Document of The World Bank

Report No: 27477

IMPLEMENTATION COMPLETION REPORT(FSLT-71740)

ON A

LOAN

IN THE AMOUNT OF US$50 MILLION

TO THE

REPUBLIC OF ECUADOR

FOR A

FISCAL CONSOLIDATION & COMPETITIVE GROWTH ADJUSTMENT LOAN

February 18, 2004

Poverty Reduction and Economic Management DivisionBolivia, Ecuador, Peru and Venezuela Country Management UnitLatin America and the Caribbean Region

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

CURRENCY EQUIVALENTS

(Exchange Rate Effective )

Currency Unit = US Dollar 1 = US$ 1

US$ 1 = 1Republic of Ecuador

FISCAL YEARJanuary 1 December 31

ABBREVIATIONS AND ACRONYMSAGD Deposit Guarantee Agency, (Agencia de Garantía de Depósitos)BCE Central Bank of Ecuador, (Banco Central del Ecuador)CAE Ecuadorian Customs Corporation, (Corporación Aduanera Ecuatoriana)CAF Andean Development Corporation, (Corporación Andina de Fomento)CAS Country Assistance StrategyCOMEXI Foreign Trade and Investment Council, (Consejo de Comercio Exterior e Inversiones)CONADES National Wages Council, (Consejo Nacional de Salarios)CONAM National Council for the Modernization of the State, (Consejo Nacional para la Modernización del Estado)CONAREM National Council on Public Sector Remuneration, (Consejo Nacional de Remuneraciones del Sector Público)CONATEL National Telecommunications Council, (Consejo Nacional de Telecomunicaciones)CONELEC National Electricity Council of Ecuador, (Consejo Eléctrico de Ecuador)FCCGL Fiscal Consolidation and Competitive Growth Adjustment LoanFEIREP Stabilization, Investment, and Public Debt Reduction Fund, (Fondo de Estabilización, Inversión Social y Producción y Reducción

del Endeudamiento Público)FTSRL Fiscal Tranparency, Stability, and Responsibility LawGDP Gross domestic productGOE Government of EcuadorHDRL Human Development Reform LoanICR Implementation Completion ReportIDB Inter-American Development BankIESS Ecuadorian Social Security Institute, (Instituto Ecuatoriana de Seguridad Social)IMF International Monetary FundLPG Liquid petroleum gasLSTR Law of Simplified Tax Regime, (Ley de Regimen de Impuestos Simplificados)LTRS Law of Tax Rationalization and Simplification, (Ley de Racionalización y Simplificación Tributaria)MEF Ministry of Economy and Finance, (Ministerio de Economía y Finanzas)MICIP Ministry of External Trade, Industry, Fishing and Competitiveness, (Ministerio de Comercio Exterior, Industria, Pesqueria y

Competitvidad)MIDUVI Ministry of Urban Development and Housing, (Ministerio de Desarrollo Urbano y Vivienda)OCP Heavy Crude Oil Pipeline, (Oleoducto de Crudo Pesado)OSCIDI Civil Service and Institutional Development Office, (Oficina del Servicio Civil y Desarrollo Institucional)PACIFICTEL Pacific Telephone — Fixed line telecommunications operator in the coastal regionPROMEC Power and Telecommunications Modernization and Rural Services ProjectPSAL Programmatic Structural Adjustment LoanQAG Quality Assessment GroupRDOs Regional Development OrganizationsSAL Structural Adjustment LoanSAPSB Subsecretariat for Potable Water and Basic Sanitation, (Subsecretaria para Agua Potable y Sanitación Básica)SBA Stand-by AgreementSENRES National Technical Secretariat for Human Resource Development and Public Sector Remuneration, (Secretaría Nacional Técnica

de Desarrollo de Recursos Humanos y Remuneraciones del Sector Público)SIGEF Integrated Public Sector Financial Management System, (Sistema de Gestión Financiera)SOTE Trans-Ecuadorian Pipeline System, (Sistema de Oleoducto Transecuatoriana)SRI Internal Revenue Service, (Servicio de Rentas Internas)VAT Value-Added Tax

WTO World Trade Organization

Vice President: David de FerrantiCountry Director Marcelo Giugale

Sector Director Ernesto May

Task Team Leader/Task Manager: Jose R. Lopez-Calix

ECUADOREC FISCAL CONSOLIDATION & EQUITABLE GROWTH LOAN

CONTENTS

Page No.1. Project Data 12. Principal Performance Ratings 13. Assessment of Development Objective and Design, and of Quality at Entry 24. Achievement of Objective and Outputs 45. Major Factors Affecting Implementation and Outcome 186. Sustainability 197. Bank and Borrower Performance 208. Lessons Learned 219. Partner Comments 2210. Additional Information 25Annex 1. Key Performance Indicators/Log Frame Matrix 28Annex 2. Project Costs and Financing 33Annex 3. Economic Costs and Benefits 34Annex 4. Bank Inputs 35Annex 5. Ratings for Achievement of Objectives/Outputs of Components 36Annex 6. Ratings of Bank and Borrower Performance 37Annex 7. List of Supporting Documents 38

Implementation Completion Report

Republic of Ecuador

Fiscal Consolidation and Competitive Growth Loan(Loan No. 7174-EC)

Preface

This is the Implementation Completion Report (ICR) for the Fiscal Consolidation and Competitive Growth loan to the Republic of Ecuador; for which Loan No. 7174-EC in the amount of US$50 million was approved on May 27, 2003 and was made effective on September 16, 2003.

This ICR was prepared by José R. López-Cálix (Senior Economist, LCSPE) based on a report by Fred Levy (consultant) and Elaine Tinsley (Research Analyst, LCSPE), who visited Ecuador in October 2003. The ICR was reviewed by Mauricio Carrizosa (Sector Leader, LCSPR), Vicente Fretes-Cibils (Lead Economist, LCSPE), and Fabiola Altimari Montiel (Counsel, LEGLA). The ICR was approved for distribution by Marcelo Giugale (Director, LCC6C). The Borrower, through Mauricio Pozo, Gilberto Pazmiño, and Diego Mancheno, contributed to this ICR by assisting the team and preparing its own assessment of the project, which is included in Section 9 of this ICR. Jose Francisco Irías, Michael Geller, Maria Antonieta Gonzalez, and Diane Stamm provided excellent editorial and processing assistance. Alexandra del Castillo and Ana María Villaquiran offered valuable support from the Bank's office in Quito.

Project ID: P082739 Project Name: EC FISCAL CONSOLIDATION AND COMPETITIVE GROWTH ADJUSTMENT LOAN

Team Leader: Jose R. Lopez Calix TL Unit: LCSPEICR Type: Core ICR Report Date: February 19, 2004

1. Project DataName: EC FISCAL CONSOLIDATION AND

COMPETITIVE GROWTH ADJUSTMENT LOAN

L/C/TF Number: FSLT-71740

Country/Department: ECUADOR Region: Latin America and the Caribbean Region

Sector/subsector: General public administration sector (70%); Other domestic and international trade (10%); Other social services (10%); Power (5%); Telecommunications (5%)

Theme: Macroeconomic management (P); Public expenditure, financial management and procurement (P); Tax policy and administration (P); Poverty strategy, analysis and monitoring (S); Regulation and competition policy (S)

KEY DATES Original Revised/ActualPCD: 03/26/2003 Effective: 09/16/2003 09/16/2003

Appraisal: 04/16/2003 MTR:Approval: 05/27/2003 Closing: 12/31/2003

Borrower/Implementing Agency: GOVERNMENT OF ECUADOR/MINISTRY OF ECONOMY & FINANCEOther Partners: na

STAFF Current At AppraisalVice President: David de Ferranti David de FerrantiCountry Director: Marcelo Giugale Marcelo GiugaleSector Manager: Mauricio Carrizosa Mauricio CarrizosaTeam Leader at ICR: Jose R. Lopez-Calix Jose R. Lopez-CalixICR Primary Author: Fred Levy

2. Principal Performance Ratings

(HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HL=Highly Likely, L=Likely, UN=Unlikely, HUN=Highly Unlikely, HU=Highly Unsatisfactory, H=High, SU=Substantial, M=Modest, N=Negligible)

Outcome: S

Sustainability: L

Institutional Development Impact: M

Bank Performance: S

Borrower Performance: S

QAG (if available) ICRQuality at Entry: S

Project at Risk at Any Time: No

3. Assessment of Development Objective and Design, and of Quality at Entry

3.1 Original Objective:Ecuador has long suffered from weak economic management, conflictive politics, and poor governance. Coupled with natural disasters and vulnerability to wide terms-of-trade swings, and despite substantial petroleum wealth, these weaknesses have resulted in poor growth performance, extreme macroeconomic instability, deteriorating social indicators, large-scale emigration, and unsustainable external debt. Largely as a last resort to exit from a severe currency and banking crisis, Ecuador formally dollarized the economy in January 2000, effectively placing the full responsibility for macroeconomic management on fiscal policy. Dollarization brought price stability, reduced mismatchings in the banking sector, increased credibility in the economic program, and contributed to the enforcement of fiscal discipline. The ability to conduct a sound fiscal policy, however, has been undermined by a narrow and volatile revenue base, weak tax administration at customs, and highly rigid expenditures complicated by overstaffed ministries, an outmoded public sector wage structure, a heavy public debt burden, and inadequate information and control systems. At the same time, dollarization removed exchange rate policy as a means of offsetting market rigidities in the real economy that raise production costs, reduce the competitiveness of Ecuador’s goods and services and diminish the country's attractiveness to new private investment.

A newly elected Ecuadorian Government (GOE) took office in January 2003. The Fiscal Consolidation and Competitive Growth Adjustment Loan (FCCGL) was a one-tranche adjustment loan to support the initial stage of the new Government’s medium-term program for establishing fiscal sustainability and improving the competitiveness of the Ecuadorian economy. More specifically, the Government of Ecuador’s (GOE’s) program seeks to enhance and make more transparent the management of public expenditures, revenues and debt; improve operational efficiency and pricing policies in the petroleum, electric power, telecommunications, and water sectors; rationalize international trade policies; and bring greater flexibility to the labor market. The actions supported by this loan have focused primarily on strategy and policy formulation; the preparation of laws, regulations, and programs; and the initiation of institutional reforms and needed price adjustments. A number of its specific objectives were carried over from uncompleted components of the Structural Adjustment Loan (SAL) approved in 2001, and complemented the structural objectives of the current Stand-by Arrangement (SBA) between Ecuador and the International Monetary Fund (IMF).

