Report No. 10404-VE

Venezuela Structural and MacroeconomicReforms - The New RegimeMarch 18, 1993

Country Operations DivisionCountry Department ILatin America and the Caribbean Region iI- .;i: .

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FOR OFFICIAL USE ONLY ji ,i

Document of the World Bank

This document has a restricted distribution and may be used by recipientsonly in the performance of their official duties. Its contents may not otherwisebe disclosed without World Bank authorization.

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FISCAL YEAR

January 1 to December 31

CURRENCY EQUIVALENTS

Currency Unit = Bolivar (Bs)Exchange Rate Effective December 31, 1992

US$1 = Bs. 79.7Bs. 1 = US$0.012

Bs. 1,000 = US$12.55

FOR OFFICIAL USE ONLY

GLOSSARY OF ACRONYMS

AEROPOSTAL LUnea Aeropostal Venezolana Venezuelan Postal Airliie

ALCASA Aluminio del Caroni, S.A. Caroni Aluminum, S.A.

BANAP Banco Nacional de Ahorro y National Savings and Loan BankPrestlmo

BANDAGRO Banco de Desarrollo Agrfcola Agricultural Development Bank

BAUXIVEN Bauxita Venezolana, C.A. Venezuelan Bauxite, S.A.

BCV Banco Central de Venezuela Central Bank of Venezuela

BIV Banco Industrial de Venezuela Venezuelan Industrial Ea ,k

CADAFE Compania Anonima de Desarrollo y Development and Cooperation forFomento Electrico Electrical Power Company

CAMETRO Compailia An6nima Metro de Caracas Subway CompanyCaracas

CANTV Compafilia Andnima Nacional de National Telephone, S.A.Telefono

CARBOSUROESTE Carbones del Suroeste Southwest Coal Company

CASA Agricolas, S.A. Agrarian Industries, S.A.

CAVEINEL Camara Venezolana de la Industria Venezuelan Chamber of ElectricalElectrica Industries

CAVN Compaffia An6nima Venezolana de Venezuelan Navigation, S.A.Navegaci6n

CORDIPLAN Ministerio de Planificacion y Ministry of Coordination andCoordinacion Planning

CORPOINDUSTRIA Corporaci6n de Dsarollo de la Corporation for the Development ofPequefla y Mediana Industria Small and Medium Industry

CTV Confederacdon Trabajadores de Venezuelan Workers ConfederationVenezuela

CVF Corporaci6n de Venezolana de Venezuelan DevelopmentFomento Corporation

CVG Corporaci6n Venezolana de Guayana Development CorporationGuayana

DFI Instituciones Financieras de Development Financial InstitutionsDesanrollo

EDELCA Electrificacid6n del Caroni Caroni Electrification Company

ELECAR Electricidad de Caracas Caracas Electricity Company

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

ENELBAR Energia Electrica de Barquisimeto Barquisimeto Elelectricity

ENELVEN Energia Electrica de Venezuela- Venezuela-Maracaibo ElectricityMaracaibo

ENSAL Empresa Nacional de Salinas National Saltworks Company

FCA Fondo de Credito Agrfcola Agricultural Credit Fund

FERROMINERA Ferrominera del Orinoco Orinoco Ironore Company

FINEXPO Fondo de Financiamiento de las Export Financing FundExportaciones

FIV Fondo de Inversiones de Venezuela Investment Fund of Venezuela

FOGADE Fondo de Garantfa de Dep6sitos Dtposit Insurance Fund

FONCREI Fondo de Credito Industrial Industrial Credit Fund

GATT General Agreement on Tariffs andTrade

HCD Hogares de Cuidado Diario Community-Based Day Care Centers

ICAP Instituto de Credito Agropecuario Fanning and Livestock CreditInsCitute

INH Instituto Nacional de Hipodromos National Race Tracks Institute

INP Instituto Nacional de Puertos National Ports Institute

INTERALUMINA Internacional de Aluminio, C.A. Aluninum International, S.A.

MEM Ministerio de Energia y Minas Ministry of Energy and Mines

MH Ministerio de Hacienda Ministry of Finance

MINFAM Ministerio -le la Familia Ministry of the Family

NGOs Non Governmental Organizations

OCEPRE Oficina Central de Presupuesto Budget Office

PDVSA Petrdleos de Venezuela, S.A. Venezuelan Petroleun Company

PEP Plan de Enfrentamiento de la Povert Alleviation PlanPobreza

RECADI Officina dAel Rgtinen de Cambios Office of the Differential ExchangeDiferenciales Rate

S&L Savings and Loans

SBIF Superiotendencia de Bancos e Superintendency of Banks andInstituci snes Financieras Financial Institutions

SIDOR Siderqrgica del Orinoco, C.A. Orinoco Steel Industries

VENAL UM Industrias Venezolanas de AlMninio Venezuelan Aluminum Industries

VIASA Venezolana Internadonal de International Venezuelan AviationAviaci6n

VV3UgEL1 STRUB-RAL AND NACR-O0C IC 33 ME-!3 3EV RESINS

TABLE OF CONTETS

ABSTRACT . . .. . . . . . . . . . . . . . . iv

BXECUTIVE SUMMARY . . . . . . . . . . . . . . . . . . . vi

1. STRUCTURAL REFORMS . . . . . . . 1 . . . . . . . . . . 1

A. IntroductLon ........... a. *.. 1

B. Major Areas of Reform ................. 2

Prlvatization . . . . . . . . . 2Prior Conditions. 2objectives, Policies and Targets . . . . . . . . . 3ImplementatLon 5Lessons and Issues... 5

Foreign-Trade Reforms ............. 6Prior CondLtionsdit.n..... . ....... 6

(a) Foreign Exchange Controls and Import Bazriers 6(b) Tariffs . . . . . . . . . * . . . . . . . 9(c) Export Incentives . . . . . . . . . . . . . 11

Reform Measures .................. 12Evaluation and Further Reforms . . . . . . . . . . . 15

C. 8ectoral Surveys . ....... . ........ . . . . 16

Agriculture ............... *......16Prior CondLtLonsi ................ 16Policy Reforms. ..... .. ........ . 17Zvaluation and Further Reforms . . . . . . . . . . . 18

Power and Energy . . . .. ............ . . 19Prior CondLtLonsiti ............... 19PolLcy Reformso. ..... ........... 21Evaluation and Fu:ther Reforms . . . . . . . . . . . 23

Infrastructure.. .. 24Prior Conditions . ............ 24Policy Reforms. .. ............... 27Evaluation and Further Reforms . . . o . . . . . . 30

Financial Sector ...... .......... . 34PrLor Conditions.......... .... . 34Pol$cyReform s ............. . ... 36Evaluation and Further Reforms . 37

Social Sectors . . . . . . . . . . . . . . . . . . . 39Prior Conditions ...... .. .. .. .. .. . . 39Policy Reforms . :... ... ... . 40Evaluation and Further Reforms. .. . . . 42

II. MACROECONOMIC REFORMS . . . . . . . . . . . . . . . . . . . . . . . 46

A. The Stabilization Policy ...... .. .. .. .. .. . . 46

Prior Conditions ....... .. ......... . 46

Major Elements of the Stabilization Policy . . . . . . 47The Foreign-Exchange Rate . . . . . . . . . . . . . 47Fiscal Policy . . . . . . . . . . . . . . . . . . . 49Monetary Policy . . . . . . . . . . . . . . . . . . 50

Impact of the Stabilization Policy . . . . . . . . . . 52

The Policy Change ....... ... .. .. .. .. . 55

Evaluation of the Stabilization Policy . . . . . . . . 58

S. Inherent Macroeconomic Problems . . . . . . . . . . . . . . . 59

Fiscal Issues ........ ... ... .. ... . 60Government Revenues . . . . . . . . . . . . . . . . 60

Government Expenditures . . . . . . . . . . . . . . 61The Budgetary Process . . . . . . . . . . . . . . . 63

Fluctuations in Oil Revenues . . . . . . . . . . . . . 64

Targets and Instruments of Monetary Policy . . . . . . 66

The Real Exchange Rate ................ . 70

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LIST 0P TABLES

Table 1: IMPORT RESTRICTIONS AND AVERAGE TARIFFS BY SECTOR AND

STAGE OF PROCESSING, 1989-91 . . . . . . . . . . . . . . . 10

Table 2: IMPORT RESTRICTIONS AND AVERAGE TARIFFS BY

MANUFACTURING SURSECTOR, 1989-91 . . . . . . . . . . . . . 14

Table 3: RATE OF INFLATION AND THE FOREIGNEXCHANGE RATE, 1970-91 . . . . . . . . . . . . . . . . . . 46

Table 4: NOMINAL AND REAL EXCHANGE RATES, 1988-91 . . . . . . . . . . 48

Table 5: FISCAL ACCOUNTS, 1988-91 (ANNUAL) . . . . . . . . . . . . . . 49

Table 6: MONEY SUPPLY, 1988-91 .51

Table 7: THE RATE OF INFLATION, 1988-91 . . . . . . . . . . . . . . . 53

Table 8: GDP AND ITS MAIN COMPONENTS, 1988-91 . . . . . . . . . . . . 54

Table 9: FISCAL SURPLUS OR DEFICIT, 1989-91, (QUARTERLY) . . . . . . . 56

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PREFACE

The Administration of Fresident P6rez, which assumed power inearly 1989, has introduced several fundamental measures of ezonomic reform andmacroeconomic stabilization. The present study, three years after theintroduction of these policies, is intended to serve as a stock-taking. Itdescribes and analyzes the circumstances under which the policies were adoptedand the nature of the policies as they were announced and implemented. Italso evaluates the achievement of the policies, and indicates the directionsin wwhich policies could be further pursued, improved, or changed. Structuralreforms are discussed in the first part of the study and macroeconomicpolicies are analyzed in the second part.

The first part has drawn on sector work and current sources ofknowledge in the Department. It encompasses the contributions of Malcolm Bale(Agriculture); Bruce Fitzgerald (the Foreign-Trade Regime); Feliciano Iglesias(the Financial Secto, Vladimir Jadrijevic (Power and Energy); Robert Taylor(Privatization and I- tructure); and Cecilia Valdivieso (the SocialSectors). The saca- -t is the work of a macroeconomic evaluation missionthat visited Venezueli .u June 25 to July 5, 1991. Mission members wereBruce Fitzgerald, Felica.dno Tglesias, Mayra Zermeno, and Michael Michaely(Mission Leader and principal author of the report). The analysis also drawson deliberations in a worksh p. on Ver- Aela's macroeconomic policies held inAnnapolis, Maryland, from September 23-24, 1991, and attended by Venezuelanofficials, World Bank staff, ane -ml _l of academia.

A draft of the report was submitted to the Venezuela Government inApril 1992, and discussed with the Government in a seminar held in Caracas onAugust 29-30, 1992. Written comments have also been made subsequently by theGovernment. The Government's concerns are addressed in this revised versionof the report.

Some of the issues discussed in Part II of this report(Macroeconomic Reforms) are analyzed more thorcughly in a study authored bySebastian Edwards, on "Venezuela: Oil and Exchange Rates--HistoricalExperience and Policy options" (Report No. 10481-VE, February 1993).Consulting that report, in conjunction with the present one, would shedfurther light on the issue of the real exchange rate.

ABSTRACT

This report provides an evaluation of the policy changesimplemented by the new administration of President Perez in Venezuela threeyears after their introduction. The pattern mostly followed in the discussion

of each policy &rea is as follows: a description of conditions andcircumstances in the opening position, prior to the introduction of newpolicies; a presentation of the nature of these policy changes; a discussionof the effectiveness of the new policies; and a suggestion of further policyrevisions. The report is presented in two parts: structural reforms in thefirst part, and macro-economic policies in the second.

Structural reforms are discussed under two headings. One is

functional: in this way, two major areas of reform, i.e., privatization and

the reform of the foreign-trade regime, are examined. The other framework issectoral. Under the latter heading the major sectors in which reforms havebeen undertaken are snrveyed: agriculture; power and energy; infrastructure;the financial sector; and the social sectors.

By and large, the report's findings indicate a deep, as well asbroad, process of structural reforms in Venezuela, leading to substantialrationalization of the operation of the economy along with an improvement ofthe Government's handling of poverty and human resources issues. Much,however, still remains to be done, particularly in extending the process ofprivatization to the Government's major enterprises and in strengtheningreforms in the agriculture and the power and energy sectors.

The analysis of the episode of macro-economic stabilizationindicates that the policies undertaken to achieve stabilization were indeedeffective, and a large measure of balance was achieved. These policies were,

however, of a transitory nature, so that in time they were at least partly

reversed. Stabilization is, thus, not entirely assured. The developments of

this episode illustrate several fundamental factors and inherent long-term

macro-economic problems such as the effect of fluctuations of oil revenues,

the low level of non-oil taxation, and some salient implications of the systemfor the country's real exchange rate and its economic structure. Thesefundamental issues, beyond the analysis of stabilization, form part of the

topic of the report's macro-economic discussion.

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EXEuTIVE SUNW&RY

i. For many years, through 1989, Venezuela .ollowed a policy markedby economic insulation and pervasive government intervention in the country'seconomic life. This policy was reinforced in the mid-1970s by the sharpincrease in oil prices--followed, a short time later, by nationalization ofthe oil industry--which handed the government a large share of the country'seconomic resources.

ii. After oil prices collapsed in the early 1980s, many Venezuelansrealized that this model of economic life and development was grosslydeficient. Perceptions of the magnitude of waste, inefficiency, anddistortion created by the government's pervasive intervention undoubtedly wereheightened by the accumulating experience of countries, particularly in LatinAmerica, that had discarded intervention in favor of free markets, withbeneficial results.

iii. In 1987-88, Venezuela, for the first time in its postwar history,faced a severe macroeconomic imbalance. International experience has shownconvincingly that a macroeconomic crisis, which calls for a radical policychange acceptable to the population and the political organization as a whole,is also an opportune time for significant economic transformations. Thereform policy package was adopted in February 1989, immediately afterPresident P6rez assumed office. Since then, the policies of structuraltransformation have been an on-going process rather tnan a one-shot operation.

