently face the following choice: They must either pursue the path of promoting competitiveness, human development, and governance, achieving fiscal discipline as a prerequisite for price stability and implementing the structural changes neededto raise productivity and eliminate serious distortions in domestic markets, or else they can yield to the temptation to squander the country's petroleumriches with populist, spending policies that are vulnerable to corruption and protect a subset of private incomes. The known effects on demand of the latter course might be positive in the short term, but are undoubtedlydisastrous for the country inthe mediumterm, as demonstrated inthe crisis of 1999. Although this development dilemma i s independent of dollarization, there is little doubt that such an exchange system would be at risk if spending-prone and rent-seeking policies are followed. With enormous social costs at stake for the majority of the population, it i s incumbent uponcivil society to play a proactive role in supporting reforms that promote fiscal prudence, competitiveness, better targeting of resourcesto the poor, and increasedtransparency inpublic finances. 3.3 Hence, the three pillars of a development agenda are: (a) promotion of solid economic performance, (b) substantial improvement of the well-being of the poor, and (c) better governance. On the economic front, the agenda i s anchored in stability, fiscal consolidation, and competitive growth. Stability i s critical for protecting the poor by stabilizing their income levels and increasing financing for social programs. Structural reforms are needed to stimulate production and trade, improve basic infrastructure, strengthen financial markets, and create more flexible and competitive inputs-especially labor-markets. On the social front, the agenda aims to reform social assistance, education, health, and social security. This i s needed to manage the tensions between the legitimate demands of the socially excluded and vulnerable groups, and public sector budget and country resources. Budget is constrained by spending cuts and shifts, and a suboptimal allocation of earmarked taxes. Country resources are affected by a number of potentially large natural disasters or external shocks. On governance, the priorities are to fight corruption, improve public service delivery and transparency, improve decentralization processes, and enhance the rule of law, which i s broadly defined to also include the equity and reliability of judicial processes, and environmental protection. Good governance i s both the result and the precondition of the legitimacy needed for structural reforms to lay the ground for a virtuous circle between long-term growth prospects and poverty reduction. This agenda should also reflect the commitment of the authorities to extend the political "contract" of the elected officials with their constituencies to alternative mechanisms of consensus building involving different segments of the Ecuadorian civil society, like the National Dialogue, following a similar pattern to other positive experiences also occurring inthe rest of LatinAmerica. 29 PreservingStability with Fiscal Disciplineand Accelerating Growth with Competitiveness A. PromotingMacrofiscalStability 3.4 Given the precarious state of fiscal accounts, the first priority should deal with its insolvency risk, taking firm steps that will allow it to obtain the high primary surpluses needed to pay interest on its debt. Ecuador has scheduled annual interest payments that fluctuate at about US$825 million (3 percent of GDP) over the next two years and amortization commitments for about US$l.O billion in 2004 (4 percent of GDP). Meeting these payments i s synonymous with complying with the recently approved Law on Responsibility, Stabilization, and FiscalTransparency (Box II. 1). Underabase case scenario, our debt sustainability analysis indicates that the primary fiscal surplus required to make these payments and achieve the intermediate goals of reducing debt i s around 5 percent of GDP in 2004 and 2005. The only way to achieve significant primary surpluses i s to generate new revenues, while adjusting current and capital spending, and redirecting public savings to key priorities of the government's strategy. o On the revenue side, a comprehensive tax simplification reform is essential in the medium term. Once oil prices return to normal levels, aax reform should aimto gradually increase the level of the (non- petroleum) tax ratio by a minimumof 2.5 percent of GDP, the countercyclical amount to be accumulated with FEIREP revenues in the fiscal rule and corresponding to the mean of revenue variation in the last decade. A tax simplification reform should combine at least five actions: 9 Simplifyingthetax structurebyeliminatingtaxesthat generateminimalrevenues; and 9 Implementing Customs reform in what appears to be a major source for tax evasion. Recently approved legislation i s encouraging in terms of cross-checking databases for tax-filers, however, it falls short inproviding full IRS authority over Customs and the full overhauling of its personnel (Box r- 111.1). Box 111.1: The Customs ReformLaw -1 On May 2, 2003, Congress approved reforms to the Customs Law that initiate the restructuring process of what i s perceived as one of the main focuses of corruption in Ecuador: the Corporacibn Aduanera Ecuatoriana (CAE). The new bill contains the followingactions: It appoints a new CAE Board, with participation of the head of the Intemal Revenue Service (IRS), and mandates it to develop a full restructuring-technical and administrative-of the CAE, including personnel severance payments and mobility. By end-October, 24 officials belongingto the Customs surveillance systemwere retired. It gives transitory (180-days) powers to the Minister of Defense to intervene in Customs surveillance, and to draft a Modemization Plan in a coordinated approach with other public entities. The Plan is scheduledto be ready by mid-2004. Coordinationwith the ports Authority, though, remains weak. Key personnelposts, like general anddistrict managers, havebeenfully transferred to military people. It allows the urgent purchase of an advanced X-ray system, in agreement with intemational standards, to control the transit of merchandise. Given its high cost, however, such equipment has not been purchased. Authorities, rather, have adopted lower-cost equipment for security, access control, closed circuit TV, surveillance of containers, and stringer requirements for valuationanddocumentation. Last, the Law allows cross-checkinginformation systems between Customs and the IRS, which is very helpful incontrolling tax evasion. 9 Approving a series of budget reformmeasuresthat will generateapproximately 1.4 percent of GDP, based primarily on limiting VAT exemptions exclusively to unprocessedbasic foods and eliminating all other exemptions, particularly those on income tax and customs duties; 9 Disapprovingconcessionof any further tax exemption, includingthe "tax relief' measuresproposed by the outgoing government in the last quarter of 2002, which included: donating 25 percent of 30 incometax (ISR) to municipalities, reducing the withholding at the source on the VAT from 1percent to 0.1percent, andreducing to zero the duty on 158products; o On the expenditure side, the 2004-2005 budgets should continue being declared a national emergency and prepared following strict austerity rules. The Government already issued an Executive Decree in2003 that freezes wages for regular civil servants, suspends overtime allowances, reduces the President's salary by 20 percent, reduces the salary of government appointees by 10 percent, reduces the number of new positions to be filled, and restrains spending on goods and services. These measures are being kept and strengthened in 2004. Possible additional measures would include: P Limitingincreasesinsalaries, goods, andservicesspending to zero inrealterms; P Rationalizingpublic investmentthrough priority poverty reductionprojects; > Revisingthe application of the mechanismthat automatically indexes salaries to projected (rather than actual) inflation that i s used by the National Council on Public Sector Compensation (CONAREM) andreplacingit with a new, performance-related, mechanism; P Reviewing existing positions in the public sector, so as to identify "ghost" servants and > duplicative andimproductive ones; and Starting to use FEIREPfunds to repurchasethe most expensive debt in Global Bonds to reduce annual interest payments. o A final priority is to make budget management accountable, transparent, and participatory. In a regional survey of budget transparency, Ecuador ranked last among 10 Latin American countries, with only about a third of respondents saying budget policy was transparent inEcuador (Figure III. 1). Inthe survey, the quality of informationand statistics is perceived as satisfactory by only a quarter of respondents and, in LAC, only better than those from Nicaragua. Areas with dramatically low positive responses, however, are the absence of evaluation of an internal comptroller (0 percent), and citizen participation inthe budget process (3 percent) andbudget oversight by civil society (4 percent) Figure 111.1: LACIndex of Budget Transparency 2003 (Percent of Respondents) I I 49 46 45 44 44 which reveals a deep scarcity of institutional mechanisms (and tools) to incorporate social auditing and accountability norms into the budget process. So far, the Government has prepared a Transparency Plan based on three pillars: (a) the upgrade of the SIGEF financial management system to consolidate NFPS financial statements and produce monthly, timely, and reliable reports on executed expenditure to be 31 published in the Government's website (Portal) beginning in 2004; (b) an e-government system to develop public procurement; and (c) a national public investment system. Inthe medium term, however, budgetary transparency should be institutionalized at all levels of government, especially sectional governments, while civil society participation should be promoted. The incoming World Bank`s Public Expenditure Review will make specific proposals to enhance budget transparency, accountability and participation. 3.5 Another pressing macro-fiscal priority is to consolidate stability by solving the Government's short-term illiquidity problem. In2003, Ecuador had total net financial requirements" in the amount of US$2.8 billion, which after including already scheduled financing, left a gap of financing to be identified of US$491 million. In 2004, financing needs decrease to US$1.2 billion, however the financing gap remains at US$416 million as a result of no arrears accumulation (Table III.l). External debt represents about 80 percent of the public debt stock. External debt composition has multilateral and Global Bonds debt representing about a third of total debt each, and bilateral debt representing about one-fifth. Multilaterals and bilateral debt service together represent about half of total public debt service over the next two years. Given the specific composition of its public debt, closing the liquidity gap of Ecuador's public finances i s critically dependent upon carrying out a sound macroeconomic program that will contribute to reducing country risk, along with a programof structural reforms that will allow the country to obtain rapidly disbursing and freely disposable funds from the multilateral agencies, and develop a credible debt reduction plan. Following the rescheduling of its bilateral externaldebt with the Paris Club in 2003, no further accumulation of external arrears i s essential to recover credibility. Table 111.1: Ecuador: FinancingGap Needs 2001 2002 2003 2004 Financing Required 1981 1987 2796 1229 NFPSdeficitlsurplus(+I-) 96 -246 -454 -643 NFPSdeposit buildup/drawdown(+I-) 33 20 362 100 Amortization 1117 1113 1099 1041 Extemal 731 710 743 823 Domestic 386 403 356 218 Additional debtreduction 0 0 77 266 Others 735 1100 1712 465 Arrears 304 832 1,629 281 Accountspayable 79 68 78 55 Assist, to bankingsector 330 200 0 0 Other 11 22 0 5 129 Financing Identified 1648 1739 2305 813 Domesticfinancing 330 222 326 405 Extemaldisbursement 587 328 316 334 Other 731 1189 1663 74 Accumulatedarrears 663 799 1589 0 Accounts payablecarriedout 68 78 74 74 Other 21 0 312 0 0 Financing Gap 333 248 491 416 Notes: 1/Includespaymentsto the IESS. 2/ Domestic financingmeans domestic bonds anddisbursements. Source: BCE andWorld Bankestimates. B. Taking Control of the Wage Bill 3.6 Controlling payroll growth is essential for fiscal stability. Although public employment increased only modestly from 1998 to 2003, the public wage bill fluctuated dramatically over the same 27. Netbecauseit does not includeUS$827million ininterest on public debt, halfof which is for paymentof AGD andNational DevelopmentCorporationbonds. 32 period in line with the severe pre-dollarization decline in real wages (70 percent) and their post- dollarization markedrecovery due to 2000 and 2002 wage increases. The 50 percent increasein2002 has been particularly troublesome, with an estimated impact of about 0.6 percent of GDP by mid-2003, according to Central Bank figures. Such payroll growth is inconsistent with dollarization. It originates from the proliferation of salary components that have undermined the government's control over the wage bill, and the lack of reliablenumbers onpublic employment. The result is a payroll systemwith a myriad of 22 separate components that multiply the base monthly salary exponentially-between 4 and 6 times on average-thus preventing any control over pay policy. Besides, there i s no government office with a reliable and comprehensive picture of the number of public employees by ministry, department, agency, post, and grade, and with the capacity to track which employees have been removed from public service (with indemnity) and to ensure that they do not return to the State's employment. Salary inequities and hiringdiscretion discourage staff, and there are unfair compensations among professionals employed in similar categories of government, particularly among those inautonomous agencies. Box III.2: The Civil Serviceand Wage UnificationLaw: A Step inthe Right Direction The Ley Orgrinica de Servicio Civil y Carrera Administrativa y de Unificacidn y Homologaci6n de las Remuneraciones del Sector Pliblico was approved on September 28,2003, and amended on January 28, 2004.. It is essential legislation for the government to gradually reestablish control over public employment and wage expenditures. The changes embodied inthe Law are significant, yet its coverage is partial. The first key accomplishment of the Law is the elimination of a myriad of monetary allowances, except for dkcimo tercer sueldo, de`cimo cuarto sueldo, and viriticos, subsistencias, dietas, horas suplementarias extraordinarias, encargos y subrogaciones. The proliferation of allowances throughout the public sector hadundermined the coherence of govemment pay scales and made it difficult to calculate, let alone control, annual increases in the wage bill. The number of permissible allowances has been reducedto a bare minimumfor those covered by the law. However, the Law exempts teachers, military, police, the Judiciary and the Legislature from the salary unification. These groups account for about 56 percent of all public sector employees. Total Public Employees(minusworkers instate enterprises): 360,000 O/w Armed Forces: 56,000 (exempted) O/w SubnationalGovernments: 34,000 Total Civilian Central Government: 270,000 O/w Teachers: 113,000 (exempted) -O/w Police: 26,000 (exempted) O/w Judiciary andLegislature(exempted): 5,200 TOTAL COVERED: about 44 percentof allpublic employees (and47 percent of Central Government). To oversee the number of public employees, their classification, and remuneration, the new Law also established a new Secretaria Nacional Tkcnica de Desarrollo de Recursos Humanos y Remuneraciones del Sector Pu'blico (SENRES). This Secretaria was granted broader powers than its predecessor (OSCIDI). As the Law left doubts as to the duplicating role of CONAREM, the amendments eliminatedit. So, it is now establishedthat SENRES will issue the resolution to approve the new Unified Monthly Pay Scale. Salary unification will strengthenthe government's capacity to monitor and control the wage bill, the fiscal effects of the Law are not allpositive. The amended Law corrected changes that the Legislature introducedin the original bill submitted by the Executive. Congress had frozen employees' social security contributions at the amount paid in September 2003. Therefore, the real value of contributions to IESS would have actually declined over time if no legislativechanges were made. Inaddition, the Legislature made indemnity payments more generous for dismissed workers (raising the cap from US$lO,OOO to US$30,000) andinserted a provision allowing many public employees who received an indemnity payment between 1993 and 1998 to demand a reliquidacidn so that their payment will equal that permitted by law in January 1998. The fiscal impact of this measure was sizable. Amendments to the Law not only eliminated such deficiencies, but extendeduntilJanuary 2005 the time for starting tc apply the "uniformed" salary scale, and rose the transition application time to5 years, instead of 3. In addition, it set a 2C percent gradual increase inthe basepay subject to an additional contribution to IESS, to be appliedfrom 2006-2010. As public salaries have been frozen in 2004 and 2005, contribution to the IESS remains the same. Finally, the amended Law set the annualceiling for dismissedworkers at 1percentofthe economically activepopulation. 3.7 The Government is actively engaged in civil service and wage unification reform. As a first step, Congress approved a new civil service reform law and its amendment, mainly aiming at salary unification and uniformization, and at creation of a new human resources policy for the public sector 33 (Box 111.2). Although the law does not have full coverage yet (about 44 percent of public servants), this bill is an essential milestone in reestablishing government control over the wage bill, reducing salary categories from a 21-grade to a 14-grade pay scale, making wage policy transparent, and facilitating an overdue single registration of public employees. As complementary actions, the Government has completed ministerial staffing reviews that have identified redundant staff. The five largest ministries (agriculture, social protection, education-administrative staff, health, and public works) remained under the 21-grade system and their staffing reviews were completed by end-December, so that they could move to the to the 14-grade pay scale in 2004. Finally, as a complement to the salary unification, the Central Bank has established a consolidated database for electronically registering the banking payment of all public employees and their benefits, which will support the identification and elimination of ghost civil servants. C. Strengthening the BankingSystem 3.8 Following dollarization, the banking system has been recovering and is adapting to the changes involved inthe dollarization of the economy. A selection of global performance indicators of the banking system shows its downfall during the crisis and its recovery after restructuring (Figure 111.2). The banking system i s highly liquidbecause of self-insurance inthe absence of a lender of last resort, and some rationing in external credit. The growth in banking deposits has been stable, and credit to the private sector grew indouble digits in 2001 and 2002, but slowed to 7 percent in2003. Nominal interest rates have declined very slowly, inspite of the elimination of currency risk, due inpartto the slow decline ininflationrates and to the highpersisting country risk. An asset quality ratio (non performing loans to total loans) halved from 12 percent to 6 percent between December 2001 and March 2003, but has slightly deteriorated since then. Overall, bank performance has increased but operating margins remain constrained by the high share of liquid assets while solvency ratios are still affected by persisting weaknesses inloan classification. 