Past difficulties in sustaining progress under adjustment loans in Ecuador led Bank management to present the FCCGL as a one-tranche operation based on prior actions. Nevertheless, the loan was intended to support a multi-year matrix of reforms, which, if sustained, could be followed by subsequent Programmatic Structural Adjustment Loans (PSALs). At the time of approving the FCCGL, the Board of the World Bank approved in parallel a first Programmatic Human Development Reform Loan (HDRL). The latter operation, also carrying forward elements of the earlier SAL, seeks to support the GOE’s program to improve the targeting and effectiveness of vital public social programs in order to shield the most vulnerable social groups in the face of the required fiscal austerity. Efforts were to be initiated under both loans towards building a national consensus around the deeper structural reforms that would be required to achieve the

- 2 -

medium-term objectives of the program. The two loans together were intended to make an immediate contribution to economic stability.

Assessment:

The objectives of the FCCGL were highly relevant to Ecuador’s current situation and long-term development agenda. Along with the HDRL, the loan was an integral element of the assistance strategy set out in the 2003 Country Assistance Strategy (CAS), which was presented to the Board at the same time. Both the overall country strategy and the central elements of the FCCGL were well documented and persuasively argued in high-quality economic and sector work carried out over the past several years. As noted above, the program supported by the FCCGL were initial steps for laying the institutional foundations of deeper reforms that would be needed over the next several years if Ecuador is to realize its development potential. Given the weakness of the legal and institutional framework in place after years of political conflict and poor governance, the FCCGL necessarily emphasized process measures—for example, preparatory studies, the formulation of policies and strategies, and the drafting and submission of laws in the first stage of the program.

The risks of the operation, as described in the CAS and the documentation for the loan, were well understood. The strong resistance of vested interests, the fragility of the new Government’s political power, the weakness of implementation capacity, and the economy’s vulnerability to external shocks all threatened, and still threaten, the sustainability of this program, just as they have led to the failures of earlier reform efforts. Despite these risks, the advent of a new reform-minded Government, Ecuador’s immediate need for external assistance and support, and the high level of collaboration among the international financial institutions fully justified the Bank’s participation and proactive efforts. By putting the FCCGL forward as a one-tranche adjustment loan, and deferring the initiation of explicit programmatic lending, the Bank was acknowledging that progress would likely be slow, and that only after this first stage might it become possible to put a realistic timeframe on full implementation of the reform program.

3.2 Revised Objective:Not applicable.

3.3 Original Components:The FCCGL was conditioned on the maintenance of sound macroeconomic policies, interpreted to mean that Ecuador remained in compliance with the terms of its IMF SBA. In addition, the FCCGL was intended to support specific objectives of the Government’s multi-year program to build the institutional foundations for (a) sound fiscal management, and (b) improving the economy’s efficiency and growth prospects. Particular emphasis is given in the first phase of the program to the achievement of stability and fiscal consolidation. The principal components of the FCCGL in support of this objective are:

• Strengthening the fiscal framework by enhancing strategy formulation, removing legal and institutional rigidities that impede administration of the public budget, introducing multiannual budgeting with quantitative benchmarks, and improving the information available to both policy makers and civil society;

- 3 -

• Increasing tax revenues through broadening the tax base, improving tax administration, and modernizing customs administration; and

• Improving public expenditure management through the immediate adoption and implementation of an explicit austerity program, strengthening control over the public wage bill, clearing debt arrears and adopting a medium-term plan for debt reduction, establishing clear rules for managing the Stabilization, Investment and Debt Reduction Fund (FEIREP), and modernizing and consolidating the accounts of the nonfinancial public sector.

The first phase of the program also includes initial steps toward improving the economy’s responsiveness and competitiveness, including:

• Rationalizing and liberalizing the trade regime through reductions in the level and dispersion of tariffs, unifying and reducing the number of required import licenses and simplifying licensing procedures, and bringing technical norms progressively into compliance with World Trade Organization (WTO) standards;

• Improving the regulatory and pricing policies applied to public enterprises in the water, electricity, and telecommunications sectors and making the sectors more attractive to private investment and management;

• Rationalizing the pricing of petroleum products, improving the management of the state oil company, PetroEcuador, and achieving effective design and enforcement of environmental regulations in the producing areas with the participation of the affected populations; and

• Reducing rigidities in the labor market.

Further actions in all of these areas are foreseen during later phases of the program, which could be supported by one or more adjustment operations. Several of these areas are also being supported by Bank investment loans and technical assistance activities.3.4 Revised Components:No applicable

3.5 Quality at Entry:There has been no Quality Assessment Group (QAG) review of the FCCGL. The conclusion of this ICR is that quality at entry was Satisfactory.

4. Achievement of Objective and Outputs

4.1 Outcome/achievement of objective:All of the prior conditions for going forward with the FCCGL had been met prior to Board presentation. This Implementation Completion Report (ICR), however, assesses progress toward the medium-term objectives of the program supported by the loan. As will be seen in the discussions of specific components, progress has had variations. Progress overall toward achieving the loan’s objectives is considered Satisfactory.

- 4 -

In particular, important progress has been made toward establishing a workable framework for fiscal management. The normalization of relations with creditors and the enactment of laws and regulations imposing fiscal austerity, limiting new debt creation at all levels of government, rationalizing public sector salary structures, strengthening the enforcement powers of the tax authorities and beginning the modernization of the customs administration, and adjusting public utility tariffs are long-sought objectives that earlier governments and adjustment loans had failed to achieve. Extending and drawing full advantage from these forward steps will not be easy, however. Resistance remains strong, and the potential benefits are not well understood by the public at large. An open and informed public debate and strong leadership from the Executive will be needed to sustain this initial progress.

The following discussion of the FCCGL is grouped under six broad headings: (a) strengthening the macroeconomic framework; (b) modernizing the tax system; (c) improving expenditure management; (d) rationalizing the trade regime; (e) enhancing the efficiency of the water, power, telecommunications, and petroleum sectors; and (f) increasing the flexibility of labor markets. The specific program elements under each of these headings, and the status of their implementation as of February 2004, are summarized in Annex 1.

4.2 Outputs by components:(a) The Fiscal Framework

The lack of an explicit and coherent fiscal framework has undermined the credibility of fiscal management in Ecuador and left it vulnerable to constant political pressures for expanded government spending. The Fiscal Transparency, Stability and Responsibility Law (FTSRL), passed by Congress in June 2002, sought to impose such a framework, but the Government at that time did not issue the regulations that would make it effective.

Assessment:

Progress under this component is rated Highly Satisfactory. Its sustainability is Likely. Institution building is rated Substantial.

As a first step in initiating its program, the President issued an emergency Austerity Decree at end-January 2003.1 The Decree put a freeze on the level of public sector employment2 and wages, prohibited overtime work, and directed a 10-percent reduction in the incomes of all civil service workers with monthly incomes above US$1,000, and a 20-percent reduction in the remuneration of the President. The Decree also prohibited the signing of new contracts for part-time workers or professionals, instructed that the 2003 budget for foreign travel be reduced by at least 20 percent, mandated the sale of all public real property (including social and recreational facilities) not indispensable for the normal functions of the agency, and prohibited the awarding of prizes, receptions, subsidies, or the like to state employees. This was followed in February 2003 by the issuance of regulations to effect key provisions of the FTRSL, including: multiannual budgeting, quantitative targets for fiscal variables, a public debt reduction plan, management of the resources deposited to the FEIREP, and enhanced transparency and citizen involvement in monitoring budget implementation. The FTRSL also prohibited the central

- 5 -

government from contracting loans on behalf of private or public enterprises, and permits state loan guarantees only for basic infrastructure projects financed by multilateral institutions or other governments, and within the established debt limits.

Putting the FTSRL into effect was a substantial step forward in establishing meaningful budgetary guidelines and providing a framework for analyzing the macroeconomic impact of the public finances. Although more ambitious quantitative targets would have been desirable, the regulations establish explicit limits on real primary expenditure growth; set multi-year targets for, among other things, reduction of the non-oil central government deficit and for reduction of the ratio of public debt to GDP; and mandate elimination over four years of the government’s debt to the Ecuadorian Social Security Institute (IESS). The regulations also define the financing sources for FEIREP and direct how FEIREP resources are to be allocated. (These provisions are discussed below in the section on Expenditure Management.) Preparation of the proposed multiannual budget for 2004–07 is only now beginning.

Preliminary official data indicate that the 2003 budget targets could have been met. Despite the actions taken under the Austerity Decree, public spending through October continued to grow above the targeted limits, and additional cuts were applied to meet the end-year fiscal performance criteria under the IMF SBA. The principal sources of expenditure growth were increases in the wage bill and pension contributions, partly carrying over from actions taken during 2002 but exacerbated by increases granted to teachers by the present Administration. Also as of end-October, reported revenue growth in 2003 was running slightly below target, but the apparent shortfall was expected to be eliminated by upward revisions in oil production and earnings data. The collection of taxes on imports through August was some 5 percent below that of the same period in 2003. The decline appeared to reflect tax evasion through smuggling, and a questionable massive shift of import classifications to zero-rate categories (see below).

(b) The Tax System

Ecuador’s tax base has been significantly narrowed by large numbers of exemptions under both the value-added (VAT) and income tax regimes. Most of these exemptions have little economic justification and have arisen over time as favors to particular interest groups, creating serious inefficiencies and inequity. Tax collections are further eroded by weak administration and by the large informal economy of small producers and merchants who keep few records of their transactions. Customs duties and the collection of VAT on imports are undermined by large-scale evasion, abetted by inefficient and corrupt customs administration. The tax system is also characterized by a large number of “nuisance” taxes, those enforcement of which is more costly than the revenues they generate. The result of these structural deficiencies is a budget unduly dependent on revenues from oil, and highly vulnerable to the variability of oil prices. The discretionary management of fiscal policy is additionally impeded by excessive tax earmarking. Efforts to correct these problems were the focus of conditionality for a floating tranche of the 2001 SAL; this tranche was ultimately cancelled after the authorities withdrew the draft tax reform legislation in the face of Congressional resistance. The present Government’s program focuses again on broadening the tax base and improving administration, and sets quantitative targets for improved tax collection.

- 6 -

Assessment:

Outcomes thus far under this component are rated Moderately Satisfactory. Sustainability is Likely, but still vulnerable to reversal by Congress. Institution building has been Modest.

Tax revenues in 2003 under the jurisdiction of the Internal Revenue Service (SRI) have significantly increased in line with program targets, buoyed by improved collection efforts and high oil prices. The Government submitted a draft Law of Simplified Tax Regime (LSTR) to Congress in May 2003. The proposed law was approved on first reading and cleared by a committee for the second reading, but was then rejected. The draft proposed allowing small producers and retailers to voluntarily pay a tax based on gross incomes in place of the income tax and VAT, while making compulsory the presentation of billing invoices from suppliers. These provisions have since been incorporated into a larger draft Law of Tax Rationalization and Simplification (LTRS), which is expected to be submitted to Congress in January 2004.