Structural Reforms

iv. Privatization. During the 1970s and 1980s, successivegovernments in Venezuela followed a development strategy relying heavily onstate control of productive sectors. In addition to traditional publicservices (e.g., water, telephone, electricity), state-owned enterprises (SOEs)dominated many sectors, including petroleum (PDVSA), mining, aluminum, power,and steel. Expansion into these sectors was part of an ambitious design todirect resources generated by petroleum to develop untapped natural resources,and promote import substitution and self-sufficiency. It was initiated in themid-1970s with the nationalization of the oil and iron ore industries,followed by heavy public investment in power, steel, and aluminum. Fundschannelled through the Fondo de Inversiones de Venezuela (FIV), set up toinvest petroleum revenues, were initially provided as loans which, in mostcases, have been converted to equity as a result of the inability of the SOEsto repay them.

v. In comparison with the other measures in early 1989, theprivatization program was slower to develop and initially very modest inscope. In mid-1989, the Economic Cabinet approved a broad SOE rationalizationstrategy, prepared by CORDIPLAN, that categorized SOEs according to the type

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of market (competitive vs. monopolistic) in whicr. they operated and thefeasibility of privatizing them. Privatization in the shorc term was to belimited to small- and medium-sized companies in tourism, manufacturing, agro-industry, and bankino.

vi. In mid-1990, the program was expanded considerably when thegovernment decided to privatize CANTV (the telephone company) and VIASA (theinternational airline). In the case of CANTV, it was recognized that the verypoor quality of telephone service was a significant constraint on thecountry's international competitiveness, particularly in the private sector,and that the expansion and improvement of servica could be achieved onlythrough the sale of a controlling block to an experienced internationa.company. In the case of VIASA, the decision was based on VIASA's mount'losses.

vii. The FIV has a well-developed procedure for privatization: aninitial diagnostic analysis of the company and the sector; design of a salesstrategy; valuation; reparation of a sales memorandum or ptospectus (for apublic share issue); nLe-qualification of potential bidders; and the publictender or share offering.

viii. By the end of 1991, the government had sold its holdings in sevenmajor enterprises: VIASA, CANTV, three commercial banks (Italo-Venezolano,Occidental, Republic), a sugar refinery (El Tocuyo), and a shipyard(ASTINAVE). These transactions yielded approximately US$2.2 billion, with thebulk of this amount (US$1.9 billion) coming from the sale of 40 percent ofCANTV to an international consortium led by GTE. In addition to these sales,the government liquidated the national ports agency (INP), privatized cargohandling and stevedoring, and transferred responsibility for administering theports to new regional port authorities. S.milar privatization initiatives areunderway in housing (INAVI) and in trash collection (IMAU).

Poreicn-Trade Reforms

ix. From 1973 to February 1983, Venezuela maintained a fixed exchangerate of 4.3 bo±ivars to the U.S. dollar that increasingly overvalued thebolivar. Early in 1983, a series of currency crises was resolved byintroducing a multiple exchange rate system that prevailed through early 1989.A free market rate applied to nontraditional exports, tourism, and capitaltransfers. From 1984-88, this rate ranged from 60 percent to 200 percentabove the official rate.

x. A pervasive system of noi-tariff barriers reinforcing a highlevel of tariffs had served as the e tctive constraint on imports. For mostitems, a potential importer had first co obtain an import permit from theDevelopment or the Agriculture Ministry that would be granted only if domesticproducers did not object. Importers had then to apply on a case-by-case basisto the Office of the Differential Exchange Rate Regime.

xi. Before the trade reforms of 1989, there were 41 tariff rates, themaximum being 135 percent. Tariffs had been established over the years on acase-by-case basis without guidelines. The spread was great: about a sixth

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of the items attracted tariffs below 1 percent and a fifth above 80 percent.In addition to ad valorem tariffs, 854 items also attracted spacific duties sothat effective rates *ere as high as 940 percent. Tariff rates by sector andstage of processing hat. the cascading pattern (high for final goods, low forinputs and capital goods) typical of import substitution. Tariff rates foritems restricted by NTBs were higher than for those freely importable. Therewere also large differences 'n average tariffs among the manufacturingsubsectors.

xii. To offset the strong ant-export bias inherent in the importzegime and the overvalued exchange rate, the government offered three exportincentives: the bono de e-vortaci6n, a subsidy to non-traditional exporterspaid as a percentage of tk.Ar export receipts; a currency retention scheme;and subsidized credit for exporters through FINEXPO.

xiii. The policy reforms in February 1989 amounted to a radicaltransformation of the trade regime. In intensity--measured by the extent ofthe changes and the speed with which they were introduced--they rank at thetop, whether in Latin America or in the world as a whole, in recent years.The cornerstone of the reform policy was the unification and floating of theexchange rate. Along with this change came the abolition of foreign-exchangecontrols and, thus, of a major device for import rationing and rent seeking.Import prohibitions and licensing have been sharply reduced, today protectingonly about 2 percent of domestic produc ion, well within the government's goalof no more than 5 percent in the medium term. The greatest incidence of QRsremains in agro-industry. Tcriffs, too, have been lowered substantially. Thetariff code for the manufacturing sector has been restructured to afford eachline of production roughly the same protection. The level and range oftariffs have been cut substantially. The average rate has been reduced from37 percent to 16 percent, with consumer goods--at 33 percent--continuing to besubject to the highest rates. The maximum tariff has been lowered from i35percent to 80 percent and then to 50 percent, and the government's announcedtarget is to reduce it to 10 to 20 percent by 1993. Discretionary tariffexonerations have been eliminated. However, exemptions established by lawremain for some entities such as state-owned enterprises, universities, andthe central government.

xiv. The reforms have been wide and deep and must lead to majoreconomic benefits. The government, to date, has maintained an admirabledegree of uniformity in the treatment of economic sectors, and has replacedthe system of QRs, ad hoc protection, and costly export subsidies with asystem that--when fully implemented by 1993--will use effective exchange ratemanagement in place of import substitution or export promotion. Moderatetariffs--between 10 and 20 percent--will provide additional protection forimport-competing domestic producers, leaving a residual anti-export bias afterexport subsidies have been eliminated.

Maior Sectoral Reforms

xv. Agriculture. Between 1984 and 1988, the government attempted tomaintain high producer prices and profits while maaintaining low and stable

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consumer prices. Imports and exports were restricted. The critical elementof the policy was that government resources would subsidize producer pricesuntil inefficiencies in the sector were rectified and the productive capacityexpanded.

xvi. The policy was unsustainable and could not have logicallyachieved the coal of removing inefficiencies in the sector. It resulted inhighly distorted relative prices and extensive government intervention. Italso entailed huge subsidies. By 1987, these were estimated at almost US$1billion a year, equivalent to about one-third of agricultural value added and2 percent of GDP. In addition, the policy failed to keep retail and wholesalefood prices low and stable. The attempt to increase resources for privatesector investment in agriculture through subsidized credit have had negativeeffects on the financial sector. Agricultural portfolio requirements anddirect credit subsidies have contributed to the underdevelopment andinefficiency of financial institutions, while poor loan repayments havebankrupted one public sector institution (BANDAGRO) and left two others (FCAand ICAP) in a critical sitiation. Further, leakages of subsidized credit tonon-agricultural activities have partially defeated the purpose of theprogram.

xvii. Unifying and floating the exchange rate has been crucial foragriculture. So were other changes in the foreign-trade regime. Since July1990, prior licensing for most agricultural commodities, with the importantexception of feed grains and poultry, have been removed. A transparent priceband mechanism for wheat, rice, white corn, oilseeds, yellow corn, and sorghumhas also been implemented to stabilize domestic prices and provide additionaltariff protection for these key commodities. Export controls on rice,legumes, and cornmeal have also been ended.

xviii. Administered producer prices have been discontinued except forccmmodities still subject to import licensing. Most agricultural inputsubsidies have besn ended, except for irrigation and fertilizers. Irrigationfees cover only about 1-2 percent of the cost of irrigation. The subsidy onfertilizers was significantly reduced in 1990. All domestic wholesale priceshave also been deregulated. The twelve food items initially subject to pricecontrols were first reduced to five, and more recently to one (sardines).

xix. Several measures have liberalized interest rates and creditallocations to agriculture. But major steps are still required to achievefull liberalization of finance in the sector. Another sphere in which evenless has been done is irrigation. The planned phasing out of water subsidieshas been very slow, and at the present rate is unlikely to achieve full costrecovery in the foreseeable future.

xx. Power and Energv. Power prices in the past decade have notreflected the cost of service and have resulted in an unsatisfactory generalrate level and distorted tariff structure. This policy has had two adverseconsequenc-s: (i) it has compounded the financial difficulties of theutilities and increased their dependence on government contributions; and (ii)it has sent distorted signals to the consumer, promoting waste and inefficient

use. A pricing policy that rationalizes the tariff structure and increases

prices to the level of costs is needed.

xxi. The reforms have been directed att (i) reducing the dominance of

the public sector through restructuring and privatization; (ii) increasing

operational efficiency; (iii) providing a strong central institution to review

and coordinate expansion plans, investment programs, and other activitiesrelated to the sector; and (iv) establishing a rational pricing system based

on long-run marginal cost criteria aimed at improving the economy's efficiency

and reducing government transfers.

xxii. At the start of the reform program, the price of gasoline was

increased significantly. Yet, even today, it is less than US$.30 per gallon--still among the lowest in the world. By comparison, the internationalwholesale price in the Caribbean market is about $.6C-.70 per gallon; anddomestic prices in European countries are about $2 per gallon. It appearsthat the government is no longer adhering to an original adjustment schedule,which was supposed to raise prices to their full opportunity costs.

xxiii. InfrastrMeture. Reforms have been undertaken in the sector's

major subsectors: telecommunications, ports, shipping, water supply andsanitation, interurban transport, and urban transport.

xxiv. The reform of telecommunications has four components, of whichthe principal component has been the privatization of CANTV through the salein November 1991 of a control block of 40 percent of its shares to aninternational consortium led by GTE for US$1.9 billion. Ali additional 11percent has been sold to the employees. Other reform measures are: theinjection of limited private competition in cellular telephones; theintroduction of a new tariff structure, with telephone rates progressivelyadjusted to cost levels; and the submission to Congress of a Telecom Law thatestablishes a new regulatory regime and introduces greater private investment

and competition.

xxv. In early 1990, the government decided to undertake the followingreforms in ports: the dissolution of INP and the dismissal of all INPworkers; the establishment of regional port authorities to oversee the ports

(with the commensurate transfer of responsibility for ports administration tostate governments); and the operation of all ports by the private sector underconcession agreements. Consulting firms and auditors were hired to design thenew ports regime and prepare the dissolution of INP. By the end of 1991, muchof the reform program had been completed.

xxvi. Over the past 12 months, the government has implemented a numberof measures to liberalize shipping and increase competition. Numerous

restrictions faced by importers and exporters have been eliminated, including

those pertaining to transshipment, opening new routes (and route extensions),

and use of CAVN for shipments financed through letters of credit. A number of

regional and bilateral agreements have eliminated cargo reserve requirements,

allowing shippers freedom of choice in selecting a carrier.

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xxvii. In water supply and sanitation, the government launched a far-reaching restructuring strategy in mid-lS90 aimed at liquidating the nationalagency, establishing autonomous and financially self-sufficient regional watercompanies, and, where feasible, privatizing operations through concessionagreements with private operators. Progress, however, has been slow.

xxviii. In inter urban tranLnortation, the main objectives are todecentralize the management of rural roads and to establish a national roadfund. The fund will be financed by new taxes on petroleum products earmarkedfor the rehabilitation and maintenance of the national highway and ruralfeeder road networks.

xxix. In July 1990, a steering group was formed under theInterministerial Commission on Urban Transport to determine objectives andpriorities, to make recommendations on the sector's institutional andregulatory frameworks, to evaluate policies, and to formulate a strategy forthe short aiid medium terms. A review of tariffs and subsidies has beencompleted, and studies have been launched on financing mechanisms,institutional arrangements (particularly the roles of the various governmentallevels), and options for expanding urban transport to the poorer areas on theoutskirts of Caracas.

xxx. The Financial Sector. Until the reiorm, interest rates weresubject to ceilings. As a result, real interest rates were mostly low and,particularly with the acceleration of inflation in the second half of the1980s, often negative. New liquid assets were formed to circumvent theregulations that made real interest rates on deposits negative (these assetsare not subject to reserve requirements).

xxxi. Beyond the segmentation created by the existence of numerouspublic credit institutions with power to determine rates and conditions ofloans, there were portfolio requirements for private banks. Commercial bankswere subject to a 22.5 percent lending portfolio requirement for agricultureand agro-industry. Interest rates for these loans were required to be belowmarket rates. A particularly serious problem is the weak financial positionof some institutions, which makes insolvency likely. Mortgage banks and S&Lsare experiencing major financial problems because of the mismatch between thematurity and rate structure of their assets and liabilities. Multiplegovernment-sponsored programs that finance housing have made most of theseinstitutions highly dependent on subsidies to survive.

xxxii. The objectives of the financial sector reform are: (i) toliberalize the financial policy environment (interest rates, allocation ofcredit, foreign ownership, universal banking, etc.); (ii) to reduce the roleof government in financial intermediation (by privatization and liquidation ofpublic banks, consolidation of DFIs, rationalization of housing financepolicy, etc.); (iii) to limit the role of the BCV to providing liquidity andto monetary management; (iv) to improve the supervision and handling of bankcrises; and (v) to increase competitiveness in banking.

