Document of

The World Bank

FOR OFFICIAL USE ONLY

aA) 3D8Z

Report No. P-5074-UR

MEMORANDUM AND RECOMMENDATION

OF THE

PRESIDENT OF H1TE

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

TO THE

EXECUTIVE DIRECTORS

ON A

PROPOSED LOAN

IN AN AMOUNT OF US$6.5 MILLION

TO

THE REPUBLIC OF URUGUAY

FOR A

SECOND TECHNICAL ASSISTANCE PROJECT

MAY 11, 1989

This document has a restricted distribution and may be used by recipients only in the performance oftheir official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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CURRENCY EQUIVALEN¶LS(December 30, 1988)

US$1 - NU$451NU$1.0 - US$0.00222

WEIGHTS AND MEASURES

1 hectare (ha) 1=O,00m 2- 2.47 acres

1 kilometer (km) - 0.62 miles1 square kilometer (km2) 100 ha1 metric ton 1,000 kg1 kilogram = 2.2 pounds

GLOSSARY OF ABBREVIATIONS

AFE - Government Railway CompanyBCU - Central Bank of UruguayBPS - Social Security BankBROU - Banco Rep6blicaCND - National Development CorporationDGI - Tax BureauGDP - Gross Domestic ProductIDB - Interamerican Development BankIl4F - International Monetary FundOPP - Office of Planning and BudgetingOSE - Government Water CompanyTAL - Technical Assistance Loan

FOR OFMCL USE ONLY

URUGUY

TEC8NICAL ASSISTANCE PROJECT IT

LOAN AND PROJECT SUIlARY

Borrowers Government of Uruguay

Beneficiaries: Office of Planning and Budgeting (OPP)Central Bank of Uruguay (BCU)Tax Bureau (DGI)Social Security Bank (BPS)Banco Repdblica (BROU)National Development Corporation (CND)

Amounts US$6.5 Million

Term.s 15 years, including 5 years of grace, at theBank's standard variable interest rate.

Financing Plan: IBRD US$6.5 millionBanco Rep6blica US$1.0 millionGovernment US$1.7 million

Total US$9.2 million

Econamic Rate of Returns n.a.

Staff Appraisal Beports n.a.

This document has a restricted distribution and may be used by recipients only in the petfonnaceOf their officia duties. Its contents may not otherwris be discbsed without Wodd Bankz authowintion.|

MEMORANDUM AND RECOMMENDATION OF TUE PRESIDENTOF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO

THE EXECUTIVE DIRECTORS ON A PROPOSED LOANTO THE REPUBLIC OF URUGUAY

FOR A SECOND TECHNICAL ASSISTANCE PROJECTIN AN AMOUNT EQUIVALENT TO US$6.5 MILLION

1. I submit the following memorandum and recommendation on a proposedtechnical assistance loan to the Republic of Uruguay for the equivalent ofUS$6.5 million. It would finance the services and related inputs requiredin the policy areas included in the Second Structural Adjustment Loan whichis submitted for your approval under a separate cover (ref. P-5071-UR).The loan would have a term of 15 years, including 5 years of grace, at theBank's standard variable interest rate.

2. Background. Since its assumption of power in March 1985, theGovernment developed and has been carrying out a medium-term economicprogram. This was designed to stabilize the economy (which had been deepin recession since 1982) and restore economic growth, reduce the externaldebt burden, improve public finances, and encourage investment andproduction. The program has embodied a consistent macroeconomic frameworkwith important structural reforms in key policy areas. This ongoingprogram includess (i) a policy and incentive framework geared to the expan-sion of exports of goods and services, including a floating and competitiveexchange rate, further rationalization of tariff protection and a comple-mentary tax policy; (ii) freedom of capital markets, interest rates andforeign exchange transactions, and an almost total absence of pricecontrols; (iii) measures to slow inflation and maintain fiscal and monetarydiscipline, to achieve a sustainable current account balance of paymentsdeficit, and to balance better resource allocation between the public andprivate sectors; (iv) actions to modernize the public sector, e.g., stream-lining the social security system and inefficient public enterprises; and(v) focusiug the public investment program on providing essential infra-structure and inputs for private sector productive activity.

3. In 1987, the Bank approved SAL X and a complementary TA project tobuttress Uruguay's program in an initial measure of assistance over theenvisaged three-to-five year adjustment period. The Bank's assistance wasconcentrated on trade policy and export promotion, public financial manage-ment, financial sector improvements and public investment programming.These had been identified as priority areas in the Government's plan forreactivating the economy without reigniting inflationary pressures. Asreported in the memorandum to the Board regarding SAL I, dated May 27, 1988(ref. Sec M88/615), there was satisfactory progress in the adjustment pro-gram which was then (and still is) on track, with the medium-term outlookcontinuing to favor growth and employment generation. In the process, theGovernment readily met the conditions of SAL I, all of whose funds have nowbeen disbursed, and demonsttated considerable receptivity to Bank advice.The first TA loan financed consultant services, training fellowships andrelated equipment to help the Government carry out the adjustment program.It has been successful in meeting its goals although the pace of disburse-ments has been slow. There were administrative delays in purchasing

equipment; several studies were conducted at less cost than anticipated;and other studies were carried out under the aegis of other loans. TheGovernment has now requested a second SAL, again with supporting technicalassistance.

4. Rationale for Bank Involvement. The Bank's involvement in theproposed technical assistance operation is directly linked to the mainemphasis in the overall country strategy on advancing the fulfillment ofthe Government's adjustment program. The Bank's presence would provide theGovernment with ti.-? important backing it considers necessary to achievethis program's objectives, particularly int (i) reducing the public sectordeficit and improving its management; and (ii) restructuring failed commer-cial banks and overcoming regulatory, supervision and other deficiencJes inthe financial sector. The project's provision of the services and otherinputs to prepare and guide the incremental policy changes and institut-ional reforms would help ensure the level of skills needed to carry outthese segments of SAL II properly. It would further help guarantee theear.'y availability of the team needed to implement the banking systemchar.gee, to which the Government attaches great priority. Uruguay'simproved economic management provides encouragement that the Government cancontinue its adjustment efforts in 1989-91, and confirms the Bank's pastdecision to provide significant resources for these purposes; it alsowarrants further support. Experience has also shown effective Governmentuse of adjustment lending to achieve significant policy reforms, far morethan has been feasible under investment projects.