In addition, the LTRS would, among other things, more rigorously limit deductions from income for tax purposes, eliminate abuses of transfer pricing and reported interest payments abroad, and prohibit the creation of new tax earmarking, while eliminating all existing earmarking not explicitly mandated by the Constitution.3 It would eliminate the VAT exemption currently accorded to luxury food goods and domestic cargo transport, among other things, and set out norms for the rebate of the VAT to direct and indirect exporters. It would reduce the excise tax on telephone services, while raising that on alcohol. It would also sharply reduce the tax on vehicles used for productive purposes, while raising that on other vehicles (by lengthening the standard amortization period). The draft LTRS would also require formal accounting statements from all businesses with assets greater than US$60,000 or annual incomes greater than US$100,000, expand the auditing powers of the Tax Administration, and authorize it to verify the consistency of tax declarations with other sources of information. On the negative side, the expected revenue generation of the LTRS has been significantly reduced by the inclusion of provisions to lower taxes on corporate reinvested profits and to permit taxpayers to designate up to 25 percent of their tax payments to go directly to local governments.

If approved in 2004, the LTRS would take effect in 2005. On balance, although the tax reform bill put forward by the Government would represent a significant rationalization and improvement of the current dysfunctional and distortionary tax regime, its fiscal impact appears likely to fall short of what is needed to achieve the medium-term objectives of its macroeconomic program, and its chances for Congressional approval are uncertain.

In April 2003, Congress approved the Customs Modernization Law, whose submission had been a prior action required by the FCCGL. Among other things the draft law sought to improve the collection of customs duties by strengthening the role of SRI on the Board of the Ecuadorian Customs Corporation (CAE), giving SRI greater access to import bills and CAE taxpayer information, restructuring the CAE, imposing stiffer penalties for the underinvoicing of imports, and improving border controls. Quantitative targets were set for improved tax collections by CAE. In approving the law, Congress watered down a number of its provisions, and, with

- 7 -

continuing resistance to restructuring from customs officials, the Government enlisted the armed forces to intervene in the CAE and to carry out the modernization program. A draft Strategic Modernization Plan for the CAE has been prepared and is currently being reviewed by an external consultant. An evaluation of CAE’s staffing and a proposal for privatizing some of its services are also in process. The restructuring of Customs has been slow, however, partly because of actions of the outgoing administrators to dismantle the existing information system. As a consequence, the military’s mandate, which was originally to end by October 15, 2003, has been extended indefinitely. Meanwhile, tax collection by Customs has fallen during the year despite rising trade and little apparent change in import composition. The decline has resulted largely from an unexplained and likely fraudulent increase in the use of special exemptions and duty-free zones. Significant continuing losses are also reported from contraband.

Earlier efforts at tax reform, including, as mentioned, that supported by the SAL, failed to overcome the political strength of the financial and bureaucratic interests vested in the current system of distortions and preferential treatment. Those interests have reportedly again mobilized opposition to the present draft LTRS, and to the modernization of customs administration. The challenge to the Government is to inform and lead the public debate of these issues and mobilize those who will benefit from the proposed changes to overcome the traditional and well-organized resistance to reform. Even if the laws are passed, successful implementation will require substantially upgraded technical and managerial skills, particularly in the CAE. The process of litigating tax offenses, which can sometimes take years, requires substantial improvement, including the training of judges. Long-standing efforts to reform taxation at the municipal level need also to be intensified to increase local tax bases and reduce their dependence on transfers from the center. Updated land and property cadastres are needed to make these efforts effective. Support for intensive technical assistance in all these areas will be needed from the international agencies.

(c) Expenditure Management

The government’s ability to manage public expenditures is severely compromised by structural rigidities that leave as little as 5 percent of annual central government expenditures subject to discretionary policy decisions. The unusual and excessive degree to which state revenues are earmarked by law, accounting for about 30 percent of total expenditures in 2002, has been noted above. The servicing of the public debt, before recently negotiated write-downs and rescheduling (see below), accounted for another 35 percent of total expenditures. In addition, the government’s wage bill absorbed about 30 percent of government spending (including debt service) and more than doubled in U.S. dollar terms between 2000 and 2002 as a result of large increases in wages and benefits agreed by the previous administration.

Efforts to reduce the number and value of earmarked taxes are discussed above. In order to increase the room for discretionary fiscal management, the GOE’s reform program also contains measures to (a) reduce the public debt, (b) bring greater order and control to public staffing and the wage bill, and (c) strengthen the financial information and management system. These latter three subcomponents are discussed in turn.

- 8 -

(i) Reduction of the public debt. The first phase of the Government’s program called for eliminating public debt arrears. As prior actions for the approval of the FCCGL, all external public debt arrears outstanding as of February 28, 2003 were eliminated, as well as arrears on all domestic bonded debt by March 31, 2003. Subsequent measures were to clear all remaining arrears during 2003 and to prepare a Debt Reduction Plan to meet the targets established in the FTSRL. About half of Ecuador’s external debt service is accounted for by Global bonds, high-interest-rate obligations that were exchanged for Brady bonds in 2000.4

Assessment:

Outcomes so far under this subcomponent are rated Satisfactory. The sustainability of the measures appears Likely. The institution building achieved is considered Substantial.

Establishing an explicit legal commitment and schedule for debt reduction, and placing constraints on new borrowings by both the central and local governments, were substantial achievements. The initial debt clearance objectives supported by the FCCGL were achieved on schedule, and Ecuador successfully concluded its negotiations with the Paris Club. Bilateral negotiations with Club members are now in progress. A Debt Reduction Plan, set out as a benchmark for a possible follow-up PSAL, was issued by the Minister of Economy and Finance on August 12, 2003. The latter requires reducing the public debt-to-GDP ratio by 16 percentage points (from 63 percent at end-2002 to 47 percent before the end of the Government’s four-year term of office), including elimination of its debt to IESS, and to continue reducing the ratio beyond that date until reaching 40 percent.5

Work has begun in the Central Bank of Ecuador (BCE) to develop capacity for the strategic management of the debt. Some US$300–400 million are expected to flow to the FEIREP in 2004, the bulk of which is to be used for debt reduction. Under the provisions of the FTRSL, 70 percent of FEIREP resources each year are to be used to repurchase external public debt and repay debt to IESS; 20 percent should be held on deposit for limited expenditures to relieve legally declared natural disasters or to compensate the budget for an unexpected decline in oil prices; and the remaining 10 percent is to be spent on basic infrastructure projects in education and health. Delay in completing the Heavy Crude Oil Pipeline (OCP), and issues regarding the definition of “heavy crude oil” and whether only oil transported by the OCP would generate revenues for FEIREP, held up implementation of this provision of the FTSRL in 2003. In the meantime, the state’s oil revenues have continued to flow directly to the budget. The channeling of resources to FEIREP will reduce the direct revenue flow to the budget.6 The sustainability of these debt reduction efforts could be threatened by sentiment, both inside and outside the government, that the country should halt servicing the external debt, and give precedence instead to the “social debt.”

(ii) Control of the state’s wage bill. The control of public sector wages has been complicated by, among other things, the large number of public enterprises and autonomous agencies outside the central budget, by the lack of a comprehensive human resources policy, excessive hiring discretion in the hands of agency managers, the application of different salary schedules by different agencies, and by a large number of salary supplements created in the various agencies over the years, partly to avoid pension charges and/or to get around centrally imposed limits. Many of these components were indexed to prices or to the minimum wage, thus building in

- 9 -

difficult-to-predict pay increases outside the control of the authorities. Fragmentation of the pay system has also created serious inequities in the pay received by workers across the public sector, resulting in constant pressures for redress by those considering themselves disadvantaged. Moreover, the government has lacked a comprehensive database of the number, grade, salaries, and skill profiles of public employees, making it impossible to formulate policy for human resource development or to reliably estimate the fiscal impact of pay adjustments. The absence of information also opened the door to reportedly large numbers of “phantom” workers, and the return to public jobs of workers previously dismissed and indemnified.

As a prior action under the FCCGL, the Government drafted a Public Sector Wage Unification Law, consolidating the plethora of salary supplements being paid to central government civil servants into the base wage, and defining the institutional mechanisms for implementing wage policy. This was to be followed by the submission to Congress of a draft Law on Civil Service and Administrative Career, which would, inter among other things, establish an agency for implementing the new public human resources policy. As a benchmark for a subsequent PSAL, staffing reviews were to be carried out in at least the Ministries of Health, Education, Public Works, Agriculture, and Social Welfare to register all civil service positions, verify existing vacancies, and evaluate functions and responsibilities.

Assessment:

Achievement under this subcomponent is rated Satisfactory. Sustainability is considered Likely. Institutional development is Substantial.

A combined Organic Law of the Civil Service and Administrative Career and of the Unification and Uniformization of Public Sector Remuneration was approved by Congress and published in the Official Register on October 6, 2003. Among the provisions of the Law is the creation of a National Technical Secretariat for Human Resource Development and Public Sector Remuneration (SENRES). Its responsibilities include the formulation of policies, norms, and instruments for managing the organizational and human resources of the public sector; the administration of a national information system on organizational management, human resources, and the incomes of public sector employees; and evaluation of the remuneration policies and norms issued by the National Council on Public Sector Remuneration (CONAREM), for which it serves as Technical Secretariat. SENRES is also charged with elaborating a system for classifying civil service positions on the basis of work complexity, level of responsibility, required education and experience, and location. Completing a process begun in 2000, the Law unifies most public employee wage components into a single base wage, effective January 1, 2004,7 prohibits the creation of any new wage complements or benefits, and mandates that the 14-grade pay scale already in effect in some agencies be put uniformly into effect in all covered agencies.8 The Law stipulates, moreover, that the percentage increase in the total payroll costs of the agencies covered may not exceed that allowed for primary expenditures as a whole under the FTSRL. Congress, however, exempted teachers, military, and the police from inclusion under the Law. These groups together account for about 60 percent of public servants.9 Nevertheless, pay raises for all state employees, and the creation of new positions, are explicitly subject to the budgetary spending limits set by the Ministry of Economy and Finance (MEF).

- 10 -

Studies leading to the reclassification of jobs and to the specification of agency-specific job needs, as a function of responsibilities and tasks actually performed, have been or are being carried out in all the agencies covered by the law. This analysis is expected to lead to recommendations for significant staff reductions and realignments of skill profiles, resulting eventually in a leaner and more efficient public sector. The studies and database being assembled are also essential to the identification of staff training needs and the mounting of programs to meet them.

Budgetary savings from the improved wage controls and the anticipated reduction in public sector employment will not be realized immediately, however. Indeed, the short-term impact on the budget will be to increase spending, because the unification of pay scales will result in increased remuneration for some workers, particularly at the lower pay levels,10 and will increase the base for calculation of pension contributions and the so-called thirteenth and fourteenth salaries. Upward pay adjustments resulting from the uniformization of the pay scales are to be phased across the 2005–09 budgets. In addition, large severance payments will have to be paid to workers dismissed as a consequence of agency downsizing, a cost which itself is likely to slow significantly the government’s ability to implement it. This problem was exacerbated by Congress, which amended the draft submitted by the Executive to significantly increase severance payments. In December 2003, the Executive submitted for the urgent attention of Congress several amendments to the law to reverse this and other changes that would raise the fiscal costs of the reform, and those amendments were approved in January 2004. Meanwhile, some savings are being achieved from the identification and elimination of “phantom workers” made possible by the increasing use of the Central Bank’s electronic payments system, which deposits paychecks directly into worker bank accounts. Improvements in the worker database, now proceeding under the jurisdiction of SENRES, should result in additional savings.