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xxxiii. In April 1990, the BCV issued an order setting the minimumdeposit rate at 10 percent and the maximum lending rate at 60 percent forcommercial and mortgage banks, finance companies, and S&Ls. The spreadbetween these limits allows sufficient scope for market determination ofinterest rates at prevailing inflation rates. The policy is to increase thelending rate ceiling and to decrease the limit on deposit rates as soon asthey become binding. The limits have not yet required further change.

xxxiv. Several laws have been sent to Congress to regulate the CentralBank, the SBIF, FOGADE, the Industrial Credit Fund (FONCREI), and theAgricultural Credit Fund (FCA). If approved, these laws will provide therequired framework to support the objectives of reform.

xxxv. The Social Sectors. Venezuela's per-capita income is amcngst thehighest in Latin America. But a highly skewed distribution of income leaveslarge segments of the population in poverty they are unlikely to escape.Infant mortality rates have fallen substantially since 1965 (from 65 per 1,000to 36 per 1,000 in 1988), but still remain double those of Jamaica and CostaRica, which have half the per capita income. Similarly, although schoolenrollments have increased rapidly over the same period, gross secondaryschool enrollment is only two-thirds that of Uruguay, Argentina, and Chile.

xxxvi. Previous anti-poverty programs attempting to redistribute incomethrough general food subsidies and free social services failed despite highexpenditures. The main beneficiaries of food subsidies tended to be themiddle and higher income groups, who could afford to buy greater quantities ofsubsidized goods. While social services were presumed to be universal andfree of charge, poor management and inefficient investment left manyb--neficiaries out of reach of service delivery.

xxxvii. In 1989, the government replaced general food subsidies withprograms specifically for lower-income groups and expanded existing programsthat target the most vulnerable members of society. These actions weredesigned to shield the poorer segments of the population from the adverseeffects of structural adjustment and to overcome past deficiencies intargeting, coverage, and administration of selected social services. Thegovernment has undertaken a huge effort in this area: the resources budgetedfor these programs in 1992 surpassed US$700 million.

xxxviii. The new strategy emphasizes a shift from general subsidies toprograms benefiting lower-income groups. Its principal objectives are to:(i) relieve the severe hardship resulting from economic decline; (ii) mitigatethe impact of adjustments in the economy necessary to achieve sustainable,long-term growth; and (iii) set the basis for human capital development, anessential factor of growth with equity. Other elements of this strategy areto improve the planning and monitoring capacity of participating ministriesand to increase the efficiency of service delivery.

xxxix. To increase the cost effectiveness of social expenditures, thegovernment has emphasized three principles in the selection of projects: (i)increased targeting of the poor; (ii) decentralization of design and

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management; and (iii) greater participation of the private sector (both for-profit and non-profit) in service delivery.

xl. Four social programs form the core of the poverty alleviationstrategy: (i) a nutritional grant program consisting of a direct cash subsidyto families of school children in low-income areas (Beca Alimentaria); (ii) amaternal-child health care and feeding program aimed at expanding primaryhealth coverage and improving health service delivery through fooddistribution to vulnerable groups seeking preventive health care (i.e.,primarily pregnant and nursing women and children under six years of age);(iii) Hogares de Cuidado Diario (HCD), a community-based day care programdirected at children of working mothers in low-income neighborhoods; and (iv)a preschool expansion program targeted to poor rural and urban areas.

Evaluation and Recommendations for Further Reforms

xli. Overall, Venezuela's program of structural reforms has been mostimpressive. Radical new policies have been introduced, on a massive scale,and implemented rapidly and without wavering. Within three years, the natureof the operation of most sectors, and in particular the role played bygovernment intervention, have gone through a massive transformation.

xlii. Needless to say, not everything could be accomplished within ashort time. Much is still left to be done--more in some sectors or aspects ofeconomic life, less in others. Of the territory yet to be covered, muchprogress is still contemplated by the Government of Venezuela. In thefollowing, we shall refer to the main changes that still have to beintroduced, whether or not they already are on the agenda of further action ofthe Government.

xliii. The privatization process, slow at the start, has gatheredmomentum and acquired substantial proportions with the sale of, inter alia,VIASA and CANTV. At present, the extension of the process into the majorareas of government-owned enterprises should be contemplated. Specifically,the privatization of the CVG conglomerate of industrial and mining enterprisesshould be the next major step. Privatization of PDVSA cannot be carried outin a single step, given the company's huge size; but a gradual process of saleof shares, rather than of the company as a whole, could be started.

xliv. Probably the most far-reaching transformation has been achievedin the trade reaime. Here, avoiding any reversal is probably more importantthan the achievement of any specific target of further reforms. Among thelatter, three measures would be particularly significant: the abolition ofremaining non-tariff barriers to imports in the agricultural sector; theelimination of remaining tariff exemptions; and the encouragement of privatecredit markets for exports, to replace the subsidized government finance.

xlv. The agriculture sector has adjusted well to the reform process,with the output mix responding to the changes in relative prices and to thelarge measure of removal of protection. But reforms in this sector, whilesignificant, have not gone far enough. The most important further steps whichshould be undertaken are: complete elimination of import licensing and

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minimum-price programs--a step the Government plans to take over the next twoyears; phasing out of price-stabilization schemes; elimination, as theGovernment indeed plans, of the fertilizer subsidy; elimination of governmentmarketing and divestiture of its storage facilities; deregulation ofagricultural credit; increase (in fact, introduction) of water charges inirrigation schemes to cover full costs; and land reform, to establish clearerentitlements and property rights.

xlvi. In the sector of Dower and_enerav, while some prices have beenliberalited in the 1989 reform, inadequate prices remain a key issue forpetroleum, electricity, and gas. Likewise, the progress towards privatizationhas been minor. Thus, the two areas of required reforms are, first, theestablishment of prices at the levels of long-run marginal costs--a policy towhich the Government is committed in principle, and which it expects tointroduce gradually; and Pt least a beginning of a gradual, long-tern. processof privatization of activities in the production and distribution ofpetroleum, gas and electricity.

xlvii. In the infrastructure sectors, the greatest progress has beenachieved in telecommunications, with the privatization of CANTV. In oorts,the dissolution of the INP and the transfer of all cargo handling andstevedoring to private forms have already had a dramatic impact on efficiency.Further important reforms would be the granting of concessions to privatefirms for operation of entire ports or individual terminals, allowingcompetition both between ports and within large ports. In water supplv andisanitation, important decisions have been made, but implementation has beendelayed. The actions required now are, primarily, the enactment of a newwater sector law; the development and implementation of a new structure ofwater tariffs; the liquidation of INOS, transferring its assets to the newregional water companies; and the transfer of the Caracas water system to aprivate operation. In the inter-urban transoort sector, the required reformsconsist, first, of establishing appropriate prices--of petroleum, or of roaduses. A concession program should be established for private sectorconstruction and operation of expressways. Finally, in urban transport, therecommended agenda for further reforms should include: the deregulation ofthe bus system--particularly of fares; the replacement of generalizedsubsidies by targeted subsidies; the strengthening of agencies involved inurban transport; and a redefinition of the roles of the public and privatesectors in the provision of passenger services within Caracas.

xlviii. The financial sector has witnessed impressive reforms:establishment of proper rules for a competitive banking system, limitingsegmentation and allowing foreign investment; privatization of banks;establishment of a much higher degree of independence of the Central Bank fromthe Treasury; and equipping the Central Bank with a new set of instruments.Almost all further required reforms are included in legislation alreadysubmitted to Congress. When enacted, these laws would provide further openingof the commercial-banking system to foreign participation; solutions to themain problems of the housing finance system; restructuring of the network ofS&Ls, now badly ailing; and a redefinition of the legal and regulatoryframework of the insurance sector and of capital markets.

xv -

xlix. In the social sectors, finally, a lot has been accomplished, overa wide front. The government has shifted from highly inefficient generalizedsubsidies, available to the entire population, to directly-targeted programsbenefiting those most in need. This strategy represents a serious effort toaddress the issue of poverty both efficiently and equitably. Many problemsremain, though, including: highly centralized management, despite seriousdecentralization efforts; expenditures skewed towards higher-cost, inefficientuses of allocated resources; lack of targeting mechanism or sufficient data toidentify target groups; insufficient attention to design and to deliverymechanisms; and inappropriate or inadequate technical skills in the operationof social-sector programs. All these issues should be addressed, within arevised version of the Government's poverty-alleviation strategy. Inaddition, in all social- sector activities encouragement should be offered tothe use of both for-profit and non-profit private-sector mechanisms fordelivery of social services.

Macroeconomic Reforms

1. The Stabilization Policy. Venezuela has had continuous inflationsince the first major oil-price increase of 1974. Until the late 1980s,however, it was moderate and rather stable, with an average annual rate of 11percent (from 1974-86) and not much variation except for a jump following thesecond oil-price increase of 1979.

li. From 1986-88, however, economic policy became heavilyexpansionary. Public-sector investment jumped from 7.7 percent to around 12percent of GDP in 1987-88, and the budoetary deficit grew to 7.2 percent ofGDP. By early 1988, the inflationarv process had gathered momentum. By thesecond half of 1988 and early 1989, the rate of inflation was roughly 4percent per month, or some 60 percent per year. Throughout these changes, thenominal exchange rate remained fixed. A rapid appreciation of the realexchange rate thus took place, with a consequent deterioration in the balanceof payments. Nominal interest rates, too, remained constant (by decree)throughout the process. At the level of 13 percent per year, the realinterest rate thus assumed a high negative value--a factor that furtherencouraged the inflationary process.

lii. The rapid acceleration of inflation and the loss of foreign-exchange reserves created a perception of crisis heightened by capital flightand the foreign-debt burden. It was the recognition of this crisis that ledthe new Administration to make stabilization the cornerstone of reform inFebruary 1989. The three major and closely interrelated components of thestabilization package were: a new foreign-excha;;ge regime, fiscal policy, andmonetary policy.

liii. The Foreign ExchanQe Rate. The change in the foreign-exchangesystem was clearly the key to the stabilization plan. Under the existingmultiple exchange rate system, the principal (official) rate, applying to mosttransactions and especially to oil exports by PDVSA, had been maintained at aconstant nominal value of 14.5 Bs/US$ since December 1986. The exchange rate,now unified and left free to float, increased immediately to 39.3 Bs/US$ by

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the end of February 1989. The nominal devaluation continued throughout 1989,by the end of which the exchange rate reached 43 BS/US$--three times its levelon the eve of the plan.

liv. Fiscal Policy. An increase in revenues from taxes on PDVSA'ssurplus was the predominant element of fiscal change and of the stabilizationpackage as a whole, and is related to the change in the foreign-exchangeregime. Most of PDVSA's income is surplus (i.e., an excess over the cost ofproduction), and most of this surplus, through taxes, constitutes a source ofgovernment revenues, which thus rise with an increase in the real exchangerate. In the event, this rise was dramatic: PDVSA's transfer to the centralgovernment increased from 11.4 percent of GDP in 1988 to 20.5 percent in 1989.A somewhat smaller fiscal improvement resulted from a reduction of thegovernment's capital expenditures. Public-sector investment declined by 2.5percent of GDP--from 13.9 percent in 1988 to 11.4 percent in 1989.

lv. Monetary Policy. Monetary developments largely reflect thechange in the fiscal stance. Having earlier exhibited a very rapid increase,the nominal supply of money (MI) declined by 3.5 percent in the first quarterof 1989, and fell further by 1.4 percent and 2.9 percent, respectively, in thefollowing two quarters. Thus, by the end of the third quarter of 1989,nominal money supply was about 8 percent below its level at the end of 1988.Combined with this change in nominal balances, a very sharp initial increasein prices practically halved real money balances: from the end of 1988 to theend of the third quarter of 1989, real money supply (M,) fell by 47 percent.Interest rates, freed by the plan, increased sharply. The controlled lendingnominal interest rate of 13 percent per year turned into a free rate hoveringat around 32 to 40 percent throughout 1989. During most of the year, thisimplied a slightly negative real interest rate; but it represented,nevertheless, a very sharp increase of the real rate.

lvi. Impact of the Stabilization Policy. The higher exchange ratetranslated into higher prices of tradable goods; combined with the increase ofpublic-sector prices, the elimination of subsidies, and the removal of pricecontrols, this led to a massive increase in the price level. This one-timejump in prices should not be confused with an acceleration of inflation. Theprocess of inflation clearly had been checked. While the monthly increase inconsumer prices averaged around 5 percent during the last quarter of 1988, itwas only about 2 percent in the last quarter of 1989. In terms of annualinflation rates, this is a reduction from about 80 percent to 27 percent. Asharp decline of real activity accompanied this process. GDP fell by 8.6percent from 1988 to 1989 (by 9.4 percent if the petroleum sector isexcluded).

lvii. The Policy Change. Towards the end of 1989, and certainly byearly 1990, the restrictive macroeconomic policy was discontinued. When"budgetary deficit" is properly defined, a deterioration of the fiscal stanceof the order of 3 percent of GDP appears in 1990. The turning point fromsurpluses to deficits occurred in early 1990. Not surprisingly, thiscoincided roughly with the changing real exchange rate, which first stabilizedand by the summer of 1990 began steadily to appreciate. The trend in the

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norninal money supply (MI) also changed. In the last quarter of 1989, moneyincreased by about 26 percent (an annual rate of 152 percent). During 1990 asa whole, nominal money supply increased by 43 percent, in contrast with a fallof 8 percent during the first three quarters of 1989. The real interest ratepeaked in the last quarter of 1989 and the first quarter of 1990--the onlyextended period in whicl. it was generally positive (within a range of 5-10percent per year). From then on, nominal interest rates have declined whileinflation has not, so that real interest rates generally have been negativeand declining.

lviii. The impact of tle policy change was almost immediate. Inflation,which had been weakening, stabilized at an average monthly rate of around 2percent during the last quarter of 1989 and the first quarter of 1990. Fromthen on it accelerated, moderately, remaining at an average monthly level of 3percent throughout the second half of 1990. During 1991, it was in the rangeof 2.5-3.0 percent. Real activity too responded to the policy change andalmost as fast. GDP, and particularly its private-sector component, startedincreasing in the second quarter of 1990, rising in 1990 as a whole by 5.3percent (3.7 percent without the oil sector) from 1989. Unemployment, whichincreased from 6.9 percent in the second half of 1989 to 10.9 percent in thefirst half of 1990, declined somewhat to 9.5 percent in the second half of1990.