5. Project Objectives. The proposed project supports the Govern-ment's objectives to restore effective competition in domestic banking andto improve the regulatory framework and Central Bank supervision of thebanking system. It also encompasses the targets of further rationalizationof the costly social security system, improved tax administration and morecomprehensive public investment programming (ref. SAL II President'sHemorandum (MOP), para. 46). Accomplishment of these objectives wouldassist the Government to meet the proposed conditions for release of theSAL II second trpnche.

6. Project Description. The project would finance the cost ofstudies designed to provide the framework for future reforms, and trainingand equipment needed for their implementation: (i) on social securityfinances and administration, aiming at more effective Social Security Bank(BPS) verification of contributions and detection of evasion (US$1.4 mil-lion, 16 percent of project costs including contingencies). This wouldhelp improve revenue controls and reduce BPS' future deficits; (ii) onfinancial sector reforms, aiming at first rehabilitating and laterreprivatizing three insolvent commercial banks (US$3.1 million, 35 percentof project costs). This component would help these institutions to developand implement new operating policies and procedures, reduce branches andstaff, and regain financial viability for their envisaged reprivatization;(iii) on tightened Central Bank supervision, so as better to detect andavert potential future problems within the banking system and to helpensure adequate compliance with new prudential rules. This would help toreinstate an adequate regulatory framework (US$684,000, seven percent ofproject costs); (iv) regarding the Banco de la Repiblica, to revamp BROU'saccounting system, computerize its operations and install modern

- 3 -

information systems and training activities (US$3.0 million, 33 percent ofproject costs); (v) regarding Uruguay's banking system development, acomprehensive study of BRCU's role, more adequate institutionalarrangements for the future exit and/or rehabilitation of distressed banks,the need for a new deposit insurance system, and ways of managing theforeign exchange risk predominant in present commercial banking(US$114,000, one percent of project costs); (vi) on tax administration, tocomputerize Tax Bureau record-keeping and collection systems (US$230,000,two percent of project costs; and (vii) on public investment planning,aiming at extending the recent system programming improvements to a widerrange of public sector agencies (US$518,000, five percent of projectcosts). A breakdown of costs and the financing plan are shown inSchedule A. Amounts and methods of procurement and the disbursemeltschedule are shown in Schedule B with details on consultant servicescontained in Schedule C. The project processing timetable is shown inSchedule D. A detailed description of the p'3ject's components is providedin Annex I. Annex II presents a matrix detailing objectives, components,expected outputs and impact of the project.

7. The total cost of the project is estimated at US$9.2 million equi-valent with a foreign exchange component of US$7.5 million. The loan wouldcover 86 percent of foreign costs and 71 percent of total costs on thegrounds of the high policy and institutional impact of the projectcomponents in relation to the Government's adjustment program. It is alsoconsidered justified in the light of the Government's nroblems in launchingand carrying out the financial restructuring program on its own.Consultants would be selected and equipment purchased in accordance withBank guidelines. The Office of Planning and Budgeting (OPP), whichsuccessfully supervised the similarly oriented TA I Project, would beresponsible for directing the successor operation. The Central Bank (BCU),National Development Corporation (CND), Tax Bureau (BCU), Social SecurityBank (BPS) and BROU would execute their respective components with portionsof the loan which the Government would make available under agreed termsand conditions. These proceeds would be on-lent to BCU and BROU onsubstantially the same terms as the Bank loan for their portions of theloan. The corresponding amounts for the central government executingagencies and BPS would be made available to them as grants. The remainingproceeds, directed to the financial sector component, would be on-lent toCND for repayment in local currency but otherwise closely reflecting theoverall financial terms and conditions of the Bank Loan. CND, thereafter,would relend to each of the banks the corresponding portions of theproceeds on the same terms and conditions on which it received the funds.

8. ARreed Actions. The actions already taken include agreement onproject arrangements and components with the Government; CUD's designationto oversee the financial sector rehabilitation program; and the latter'sapproval by the pertinent legislative committee. The Central Bank hasdrafted in consultation with the Bank new prudential regulations, whoseissuance would be conditions of effectiveness for the SAL. Agreement hasbeen reached on the qualifications of the three banks' new Chief ExecutiveOfficers (CEOs) to be employed for managing the banks' restructuring andtheir employment prior to disbursement of the SAL II loan's financialsector component. Conditions of TA loan effectiveness would include theexecution of the subsidiary loan agreement with the CND. The other

- 4 -

agreements referred to in para. 7 above, also satisfactory to the Bank,will condition disbursements of the respective components. It is proposedthat project funds supplement CND's compensation for the consultants CNDwould employ to serve temporarily as the banks' CEOs and their mainsubordinates on a temporary basis and for a finite task. Uruguay haslimited expertise in this area. Strong incentives are needed to attractspeedily such personnel and to motivate their speedy completion of thebanks' restructuring. The rigidities of the Government's budget controlsand its low salary levels would impede the recruitment of able individuals.Therefore, the proposed loan would provide US$2,000 per month for each ofthe CEOs and CND's Coordinator and US$1,000 per month for their four seniormanagers over 24 months, along with CND's lawyer and por* )lio collectionmanager.

9. Benefits. The project is expected to bring about major improve-ments in the effectiveness of the social security system, tax adminis-tration, financial sector regulation, competitiveness of commercial bankingand the public investment process. Regarding the financial sector reforms,the project will play a particularly important role in ensuring the avail-ability of high caliber, internationally experienced experts to assist inguiding the restructuring operation and the changes in the Central Bank'sregulatory system. In addition, since SAL II may be rapidly disbursed, theproposed TA loan may provide grounds for Bank support for financial sectordevelopment over the next several years. Further, the project is expe-tedto produce a valuable input for policy discussions witb the new Adminis-tration.