(iii) Financial information and management. The Government’s ability to manage overall expenditures is seriously hindered by the lack of an effective information and financial management system to provide the budgetary authorities, and the general public, timely and reliable information regarding budget implementation. A World Bank investment loan was approved in March 2002 to support the technological upgrading of the existing Integrated Public Sector Financial Management System (SIGEF) to broaden its coverage and permit the timely consolidation of the public sector accounts, and strengthening the Office of the Contraloría General.11 The signing of the loan was delayed until August 2003, however, as successive Finance Ministers under the previous Government and the new team under the present Government raised questions about its priority and design.12

In order to strengthen financial information and control, the GOE’s program calls for carrying out the plans for upgrading the SIGEF system to produce timely and reliable monthly reports on executed expenditures by mid-2003 and consolidated public sector financial statements to be published on the government’s website beginning in 2004. The financial accounts of PetroEcuador, the public enterprises controlled by the Solidarity Fund, and Regional Development Organizations (RDOs) are also to be published on the website beginning in 2004. An electronic public procurement system, and a national public investment system are also to be developed.

- 11 -

Assessment:

Outcomes under this subcomponent are rated Moderately Satisfactory. Sustainability is considered Likely. Institutional development is thus far Modest.

As a prior action under the FCCGL, the MEF prepared a Transparency Plan based on the above three elements. The upgrading of the SIGEF system has proceeded slowly, however, for the reasons noted. A consolidated financial statement for the central government is expected to be issued by December 2004. Partial reports on actual expenditures are currently available on the GOE’s website. PetroEcuador’s accounts are already available on the website, and MEF is currently compiling the data gathered from studies of the RDOs. However, the Solidarity Fund has so far resisted publication of the accounts of the state electricity and telecommunications companies. An Executive Decree was issued on November 10, 2003 mandating the use of an electronic procurement system, Contratanet, in all public institutions. The system is now operational, and an implementation plan, including elaboration of the necessary legal and regulatory framework and training staff in its use is currently being prepared under the auspices of the Commission for the Civic Control of Corruption. During the subsequent stage of the Government’s program, a new Procurement Law is to be submitted to Congress to streamline current procedures, incorporate revised consulting standards, and create a national regulatory body to ensure proper enforcement of the legal framework. A work program is also being prepared by an external consultant, in collaboration with MEF, to develop a system for the monitoring and evaluation of public investment. This system is expected to become operational during 2004.

(d) The Competition and Trade Regimes

The competitiveness and efficiency of the Ecuadorian economy suffer from, among other things, an inadequate legal framework in support of internal competition, and costly administrative and regulatory barriers to the formation of new businesses.13 High and widely dispersed import tariffs, extensive and often duplicative import licensing requirements, and a multiplicity of technical norms on imports, those primary purpose of which is to protect domestic producers rather than the public health and safety, create significant anti-export bias. Lack of transparency and considerable leeway for discretional administration of these barriers create uncertainty, invite corruption, and further raise the costs of external trade.

The Government’s competitiveness agenda includes revision of the Law of Competitiveness and a slate of external trade reforms, in addition to reforms in the infrastructure and petroleum sectors (discussed in the following section). With regard to trade, the program calls for simplifying the import tariff regime; to reduce the number of imported goods requiring licenses and simplify import licensing procedures; and to reduce import processing time to only 24 hours by the end of 2003 (as compared to the current 40 to 60 days). The GOE has also committed to begin reducing by 10 percent per year the number of technical norms that are incompatible with the WTO, or convert them into norms that are compatible.

- 12 -

Assessment:

Outcomes under this component are so far Satisfactory. Sustainability is rated Likely but remains vulnerable to strong political resistance. Institutional development has so far been Modest.

As prior actions for the FCCGL, the GOE issued Executive Decree 233-A rescinding selected tariff concessions adopted at the end of the prior Government’s term in office, and the Foreign Trade and Investment Council (COMEXI) issued a series of Resolutions unifying all duplicative import licenses. The SRI has installed a system for the electronic processing of import licenses, and final tests of the system were scheduled for late November. The system is to begin operating in the Ministries of Agriculture, Health, and Industry, which together account for about 90 percent of licensing requirements. Preparation has begun of a Trade Policy Strategy, and working groups have been formed to identify import licenses for elimination. A study is also under way pursuant to the preparation of a draft Law of Administrative Simplification that would include elimination of all import licenses requiring such legislation. On April 24, 2003, the Ministry of External Trade, Industry, Fishing and Competitiveness (MICIP) issued a Directive prohibiting the introduction of any new technical norms incompatible with the WTO.14 The Ecuadorian Standards Institute, in collaboration with the private sector, has begun preparation of a list of technical norms to be made compatible with WTO standards, but no progress in this regard is reported thus far. A draft Law on Competition Policy has been prepared, and comments are being sought from the business community. It is expected to be submitted to Congress in early 2004.

(e) The Infrastructure and Petroleum Sectors

(i) Water and sanitation. Ecuador’s water and sanitation sector has been characterized by extreme decentralization, low efficiency, inadequate investment, limited coverage, and pricing at only a fraction of economic cost. Policy and price-setting and service provision have been the responsibility of more than 200 municipal governments with little central coordination. The financing of current costs has been heavily dependent on transfers from the central government, some 80 percent of which have been absorbed by the two major cities, Quito and Guayaquil.15 The financing and execution of investments in the sector have depended on the central authorities.

During the first phase of the GOE’s program, the Subsecretariat for Potable Water and Basic Sanitation (SAPSB) was to be restructured to strengthen its sector policy and leadership functions, including setting standards and providing technical assistance, while shifting the responsibility for executing investment projects to the local level. The second stage of the program calls for the submission to Congress of a new water and sanitation law. The Government also intends to gradually raise water tariffs nationwide with the objective of full coverage of current costs within six years. Meanwhile, it plans to introduce an incentive formula for the allocation of transfers that rewards operational efficiency and self-financing efforts. It is hoped that these changes will lead eventually to increased interest from private investors to play an active role in the sector.

- 13 -

Assessment:

Progress thus far under this subcomponent is rated Satisfactory. The sustainability of this progress is rated Likely. The institution building achieved thus far is rated Modest.

The Ministry of Urban Development and Housing (MIDUVI) issued a Resolution at the end of September 2003 approving the agreed restructuring of the SAPSB. The restructuring plan was prepared, with assistance from World Bank staff, and is being implemented, even though not yet formally approved by the Civil Service and Institutional Development Office (OSCIDI).16 One challenge will be to recruit or develop the skills needed to staff the Subsecretariat’s new normative and oversight role. The National Council for the Modernization of the State (CONAM), with financial support from the World Bank, has contracted a consultant to prepare the new water and sanitation law and regulatory framework, and a draft is expected to go to Congress by mid-2004. The establishment of a Water Fund to finance water investments in accordance with uniform, performance-based criteria awaits passage of that law, with its financing provided in the 2004 Budget.

As in many other aspects of the program, the sustainability of this effort will depend on the Government’s determination and ability to mobilize support from the potential beneficiaries of these changes—namely, the large numbers of poor and rural families not currently reached by piped water and sanitation systems—to overcome the inevitable resistance of those who should start paying the economic costs of these services.

(ii) Electric power. Ecuador’s electric power sector suffers from, among other things, inadequate tariffs, political interference, poor management and bill collection, and substantial distribution losses.17 Sector reforms initiated in the late 1990s stalled, and the sector is not financially viable under present circumstances. The Government’s program calls for the preparation and adoption of a sector strategy to reduce its deficits, restructure its debts, and attract private investment and management expertise. Practically all generation and distribution companies and the monopoly transmission company are majority-owned by the State.18 The financial frailty of the sector, in addition to political resistance and the uncertainty of the legal and regulatory framework, continues to inhibit badly needed private investment. Under the GOE’s program, monthly increases in electric power tariffs, which had been suspended in 2002, were to be resumed with particular focus on households consuming less than 300 kilowatt-hours per month.19 The tariffs charged to other customer categories were estimated to already fully cover economic costs.

Assessment:

Progress under this subcomponent is rated Satisfactory. Sustainability of the progress made is rated Likely. The institution building achieved thus far is rated Modest.

The power sector regulatory agency, CONELEC, issued a Decree on January 31, 2003 to raise electricity tariffs for customers consuming less than 300 kilowatt-hours per month. Tariffs for these customers are being adjusted by 1.64 percent per month, with the objective of reaching full cost coverage over a three-year period.20 By end-November 2003, prices had reached above 85

- 14 -

percent of economic costs, the level set as a benchmark for an eventual PSAL. At the same time, CONAM, CONELEC, and the Solidarity Fund are preparing a strategy for increasing sector efficiency and putting it on a financially viable basis. The draft strategy is reportedly in its final stages of preparation, with consultations under way with the power companies. The bases for contracting private management for the electricity distribution companies (and for the telecommunications companies) were issued at the end of September 2003, and the deadline for bids is now set for mid-February 2004. Creating a business environment attractive to private investors is likely to take time, however, and will require an informed public debate to build the necessary political consensus. Without a successful effort in this regard, Ecuador will remain hard-pressed to achieve the management efficiencies and mobilize the investments needed to expand consumer coverage.21

(iii) Telecommunications. Problems in the telecommunications sector are similar to those described for electric power. Tariff adjustment initiated in 2001 stopped short of stated objectives, and the prices for residential local calls have remained heavily subsidized by high rates charged on long distance calls and public telephones. With competition for international long distance calls now increasing, such cross-subsidization is not viable for the two highly inefficient state-owned telephone companies, one of which, Pacific Telephone (PACIFICTEL), ran significant losses up to 2002 and is unable to service its debt. Service quality is poor, and line failures are frequent. Meanwhile, an outdated and internally inconsistent telecommunications law, which allows substantial discretion to the two sector regulatory bodies, provides a discouraging environment for the entry of private investors.

As prior conditions of the FCCGL, CONAM has adopted a strategy for modernizing the sector, and CONATEL, the telecom regulatory body, granted a third license for mobile telephone services in competition with the two foreign providers. The award went to a new company, Telecsa, jointly formed by the two state-owned companies, PACIFICTEL and ANDINATEL. They lack, however, the resources and expertise necessary to offer an efficient and credible alternative. Key elements of the sector strategy include finding private administrators for managing the state-owned companies and attracting private investment and management to Telecsa.22 Also under the GOE’s program, the National Telecommunications Council (CONATEL) is to draft a new telecommunications law that would, among other things, consolidate the existing regulatory agencies into a single entity, eliminate existing legal inconsistencies, and improve the regulatory environment for attracting private investment.