3.9 The banking sector is in the process of initiating a very deep restructuring. A set of initial banking restructuring measures was implemented under the Stand-By Arrangement (SBA) (Box 111.3). However, remaining banking sector vulnerabilities should include additional measures to strengthen regulationand supervision according to Basle standards; an effective supervision of financial institutions on a consolidated basis; mechanisms to institutionalize banking exit norms; techniques to assess banking losses; procedures to speed up a banking crisis resolution by merging, closing, or restructuring; the creation of a liquidity fund to provide contingent liquidity to minimize external contagion. Other pending issues are an incomplete regulatory institutional framework characterized by a Bank's Superintendency still lacking political independence; by a Deposit Guarantee Agency (AGD) which should uniquely be concerned with small depositors protection and should rapidly move away from its past obligations as the bank restructuring agency; and by a Central Bank that should more effectively seek a clear definition of its responsibilities as the technical authority and the supervisor of the payment system. Box 111.3: Initial Measures for the Restructuring of the Financial Sector under the IMF-SBA Sign contracts to conduct independentaudits of at least eight closed banksin the AGD, and complete the auction of all the restructuredprivate sector debt portfolios of closed banks held in the AGD. Status: ongoing. Seven institutions have beenliquidated, and 5 additionalones were authorized to be completed. Sign contract with an intemational investment bank to prepare Banco del PacrjSco for sale, and complete it Status: contractwas signed on May 7,2003, but the Bankhasnot been soldyet. Sign contract with independent intemational firmto manage the Filanbanco liquidation trust funds containingthe loan portfolio andreal estate assets. Status:Loan portfolio implemented on May 7, 2003; real estate ongoing. Conclude retuming all blocked deposits in Filanbanco and the AGD banks in liquidation to depositors. Status: ongoing. The trust Fundfor Filanbanco assetshasnotbeenyet established. 3.10 Measures aimed at improving the regulatory framework should be supplemented by a strengthenedfinancial institutions' support for the real economy for example through micro, rural 34 and housingfinance. Although the number of bank loans to housing and small and medium enterprises has increased it still remains modest, and there i s much to be done to improve the access to bank credit and to extend loan terms. This i s even more important, considering that while companies with international connections have doubled direct borrowing abroad (often through back to back operations) bringingprivate external debt to over US5 billion since 2001, small and mediumsize firms do not have access to foreign credit. Policy measures intended to increase the access to domestic credit should move away from an outdated approach based on ceilings on interest rates and on subsidized lending by public banks that has missed its objectives and has generatedhuge fiscal costs for public banks' recapitalization. New measures should therefore include a sweeping reform of the existing development banks in public hands, an upgrade of creditor rights through a revision of the existing bankruptcy rules, a wider coverage of credit registers extended to microcredit and a tight implementation of measures aimed at reducing large loans concentration and connected lending. 3.11 Financial reforms outside the banking systemare lagging. No adequateeffort is beingmade to strengthen capital markets, contractual savings, insurance and pension services. The rivalry between the political constituencies of the costa and of the sierra has frustrated any effort to reduce the extreme segmentation of the domestic stock markets between Quito and Guayaquil and has resulted in tremendously burdensome rules for issuers and investors that have drained liquidity out of the domestic market and have pushed Ecuadorian issuers and investors toward foreign markets. These shortcomings have been worsened by the poor Government management of its domestic debt issues that has failed to createcredible benchmarks with sufficient liquidity. Finally the lack of an adequateregulatory framework for collateralized lending has prevented the interbank market from developing and reallocating liquidity across banks more effectively. Overall these factors have resulted in the substantial absence of liquid stocks and bonds and have made mutual funds useless.A weak regulatory framework and fiscal obstacles have further limited the development of contractual saving by life insurance companies while the 2001 pension reform, unless reconsidered, does substantially preclude the offer of pension services on the part of private financial intermediaries. Contrary to past neglect for risk management policies, a greater emphasis should be placed on risk hedging instruments, from general insurance to life and catastrophic risk insurance, that by reducing individual borrowers' income volatility would facilitate access to bank and to mortgage credit. Figure 1II.Z: FinancialSystem Indicators Active interestRates InNominal Ecuador11 interestRates Rates -40 -60 Real Rates -80 5 - -loo Jan Jul- Jan Jui- Jan Jul- Jan Jul- Jan Jul- Ojan Jul- Jan Jul- Jan Jul- Jan Jul- Jan Jul- -99 99 -00 00 -01 01 -02 02 -03 03 -99 99 -00 00 -01 01 -02 02 -03 03 NetLiquidityof Private Banks BankingSystemArrears 60% Dec 9Wun 03 (portfoliopastdudtotal portfolio) 50% 40% 30% 20% 10% 4 0% n 2 c- r- -0Op c- r- -01p- c- r- -02p- C- r- -03 0 99 00 ~~~ 00 00 01 01 01 02 02 02 03 Dec-01 Mar-02 Jun-02 Sep-02 Dec-02 Mar-03 Jun-03 35 D. Improving the Investment Climate andLabor Markets Flexibility 3.12 A 2003 Bank survey on Investment Climate Assessment (ICA) found critical shortcomings in Ecuadorian firms (Annex B). The major constraints to operating are related to the overall policy, financial, and competitiveness environment: regulatory policy uncertainty (61 percent), high costs of financing (56 percent), macroeconomic instability (54 percent), corruption (49 percent), and anticompetitive practices (47 percent). The poor quantity and quality of infrastructure services (and the highcost of electricity) available to Ecuadorian firms are important constraints that cause a significant increase in operating costs, and reduce productivity and growth. 3.13 A marked improvement of the investment climate is critical to the sustainability of the dollarization process in the medium term. In consultation with the private sector, the Central Bank, the Ministryof ForeignTrade and the National Council on Competitiveness have proposed multiple Agendas for Competitiveness. However, these agendas lack priorities and a consensual sequencing, which calls into question the realism of the measures proposed and the difficulties of implementing them. This i s why it is imperative to design a simplified agenda of policies and laws that are critical to improve the investment climate. Based on the survey findings, this agenda should include support measures to reduce rigidity of labor markets, reform trade policy, strengthen the petroleum industry, develop basic infrastructure, promote domestic competition among firms, and eliminate market entry-level barriers for new enterprises. Topics like addressingcorruption andjudicial reformare treated later. 3.14 Future wage increases in the labor market should be de-linked from the inflation rate and get associated with productivity. In 2003, the Government completed an assessment of the labor market and made an adjustment of 2004 salary increase around the projected floor average inflationrate (4.4 percent). In 2004, it also expects to develop a consultative process-called Mesas de Trabajeincluding authorities, entrepreneurs, and workers' organizations. Ten topics have been selectedto be covered by such Mesas: labor policy, labor productivity, labor law enforcement, training, internationallabor law, retirement and pensions, a new Labor Code, a new Labor Procedures Code, outsourcing, and bargaining methods. This would imply simplifyingthe wage negotiation process by no longer revising wages according to predicted inflation only, but somehow to productivity; and minimizing the role of the Tablas Secton'ales as reference indicators, in establishing the single minimumwage. E. Developing Trade FacilitationReform 3.15 Trade facilitation reform to correct an anti-export bias is fundamental to promoting nontraditional exports. The anti-export bias is a combination of tariffs and non-tariff barriers, and subsidies, that protect domestic production and affects exports, making inputs for local production (and consumption goods) more expensive. Such bias preserves rent-seeking activities and preventing the modernizationof firms and competition based on profitability. In early 2003, Ecuador had seven import tariff rates ranging from zero to 35 percent, with a simple average tariff of 11.3 percent. The external tariff approved by the Andean Community (CAN) covered about 62 percent of tariff items. The combination of high Ecuadorian tariffs for final products and tariff dispersion leads to a wide range of effective protection rates that force consumers, including the poor, to subsidize uncompetitive, high-cost local producers. The anti-export bias i s reinforced by the discriminatory application of nontariff barriers (NTBs). Import licenses and technical norms are the most important NTBs. On one hand, licenses are distributed in a discretionary manner. They are still applied to about 1,600 out of 6,707 tariff items, and about 8 percent of those were duplicated and concentrated in the health and agricultural sectors. Import licenses covered about 25 percent of all tariff positions, which account for about 10 percent of total imports into Ecuador. The majority of these licenses contradict the norms of the World Trade Organization (WTO). On the other hand, there were 757 obligatory technical norms and 1,339 optional norms used as obstacles against imports. About half of them were concentrated in five categories: food, 36 construction materials, chemicals, mechanical components, and oil products. Upon its accession to the WTO in 1996, Ecuador signed the WTO Normalization Code, buthas not appliedit. 3.16 Since 2003, the Government started work on five fronts of a trade facilitation agenda, while searching a Free Trade Agrement with the U.S. First, the Customs tariff scheme was reduced from seven to five rates of 0, 5, 10, 15, and 20 percent in 2003, and such reduction was consistent with its agreements with other Andean countries. However, as the impact of such reduction on the average tariff rate was small-the average rate i s at 11.3 percent-this effort can be considered only as an initial effort, since the recent Latin American tendency i s toward much lower tariffs (average rates certainly below 10 percent), and significant reduction of tariff dispersion and effective protection rates. Second, Ecaudor has unified all duplicative import licenses and started to eliminate those that did not register commercial activity from 1991through 2000 (about 919 tariff positions). Third, it has setup a pilot simplified regime for import licensing, aiming to reduce processing time from 40 to 60 days to 24 hours. Fourth, it has prohibited any further issuanceof technical norms that do not comply with WTO regulations and started to gradually eliminate or convert those already existingto become WTO-compatible. Fifth, it has started Customs modernization, but with little perceived results in2003. All of these policies would pave its way toward FTAs. 3.17 Ecuador needs to prepare a comprehensive trade policy strategy to face negotiations for Free Trade Agreements, especially with the U.S., and implementation of its trade facilitation agenda. The strategy will make compatible Ecuador's position toward WTO, the U.S., ALCA, Mercosur and other regional free trade arrangements.28 In addition, and in order to get maximum advantages from incoming FTAs, Ecuador also needs to implement a complementary agenda of reforms in other critical areas identified by FTAs, like: Customs reform, labor and intellectual property rights, trade in services, investment disputes, and private participation in infrastructure services, as well as deal with those reforms that would favor an increase in its non-oil exports supply and external competitiveness. 3.18 Although preliminary findings reveal that static benefits from an ALCA with the US. would be small for Ecuador, although still bigger than self-excluding its participation from it, the greatest indirect benefits will be threefold, one arising from the positive inflows of foreign direct investment and market access permanent guarantees, another from the increased access to new technology and services; and the third one from the locking in of key structural ref0rms.2~Light (2003) estimates for Ecuador that under ALCA, welfare (consumption derived from GDP growth and employment) falls by almost the same percentage with or without participation. It falls because there i s increased competition for Ecuadorian products in the U.S. market from exports of other Latin American countries that at present do not have the same preferential treatment as Andean countries have under the bilateral arrangement between Andean countries and the United States (Table A.14)-that is, the so- called trade diversion. However, this fall in consumption i s more than offset by increased exports (6.5 percent) and manufactured exports (10.4 percent) if Ecuadorjoins ALCA, as opposed to negative rates in both indicators if Ecuador does not participate in it. Export volumes increase for all sectors of the economy except cereals, oils, sugar, and milk products. Projected export increases are significant for food products, textiles, energy (oil), and miningproducts. Import volumes increase as well for all sectors of the economy, especially for agricultural products, food products, and cereals. The combination of these outcomes leads to a marked increase inEcuadorian production of agricultural, energy (oil), and food 28. Following Central American experience in negotiating an ALCA with the United States, the paper should contain chapters on (a) tariff reduction, (b) non-tariff barriers, (c) origin norms, (d) disloyal practices (antidumping and compensatory measures), (e) services, (f) subsidies, (g) investment, (h) agricultural goods (including price bands rationalization), and (i) labor mobility. 29. This paragraphi s basedon very interestingbut preliminary findings by Light (2003) that must be taken with much caution, since they group estimates for a scenario combining the economies of Ecuador and Bolivia, but under model assumptions and structural coefficients reflecting the Ecuadorian economy. 37 products, and to a decrease of those domestic products, whose exports decline or which face an increased competition from products of ALCA participants, such as manufactured products. In addition, return (productivity) for factors (skilled labor, labor, and capital) increases under ALCA, whereas it continues deteriorating under the scenario of self-exclusion from it. Finally, but no less important, under ALCA, Ecuadorian fiscal losses are estimated at about US$100-200 million due to projected tariff reductions, which prompts the need to find compensatory revenues through tax reform.30 These findings stress the importance of lessons from NAFTA and other FTA assessments: the benefits from future FTAs for Ecuador will ultimately depend not from the negotiation proposal itself, but on the stance of domestic policies and the strength of domestic institutions. Entering a FTA without filling the competitiveness gaps and reforming the regulatory and institutional framework that affect the investment climate i s a recipefor not taking full advantage of all the potentialbenefits associatedto them. F. Improving the Oil andInfrastructure Sectors 3.19 An exports-based agenda should confront these challenges by seeking greater private sector participation, competitive market-based tariffs, and an adequate regulatory framework. The oil sector i s the mainengine for growth and requires urgent modernizationto attract foreign investment. The sectors of water and sanitation, electricity, and telecommunications confront problems such as low coverage (particularly in rural areas), low efficiency, and poor quality of services, derived in part from pricing policies setting tariffs below real economic costs, and incomplete institutional and regulatory frameworks. , 18. Oil. The oil sector i s critical in Ecuador's economy. It accounts for about 13 percent of 155 9 150 GDP, not including the multiplier 145 4 - effects to other parts of the d 140 4 A economy, a third of NFPS revenues, 4 * 4 and nearly half of exports. The m 135 extraction, production, 5 115 -a state-owned PetroEcuador has the u) 130 = c 125 -4 legal monopoly over crude oil 120 commercialization, and 1 1 0 1 , " ' I ( 1 1 3 industrialization, while the Drivate m m z zWm zmmz( zmOzmb, c ummco uZ co2u01 c" ' 1 I I I# " I I m O m 0 o sector participates in exploration and production activities. In 2003, private companies will contribute about 47 percent of nationalproduction. At the projectedextraction rates, oil wells could rundry in2021 (IMF2003). The rate of oil extractionhas been steadily decreasing inthe late nineties (Figure 111.3), but partly recovered and i s currently around 150 million barrels a year in almost equal parts. The declining trend inextraction of crude oil by PetroEcuador, due to underinvestment, i s offset by an increasingtrend in extraction by private companies. Driven by higher private investment, the rate of extraction is expected to increase by about 200 million to 265 million barrels a year, once the new heavy oil pipeline (0CP)-a consortium composed of the main private companies operating in the country-is at full capacity. The OCP started functioning in November 2003, and i s projected to double the transport capacity previously concentrated inthe government-owned pipeline, the SOTE. 3.20 Taxes and Subsidies. Within the petroleum derivative market, of which domestic consumption accounts for 94 percent of demand, price distortions caused by implicit taxes and subsidies should be 30 Notice that all outcomes are compared with the present preferential arrangement between the U.S. and Andean countries. However, this preferential arrangement expiresin2006, and U.S. authorities have indicatedthat it will not be extended 38 removed and made transparent. By examining the actual price of the products compared to their economic costs, we can derive the implicit tax or subsidy. Table 111.2 illustrates the implicit taxes and subsidies of the different petroleum products. Whereas gasoline products are taxed, diesel, fuel oil, and GLP (liquefied gas) are subsidized, with the latter substantially so. At present consumption levels, net subsidies equal nearly $200million, or 0.7 percent of GDP. Table 111.2: EffectiveTaxes or SubsidiesonPetroleumProducts,2003 ImplicitTax Estimated Tax Tax (Subsidy) Consumption (Subsidies) (Subsidies) Centdgallon MlnGallons MlnUS$ % of GDP GasolinaSuper 0.47 100.8 47.4 0.2 GasolinaExtra 0.19 453.6 85.2 0.3 Diesel (0.05) 735 (37.9) -0.1 GLP (0.75) 352.8 (263.3) -1.0 FuelOil (0.05) 483 (24.9) -0.1 FiscalImpact (193.4) -0.7 3.21 The negative perception of Ecuador's investment climate and sector-specific issues might prevent the sector from taking full advantage of the new transport capacity. In2003, whereas prices were booming, PetroEcuador's oil production fell by around 8 percent, partly offset by an end-quarter surge in private oil production. Oil companies also claim that the present legal framework does not protect the opening of proven oil fields to private sector firms: once contracts are signed, they may be challenged and may fail to stand up in court. So, by end-year, a new draft Hydrocarbons Law was submitted to Congress, The draft Law addresses this issue, but the discussion of the Law has been postponed. In the meantime, oil companies are asking ways to make contracts more attractive, for instance, through the elimination of the 35 percent of participation or 15 percent in royalties. Solving these initiatives successfully i s necessaryto increaseproduction, but more important sector-specific issues remain unsolved, such as: (a) lack of political consensus for establishing the required contractual framework to attract private investors inold and new exploration and production ventures; (b) an outdated institutional framework gives PetroEcuador monopoly rights that discouraged foreign investment flows for the modernization of refinerias, thus depreciating product quality, and elevating commercialization and marketing costs; (c) tax distortions and subsidies on combustible fuels that prevent competition from fuel imports; and (d) spending-prone and poor management by PetroEcuador. Therefore,the new legal framework should be broader and end PetroEcuador' s monopoly, promote greater competition and provide incentives to invest in upstream ventures, refineries and new distribution and marketing installations. Tax distortions should be adjusted, oil and natural gas (GPL) subsidies should be reduced by fiscal considerations-and made transparent about their amount and beneficiaries-and the market for fuel imports liberalized. Finally, PetroEcuador accounts mustbe regularly audited, ineconomic, financial and environmental terms. 3.22 Water and Sanitation. The water and sanitation sector i s characterized by low cost recovery, a highdependencyon subsidies (transfers) from the Central Government to cover their deficit, and the lack of an integrated national system of water resources. All water and sanitation services have decentralized providers that dependon municipal governments. Three key measures are needed to improve quality and efficiency and to extend coverage: (a) enactment of a new legal and institutional framework by restructuring the Subsecretariatof DrinkingWater and Basic Sanitation (SubsecretariadeAgua Potable y Suneumiento Brisico, SAPYSB), and submission to Congress of a new water and sanitation law; (b) reform of the transfers formula to introduce incentives for profitability among service providers; and (c) creation of a Water Fund inside the Ministry of Urban Development and Housing (MIDUVI) to link 39 transfers to the sector to performance-based criteria by local water companies. The ongoing preparation of the water law shouldensure consistency with existingenvironmental laws and regulations. 