Inherent Macroeconomic Issues

lix. Government Revenues. Aside from oil revenues, derived from thetax on the PDVSA surplus, government revenues are amongst the lowest in theworld, just 5-6 percent of GDP. Essentially, oil revenues have replaceddomestic taxation as a means of financing both current and capitalexpenditures.

lx. A strong case could be made to justify the increase of non-oilrevenues. First, at present levels of oil exports (volume and price), and ofgovernment expenditures, a substantial gap exists between revenues andexpenditures - the latter exceeding the former by some 4-5 percent of GDP.Second, even if such gap had not existed at present, it may be expected in thefuture: given the constraints on oil exports, government revenues may beexpected to rise, as a trend, less than its expenditures. Finally, it mightbe argued that the assignment of oil revenues is inappropriate: that insteadof financing public current expenditures, as they have all throughtout, theyshould have been used to increase the economy's capital stock, whereas publicconsumption services should be financed through taxation. To the extent thatthis argument is accepted, it would call for gradually increased taxation,although probably not to the extent needed for the full replacement of oilrevenues, and a corresponding increase in the assignment of governmentresources for investment; that is, an increase of the government's saving.

lxi. This should not be confused with an increase in the government'sown investment through state enterprises--a direction which the Government ofVenezuela is indeed reversing following its large-scale privatization effort.The increased government saving rather should be directed to Drivate-sector

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investment, through the placement of the government's resources in the capitalmarket.

lxii. It is evident that the existing tax structure could yieldsubstantial additional revenue through improved tax administration, theclosing of loopholes, and the reduction of exemptions. Beyond this, there arethree main candidates for raising the level of net taxation: (i) domestic oilprices, which even after they were raised in early 1989, are still among theworld's lowest and contain a large implicied subsidy; (ii) other public-sectorprices, which still imply large subsidies in various government-provided goodsand services, especially electricity and water; (iii) a value-added tax (VAT),a major government objective during the last two years. Altogether, tCesethree changes could yield a revenue of over 5 percent of GDP.

lxiii. Fluctuations in Oil Revenues. Oil revenues are highly volatile,primarily because of changes in oil prices. Ideally, the government shouldadjust its spending to changes in permanent income, rather than to transitorychanges. Failure to behave according to this pattern would lead to twocomplementary scenarios. One is that the government adjusts its spendingcontinuously to the fluctuations in revenues, opening the way to cycles ofinflation and recession. The other is the well-known "ratchet" effect, wheret' e government matches expenditures to increased oil revenues and maintainsthis higher level of spending even when oil revenues fall, thereby creating afiscal deficit or reinforcing an existing one.

lxiv. An oil stabilization fund should be of prime importance foreconomic policy and a vital condition for the long-term maintenance ofmacroeconomic stability. This fund should perform the following functions:(i) it should establish a formulation for identifying the permanent level ofoil revenues for any given year; (ii) each year it should transfer to thegovernment an amount equal to this permanent level; and (iii) it should investany excess after the transfer in foreign exchange, and draw on its foreignassets if there is a deficit.

lxv. Taraets and Instruments of Monetary Policy. The Central Bank hasa potentially inconsistent set of targets: the level of foreign-exchangereserves; the rate of expansion of the money supply; and, often, the nominaland the real rates of exchange. Both the nominal and real rates of interestari also considered targets. Until recently, the Central Bank attempted tocontrol not money supply but the monetary base. In the absence of a portfolioof government bonds, it does not conduct open-market transactions ingovernment paper. The monetary base is thus determined as follows: A netacquisition of foreign exchange is offset to the desired degree by an open-market sale of the Central Bank's own short-term paper (the zero-coupon bond).This practice has serious implications. To the extent that the rate ofinterest on the paper (deflated by the rate of devaluation) is higher than therate of interest on the foreign-exchange holdings, a fiscal liability iscreated. Even more important is that the paper acquired by the public throughthese sales is liquid enough to be a very good substitute for money.

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lxvi. There should be just one target for monetary policy: the moneysuoplv. As the system's anchor, it would ensure a stable and low rate ofinflation, given appropriate targeting. of course, a stable and low rate ofexpansion of the money supply presupposes the government has no need toborrow.

lxvii. The Central Bank would determine money supply by the use of threeinstruments that affect either the monetary base or the money multiplier:open-market operations; changes in minimum-reserve ratios; and the discountwindow. In principle, the number of such instruments can be increased asinstitutions develop. In conducting open-market operations, the Central Bankcould add transactions in securities other than its own zero-coupon bonds;specifically, PDVSA bonds may be introduced. As a rule, at least some use ofchanges in minimum-reserve ratios as an instrument of controlling money supplywould be beneficial, although not for fine-tuning through continual smallchanges of monetary aggregates. Rediscounting by the Central Bank iscertainly an effective instrument to control the monetary base and the moneysupply, and its recent use bears repetition.

lxviii. Exchanae-Rate Policy. Whether or not the real exchange rateshould be managed is probably the central issue of macroeconomic policy inVenezuela. There is a strong argument to allow the rate to be determinedstrictly by market forces, which would ensure maximum levels of efficiency andproduction and the highest rate of growth. The only factor that might justifyintervention is the predominant role of oil exports. It is conceivable thatbecause of it the allocation of resources to maximize production is notnecessarily compatible with the achievement of long-term growth, and that thespecial nature of the oil industry denies the country the benefits of theexternalities generated by tradable activities.

lxix. This case is not easy to establish. The government will have tomake a policy decision based more on speculation than on information andquantitative analysis. But the important point is that, if the principle ofdiversifying exports is adopted, the real exchange rate would be the bestinstrument of policy implementation. An exchange-rate policy would uniformlyencourage exports as well as import-competing activities, thus ensuringmaximum efficiency.

lxx. Raising the real exchange rate would require creating, orexpanding, an excess of saving over domestic investment by increasing thebudgetary surplus. This surplus would finance an accumulation of foreign-exchange reserves, which in turn would reflect a current-account surpluscreated by the increased real exchange rate. Without an accompanyingbudgetary surplus, any attempt to increase the exchange rate throughintervention in the foreign-exchange market would lead to a rise in thenominal exchange rate, followed shortly by a nearly equivalent rise indomestic prices, with only a very limited impact on the real rate of exchange.

lxxi. However, the unique position of oil revenues in Venezuela'seconomy, leads automaticallv to the creation of a budgetary surplus by an

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increase in the real exchange rate. This is the essence of the earlierdiscussion of the nature of the stabilization policy of 1989. Since thegovernment, through PDVSA, is the major supplier of foreign exchange, anincrease in the exchange rate yields increased government revenues and anincreased surplus. It is essential for the government to realize that theincrease in revenues should not be a signal for increasing governmentexpenditures. It should be devoted to creating a budgetary surplus if thereal-exchange rate depreciation is to be sustained. Moreover, this surplusshould not be a temporary phenomenon but a Dermanent feature of the budget.

lxxii. The structural changes resulting from such an exchange-ratepolicy would be a higher real exchange rate leading to the diversification ofnon-oil exports and the creation of a current-account surplus. This surpluswould be reflected in the accumulation of investments abroad. This, in turn,would be offset by a reduction of domestic consumption and investment, withinvestment beiag directed in a pattern quite different from what it would h;-vebeen without a change in the real exchange rate.

It STRUCTURAL REFORMS

A. Introduction

1.1 For many years, through 1989, Venezuela followed a po'i.y markedby economic insulation and pervasive government intervention in the country'seconomic life. This policy was reinforced in the mid-1970s by the sharpincrease in oil prices--followed, a short time later, by nationalization ofthe oil industry--and made the government the major investor in the economyand the major owner of the country's productive wealth. However, theavailability of oil did not explain excessive government interference in theprivate sector through regulation, prohibitions, and discriminatory taxationand subsidization. Nor, a fortiori, did it explain the economic insulation(other than in the oil sector), through widespread import restrictionsenforced by prohibitive tariffs, multiple exchange rates, and non-tariffbarriers. These measures originated from a general belief, held in much ofLatin America until recently, that government knows best; and that governmentintervention, rather than private enterprise, will produce desirable outcomes.

1.2 After oil prices collapsed in the early 1980s, many Venezuelansrealized that this model of economic life and development was grosslydeficient. As the growth rate of an economy used to rapid expansion for manyyears declined sharply, they saw that oil bonuses would not suffice to offsetthe consequences of misguided policies. The volume of oil exports wasrelatively constant, and real oil prices could be expected to keep falling.With the debt crisis of 1982, capital inflows, another source of investmentand growth, were reversed.

1.3 Growing numbers of Venezuelans also began to realize themagnitude of waste, inefficiency, and distortion arising from pervasivegovernment intervention in the country's economic life. They were undoubtedlyinfluenced by the accumulating experience of countries, particularly in LatinAmerica, that had discarded intervention in favor of free markets, withbeneficial results. This experience also reinforced the perception that large-scale economic restructuring was necessary to sustain these benefits.

1.4 In 1987-88, Venezuela, for the first time in its postwar history,faced a severe macroeconomic imbalance (which will be discussed in the secondpart of this study). More than once, international experience has shownconvincingly that a macroeconomic crisis, which makes a radical policy changeacceptable to the population and the political organization as a whole, isalso an opportune moment for significant economic transformations unlikely innornal times. It is thus not surprising that in Venezuela these wereintroduced simultaneously with the policy of macroeconomic stabilization.

1.5 This policy was adopted in February 1989, immediately afterPresident Perez took over the administration. Since then, structuraltransformation has been an ongoing process rather than a one-shot operation;

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it will therefore be discussed with reference to announced policy directivesand their implementation.

1.6 The policy changes will be analyzed by their nature and byeconomic sector, leading in consequence to some repetition in the discussionthat follows. The next section treats of their nature, under Drivatizationand dereculation and foreign-trade reforms. The section following thatdiscusses their impact on the agriculture, power and energy, infrastructure,financial, and social sectors.

B. Malor Areas of Reform

Privatization

Prior Conditions

1.7 During the 1970s and 19808, successive governments in Venezuelafollowed a development strategy that relied heavily on state control ofproductive sectors. In addition to traditional public services (e.g., water,telephone, electricity), state-owned enterprises (SOEs) dominated manysectors, including petroleum (PDVSA), mining, aluminum, and steel (CVG).Expansion into these sectors was part of an ambitious design t directresources generated by petroleum to maintain artificially low prices for keygoods and services, develop untapped natural resources, and promote importsubstitution and self-sufficiency. It was initiated in the mid-1970s with thenationalization of the oil and iron ore industries, followed by heavy publicinvestment in power, steel, and aluminum. Funus channelled through the Fondode Inversiones de Venezuela (FIV), set up to invest petroleum revenues, wereinitially provided as loans, which, in most cases, have been converted toequity as a result of the inability of the SOEs to repay them. By the end of1989, the FIV had equity totalling roughly US$2 billion (book value athistoric costs) in more than 30 SOEs in mining, electricity, basic industries(steel, aluminum), manufacturing (cement, pulp and paper), shipping, andfinance.

1.8 By the end of the 1980s, there were about 125 commerciallyoriented SOEs in Venezuela in the following groups:

* The petroleum sector, including PDVSA (the state-owned oilcompany) and seven subsidiaries in associated anddownstream activities (e.g., natural gas, petroleumdistribution, fertilizers, petrochemicals)1';

* Twenty financial SOEs, including banks, specialized creditagencies, and insurance companies;

PDVSA also has equity in several downstream joint ventures.

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* Fourteen basic industry and infrastructure enterprisesunder the Corporaci6n Venezolana de Guyana (CVG), includingsteel (SIDOR), aluminum (VENALUM, ALCASA, INTERALUMINA),iron, bauxite and coal mining (FERROMINERA, BAUXIVEN, and

CARBOSUROESTE), hydro-electric generation (EDELCA), andother capital-intensive industry and mining operations;

* Fifteen SOEs providing public services (e.g., electricity,water, ports, telephones); and

* About 70 smaller SOEs operating in a variety of sectors

(e.g., tourism, agro-industry, manufacturing), many of them

created under the now-defunct Corporaci6n Venezolana de

Fomento (CVF), an industrial development agency established

in the 1970s.

1.9 There was little private investment during this period. In 1984-

88, SOEs accounted for 22 percent of GDP, 34 percent of investment, and 5

percent of employment. Excluding PDVSA, SOEs accounted for 6 percent of GDP,

23 percent of investment and 3 percent of employment during this period.

1.10 The adjustment measures undertaken by the P6rez government had an

immediate detrimental impact on many SOEs, particularly those functioning in a

highly protected and distorted environment (e.g., SIDOR). The overall SOE

deficit increased from 0.9 percent of GDP in 1988 to 2.0 percent in 1989.Government transfers to SOEs exceeded US$1 billion (2.5 percent) in 1989. It

was in this context that the new government initiated a broad public

enterprise reform program aimed at: reducing the scope of the public sector

in the economy; reducing the fiscal burden of SOEs; improving the efficiency

of key public services; and adjusting prices of SOE goods and services to

economic levels.

Obiectives, Policies and Targets

1.11 In comparison with the other measures in early 1989, the

privatization program was slower to develop and initially modest in scope. In

mid-1989, the Economic Cabinet approved a broad SOE rationalization strategy,

prepared by CORDIPLAN, that categorized SOEs according to the type of market

(competitive vs. monopolistic) in which they operated and the feasibility of

privatizing them. Privatization in the short term was to be limited to small-

and medium-sized companies in tourism, manufacturing, agro-industry, and

banking. Most of these (eg., cement, sugar) were CVF holdings and many were

bankrupt or operating at very low capacity. They were targeted for several

reasons. There was no justification for maintaining state ownership; there

was no need for major restructuring prior to privatization (in terms of

layoffs, debt repayments, and legal or regulatory changes); and privatization

was not likely to engender much labor or political opposition. The larger

SOEs, which were thought to be more difficult to sell, were expected to be

privatized in a second phase.

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1.12 The initial program covered 70 majority and minority holdings,including 34 hotels and tourist facilities, 3 banks, 6 cement and brickcompanies, 16 agro-industrial holdings (sugar, milk products), 3 textilecompanies, 4 metallurgical firms, and 2 shipyards. Together they accountedfor less than 1 percent of SOE assets (roughly US$300 million out of a totalof US$42.6 billion, including PDVSA)V and slightly over 2 percent of SOEemployees (4,350 out of 186,000).

1.13 In mid-1990, the program was expanded considerably when thegovernment decided to privatize CANTV (the telephone company) and VIASA (theinternational airline). In the case of CANTV, it was recognized that the verypoor quality of telephone service was a significant constraint on thecountry's international competitiveness, and that the expansion andimprovement of service could be achieved only through the sale of acontrolling block to an experienced international company. In the case ofVIASA, the decision was based on its mounting losses and the realization thatthe only way to stop the financial hemorrhaging was to sell the company.