Assessment:

Progress thus far under this subcomponent is Unsatisfactory. Sustainability of current efforts is uncertain. Institution building has so far been Negligible.

The preparation of a new telecommunications law is in process with the intention of submitting a draft to Congress by March 2004. Meanwhile, telephone rates continue well below economic costs and below the rates authorized by CONATEL in December 2001. The Solidarity Fund published on September 29, 2003 the bases for contracting private management for ANDINATEL and PACIFICTEL, with the objective of awarding three-year management contracts, followed by

- 15 -

two additional years of technical assistance, by mid-December 2003, but the process was cancelled in February 2004, due to the lack of qualified, interested bidders. Bank staff has expressed serious reservations about the probability of a successful outcome under the terms being offered, including the unlikelihood that PACIFICTEL could be turned around in three years.

(iv) The petroleum sector. Petroleum accounts for about 15 percent of Ecuador’s GDP, 40 percent of its exports, and a third of state revenues. Nevertheless, weak management of the state oil company (PetroEcuador), high wages and benefits, price controls on oil derivatives, transport bottlenecks, and an unstable legal and tax framework have resulted in low investment, high production costs, heavy budgetary subsidies, a poor environmental record, and a steady decline in production despite large reserves and attractive exploration opportunities. Lack of transparency of PetroEcuador’s accounts makes actual costs difficult to ascertain, weakening external oversight and thus leading to suspicions of corruption. The finances of PetroEcuador also suffer from arrears in payments from the electricity companies, while new investment is dependent on support from the state budget. Under its medium-term reform program, the Government intends to reduce oil subsidies and make them more transparent, to enforce environmental regulations, and to promote private sector participation in the sector.

Assessment:

Progress under this subcomponent is thus far Moderately Satisfactory. Sustainability is Likely. Institutional development is thus far Modest.

As a prior action under the FCCGL, the Government issued Executive Decree No. 17, at the end of January 2003, increasing gasoline prices by an average 21 percent and the diesel price by 3 percent, and has maintained its commitment to continue adjustments in accordance with market conditions. It is intended that fuel prices be liberalized in 2004. The amounts originally allocated to transfers for PetroEcuador in the 2003 budget were reduced by US$100 million, and a comparable reduction is included in the 2004 proforma budget. An external audit of PetroEcuador has reportedly been completed, although the final report has not yet been issued. PetroEcuador is also to prepare and publish an environmental impact study and carry on an environmental management plans as required under existing laws. A contract award is currently pending for this work, financed by the Andean Development Corporation (CAF), and is to be carried out in consultation with the affected local communities.23 In parallel to the FCCGL, and in collaboration with the Inter-American Development Bank (IDB) and CAF, the World Bank is assisting the MEF in undertaking an economic and financial analysis of the state oil refinery.

The price adjustments for petroleum products were an important step forward toward limiting subsidies and allocative inefficiencies and improving investment incentives. The major remaining subsidy is on liquid petroleum gas (LPG). Although defended as a real income supplement to poor families, it is enjoyed by consumers at all income levels. Its removal will need to be accompanied by a compensatory mechanism that targets the benefits to the truly poor. The MEF economic and financial analysis of the state oil refinery will provide important clarification of the true costs in the sector as a basis for more rational pricing and investment decisions.

- 16 -

(f) Labor Market Flexibility

Although the Economic Transformation Law of 2000 simplified wage policy in the private sector and introduced more flexible hiring through hourly and temporary contracts and outsourcing, Ecuador’s formal labor market continues to suffer from rigidities that reduce the country’s international competitiveness. In particular, wage setting in the formal sector continues to be guided by automatic indexing to future projected inflation, with intersectoral minimum wage differentials determined by sectoral wage tables established by the National Wages Council (CONADES).24 Wage setting on this basis is divorced from productivity, impedes adjustment to changing supply and demand patterns, and contributes to unemployment and to the growth of the informal sector.25 The rigidities introduced into the formal labor market contrast with and create substantial distortions vis-à-vis the fragmented informal sector, where labor regulations are easily evaded, and where wages and working conditions are highly sensitive to market forces.

Under the Government’s reform program, a process of consultation on labor market reforms, referred to as Labor Roundtables (Mesas de Trabajo) is to be launched with the participation of workers organizations, employers, and the government in early March. Out of this process, it is hoped to reach agreement, among other things, on a new labor code, arrangements for worker training, the enforcement of labor law, retirement and pensions, and new guidelines for wage adjustment that would include productivity growth as a principal indicator. During the first stage of the reform program, the Government requested that the Bank assist in carrying out a labor market analysis. The completion of a labor market assessment, in consultation with workers and employers, was stipulated as a benchmark for a future PSAL. It is intended eventually to de-link salary adjustments from the inflation rate and to transform the sectoral tables into non-obligatory reference points for sectoral minimum wages.

Assessment:

No rating is given to progress under this objective, inasmuch as no specific actions were identified for action under the FCCGL, and preparatory work for subsequent actions under the Government’s program has only recently begun. The analysis of the labor market is currently under way with World Bank assistance, but so far without worker or employer participation, reportedly reflecting a lack of enthusiasm by both parties. With urging from the Ministry of Labor, worker and employer organizations signed a declaration at the end of October 2003 “to support the resumption of a systematic tripartite social dialogue.” A larger follow-up conference with the support of the IDB and the World Bank is scheduled for March 2004, and it is hoped that these meetings will give impetus to the organization of the Mesas de Trabajo.

4.3 Net Present Value/Economic rate of return:Not applicable.

4.4 Financial rate of return:Not applicable.

4.5 Institutional development impact:

- 17 -

Compared against the specific objectives set out for the FCCGL, the institution building that has occurred since the beginning of 2003 has substantially met expectations. Measured against what will be needed to reach the medium-term objectives of the program, however, the institutional development impact must still be viewed as modest. Although concrete actions have been and are being taken, the principal focus of the FCCGL has been to lay the foundations for more substantive institutional reforms in the future. In this regard, some important foundation stones have been laid: including the fiscal framework provided by the FTSRL; including establishment of the FEIREP; the new Civil Service Law and its rationalization of the civil service wage structure; the approved restructuring of the management of the water and sanitation sector; the institution of price adjustments of electricity and petroleum products; and the normalization of external financial relations. The tax reform law currently before Congress will, if passed, also constitute an important foundation for more stable, efficient, and equitable financing of public expenditures. A number of important studies and strategy formulation exercises are also under way that are hoped will lead to further improvements in the laws, regulations, and policies that will shape Ecuador’s competitiveness and growth prospects.

For these positive beginnings to take root, however, Ecuador’s conflictive politics and the powerful and long-standing resistance of vested interests to change will have to be overcome. As recognized in the GOE’s medium-term program, difficult and politically controversial measures remain to be taken. To continue the progress made over the past year, a determined and coherent effort will be needed to “sell the program” and build the internal political consensus that will be essential to its sustainability.

5. Major Factors Affecting Implementation and Outcome

5.1 Factors outside the control of government or implementing agency:The present Government inherited a precarious economic situation characterized by unsustainable debt, large external financing requirements, and a history of frequent economic crises that had led the previous Administration to formally dollarize the economy despite the absence of fundamental preconditions for managing such a system—such as the institutional basis for strong fiscal management, diversified export capacity, and flexible factor markets. Building these capacities, moreover, and mobilizing the foreign and domestic investments necessary to make them productive is made exceedingly difficult by political instability and conflictive, non-transparent, and non-participatory governance.26 Given the Government’s limited political base and the fractiousness of the Congress, reform legislation that, by definition, challenges vested interests faces uncertain prospects for passage.27 Laws submitted by the Executive are frequently rejected, “watered down,” or suffer damaging amendments contrary to Government wishes and commitments. The Congress itself is under heavy political pressures when important economic interests are at stake, and often lacks the technical skills and staff support needed to deal responsibly with the complex issues involved.

5.2 Factors generally subject to government control:In addition to the initiative it enjoys to prepare legislation, and thus to instigate and focus the reform process, the government’s principal mechanism of control is the state budget. Although its freedom to allocate resources within the budget is restricted by the rigidity of previous expenditure commitments—for example, debt service, the wage bill, and earmarked revenues—it

- 18 -

has clear responsibility for the fiscal aggregates. In this regard, the present Government, and hence the management of the FCCGL program, has enjoyed unusual continuity in the leadership and technical-level staffing of the Ministry of Economy and Finance (MEF).28 This continuity has been an important factor in moving the program forward.

The Government bears principal responsibility for leading and informing the public debate of its reform initiatives and working intensively with the Congress to seek their passage. Those with vested interests jeopardized by reform recognize the stakes and are long practiced in mobilizing resistance to change. It is up to the Government to mobilize consensus among those who may not understand the issues and their interest in them, many of whom have long been on or beyond the fringes of public decision-making in Ecuador.

5.3 Factors generally subject to implementing agency control:The program supported by the FCCGL covers a large number of measures to be taken across multiple sectors and involving many different agencies. The FCCGL is also unusual in its multiple interrelationships with other World Bank loans, as well as the IMF SBA and the assistance provided by the IDB and other donors. The task of selling the program within the government and coordinating its multi-faceted activities has been principally the responsibility of the MEF. The continuity in MEF’s managerial and technical leadership, noted above, has been crucial to meeting this complex political and administrative challenge.

5.4 Costs and financing:Not applicable.

6. Sustainability

6.1 Rationale for sustainability rating:Sustainability ratings have been given above to the several loan components. The overall sustainability of the program is rated Likely, although precarious. The GOE has managed to get reform framework legislation adopted by Congress where previous administrations have failed, and, even though the versions adopted differ from the draft laws that were submitted, the changes have not been as destructive of forward progress as in the past. Putting the FTSRL and the civil service reform law into effect will make it more difficult to reverse the reform trend. This modicum of success, however, may reflect more the sense of crisis that has opened public willingness to experiment with change than a true swing of public consensus in favor of the reform path set out in the Government’s program. As such, the momentum could quickly be lost unless the public is convinced that institutional progress being made is improving prospects for the future. The protection and improvement of social programs being supported by the HDRL in parallel to the FCCGL is a crucial pillar for building political support for the overall program.

All of the risks pointed out in the loan documentation for the FCCGL still exist and should not be underestimated. The resources available for needed investments and social programs are severely constrained, and private foreign investors, who could be an important source of investment and the technology needed to improve competitiveness, remain skeptical. Vulnerability to external shocks is great, institutions are weak, vested interests are well entrenched, and the Government’s political position is not strong. Missing from the program so far is an intensive and well-articulated strategy for building consensus among the public and for working with the

- 19 -

Congress and other centers of power to advance the program’s objectives.