3.23 Electricity. The electricity sector has gone through an incomplete reformprocess since 1996 and i s not financially sustainable. Reforms to separate electricity generation, transmission, and distribution functions, and to put in place a wholesale energy market regulated by the National Electricity Council (CONELEC) and efficiently administered and monitored by the National Center of Energy Control (CENACE), are incomplete. The Solidarity Fund (FS) and local government owners of power distribution companies have failed to upgrade their management, permitting average losses of about one- thirdof energy generated, as acombinationof distribution losses(average25 percent) andinsufficient bill collection (average 10 percent). Cross-debts between the Government and power distributors and generators i s also an issue. About 40 percent of the rural population do not have yet access to electricity. Projected losses of power distributors and generators in2004 are US$500 million. 3.24 An electricity sector reform strategy made limitedprogressin2003. The GOE promoted the signing of interagency agreements to improve payments from electricity distribution companies to PetroEcuador, tariff adjustment toward reaching the estimated economic cost of US10.4 cents per kilowatt hour on average, and failed attempts to find a private administrator for power distribution companies. All customer categories are now charged a tariff that fully covers economic cost, except "small" residential customers with consumption lower than 300 kilowatt hours per month, for whom subsidies cover 89 percent of economic costs. Originally, full values were projected to be reachedfor all customers over a three-year period, with a gradual increase of 1.64 percent per month(representing about 2 to 3 percent of total expenditure for poorest households). However, since November 2003, however, tariff increaseshave been frozen and the President has promisedto reduce tariffs for industrial consumers by 5 percent, inApril 2004, once the dry season ends. Genuine reforms inthe sector to mobilize private investment and achieve sustainable efficiency improvements require implementation of a strategy to reduce the financial deficit and improve the efficiency in the sector with the following elements: (a) effective agreements for effective payments to electricity distributors and to generators from PetroEcuador; (b) transfer of management of electricity companies to private (foreign) companies; (c) debt restructuring for all government-owned companies in the sector; (d) definition of efficiency indicators; and (e) complete transparency and removal of regressive consumption subsidies, while establishing an appropriate subsidized tariff protection for poorest households (below 100-150 Kw/month). 3.25 Telecommunications. Telecommunications also has a weak regulatory framework that is a disincentive for (foreign) investors, because it gives the regulatory entities (CONATEL and SUPTEL) excessive discretion with respect to key decisions. The current Telecommunications Law i s obsolete and has many contradictions due to its multiple revisions. CONATEL signed concession contracts with ANDINATELand PACIFICTEL that authorized them to apply tariff increasesfor residentialconsumers to price cap limits set in December 2001, but these adjustments have been delayed. In 2003, whereas international and commercial tariffs were adjusted downward to levels that eliminated cross-subsidies, the prices for residential local calls are still subsidized by long-distance calls. ANDINATEL and PACIFICTEL also attempted to find an international private administrator that raises their operational surpluses, while bringing investment and know-how, but failed to find a qualified bidder, reportedly because the biddingproposal was unattractive. Both companies, though obtained operational surpluses for US$80 and US$3 million. For its part, TELECSA, the new cellular phone company created by ANDINATELand PACIFICTEL, has already hired an internationaloperator for its management. Inthe future, the GOE should draft a new telecommunications law providing single-sector authority, simplified entry by firms to the sector, and elimination of the present regulator's discretionary faculties. Local residential rates should also be adjusted to the price cap limits set by CONATEL, and (international) privateinvestors should be attracted to managethe two telephone companies. 40 BoostingSustainable and EquitableDevelopment 3.26 Any legitimate development policy agenda requires poverty and inequality reduction policies as a key pillar. Sustainedimprovements in social+ducation and health-indicators are both a means to increase productivity and, by the same token, the country's long-term growth prospects, and are an end in itself for the dignity and welfare of a population. Followingthe devastating effects of the twin crises on poverty, fiscal discipline and structural reforms are bound to put a further strain on socially vulnerable groups inthe short term, unless measures are taken to protect them. Thus, austerity leaves no choice but to select and protect priority pro-poor spending, and target it on the poorest effectively, to mitigate the impact of adjustment. A. Social Outcomes 3.27 Ecuador is committed to the Millennium Development Goals. These cover the areas of poverty, malnutrition, mother-infant health, education, gender-equity, and environmental sustainability. As a first step, the GOE has announcedan ambitious effort to meet eight quantitative social outcomes-a subset of the Millennium Development Goals (MDGs). Some progress have been already done. For instance, in health, infant mortality and maternal mortality rates declined by about one-third during the 1990s, putting Ecuador halfway toward the goals of two-thirds reductions in these indicators by 2015 (Table III.3). 3.28 Achieving those targets poses, however, a formidable challenge. For instance, complying with these goals require significantly reversingthe trend toward lower public spending in the social sectors. In GDPterms, spending ineducation has fallen from 5.8 percent in 1988to 2.5 percent in2002 (Rojas 2003 and World Bank, 2004), only to reverse to 2.9 percent of GDP in 2003. With only 1.2 percent of GDP assigned to health in2002-a ratio slightly increased to 1.4 percent of GDP in2003-Ekuador has one of the lowest health spending ratios in the L A C region. There i s also a strong commitment to malaria and dengue control, as evinced by frequent vector control campaigns, particularly inthe Costa,and Congress has approved a Free Motherhood Law (LMG) to improve maternal health. In sum, the likelihood of meeting the MDGs i s very closely linked to the rate of GDP growth, to the amount of additional social expenditure devoted to them, and to urgent improvements in the quality (measured by incidence and efficiency) of public spending. 3.29 Bank preliminary estimates are very skeptical about chances that Ecuador will reach some MDGs. Based on a conservative 4.0 percent annual growth in GDP (a base case scenario), show that Ecuador would "likely" not reach its goals in primary education (100 percent coverage); but would "possibly" reach its goals ininfant mortality (66 percent reduction) and sanitation (50 percent reduction in the population without access to potable water). It would, however, not reach its target in children under 5 years of age mortality (66 percent reduction); and would be "very unlikely" to reach its poverty reductiongoals (50percent reductioninpoverty and extreme poverty) (Schady 2002 and The World Bank 2004). Therefore, the Bank's own target estimates, some of them included as benchmarks inthe Country Assistance Strategy (CAS), are more conservative than those established by the Government (see column 2007-WB inTable 111.3 below).31 31. More recent estimates done under the Public Expenditure Review indicate, however, that Ecuador could reach the MDGreferring to primary educationenrollment and children mortality (The World Bank/IDB, 2004). 41 Table 111.3: Government of Ecuador's Key Poverty Reduction Goals Indicator units 2003 2007-GOE 2007-WB 2015- MDG 1. Eradicate Extreme Hunger and Poverty EconomicGrowth % 3.5-4.0 5.0 2.7-3.5 Poverty %population 51.0 38.0 46.0 30.1 Extreme poverty %population 25.0 10.3 22.0 14.0 Socialspending % GDP 7.7 12.5 2. Achieve Universal Primary Education Illiteracy rate % 10.3 8.0 Average years of schooling Years 8.0 9.4 Primary enrollment % 90.0 95.0 91.3 100.0 3. Promote Gender Equality and Empower Women Female/malenet primary enrollment % 101% Parity target hasbeenmet 4. Reduce Child Mortality Child mortality rate 34.0 28.8 19.0 Infant mortality rate** Per 1,000 live births **11.5 8.8 9.0 18.0 Crude death rate Per 1,000ofpopul. 4.3 3.6 5. Improve Maternal Health Matemal mortality rate Per 100,000 of popul. 80.0 67.0 40.0 PoDulationwithout access to health % 23.2 17.0 17.0 6. Combat HIV/AIDS, malaria, and other diseases Incidence of dengue, malaria, HIV % Rising Reduce Halt/ Reduce Reduce 7. Ensure Environmental Sustainability Pipeddrinkingwater %population 41.9 49.5 49.5 Sanitation system %population 46.I 54.4 Overcrowdinginhomes %homes w >3hOOm 29.6 24.9 Note: ** TheGovemment'sindicatoris basedon anurbandataset. Govemment's key goals for 2007 are inbold. Source:Ecuador CAS basedonGOEProgramde OrdenamientoEcon6micoy DesarrolloHumano(2003), WB (2004). 3.30 Social programs are affected by several shortcomings. Inaddition to the low levels of public spending ineducation and health, spending on social protection has slightly increased from 0.2 in 1999 to 1.3 percent of GDPin 2003, especially associatedto the Bono de Desarrollo Humano (not including fuel subsidies) (The World Bank, 2003). Other problems affecting the social sectors have to do with an inequitable distribution of resources, inefficient provision of basic services, and low coverage. Poor quality affects especially poor and indigenous populations, and there are no anticyclical social programs inEcuador. Themainsector-specific challengesfollow. B. Addressing Social Sector-Specific Challenges 3.31 The basiceducation reformof 1996, basedupona national dialogue and ratifiedby the 2002 Social Contract for Education, remains incomplete. Such reform had three pillars: (a) a ten-grade basic education, (b) a curriculum reformto improve teaching of Spanish, math, multicultural learning and environment awareness through decentralized management of autonomous schools and active participation of communities, and (c) the strengthening of bilingual education. The 10-grade basic education system has not been introduced; the intercultural bilingual education system was created in 1998, but only reached a coverage of about 90,000 students in almost 200 primary schools by 2003 (somewhere around two-thirds of children in that category) and 13,700 students in secondary education (about 1percent of secondary school enrollment). The curriculum reforms-supported by Redes Amigas grouped under Education Unit Centers, a WB- and IDB-financed program, and Centro Educativos Matrices have promoted decentralized school management, but currently only cover about 58 percent of pupilsenrolledinpublic primary schools inrural areas (40 percent living inthe poorest areas). 42 3.32 Reform will have to focus on improving the quality of basic education, especially teachers' qualifications. Results of academic achievement testing show deficiencies in the quality of teaching at the basic level. Moreover, few investments have been made in the sector, the maintenance of infrastructure i s minimal, insufficient teaching supplies are provided, and teacher salaries are moderate. Spending on education i s poorly balanced: the first quintile of the population (by income) receives 12 percent of public spending; the fifth quintile (highest incomes) receives 25 percent. Low quality reflects serious problems of administrationand governance. The disparities are highest at the tertiary level, where 70percent of subsidies preassignedto privateuniversities benefit the top quintile while lessthan 1percent of these subsidies benefit the poorest quintile. There i s high turnover of top-level authorities and a duplication of functions in some administrative units of the Ministry of Education and Culture (MEC); administration is excessively centralized; there i s little communication between the MEC, its provincial offices, and schools; the selection, hiring, and promotionprocess of teachers i s opaque; the distribution of teachers i s inadequate (too many teachers in some areas and not enough in others); and the salary structure for teachers bears no relation to improving the quality and balance of the system. Moreover, budgets are assigned to teachers rather than to schools, so that teachers at times move e.g. from rural to urban schools, taking their budget assignments with them and leaving the rural schools with noresources. 3.33 Solving these problems requires to complete and expand the 1996 education reform. Inhis first year speech, President GutiCrrez recognized that education reform is lagging and declared 2004 as the year of education. Besidesbringingstability to top education authorities-there were 3 ministers in2003-sector reformshould concentrate on a basic agenda, as follows: The ten-grade basic education system should be reconsidered. All children should complete basic education, and have access to better-quality schooling. Programs aimed at increasing coverage must be focused on underserved low-income groups living inrural and indigenous areas. The MEC must consider new methodologies, such as "tele-high school," to reach underprivileged groups. Decentralized strategies to expand coverage, such as Redes Amigas or Education Matrix Centers should be promoted. Pilot projects for greater decentralization, enhanced autonomy, and greater parent participation, such as about 1,800 secondary schools that already receive lump sum transfers from MEC, and have autonomy to uses such resources to pay teachers and cover basic ioperational costs, should be expanded. Teachers's evaluation should be strengthened. The MEC should evaluate different strategies to attract new teachers on an ongoing basis, design a planto provide the educational system with at least the minimumnecessary teaching materials, and institutionalize the APRENDO system for measuring results, while giving special attentionto bilingual education inthe country. Public spending on education should be gradually increased, while previously improving quality, thus focusing on targeting of resource allocations, as well as methods of assignment, oversight and accountability of education budgets. 3.34 Health. About 30 percent of the population does not have access to basic health services. More than two-thirds of the populationdoes not have formal healthinsurance, and the Ministryof Public Health (MPH) and other institutions are unable to provide service to almost half of those with the worst health indicators. Insufficiently attended births and lack of access to basic health care are the main factors responsible for an unbalanced epidemiological profile. The coverage of health services has two dimensions: (a) the breadth of coverage, that is the proportion of the total population that has effective access and financial risk protection; and (b) the depth of coverage, meaning the extent to which services are available to people without exposure to out-of-pocket payment. The breadth of coverage i s very low in Ecuador, estimated at about 22 percent of the total population. Depth of coverage is even worse, especially for the poor population. The Law on Free Maternity Care (LMC) i s limited to a very basic package of services for maternal and child care only, and this system lacks adequate financial coverage and depends on a system of referrals to (also problematic) public hospitals when severe health problems are detected. 43 3.35 Poor coverage is reflected in high infant and maternal mortality rates and premature births. For every 100,000 births, 160mothers die as a result of complications from pregnancy, birth, or postnatal problems; 4,300 children die every year before their first birthday. Deaths due to infections and violence particularly affect the young population and are as common as mortality due to cancer. Interregional differences are great: life expectancy inthe province of Pichincha i s 15 years higher than in the provinces located inthe Amazon region. Inequitablehealthcoverage translates into sharp differences inlife expectancy at birth, whichrangesfrom 75 years for inhabitants ofPichinchaprovince surrounding Quito, to 65 years in the poorest highlandprovince, Chimborazo, and only 60 years inthe Amazon. The healthproblems are accentuatedby inadequatenutrition and lack of access to care centers. 3.36 Inthe healthsector,there was nomajor progressinimplementingsector reformin2003, as the ministry also experienced high rotation-including three ministers-of top authorities. The GOE's long-term goal, however, is to guarantee the population access to a basic package of essential services that i s financially sustainable, offered through networks of public and private providers. The "universal" coverage will be achieved in stages, through the gradual transfonnation of existing institutions that currently provide or finance basic health care to some segments of the poor population. Formal agreements will be signed between some health care providers that currently target the poor and the Ministry of Health, so that the population with no current access to health care can receive services there-financed by the Ministry of Health. Next, a comprehensive cost-effective basic health care package will be defined that can be provided universally, and agreements will be signed with the Ministry of Health for the provision of this basic package to those without protection. Over time, an increase in coverage of the vulnerable population will come from the contracting of networks of providers with access to this population. As a first step, several possible actions are: 9 Improving the LMC to broaden its coverage, while considering the social and cultural factors that limit the demand for basic services, and increasing coverage by the Rural People's Social Security program (Seguro Social Campesino, SSC) along with that of the LMC. The SSC's financial limitations prevent it from being broadenedto cover everyone, but the mother-child populations may receive the same services under the LMC. 9 Introducingbasic healthservicesthrough the Bono Solidario for the retired and disabled: preventive and informational services, outpatient treatment, and hospitalizationfor prevailing acute illnesses, and a basic package for chronic illnesses and surgery. This would provide coverage to approximately 230,000 pensioners and 8,000 disabled people who have no other resources for medical attention. 9 Redefiningtheessentialfunctions ofthe MPHby shifting itsrolefromadirect supplier of servicesto one of accrediting establishments, monitoring the service quality, creating a health monitoring system, and providing training for interventions in situations of epidemiological risk. As part of this redefinition, sectoral associations could be established with the Ecuadorian Social Security Institute (IESS). Coordinationbetween MPHand IESS health services i s an important areafor strengthening. 9 Creating aregulatoryframework for a systemof regional healthservicesnetworks with levels scaled according to their complexity. The MPH installations, decentralized establishments, and the SSC would all participate, and at the local level would focus their efforts on primary care and basic services. 9 Creating a new insurance program for the poor population, covered under the SSC, which would consolidate and progressively replace the benefits of the LMC and the health provisions of the Bono Solidano. 9 Graduallyincreasingpublic spendingonhealth. 44 C. Improvingthe Safety Net 3.37 Social Protection. The economic crisis of 1998-1999 generated new demands for social assistance. The groups in chronic poverty have been joined by groups requiring temporary social assistance. In2001, Ecuador spent close to US$264 million on 22 Priority Social Programs (PSPs), or about 1.5 percent of GDP, above the average in the countries of the region. About 60 percent of this amount was allocated to two programs for transferring cash: the Bono Solidario and the Beca Escolar (educational scholarships). The two most important programs were the School Breakfast and Lunch program--US$24 million-and the Bono Solidario--US$155 million. The subsidies on cooking gas and gasoline are not includedinthe 22 PSPs. Bothcost about US$500million, are nondiscriminatory, and are mostly consumed by higher- income citizens, that is, they are regressive. No anticyclical programs aiming to protect individuals against temporary reductions in their income or well-being, or in times of crisis, when the number of poor increases as a consequence of temporary impacts on major sectors of the population, exist. A typical example of an anticyclical programi s unemployment insurance. Table 111.4: Incidence of Social Expenditure by MainProgramsand Income Quintiles Income Per Bono D. Subsidies on Energy HealthServices Capita Humano Accordingto Suppliers Cooking- Gasoline Ministryof Farmer's SS General Gas Health Insurance (IESS) Poorest 20% 5% 27% 8% 0% 19% 26% 5% Second quintile 9% 28% 14% 1% 23% 35% 7% Thirdquintile 13% 25% 20% 4% 22% 13% 21% Fourth quintile 20% 16% 24% 10% 24% 21% 22% Richest 20% 53% 4% 33% 85% 11% 5% 46% Education Childcare School Primary Secondary Tertiary Tertiary Programs Meals Public Private Poorest 20% 16% 38% 35% 15% 3% 0% Second quintile 37% 15% 26% 23% 12% 1% Thirdquintile 20% 12% 20% 26% 16% 6% Fourth quintile 19% 33% 13% 22% 28% 22% Richest 20% 7% 2% 6% 14% 40% 70% Source: Vos andothers (2002) basedon Encuesta de Condicionesde Vida (1999). 