10. Risks. While the Government's successful completion of SAL/TAL Iindicates its commitment to sustained structural reforms, the politiceluncertainties surrounding an election year and new leadership subsequentlymay present risks on the extent of continued follow-up of the measures,which the TA project would support. This has been taken into account inthe design of the project. The risks attendant to restructuring of theinsolvent banks are considerable. They are, however, overshadowed by thefirm Government decision to implement these measures and the high costs ofalternative solutions. The presence of skilled technical experts shouldhelp as well.

11. Recommendation. I am satisfied that the proposed loan wouldcomply with the Articles of Agreement of the Bank, and recommend that theExecutive Directors approve the proposed loan.

Barber B. ConablePresident

By Mr. Moeen A. Qureshi

AttachmentsWashington, D.C.May 11, 1989

-5-

Schedule A

URUGUAY

TECHNICAL ASSISTANCE LOAN IIESTIMATED COSTS AND FINANCING PLAN a/

(US$ thousands)

Estimated Costs Local Foreign Total

A. Consultant ServicesPublic Investment Planning 30 75 105Commercial Banks Restructuring 1,104 1,375 2,479Banking Study 20 80 100

Sub-total 1,154 1,530 2,684

B. EquipmentBanco Rep0blica -- 2,000 2,000Social Security Bank -- 1,200 1,200Tax Bureau _- 200 200Planning Office _- 100 100Central Bank - 100 100

Sub-total 0 3,600 3,600

C. TrainingBanco Repdblica 120 542 662Central Bank Supervision 100 400 500Commercial Banks 50 200 250Public Investment 50 200 250

Sub-total 320 1,342 1,662

Total Base Costs 1,474 6,472 7,946

Contingencies 212 997 1,209

TOTAL PROJECT COST 1,686 7,469 9,155

Financing Plan Local Foreign Total--- (U.S. Thousands)-----

IBRD __ 6,500 6,500Banco Repdblica -- 969 969Government 1,686 -- 1,686

TOTAL 1,686 7,469 9,155

a/ The estimated costs of the project do not include taxes and duties.

-6-

Schedule B

URUGUAY

TECHNICAL ASSISTANCE LOAN II

Procurement Method(US$ Thousands)

Items LIB Other Total Cost

Consultant Services 3,151 3,151(1,830) (1,830)

Goods 4,104 4,104(3,100) (3,100)

Training 1,900 1,900(1,570) (1,570)

TOTAL 4,104 5,051 9,155Total from Loan (3,100) (3,400) (6,500)

Notes: (1) Cost estimates do not include duties and local taxes, whichare negligible.

(2) 'Other" methods include local shopping and purchase ofservices from consultants consistent with Bank guidelines.

(3) Figures in parentheses are the respective anounts to befinanced from the proposed Bank loan.

Disbursements Category Amount Percentage(US$000)

A. Consultant Services 3,410 100? of foreign expendituresand Training and 80t of local expenditures

B. Equipment 2,000 1002 of foreign expenditures(except 502 for BROU) and 802of local expenditures

C. Unallocated 1,090

Estimated Disbursements 1989 1990 1991------ US$000 by Bank FY

Annual 1,500 4,000 1,000Cumulative 1,500 5,500 6,500

-7-

Schedule CPage 1 of 2

URUGUAY

TECHNICAL ASSISTANCE LOAN IICONSULTANT SERVICBS

(US$ thousands)

Local Forei&n Total

A. Public Investment Planning 30 75 1051. Experts for Investment

Programming and SectorialPlanning Units (8 months) 10 30 40

2. Expert in PerformanceContracts and ControlMechanism for PublicEnterprises (8 months) 10 25 35

3. Experts in Macro-Planningand Organization Planning 10 20 30

B. Commercial Banks Restructuring 1,104 1,375 2,479

1. Managementa. Restructured Commercial

Banks (24 months each) 936 504 1,4403 CEOs (US$2,000 a month) 216 144 3603 Financial and Planning 144 72 216Managers (US$1,000 a month)

3 Marketing of Banking 144 72 216Services Specialists(US$1,000 a month)

3 Personnel and Branch Office 144 72 216Managers (US$1,000 a month)

3 Legal Advisors (US$1,000 144 72 216a month)

b. CND (24 months each) 168 120 2881 Coordinator (US$2,000 a 72 48 120month)

1 Lawyer (US$2,000 a month) 48 48 961 Portfolio CollectionManager (US$1,000 a month, 48 24 72

SW edule CPage 2 of 2

Local Forei8n Total

2. Technical Specialists -- 751 751

a. High-caliber Specialists forshort-term assignments insupport of CND and the CEO'stabout 13 months of servicesaltogether at US$1,200 aday; travel and subsistenceexpenses for US$100,000) -- 501 501

b. Project Execution Advisors(some 6 months of servicesat about US$1,200 a day;travel expenses budgeted atUS$5,000) __ 250 250

C. Banking Study 20 80 1002 Consultants (6 months eachat US$10,000 a month;travel expenses totalUS$20,000) 20 80 100

TOTAL 1,154 1,530 2,684_ _ ,m

-9-

Schedule D

URUGUAY

TECHNICAL ASSISTANCE LOAN II

Timetable of Rey Processing Events

(a) Time taken to prepare project: 5 months

(b) Project Prepared by: Planning and Budgeting Office

(c) First Bank Mission July 1988

(d) Appraisal Mission: October 1988

(e) Negotiations: May 3-5, 1989

(f) Planned date for Effectiveness: July 1989

(g) List of relevant PCRs and PPARs None

- 10 _

Schedule EPage I of 2

,URUAY

TECHNICAL ASSISTANCE LOAN II

Status of Bank Group Operations in Uruguay(as of March 31, 1989)

(US$million)Amount

Loan (Less cancellations)NO. Year Borrower Purpose Bank Undisbursed

Loans fully disbursed 421.5

1831 1980 Uruguay Agricultural Develop. 24.0 1.51930 1980 Uruguay Industrial Credit 13.7 .12033 1982 ANTEL ' Telecommunications 24.0 14.32238 1983 Uruguay Highways 45.0 16.52484 1985 UTE 2/ Power 4.0 3.52622 1985 UTE 2/ Power 45.2 44.52802 1987 ANCAP Refinery Modernization 24.4 21.22843 1987 Uruguay Technical Assistance 1.0 0.82921 1988 Uruguay Water Supply Rehab. 22.3 22.23021 1989 Uruguay Transport 80.8 80.8

Total 705.9of which has been repaid 252.9

Total now outstanding 453.0

Amount sold 4.6of which has been repaid 4.6

Total now held by Bank 448.4

Total undisbursed 205.3

1/ National Telecommunications Administration.2! National Power Company.3/ National Fuel Company.