6.2 Transition arrangement to regular operations:Not applicable.

7. Bank and Borrower Performance

Bank7.1 Lending:The Bank’s lending performance has been Satisfactory. The program was preceded and underpinned by solid economic and sector work and extensive discussions with both the previous and current Governments. Some of the specific measures were carryovers from the 2001 SAL, for which the background work had already been done. The operation was well integrated into a clear and coherent CAS that had been widely vetted with civil society organizations, and the program’s objectives are also being supported in a coordinated fashion by other elements of the lending program. The program’s coverage of sectors and issues seems excessively broad relative to the coordinating capacities of both Bank staff and GOE counterparts. However, the measures taken under the loan in some areas are initiating steps for which the GOE specifically requested the Bank’s imprimatur and advice. Overall, the policy matrix has served as a highly useful vehicle for organizing the GOE’s own internal discussions, strategy formulation, and implementation efforts.

Collaboration with both the IMF and the IDB has been close and effective. All parties report good exchanges of information and substantial agreement on the priority issues and measures to be taken. This is seen also in the overlap and mutually supporting quality of the respective lending programs.

The Bank helped to organize and has participated in a number of seminars and conferences with civil society organizations in preparation of the CAS and the two recent adjustment loans and to disseminate the background analytical work. This has been highly useful for bringing an analytical and objective focus to politically volatile issues that have often generated more heat than light. Such discrete events necessarily operate at a high level of generality, however, and usually lack follow-up. Civil society representatives complain that they do not know what influence their suggestions may have had, and, for the most part, they do not appear to have become active supporters of the reform agenda. Given the urgency of building an active political consensus for reform, the Bank should consider becoming more proactive in assisting the Government to inform the debate of specific measures as they move through the political process.

7.2 Supervision:Since the FCCGL was a one-tranche adjustment loan, there has been no need for supervision in the usual sense, and a “gray area” exists between the supervision of the FCCGL and the preparation of a possible follow-up PSAL, those results of which will only become known over time. Through this dialogue, however, Bank staff have given substantial assistance and support to the MEF and line agencies in the preparation and implementation of the program.

7.3 Overall Bank performance:Overall, Bank performance has been Satisfactory.

- 20 -

Borrower7.4 Preparation:Borrower preparation performance was Satisfactory in light of the delays normal to a change in Government. The new economic team began working intensively with the Bank team immediately after the 2002 elections to prepare the Austerity Decree and other key pieces of legislation, and moved quickly to put key framework measures into effect upon taking office.

7.5 Government implementation performance:Borrower implementation performance overall has been Satisfactory. Fulfillment of the prior conditions for the FCCGL was completed, albeit somewhat later than had been expected. That progress since has been uneven across the sectors and issues was to be expected given the broad scope of the program, the weakness of existing institutions, and the conflicting interests at stake. Despite the formidable obstacles, a sense of forward motion has been maintained. Nevertheless, the Government could be more proactive in building the public consensus and gaining the political support it needs to achieve its reform objectives.

7.6 Implementing Agency:Implementing agency performance has been Highly Satisfactory. The counterpart team in MEF has worked hard and well to coordinate the many activities and agencies involved in carrying out the reform program.

7.7 Overall Borrower performance:Overall borrower performance is rated Satisfactory.

8. Lessons Learned

The Government of Ecuador inherited a precarious macroeconomic situation with a high degree of vulnerability to external shocks and the need to move quickly to establish the bases for sound economic management and stable growth if yet another economic and political crisis was to be avoided. The speed with which a turnaround could be achieved, moreover, was impeded by economic rigidities, weak institutions, and a political system and governance tradition that had long failed to mediate the deep conflicts among its social and economic groups. There is an unavoidable tension in such situations between the urgency of progress and the practical limits on the government’s ability to enact and implement the needed reforms. In developing their assistance strategies and giving their support, the Bank and other donors must be sensitive to this tension, judiciously weigh the risks, and seek an effective balance between pressing for action and patience in assessing progress. The programmatic approach to adjustment lending is well suited to achieving this balance.

At the same time, the enactment of laws, the reform of policies, and the restructuring of institutions define the necessary framework for reforms. The implementation and success of reforms depend, however, on the effective application of technical knowledge, skills, and procedures. Resources for technical assistance and training are thus needed in parallel to adjustment lending support to make the latter effective. The benefits perceived by the line agencies receiving this assistance are often also important to gaining their support of the reform agenda.

- 21 -

Efforts to bring public expenditures under control and to rationalize staffing levels and pay scales can have, and be thwarted by, large short-term costs before realizing their potential savings. External financial assistance may be needed and justified to move these efforts forward.

Finally, the ability of a democratic government to push reforms forward is itself a function of the quality of the public discussion and debate required to build a supportive consensus. The international financial institutions have an important role to play in informing that debate in a country like Ecuador, and this role should be an integral part of the assistance strategy. The success of the reform program will depend heavily on the effectiveness of the Government’s own leadership in building support.

9. Partner Comments

(a) Borrower/implementing agency:General Comments

Given the complexity of the socio-economic and political environment of Ecuador, making general assessments on policy implementation can lead to misleading or partial conclusions. The background analysis of the World Bank’s loan on Fiscal Consolidation and Competitive Growth should take into account a few domestic details that make the difference among countries developing similar reform agendas.

For example, it could be argued that during the 1990s, there was a dominant period of relative political stability in Ecuador and, only at the end of the decade, did political problems develope with great celerity. Such assertion would modify the Bank’s interpretation of the crisis of the end-1990s. It should be remembered that during the same decade, multi-laterals worked actively—jointly with different governments—in designing and implementing economic policy, with a focus on the reform of the State. Perhaps this narrow agenda, coupled with the illusion of an apparent economic stability (plus the “boom in domestic demand” linked to a fixed exchange rate policy), was another reason that prevented paying more attention to other development areas in a timely manner and with insight, which could have prevented the political crisis.

With this background in mind, the dollarization process could be seen not just as a result of a “large period of political instability and economic crisis.” Instead, it could have been the consequence of a too too-narrow focus of reforms in the 1990s, accompanied by a deep and rapidly developing mismanagement of the crisis of the financial system, despite the seemingly successful implementation of early financial sector reforms. The financial crisis obviously destroyed any government’s legitimacy.

It could also be an overstatement to identify as Ecuadorian particularities the “power of vested interest” or the “government fragility” or “the extreme vulnerability of the economy to external shocks.” The political and economic history of Latin America, and in particular of the Andean countries, is full of similar examples. Besides, strong governments do not guarantee success in reforms. The Mahuad, Duran Ballén, and Febres Cordero administrations started with strong political and economic support, but finished with much lower results than expected.

- 22 -

It must be recognized that the acknowledgement of these complexities, however, has led the World Bank to change the contents of its reform programs. At present, the reform program is broader and the Bank seems to place more emphasis on accompanying the reform process itself, than on simply verifying its outcomes. The overall success of this adjustment operation should give credit to this positive change in focus.

The Project

1. Overall, the project was well designed and took into account many elements reflecting Ecuador’s institutional shortcomings. The project provided enough flexibility to understand these issues and, consequently, to consider policy alternatives.

2. It must be said noted that the structure and composition of fiscal expenditure has “perverse components” or incentives that are an obstacle to a sustainable path, but some of them were introduced to correct previous distortions and with the multilaterals’ blessing. Tax earmarking, for example, had its origins in the need to reduce discretionary spending allocations by the MEF, to eradicate corruption, and to be in line with the nascent decentralization process. This mechanism was suggested and supported by multilaterals in the 1990s. Dismantling this structure in the 2000s has become complex and politically very sensitive. The project rightly acknowledged such situation and preferred not to include any policy action referring to tax earmarking.

3. It should be indicated that the main objective of the new Ley de Servicio Civil y Carrera Administrativa is to remove the inertial components that led it to increase the wage bill annually.

4. Similarly, the main proposal of the Tax Reform Law is not to increase tax revenues, but to simplify the actual tax system, while building up new rules and procedures to (a) introduce a transfer pricing concept; (b) remove fiscal loopholes, especially those related to VAT and ISR tax exemptions and tax elusion through the deduction of inflated externally-related credit; (c) eliminate special treatment for free trade zones, and (d) eliminate nuisance taxes. This should be clarified.

5. Two additional points:

a. The “transitoria tercera” of the Constitution requires the Executive to honor its debt with the social security institute—IESS—in 10 years, starting when an agreement is achieved and signed, hopefully early this year. b. The Tax Reform Law does not consider a tax reduction for vehicles used in productive proposes. The proposal is rather to maintain the current situation, which means that changes suggested both in the amortization period and in the base table would not be put in place for these sort of vehicles.

6. The Report rightly highlights that the Government should put more effort to work into the

- 23 -

“transparency issue.” Notice, however, that two of the three reform areas related to this project are supported by a technical assistance project with the World Bank. These areas are those related to the implementation of the SIGEF and SNIP components of the Transparency Plan. SIGEF II has just been approved by the authorities and, hopefully, with all expected rectifications to be introduced to overcome past and present difficulties, it will achieve its goals and satisfy the Government’s high expectations about its future performance.

7. It should also be stressed that in early January 2004, the President ordered the immediate publication of the audited balances of all enterprises grouped under the Solidarity Fund and their transfer to the MEF. A similar instruction was given to the Regional Development Organizations. The President was very concerned and did not understand why this issue task was not accomplished in 2003.

8. Another positive aspect that it is necessary to highlight is that the on-going preparation for a Free Trade Agreement with the United States is totally in line with trade reform commitments agreed for March 2004 and March 2005 under the loan.

The Bank

The country acknowledges and thanks the great commitment to and pro-active attitude of the World Bank team in the preparation and follow-up implementation of this loan. The close support offered by Bank staff in designing and monitoring reform commitments, allowed sufficient flexibility to understand shortcomings in the institutional environment, and provided timely and focused technical advice and training to staff of the MEF. The Government sincerely expects that this support will be maintained in the development of further operations.

The Lender

The Government of Ecuador’s main goal is to reduce poverty and create the economic and institutional conditions to overcome the critical situation in which the majority of Ecuadorians live. This project has introduced key initial structural reforms, those effects of which will only start to materialize this year. We sincerely hope that the sustainability of these reforms will allow the building of a base to consolidate economic stability, improve the standards of living, and strengthen the pillars of Ecuador’s development.

The role of the World Bank in preparing this loan has been crucial and respectful, not only in terms of financing, but in terms of promoting a continuous and open discussion of development trade-offs. This advice has resulted in better informing the Government about alternatives that should be considered in defining the country’s development agenda. Aware of paradigms often associated to multilaterals, there has to be no doubt that the Government has, however, preserved the autonomy of its decisions and the sovereignty of its actions.

Thank you very much.

Ministry of Economy and Finance, Republic of Ecuador

- 24 -

Quito, January 28, 2004

(b) Cofinanciers:Not applicable.

(c) Other partners (NGOs/private sector):Not applicable.