3.38 The social protectionnetwork has major shortcomings. The social protection system suffers from procyclical spending, highfragmentation (over 20 "priority programs"), and poor targeting (Table 111.4). Its functions (and budget) contract in times of crisis and expand innormal circumstances, that is, they are procyclical. This also manifests itself in the absence of PSPs with established minimum spending levels that are effectively met under budget execution, and in the lack of a mechanism for automatically updating the database of program beneficiaries. The multiplicity of social programs has high potential for continuous duplication and overlap. Most of the programs under the social network feature regressive spending, and those presumed as pro-poor targeted lack consistent criteria for choosing beneficiaries. Indeed, with the exception of primary education, the Bono de Desarrollo Humano (unifying the Bono Solidario and the Beca Escolar), and the farmers' social insurance, all remaining universal social programs are regressive, that is, they benefit the population with higher-than-average incomes (Vos and others 2002). Inaddition, some programs, like gasoline and liquidgas subsidies, target high-income (rather than low income) populations specifically. Finally, pro-poor targeted programs- Bono de Desarrollo Humano, School Breakfast and Food Meals, and Childcare Attention have a reasonable coverage of vulnerable groups, but vary in their effectiveness, do not use consistent targeting 45 criteria, and need to improve their ~overage.~'In particular, the Bono Solidario has multiple design problems: it i s static, it does not have a mechanism to update its intended beneficiaries, there were errors inits original focus on the target population, there is a lack of clarity inthe program's objectives, and it does not generate mechanisms for ending the dependence on the Bono. Some recent programs, though, such as the Education Scholarship, represent a fundamental change. Indeed, this program pioneered the use of a clear targeting tool, a system known as SELBEN, the Beneficiary Identification and Selection System (Sistemade Identijlcacio'ny Seleccidn de Beneficiarios), and it also provides money transfers in an attempt to influence the behavior of the beneficiaries. 3.39 In a context of fiscal adjustment, the social protection network partly implemented needed reforms in2003. Despitethe minister of Social Welfare was changed three times, a common feature for all social ministries, there was some progress, especially linkedto changes inthe Bono policies: the Bono de Solidaridad and the Beca Escolar were merged into the Bono de Desarrollo Humano, with increased benefits, and prospects for revisedtargeting, coverage, and evaluation. However, this i s only a first move a series of proposed reforms. 9 First, an anticyclical feature of the budget assigned to social protection needs to be applied, using some mechanisms (like floor spending) to ensure that the system can adapt in times of crisis, when the number of people demanding social assistance grows. In 2003, the Government committed to ensure minimum floor spending allocations to 6 priority social programs-Bono, Programa de Alimentacidn Escolar, Programa de Alimentacidn para el Desarrollo Comunitrario, Programa Nacional de Alimentacidn y Nutricidn, Plan Ampliado de Inmunizaciones, Ley de Matemidad Gratuita and Public Investment in Education. Results indicate that around 80 percent of such allocations were executed, not without severe administrative difficulties. 9 Second, the number of programs inthe current social assistance system should be diminished. This requires a review of the benefits, targeting criteria, objectives, and administration of all programs. Subsidies on energy that demand a major political commitment are not easy to implement and have beendelayed untila proper evaluationof alternative targeting mechanisms i s implemented. > Third, regarding Ecuador's largest assistance program, the Bono Solidario (Cash Subsidy Program), the new administration should focus its efforts on ways to take advantage of the program's structure to serve as the backbone of the social assistance system (see next section), or the targeting tool of the gas subsidy. The incoming Poverty Assessment identifies additional proposals for reforming the social protectionframework (World Bank, 2004). D. Completing PensionModernization 3.40 Pension Reform at a Crossroads. The formal social security sector has very low effective coverage (26 percent of the Economically Active Population [EM]). There i s no coordinationamong the income protection schemes for the elderly (for example, the formal social security system, the Bono Solidario, and the Seguro Social Campesino (SSC), the noncontributory insurance scheme for independent rural workers. Access to pensions and income supplements among the elderly inEcuador i s one of the lowest in LAC, judged by traditional indicators, like the proportion of the EAP that pays into the contributive system, or the proportion of people age 60 or older with benefits. With only 15 percent of older individuals receiving a contributory pension and another 15 percent receiving a noncontributory benefit, Ecuador is the country with the second-lowest percentage of contributors to formal pension schemes, after Bolivia. Because the elderly are a significant proportion of the poor, coverage should be expanded inthe formal sector and inthe informal sector. This may be accomplished by improving labor 32. Well-targeted cash-transfer programs, like Progesa-Mexico and PRAF-Honduras, reach above 40 percent of the populationlocated inthe first quintile, and 62 and 80 percent, respectively, locatedinthe second quintile (De Ferrantiand others 2003). 46 market conditions, enforcing existing legislation, and designing and implementing well-targeted and fiscally sustainable noncontributory benefits. 3.41 The formal contributory pension scheme faces a number of financial challenges with potentialfiscal implications. First, inthe past, the Government of Ecuador has runsubstantial arrears on its contributions to IESS as an employer, and on the 40 percent of pension payments it i s liable for, according to the law. The Constitution requires that the GOE and the IESS reach an agreement on the value of this debt, and that it be paid by 2009. There i s an agreement on the value of the debt in Sucres: but depending on the valuation mechanisms used to assess the historic debt, the total liability fluctuates between US$O.4-$2 billion. Second, the 40 percent payment by the GOE to IESS i s maintained by the new Social Security Law, with the added problem that it also applies to increases in pension benefits, which are determined exclusively by the IESS. 3.42 The administration of IESS funds lacks transparency and allows for cross-subsidiesamong programs. Ecuador is one of the few countries inLatinAmerica where the health and pension funds had not been separated. Until recently, this meant that there was no separate accounting or financial management of the funds, which left the door open to possibly large cross-subsidies from one fund to the other. In2002, an Intervention Commission approved separate accounting. Additionally, there are only recent regulations at the IESS with respect to publication of balances or to provision of transparent account of the use of funds or its investment criteria. Besides this, the GOE has not articulated an integrated pension policy yet, although many institutions have their own strategies and clienteles. This fragmented system displays coverage gaps, reduce mobility between employers and institutions and, possibly, inequitiesthat can be counterproductive. 3.43 Indefininga strategy to increase coverage,the fiscal implications should becarefully taken into account. Following an actuarial analysis of pension regimes, institutional reforms should be implemented slowly to improve the long-term sustainability of the pension system, easing the fiscal pressures and incorporating defined contribution components in the formal sector. A new legal framework that defines the long-term structure of the social security system in clear terms and generates the conditions for the development of a financially sustainable system with high coverage should be approved. Negotiations are under way to determine the value of the GOE's debt with IESS and the schedule of payments, and a revision of the current Social Security Law, which has been questioned on legal grounds in the superior courts of Ecuador. More pressing issues are the recent increase in average benefits and the ratio of beneficiaries to contributors. Given a recent increase in average benefits, the assessment of long-term fiscal consequences of pension trends i s being developed with assistance from the World Bank. The assessment not only covers IESS, but also the pension institutions covering the army (ISFA) and the police (ISPOL). Recent attempts by Guayaquil and Quito mayors to create municipal insurance schemes, guaranteed by public resources, for the same populations as the IESS, are likely to contribute to fragmentation of the system rather than necessary improvements in social security coverage, and are therefore not warranted. Providing Quality Government Services A. Addressing Governance and Corruption 3.44 Detailed surveys indicate that the issue of corruption is of considerable concern to Ecuadorian citizens and affects their daily lives. Corruption i s shown in cross-country studies to be associatedwith worse rather than better service, to impact the poor disproportionately inthe allocation of public resources, and to increase public disaffection with the polity. As Ecuador went through its severe crises, the trend on most measures of governance has been toward a worsening performance on such indicators as accountability, political stability, government efficacy, regulatory capacity, rule of law, and control of corruption. Since President GutiCrrez has made improving governance and reducing corruption 47 two of his administration's key priorities, it will be important to gather new evidence to see whether it points to a halt inthe downward trend beginningin2003. 3.45 In order to achieve these goals, it is essential that the Government takes the lead in improving governance. To do so, the GOE will need to identify the institutional strengths and weaknesses of the public sector. This will allow it to isolate the underlying causes for inadequacies in public services and the prevalence of corruption, and enable it to develop a program with monitorable indicators to address these issues. This will require considerable political leadership and long-term commitment to mobilize broad support for specific measures, such as introducing results-oriented indicators for the performance of public services, reforming public procurement and financial managementpractices, increasing accountability and transparency inpublic resource allocations, pursuing civil service reforms, and on one hand improving legal protection for public officials who attempt to enforce laws and regulations while on the other hand pursuing cases of gross negligence or bad faith in public service. 3.46 The Government was elected with a mandate to fight corruption and increase the transparency of concession or procurement of public services. Ecuador's Civic Commission for Controlling Corruption (CCCC), established constitutionally in 1998, has successfully set up a web-based public contracting system, Contratanet, which the Government hopes to implement widely in public procurement. The Government has also proposed to extend the Integrated Financial Management System (SIGEF) to all public entities and widen its reach through a Transparency Portal (website) system. Other proposed reforms are to increase the coordinationamong key oversight agencies, including the Offices of the Government Auditor, Attorney General, and Prosecutor. Indicators of service quality and productivity will be introduced throughout institutions that manage public funds. A new procurement law i s also under preparation. Moreover, the Government intends to promote greater accountability and participation through a dialogue with several domestic actors. B. UpgradingDecentralization 3.47 Public centralized decision making is often partly to blame for the poor quality of the delivery of services. This i s the case of Ecuador with still centralized services-education, health, public works, police, etc- and very poor accountability. In fact, a well-designed decentralization process i s missing, which is partly to blame for poor quality public spending. Shortcoming in the present Ecuadorian decentralization framework are multiple: (a) it lacks a clear definition of areas of responsibility for the second tier of public administration (functional decentralization) inrelation to lower layers of local authorities; (b) there i s no correspondence between a noncoordinated transfer of resources with transfers of responsibilities by authorities; and (c) local governments have no transparent expenditure and debt management. As a result, decentralized spending has poor quality and no accountability, with a high risk of not measuring the fiscal contingent liabilities of the subnational governments. Consequently, if these governments run high fiscal imbalances, their imbalances could eventually impact on the fiscal health of the national government, with major implications for macroeconomic stability. 3.48 A few measuresare neededto upgradedecentralization: 9 On the onehand, in2003, the Government hascomplied with the constitutionally mandatedtransfer of 15 percent of revenues from the Centralto localgovernments, but this process has not been neither timely, nor transparent. 9 Onthe other hand, suchincreasedamount of resourcesshould havebeenassociatedto the transfer of responsibilities and performance-based results. This implies that subnational governments should meet minimumstandards including accounting, budget management, regular reporting, sanctions for noncompliance, and dispute settlement procedures. None of this has been enforced so far. 48 9 Reschedulinglocal government debt might also be needed, once an initial assessment is completed. This could be coupled with quarterly budget reporting and publication of municipal accounts in the website. Independent credit ratings for new Bank lending applications for the largest three cities would be advisable. C. Consolidating Judicial Reform 3.49 The need for an effective, efficient, and transparent legal andjudicial system is essential to improve the rule of law in Ecuador. The process of legal and judicial reform is long term. An important initiatives for judicial reform were launched in 1996. Plans to support a second phase of judicial reform are in great demand from the general public, given Ecuador's poor ratings in governance and in the predictability of judicial processes. The Government says that legal and judicial reform i s a priority. The main challenges include limited access to justice for the poor, delays in dispute resolution, unpredictability in contract enforcement, and the perception of lack of transparency. The Chief Justice, through the Supreme Court and the Judicial Council, is leading an effort to develop a comprehensive plan reflecting specific priorities, sequencing it with stakeholders and developing a program to scale up successful pilot projects. Inthis context, efforts should be made to: (a) strengthen the legal framework supporting judicial independence; (b) develop a comprehensive plan to improve legal andjudicial training of judges, lawyers, and court clerks; (c) introduce legal, regulatory, and institutional reforms to combat corruption; (d) improve access to justice, notably for women and for poorer Ecuadorians, through further institutionaland legal reform; and (e) encouragepublic participationinfuture reformefforts. D. Strengthening Oil EnvironmentManagement 3.50 Important environmental liabilities still persist in the oil sector. In some of the fields operated by Petroecuador, wastewater discharge into the environment is a problem yet to be resolved. Of the 140,000 daily barrels of processing water used in the facilities of Petroecuador, 99,400 barrels (71 percent) are reused; however, 40,600 barrels (29 percent) are discharged naturally into the environment. Furthermore, there are hundreds of petroleum waste-collecting pools that are not being treated. An estimated US$400 million would be needed for this remediation. Another problem i s the burning of the gas by-products. Moreover, there i s a lack of incentive to adopt new technologies that are more environmentally friendly. Though recent progress as been made in civil society participation, more capacity i s needed to hold discussions with key stakeholders and to make consultations with and the participation of the local towns more productive. And, although the environmental budget of Petroecuador has increased in recent years, it still corresponds to only about 1 to 2 percent of total investments. 3.51 A critical ruling area for growth in an oil-producing country is the enforcement of oil- environmental regulations. Ecuador has some.of the most advanced environmental legislation inLAC. The Law on Environmental Management was approved inJuly 1999 regulating the execution of industrial projects. Moreover, the Environmental Regulations on Hydrocarbon Operations were approved in February 2001to regulate the development of petroleum industry activities involving environmental and social management. Its main modification was the raising of environmental standards to international levels, with special emphasis on the injection of formation waters, emissions monitoring, and environmental auditing procedures. The Regulations for the Consultation and Participation of the Indigenous Populations inHydrocarbonActivities were also approved inDecember 2002. These clarify the rights of local communities, particularly indigenous peoples, to be consulted prior to the bidding process for new oil exploration and exploitation contracts, and prior to the start of the oil contract execution. Results have been positive. In2002, under a newly decentralized framework for the Ministry, responsibilities of the regional offices were expanded, leading to the creation of the Regional Office for Environmental Protection. This framework and added institutional support has greatly enhanced 49 monitoring capacity in 2003, leading to a nearly 400 percent increase in field inspections in 2003, 28 percent increase in environmental studies, and above 200 percent increase inpublication of environment studies. The GOE has also created a tripartite (government-community-oil industry) commission to review the application of regulations governing the consultation process on hydrocarbon investments in indigenous and environmentally sensitive areas. 50 IV. MEDIUM-TERMOUTLOOKAND RISKS 4.. The internationalcommunity is well aware that the GOE has taken a number of sound and comprehensive policy initiatives since it took office on January 15, 2003. Previous chapters have described the political setting, major challenges, and core components of such agenda. Inthis chapter, we examine whether the proposed policies are able to achieve the promisedturnaround that the Government i s seeking, laying to rest the threat of a debt crisis, beginningto close the social and governance gaps, and fostering fast, competitive, and equitable growth. Our overall answer is cautiously positive, for Ecuador's stability and recovery are promising, but vulnerable. This chapter is devoted to macro prospects, assessingvulnerabilities, and proposingremedies for mitigatingpotential risks. A. The Outlook for Growth: A Base Case Scenario 4.2 In a context of modest recovery of the international and regional economies, falling international oil prices, and weak domestic consensus, it would be optimistic to expect very high growth and rapid benefitsin the near term from the reform program inwhich Ecuador is engaged. Poverty rates and, especially, income distribution, are sticky variables, which are unlikely to change rapidly even though the restoration of purchasing power of the population has recovered to 1998 levels following dollarization. The rate of growth of remittances inflows should gradually decrease over time with decreasing migration flows and mild economic recovery inthe U.S. and Europe. Social expenditure will be constrained for some time by the need to exit the debt trap, and it remains to be seen whether the new authorities succeed in fighting corruption and improving governance with tangible results. It takes time to raise educational andhealth standards. 