- 11 -

Schedule EPage 2 of 2

URUGUAY

TECHNICAL ASSISTANCE LOAN II

Statement of IPC Investments in Uruguay(as of March 31, 1989)

Fiscal Type of (Amount in US Million)Year Obligor Business Loan Equity Total

1979 Fabrica Uruguaya de Motor Vehicles 3.80 - 3.80Neumaticos* and accesories

1979 Acodike Suergas S.A * Chemicals and 0.95 - 0.95petrochemicals

1979/ Astra Pesquerias Food & Food 7.40 2.25 9.651983 Uruguayas S.A. processing

1980/ Sur Invest Casa Money and capital 20.80 1.79 22.591989 Bancaria S.A. market

1985 Azucitrus S.A. Food and food 7.61 2.40 10.01processing

Total gross commitments 40.56 6.44 47.00

Less cancellations, terminations,repayments and sales 22.98 . 22.98

Net held by IFC 17.58 6.44 24.02

Total Undisbursed 1.48 0.45 1.93

*Fully repaid

ANNSX IPage I of 12

URUGUAY - TECHNICAL ASSISTANCE LOAN

I. BACKGROUND

1. The Bank has financed substantial technical assistance in previousoperations as followss

(a) Highways III (Loan 2238-UR). This loan includes technicalassistance to the planning unit of the Ministry of Transportand various expert services in the areas of highway engine-ering and traffic safety:

(b) Agricultural Develipment (Loan 1831-UR). The loan includesfunds for staff training and transfer of agriculturaltechnology;

(c) Telecommunications (Loan 2033-UR). The loan provides fundsfor a management and administration study;

(d) Power Engineering (Loan 2484-UR) and Power SectorRehabilitation (Loan 2622-UR). These loans finance variousoperational and planning studies designed to improveoperating practices and reduce system losses;

(e) Technical Assistance I (Loan 2843-UR). The loan supports theprogram of reforms of SAL I and the preparation of studiesfor other actions under SAL II. It covers fiscal reform,public investment programming, social security, capitalmarkets, and administrative reforms;

(f) Water Supply Rehabilitation (Loan 2921-UR). The loanprovides funds for technical cooperation and training througha corporate twinning arrangement with a foreign watercompany, and technical cooperation for planning andcoordinating project execution; and

(g) Transport I (Loan 3021-UR). The loan provides funds fortechnical cooperation and training to support policy reformsand institutional development of the Ministry of Transportand Public Works and the National Port Administration.

2. The experience with provision of technical assistance to Uruguayhas been generally satisfactory; consultants' recommendations have beengiven adequate attention with a reasonable share of the recommendationsproperly implemented. However, consultant recruitment often takes longerthan expected because of the complex approval procedures involving variousagencies. Other procurement actions have been delayed by firms whose bidswere unsuccessful, exercising their rights of appeal. Procurement problemshave lessened since the new Government came to office in March 1985. TA Isupported some of the reforms of SAL I (e.g social security, corporate andother legislative reforms) and is also providing analytical underpinning

ANNIX .Page 2 of 12

for reforms under SAL II. It also financed consultants for the preparationof reform elements, such as performance contracts in the case of the watercompany (OSE) and railroads (AFE).

I1. PROPOSED COMPONENTS

3. The proposed project consists of several components related toimportant reform areas which are addressed under the proposed SAL II asfollows:

A. Social Security Finances

Background

4. The Government's reform agenda continues to emphasize bringingUruguay's social security system more in line with the country's financialmeans. The system has developed extensively since its origin in the earlypart of this century. Its cost loomed large in the overall Central Govern-ment deficit in the initial 1980s. Social security expenditures on the- d-age, survivors and disability (IVS) program of BPS and the armedforces, family allowances, health and unemployment insurance representedabout 11.2 percent of GDP in 1986, exceeding revenues by 3.1 percent ofGDP. The social security deficit was an important factor also in under-mining the pre-announced exchange rate policy of the late 19708 and early1980s through its impact on the fiscal deficit.

5. The major issues of the IVS system of BPS are: (i) reducingretirement and other benefits to a level that Uruguay can afford over thelong term, (ii) financing these benefits while reducing the fiscal deficit;and (iii) improving the system's administration. These reflect Uruguay'slow population growth (0.5 percent a year), aging population with high lifeexpectancy, and low ratio of active workers to beneficiaries. Additionaldetails on the evolution of the system, past reform efforts and policyproposals may be found in Report No. 7067-UR, entitled "Uruguay - AnInquiry into Social Security.'

6. Under SAL I, the Government modified the IV program in a mannerwhich should ensure that it will be financially self-sufficient by year2000. This has been determined in accordance with a methodologysatisfactory to the Bank. In addition, reasonable progress was achieved inreducing the deficit of the IVS program. Legislation approved in 1987introduced new earmarked taxes which are expected to reduce the deficit ofthe old age, survivors and disability program of BPS (which was about 1.2percent of GDP in that year) by 0.2 percent of GDP in the short run. ForSAL II, the authorities intend to obtain additional improvements alongthese lines. Specifically, they propose to modernize and tighten BPS'controls on revenue collections and inspections. This would be accompaniedby reforms to strengthen further the system, including reductions of thewage replacement ratio.