10. Additional Information

Endnotes

1. Normas para el Incentivo Patriotico al Ahorro, published in the Official Register on January 30, 2003. 2. The health, education, and social security sectors were exempted from the freeze, but with the stipulation that employment levels could in no case exceed the levels of November 24, 2002.

3. The “tax expenditures” thus eliminated would still be honored with equivalent resource transfers in the 2004 budget and converted in the 2005 budget to explicit expenditures subject to budgetary priorities. The draft law expressly stipulates that care be taken not to abruptly cut off funding to the beneficiary institutions.

4. Global bonds maturing in 2012 carry interest charges of 12 percent, while those maturing in 2030 are currently paying 7 percent, with the rate graduating over time.

5. Calculation of the debt to the IESS, which emanates from failures to transfer state pension contributions, is complicated by the determination of the sucre-U.S. dollar exchange rate to be applied. The amount is currently estimated at a range of about US$500 million to US$2 billion. Not covered under this provision are the contingent obligations associated with the actuarial deficit of the IESS, and the obligations of the Deposit Guarantee Agency (AGD). The FTSRL also requires local governments to reduce their levels of debt relative to their revenues, and for those whose debts exceed 100 percent of revenues and/or whose total debt service exceeds 40 percent of revenues to prepare four-year debt reduction plans.

6. Should this result in the need for additional debt financing for the budget, the fiscal savings would come from the difference between the interest rates on new debt and the very high interest rates being paid on the repurchased global bonds.

7. Specifically excluded from the unified base wage are the so-called thirteenth and fourteenth salaries.

8. Grade levels in accordance with the 14-grade scale are to be assigned to all covered employees no later than March 2004.

9. The terms of employment for these professions, along with the Judiciary, the Congress, and the autonomous agencies, are governed by separate laws.

10. For example, under the now abandoned 21-grade salary schedule, the lowest-paid workers received

- 25 -

only US$45 per month as compared to US$100 per month for the lowest-paid workers under the 14-grade system. In accordance with the reform law, no public worker may suffer a reduction in pay as a result of t the reclassification of his job.

11. The SIGEF was developed under a previous World Bank Modernization of the State Project. The system was first developed at the level of individual institutions and, by the end of 2002, was operating in agencies accounting for about 85 percent of budgetary expenditures. It does not permit, however, an effective consolidation of information for executed budget and use as a fiscal management tool, nor is the MEF adequately staffed to manage the integration.

12. A floating tranche under the 2000 SAL in support of public sector reform was eventually cancelled for failure, among other things, to promulgate the agreed Law for the Management of the Public Finances.

13. In the 2002 survey of the World Economic Forum, Ecuador ranked the lowest among 80 countries in terms of business climate and respect for laws.

14. Ecuador signed the WTO Normalization Code in 1996 but has not heretofore applied it.

15. Consumers in Quito are reported to pay US$.04 per cubic meter of water, while those families lacking connection to public systems pay an estimated US$5.00 per cubic meter.

16. Bank assistance for institutional development in the water and sanitation sector, and for the development of sustainable rural water and sewerage services, is being provided through an Adaptable Program Loan approved in October 2000.

17. In 2001, payments were collected for only about 69 percent of the power delivered to distributors. Substantial payments arrears have accumulated in the system, with large amounts owed to the generation companies and to the state oil company, PetroEcuador, which continues to supply fuel to the sector despite nonpayment.

18. The State shares are held by the Solidarity Fund, an entity that was established to administer proceeds from the sale of state-owned companies and to allocate them to social sectors. These sales have not occurred, however, and the Fund is ill-equipped to exercise its de facto ownership responsibilities.

19. This group, representing about 60 percent of household electricity consumers, was estimated to be paying only about 80 percent of the economic cost of their service.

20. Estimated costs have also been lowered as a result of new investments and by lengthening the nominal useful life of the sector’s capital stock. Even with these adjustments, Ecuador’s power supply costs are significantly higher than those of its neighbors, and it is increasing its electricity imports from Colombia and also anticipating imports of gas from Peru.

21. A World Bank investment loan (Power and Telecommunications Modernization and Rural Services Project, PROMEC) was approved in November 2001 to strengthen regulation and supervision of the power and telecommunications sectors, expand services in rural areas, promote more efficient energy use and environmental protection, and encourage greater citizen participation and consultation.

22. Earlier efforts in the late 1990s to privatize the then-existing single state telephone company were unable to overcome domestic political resistance and investor uncertainty, and ended with the split of the

- 26 -

company into two. Efforts similarly failed at the end of 1992 to attract private investment into the new cellular company and resulted in the government-mandated joint undertaking by the two state companies.

23. A grant from ESMAP is helping to train indigenous groups to negotiate with prospective investors, while an Institutional Development Grant is supporting a tripartite dialogue on the development of regulations for hydrocarbon investments in indigenous and environmentally vulnerable areas.

24. Employers and employees can agree on additional wage increases through company or sector-wide collective bargaining.

25. The Economic Transformation Law also mandated the unification of salary supplements into the base wage for private sector workers in a manner similar to that now under way for public servants. While making pay more transparent, the immediate effect has been to raise labor costs to employers by bringing the former supplements into the base for calculating pension contributions.

26. The word “ungovernability” frequently arose in the interviews conducted in preparing this ICR.

27. The Government’s political position was made more fragile in mid-2003, when a group representing Ecuador’s large indigenous population decided to leave the Government coalition.

28. In the previous 23 years, Ecuador had 29 finance ministers, averaging less than 10 months each in office. In the three years during which the SAL was under implementation (February 2000–March 2003), there were 6 six Finance Ministers with an average duration of seven months each.

- 27 -

Annex 1. Key Performance Indicators/Log Frame Matrix

ISSUES* ACTIONS TAKEN AND STATUS AS OF NOVEMBER 2003The ordering of issues follows that of the Policy Matrix for FCCGL, as presented in Annex 2 of the President’s Report.

I. Macroeconomic FrameworkWeak macroeconomic balances and low credibility of the macroeconomic program.

A Stand-by Arrangement with Ecuador was approved by the IMF Board on March 21, 2003, and a first review under the program was completed, although with several waivers, in August 2003. The second review is being completed.

II. Fiscal Consolidation and Debt SustainabilityA. Fiscal FrameworkPro-cyclical and erratic fiscal policies have resulted in expansionary spending, lack of transparency, resource misallocation, and declining primary surpluses.

Executive Decree No. 121 was issued on February 10, 2003, regulating implementation of the Fiscal Transparency, Stability, and Responsibility Law (FTSRL) of June 4, 2002 and establishing the norms for multiannual budgeting, quantitative benchmarking of fiscal management, a public debt reduction plan, investment by public enterprises, management of the Stabilization, Investment, and Debt Reduction Fund (FEIREP), and fiscal transparency and greater citizen control.

Preliminary official data indicate that the budget targets for 2003 set out in the FTSRL were met. The 2004 budget is consistent with the FTSRL benchmarks.

A permanent commission to manage FEIREP, composed of the Central Bank of Ecuador (BCE), MEF, and PetroEcuador, was established, and the regulations for its management have been formulated. Issues regarding the definition of “heavy crude oil”, from which FEIREP’s principal revenues were to derive, were reviewed by the Attorney General (Procurador General del Estado), who reaffirmed that the revenues from heavy crude transported through both pipelines [Heavy Crude Oil Pipline (OCP) and Trans-Ecuadorian Pipeline System (SOTE)] should be transferred to FEIREP.

A preliminary roadmap has been defined for preparation of the multiannual budget for 2005–07.

B. Tax Policy and AdministrationA large number of tax exemptions and “nuisance” taxes, revenue earmarking, weak tax administration, inefficient and corrupt administration of customs, and tax avoidance in the informal economy significantly narrow the tax base and leave revenues excessively

A draft Law of a Simplified Tax Regime was submitted to Congress in May 2003, but was rejected by Congress at the second reading. Its principal provisions have been incorporated into a larger draft tax reform bill to be submitted to Congress in early 2004.

Congress approved the Customs Modernization Law in April 2003, intended to reorganize the Customs Administration (CAE) and improve customs collections. The armed forces have been given temporary responsibility for the administration of the CAE. A strategic Modernization Plan for the CAE is currently being reviewed by an external consultant, and evaluations of its staffing and of a proposal for privatizing some of its services are in process.

IRS tax collections for 2003 rose by at least 7.5 percent compared to the same period in 2002 under a plan agreed with the Bank to increase tax audits and

- 28 -

dependent on oil revenues.

intensify cross-checking.

C. Public Expenditure ManagementOverall expenditure control: Information about the fiscal accounts of the national government, public enterprises, autonomous agencies, and sub-national governments is unreliable and untimely, with little transparency and disclosure.

Control of the public wage bill: Inadequate information about the number and placement of public employees, and a complex payment system undermines government control and results in an inordinately high payroll.

Executive Decree No. 44, issued on January 22, 2003, froze the wages of regular civil servants, suspended overtime allowances, and reduced by 10 percent the salaries of civil servants earning more than US$1,000 per month. A budget for 2003, consistent with this Austerity Decree and with the FTSRL, was approved by Congress in February 2003. These austerity measures, with the exception of teacher salaries, have been extended in the 2004 budget.

The Government prepared and implemented a Transparency Plan including: § Significant upgrading of the electronic Integrated Public Sector Financial Management System (SIGEF). SIGEF is to produce consolidated reports on executed expenditures by December 2004. Partial reports on executed expenditures are currently being published on the Government’s website. § The development of an e-government system for public procurement, which was prepared under the auspices of the Commission for Civic Control of Corruption. Executive Decree No. 122 of November 10, 2003 mandated the use of the system, Contratanet, in all public institutions, and the system is now operational. An implementation plan for the reform of public procurement, including the legal and regulatory framework and training of the pertinent staff, is under development.§ The development of a system to facilitate the monitoring and evaluation of public investments. The system, which is currently under preparation by a consultant hired under the Bank’s Public Sector Financial Management Loan in collaboration with the Subsecretariat of Public Investment in the MEF, is expected to be completed in 2004.

The accounts of PetroEcuador are now published on its website. Similar requests to the Solidarity Fund regarding the accounts of the state electricity and telecommunications companies have been denied by the Fund, and a Presidential directive was issued directing compliance. Studies of the financial management of the Regional Development Organizations have been carried out and the MEF is now compiling the relevant data for publication of their financial acounts.

An Organic Law of the Civil Service and Administrative Career and of the Unification and Uniformization of Public Sector Remunerations was approved by Congress and published in the Official Register on October 6, 2003. Key components include the consolidation of all salary supplements of central government civil servants into the base wage and the adoption across covered agencies of a uniform 14-grade pay scale. Proposed amendments were approved by Congress in January to correct several distortionary additions made by the latter to the original draft law presented by the Executive.

Staffing reviews are being carried out in the remaining Ministries of Public Works, Agriculture, Health and Education to register all civil servant positions, verify vacancies, and evaluate functions with responsibilities. These reviews are scheduled to be completed by early 2004.