4.3 A base case scenario assumesmoderate growth with low inflation, with no major exogenous shocks to the present regime. It i s based on the assumption that the economic program will be successful in sustaining dollarization (Box IV.1). 33 Under this scenario the government would have steady growth and lower inflation, favored by slow expansionary spending, an increase in non-oil tax revenues, and sizable primary surpluses,. Stability will induce a reduction in interest rates to foster private-foreign and domestic-investment and exports as the main sources of growth. Restructuringof Box IV.1: The BaseCase Scenario During 2004-06, key assumptions are: growth averaging 4.0 percent, with single-digit inflationrates, converging to international levels (2 percent) by end-period; decline inoil prices in2005-06, with falling prices partly offset by new oil exports. o A WTI oil price assumptionof $32 per barrel is usedfor 2004, and $20 per barrel for 2005-06 . o Steady private investment inthe oil sector occurs. Oil production should increaseby about 40 percent, or 64 million barrels (and increase from 400,000 bpd to 570,000 bpd), during 2003-06. Of this increase, PetroEcuador's production is expected to remain relatively flat, increasing only 9.5 percent during this period, whereas private companies should see their production levels increasing 81percent. o The increaseinoilproductionwill support growth rates of 4.0 percent inthe periodforecast. o As a result, on the internal balances, the NFPS primary surplus should average 5 percent of GDP (for an NFF'S overall balance surplus of 2.2 percent of GDP) arising from temporarily increased oil and tax revenues, austerity measures and declining public spendingin real terms. o Compliance with all fiscal rules contained in the Fiscal Transparency, Stabilization and Responsibility Law (Ley de Transparencia, Estabilizacidny ResponsabilidadFiscal, FTSRL) is also assumed. o The high primary surpluses will allow the government to cover their amortization payments with little additional financing. Moreover, funds from the FEIREP will be usedto repurchasedebt. The period ends with a gradual decline of the public debt-to- GDP ratio to the minimum sustainable ratio of 40 percent of GDP in2006, the benchmark set up inthe fiscal rule, as a result of the active repayment of expensive domestic and external (global) debt with the primary surpluses. Such ratio should continue declining over subsequentyears. 33. This section was prepared with inputs from Horacio YCpez and Elaine Tinsley. 51 the banking system will continue. All inheritedpublic debt arrears are cleared in 2004, while preventing any default over the next three years, and reaching the public debt-to-GDP ratio mandated by the fiscal rule of 40 percent by 2006. Partial grant financing of the priority social expenditure will be identified by the GOEto bringadequateprotection to the poorest, while minimizing the potentially negative short-term impact of adjustment measures, thus preserving minimumsocial and political consensus over the difficult measuresto be adopted. B. Risks: What if Oil ProspectsDeteriorate? 4.4 Bringing more oil production online and complying with the FEIREP debt repurchase program has critical implications for the macroeconomic outlook. On one hand, private oil companies have started to boost their production rates, but filling the pipeline could take longer than initially envisioned. With the new oil pipeline operating, Ecuador has the potential to raise its oil exports from 400,000 barrels per day (bpd) to 900,000 bpd, while increasing public oil revenues significantly from current US$1.7 billion up to about US$3.0 billion. Private investment in the past couple of years, however, was lower than expected mostly due to legal disputes between the private fm and the government over the application of the drawback (VAT rebate). Judicial insecurity i s also, commonly cited for holding back investment. Therefore, the rate that the second pipeline fills up will depend on the business environment that the government createsto encourageprivate sector investment inoil, including provision of legal and economic stability of oil contracts-beginning with the resolution of the VAT problem-and finding a contractual formula to allow PetroEcuador to partner with private companies to develop reserves in its most important oil fields, including those resulting from the exploration of new areas. Inearly December 2003, the GeneralProcurador mandatedthat the amount of funds entering FEIREP would be basedon the marginal increaseinfiscal revenues earned through crude oil transported through both the OCP and SOTE. Of the FEIREP funds, 20 percent would be designated to a stabilization fund, 10 percent to social expenditure, and 70 percent to debt repurchasing. In addition, of the oil revenues above the $18 benchmark that enter into the previously existing Oil Stabilization Fund (FEP), 45 percent would also enter FEIREP. On the other hand, just increasing the amount of fiscal revenues available i s not enough to guarantee that the government will channel increased funds into the FEIREP and that these will effectively be used for debt repurchasing. Moreover, a major concern is that retirement of local debt to IESS and possibly to CFN could be used to stimulate domestic demand with pensions increases and banking credits, thus generating inflationary pressures and having no impact on improving the country's debt creditworthiness 4.5 A Low Case scenario would turn the economy into a low-growth, unsustainable debt path. Inthis extreme scenario, we examine the impact of lower oilproductionlevels andprices onthe macro and fiscal accounts. Incomparison to the base case, overall oil production rises, but at a more moderate rate of about 12 percent during 2003-06, equal to 19 million barrels (or from 418,000 bpd to 471,000 bpd). Private oil companies show an upfront production level increase of 40 percent, but beyond 2004 this level remains fairly constant. On the public side, PetroEcuador production levels continue their downward decline-for lack of addressing inefficiency and low investment rates-falling 15 percent by 2006 (Figures IV.l and IV.2). In addition, while prices are still relatively high in 2004, they decline to $12/barrel in 2006 - the same level that triggered the previous crisis. ,Lower production contributes to real GDP growth falling to 2 percent and also results in fewer revenues to the government. Hence, ,by 2006, the combined impact of lower production and prices would lead to a primary deficit of 0.3 percent of GDP, yielding an overall deficit of 3.1 percent. With fewer funds entering the FEIREPupto 2005, and nothing in 2006, debt repurchasing is limited and the debt ratio only declines to 52 percent of GDP in 2006 compared to 40 percent in the base case. A comparison of the outcomes of both scenarios i s depictedby Figure IV.3. 52 Fig. IV.l: Base Oil Production (Millionbarrels) Fig. IV.2: Low Oil Production(Millionbarrels) 250 1 1 250 200 5 150 100 50 0 2003 2004 2005 2006 2003 2004 2005 2006 EPetroEcuador W Private PetroEcuador W Private Figure IV.3: Comparisonof Base and Low Case RealGDP(xchange) 011Production(Millionbarrels) 5.0% 2 I 220, I 4.0% 3.0% 2.0% 1.O% 120 - 0.0% 100 7 2003 2004 2005 2006 2003 2004 2005 2006 -Ease -Low -Ease -Low PrlmarySurplus (%OW) PublicDebt(kGDP) 6.0% 60% - 5.0% 50% - `Ir, 4.0% 3.0% 40% - 2.0% 1.O% 30% - 0.0% 20% 7 -1.0% 2003 2004 2005 2006 -Base -Low -Base -Low FiscalBalance(XGDP) m mmows(Millionlis$) 3.0% - 1-1 I 2.0% - 1.0% - :~~ 0.0% - -1.0% - 200 -2.0% - -3.0% - 100 -4.0% 0 4 \ 1 3nnR 3 n ~ 7nn.5 7m 2003 2004 2005 2006 -Base -Low -Ease -LOW 4.6 Removing the oil price effect from the Low Case scenario, would improve debt sustainability, however low production still has a considerable effect. Without the fall in prices (using prices from the Base Case), by 2006 the primary balance would remain positive, but fall to 1.2 percent, meanwhile the overall deficit would be 1.6 percent, and debt ratio would decline to 49.6 percent in 2006. Indeed, netting out the multiplier impact of other revenues, lower production levels alone still contribute about 2 percent to a fall inthe primary surplus. 53 4.7 A High Case scenario could alternatively reinvigorate the economy. The barrel of the reference crude WTI averaged over US$30 during 2003. If oil prices remain high, oil production levels by private companies increase beyond present forecasts, the recovery of the U.S. economy places new emphasis on Ecuadorian exports, fiscal discipline allows bigger than projected fiscal surpluses and public debt repurchases, and inflation continuous its declining trend, the economy could move faster than expected to annual growth rates above 5 percent, with an additional reduction of 1-2percentage points in the projected decline inpoverty rates. C. OtherRisks 4.8 There are other significant risks associated with the base case economic projections. Beyond an oil price downfall, the Ecuadorian economy remains vulnerable to other domestic and external asymmetric shocks that, should they materialize, could derail the economic program. For instance, the economy i s vulnerable to non-oil terms-of-trade shocks, especially arising from bananas, and shrimp. Remittance flows might fall faster if migration policies in labor-recipient countries like the United States and Spain continue to get tougher. Global or regional economic recovery could take longer than projected. Competitive depreciations by neighboring countries might affect external competitiveness. The projected external financing might not materialize if another sudden stop arises. Without seeking to be exhaustive, we consider four types of risks: external (contagion, sudden stop, overvaluation, eroding external competitiveness, and a risinginternationalinterest rate); institutional; social; and political. 4.9 External risks. The external environment might turnworse than depicted inthe low case. Given dollarization and the absence of any meaningful lender of last resort for the banking sector, external economic shocks might make a deflationary fiscal adjustment socially unbearable and put the fragile bankingrecovery at risk. o Contagion. Since 2000, and following the Argentine crisis that Ecuador weathered relatively well, contagion ratios remain highinLatin America, and Ecuador i s no exception. Contagion is defined as a significant increase (shift) in cross-market linkages after a shock to an individual country (or group of countries) (Forbes and Rigob6n 2000). Cross-market linkages can be measured by a number of different statistics, such as the correlation in asset returns, the probability of a speculative attack, or the transmission of shocks or volatility. Hence, a simple measure of contagion i s co-movement in country risk in LAC, that is, the mean of bilateral correlation coefficients of changes in EMBI+ spreads (Perry and Fiess 2003). An increase in this measure signals higher co-movement of country risk. Figure IV.4 shows that co-movement in Ecuador EMBI+ and LAC EMBI+ spreads reached significant (above a threshold) levels starting in mid-2001, and that these remain high particularly after March 2003, possibly due to the resumption of the rally in emerging market bonds.34 Perhaps the current highlevel of co-movement (around 0.5) for Ecuador and (slightly higher) for LAC can be better understood when put inperspective: the 2003 level of co-movement i s similar to the one of the Russian crisis in 1998, or of the Brazilcrisis, when the real abandoned its fixed exchange rate regime. o Sudden Stop. As far as contagion indicators reflect regional uncertainties and accompany highlevels and volatility of spreads inLAC, these will have important consequences on market access, spreads, and trends in capital flows across the region. Prospects for a sudden stop of capital inflows in Ecuador are lower than in 1998, but non-negligible. Propelled by the construction of the new oil pipeline, FDI flows remain positive, significant, and stable, and the combination of the oil windfall with highlevels of family remittances show a muchlower current account than the unsustainable pre- dollarization levels (9.3 percent of GDP) of 1998. However, Ecuador's public and financial sectors remain mismatched, the former interms of debt composition relative to GDP composition intradables compared to nontradables, and the latter in terms of the allocation of dollar credit to tradable 34. This figure was calculated byNorbert Fiess andConrad0 Garcia-Corado. 54 compared to nontradable sectors. Although we provide no estimate of the former, financial mismatches on the side of borrowersremain significant and increasing inEcuador: as a percentageof GDP, dollar credit to nontradables sectors increased from 15 percent in 1998 to 23 percent in 2002 (Izquierdo 2002). In the event that a quarter of this amount became non-performing, it would be a substantial contingent liability burden to bear, for both banks and the public sector. To mitigate this risk, financial mechanisms like overprovisioning in nontradable sectors during booms, followed by underprovisioning duringrecessions, havebeen suggested(Izquierdo 2002). FigureIV.4: Co-movementin Ecuador EMBI+spreadand LAC EMBI+ Spreads (correlations between changes in Ecuador EMBI+and LAC EMBI+ spreads) Ecuador EMBI+and LAC EMBI+ (withoutArgentina Ecuador EMBI+and LAC EMBI+ Co-movement w/o Argentina o Overvaluation of the Real Exchange Rate (RER). RER swings can have devastating effects, especially under dollarization. The collapse inthe capacity to service debt by developing countries i s more relatedto RER volatility than to output declines (Hausmann and Rigob6n 2003). A sudden stop can lead to a substantial RER depreciation if the RER i s significantly appreciated, and the fiscal and/or current account deficits are high. Because the speed of price adjustment to RER depreciation inthe nontradable activities under dollarization is slower than under a floating regime,35the number of nonperforming loans would increase, thus raising the chances of a possible bailout and, if so, a reversal to an increasing trend inthe public debt-to-GDP ratio. InEcuador, the volatility of the RER significantly rose after dollarization, increasing from 12.5 percent during 1995-99 to 24.5 percent during 2000-02.36 The RER appreciated sharply (by 60 percent) between 2000 and 2002 (Figure IVS), but a weak dollar has likely contributed to a real depreciation of the real exchange rate with respect to its main non-U.S. partners since 2003. To mitigate this risk, non-expansionary policies, like preserving highprimary fiscal surpluses and keepingmoderate current account deficits, are critical. 35. Revaluation effects from RER depreciations on debt stocks are larger under dollarization, because it i s more difficult to absorbthemonly with fiscal policy (flow) and increases the risk of repudiation. This i s pricedby investors inbond spreads (Izquierdo2002). 36. Estimatesare available uponrequest. FigureIV.5: Ecuador:Changesin RealGDP and RealEffective ExchangeRate(REER) (percent) 50.0 40.0 30.0 -Change in REER 20.0 10.0 0.0 -10.0 \v I/ -20.0 V -30.0 ' Sources:WEO, and IFS statistics. o Eroding External Competitiveness. Successive devaluations by neighboring countries, lax domestic wage increases in real terms, continuous low growth in total factor productivity, and persistent low performance in international rankings of governance and corruption, would further deteriorate external competitiveness. Driven by large family remittances, both prices and real wages have increased more rapidly in the nontradable than in the tradable sectors and financed imports of consumer goods. Ina country preparing for a regional Free Trade Agreement with the United States, containing wages, boosting productivity with technology and skills training, and gaining ground in governance and international quality are essential to maintain external competitiveness over the mediumterm. o Rising International Interest Rates. The debt burden remains heavy, even though it features a declining trend since dollarization. Risinginternationalinterest rates would make it heavier because, following default in2000, the country remains with no access to internationalcapital private markets, and the cost of domestic public debt would increase in line with rising domestic interest rates. To mitigate this risk, Ecuador should implement a comprehensive debt-reduction strategy and strengthen debt management with a view to reentering international markets by 2005-06. In the near term, this implies fully clearing past arrears, preventing the accumulation of new arrears, and complying with bilateral debt rescheduling agreementsagreed with the Paris Club in2003. 4.10 Inthe nextthree years, there could be some combinationof adverseexogenous shocks that could test the dollarization regime, unless Ecuador is prepared. To mitigate the impact of external risks, the government should design and implement a prudent fiscal policy for insuring against and reacting rapidly to unfavorable new shocks. To support Ecuador emerging from its debt difficulties, it should keep replenishing the oil stabilization fund and repurchasing debt as mandated by law. Sustainability of dollarization would also be favored by an increased share of non-oil tax revenues, diversified non-oil exports, strengthened prudential regulations, the strengthening of a liquidity fund for commercial banks, increased labor market flexibility, and higher private participation in key investment sectors. 4.11 Institutional Risk. In the event of a protracted oil boom beyond 2003, government officials might be tempted into premature relaxation of either the drive for structuralreform or the rigorous fiscal policy neededto overcome the debt crisis, or both, by using available FEIREP resources. From 2004, a sizable amount of FEIREPresources will be a big temptation to relax spending, and countries affected by 56 Dutch disease have a poor record in resisting temptations. Continuous Cabinet changes--especially in the social sectors4uring the fxst year of the present administration, non-transparent public financial management, and the little control the Central Government has over expenditure by sectional (subnational) governments, also weakens the Government's institutional capacity to sustain the drive for fiscal reform. To mitigate this risk, the Government must ensure strict compliance of the distribution of FEIREP resources with the fiscal rule, and prioritize external debt reduction to cushion against shocks that could raise expenditures ina downturn and increasethe risk of insolvency. 4.12 Social Risk. The fragile social coalition that supported the election President Gutidrrez might further break up. Ensuing social unrest could lead to opposition in the streets to the reform agenda and prevent the government from implementing key, but unpopular, measures. To mitigate social risk, the GOE should strengthen efforts to promote a national dialogue with civil society, including union and indigenous leaders, and implement its social agenda which is designed to increase the financing and quality of social spending and enhance the coverage and delivery effectiveness of basic public services. Since weak and poorly performing institutions and continuous ministerial changes have limited the impact of its policy actions, it will be important to strengthen efforts inthis area. 4.13 Political Risk. The President i s viewed as an outsider among the traditional political elites and faces a fragmented Legislaturewith a small minority of elected Deputies inhis party, SP. This makes any political coalition fragile and unstable. The biggest concern of firms in the Investment Climate Survey (see Annex B) i s the danger that government officials will not stay the course as an outcome of their political coalitions. Efforts to force deviation from the GOE's agenda would materialize through the approval of much-watered-down versions of the original laws, like happened in the new Customs, Civil Service and Wage Unification reform bills in 2003. However, the sustainability of the development agenda requires that the Government stay on course, as abandoning a sustainable development agenda would likely imply not only an economic and social downturn for the country but also political failure for the Government. To mitigate this risk, the new Administration should prevail in maintaining strong efforts to develop its dialogue with members of Congress and political forces on a commonly agreed national agenda. In fiscal terms, agreeing on a medium-term expenditure framework-reflected in a participatory multiyear budgeting exercise mandated by the fiscal law-would facilitate preserving consensus through political negotiations. Authorities should also minimize the need for new laws, given the status of fragmented coalitions inCongress and make budget policy more transparent. D. Alternatives to the ExistingDevelopmentFramework 4.14 The risk of failure to reform the real sector is high. The sine qua non conditions for sustaining price stability and the drive for structural change are to deepen fiscal solvency, introduce flexibility in goods and services markets, and increase the productivity of the factors of production. Nevertheless, these conditions will not happen overnight and without facing adverse shocks. Besides, dollarization does not immunize a country from the balance sheet effects of an RER adjustment (Roubini 2001). Given the existence of inflexible markets-such as the formal labor market-con-ectionof RER overvaluation and adjustments to shocks under dollarization would occur slowly, primarily through painful reductions in production, with the corresponding contraction in demand derived from inputs, particularly labor. Deflation and unemployment would further erode the capacity to pay banking debts, especially from those whose earnings mostly come from the nontradable sector. This potential situation would not only create pressureto "abandon" the model, in view of increased unemployment, but would also contribute to an increase in commercial bank arrears, as a result of the decline in general economic activity. This in turn would make achieving the goals of both fiscal adjustment and recovery of the banking system less feasible-creating a vicious circle that would be difficult to break. 