7. Evasion of social security system contributions is high withsubstantial nonpayment and under-declaration of wages. The greatestleakage has been detected in industry and commerce. About 27 percent of

ANNEX IPage 3 of 12

workers in these sectors do not report, and actual payroll contributionscomprise 52 percent of the estimated total obligations. Of the estimatedevasion level in industry and commerce, 38 percent is attributed to non-payment and 46 percent to underreporting. The Government considers thatreducing these levels of evasion provides an excellent opportunity toimprove the retirement program's finances. Accordingly, with the aid ofenhanced BPS computerization to be financed under the loan, the authoritiesintend to effect administrative improvements and to install better controlmechanisms. These would help bring about the introduction of socialsecurity (or comparable) control numbers, individual accounts on eachworker's lifetime contributions, records which could be cross-checked withtax records, the data for identifying underpayment or late payment, etc.Achievement of these goals is one of the conditions established for therelease of the second tranche of the proposed SAL II loan.

Objective

8. The principal aim of the technical assistance is to enable the BPSto monitor more efficiently contributions, in particular revenue collect-ion, and the programming of in situ inspections, lifetime contributions andbenefits.

Scope

9. The proposed technical assistance will be directed to the revenuecollection unit of the Social Security Bank. The latter's computer equip-ment currently is insufficient for the unit's requirements and is largelyobsolete. The proposed new equipment would supplement BPS' own scheduledinvestment outside of the project of some US$1 million for computers tohandle benefit payments. The project would provide:

(a) acquisition of computer equipment and software (aboutUS$1.0 million of base project costs); and

(b) technical support to design the corresponding programs(about US$200,000 of base project costs).

B. Tax Administration

Background

10. The adjustment program places considerable emphasis on Governmentactions to improve public finances so as to increase public savings, andcontribute to a better balance in resource allocation between the privateand public sectors. This was intended to follow up on the fiscal reformsinitiated in the early 1970s to streamline the tax structure, eliminatedistortions in relative prices between capital and labor, and to givegreater weight to export activities. Under the new program, the Governmentmoved to reduce import tariffs and agriculture export taxes, revise agri-culture producers' income taxes, and extend the value added tax toagriculture sales. These reforms, as well as the growing economy, resultedin increased tax revenues of about 4 percent of GDP in 1986-87 over the1984-85 level.

ANNEX IPage 4 of 12

11. The Government also is undertaking tax studies, financed under TALI, to analyze the impact of its recent reforms, along with possible ways ofrestructuring the system so as to provide greater incentives for productiveinvestments and exports, as well as reduced evasion. These are intended toprovide the basis for new'legislative proposals. The completion of thesestudies would be one of the factors to be monitored in connection with therelease of the second tranche of the proposed SAL II. For the future, theGovernment intends to maintain the growth of tax revenues as a percentageof GDP in order to reduce the inflationary impact of the public sectordeficit on the economy. For this purpose, it has set the targets of afurther reduction in tax collection lags and increases in assessments, witha view to helping to cut the overall public sector deficit to 3.5 percentof GDP in 1989. It also desires, apart from advancing the aforementionedtax law changes, to press ahead with further improvements in taxadministration. It has already progressed with the automatization ofprocessing and simplification of declarations in the systems covering VAT,consumption, net worth and corporate taxes; with upgrading the Tax Bureau'ssupervision and auditing; and centralizing taxpayers accounts. Thisyielded a revenue increase of about 0.6 percent of GDP in 198b. Theproposed project includes provisions for expanding on these accomplishmentsthrough further computerization of tax administration, supplementingcollateral technical assistance from the German Government, the IDB and theIMF.

Objectives

12. The principal aim is to support the effort underway to modernizethe tax collection system and reduce tax evasion.

Scope

13. Computer equipment and related services will be acquired underthis component (US$200,000 of base project costs).

C. Public Sector Programming and Investment

Background

14. The direction of public sector investment has taken on specialimportance in Uruguay. The economic crisis of 1982-85 brought investmentsto new lows, exacerbating the effects of the extended economic contractionfrom the mid-1950s to the mid-1970s. The need to expand these low levelshas had to be reconciled with relatively limited national savings and theneed to generate adequate fiscal transfers for servicing the high externaldebt obligations. Another factor in the equation is the Government'sstrong preference for private sector control of productive activity.

15 The adjustment program sets as a target designing the publicinvestment program so as best to meet the essential inputs, infrastructureand services for a revitalized private sector, while also addressing pres-sing social problems. This has necessitated strengthening programmingmechanisms, starting with the Office of Planning and Budgeting (OPP), whichwas achieved under TAL I. The 1989-90 program envisages a continuation ofthis activity and its expansion to the full scope of public sector

ANNEX IPage 5 of 12

agencies. Existing planning units in the transportation, public works andwater organizations would be reinforced; new ones are being established intelecommunications, health and education agencies. The planning unitswould concentrate on the preparation of the 1990-95 investment program forthe consideration of the next Government. Completion of its first phase,updating the 1989-90 slicO in line with the Government's Development PolicyStatement, is one of the proposed conditions foi release of the SAL II'ssecond tranche.

Ob3ective

16. The objective is to strengthen further the Planning and BudgetOffice and sectoral planning units to improve the formulation ofmacroeconomic development programs and the corresponding investmentprogramming and project formulation, execution and monitoring.

scope

17. The technical assistance will cover:

(a) strengthening of the structure and procedures used by themain implementing agencies to identify, prepare, select andfollow-up on projects;

(b) improvements of budgetary procedures and their relationshipto programming public investments over a multi-year period;

(c) development of p rformance contracts and/or other evaluationsystems for public enterprises; and

(d) analysis of the institutional framework and procedures fordetermining the level and composition of public investment ineach sector, monitoring projects under execution, andpreparation of new projects;

The base costs of the required consultants, related equipment and trainingis estimated at US$455,000.

D. Tightened Supervision of Commercial Banks

Background

18. The major objectives of the Government in the financial sector areto reestablish a sound banking system, restore the necessary safeguards tocredit operations and strengthen the regulatory framework of commercialbanks. There are significant deficiencies in these areas resulting largelyfrom a combination of misguided past macro policies and lax enforcement ofregulatory and supervisory standards. To avoid a repetition of previousnmistakes, the authorities recognize that strengthened prudentialregulations and supervision by the Central Bank are essential (ref. paras.86-87, SAL President's Report).