A consolidated database to register all public employees and their salary benefits was approved by Presidential Decree No. 571, published in the Official Register

- 29 -

on July 22, 2003. The Decree mandates that all public sector institutions should use the Interbank Payments System of the BCE for making payments corresponding to the remuneration of public sector employees. This will permit cross-checking with the future information generated by a module of SIGEF, to be installed and operated in the Subsecretariat of the Budget.

D. Public DebtInherited arrears and lack of transparency in the management of the national and sub-national public debt.

One hundred percent of arrears accumulated on the external public debt up to February 28, 2003, and 100 percent of arrears on the domestic bonded public debt accumulated up to March 31, 2003, have been cleared. No external arrears are accumulated.

A Plan for the Reduction of the Debt, in accordance with the FTSRL, was published in the Official Register on August 28, 2003 (Ministerial Resolution No. 226).

The Attorney General issued a decision on November 17, 2003 determining that all production of heavy crude oil would generate revenues to FEIREP, regardless of whether the oil was transported through the new Heavy Crude Oil Pipeline (OCP) or through the older Trans-Ecuadorian Pipeline System (SOTE).

III. Accelerated Growth through Improved Competitiveness and Greater Market FlexibilityA. Competition and Trade PoliciesThe present policy framework provides inadequate support to competition. There are high regulatory and administrative barriers to new business formation. Inefficient import substitution results from high and disparate tariffs, duplicative licensing requirements with broad management discretion and lack of transparency, and a multiplicity of technical norms that do not comply with WTO regulations.

A draft Law on Competition Policy has been prepared and is expected to be submitted to Congress in early 2004.

Working groups have been created to identify import licenses for elimination. The Internal Revenue Service (SRI) has installed software for the electronic processing of licenses, and final tests are scheduled for early 2004. The system is to begin operating in the Ministries of Agriculture, Health, and Industry, which together account for about 90 percent of all licensing requirements.

Preparation has begun of a draft Trade Policy Strategy to make Ecuador’s policies compatible with its commitments under the WTO, the Andean Pact, and the eventual Free Trade Agreement of the Americas.

Executive Decree No. 233-A has rescinded selective tariff concessions that had been effected in late 2002, and the Foreign Trade and Investment Council (COMEXI) has issued Resolutions 182, 183, and 184 unifying all import licenses.

On April 24, 2003, the MICIP issued a directive unifying duplicative norms and prohibiting the creation of technical norms that are not compatible with the WTO. The preparation by MICIP of a list of technical norms to be made compatible with WTO standards is currently in the hands of the Ecuadorian Standards Institute in collaboration with the private sector.

B. Pricing and Regulatory Policies for Basic Infrastructure The Ministry of Urban Development and Housing (MIDUVI) issued a

- 30 -

The legal and regulatory framework for the water sector is incomplete.

Inadequate adjustment of tariffs and operational inefficiency leaves the electricity sector financially unsustainable.

A deficient legal and regulatory framework, inefficient management, lack of competition and private investment, and inadequate rates for local calls result in poor telecommunications services and the need for state subsidies.

Large budgetary transfers are required by the state oil monopoly as a result of poor management and the failure to set the prices of petroleum products according to real economic costs.

Resolution on September 30, 2003 approving the restructuring of the Subsecretariat of Water and Sanitation and changing its role from that of a direct executor of investment projects to that of sector leadership, policy-making and oversight.

A draft Water and Sanitation Law is under preparation by external consultants, and a bill is expected to be submitted to Congress by mid-2004. The establishment of a Water Fund to provide financing for water investments in accordance with uniform, performance-based criteria awaits passage of the law, and its financing provisions should be included in the 2004 budget.

The electricity regulatory agency (CONELEC) issued a Decree on January 31, 2003 to raise electricity tariffs gradually for residential customers consuming less than 300 kilowatt-hours per month. The monthly increases were maintained through November 2003, bringing rates above their agreed targets. No progress is reported, however, in reducing the operational deficit of the electricity companies.

The bases for contracting private management of the electric distribution companies and both telecommunications companies (ANDINATEL and PACIFICTEL) to private enterprises were published on September 29, 2003 with the intention of awarding contracts by early 2004, but it failed to be completed.

CONATEL granted a third license for mobile telephone services (to Telecsa, a joint venture of ANDINATEL and PACIFICTEL), and got a foreign management company. CONAM has adopted a strategy for modernizing the telecommunications sector, including finding private administrators for ANDINATEL and PACIFICTEL and attracting private investment into Telecsa, but bids have failed to attract qualified bidders.

A new draft Telecommunications Law is under preparation by CONATEL and is scheduled to be submitted to Congress by early 2004.

Executive Decree No. 17, published in the Official Register on February 4, 2003, raised the prices of gasoline by an average 21 percent, and the price of diesel by 3 percent. Fuel price adjustments have been frozen, in an election year, but with a view toward liberalizing prices during 2005.

The MEF reduced the 2003 budgetary allocation for PetroEcuador by US$100 million from the amount originally proposed. A similar reduction was done for about US$100 million in the 2004 proforma budget.

An external audit of PetroEcuador has been completed, and the final report is to be issued in February 2004. An environmental impact study of PetroEcuador, financed by CAF, is to be developed in the second half of 2004. Studies for developing an environmental management plan for PetroEcuador have been completed. Their publication is pending.

C. Increasing the Flexibility of Labor MarketsSalary indexation The Ministry of Labor has completed an evaluation of the labor market in

- 31 -

mechanisms create undue rigidity in labor markets and could undermine the reduction of inflation.

consultation with workers and employers. As part of the process, a National Tripartite Dialogue is being mounted with the help of the International Labor Organization, and a conference on the “Reform of the Private Labor Market” is being organized for March 2004 with the support of the IDB and World Bank. The Dialogue is to deal in a concerted way with all critical issues.

- 32 -

Annex 2. Project Costs and Financing

Not Applicable

- 33 -

Annex 3. Economic Costs and Benefits

Not Applicable

- 34 -

Annex 4. Bank Inputs

(a) Missions:Stage of Project Cycle Performance Rating No. of Persons and Specialty

(e.g. 2 Economists, 1 FMS, etc.)Month/Year Count Specialty

ImplementationProgress

DevelopmentObjective

Identification/PreparationFebruary 2003 6 Mission Leader (1), Sector

Specialists (4), Country Analyst (1)

March 2003 8 Mission Leader (1), Sector Specialists (7)

Appraisal/NegotiationApril 2003 7 Mission Leader (1), Lead

Economist (1), Lawyer (1), Country Analyst (1), FMS (2), Consultant (1)

SupervisionSeptember 2003 1 Mission Leader (1) S SOctober 2003 6 Mission Leader (1), Sector

Specialists (5)S S

December 2003 3 Mission Leader (1), Sector Specialists (2)

S S

ICROctober 2003 2 Consultant (1), Country

Analyst (1)S S

Most of the identification and previous preparation and sector work activities were completed during a November 2002 Policy Notes mission and a January 2003 seminar with Authorities. Several complementary projects (particularly in power, telecom and water) allowed for joint missions, thereby providing significant saving in travel and other operational costs. The key purpose of the September, October and December 2003 missions was to provide agreed follow-up supervision and tailored made technical assistance, so as to provide early assistance in the preparation of the measures to be adopted under the next operation. FCCGL II is based on sustained progress in this loan.

(b) Staff:

Stage of Project Cycle Actual/Latest EstimateNo. Staff weeks US$ ('000)

Identification/Preparation 11.42 194.87Appraisal/Negotiation 2.00 8.18Supervision 4.38 29.54ICR 1.50 29.98Total 19.30 262.57

- 35 -

Annex 5. Ratings for Achievement of Objectives/Outputs of Components(H=High, SU=Substantial, M=Modest, N=Negligible, NA=Not Applicable)

RatingMacro policies H SU M N NASector Policies H SU M N NAPhysical H SU M N NAFinancial H SU M N NAInstitutional Development H SU M N NAEnvironmental H SU M N NA

SocialPoverty Reduction H SU M N NAGender H SU M N NAOther (Please specify) H SU M N NA

Private sector development H SU M N NAPublic sector management H SU M N NAOther (Please specify) H SU M N NA

- 36 -

Annex 6. Ratings of Bank and Borrower Performance

(HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HU=Highly Unsatisfactory)

6.1 Bank performance Rating

Lending HS S U HUSupervision HS S U HUOverall HS S U HU

6.2 Borrower performance Rating

Preparation HS S U HUGovernment implementation performance HS S U HUImplementation agency performance HS S U HUOverall HS S U HU

- 37 -

Annex 7. List of Supporting Documents

Fretes-Cibils, Vicente, Marcelo Giugale, José Roberto López-Calix. 2003. Ecuador: An Economic and Social Agenda in the New MilleniumMillennium. Washington, D.C.: World Bank., 2003.

International Monetary Fund. 2003. “Ecuador—First Review Under the Stand-by Arrangement.,” Report No. EBS/03/110, July 24. Washington, D.C.

Ministro de Economía y Finanzas. 2003. “Plan de Reducción de Endeudamiento Público.,” Acuerdo 226, 12 de agosto.

Presidencia de la República. 2003. “Ley Orgánica de Responsibilidad, Estabilización y Transparencia Fiscal.,” Registro Oficial No. 589, 4 de junio.

Presidencia de la República. 2003. “Ley Organica de Servicio Civil y Carrera Administrativa y de Unificación y Homologación de las Remuneraciones del Sector Público,.” Registro Oficial No. 184, 6 de octubre.

Presidencia de la República. 2003. “Proyecto de Ley de Racionalización y Simplificación Tributaria.,” 30 de octobre.

Presidente Constitucional de la República. 2003. “Normas para el Incentivo Patriótico al Ahorro.” Registro Oficial No. 11, 30 de enero.

Presidente Constitucional de la República. 2003. “Reglamento a la Ley de Responsibilidad, Estabilización y Transparencia Fiscal.” Registro Fiscal No. 18, 10 de febrero .

World Bank. 2000. “Proposed Loan for a Structural Adjustment Program.” President’s Report, Report No. P7377 EC, May 18.

World Bank. 2002. “Project Appraisal Document: Ecuador Public Sector Financial Management Loan.” Report No. 23712 EC, February 25.

World Bank. 2003. , “Country Assistance Strategy for the Republic of Ecuador.” Report No. 25817 EC, April 29, 2003. Washington, D.C.

World Bank. 2003. , “Implementation Completion Report for Ecuador Structural Adjustment Loan.” (Draft), August.

World Bank. 2003. , “Proposed Fiscal Consolidation and Competitive Growth Adjustment Loan.” President’s Report, Report No. 25786-EC, April 28.

World Bank. 2003. “Proposed Programmatic Human Development Reform Loan I.” President’s Report, Report No. 25791-EC, April 28.

Various mission reports, aide memoires, official letters, and memoranda.

- 38 -

- 39 -