4.15 Prospects for sustaining dollarization are, however, high in the near term, as long as Ecuador is capable of generating large fiscal surpluses (around 4-5 percent) and complying with its 57 FEIREP-mandateddebt-repurchasingprogram. Ifshocks bringEcuador to lose fiscal discipline and there is a backlash in reforms, officials would still dispose of a few temporary buffers such as drawing down FEIREPresources that would otherwise be devoted to repurchasedebt, runningarrears in domestic payments or against external bilateral creditors, or drawing down domestic deposits or funds indeposit at the Liquidity Fund, before they could consider tampering with the dollarization regime. These solutions, though, would be palliatives and would not prevent adopting sooner rather than later the required fiscal adjustment to the shocks. It i s therefore essential to apply the broad agenda of structural reform recommended in this report, and based upon what the Government's Program aims, to prevent Ecuador runningintoanother crisis inthe nearterm. 4.16 Conclusion. The lack of fiscal prudence and structural reforms during the 1980s and 1990s, exacerbated by external shocks, were the main factors that led to the unsustainable economic situation that prompted Ecuador to dollarize. This fiscal prudence and these structural reforms are even more essential with dollarization, and there i s no de-dollarization scenario in which the banking sector, investment, growth and poverty reduction would not be severely impacted, or in which essential fiscal prudence and structural reforms could be averted. This Development Policy Review therefore concludes that it is essential to stay on a prudent course and to engage in broad dialogue with civil society to strengthenimplementationof the economic and social agendaof the government. 58 Annex A: StatisticalAnnex Table A.1: Real Gross Domestic Product by Industry (Millions 2000 US$) Table A.2: Real Gross Domestic Product by Industry (Percent annual change) Table A.3: Gross Domestic Product by Industry Table A.4: National Accounts, 1993-2003 Table AS: Operations of the Non-financial Public Sector Table A.6: Balance of Payment Table A.7: Exports and Imports Table A.8: Debt and Debt Service Indicators Table A.9: Monetary Accounts UnderDollarization Table A.lO: Economic Growth and Total Factor Productivity inLatin America, 1991-2000 Table A.11:Ecuador Social Indicators Table A.12: Ecuador: Contributions to Growth, 1991-99 Table A.13: Ecuador Public Sector and Oil -OLS Estimates, 1971-2001 Table A.14:ALCA Scenarios: Impact on Ecuador Table A.15: Base Case Debt Sustainability Analysis Table A.16:Low Case Debt Sustainability Analysis 59 TableA1 Real Gross DomesticProductbyIndustry Millionsof 2000 Dollars 1993 1994 1995 I996 1997 1998 1999 ZWO 2001(p) 2002(p) 2003(e) Agriculture, Livestockand Forestry 1003 1080 1109 1201 1309 1244 1405 1466 1471 1581 1599 Banana,CoffeeandCocoa 299 330 357 368 421 331 442 443 404 Cereales 145 153 144 157 173 133 130 137 150 Flowers 34 51 65 78 128 155 181 221 229 Other Crops 167 177 177 194 184 192 208 211 226 Livestock 245 253 245 259 268 285 288 279 289 ForestryandWood 112 115 121 124 135 146 158 175 173 Flshlngand Seafood 214 224 244 255 292 310 289 227 233 247 253 Shrimp 93 97 111 112 145 157 126 67 71 Fishing 122 127 133 143 147 153 163 159 162 Mineralsand Mining 2821 3152 3219 3245 3184 3133 3177 3430 3489 3366 3514 Extractionof Crude Petrol, NaturalGas, and RelatedServices 2742 3071 3131 3142 3102 3089 3115 3361 3418 Mining 79 81 69 103 82 84 61 59 71 Manufacturlng 1990 2049 2102 2208 2330 2458 2329 2170 2233 2246 2274 Foodand Drinks 1023 1055 1104 1162 1253 1340 1285 1056 1099 Tobacco Products 8 7 7 7 7 7 8 6 6 Textile, Clothingand Leather 351 350 341 380 399 404 382 408 409 Wood andWood Products 163 184 175 161 193 209 217 229 222 Paperand PaperProducts 75 87 68 91 95 95 90 95 97 ChemicalsandPlastics 169 172 174 174 174 165 162 169 179 Metalsand Nonmetal Products 137 144 143 146 136 141 124 139 144 Machinesand Equipment,Transport Equipment 65 68 70 67 72 77 61 64 74 Petrolrefineryproducts -850 -659 -731 -876 -684 -893 -1132 -1360 -1254 -1272 -1310 ~~ectrlciiyand Water 123 127 103 116 124 134 165 169 177 181 166 Construction 1138 1217 1222 1238 1271 1268 952 1127 1172 1344 1379 Wholesaleand RetallBusinesses 2322 2430 2427 2556 2673 2693 2392 2483 2601 2706 2730 Hotelsand Restaurants 183 186 196 202 210 222 193 199 198 198 ' 202 Transport, Storage and Communication 1258 1252 1309 1352 1463 1601 1597 1720 1749 1771 1823 Transportand Storage 1145 1139 1166 1181 1269 1322 1321 1413 1414 MailandTelecommunications 113 113 143 171 194 260 276 307 335 Rnandal lntennedlatlon 435 527 619 689 674 580 295 301 415 455 470 Real Estateand Rental Activltles 90.2 698 940 975 1017 1047 981 1004 1086 1086 1109 PubllcAdmlnlstrationand Defense;Obligatory SoclalSewrlty 869 812 749 742 763 609 784 835 849 677 918 Education 447 431 441 468 484 498 524 536 540 542 547 Socialand HealthServlces 205 214 223 233 239 247 249 260 270 263 266 Other Communfty,Socialand HumanServlces 75 65 108 97 105 118 113 116 115 115 117 DomesticServices InPrlvateHouseholds 23 24 25 25 26 27 28 28 29 30 30 IndirectFlnanclal IntermediatlonSeWlces -471 -546 -568 -673 -670 -567 -380 -385 -513 -515 -531 GROSS VALUE ADDED OF INDUSTRIES 12887 13504 13739 14053 14609 14910 13941 14326 14859 15221 15577 Other GDP elements 1383 1437 1464 1515 1590 1532 1558 1606 1890 2099 2176 GROSS DOMESTICPRODUCT 14270 14941 15203 15568 16199 16541 15499 15934 16749 17321 17753 Source:Central Bank 01 Ecuador (p) preliminary (e) estimated 60 Table A 2 RealGross Domestlc Productby Industry Percentannualchange 1994 1995 1996 1997 1998 1999 2000 2001 (p) 2002(p) 2003(e) Agriculture,Livestockand Forestry 7.7 2.6 8.3 9.1 -5.0 13.0 4.3 0.4 7.5 1.2 Banana, Coffeeand Cocoa 10.2 8.2 8.8 8.5 -21.4 33.4 0.2 -8.6 Cereales 5.7 -5.5 8.8 10.0 -23.0 -2.6 5.3 9.9 Flowers 49.2 26.3 20.7 63.2 21.6 16.5 22.0 3.6 Other Crops 5.9 -0.1 9.3 -4.9 4.5 8.3 1.3 7.0 Livestock 2.9 -3.2 5.9 3.3 6.5 1.1 -3.3 3.6 Forestry and Wood 3.5 4.0 2.7 9.2 6.1 6.6 12.5 -1.2 Fishing and Seafood 4.7 8.6 4.7 14.6 8.1 -6.7 -21.6 2.8 5.7 2.6 Shrimp 4.6 14.3 1.o 30.0 8.1 -19.7 -46.6 5.5 Fishing 4.8 4.3 7.6 2.5 4.1 6.7 -2.3 1.7 Mineralsand Mining 11.7 2.1 0.8 -1.9 -1.6 1.4 8.0 1.7 Extractionof Crude Petrol, NaturalGas, and RelatedSerfices 12.0 1.9 0.3 -1.3 -1.1 1.5 7.9 1.7 Mining 2.4 9.9 16.7 -21.1 -21.o -4.9 12.0 3.3 Manufacturing 2.9 2.6 5.0 5.5 5.5 -5.2 -6.8 2.9 0.7 1.2 Foodand Drinks 3.1 4.6 5.2 7.9 6.9 -4.1 -17.7 3.9 Tobacco Products -13.0 3.1 -7.8 -0.8 9.0 14.7 0.7 0.5 Textile, Clothing and Leather -0.3 -2.5 11.5 5.1 1.2 -5.5 6.6 0.3 Wood and Wood Products 1.o 6.7 3.0 7.0 8.1 3.9 5.3 -2.8 Paperand Paper Products 16.9 1.o 3.5 4.2 -0.1 -5.7 5.8 1.9 Chemicalsand Plastics 1.9 0.7 0.5 -0.2 6.2 -12.1 4.3 5.8 Metalsand Nonmetal Products 5.6 -1.1 2.6 -7.1 3.7 -12.2 12.1 4.1 Machinesand Equipment,Transport Equipment 5.7 2.9 -4.3 6.9 6.6 -20.8 5.7 14.7 Petrol RefineryProducts 1.3 11.o 19.8 1.o 0.9 26.8 20.1 -7.8 1.4 3.0 EiectrlcityandWater 3.8 -18.8 11.9 6.8 8.5 23.0 2.6 4.6 2.4 2.5 ConstrucUon 7.0 0.4 1.3 2.7 -0.2 -24.9 18.3 4.0 14.7 2.6 Wholesale and RetaliCommerce 4.7 -0.1 5.4 4.5 0.7 -11.2 3.6 4.7 4.0 0.9 Hotels and Restaurants 2.7 4.2 3.0 3.9 6.1 -13.3 3.1 -0.4 -0.2 2.0 Transport,Storageand C0t"nlCatlOn -0.5 4.6 3.2 8.2 9.4 -0.3 7.7 1.7 1.3 2.9 Transportand Storage -0.5 2.4 1.3 7.4 4.2 0.0 7.0 0.1 Mail and Telecommunications 0.1 26.5 19.2 13.9 43.8 -1.3 11.2 9.1 Financial lntermedlatlon 21.1 17.6 11.2 -2.2 -16.9 -47.3 2.2 37.6 9.7 3.2 Real Estateand RentalActivitles -0.4 4.7 3.7 4.3 2.9 -6.3 2.3 8.2 0.0 2.2 Public Admlnlstratlon and Defense; Obllgatory Social Security -6.5 -7.8 -0.9 2.6 6.0 -5.6 9.3 1.7 3.3 4.7 Educatlon -3.7 2.5 6.0 3.5 3.0 5.0 2.3 0.7 0.5 0.8 Soclal and Health Services 4.5 4.2 4.2 2.7 3.5 0.8 4.4 3.7 -2.6 1.3 Other Communlty, Soclaland HumanServices 12.0 28.2 -10.7 9.0 11.9 -4.4 2.9 -0.7 -0.2 2.1 DomestlcServlcesIn PrivateHouseholds 1.9 3.1 1,8 4.4 3.0 3.4 2.4 2.8 1.7 0.6 Indirect FlnanclalIntermedlatlonServlces 16.0 4.0 18.5 -0.5 -15.3 -33.0 1.3 33.2 0.4 3.2 GROSS VALUE ADDED OF INDUSTRIES(pb) 4.8 1.7 2.3 4.0 2.1 -6.5 2.8 3.7 2.4 2.3 Other GDP elements 3.9 1.9 3.5 4.9 2.7 -4.5 3.2 17.5 11.1 3.7 GROSS DOMESTIC PRODUCT(pc) A 7 ... 1 7 ... 2.4 A I ... 2.1 -6.3 2.8 5.1 3.4 2.5 Source:CentralBankof Ecuador (p) preliminary (e) estimated 61 Table A.3 Gross DomesticProduct by Industtly Millions of US Dollars 1993 1994 1995 1996 1997 1998 1999 2000 2001(p) 2002(p) 2003(e) Agriculture, Livestockand Forestry 2178 2480 2597 2606 2802 2307 1653 1486 1647 1917 2089 Banana, Cofleeand Cocoa 606 720 813 912 1026 566 574 443 416 Cereales 258 312 308 317 369 260 132 137 150 Flowers 43 70 90 97 163 192 215 221 262 OtherCrops 410 442 425 432 375 359 236 211 217 Livestock 686 713 737 611 602 648 300 279 410 Forestry andWood 176 203 225 237 268 263 195 175 193 FishingandSeafood 559 667 777 716 938 902 300 227 243 277 302 Shrimp 350 430 507 468 656 632 119 67 69 Fishing 209 237 270 248 280 270 182 159 174 Mlneralsand Mining 1595 1682 1914 2337 1956 978 2063 3430 2590 2845 3197 Extraction of CNde Petrol, NaturalGas, and Related Services 1483 1558 1773 2183 1848 896 1998 3361 2514 Mining 112 125 140 154 108 82 65 69 75 Manufacturing 2204 2717 2829 3028 3078 2911 2358 2170 2466 2663 2698 Foodand Drinks 849 1192 1125 1309 1370 1318 1251 1058 1249 Tobacco Products 9 8 11 8 7 7 6 8 8 Textile, Clothingand Leather 335 382 386 420 427 361 338 408 462 Wood andWood Products 272 299 355 338 363 372 251 229 246 Paperand Paper Products 111 149 234 225 213 169 118 95 114 Chemicalsand Plastics 268 296 296 293 275 254 174 169 189 Metals and Non-metalProducts 188 209 234 264 232 236 153 139 130 Machinesand Equipment,Transport Equipment 172 183 188 172 171 154 67 64 65 Petrol RefineryProducts -464 -378 -548 -784 -593 -151 -746 .I360 -727 -966 -1304 ElectrlcllyandWater 252 280 146 161 293 324 231 169 352 433 500 Constructlon 368 584 890 903 1029 1271 894 1127 1502 1914 2135 Wholesale and Retail Commerce 2018 2508 2602 2798 3154 3329 2376 2483 2893 3378 3711 Hotelsand Restaurants 289 312 338 349 362 341 176 199 424 475 527 Transport, StorageandCommunlcatlon 1277 1678 1910 1824 1988 2300 1825 1720 3370 3775 4247 Transport and Storage 1142 1465 1845 1553 1726 1941 1556 1413 2708 Mail andTelecommunications 135 213 266 271 262 358 269 307 663 Financial Intermediation 463 644 799 863 857 724 245 301 564 676 749 Real Estateand RentalActivlties 1460 1923 2282 2468 2938 2764 1638 1004 1546 1858 2114 Publlc Administrationand Defense: Obllgatory SocialSecurlty 884 1145 1185 1277 1452 1524 1165 835 1133 1369 1631 Education 556 700 846 975 1160 1145 778 536 904 1114 1267 Socialand HealthServices 384 518 575 847 695 694 371 280 401 483 524 Other Community,Soda1and HumanServlces 105 133 180 148 170 195 137 116 153 178 208 DomestlcServicesInPrivate Households 61 68 74 71 74 72 47 28 37 44 48 IndirectFinancialIntermediationServlces -530 -882 -741 -864 -888 -754 -358 -385 -706 -801 -864 0 GROSSVALUE ADDEDOF INDUSTRIES 13660 16959 18454 19533 21464 20875 15154 14326 18815 21613 23979 OtherGDP elements 1397 1614 1741 1735 2172 2381 1520 1608 2210 2698 3141 0 GROSS DOMESTICPRODUCT 15057 18573 20196 21266 23638 23255 16674 15934 21024 24311 27120 Percentof GDP Agriculture, Livestockand Forestry 14.5 13.2 12.9 12.3 11.9 9.9 9.9 9.2 7.8 7.9 7.7 Fishingand Seafood 3.7 3.6 3.8 3.4 4.0 3.9 1.8 1.4 1.2 1.1 1.1 Mineralsand Mining 10.6 9.1 9.5 11.0 8.3 4.2 12.4 21.5 12.3 11.7 11.8 of which Petroleum 9.8 8.4 8.8 10.3 7.8 3.9 12.0 21.1 12.0 Manufacturing 14.6 14.6 14.0 14.2 13.0 12.5 14.1 13.6 11.7 11.0 10.7 Petrd RefineryProducts -3 1 -2.0 -27 -3.7 -2.5 -0.6 -4.5 -8.5 -3.5 -4.0 4.8 Electricityand Water 1.7 1.5 0.7 0.7 1.2 1.4 1.4 1.1 1.7 1.8 1.8 Construction 2.4 3.1 3.4 4.2 4.4 5.5 5.4 7.1 7.1 7.9 7.9 Wholesaleand Retail Commerce 13.4 13.5 12.9 13.2 13.3 14.3 14.2 15.6 13.8 13.9 13.7 Hotelsand Restaurants 1.9 1.7 1.7 1.6 1.5 1.5 1.1 1.2 2.0 2.0 1.9 Transport, Storageand Communication 8.5 9 0 9.5 8.8 8.4 9.9 10.9 10.8 16.0 15.5 15.7 FinancialIntermediation 3.1 3.5 4.0 4.1 3.6 3.1 1.5 1.9 2.8 2.8 2.8 Real Estateand Rentd Activities 9.7 104 11.3 11.7 12.4 11.9 9.8 6.3 7.4 7.6 7.8 PublicAdministrationand Defense; Obligatory Socia Security 5.9 6.2 5.9 6.0 6.1 6.6 7.0 5.2 5.4 5.6 8 0 Education 3.7 3.8 4.2 4.6 4.9 4.9 4.7 3.4 4.3 4.6 4.7 Socid and HealthServices 2 6 2.8 2.8 3.0 2.9 3.0 2.2 1.6 1.9 1.9 1.9 OtherCommunity, Socialand Human Services 0.7 0.7 0.9 0.7 0.7 0.8 0.8 0.7 0.7 0.7 0 8 Domestic Services in Private Households 0.4 0.4 0.4 0.3 0.3 0.3 0.3 0.2 0.2 0.2 0.2 IndirectFinancialIntermediationServices -3.5 -3.7 -3.7 -4.1 -3.8 -3.2 -2.1 -2.4 -3.4 -3.3 -3.2 GROSSVALUE ADDEDOF INDUSTRIES 90.7 91.3 91.4 91.8 90.8 89.8 90.9 89.9 89.5 88.9 88.4 Other GDP elements 9.3 8.7 8.6 8.2 9.2 10.2 9.1 10.1 10.5 11.1 11.6 GROSS DOMESTICPRODUCT 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Source: CentralBank of Ecuador (p)preliminary (e) estimated 62 Table A4 National Accounts, 1993-2003 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2W3(e) Millions of 2000 Dollars ~~ Real GrossDomesticProduct 14270 14941 15203 15568 16199 16541 15499 15934 16749 17321 17753 Total Consumption 10590 10946 11166 11237 11716 12142 11315 11762 12325 12805 13257 Public 1541 1557 1627 1543 1616 1561 1493 1564 1571 1621 1697 Private 9049 9389 9561 9694 10103 10562 9622 10199 10754 11164 11560 FixedCapital Formation 3774 4024 3942 3774 3675 4026 2913 3265 3660 4302 4367 Public 679 706 664 677 646 677 619 458 600 832 574 Private 3095 3316 3258 3097 3229 3350 2295 2607 3060 3470 3613 Change in stocks 66 280 248 47 425 663 -429 -60 725 1038 1120 Exportsof Goods and Services 4248 4744 5279 5408 5631 5535 5965 5906 5828 5878 5702 Importsof GoodsandServices 4408 5053 5454 4899 5651 6047 4265 4939 5769 6766 6712 PercentChange Real GrossDomestlcProduct 4.7 1.7 2.4 4.1 2.1 -6.3 2.6 5.1 3.4 2.5 Total Consumption 3.4 2.2 0.4 4.3 3.6 -6.6 3.9 4.8 3.9 3.5 Public 1.0 4.5 -5.2 4.7 -2.2 -5.5 4.7 0.5 3.2 4.7 Private 3.8 1.8 1.4 4.2 4.5 -7.0 3.8 5.4 4.0 3.4 Fixed CapitalFormation 6.6 -2.0 -4.3 2.7 3.9 -27.7 12.1 12.1 17.5 2.0 Public 4.0 -3.1 -1.0 -4.5 4.6 -6.7 -26.0 31.0 36.7 -31.0 Private 7.2 -1.6 -4.9 4.3 3.8 -31.5 22.3 9.0 13.4 9.9 Change in stocks 323.3 -11.3 -60.9 797.7 107.5 -148.6 -86.0 -1308.3 43.1 7.9 Exports of Goodsand Services 11.7 11.3 2.4 7.6 -5.1 7.6 -1.0 -1.3 0.9 -3.0 Importsof Goodsand Services 14.6 7.9 -10.2 15.4 7.0 -29.5 15.8 17.2 17.2 -1.1 Millions of Doilars GrossDomesticProduct 15057 16573 20196 21268 23636 23255 16674 15934 21024 24311 27120 TotalConsumption 12220 14829 16352 16589 16584 16976 13123 11762 16625 19367 21516 Public 1767 2237 2525 2567 2902 2857 2066 1564 2134 2550 2879 Private 10453 12592 13827 14022 15682 16120 11035 10199 14491 16637 16637 FixedCapital Formation 2657 3521 3797 3652 4234 4623 2826 3265 4541 5549 5976 Public 519 555 666 701 724 836 629 458 744 1070 791 Private 2325 2564 3129 3151 3510 3767 2197 2807 3797 4476 5185 Changein stocks 219 540 557 338 838 1253 -371 -60 854 1191 1120 Exports of Goodsand Services 3776 4576 5196 5612 6056 4997 5257 5906 5613 5829 6530 Importsof Goodsand Services 4016 4894 5707 5124 6078 6595 4161 4939 6608 7644 8022 Percentof GDP Gross DomesticProduct 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Total Consumption 81.2 79.8 81.0 78.0 78.6 61.6 76.7 73.6 79.1 79.7 79.3 Public 11.7 12.0 12.5 12.1 12.3 12.3 12.5 9.8 10.1 10.5 10.6 Private 69.4 67.6 66.5 65.9 66.3 69.3 66.2 64.0 68.9 69.3 66.7 FixedCapitalFormation 19.0 19.0 18.8 16.1 17.9 19.9 17.0 20.5 21.6 22.6 22.0 Public 3.4 3.0 3.3 3.3 3.1 3.6 3.8 2.9 3.5 4.4 2.9 Private 15.4 13.8 15.5 14.8 14.9 16.3 13.2 17.6 16.1 18.4 19.1 Chanae in stocks 1.5 2.9 2.8 1.6 3.5 5.4 -2.2 -0.4 4.1 4.9 4.1 Exports of Goodsand Services 25.1 24.6 25.7 26.4 25.6 21.5 31.5 37.1 26.7 24.0 24.1 Importsof GoodsandServices 26.7 26.3 26.3 24.1 25.7 28.4 25.0 31.0 31.4 31.4 29.6 Source:Central Bankof Ecuador,WB calculations 63 TableA5 Operations of the Non-financialPubllc Sector Millionsof Dollars 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 TOTAL REVENUES 3441 4052 4599 4656 4714 4027 3515 4126 4942 6271 Petrol 1195 1194 1329 1575 1270 913 1049 1460 1352 1390 Export 788 645 863 939 626 250 746 1287 955 971 Saleof deriviatives 407 550 646 635 644 663 303 173 397 419 Non-petrol Revenues 1877 2328 2717 2607 3134 3096 2334 2516 3484 4695 VAT 449 562 621 633 779 831 591 693 1456 1667 ICE (SpecialConsumptionTax) 124 113 82 97 148 124 69 75 137 220 income 185 252 344 342 401 354 144 314 540 584 Capital circulation 328 169 8 Internationaltrade 214 284 298 244 420 592 310 217 354 414 Socialsecuritycontributions 370 450 506 450 455 451 230 228 455 767 Others 535 668 886 841 931 743 865 620 535 1036 Operational surplus of non-flnanclal public enterprises 389 529 553 475 310 18 132 150 106 187 TOTAL EXPENDITURES 3455 3952 4804 5221 5220 5145 4165 3889 4932 6117 Current Expendltures 2517 2875 3616 3773 3970 3990 3165 3095 3488 4536 Interest 630 666 786 631 995 987 1183 1052 985 869 Extemai 556 589 669 659 751 749 837 853 777 665 Domestic 74 77 117 173 243 238 348 199 208 205 Salaries 1012 1228 1426 1482 1542 1691 991 761 1169 1761 Goods andServices 409 370 305 533 600 569 397 410 813 901 Others 466 611 1099 927 833 744 594 871 721 1005 Capltal Expenditures 938 1077 1188 1449 1250 1155 1Mx) 795 1444 1582 Gross fixedcapitalformation 876 981 998 1265 1246 1143 982 782 1198 1417 Centralgovemment 120 386 381 498 478 602 485 425 682 611 Non-financialpublic enterprises 414 440 389 544 486 199 245 83 143 236 Regionalgovernments 109 122 159 154 190 260 224 246 329 459 Others 234 53 69 69 91 82 27 29 44 111 Other capitalexpenditures 62 96 190 184 4 12 18 12 246 165 PRIMARY BALANCE 616 766 581 266 489 -131 533 1290 995 1023 OVERALLBALANCE -15 100 -205 -566 -506 .1118 650 237 80 154 Percentof COP TOTAL REVENUES 22.9 21.8 22.8 21.9 19.9 17.3 21.1 25.9 23.5 25.8 Petrol 7.9 6.4 6.6 7.4 5.4 3.9 6.3 9.2 6.4 5.7 Export 5.2 3.5 3.4 4.4 2.6 1.1 4.5 8.1 4.5 4.0 Saleof deriviatives 2.7 3.0 3.2 3.0 2.7 2.9 1.8 1.1 1.9 1.7 Non-petrol Revenues 12.5 12.5 13.5 12.3 13.3 13.3 14.0 15.8 16.6 19.3 VAT 3.0 3.0 3.1 3.0 3.3 3.6 3.5 5.6 6.9 6.9 ICE(SpecialConsumptionTax) 0.8 0.6 0.4 0.5 0.6 0.5 0.4 0.5 0.7 0.9 Income 1.2 1.4 1.7 1.6 1.7 1.5 0.9 2.0 2.6 2.4 Capitalcirculation 0.0 0.0 0.0 0.0 0.0 0.0 2.0 1.1 0.0 0.0 Internationaltrade 1.4 1.5 1.5 1.1 1.8 2.5 1.9 1.4 1.7 1.7 Socialsecuritycontributions 2.5 2.4 2.5 2.1 1.9 1.9 1.4 1.4 2.2 3.2 Others 3.8 3.6 4.3 4.0 3.9 3.2 4.0 3.9 2.5 4.3 Operatlonalsurplus of non-financial publlc enterprises 2.5 2.8 2.7 2.2 1.3 0.1 0.8 0.9 0.5 0.8 TOTAL EXPENDITURES 22.9 21.3 23.8 24.6 22.1 22.1 25.0 24.4 23.5 25.2 Current Expenditures 16.7 15.5 17.9 17.7 16.8 17.2 19.0 19.4 16.6 18.7 Interest 4.2 3.6 3.9 3.9 4.2 4.2 7.1 6.6 4.7 3.6 Extemai 3.7 3.2 3.3 3.1 3.2 3.2 5.0 5.4 3.7 2.7 Domestic 0.5 0.4 0.6 0.8 1.o 1 .o 2.1 1.2 1.o 0.8 Salaries 6.7 6.6 7.1 7.0 6.5 7.3 5.9 4.8 5.6 7.2 Goods and Services 2.7 2.0 1.5 2.5 2.5 2.4 2.4 2.6 2.9 3.7 Others 3.1 3.3 5.4 4.4 3.5 3.2 3.6 5.5 3.4 4.1 Capital Expenditures 6.2 5.8 5.9 6.8 5.3 5.0 6.0 5.0 6.9 6.5 Gross fixed capitalformation 5.8 5.3 4.9 5.9 5.3 4.9 5.9 4.9 5.7 5.6 Centralgovemment 0.8 2.0 1.9 2.3 2.0 2.6 2.9 2.7 3.2 2.5 Non-financialpublic enterprises 2.7 2.4 1.9 2.6 2.1 0.9 1.5 0.5 0.7 1.0 Regionalgovernments 0.7 0.7 0.8 0.7 0.8 1.1 1.3 1.5 1.6 1.9 Others 1.6 0.3 0.3 0.3 0.4 0.4 0.2 0.2 0.2 0.5 Other capitalexpenditures 0.4 0.5 0.9 0.9 0.0 0.1 0.1 0.1 1.2 0.7 PRIMARY BALANCE 4.1 4.1 2.9 1.2 2.1 -0.6 3.2 8.1 4.7 4.2 OVERALLBALANCE -0.1 0.5 -1.0 -2.7 -2.1 -4.8 -3.9 1.5 0.4 0.6 Source: Central Bank of Ecuador 64 Table A.6 Balanceof Payment Millionsof USDollars 1993 1994 1995 1998 1997 1998 1999 2000 2001 2002 I.CURRENTACCOUNT -845 -912 -994 4 -427 -2001 877 921 -550 -1178 A Goods 214 138 -66 962 523 -1035 1545 1399 -397 -1004 Exports 3136 3925 446a 4940 5371 4319 4517 5057 4762 5192 Petrolandderivatives 1257 1305 1530 1749 1557 923 1480 2442 1900 2061 Other exports 1879 2620 2938 3191 3814 3396 3037 2614 2882 3131 Imports -2922 -3767 4535 -3978 -4849 -5353 -2971 -3657 -5179 -6196 Consumptiongoods -581 -768 -1058 -888 -1094 -1168 -621 -830 -1366 -1739 Other imports -2341 -2999 -3476 -3090 -3755 -4186 -2350 -2827 -3813 -4457 6.Servlws -454 -432 -446 -427 -544 -563 -451 -420 -523 -566 Exporl 636 676 728 683 686 678 730 849 911 961 Import -1090 -1107 -1173 -1111 -1230 -1241 -1181 -1269 -1434 -1546 C. Income -660 -940 -924 -1G23 -1027 -1171 -1307 -1411 -1269 -1262 Income received 32 61 98 80 128 119 75 71 48 30 Income paid -892 -1001 -1022 -1103 -1155 -1290 -1382 -1481 -1316 -1292 Remunerationof employees -3 -5 -4 -9 -4 -5 -5 6 -7 -7 Returnon direct investment -93 -141 -144 -189 -194 -231 -249 -260 -333 -302 Returnon podoiio investment 0 -1 -200 -325 -368 -396 -390 -463 -301 -292 Retumon other investment(2) -796 -855 -675 -581 -589 -659 -738 -733 -676 -691 D. CurrentTransfers 256 322 442 492 621 767 1090 1352 1639 1654 of vhich: Remittances 201 273 382 485 844 794 1084 1317 1415 1432 II. FINANCIALAND CAPITALACCOUNT -34 194 -15 150 -2 1459 -1342 -8607 918 1000 A CapltalAccount 5 18 17 14 11 14 2 -1 -63 20 6.Financial Account -40 176 -32 135 -13 1445 -1344 -683 981 981 Foreigndirect investment 474 576 453 500 724 870 648 720 1330 1275 Net podolio investment 1 6 3 -4 -242 -34 -46 -5583 117 0 of which: Debt 0 0 -10 -10 -264 -40 -47 -5583 116 -1 Other investment -515 -407 -488 -361 -495 610 -1947 -1743 -466 -295 Assets -140 -177 -668 -302 -560 -54 -725 -1274 -1333 -1532 Liabilities -375 -230 181 -59 65 663 -1222 -469 867 1237 Commercialcredit -68 -48 -57 -691 -608 -382 -277 -11 -183 -21 Loans -333 -471 14 712 450 815 -645 -371 859 1671 of which: general government -613 -719 -668 152 -169 -51 121 118 302 -13 of which: private sector(3) 349 225 737 404 562 640 -621 -305 807 1856 Moneyanddeposits 26 288 240 -79 223 230 -300 -87 191 -412 Other Liablities -1 0 -17 0 0 0 0 0 0 0 111. ERRORS AND OMISSIONS 207 -58 -443 -224 -87 -243 -479 -20 -599 50 BALANCEOF PAYMENT -673 -774 -1452 -71 -515 -785 -945 -5707 -230 -128 FINANCING 873 774 1452 71 515 785 945 5707 230 128 Reserves(4) -444 -563 178 -246 -251 460 492 -307 106 66 Useof iMFcredit -26 125 -23 -29 -11 -65 -70 151 48 0 Exceptionalfinancing 1145 1232 1297 346 777 390 523 5863 77 62 Notes: CurrentAccount Balance/GDP -5.6 -4.9 -4.9 0.0 -1.8 -6.6 5.3 5.8 -2.6 -4.8 Source: Central Bank of Ecuador (1) From 1997the data is provisional. (2)Correspondsto interest paymentson short andmedium-termexiemaidebt andinterest arrears. (3)Disbursementsand amortizationsof private debt (4)From2OW, the value correspondsto FreelyDisposableinternationalReserves.A negativesignifiesan increase. 