1.14 By the end of 1991, the government had sold its holdings in sevenmajor enterprises: three commercial banks (Italo-Venezolano, Occidental,Republic); VIASA; CANTV; a sugar refinery (El Tocuyo); and a shipy1ard(ASTINAVE). These transactions yielded approximately US$2.2 billion, with thebulk of this amount (US$1.9 billion) coming from the sale of 40 percent ofCANTV'/ to an international consortium led by GTE. In addition to thesesales, the government liquidated the national ports agency (INP), privatizedcargo handling and stevedoring, and transferred responsibility foradministering the ports to new regional port authorities. Similarprivatization initiatives are underway in housing (INAVI) and in trashcollection (IMAU).

1.15 During 1992, the government expected to privatize the followingenterprises: (a) fifteen hotels, in three separate bidding packages; (b) fiveout of the six remaining state-owned sugar refineries; (c) the domesticairline (AEROPOSTAL); (d) the Caracas water and sewerage system (through aconcession contract with a private operator); (e) the racetracks (INH);(f) the Caracas cable car and associated Humboldt Hotel; (g) the saltrefineries (ENSAL); (h) a Caracas entertainment park (Poliedro); (i) somesmall CVG and CVF holdings in the cement, metallurgical, textile and dairyindustries; and (j) three regional electricity companies (ENELVEN, ENELBAR andENELCO). The successful privatization of these companies is dependent uponthe establishment of an appropriate regulatory framework for the sector.

2/ SOE data for 1987 (most recent complete year available) showtotal assets (historical cost) of Bs618 billion, or US$42.6 billion equivalentat the then-official exchange rate of Bsl4.5/US$. PDVSA accounted for US$12.3billion equivalent of this total.

3/ Forty percent of the common shares, but with control of the Boardof Directors. In addition, 11 percent was sold to CANTV employees. Thegovernment has retained 49 pes cent, but expects to sell this later via publicshare issues.

1.16 An interministerial commission was established by decree in July1989 to oversee privatization. It is chaired by the FIV President(ministerial ranking) and includes the Ministers of Planning, Finance, andDevelopment (Fomento), as well as representatives of the Confederation ofLabor (CTV) and the Chamber of Commerce (FEDECAMARAS). The FIV acts assecretariat to the commission and manages the program. A new law passed byCongress in Devember 1991 formally transforms the FIV into the government'sprivatUation and restructuring agency and calls for the phased elimination ofgovernt'ent transfers to the FIV.W In addition to the FIV Law, Congressrecently passed a Privatization Law formalizing the policies andimplementation procedures for the program.

1.17 The FIV has a well-developed process for preparing andimplementing privatization, which includes the following steps: an initialdiagnostic analysis of the company and the sector; design of a sales strategy;valuation; preparation of a sales memorandum or prospectus (for a public shareissue); pre-qualification of potential bidders; and the public tender or shareoffering. Consulting firms and investment banks are hired for the technicalwork. Virtually all of the privatizations to date have been via sealed bidsthat are opened in public. All transactions have been on a cash basis (i.e.,no debt-equity swaps or installment payments). The major transactions havealso included employee share ownership programs.

Lessons and Issues

1.18 Several lessons can be drawn from the privatization experience todate:

* privatization has been most rapid inthose enterprises where new managementwas brought in to implement the changes(e.g., CANTV, VIASA and INP);

* consensus with the political parties and labor unions isimportant. In this context, FIV management indicated thathaving labor and business representatives on theprivatization commission ensures that all issues arediscussed at an early stage; and

* in more complex cases, privatization needs to beaccompanied by broader reform of the sector to ensurecompetition and economic efficiency (see infrastructurechapter ir paras. 1.111, 1.112 and 1.114 for a discussion

4/ Under the original legislation that created it, the FIV receives5 percent of the government's petroleum revenue. Under the new law, this willbe phased out as follows: 3 percent in 1992, 2 percent in 1993, 1 percent in1994, and zero thereafter.

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of competition issues in the telecommunications and portssectors).

1.19 Two issues have emerged at this stage: the scope and directionof the program for the medium term; and the handling of redundant labor.

(i) ScoRe. The successful privatization of CANTV has generatedpublic support and foreign investor interest in theprogram, making this an opportune time for the governmentto consider privatizing CVG's industrial and mining SOEs(e.g., SIDOR, ALCASA). This would confirm the government'sintent to reduce public sector participation in productionactivities (where direct ownership no longer serves anypublic policy objectives), provide the needed capital forsector expansion, and eliminate government support, eitherdirectly (through loans, equity, or transfers) orindirectly (through loan guarantees), for these companies'ambitious investment programs. It would also improveefficiency and performance through the introduction ofprivate management and shareholders.

The phased privatization of PDVSA and its subsidiariescoulz' also be considered, though this would clearly be morecontentious and would also face constitutionalrestrictions. The example of Petro-Canada may beinstructive. The Canadian Government initiated a phasedprogram to privatize Petro-Canada via a series of publicshare issues, giving Canadian citizens the feeling that theCanadian public owns Petro-Canada. A similar strategy maybe possible for PVDSA.

(ii) Labor. Although more than 20,000 workers have been laidoff in SOE restructurings and liquidations (e.g., ports),there have been no workforce reductions prior to the saleof companies being privatized. Most sales have requiredthe new owners to honor existing collective contracts.While this strategy has bought labor peace for theprivatization, it may lead to future labor strife when thenew owners seek to shed excess labor. Labor problems havealready arisen in VIASA (a pilots' strike in December 1991)and, to a lesser degree, in CANTV (a threatened sympathystrike). The government's position has generally been thatthe problem of excess labor (of which bidders were fullyaware) is better handled by the private sector.

Forei$n-Trade Reforms

Prior Conditions

(a) Foreion Exchange Controls and Import Barriers

1.20 A pervasive system of non-tariff barriers reinforcing a highlevel of tariffs had served as the effective constraint on imports prior tothe reform.

1.21 From 1973 to February 1983, Venezuela maintained a fixed exchangerate of 4.3 bolivars to the U.S. dollar that increasingly overvalued thebolivar. Early in 1983, a series of currency crises was resolved byintroducing the multiple exchange rate system that prevailed through early1989. Initially, an exchar.ge rate of 4.3 Be. per U.S. dollar was set for thepetroleum sector, essential imports, and foreign debt service; an officialrate of 6.0 Bs. applied to most commercial transactions; and a free marketrate applied to nontraditional exports, tourism, and capital transfers. Theofficial rate was raised to 7.5 Bs. in March .;984 and to 14.5 Bs. in December1986, and there were numerous shifts of items among categories. At one pointthe system included four rates: 4.3 Bs. for foreign debt; a 6.0 preferentialrate; the 7.5 official rate; and the free market rate. From 1984-88, the freemarket rate ranged from 60 percent to 200 percent above the official rate,averaging 110 percent. In February 1989, the multiple rates were unified andthe exchange rate was floated.

1.22 For most items, a potential importer had first to obtain animport permit from the Development or the Agricultural Ministry that would begranted only if domestic producers did not object. Since tariffs wereprohibitive, the importer had to apply for the tariff to be reduced to areasonable level.

1.23 Importers had then to apply on a case-by-case basis to the Officeof the Differential Exchange Rate Regime (Oficina del R6gimen de CambiosDiferenciales, RECADI) or its successor organization (commonly called ex-RECADI). The procedures changed frequently, there were no clear criteria fordecisions and the priorities were general: (1) food and medicines; (2) rawmaterials; (3) intermediate goods and CKD kits; (4) capital goods; and (5) allothers.

1.24 From 1983-88, the most heavily subsidized commodities through theexchange rate were food and raw materials, and the most heavily taxed wereconsumer goods--particularly luxuries--and alcoholic beverages. Capital goodsand transportation equipment were taxed about equally. This pattern of taxingconsumer goods and subsidizing inputs was intended to protect domesticproduction. Industry was given greater protection than agriculture, but bothagricultural inputs and food imports entered at favorable rates, so thateffective protection was generally minimal and, in cases, could even have beennegative. For example, in 1984 and 1985, agricultural inputs entered at anaverage exchange rate of 5.0 Bs. and 6.2 Bs. and basic foods at 4.6 Bs. and5.2 Bs., respectively.

1.25 It is difficult to estimate the benefits rendered by RECADI fromexisting data, but it is clear that they were large. For all imports, thebenefits averaged nearly 15 percent of GDP; and for the imports where RECADIexerted the greatest discretion, benefits averaged 6 percent of GDP. Whilethe government's goal was to reduce consumer prices, the benefits may actually

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have gone to importers, distributors, or domestic producers. The market pricefor any given item could have been determined by the exchange rate, thelicense, a reduced tariff, or price control.

1.26 In 1982, the import of 1 percent of the items in the tariff codewas prohibited, and 6 percent required a license. The remaining 93 percentwere either freely importable or required a health permit. This changedabruptly in 1983, when imports of 8 percent of the items were prohibited and34 percent were reserved for import by the government and required a license(a delegation of the government's right to import.) By the time of the1989 trade reform, 11 percent of tariff items were on the prohibited list, and29 percent required licenses or delegations (see Table 2).

1.27 Depending on the item, import permits were granted by theDevelopment Ministry, the Finance Ministry, or the Agriculture Ministry.Importers often had to give the Development Ministry a "letter of noobjection" from the producers, association stating that the domestic industrywas unable to produce the items in the quantity to be imported. The importlicenses the Development Ministry issued generally exceeded the foreignexchange budget the Finance Ministry administered, so that, effectively, bothministries administered industrial policy. The system of import permits wasalso used to establish de facto import monopolies for state enterprises insteel, aluminum, and petrochemicals. For example, only SIDOR could importsteel, regardless of whether or not it produced competing items.

1.28 To approximate the domestic production covered by NTBs, an indexwas developed by weighing 1987 production levels (at the four-digit ISIClevel) with the percentage of tariff items, under each classification,produced in each sector. These numbers, aggregated to the two-digit ISIClevel, are shown in Table 1 and indicate that before the 1989 reforms, 17percent of domestic manufacturing was protected by import prohibitions and 33percent by licenses, 6 percent required a health permit,W and 43 percentwere free of NTBs. Combining this index with the unweighed incidence ofimport restrictions shows that the 10 percent of prohibited items represented17 percent of domestic production, the 29 percent requiring licensesrepresented 36 percent of domestic production, and the 3 percent requiringhealth permits represented 6 percent of production. The 57 percent of tariffitems that were free of NTBs corresponded to 43 percent of domesticproduction. The subsector in which this gap was most dramatic was wood andcork products, where 10 percent of the imports were prohibited but represented56 percent of production.

5/ Delegations were used to restrict imports from the Andean CommonMarket. Since it was prohibited from requiring licenses for such imports, thegovernment declared itself the sole importer and then delegated this right tothe private sector as it would an import license.

6/ These are instances where health permits are used with the samerestrictive effects as licenses or prohibitions; however, it is not known howwidely this may have occurred in Venezuela.

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(b) Tariffe

1.29 Before the trade reforms of 1989, there were 41 tariff rates, themaximum being 135 percent. Tariffu had been established over the years on acase-by-case basis without guidelines. The spread was great: about a sixthof the items attracted tariffs below 1 percent and a fifth above 80 percent.In addition to ad valorem tariffs, 854 items also attracted specific duties sothat effective rates were as high as 940 percent. Average tariff rates bysector and stage of pracessing had the cascading pattern (high for finalgoods, low for inputs and capital goods) typical of import substitution (Table2). Tariff rates for items restricted by NTBs were higher than for thosefreely importable. There were also large differences in average tariffs amongthe manufacturing subsectors.

1.30 Protection was provided by licenses and exchange allocationssince tariffs, while high, were routinely reduced. In 1984-85, importers onaverage paid only 28 percent of the statutory tariff. In 1985, there were 17reduced rates between 0 percent and S0 percent, though about 85 percent wereeither 1 percent, 5 percent, or 10 percent. Rates varied not only amongimport items but also among importers.

1.31 Actual tariff collections averaged about 10 percent of importvalues (and about 1.2 percent of GDP) in 1984-85. Exonerations were abouttwo-and-a-half times as great as tariff receipts. In 1984 and 1985,exonerations were 12.2 billion Be. and 14.5 billion Bsa, respectively, or 2.9porcent and 3.2 percent of GDP. Since tariffs represent about 4 to 5 percentof government receipts, the effect of the exonerations was to reducegovernment revenues, but the exonerations were not coordinated with overallfiscal policy. Table 1 shows the level of tariffs and the extent ofquantitative restrictions for the economy as a whole and for the majorsectors.

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Table 1: IMPORT RESTRICTIONS AND AVERAGE TARIFFS BY SECTOR ANDSTAGE OF PROCESSING, 1989-91

LICENSE REQUIREMENTS AVERAGE TARIFFSAll

1989 Import Proh. Lic. Hith. Free Items Proh. Lic. Hlth. FreeItems 9 % % %_

Entire Economy 6145 11 29 5 55 37 57 46 41 27

Agriculture 299 20 38 36 05 36 30 40 39 13Mining 97 5 11 - 84 14 10 26 - 12Manufacturing 5749 10 29 3 57 37 60 46 43 28

Raw Mat., Live Anim., Agri. Prod. 349 13 26 35 26 29 27 33 39 11Intermediate Semi-Processed Inputs 1797 0 15 02 82 22 25 29 36 20Processed Food and Agri. Prod. 471 20 48 17 15 46 46 51 47 31Processed Food with Additives 196 44 47 2 7 72 78 67 35 78Pharmaccutical Inputs 68 - 16 53 31 35 - 46 44 14Other Intermediate Inputs 1052 6 43 - 51 42 53 45 30 39Capital Equipment & Assemblies 1026 5 23 - 73 27 49 37 - 23Transport Equipment 215 7 49 - 44 43 69 50 - 31Finished Goods: Industry 374 13 39 1 47 51 55 55 35 47Finished Goods: Consumer 597 43 31 - 26 61 60 65 - 58

1990

Entire Economy 6903 5 5 8 82 19 40 27 18 17

Agriculture 330 24 32 39 06 22 30 21 19 09Mining 109 - - 1 99 6 - - 10 6.anufacturing 6464 4 4 7 85 19 42 30 18 18

Consumer Goods 2215 12 8 9 71 33 43 35 28 32Intermediate Goods 2699 1 2 8 89 12 30 11 08 12Capital Goods 1548 0 - 2 98 12 50 - 19 12

I991

Entre Economy 6967 0 2 16 82 16 32 20 11 15

Agriculture 336 9 85 6 12 - 13 12 11Mining 111 - - 1 99 7 - - 10 7Manufacturing 6520 0 2 12 86 16 32 21 19 15

Consumer Goods 2212 0 4 24 72 25 32 26 24 25Intermediate Goods 2729 - 2 9 89 12 - 13 9 12Capital Goods 1577 - - 2 98 11 - - 16 11

Note: Average tariffs in 1989 reflected only ad valorem tariffs; 651 items also attracted specific tariffs.Sources: Gaceta Oficial de la Republica de Venezuela, #4176, March 30, 1990; #4271, May 7, 1991.