ANNEX IPage 6 of 12

Objective

19. The basic objective is to accomplish stronger supervision over thecommercial banks and to adapt the regulatory framework to new internationalstandards (Basle agreement) so as to enhance the health of the bankingsystem. The program aims at upgrading the skills of the existing and newCentral Bank supervision staff as well as at increasing the number of bankinspections. It will also review the organization, staffing, salaries andbudget of BCU's supervision department and improve computerized inspectionsand internal reporting.

20. The Government's Letter of Development Policy underscores theimportance of obtaining stricter application of BCU supervision proceduresand an increased number of its annual inspections. It also states that theunderlying purposes are to: (i) improve the transparency and quality of thecommercial banks' financial reporting; (ii) improve these banks' operatingpractices; and (iii) reinforce Central Bank control over the BancoRepdblica. For this purpose, the Central Bank has developed new prudentialregulations, whose issuance would be a condition of effectiveness of theSAL. Under these regulations, new capital adequacy guidelines will beintroduced, along with a system of risk weights for assessing thisadequacy. Stricter norms would be introduced for determining which loansare non-performing, and there would be a similar tightening of provisioningrequirements to cover bad loans. St-ndards and the performance of externalauditors will be reviewed to ensure that certification by these auditorsmeet accepted international standards, detect potential problems and permitearly corrective actions by the banks on their own or at the request of theCentral Bank. To meet these objectives, the Central Bank is increasing itssupervision staff. New personnel will need to be trained in supervisiontechniques, partly through exchanges of experiences with peer institutions.

Scope

21. The technical assistance is composed of: (i) training of BCUsupervision staff; (ii) reviewing BCU's computerized reporting system toimprove commercial banks' reporting and upgrade auditing procedures;(iii) introducing new computer models to evaluate commercial banks'financial posit.on; and (iv) acquiring computers and related materials.Their estimated jase costs are US$600,000. The training program willrequire a combination of on-the-job training, classroom instruction andseminars:

(a) a program of in-house seminars, with the support offoreign instructors, to train the new inspectors aswell as upgrade the skills of those already on thejob in such areas as risk assessment, solvencyratios, and adequacy of networth; portfolioanalysis, and provisioning; asset and liabilitymanagement, and foreign exchange risk management;and the main elements for computerized and in situinspections;

ANNEX IPage 7 of 12

(b) training to improve the evaluation of computerizedreports and to detect reporting errors, as well asto introduce new computer models to evaluate thefinancial position of commercial banks;

(c) participation of supervisory personnel in coursesand/or seminars conducted by other central banks orregulatory agencies;

(d) foreign specialists to participate as instructorsin three seminars to be held annually in theCentral Bank for the next three years; and

(e) books, reference materials, instructional aids, andany other necessary materials.

E. Rehabilitation of Commercial Banks

Background

22. After an intensive review of the condition of several insolventlocal banks in which the Government had to intervene, together with theeffects of this situation on the financial sector and the economy, theGovernment has decided to revitalize these institutions (ref. SAL IIPresident's Report, para. 68). Its intention is to convert them intoviable entities suitable for acquisition by the private sector. TheGovernment plans to remove the banks from the control of Banco Repcblicawhich temporarily absorbed these institutions under special arrangements.The plan is to restructure three of the banks, and to liquidate the fourth(which is not viable). The National Development Corporation (CND) wouldprovide the necessary legal framework for cleansing the three banks'portfolios, and to oversee generally their restructuring. The planning andexecution of these programs would be accomplished, however, by new chiefexecutive officers (CEOs) of the banks and their teams (credit, financialand planning, marketing, legal and personnel managers). CND would providesupporting services (a lawyer and portfolio collection specialist) inaddition to a coordinator for the overall operation.

23. These CEOs would be responsible for preparing completerestructuring programs for their banks to cover financial, organizational,managerial and staff arrangements. Their contents and proposed action planwould be based on criteria to be specified in the CEOs' contracts, to beagreed with the Bank prior to SAL II disbursements for this component. The"rescue packagesf would meet such criteria as adequacy of capital, assetquality, management excellence, earning capacity, and liquidity. Theywould also provide for cuts in personnel and number of branches and theintroduction of new services and stringent lending policies, as requiredfor each bank's individual needs.

ANNEX IPage 8 of 12

Ob ectives

24. The proposed technical assistance for the restructuring programinvolves supporting the appointment of the chief executive officers andtheir senior managers in 6rder to help ensure that these posts are filledby suitably qualified professionals. This suppc-t would also help providethe services of high level specialists in this field to advise the CND andthe three banks' new CEOs and management teav.s on carrying out thisprogram. The training of the banks' staffs in new policies and proceduresis included as well.

Sope

25. The components are:

(a) New Management Teams. The banks' new CEOs wouldcommand the major authority and bear the principalresponsibility for restructuring their respectiveinstitutions, for which they would be supported bythe aforementioned credit and other managers. Theywould be accountable, through performance contractsfor such tasks as reductions of employees andbranches, as well as organizational realignments.These responsibilities will demand the recruitmentof high level personnel, with skills not in greatsupply in Uruguay, for which attractivecompensation arrangements will be needed. Further,their performance contracts would specify theobjective of achieving improvements on a speedybasis for the projected privatization. On theseaccounts, plus the importance of solving thefinancial sector problem, the proposed loan wouldinclude provision for their salary supplements on atemporary basis and for finite tasks. These wouldaverage US$2,000 per month for each of the new CEOsand US$1,000 per month for each of their foursenior managers over a 24-month period. The CEOsand their subordinates would be obtaining US$3,000and US$2,000 per month respectively from the CND astheir base salaries. The US$2,000 supplement wouldbe given also to CND's coordinator, legal advisor,and portfolio collections specialist of therestructuring operation. The base cost under theproject is estimated at US$1.4 million.