65 Table A.7 Exportsand Imports Millions of US dollars 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Total Exports 3066 3843 4381 4873 5264 4203 4451 4927 4678 5030 Primary 2522 3159 3556 3809 4253 3199 3389 3698 3432 3715 Crude Petrol 1152 1185 1395 1521 1412 789 1312 2144 1722 1836 Bananas 568 708 857 973 1327 1070 954 821 865 969 Coffee 89 366 185 129 92 72 57 22 15 10 Shrimp 471 551 673 631 886 872 607 285 281 251 Cocoa 48 66 82 91 60 19 64 38 55 89 Wood 14 20 31 29 38 23 26 20 24 30 Tuna 10 21 67 59 69 61 42 51 65 58 Fish 45 52 23 26 30 22 28 22 22 28 Flowers 40 59 84 105 131 162 180 195 238 291 Others 86 129 156 244 209 110 118 100 144 149 Industrial 544 684 824 1063 1011 1004 1062 1229 1247 1315 Petrolderiviatives 105 120 134 228 146 134 167 298 178 223 Processedcoffee 28 48 59 30 30 33 21 23 29 31 Processedcocoa 35 35 51 73 72 28 42 39 32 38 Fishmeal 12 10 12 54 23 13 10 19 22 12 Other processedfish products 75 105 121 152 185 255 265 235 272 345 Chemicalsand medicines 27 32 44 46 51 57 59 61 68 73 Metal manufactures 91 119 118 109 142 130 90 136 188 142 Hats 8 8 6 5 5 4 3 3 3 3 Textiles 30 41 46 52 61 52 52 59 66 58 Others 134 166 232 315 296 298 352 355 388 391 Total Imports 2223 3209 3737 3571 4520 5110 2731 3401 4936 5953 Consumptlongoods 469 715 738 779 948 1080 572 762 1322 1687 Non-durable 212 304 396 459 563 660 412 458 712 908 Durable 257 411 340 319 385 420 160 304 609 779 Fuelsand lubrlcants 59 78 200 122 379 273 200 256 250 232 Prlmarymaterials 825 1157 1523 1586 1796 1991 1191 1491 1795 2113 Agriculture 72 114 173 219 246 247 180 212 228 240 Industry 686 957 1245 1221 1393 1572 935 1199 1408 1554 Construction material 66 86 106 145 157 171 76 80 159 319 Capltalgoods 869 1259 1275 1083 1396 1786 772 890 1567 1920 Agriculture 26 31 40 34 43 51 18 25 39 29 Industry 530 596 701 698 918 1108 521 533 887 1165 Transportequipment 313 632 533 351 435 607 233 332 641 726 Others 2 0 i t I I I 2 3 2 Source: Central Bank of Ecuador 66 Table A.8 Debt and DebtService Indicators Millionsof US Dollars unlessothelwiseindicated Indicator 1998 1999 2000 2001 2002 Total ExternalDebt Total debt stock (TDO) (1) 16331 16282 13551 14310 16109 Netdisbursements(1) 1080 -297 -2536 1297 1643 Total debt service (TDS) (1) 7576 6581 11964 6756 6901 Debt and Debt Service Indicators (YO) TDOiXGSb 275.9 253.5 185.8 200.0 211.4 TDO/GDP 70.2 97.6 85.0 68.1 66.3 TDSiXGS (2) 128.0 102.5 164.0 94.4 90.6 ConcessionalDDO 11.8 12.6 15.0 13.5 Public External Debt Extemaldebt stock (1) 13171 13752 11470 11462 11414 Netdisbursements (1) 507 392 -2230 490 -213 Debtservice (1) 1384 1078 7947 2492 1418 Public Debtand Debt Service Indicators (x) Total PublicDebffGDP 66.6 98.3 86.7 67.3 58.0 o/wextemal 56.6 82.5 71.9 54.5 46.9 Public InterestPaymenffRevenue 22.1 35.9 25.5 20.2 13.9 Public Ext. DebtService/ Revenue 31.2 28.7 192.6 50.5 22.6 Public Ext. DebtService/XGS 23.4 16.8 104.3 30.9 16.1 IBRDexposure Indicators("h) IBRD DS/publicDS 9.1 10.8 10.8 8.2 8.6 Preferredcreditor DS/public DS ("A) (3) 33.0 38.1 33.9 30.1 34.5 IBRDDSKGS 2.2 2.2 2.2 1.9 1.8 IBRDTDO (US$m)d 854 861 862 898 835 Share of IBRDportfolio("A) 1 1 1 1 1 IDATDO(US$m)d 23 22 21 20 19 IFC(US$m) Loans 10.8 22.7 33.3 33.2 30.4 Equityandquasi-equity 0.3 5.6 14.6 14.6 14.6 (1) Includespublic and publiclyguaranteeddebt, privatenonguaranteed,use of IMFcredits, net short- termcapital, and refinancingand condonation.Debtservice in 2000 includesrefinancingof $3.5 blnof Bradybonds. (2) "XGS"denotesexportsof goodsand services, includingworkers' remittances. (3) Preferredcreditorsare definedas IBRD, IDA,the regionalmultilateraldevelopmentbanks,the IMF, and the Bankfor InternationalSettlements. 67 Table A.9 Monetary Accounts Under Dollarization Millions of US Dollars 1999 2000 2001 2002 Prel. 1. Central Bank Net Foreign Assets 872 1,180 1,074 1,008 Net Domestic Assets 254 -919 -785 -704 Public sector 979 346 277 77 Bankingsystem 412 170 282 356 Other -1,137 -1,435 -1,344 -1,137 o/w IMFcredit 0 143 190 301 Liabilities 1,126 261 289 304 II.CommercialBanks Net ForeignAssets -224 137 506 728 Net Domestic Assets 3,497 3,770 4,363 5,029 Net assets held in the BCE 149 225 124 190 Net credit to the public sector 312 214 268 177 Netcreditto the private sector 2,765 2,623 3,066 3,483 Other 271 708 905 1,180 Liabilitiesto the private sector 3.273 3,907 4,869 5,757 111. Consolidated Banking System Net ForeignAssets 648 1,317 1,580 1,736 Net Domestic Assets 2,986 2,625 3,316 4,061 Net credit to the public sector 1,291 560 545 253 Net credit to the private sector 2,765 2,623 3,066 3,483 Other -1,070 -558 -295 325 Liabilitiesto the private sector 3,634 3,942 4,896 5,797 (Flows, in millionsof US. dollars) Consolidated banking system Net foreign assets ... 669 263 156 Net domestic assets ... -361 691 745 Net credit public sector ... -731 -15 -292 Net credit private sector ... -142 443 417 Other ... 512 263 620 Liabilitiesto the private sector ... 308 954 901 Deposits in cuenta Unica ... ... -310 32 NFA (NIR-traditional Funddefinition) ... ... -153 -177 Excess NFA ... 1,030 -181 -192 Memorandum items: Liabilitiesto the private sector (percent change) ... 8.5 24.2 18.4 (percent of GDP) 21.8 24.7 23.3 23.8 Net credit to the privatesector (percent change) ... -5.1 16.9 13.6 (percent of GDP) 16.6 16.5 14.6 14.3 NFA (Funddefinition) (US$ millions) 872 1,037 884 707 Treasury deposits incuenta unica (US$millions) ... 396 86 118 Excess NFA (US$ millions) -254 776 595 403 Source: Central Bank of Ecuador, IMF 68 TableAlO. EcononicGrowthandTotal FactorProductivilyInLatinAmrica, 199l-2ooo Sn@e11 AdjustedZ AdjustedY G-oMtl TFP TFP TFP 6.6 lbQMitT.3 3.1 lprgerdim 2.5 3.7 5.9 2 coroiricanW i c 29 2 coroiricanW i c 2.4 2.7 5.3 3Chile 2.8 3Chile 2.4 1.9 4.6 4costaRca 2.0 4-Y 1.5 1.6 4.6 5uruguay 1.9 5costaRca 1.4 1.2 4.5 6M i a 1.7 6 W i a 1.2 0.9 4.1 7 m 1.6 7 P a " 0.8 0.5 4.1 8Panama 1.1 6% 0.5 0.3 3.8 9BSaiVaCkN 0.9 9OSaiVaCkX 0.3 0.1 3.5 10Guatwnala 0.6 1OGuatemala 0.1 -0.1 3.3 11&Am 0.4 11WAW 0.1 -0.1 3.2 12Bradl 0.4 12TrinidadardThga -0.2 -0.2 3.1 13Nicaragua 0.4 13Wi -0.3 -0.5 3.0 14TrinidadandT h g a 0.2 14Ncaragua -0.6 -0.5 2.7 15Venensla -0.2 15Cdombia -0.9 -0.5 2.7 1 6 C d a a -0.3 16P a w w -1.2 -0.9 2.0 17Eclradcr -0.9 17Eatador -1.3 -1.1 2.0 18WumS -0.9 1 8 V d a -1.5 -1.2 1.8 19Paraguay -1.1 19Honduras -1.5 -2.6 0.3 2oJamaica -2.6 20J M c a -3.0 -4.0 Average 3.6 0.7 Average 0.1 0.1 wan 3.4 0.5 Wian 0.1 wan -0.1 Socrce:Lcayza,N., .P. Fajnzylber,andC. Calderon(mCe). 69 Table All. Ecuador SocialIndicators Latest single year Same regionhncomegroup Latin Lower- America middle- 1970-75 1980-85 1995-2001 & Carib. income POPULATION Total population, mid-year(millions) 6.9 9.1 12.9 523.6 2,163.5 Growth rate (% annual average for period) 2.9 2.7 1.9 1.5 1.o Urbanpopulation ("Aof population) 42.4 51.2 63.4 75.8 45.6 Total fertility rate (births per woman) 5.6 4.3 2.9 2.5 2.1 POVERTY ("A of population) National headcount index 35.0 Urban headcount index 25.0 Rural headcount index 47.0 INCOME GNI per capita (US$) 620 1,470 1,080 3,580 1,230 Consumer price index (1995=100) 0 3 909 Food price index (1995=100) 3 709 INCOMWCONSUMPTIONDISTRIBUTION Gini index 43.7 Lowestquintile (% of incomeor consumption) 5.4 Highest quintile (% of incomeor consumption) 49.7 SOCIAL INDiCATORS Publicexpenditure Health (% of GDP) I.2 3.3 2.6 Education ("A of GDP) 1.6 4.4 4.6 Social security and welfare (`77 of GDP) Net primaryschool enrollment rate ("A of age group) Total 82 99 97 92 Male 82 99 98 92 Female 82 100 96 93 Access to an improved water source ("A of population) Total 85 86 80 Urban 90 94 95 Rural 75 65 70 Immunizationrate ("A under 12months) Measles 51 99 91 84 DPT 41 90 89 83 Child malnutrition (% under 5 years) 14 9 10 Lifeexpectancyat birth (years) Total 60 66 70 71 69 Male 59 64 69 67 67 Female 62 67 72 74 71 Mortality Infant (per 1,000 live births) 76 54 24 28 33 Under 5 (per 1,000 live births) 119 78 30 34 41 Adult (15-59) Male(per 1,000population) 258 229 199 221 205 Female (per 1,000 population) 208 176 120 124 130 Maternal(modeled, per 100,000 livebirths) 210 Births attended by skilledhealthstaff ("A) 27 69 87 Note: 0 or 0.0 meanszero or less than halfthe unit shown. Net enrollment rate: break in series between 1997and 1998due to change from ISCED76to ISCED97; ratios exceeding 100indicatediscrepancies betweenthe estimates of school-age population and reportedenrollment data. 2003World Development IndicatorsCD-ROM,World Bank 70 Table A12: Ecuador: Contributions to Growth, 1991-99 1991-93 1994-96 1997-99 1991-99 2000-03 Overall Real GDP Growth 3.5 2.9 -1.2 1.8 3.5 Growth contributionfrom: Petroleum sector 36.7 15.1 -29.1 7.6 15.0 Nonpetroleum sector 63.3 84.9 129.1 92.4 85.5 Non-Oil GDPGrowth 2.9 2.7 -1.4 1.4 2.1 (Contributionto Non-Oil Growth by Sector) Agriculture 0.1 26.8 0.3 9.1 Manufacturing 30.2 21.5 14.3 22.0 Electricity 2.4 0.1 1.1 1.2 Construction -6.0 1.8 7.6 1.2 Trade 24.1 20.0 17.3 20.5 Transport 12.6 9.3 8.7 10.2 Financialservices 55.3 11.9 -3.3 21.3 Other services 42.9 22.1 25.5 30.2 Public Administration -68.6 -16.1 5.5 -26.4 Others 7.0 2.6 23.0 10.9 (Contributionto OverallGrowth by Demand Component) Domestic Demand 55.8 55.8 77.3 63.0 Consumption 39.4 49.3 22.4 37.0 Investment 16.4 6.5 54.9 26.0 Net Export 44.2 44.2 22.7 37.0 Source: Ronci, Sanchez, and Offerdal (2000). Table A.13: Ecuador PublicSector and Oil-OLS Estimates,1971-2001 Dependentvariable TAXREV OZLTAXES GOVEXP log(NoNozLGDp log(NoNozLGDp) log(NoNozLGDp ) Constant 0.765 -0.378 2.112 (1.658) (-0.424) (4.065) Laggeddependent 0.754 0.292 0.317 (5.339) (2.482) (1.828) Log Priceof Oil -0.085 0.355 0.155 (-1.878) (2.543) (2.454) LogOil Production 0.010 0.141 -0.100 (0.195) (0.916) (-1.988) R2 0.583 0.591 0.598 DW 1.617 1.459 1.634 Note: t-statisticsappear in parentheses;DW is Durbin-Watsonstatistic. Source:Own calculations. 71 Table A14 ALCA Scenarios: Impacton Ecuad ImportsVolume ExportsVolume Production ALCA I ALCA-XAN ALCA 1 ALCA-XAN ALCA I ALCA-XAN CER 16.83 -2.47 -14.26 0.84 -5.65 0.51 OSG 5.98 0.38 -2.97 -8.65 -1.52 -2.69 AGR 38.60 -3.37 6.83 0.70 1.24 0.37 ENR 3.21 -2.58 8.20 -1.06 4.21 -0.47 MFR 4.14 -0.69 0.52 0.85 -3.13 0.49 OFD 20.25 -3.08 10.79 0.38 1.95 0.16 TEX 1.02 -4.06 10.02 0.40 -0.48 0.42 MAN 1.89 -0.79 4.78 1.17 -1.94 0.82 SER 0.29 -2.30 8.36 1.47 -0.13 0.01 DWE -1.44 -0.37 Macro Results FactorsReturn ALCA I ALCA-XAN ALCA-XAN EV -0.55 -0.46 SKL-LABOR 1.29 -0.23 DOMPROD -0.64 -0.08 LABOR 1.50 -0.45 TAXCHG -434.34 -21.03 CAPITAL 1.oo -0.10 RER 2.65 0.22 MCHG 10.44 -2.14 XCHG 6.51 -0.47 Note: ALCA-XAN (ALCA without Andean countries); Fiscal losses for Ecuadoronly are estimated at US$100-200M (from US$434Mindicated inthe table) AGR other agricultural, ENR energy and mining, MFR manufactures, OFD food products and meat, TU: textiles, MANother manufactures, SER services, DWEconstruction, EV welfare, DOMPRODdom. production, TAXCHG tax revenue change, RER real effect exchange rate, MCHG manufactory change, XCHG exportschange, SKL-LABOR skilled labor, LABOR. Source: Light (2003). 72 Table A15. Base Case DebtSustainability Analysis In US mln unless otherwise specified BASE CASE 2003 2004 2005 2006 OILSECTOR Oil production(Mln Barrels) 153 177 191 208 Petroecuador 75 74 74 81 Private 78 103 117 127 Oil production(barrels per day) 418 486 523 570 WTI Priceassumption ($/barrel) 31.1 32.0 20.0 20.0 Petrol Fiscal Revenues 1,664 1,830 1,231 1,341 o/w FEIREP 107 450 303 330 DEBT SUSTAINABILTITYANALYSIS GDP 26,913 28,968 30,729 32,597 % change in realterms 2.6% 4.5% 4.0% 4.0% Revenues 6,909 7,566 7,983 8,380 Petroleum 1,664 1,830 1,231 1,341 Non-Petroleum + Public Enterprisesurplus 5,245 5,736 6,752 7,038 Primaryexpenditures 5,635 6,112 6,453 6,812 NFPS Primarybalance 1,274 1,454 1,530 1,567 Interestpayments 815 811 848 844 NFPS Overall balance 454 643 682 723 Scheduledamortizations 1,099 1,041 1,010 1,167 Additional debt repurchase31 77 266 165 199 Newdisbursements 722 1,049 493 643 Public debt stock 4/ 14,329 14,071 13,390 12,667 Public external debt stock 11,467 12,146 11,465 10,742 Percentof GDP NFPS Primary balance 4.7% 5.0% 5.0% 4.8% Interestpayments 3.0% 2.8% 2.8% 2.6% NFPSOverall balance 1.7% 2.2% 2.2% 2.2% Public debt stock 53.2% 48.6% 43.6% 38.9% Public external debt stock 42.6% 41.9% 37.3% 33.0% I / Revenues for the incrementalparticipationof the state basedon August 2003 production. 21 Revenues from crude exports over the $18/bbl pricethat enters into a stabilizationfund, of which 45% enters in FEIREP. 3/ Assumes 15%of the 70% allocated for debt repurchaseis usedfor IESSdebt. 4/ Includesarrears. Assumes constant levelof domestic debt. 73 Table A16. Low Case DebtSustainabilityAnalysis In US mln unless otherwisespecified LOW CASE 2003 2004 2005 2006 OIL SECTOR Oil production (Mln Barrels) 153 171 166 172 Petroecuador 75 68 63 63 Private 7a 103 103 109 Oil production (barrels per day) 41a 468 455 471 WTI Priceassumption ($/barrel) 31.1 28.0 20.0 12.0 Petrol Fiscal Revenues 1,664 1,543 1,070 665 o/w FEIREP 107 380 263 DEBTSUSTAlNABlLTlTYANALYSIS GDP 26,913 28,275 29,417 30,606 % change in real terms 2.6% 2.0% 2.0% 2.0% Revenues 6,909 7,142 6,895 6,725 Petroleum 1,664 1,543 1,070 665 Non-Petroleum Public Enterprisesurplus + 5,245 5,598 5,825 6,060 Primaryexpenditures 5,635 6,112 6,453 6,ai 2 NFPSPrimarybalance 1,274 1,030 442 (87) Interest payments ai5 ai1 a54 a74 NFPSOverall balance 454 218 (412) (961) Scheduledamortizations 1,099 1,041 1,010 1,167 Additional debt repurchase3/ 77 224 157 Newdisbursements 722 1,431 1,579 2,128 Publicdebt stock 4/ 14,329 14,496 14,908 15,869 Publicexternaldebt stock 11,467 12,571 12,983 13,944 Percentof GDP NFPS Primarybalance 4.7% 3.6% 1.5% -0.3% Interest payments 3.0% 2.9% 2.9% 2.9% NFPSOverall balance 1.7% 0.8% -1.4% -3.1% Publicdebt stock 53.2% 51.3% 50.7% 51.9% Publicexternaldebt stock 42.6% 44.5% 44.1% 45.6% 1/ Revenuesfor the incrementalparticipationof the state basedon Auaust 2003 production. . . 2/ Revenuesfrom crude exportsover the $18/bbl price that enters into a stabilization fund, of which 45% enters in FEIREP. 3/ Assumes 15%of the 70% allocatedfor debt repurchase is usedfor IESSdebt. 4/ Includesarrears. Assumes constant levelof domestic debt. 74 Annex B: TheEcuadorianInvestmentClimate-Preliminary Findings3' 1. This Appendix presents the main preliminary findings of a survey on the Investment Climate Assessment (ICA) for Ecuador. Work to improve the investment climate i s recognized as a key pillar of World Bank Group work to promote economic growth and poverty alleviation in developing countries. The main focus of ICAs is on microeconomic and structural dimensions of a nation's business environment, viewed in an international perspective. To this end, ICAs look in detail at factors constraining the effective functioning of product markets, financial and non-financial factor markets, and infrastructure services, including in particular weaknesses in an economy's legal, regulatory, and institutional framework. ICAs also provide the tools and analytical framework to identify reform priorities ina country's investment climate, by linking constraints to firm-level costs and productivity. 2. The main objective of the Ecuador I C A is to develop a better understanding of the constraints on investment and more rapid growth of productivityand exports inthe private sector. In particular, the proposed ICA seeks to (a) measure in a standardized way the investment climate conditions in Ecuador, (b) provide comparisons of those conditions with those prevailing in other countries and regions, and (c) identify the features of the investment climate that matter most for productivity and hence income growth. 3. The investment climate can be described as the policy, institutional, and behavioral environment, both present and expected, that influences the returns, and risks, associated with investment (Stern 2002). The environment i s thought to have six components: a) Stability: The country's degree of political and economic stability, encompassing both political economy issues and macroeconomic, fiscal, monetary, and exchange rates policies. b) Openness: The extent to which the country is integrated into the global economy, as determined by its national policy toward foreign investment, commercial policies, and informal barriers to trade, such as those derivedfrom inefficiencies inports or customs. c) Governance: The efficiency of the legal and regulatory framework, as reflected in the efficiency of the judicial system, the burden that firms face incomplying with regulations, the quality of the services provided or regulated by the government, the extent of corruption and, more generally, the prevalence of the rule of law. d) Infrastructure: The quality and quantity of available physical infrastructure, including power, water, transport, and telecommunications. e) Finance: The development of the country's financial system, and the extent to which firms of all sizes have access to financial services at reasonablecosts and conditions. f) Skills and technology: The availability of skilled workers and the extent to which firms have access to state-of-the-art technologies. Underlying this approach i s the idea that openness and good macro policies are necessary but not sufficient conditions for achieving sustained growth. Thus, the emphasis i s placed on microeconomic issues or, in other words, on issues that relate to the effective functioning of specific markets, including those for products, financial and non-financial factors, technology, and infrastructure services. Accordingly, the results reported here focus on the second through sixth above-described components of the investment climate. 37. This Appendix is a timely contribution by Pablo Fajnzylber. It reveals preliminary findings from an InvestmentClimate Assessment Survey (ICA) for Ecuador. ICAs are coordinatedby the Latin American Finance, Private Sector Development and Infrastructure unit (LCSFP) and the Development Research Group (DECRG) of the World Bank. Details on methodology are availableon request. 