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(c) Export Incentives

1.32 To offset the strong anti-export bias inherent in the importregime and the overvalued exchange rate, the government offered three exportincentives: the bono de exportacifn, a subsidy to non-traditional exporterspaid as a percentage of their export receipts; a currency retention scheme;and subsidized credit for exporters through FINEXPO. The bulk of exportsubsidies went to state-owned enterprises, which generate most of thenontraditional exports (65 percent of exports qualifying for the bonos deexportaci6n).

(i) Export Subsidy. About 80 percent of nontraditional exportsqualified for the export subsidy, a negotiable bondapplicable to any federal tax. The subsidy was paid to theexporter as a percentage of the f.o.b. value of exports,and the value of the bond was exempt from taxation. Therate paid to the exporter changed frequently and wasbetween 15 and 48 percent at its peak, depending on thedomestic value-added content of exports. From 1984-87, thebonds averaged .3 percent of GDP and 18 percent of thevalue of eligible exports.

The subsidy initially was designed to compensate exportersfor the difference between the free market rate and theofficial rate at which they were required to exchange theirforeign currency at the Central Bank. However, the freemarket rate continued to rise and, while the rate of thesubsidy and the method of its computation were changedfrequently (and on short notice), it seldom offeredsufficient compensation. The subsidy was offered at ratesbetween 15 and 48 percent (depending on the domesticcontent) on the eve of the 1989 reform.

(ii) Currency Retention. After the multiple exchange ratesystem was adopted in early 1983, nontraditional exporterswere offered a currency retention scheme, whereby grossforeign currency proceeds from exports--minus 50 percent(later 80 percent) of the value of inputs imported at theofficial rate--could be exchanged at the free market rate.From 1984 through 1986 the free market rate was at leasttwice the official rate, and this scheme provided aconsiderable incentive. It was discontinued in December1986 when, combined with the export subsidy, it appeared toovercompensate exporters--particularly where the good had ahigh import content. This subsidy was thought by many toencourage inefficient exports, sometimes to the extent thatthe foreign exchange cost of the export was greater thanthe foreign exchange receipts (i.e., the foreign-exchangevalue added was negative).

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Currency retention was more important than the exportsubsidy. In 1986, when the difference between the officialand free market rates made the retention scheme mostcostly, nontraditional exports eligible for the subsidywere 9.9 billion Bas. and received subsidies of 1.8 billionBe. If the average domestic content of the exports was 65percent, then about 8.2 billion Be. could have beenexchanged at the free market rate. The differentialbetween the free and official rates in 1986 averaged 160percent (19.7 Bs./USS compared with 7.5 Bs./US$), so thevalue of the currency retention would have been 13.1billion Be. Thus, in 1986, currency retention for thisgroup of exports was about 2.8 percent of GDP, when totalnonpetroleum exports were 4.4 percent cf GOP and theexports recelving the bonus just 2.0 percent of GDP. Tothe extent that the scheme was merely compensatingexporters for the overvalued exchange rate, it encouraged amore efficient allocation of resources. Where itovercompensated exporters (e.g., low value-added exports),it encouraged an inefficient allocation.

(iii) FINEXPO Credit. The Export Financing Fund (Fondo deFinanciamiento de las Exportaci6nes, FINEXPO) of theCentral Bank offers extensive facilities for exportfinancing. Financing is available at preferential rates--up to 7 percent below market--and commercial terms of up to12 years for feasibility studles, market research,promotional expenses, fixed capital investment, workingcapital, inventory financing, and direct medium- or long-term financing for foreign buyers. About three-fourths ofthe credit authorized is post-shipment financing, and one-fourth is pre-shipment. In 1988, FINEXPO approved 3.4billion Bs. in credit, or about 13 percent of the 26.9billion as. of nontraditional exports. If the averageconcession in the interest rate was 5 percent, then theamount of subsidy would have been less than .01 percent ofGDP. Reform of these credit subsidies will be included inthe government's overall financial sector program.

ReforM Measures

1.33 The policy reforms in February 1989 amounted to a radicaltransformation of the trade regime. In intensity--measures by the extent ofthe changes and the speed with which they were introduced--they rank at thetop, whether in Latin America or in the world as a whole, in recent years.

1.34 The cornerstone of the reform policy was the unification andfloating of the exchange rate, which will be discussed extensively in theanalysis of macroeconomic reforms. Along with this change came the abolitionof foreign-exchange controls and, thus, of a major device for import rationingand rent seeking.

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1.35 Import prohibitions and licensing have been sharply reduced,today protecting only about 2 percent of domestic production, well within thegovernment's goal of no more than 5 percent in the medium term. The greatestincidence of QRs remains in agro-industry.

1.36 Tariffs, too, have been lowered substantially. The tariff codefor the manufacturing sector has been restructured to afford each line ofproduction roughly the same protection. The level and range of tariffs havebeen cut substantially. The average rate has been reduced from 37 percent to16 percent, with consumer goods--at 33 percent--continuing to be subject tothe highest rate. The maximum tariff has been lowered from 135 percent to 80percent and then to 50 percent, and the government's announced target is toreduce it to 10 to 20 percent by 1993. Discretionary tariff exonerations havebeen eliminated. However, exemptions established by law remain for someentities such as state-owned enterprises, universities, and the centralgovernment. The Development Ministry does not have a complete list ofexemptions but estimates that they affected less than 3 percent of imports in1988.

1.37 The post-reform tariff levels and the incidence of non-tariffbarriers are presented in Table 2. A comparison with Table 1 shows the extentof the change introduced by the reform.

1.38 As part of the reform program, the export subsidy rate waslowered from 30 to 15 percent (18 percent for agriculture) in March 1990. InSeptember 1990, it was reduced further to 5 percent for manufactured exportsand 6 percent for agricultural exports. It was subsequently reduced to 1percent for manufactured exports and increased to 10 percent for agriculturalexports.

1.39 Venezuela has acceded to the GATT and is adopting GATT-consistentimport and export norms and procedures. It is working in concert with othermembers of the Andean Common Market to adopt uniform anti-dumping and anti-subsidy procedures. It has eliminated all export restrictions (except on thefew items where there may be subsidies) and introduced a duty-drawback schemewith a flat rate of 5 percent. The Foreign Trade Institute is beingrestructured, using as its model the office of the U.S. Trade Representative.

1.40 Following further changes in 1992, the present (fall 1992)maximum tariff rate is 25 per cent (with two exceptions in the automobilebranch). Export subsidies have been totally eliminated in all activitiesexcept agriculture, in which they have been retained for about 200commodities. A free-trade agreement has been signed with Columbia; whereasVenezuela has granted a free-trade status to the Caribbean countries withoutreciprocity.

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Table 2: IMPORT RESTRICTIONS AND AVERAGE TARIFFS BYMANUFACTURING SUBSECTOR, 1989-91

1989 LICENSE REQUIREMENTS AVERAGE TARIFFSAll

Subsector Import Proh. Lic. Hlth. Free Items Proh. Lic. Hlth. FreeItems % % %% % 9 . t % %

All Manufacturing 5749 10 29 3 57 37 60 46 43 28

31 Food, Beverages, Tobacco 550 30 49 12 9 58 65 58 65 5832 Textiles, Leather 584 30 36 5 30 53 60 53 44 4633 Wood, Cork Products 88 10 34 14 41 75 82 98 51 6234 Paper, Printing 172 6 20 - 74 45 49 62 - 4035 Chemicals, Petroleum, Coal 1814 2 17 4 77 22 57 31 35 1936 Nonmetallic Minerals 183 15 30 - 55 53 53 60 - 5037 Basic Metal Industry 331 0 36 - 64 22 45 17 - 2438 Metal Products, Machinery 1796 07 33 - 60 37 56 47 - 2939 Other Manufacturing 199 34 26 - 41 54 53 51 - 56

1990

AU Manufacturing 6464 4 4 7 85 19 42 30 18 18

31 Food, Beverages, Tobacco 608 25 25 25 26 35 40 32 32 3532 Textiles, Leather 973 10 0 2 88 36 48 10 10 3533 Wood, Cork Products 98 21 - 16 63 37 44 - 28 3834 Paper, Printing 188 - - - 100 18 - - - 1835 Chemicals, Petroleum, Coal 1734 0 7 14 79 09 50 04 10 0936 Nonmetallic Minerals 168 2 - - 98 24 45 - - 2437 Basic Metal Industry 390 - - 4 96 07 - - 04 0738 Metal Products, Machinery 2073 1 - 1 98 15 29 - 20 1539 Other Manufacturing 223 17 - 3 80 27 47 - 35 24

1991

All Manufacturing 6520 - 2 12 86 16 32 21 19 15

31 Food, Beverages, Tobacco 614 - 19 77 05 23 - 24 24 1532 Textiles, Leather 966 - - 2 98 27 - - 10 2833 Wood, Cork Products 99 - - 14 86 30 - - 29 3134 Paper, Printing 187 - - - * 100 16 - - - 16835 Chemicals, Petroleum, Coal 173 30 1 13 86 10 30 5 11 1036 Nonmetallic Minerals 172 - - - 100 20 0 0 0 2037 Basic Metal Industry 414 - - 5 95 09 - - 07 0938 Metal Products, Machinery 211 60 - 2 98 13 30 - 17 1339 Other Manufacturing 219 0 - 3 96 22 40 - 20 22

Sources: LEGIS, Arancel de Aduanas de Venezuela No. 95 (1989);Gaceta Oficial de Ia Republica de Venezuela, #4176, March 30, 1990, #4271, May 7, 1991.

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Evaluation and Further Reforms

1.41 It is too early to evaluate the impact of the reforms on theeconomy. They cannot be expected to affect imports in any significant way insuch a shorc time, particularly in view of the recession that accompaniedmacroeconomic stabilization and lasted for over a year. A fortiori, theinfluence of fundamental changes in the structure of the economy, inefficiency, patterns of investment, and the like, will be evident only afterseveral years.

1.42 But the reforms have been wide and deep and must lead to majoreconomic benefits. They have replaced the system of QRs, ad hoc protection,and costly export subsidies with a system that--when fully implemented by1993--will use effective exchange rate management in place of importsubstitution and export promotion. Moderate tariffs--between 10 and 20percent--will provide additional protection for import-competing domesticproducers, leaving a residual anti-export bias after export subsidies havebeen eliminated.

1.43 The most important single element of the trade reform program hasbeen the unifying and floating of the exchange rate. It will be necessary tomanage the rate to avoid the mistakes of the 1980s if there are unexpectedchanges in petroleum prices. This is discussed more thoroughly in the nextpart in the context of macroeconomic policies.

1.44 Exchange rate management will encourage an efficient allocationof resources between the traded goods sector (importables and exportables) andthe nontraded goods sector. Investors need a clear understanding of thegovernment's exchange rate policies and the ability to formulate reliableestimates of future exchange rates. This is a fundamental determinant ofinvestment in the traded goods sector.

1.45 The thrust of the adjustment program has been to reorient theeconomy by substituting broadly applicable principles for the previous arrayof industry-specific rules and standards. With the notable exception ofagriculture, the government, to date, has maintained an admirable degree offairness in the treatment of economic sectors. This is an important elementof the program, both politically, by showing impartiality, and economically,by allowing market forces, rather than bureaucratic or political decisions, todetermine the most robust activities.

1.46 The remaining licenses and prohibitions are concentrated insubsector 31 (see Table 2), where about 19 percent of production is covered bylicenses which were retained pending resolution of the agricultural tradereform and should be eliminated in cinjunction with it.

1.47 Legislation should be introduced to eliminate the remainingtariff exemptions, which give domestic enterprises an unfair commercialadvantage and some foreign producers preferential treatment. Protecting thedomestic manufacturer denies the foreign manufacturer a price advantage, butimplicitly requires consumers of the product to bear the added cost. To

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exempt some consumers and not others from the burden of protection isinequitable.

1.48 The government should encourage private markets to providesuitable instruments for export credit and credit insurance. FINEXPO offers alimited number of exporters subsidized credit rates for which there is nojustification because they encourage many diste-rtions in industrialincentives. Exporters should pay market rates for credit.

C. Sectoral Surveys

Agriculture

Prior Conditions

1.49 Until 1983, inconsistent policies and negative protectionhampered agricultural development. The controlled exchange rate and lowprices for domestic agricultural products reduced profitability (despite someinput and credit subsidies) and the acreage cultivated.

1.50 From 384-88, however, there were attempts to improveagricultural growth. The policy was based on the belief thats (a) farmerswould respond to price incentives and improved services by increasing output;and (b) the increased output would lower consumer prices. It was an attemptto maintain high producer prices and profits while maintaining low and stableconsumer prices. Imports and exports were zestricted and the budgetaryallocations for infrastructure and support services were increased. Thecritical element of the policy was that government resources would subsidizeproducer prices until inefficiencies in the sector were rectified and theproductive capacity expanded.

1.51 The following policy instruments were used to increase theincentives to domestic production and maintain low and stable consumer prices:(a) quantitative import restrictions to protect domestic agriculturalproduction and induce local agro-industries to purchase domestically producedcommodities at prices set by the government; (b) a preferential exchange ratefor the import of wheat, sorghum, and soybeans, and of fertilizers and animalfeed for farmers; (c) highly subsidized credit and water for irrigation; (d)direct consumer subsidies for corn meal and milk; (e) price controls atwholesale and retail levels for a range of foodstuffs; (f) export prohibitionsto prevent subsidized and price-controlled outputs and inputs from leaving thedomestic market; and (g) interventions in the agricultural marketing chain,such as the ownership and operation of storage facilities, and control of themarketing and export of coffee and cocoa.