(b) Technical Specialists. The new CEOs will designrestructuring programs for their institutions tocover financial, managerial, operating and staffingimprovements. They will need to install stringentlending policies; improve competitiveness andprofitability; and achieve operating efficienciesin turning around the distressed banks. Foraccomplishing these purposes, the Government has

ANNEX IPage 9 of 12

requested the services of five advisers (who may beemployed individually or provided by a firm) toassist the CEOs and also counsel the CND over an upto 30-month period. Their cost is estimated atUS$500,000 million. In addition, high leveltechnical eXperts would be employed under theproject to visit periodically Uruguay for purposesof providing independent diagnoses of and counselon the restructuring operation to the Governmentand the Bank. Their services are estimated to costUS$250,000.

(c) Training. Managerial and professional leveltraining is required at all three banks. It willbe necessary to conduct seminars in the mostcritical at,-as of credit, asset, risk assessment,and liabilities management, foreign exchange risks,financial analysis, portfolio supervision andrecovery and new management practices. Part ofthis assistance may be requested from establishedbanking training institutes experienced inproviding such services. US$250,000 is requiredfor this purpose.

F. Banco de la Rep6blica del Uruguay (BROU)

Background

26. BROU is a sound state-owned commercial bank, which offers anextensive array of financial services to the public. BROU's operating andaccounting practices are, however, old-fashioned and conservative. Theyare in need of a major effort to bring them to modern standards, tointroduce computerization of operations, and to analyze lending operationsbetter. This will be initiated through the implementation of a plan ofaction for the development of a comprehensive and integrated management andfinancial information system, which will be put in place in conjunctionwith the revision of the Central Bank's accounting system. The separationof BROU's accounts between banking and von-banking functlons is one of theproposed conditions for release of the SAL II's second tranche. Also, thenew accounting framework will be needed to ensure BROU an efficientmechanism for the modernization of its operations as well as the productionof information required for assessing debtors' obligations (includingarrears, accrued interest and other elements that would supplement thestandards defined under the new regulatory framework of the Central Bank).Assistance for these purposes would be paralleled by an assessment ofBROU's future role in the sector (ref. para 30).

Objective

27. The objective is to assist BROU to strengthen its informationsystems capability and increase its efficiency.

ANNEX IPage 10 of 12

SCo

28. The components are:

a. Development'of a comprehensive and integratedmanagement and financial information system bymeans of the following activities:

(i) Definition of the scope of the informationsystems to be introduced. This willinclude: undertaking a requirementsdefinition study for planning, budgeting,control and operations in all areas of BROU;and identifying areas for improvements andinformation necessary for more effectivefunctioning of BROU; quantifying theexpected benefits to be derived from theirimplementation and establishing prioritiesfor action;

(ii) Isplementation of the information systemstrategy to include the acquisition andutilization of the computer equipment andsoftware required therefore and thefollowing activities:

(a) defining the major elements ofapplication systems necessary forintegrated operations;

(b) assessing the institutional capacity toabsorb the new technology anddistribution of data processing andanalysis capabilities, as required; andrecommending a phased implementationprogram;

(c) recommending software packages anddefining the computing equipment andcommunication links required;

(d) reviewing BROU's data processing sectionand as needed, recommending neworganization responsibilities.

b. Development of and carrying out a training programfor purposes of: (i) upgrading staff skills inoverall bank management, lending operations andsupervision thereof, planning and financialmanagement, and liability management, along withrecent developments and techniques in commercialbanking; (ii) improving accounting and auditingstandards; and (iii) upgrading the quality ofmanagement systems.

ANNEX IPage 11 of 12

Cost Estimates

29. The base cost of computer equipment to be installed in the83 branches of BROU and its main offices, applications software, referencematerial is estimated at US$1.1 million. To strengthen BROU's capabilityand to raise its efficiency as well as its information system, specializedexpertise is needed from the outside. One project manager would becontracted to coordinate the establishment and implementation of theinformation system. One banking expert and one system expert would also beappointed. Provision is made for 24 months of consulting services foradditional supporting activities. Total cost of providing these experts isestimated at US$900,000. In addition, approximately US$662,000 isrequested to meet the base costs of teaching aids, providing experts toconduct seminar and/or courses in Uruguay; and sending EROU's staff abroadfor training.

G. Banking Study

30. The project would include a comprehensive study regarding threeimportant aspects of Uruguay's banking system. The first would be anassessment of the financial sector's future requirements, covering amongothers, BROU's role and a new institutional mechanism for the rescue andrehabilitation of private banks in the future. The second assessment wouldevaluate Uruguay's experience with the existing deposit insurancemechanisms created in 1965. A third would examine ways of covering thelarge foreign exchange risk in commercial banking at present. US$100,000is budgeted for the two consultants to be recruited for the study, whichwould be completed by July 30, 1991. Subsequently, the Government willreview with the Bank the findings and recommendations of the study andprepare, as appropriate, plans of followup action including a timetablefor their completion.

III. OPERATIONAL CONSIDERATIONS

31. Project Cost and Financing. Total cost of the technical assis-tance program, net of taxes and duties, is estimated at US$9.2 millionequivalent. This total includes: consultants costing US$2.6 million;equipment, US$3.6 million; training, US$1.6 million; and price contingen-cies, US$1.2 million. The loan would cover 86 percent of the foreignexchange cost and 71 percent of total costs. This proportion of financingis recommended on the grounds of the high policy and institutional impactof the project components in their relation to the Government's adjustmentprogram. It would help ensure the early availability of the teams neededfor the financial restructuring component.