75 MainResults 4. Investment climate constraints. Firms were asked to indicate whether a list of 18 issues were problems for the operation and growth of their business and, if the answer was affirmative, to judge its severity on a four-point scale. Figures B.l, B.2, and B.3 report the percentage of manufacturing fm that evaluated the corresponding constraints as "major" or "very severe.'' Figure B.1 shows the top constraints, defined as those that were mentioned as important by more than a third of the surveyed fm, while Figures B.2 and B.3 include the constraints that were mentioned, respectively, by between 20 percent and 30 percent of the firms, and by less than 20 percent of the respondents. Figure B.l: Top Constraints,as Viewed by Firms(percent that rate them as "major" or "severe") 0% 10% 20% 30% 40% 50% 60% 70% Policy Uncertainty Costof Financing MacroInstability Corruption Anticompetitiveand InformalPractices Access to Financing Tax rates 5. The top constraints are (a) stability: policy uncertainty and macro instability are mentioned by, respectively, 61 percent and 54 percent of the firms; (b) governance: anticompetitive and informal practices (47 percent), corruption (49 percent), and high tax burden (38 percent); and (c) finance: cost (56 percent) and access (43 percent). The skills and education of workers are considered major problems by only 22 percent of the firms. Finally, in the area of infrastructure, problems are considered major or very severe by only 28 percent of the f m s in the case of electricity, 18 percent for telecommunications, andless than 10percent for transportation and access to land. Figure B.2: Intermediate Constraints,as Viewed by Firms(percentthat rate themas "major" or "severe") 0% 10% 20% 30% 40% 50% Judicial Insecurity Tax Administration Electricity Crime and Violence Customs Skills and Educationof Workers 6. However, a more detailed analysis of the answers to these questions by specific groups of firms reveals interesting differences from the national averages. For instance, except with regard to finance, foreign f m s tend to be more pessimistic than domestic f m s when ranking the severity of problems, particularly with regard to government regulations and infrastructure. This suggests that domestic f m s may be biased by their lack of international benchmarks. Exporters, on the other hand, 76 rank the problems related to finance, instability, and corruption as greater constraints on their operations than do nonexporters. Problems also vary with the size of the firms.Microenterprises with fewer than 10 employees, for example, view the access to and cost of finance as more severe constraints than larger firms. As for regional differences, the companies surveyed inthe province of Guayas tend to have more problems or at least be more pessimistic, but there are specific areas in which other regions report larger constraints-for example, anticompetitive practices inTungurahua (95 percent) and corruption inManabi (71 percent). Finally, there is considerable variation in problems and perceptions across economic sectors. For instance, hotels complain more about crime (49 percent) and corruption (62 percent), and textiles firms report the highest rate of problems inthe areaof anticompetitive practices (71 percent). Figure B.3: Lowest Constraints,as Viewed by Firms(percent that ratethem as "major" or "severe") 0% 10% 20% 30% 40% 50% Telecommunications 18% Labor Regulations BusinessLicensingandOperatingPermits Transportation Accessto Land - 7. Openness. Although Ecuador's ratio of trade to GDPis larger than that of most of its neighbors, there i s evidence that the country's degree of commercial integration in the world economy i s still relatively low. Indeed, in2000 Ecuador's foreign trade was about 30 percent lower than expected given its size, measured by population and territory, and the fact that it i s endowed with hydrocarbons and access to maritime routes (Figure B.4). Inorder to better understand what drives Ecuador's relatively low level of trade openness, one needs to consider both formal and informal barriers to trade. The survey provides some evidence on the latter, in particular with regard to customs. Interviews performed with importers revealed that it takes them 17 days on average to clear customs inEcuador, compared with 10.8 inVenezuela, 9.3 inPeru, 6.5 inColombia, and 3.4 inMalaysia (Figure B.5). Moreover, the variance of the period needed to clear customs i s also larger in Ecuador than in other countries, which can lead importers to hold larger inventories and face higher financial costs. Similar results are obtained for exports: on average it takes 8.8 days to clear customs before being allowed to ship the merchandise abroad, compared to 5.3 days inPeru, 5.1 inChina, and 2.6 inMalaysia. Figure B.4: DifferentialbetweenActual and ExpectedRatio of Trade to GDP,2000 79.3% 77 Figure B.5 Average and MaximumDaysto Clear Customs,for Imports 40 - 32.0 30.2 31.9 averageperiod longestperiod 8. Customs is a major informal barrier to trade. The problems at Customs, coupled with possible inefficiencies at the ports and the relatively low volumes that are traded (except for traditional export products) to and from Ecuador, contribute to increasing the costs of importing and exporting goods in Ecuador, which in turn reduces the country's degree of openness, regardless of the existing formal bamers to trade. This i s reflected, for instance, in the fact that Ecuador faces greater transport costs for exporting to the United States than countries that are located farther away from that market (Figure B.6). These problems may be aggravated ifthe Ecuadorian ports fail to adapt themselves to new security requirements that are being adopted by the United States. Figure B.6: Maritime Transport Costsfor exportsof Textilesto the U.S. (percent advantagewith respect to Ecuador) Data for 1998from US Dept of Transportation Import Waterborne database - 9. Besides the problems at customs and ports, there is evidence that some formal barriers to trade may still persist inEcuador. Indeed, importers complain about the complexity of the procedures to obtain import permits, as they involve two or three different agencies, and permits are sometimes arbitrarily denied without clear justification. Inthis respect, the survey indicates that import permits take on average 8.6 days. However, the standard deviation i s 12.6 days, and 9 percent of the importers state that public officials have suggested informal payments be paid to them in order to expedite the permits. 78 Inaddition, anecdotal evidence indicates that exporters face problems in obtaining, inEcuador, sanitary certifications that are recognized in their export markets-notably in the United States. Thus, there appears to be room for reducing non-tariff barriers to imports, and for providing exporters with better conditions to surmount non-tariff barriers imposed intheir export markets. 10. Power and telecommunicationsinfrastructure. The constraints inthe area of infrastructureare not among the ones mentioned most frequently by the surveyed f m s . However, data from the survey and other sources suggest that Ecuador faces great challenges in the fields of both electricity and telecommunications. Ecuador's installedelectricity generation capacity i s lower, inper capita terms, than that of Colombia, Venezuela, Chile, Brazil, and Mexico, and surpasses only Bolivia and Peru. A similar picture emerges in the case of telecommunications. Ecuador surpasses Peru in terms of its density of fixed lines and mobilephones. Butit only surpasses Bolivia interms of main lines per capita, and it loses inbothindicatorstoneighboringcountries suchas Colombia, Venezuela, andChile, and to other potential competitors, such as Brazil and Mexico inLatin America, and China and Malaysia inAsia. Partly due to the country's relatively low power generation capacity, but also due to problems inthe distribution stage, Ecuadorian firms face high costs and low quality of services in this area. Power outages, for example, affect 72 percent of manufacturingfirms. They are relatively common-almost 10per year, compared to 1on average in Malaysia-and imply losses of about 5 percent of sales for the affected firms (Figure B.7). Moreover, new electricity connections take on average 41 days, which i s about twice as along as it would take in China or Malaysia, and also more than inPeru (Figure B.8). Not surprisingly, about one- thirdof the manufacturingfirms ownprivategenerators. Figure B.7: Power Outages: Frequency and Lossesas Percent of Sales 20 15 14.0 14.5 5 a 10 5 0 Malaysia Brazil Peru Ecuador Bolivia Pakistan Number of power outages Losses as % of sales Figure B.8: Number of Days to Installa New Phone Line and a New Electricity Connection 1 1OW rn 150.4 120 v) n 3 80 40 0 pem Malaysia China Pakistan Ecuador Bangladesh New electricityconnection 1 79 11. The installation of new phone lines takes even longer: four months on average, or about 10times more than in Peru, China, and Malaysia (Figure B.8). These delays inevitably lead to corruption, with as much as 27 percent of the surveyed firms reporting that informal payments were suggested to expedite installations. Interruptions in services are also frequent, affecting 37 percent of the surveyed firms, and taking place on average once a month. 12. Water infrastructure. Ecuadorian firms depend to a large extent on public sources, becausethe percentage of plants that have their own wells i s relatively low by international standards (14 percent). Accordingly, water bought from private providers or extracted from wells represents less than 16 percent of total consumption. This, however, implies that Ecuadorian firms are more vulnerable to the inefficiencies of public providers. New water connections, for example, take on average 63 days, compared to 13 inMalaysia. 13. Transportation. The survey indicates that about 1.5 percent of sales are lost during transportation due to breakage, theft, or spoilage, which i s more than i s found inother countries where the same questions have been asked (Figure B.9). Anecdotal evidence suggests that security i s an important issue with regard to transporting merchandise between some Ecuadorian cities, which frequently leads truckers to use convoys protected by armed guards. Insurance policies are in short supply, and when available they tend to be expensive and in many cases require road transportation to take place only duringdaylight. Inaddition, private companies complain of the highcosts of land transportation, which they associate with the monopoly power exerted by the trucking union. Even for aerial and maritime transport, exporters indicate that transportation costs are high due to the market power of shipping companies, and to the relatively low volumes transported by Ecuadorian companies. Figure B.9: Percentage of Production Shipments Lost during Transport 1.6 1.2 2 0.8 u) -0 0.4 0.0 14. Governance. Ecuadorian firms seem to have little trust in their institutions. More than 46 percent of the respondents-compared to 15 percent in China-indicate that government officials do not interpret the regulations that affect their fm in a consistent and predictable way. Almost 57 percent state that they do not have confidence in the judiciary: they do not believe that their contractual and property rights would be enforced in the event of a business dispute (Figure B.lO). Not surprisingly, manufacturing f m s report that only 3 percent of the disputes over payments are taken to the courts, where cases take on average four years to be resolved. The weakness of the Ecuadorian legal and regulatory framework i s also reflectedinthe low quality of the services provided by government. Almost 50 percent of the firms describe the government as inefficient with regard to the delivery of public services-for example, public utilities, public transportation, security, education, health, and so forth. Given this and the complaints regarding the tax system, it i s not surprising that on average only 80 percent of the firms' revenuesare reported to the tax authority. 80 FigureB.10: Percentageof Firms that Do Not Have Confidenceinthe Judiciary OU 40 20 0 Bangladesh China Malaysia Peru Pakistan Ecuador 15. The evidence also suggests the existenceof a sizable regulatory burden. Private firms spend considerable amounts of time and money in order to comply with government regulations. Indeed, as much as 15 percent of senior management's time i s spent dealing with requirements imposed by public regulations, including dealing with officials, completing forms, and so forth. Moreover, the surveyed firms report that they spend on average 15 days per year in inspections and other mandatory meetings with public officials. Almost half of that time i s spent in meetings with representatives of the tax authority, which consume seven days per year on average. Inaddition, between two and three days are spent dealing with each of the agencies that oversee the regulations in the areas of labor and social security, the environment, and sanitary standards. 16. There is also a high prevalence of corruption. Two-thirds of the companies recognize that in their sector it i s a common practice to make informal payments to public officials in order "to get things done" (Figure B.11). They also report that those payments represent on average 5 percent of the sales ina typical company. Informal payments are most common in the case of firms that apply for new phone lines, but they are also used for other public services, such as permits and licenses. As for the more general prevalence of the rule of law, the survey data reveal that as much as 36 percent of the firms were victim to some type of criminal act during2002. The losses associated with those crimes representedon average 3.5 percent of the companies' annual sales. While 58 percent of the crimes were reported to the police, only 7 percent of them were solved. Figure B.11: Gift or PaymentsRequired for Connectionsor Permits (% of firms) 30 97 n 20 10 0 import license construction electrical water operating mainline permit connection connection license telephone connection 17. Finance. The level of credit to the private sector grew considerably during the late 1990s, before the 1999collapse of the banking system. Although access to credit has yet to recover to pre-crisis levels, the current stock of claims on the private sector by banks and other financial institutions, 38 percent, i s relatively highas a share of GDP, at least by Latin American standards. However, if the comparison i s 81 made with Asia or Organization for Economic Co-operation and Development countries, it i s clear that Ecuador still faces important challenges interms of the depth of its financial sector. As inother countries, access to credit grows with the size of the fm: as seen in Figure B.12, around 63 percent of microenterprises have at some point received a loan or overdraft from a financial institution, compared to 81 percent for firms with more than 50 employees (about 29 percent more). It appears, however, that smaller firms have benefited to a lesser extent from the recovery of the financial sector after the crisis. Indeed, only about 40 percent of the firms with less than 50 employees report having received loans during2002 or 2003, compared to about 65 percent for larger firms (about 62 percent more). Thus, credit has become even more concentrated than before, as banks have behaved more prudently with regard to their smaller clients. Figure B.12: Share of Firmswith Loans or Lines of Credit by Size (%) 100 81.8 81.4 80 60 40 20 0 Ecuador Less than 10to 20 21to 50 51to 100 Morethan 10empl. empl. empl. empl. 1OOempl. 18. In addition, larger firms have access to bank loans under better conditions than their smaller counterparts. Collateral requirements, for instance, are quite highinEcuador, reaching on average almost 180 percent of the value of the loans (Figure B.13). For firms with more than 100employees, however, the average requirement is 159 percent. Similarly, the average term of the loans received by microenterprises i s 10 months, compared to an average of 22 months for larger f m s . As for interest rates, they are lower for firms with more than 50 employees: 18percent per year, compared to 22 percent for smaller fm. Figure B.13: Average Value of collateral as Percent of the Loan 200 178.5 150 100 50 0 Pakistan Malaysia China Bangladesh Peru Ecuador 82 19. It is thus not surprisingthat larger fm finance a larger share of their investments usingbank loans: 34 percent in the case of firms with more than 50 employees, compared to 23 percent for the smaller f m s . As a substitute, smaller firms use to a larger extent informal sources of finance, supplier credit, and credit cards. Together, these sources are responsible for the financing of 25 percent of the investments of firms with at most 50 employees, compared to 9 percent for larger firms. 20. Skills and Technology. Only 22 percent of the surveyed firms rank the problems associatedwith workers' skills and education as "major" or "very severe." Intheory, this could reflect either an adequate supply of skilled workers, or a relatively low demand for them. Ecuadorian firms report that on average less than 3 percent of its workers have less than 6 years of schooling, and 25 percent have more than 12 years of schooling, which also places Ecuador-and Peru for that matter-in a better position than countries like Malaysia and Pakistan (Figure B.14). Aggregate education statistics, however, suggest that Ecuador i s above the world median in terms of the educational attainment of its population (a stock), but below the median in terms of secondary enrollment (a flow), which raises concerns about a possible downwardtrend inthe country's internationalstandings inthe area of education.38 Figure B.14: Workforce with lessthan6 or more than 12years of schooling(%) 40 36 3 34 9 35 30 25 20 15 10 5 0 Peru Ecuador Malaysia Pakistan Less than 6 years more than 12 years 1 21. Labor Supply. The perception that supply is not an issue i s also consistent with the fact that Ecuador has endured high rates of unemployment in the last few years, finding candidates for most job openings easily. This i s confmed in the survey: the time that it takes to fill vacancies for skilled and unskilledworkers inEcuador i s small compared with Peru, Malaysia, or Bangladesh (Figure B.15). 38. Ecuador i s in the world's 58th percentile in terms of average years of schooling of the population (6.25 in 1995), as calculatedby BarroandLee (2000) for asample of 104countries. Within Latin America, Ecuador is inthe 66thpercentile. Interms of school enrollment, however, World Development Indicators data for 122 countries place Ecuador at the 29th percentile, with agross secondary enrollmentof 57.4in2000. 83 FigureB.15: Weeks NeededTo FillVacanciesof SkilledandUnskilledWorkers 6 5 4 3 2 1 0 Malaysia Peru Bangladesh Ecuador Pakistan Productionor service worker 1 22. Labor Demand. The evidence on the changes inthe demand for skilled workers suggests that in the formal sector the relative demand for workers with tertiary education has increasedsince 1997, compared with the demand for workers with secondary education. The opposite has occurred in the informal sector, where workers with secondary education have been relatively more in demand both in comparison with those with some college education, and with those with primary education only. It i s still possible, however, that regardless of these overtime changes, the level of the demand for skilled workers in Ecuador remains relatively low by international standards, possibly due to low levels of adoption of state-of-the-art production technologies. Moreover, the recent changes in the demand for skills could still be too small to create bottlenecks, which would explain the low concerns expressedby the surveyed firms in this area. To some extent, this hypothesis i s supported by the low fraction of firms (17 percent) that have received I S 0 certification inEcuador. However, a more detailed analysis would be necessary to better understand what drives the demand for skilled workers across firms, and to verify whether the low level of adoption of new technologies can explain the few concerns expressed by the firms inthis area. 23. As for government regulations, the fraction of firms that rated those that affect labor contracts as sources of major or very severe problems is even smaller (14 percent) than with regard to workers' skills. This is somewhat surprising since the Ecuadorian labor regulations are known to be some of the more restrictive in the region. One possible explanation i s that, as suggested by MacIsaac and R a m (1997), compliance with this legislation i s limited, because the government has partial enforcement capabilities. Moreover, at least in the private sector, wage contracts can undo some of the distortions, for instance by loweringbase earnings, so highmandated benefits do not necessarily translate into higher take-home pay. Inaddition, firms tend to avoid long-term contracts, using temporary work or outsourcing as mechanisms to minimize their legal obligations toward workers. In this survey's sample, for instance, almost 25 percent of the workers were temporary. Moreover, the survey data also show the existence of highrates of turnover inEcuador (Figure B.16), particularly among smaller firms. This, it i s worth noting, has potentially deleterious consequenceson productivity, since f m s have a lower incentive to invest intraining temporary workers, and temporary workers have little incentive to be productive. 84 FigureB.16: Rateof Labor Turnover inEcuador and Selected Countries (% of workers that are hired or fired ina givenyear) 60 50.4 50 40 30 20 10 0 Pakistan Bangladesh Ecuador Malaysia 85 86 References Artana, Daniel. 2002. "La ProblemiticaFiscal en Ecuador." Washington, D.C.: Banco Interamericano de Desarrollo. Barro, Robert, and J. W. Lee. 2000. 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