1.52 Overall, the agricultural sector achieved a high average annualgrowth rate of 6.3 percent from 1984 to 1988. But the policy clearly wasunsustainable and, from the outset, was unsuccessful in removinginefficiencies in the sector. It resulted in highly distorted relative pricesand extensive government intervention. It also entailed huge subsidies. By

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1987, these were estimated at almost US$l billion a year, equivalent to aboutone-third of agricultural value added and 2 percent of GDP. In addition, thepolicy failed to keep retail and wholesale food prices low and stable. With abase of 100 in 1984, retail food prices reached 189 in 1988 compared with 206for all retail products. Retail prices also outpaced average householdincome, causing a large loss in food purchasing power, predominantly affectingthe lower-income groups.

1.53 The attempt to increase resources for private sector investmentin agriculture through subsidized credit have had a negative effect on thefinancial sector. Agricultural portfolio requirements and direct creditsubsidies have contributed to the underdevelopment and inefficiency offinancial institutions, while poor loan repayments have bankrupted one publicsector institution (BANDAGRO) and left two others (FCA and ICAP) in criticalcondition. Further, leakages of subsidized credit to non-agriculturalactivities have partially defeated the purpose of the program.

Policy Reforms

1.54 Unifying and floating the exchange rate has been crucial foragriculture, but in addition the government has adopted several new policiesspecifically for the sector.

1.55 Trade. In July 1990, all 117 agricultural commodities wereremoved from the prohibited list of imports and 70 - with the importantexceptions of feed grains, soybeans, and poultry - from the list of importsrequiring prior licensing. Four tariff levels were introduced, andrestrictions on agricultural exports were eliminated, except for sardines. Atransparent price band mechanism for wheat, rice, and white corn has also beenimplemented to stabilize domestic prices and provide additional tariffprotection for these key commodities, and is in the process of being appliedto yellow corn, oilseeds, and sorghum. Export controls on rice, legumes, andcornmeal have also been ended.

1.56 Administered producer prices are being phased out. They havebeen removed from rice, palm oil, and sugarcane. They will be removed fromsunflowers, crude milk, yellow corn, sorghum, and soybeans by May 31, 1992.Further, minimum prices for white corn, copra and coffee are frozen at theirpresent nominal levels, and the Administration will be introducing legislationby October 31, 1992, to eliminate the leg.l requiremant for setting minimumprices.

1.57 Input Prices. Most agricultural input subsidies have been ended,except for irrigation and fertilizers. Irrigatitn fees cover only about 1-2percent of the cost of irrigation. rhe subsidy on fertilizers wassignificantly reduced in 1990 by increasing the controlled prices to 50percent of opportunity cost.

1.58 Retail Pricas. The twelve food items initially subject to pricecontrol were first redu_ed to five (precooked cornmeal, mixed vegetable oil,white cheese, sugar, and sardines) and more recently to one (sardines).

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1.59 Agricultural Credit. Several measures have liberalized interestrates and credit allocations and to streamline the development bankingfunctions for agricultural financing: (i) a reduction of the agriculturalportfolio requirement for commercial banks from 22.5 percent to 17.5 percent,with a further reduction to 12 percent by 1992; (ii) an increase inagricultural lending rates to 85 percent of the variable interest rates onnon-preferential loans by commercial banks; (iii) the liquidation of BANDAGRO;and (iv) the restructuring of FCA as a new and more effective second-tieragricultural credit institution.

Evaluation and Further Reforms

1.60 The policy reforms of 1989 and 1990 have begun to correct thedistortions evident in uncompetitive agricultural production and high foodprices. Resources are being reallocated to those tradeable commodities whereVenezuela has a comparative advantage. While value added in the agriculturalsector declined by about 5 percent from 1988 to 1989 (compared with about 8percent for the overall economy) and stabilized in 1990, growth in 1991 isestimated at about 6 percent. The sector is adjusting well to the newrelative prices and the mix of outputs is changing. Before the reformprogram, extensive regulation and protection raised domestic prices muchhigher than import parity levels. The crucial question is whether the reformshave gone far enough or whether residual regulations and interventions arecontinuing to cause distorted patterns of investment and production. Theanswer appears to be that the reforms, although significant, need to gofurther if the sector is to be market driven. The most important measures forthe near and medium term are described below.

1.61 Trade and Producer Prices. Over the next two years, thegovernment plans to eliminate import licensing and the associated minimumprice program. Ideally, the price stabilization scheme should also be phasedout and replaced by market-based mechanisms (such as futures trading andforward contracts).

1.62 Input Prices. In September 1991, the fertilizer subsidy wasreduced further by increasing the controlled price to 70 percent ofopportunity cost. Planned increases in prices over the next two years shouldbring them to 100 percent of opportunity cost.

1.63 Agricultural Marketin . Some traditional governmentinterventions in agricultural marketing continue, including the running ofstorage facilities and the marketing and export of coffee and cocoa. Afterthe food riots in 1989, the administration created a marketing parastatal,CASA, to guarantee an adequate supply of food by intervening if necessary inany aspect of the food marketing chain. The functions and powers of CASA arevague and ill-specified, and it has received very little financial support.

1.64 Its future is now being considered. In principle, the policy isto divest the government of ownership of all storage facilities and to ensurethat CASA does not become another reason for subsidies. Currently, CASA'srole is limited to: (a) purchases of commodities from producers to support

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market prices (limited to white corn in 1992 and discontinued thereafter); (b)importing foodstuffs only in case of emergencies; (c) ascisting in theestablishment and operation of central wholesale markets; (d) providingtechnical assistance to producer and consumer food marketing cooperatives; (e)requiring that any marketing program to lower basic food prices for lower-income families (popular markets, basic basket program) is self-sustaining;and (f) managing storage facilities until divestiture occurs in accordancewith the program to be formulated. A timetable for divestiture is expected tobe developed shortly.

1.65 Domestic marketing controls on coffee and cocoa, and the exportmonopoly of FONCAFE and FONCACAO have ended. These two institutions are alsobeing restructured to eliminate their credit activities and strengthen theirtechnical assistance role.

1.66 Credit. Agricultural credit markets are to be liberalizedfurther by (a) totally deregulating agricultural interest rates; (b)eliminating the portfolio requirement; and (c) restructuring FCA into a viableself-sustained agricultural credit institution.

1.67 Irrigation. Ir_.igation water invoicing is to be increased sothat eventually all operation and maintenance costs, as well as investments inmodernization or rehabilitation, will be recovered. Water charges for newschemes also will be set to recover capital costs. This is probably the arealeast touched by the reform policy, one in which much waste has occurred, andin which planned policy changes are obviously inadequate. The phasing out ofwater subsidies is very slow, and it is doubtful whether full cost recoverywill be achieved in the foreseeable future.

1.68 Leqal and Regulatory Framework. Some provisions of the AgrarianReform Law are not consistent with the new environment in Venezuela, deterringon-farm investment by preventing individuals who have received land under thelaw from transferring their titles. This has been further complicated by thelack of a land cadastre. The government is considering some means to giveagrarian reform beneficiaries access to credit, given the present constraintson title transfers. The land cadastre is being completed with Bank support.

Power and Energy

Prior Conditions

1.69 The power sector consists of four state-owned (EDELCA, CADAFE,ENELVEN, and ENELBAR) and seven private companies. EDELCA, a generation andtransmission company, owns and operates the hydro-plants on the Caroni River,and is the bulk supplier to the industrial complex in Guayana and otherutilities; CADAFE, a generation, transmission and distribution company, servesmost of the country (almost 60 percent of all residential consumers) exceptfor the largest urban centers and the industrial area of Guayana; ENELVEN, ageneration, transmission and distribution company, serves Maracaibo andWestern Zulia; and ENELBAR serves Barquisimeto and its outskirts. The main

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private company, Electricidad de Caracas, serves most of Caracas and ownsthree smaller private companies.

1.70 Several government agencies are in charge of guiding andregulating the power sector. Because of their overlapping responsibilitiesand the absence of a clearly defined regulatory framework, the sector is notsubject to effective supervision. The Ministry of Energy and Mines (MEM) andits Tariff Committee (TC) are supposed to be responsible for establishing;respectively, energy policy and tariff schedulcq, but they lack the necessaryauthority and technical expertise. MEM's authority has been underminedfurther because most of the state-owned companies report directly to theVenezuelan Investment Fund (FIV), their majority shareholder, while EDELCAreports to the Guayana Regional Corporation (CVG)--its majority shareholder.The Ministry of Development (MOD) is responsible for approving retail tariffadjustments based on the TC's recommendations. Tariffs for intercompany salesand from EDELCA to industrial consumers in Guayana, are not subject toregulation but are fixed through bilateral agreements. The Ministry ofCoordination and Planning (CORDIPLAN) plays a central role, establishingnational development policies and reviewing the sector's investment plans.

1.71 The current legal and institutional arrangements of theVenezuelan power seccor do not favor economy and efficiency. As there is noelectricity law, the country lacks fundamental regulations for the industry.Several unsuccessful efforts have been made in the past to enact anElectricity Law which would provide an integrated, comprehensive and rationalbasis for regulating electric utilities. In addition, there have beenproposals to reorganize the activities of, and the government's control over,the national (government-owned) electric utilities, involving the creation ofa holding company. Resolution of issues raised by these proposals may takeconsiderable time. Substantial progress is expected in solving sectorproblems based on actions that could be taken in two respects: (i)establishment of a coordination unit to handle the sector issues of all,public and private utilities, including investment planning with a nationalperspective; and (ii) the establishment of a new regulatory framework throughthe issuance of an Electricity Law for the sector and the establishment of asector regulatory agency.

1.72 The power sector has been a major recipient of governmentinvestment, and its substantial growth during the last 15 years reflects anambitious development strategy that has emphasized increased investments ingeneration and the maintenance of artificially low prices for electricity.

1.73 As a rule, prices in the past decade did not reflect the cost ofservice and have resulted in an unsatisfactory general rate level anddistorted tariff structure. This pricing policy has had two adverseconsequences: (i) it has compounded the financial difficulties of theutilities and increased their dependence on government contributions; and (ii)it has sent distorted signals to the consumer, promoting waste and inefficientuse of electricity. A pricing policy that rationalizes the tariff structureand increases prices to the level of costs was needed.

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1.74 Unrealistic tariffs, compounded by inefficient bill collections,have severely impaired the finances of the national utilities, which haverequired substantial equity financing by the FIV and equity contributions anddirect subsidies from the government. Rescuing the utilities whenever theywere unable to meet their financial obligations has offered them no incentiveto be efficient.

1.75 Petroleum obviously is Venezuela's key sector. Venezuela is theworld's fourth largest oil-exporting country, with more than 2 million barrelsper day. The income of PDVSA, the government-owned oil company, has providedaround 70 percent of total government revenues in the last two years; itsforeign-exchange receipts are at least 75 percent of foreign-exchangeearnings; and its value added is nearly a quarter of the economy's GDP.

1.76 PDVSA generally is considered an efficient and sophisticatednational oil company. Its coordinating committees, with representatives fromthe operating subsidiaries, integrate various activities. PDVSA is run by theGeneral Assembly (stockholders). The Ministry of Energy and Mines (MEM) isthe sole shareholder, with the Minister serving as chairman, and thus is thegovernment entity responsible for the oil industry, approving the generaldirection of policies, new investments, domestic prices, and conservation.General policy directions are approved by the President, and MEM and Congresscan become involved in budget issues. The budget is approved annually at thestockholders' meeting. PDVSA reports on its activities through an annualreport, financial statements, and a Fivs-Year Plan, all approved by thestockholders. MEM exercises supervision through its Hydrocarbons Division butleaves the management to PDVSA's well-trained technocrats. Thus, PDVSA hasescaped the political interference and labor union problems oftencharacteristic of national oil companies.

1.77 Venezuela has substantial gas reserves. Since 1985, followingthe construction of pipelines and infrastructure, domestic utilization of gashas started--primarily by PDVSA itself and partly by industrial power andpetrochemical users (very little by residential users). Natural gas has freedsome one-half million barrels per day for exports.

Policy Reforms1.78 In the power sector, the reforms have been directed at: (i)reducing the dominance of the public sector through restructuring andprivatization; (ii) increasing operational efficiency; (iii) providing astrong central institution to review and coordinate expansion plans,investment programs, and other activities related to the sector; and (iv)reviewing the sector regulatory framework through the establishment of aregulatory agency and issuance of an Electricity Law.

1.79 Public enterprises with financial problems or posing bottlenecksto efficient production of electricity will be restructured. Among eightmajor public enterprises, CADAFE (one of the largest public power utilities)has been selected for restructuring and possible privatization. Therestructuring of CADAFE (para. 1.78) will consist of the company's complete

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reorganization and decentralization. The restructuring of the whole sectororganizational structure is also being considered (paras. 1.79 and 1.80).

1.80 The reorganization of CADAFE has started with the establishmentof four autonomous regional distribution companies. At present thesedistribution companies are only responsible for operating and maintainingtheir systems, while administrative and financial matters are handled byCADAFE. By December 1992, all responsibilities are to be transferred to thedistribution companies, after which they will be fully autonomous andprogressively privatized. CADAFE also plans to separate its transmission andgeneration functions, and then privatize large thermal generation, as part ofa broader sector restructuring and privatization program.

1.81 The Government has been considering the establishment of asupervising entity for state-owned power companies, which would hold thestate's shares in these companies, and organize them as follows: (i) threegenerating companies, namely EDELCA, Planta Centro, and Uribante Caparo (atpresent, these last two are under CADAFE's control); (ii) four distributioncompanies; and (iii) a national transmission company to operate theinterconnected grid. ENELVEN and ENELBAR will maintain their presentstructure (under FIV's control) and are part of the government plans forprivatization in the short-term. Mainly because of struggle between EDELCAand CADAFE over control of the transmission network, the restructuringcommission failed to report by the required deadline in December 1991.

1.82 Within the context of the Policy Reform Program, the governmentdecided to establish a tariff regulatory body (composed of representatives ofthe Ministries and institutions concerned with the power sector) and to bringelectricity prices more in line with costs. Decree no. 368 of July 27, 1989,created the Tariff Committee as an independent body and a technical office toadvise it. The Committee was to: (i) define the principles for tariffsetting; (ii) define the target minimum rate of return for electricitycompanies; (iii) review tariff requests presented by the power companies; and(iv) recommend to the government possible tar.ff adjustments.