32. Procurement and Disbursement. Contracting of consultants will becarried out in accordance with Bank guidelines. Procurement of computingequipment for the tax, social security, public investment, BCU and BROUcomponents, estimated to cost US$3.6 million aggregate, would be carriedout under limited international bidding procedures on the basis ofquotations from at least three suppliers. Training materials would bepurchased through local shopping. Contracts above US$50,000 will be

ANNEX IPage 12 of 12

submitted for prior Bank review. The Bank would disburse 100 percent ofthe foreign, and 80 percent of the local, costs of consultants andtraining. The same formula would apl.y in the case of equipment wit4 theexception that BROU would finance 50 percent of foreign expenditures forcomputing equipment. The target date for completion of the project wouldbe June 30, 1992, and the Closing Date would be December 30, 1992. Aspecial account would be set up in the Central Bank on terms and conditionssatisfactory to the Bank, with an initial deposit of US$1.4 million. Thisproportion of the Loan is justified by the short-run nature of the program.Retroactive financing of up to US$0.7 million equivalent would be availablefor expenditures after January 15, 1989. Disbursements would be made onthe basis of full contractual documentation for all contracts valued atUS$50,000 or more, local consultants' fees, and training materials. Allother disbursements would be made on the basis of certified statements ofexpenditure, which would be retained by the Central Bank and made availableto the Bank upon request.

33. The OPP and other executing agencies would establish and maintainaccounts for all project expenditures under the proposed loan in a clearlyidentifiable manner. Such accounts and supporting records would be auditedannually by independent auditors acceptable to the Bank and the auditreports would be submitted to the Bank within six months after the end ofthe year.

34. Benefits and Risks. The technical assistance to be provided underthe proposed loan is designed to support implementation of the Govern-ment's Structural Adjustment Program, both in carrying out policy actionsand programs already agreed, as well as in preparing the way for additionalreforms in key areas. The program will support the Government's efforts toreduce the fiscal deficit by controlling transfers to the social securitysystem, and improving tax structure and collection. The studies will alsosupport better public sector investment programming.

35. There is a risk of delays in the appointment of consultants whichcould jeopardize timely implementation. However, since the completion ofsome studies is required as a condition of disbursement for the secondtranche disbursement of the SAL II, we expect that the delays will be mini-mized. Thera is also a risk that some recommendations of the studies willnot be implemented as fully or in as timely a fashion as desired, given thepolitical nature of some of the issues. However, implementation of policyrecommendations and specific action programs would be closely monitored aspart of continuing discussions between the Bank and the Government in thecontext of the Structural Adjustment Program. This and the Government'ssatisfactory record in obtaining Parliamentary approval of sensitiveeconomic measures provide favorable grounds for presuming success.

ANNEX 11Pogo I of a

SECO TE0HICAL ASSIUS PROCT

Goevn=a t Objectiva Co poenmt Aetivittis ExpeOte O1tputl11pact

1. Reduction of Social Securityfinancial deficit to 2%

Project Goal: Improve monitoring of Acquire computing equipment for A computer-supported system to enable

compliance with Social Security contribution Social Security Bank (BPS) staff to BPS to monitor contributions more

requirements; Increase control of devolop better reporting and offectivelyand program its inspections

contributions (Annex I, paras. 4-9). controls. better. It is expected that revenue

collections would significantly improve

as a result.

2. Increase Control of Tax Revonues

by 1 X of CDP

Project Goal: Improve monitoring of Acquire computing equipment for Tax A computer-supported system to enable

compliance with VAT, income and capital Bureau (DCI) staff to improve DOI to monitor contributions more

taxes (Annex I, paras 10-19). reporting and controls. effectivelyand program its Inspectionsbetter. It Is expected that revenuecolloctions would significantly improve

as a result.

8. Expanded Public Investment Planningupgrading

Project Goal: Ioprove formulation Consultants and equipment ft.r Increased ability of Government

development programs, and correspording carrying out studies on (1) sector ministries and stato enterprise to

formulation, oxecution and monitoring of lnvesotmnt planning machinery; (ii) properly prepare carry out and monitor

Investment projects (Annex I, pars. 14-17). better relating budget procedures development projects, following

and Investment programing; and Planningand Budget Office Initiatives.

(1t1) performanc evaluation ofstate enterpriss.

ANNEX IIPage 2 of 8

4. TIghtened Central Bank Supervision ofCommercial Bank

Project Goal: Enhance new prudential Training of new and upgrading of Increased efficiency of supervision

regulations; implement upgraded reporting by prosent Central Bank supervision staff to audit commercial banks'

and supervision of commercial banks (Annex stiff and purchase of computer financial reporting and discharge their

r, paras. 18-21). equipment to modernize reporting and inspectionson a more frequent basis.

inspection activitios. Itis expectedthat the banks' practiceswillimprove substantially asaconsequence.

5. RestructurIng of Insolvent banks

Project Goal: Revitalize three distressod Consultants and training for The financial and manazerial improve-

banks to regain their viability and permit advising the banks' new CEO's to monts would permit the termination of

their reprivatization (Annex I, paras. restructure their operations; the present Covernment operational22-25). Improving their staffs' policies and support ofthe banks, and facilitate

procedures; and providing theirestoration to a more self-specialized advice to the National sustaining basis, and thus battertheir

Devolopment Corporation on the prospects for sale to new private owners.management of the restru'turing Bankingaystem competitiveness wouldprogram increaso accordingly.

Improved capability of the CND toSupplement incentives for new CEOs obtainthe requirod level of consultantsthrough salary increments, for thebanks' CEO positions and four

principal managers. thus facilitatingprompt, successful termination of therestructuring process.

6. Improvement ot Banco Repfiblica

Project Goal: Modernize BRORU s accounting Acquire computing equipment and Inereased ability of BROU to metand data systems (Annex I, pares. 26-29). train staff to help BROU to devolop Central Bank reporting norms, better

a comprehensive management and assess credit requests and upgrade thefinancial information system. lovel of its administrative operations.

ANNE U1

PagO 8 of a

7. Improved Financial Sector Institution

Policies

Project Goal: Analyze requ;resents and Consultants to conduct the study on Improvod ability of the Government to

define solutions for sector problems (1) financial sector's future deal with distressed banks; to reduce

(Annex I, para. 80) requirements covering BROU's role distortions resulting from the

and ways of meeting any future bank "dollarization" of banking; and to

restructuring situations; (;t) definoan appropriate level of

covering the foreign exchange risk protectionfor local and offshore

In commercial borrowing; and (lii) depositors in Instances of banking

tho adequacy of present deposit distress.

Insurance provisions.