1.83 So far the Committee has not been fully effective, largelybecause of a lack of authority, an adequate structure and budget, andqualified staff. Despite this, it has been able to coordinate the utilitiesefforts to establish and enforce a uniform system of accounts for tariffadjustment requests from the power utilities and for tariff setting within thegeneral government policy. It has also been able to complete technicalstudies on tariff structure and levels for each utility, a long-run marginalcost study for electricity tariffs, and a study to define the criteria to beused by the utilities in the revaluation of assets. It has played animportant coordinating role among regional and public or private sectorentities.

1.84 By Decree 1790 of 08.21.91, the government created twocommissions to carry out the .nain tasks for this purpose, within four months.One of the commissions was to propose a new regulatory framework for thesector through the issuance of an Electricity Law and the establishment of a

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regulatory body. The commission has completed a draft decree to establish aregulatory agency and is working in the preparation of the Electricity Law.

1.85 The other commission was to draft the statutes and prepare aprogram for establishing a sector holding company (for state-owned powerenterprises) and its subsidiaries. This commission, however, has apparentlydone little work, and the government has put on hold the creation of a sectorholding company, reportedly because of disagreement between EDELCA and CADAFEon the creation of a national transmission company.

1.86 On March 22, 1989, Decree no. 1C2 authorized a one-time tariffincrease (30 percent and 50 percent for residential and industrial consumers,respectively), followed by monthly adjustments (3 percent and 5 percent,respectively) for 20 months. These adjustments affect all national andprivate companies but EDELCA, whose tariff schedules are negotiated directlywith its consumers. Further adjustments took place in April 1991, raising thereal price, in comparison with March 1989, by 1 p_zcent for residential use,152 percent for commercial use, 107 percent for industrial use, and 97 percentfor all other uses. The government has adopted the principle that the tariffstructure should be based on long-term marginal costs, and tariff levelsshould be based on financial requirements. The principle is to be implementedwhen on-going studies of this issue are completed.

Evaluation and Further Reforms

1.87 Inadequate prices remain a key issue for petroleum and forelectricity, gas, and water. The new policy essentially increased power ratesin a manner that increased differentials and distortions. The largest tariffincreases applied to commercial and industrial users, whose tariffs hadalready been close to marginal costs; whereas the smallest changes applied toresidential users, whose tariffs have all along been below cost. On thepetroleum side, there have been problems. A February 1990 decree establishedgradual price increases of petroleum products and fertilizers, which by early1993 should reach the levels of their export opportunity costs. Presently,gas tariffs are different for different categories of consumers and can varyby load factor; but the average tariff is very low. Fertilizer prices in 1990were estimated to be 65-75 percent of opportunity (border price) costs. TheAgriculture Ministry subsidizes fertilizers and is supposed to compensatePDVSA for the differential, but there is some doubt about whether this paymentis actually made.

1.88 The price of gasoline in May 1991 was roughly US$.25 per gallon--still among the lowest in the world. It was doubled to this level in 1990,and riots ensued in some areas. By comparison, the international wholesaleprice in the Caribbean market is about US$.60-.70 per gallon. other fuelprices are also below export opportunity costs. It appears that thegovernment is no longer adhering to the adjustment schedule, which is supposedto bring prices to their full economic opportunity costs.

1.89 If natural gas production is to be economically viable and gassubstitution encouraged to free oil products for export, it is imperative thatthe domestic prices of gas and its alternative fuels, i.e., residual fuel,

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diesel, propane, and butane, be raised to their full economic cost.

Furthermore, the price paid at the wellhead by the joint venture in the San

Cristobal Colon LNG project needs to be determined.

1.90 The government's plan to organize the power-sector activities

into separate generation, transmission, and regional distribution companies

would support the government's long-term objsctives. However, the proposed

holding company could be too powerful in the sector to be held publicly

accountable. To avoid this outcome, a better option should be to leave the

ownership divided between CVG and FIV. If the Government does set up this

holding company, it should ensure that it appoints a properly constituted

Board of Directors that is given the autonomy to set policies for the

companies and hold its management accountable for performance.

1.91 The progress towards privatization in the sector has been minor.

Privatization of most of the power system--except EDELCA's hydro generation

and the main EDELCA and CADAFE transmission network--is being considered. The

government recognized that the establishment of a regulatory agency (by law)

and the unfreezing and adjustment of power tariffs are preconditions for this.

PDVSA has announced that it is opening 46 fields, which are considered

marginal, to foreign companies under operating agreements. Approximately 130

companies are now interested in bidding for the right to reactivate these

fields. PDVSA is inviting them to work as contractors to a PDVSA affiliate,

which is acceptable politically because this type of arrangement is allowed by

the Nationalization Law and the number of fields is small. The companies

would put up the funds to reactivate the fields and would collect a fee per

barrel produced; bu- the oil would be owned, delivered, and sold by the PDVSA

affiliate. The production fee would be independent of the price at which

PDVSA sells the oil. Royalties and taxes are to be paid by PDVSA.

Infrastructure

1.92 This section reviews the reform process in telecommunications,

ports, shipping, water supply and sanitation, interurban transport (including

highways), and urban transport., For each subsector, the report describes:

(i) the prior conditions; (ii) policy reforms enacted by the P6rez

Administration; and (iii) evaluation and further reforms.

Prior Conditions

1.93 Telecommunications. Telecommunications service in Venezuela is

perhaps the single greatest obstacle to economic growth and development,

particularly business expansion. There are approximately 1.4 million

subscribers, but unmet demand exceeds 1.5 million and some customers must wait

over one and a half years for a telephone. Service quality is poor, with call

completion rates of only 24 percent for international calls and 49 percent for

local calls. Faced with these problems and the inability of the state-owned

monopoly (CANTV) to improve or expand service, the government decided in late

1990 to privatize CANTV and open the sector to iLcreased competition and

private investment.

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1.94 Ports. The government placed a high priority on.the reform ofthe port system, whose inefficiency is viewed as a major impediment to tradeand economic growth. The maritime foreign trade of Venezuela amounts toapproximately 35 million tons per year (excluding petroleum) and is handledthrough a combination of public and private ports, including: (i) eightpublic ports owned and operated by the national ports agency (INP), which wasregarded as very costly and inefficient; (ii) industrial terminals in theRiver Orinoco serving CVG; (iii) other private industrial terminals servingsingle industries, located primarily on the North Coast and Lake Maracaibo;and (iv) the petroleum terminals operated by PDVSA.

1.95 The reform focused on the INP ports, which handle roughly 10million tons of cargo annually, representing 90 percent of the general cargoand virtually all the container traffic. INP was responsible for providinglabor, equipment, and all services but suffered from low productivity andinadequate equipment, particularly efficient container handling. As a result,shippers frequently hired private firms to handle loading and unloading, whilestill paying INP tariffs and being subject to its restrictive laboragreements. The shipping conferences applied various cargo surcharges forcongestion and port cost differential at an expense for the nation estimatedat US$30-50 million annually. To add to this, INP was a burden on thegovernment's budget, with annual transfers averaging US$25 million in 1989 and1990.

1.96 Shigoing. As with ports, inefficient and restrictive practicesin shipping are a serious impediment to trade expansion and economic growth.Venezuela, like many other countries, had restrictive shipping legislationdesigned to promote the national fleet. Under the Venezuelan Merchant MarineLaw, shippers were obliged to transport 50 percent of their cargo via nationalships (public and private). Further restrictions applied to state-ownedenterprises, obliging them to ship 100 percent of their cargo via the state-owned shipping line, CAVN. When CAVN lacked adequate capacity, it charteredvessels. If this was still insufficient, the Ministry of Transport (MTC)could grant a waiver for the use of other shipping companies, but there were anumber of administrative steps required in obtaining a waiver.

1.97 CAVN is highly inefficient. Its fleet is seaborne only 55percent of the year (though some of the downtime reflects the inefficiency ofINP ports, rather than CAVN's). Excluding export bonuses, CAVN lost roughlyUS$25 million in 1988 and 1989. These losses can be ascribed to:overstaffing (1,690 employees for a fleet of only 12 ships); a small, outdatedfleet, unsuited to current demands for specialized vessels; and an uneconomicroute structure, reflecting in part an implicit objective to provide regularworldwide service for Venezuelan shippers.

1.98 Water SuDolV and Sanitation. The water supply and seweragenetworks provide 85 percent and 61 percent coverage, respectively, to urbanresidents and 80 percent and 15 percent, respectively, to rural residents.Although this ranks high in comparison with other Latin American countries,service has steadily deteriorated through the 1980s, primarily as a result oftwo factors. First is the absence of significant tariff increases since 1981;

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this has resulted in current tariffs covering only about 10, percent of costs'flrgely operating costs only, as capital investments have not been made due

lack of funds). The second factor is the inefficiency of INOS, theational agency responsible for water supply and sewerage services. Theagency is heavily overstaffed, with 15,260 employees--a ratio of 10 per 1,000connections, compared with an average of 3.6 in five other Latin Americancountries. Losses are extensive; in 1988 INOS reportedly billed for only 37percent of the water it produced, and in 1990 its operating los exceeded theequivalent of US$125 million. Maintenance is inadequate throughout thesystem. Government budgetary transfers, ior both operations and investments,totalled the equivalent of US$110 million last year and are forecast at US$170million this year.

1.99 Highwavs and Interurban Transport. Roads are the principal modeof transport in Venezuela, carrying almost all cargo traffic except petroleumand ores, and 99 percent of intercity passenger movements. Inland watertransport, which once played a major role, has been overtaken by roadtransport and is now used mainly for the export of minerals on the Orinocoriver. The railway system is limited to a 240 km line to Puerto Cabello thatcarries about 500,000 tons and 300,000 passengers, and three special-purposelines that serve the mining industry.

1.100 The cosd network consists of expressways (1,500 km), highways(25,500 km), ana .gricultural feeder roads (44,000 km). Over 90 percent ofthe country's non-urban traffic is carried on the expressways and highways.The highways, which were built in the 1960s and 1970s, have been used moreheavily than expected and generally have been inadequately maintained. About22 percent of the highway network requires extensive and costlyrehabilitation, and about 50 percent will soon reach that point without timelypreventive maintenance and strengthening. The higher cost of road transporton deteriorated highways is affecting economic growth, especially in theagricultural and industrial sectors, and Venezuela's export potential.

1.101 Three main factors have contributed to the decline of the roadsystem. First, road users have been given subsidies in the form of low fuelprices. Secondly, the management of the system, highly centralized in theMTC, has neglected rural roads and overlooked the needs of local communitiesand agricultural development objectives. Thirdly, road programs have beenfunded mainly through unpredictable and inadequate budget allocations from thenational treasury, which has hampered the appropriate programming ofexpenditures and the effective management and maintenance of the networks.

1.102 Urban Transport. In Caracas, public transport services areprovided by both the public and private sectors. These services include:CAMETRO, which operates the subway and metrobus system; regular bus servicesprovided by private companies; and "por puesto," privately owned minibusesoperated on specified routes. Metro ridership has been increasing by 30percent annually and is now estimated at 1 million passengers daily, orroughly 20 percent of total trips. In comparison, ridership on regular buseshas been declining and is estimated at less than 10 percent of the trips, and"por puesto" with about 56,000 minibuses in the metropolitan area accounts for

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35 percent of the trips. Despite the growth of metro ridership, private carsand taxis still account for up to 40 percent of transport in Caracas in terms

of riders/day, a reflection of low prevailing gasoline prices. Other largecities are served mainly by "por puestos," many of them facing rapidly growing

congestion problems.

1.103 All three levels of government (national, state, and municipal)

have responsibilities for urban transport, but there is little coordination,particularly in the major metropolitan areas. The MTC regulates taxi and "por

puesto" tariffs, as well as intermunicipal bus rates, including those for the

metropolitan area of Caracas. Fares generally have not kept pace with fuel

price. CAMETRO fares range from about US$.14 (for a trip of up to four

stations) to US$.21, which are very low in comparison with subway fares inother countries. CAMETRO receives a small operating subsidy (US$10 millionbudgeted for 1992). However, it is unclear whether fare revenues plus this

subsidy are enough to cover depreciation and debt servicing. Many private busoperators are in financial difficulties from a combination of rising costs and

controlled fares. The number of buses in service declined from about 1,500 in

1975 to about 500 in 1989, partly because of these difficulties and partlybecause of the introduction of the metro. The "por puestos" tend to be betteroff financially because fares are higher and graduated with distance.

Policy Reforms

1.104 Telecommunications. The reform program has four elements:

* the sale in November 1991 of 40 percentof the shares of CANTV, with majorityvoting control, to an international

consortium led by GTE for US$1.9 billion.An additional 11 percent has been sold tothe employees. GTE has already signedthe sales agreement and taken overmanagement of CANTV.

* the introduction of limited privatecompetition through the granting of alicense to Telcel (a Bell Southconsortium) to operate the secondcellular band, 7/ and permission forprivate networks to provide value-addedservices.

* tariff increases under a phased programto progressively adjust telephone rates

7/ The privatized CANTV operates the other cellular band.

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to economic levelsP' and ensure adequatefinancing for CANTV's investments. Rateswill be automatically adjusted under aprice cap system (inflation less aproductivity factor).

* a new Telecom Law that, inter alia,establishes a new regulatory agency(CONATEL) and opens up the sector togreater competition and privateinvestment. The law is still beforeCongress. In the interim, CONATEL hasbeen established by decree.

1.105 Ports. Shortly after the government took office, a public-private sector commission was set up to consider increased private sectorparticipation in port operations. This commission proposed two options: (i)a continuation of the existing arrangement, with improvements in productivityand efficiency; and (ii) a radical restructuring of INP involving large-scalelayoffs and increased private sector participation. The government chose thesecond option, and in early 1990 approved: the dissolution of INP and thedismissal of all INP workers; the establishment of regional port authoritiesand the transfer of administrative responsibility to the state governments;and the operation of all ports by the private sector under concessionagreements.

1.106 No progress was made, however, until February 1991, when a newINP president (from PDVSA) was appointed with the specific mandate to dissolveINP. Consulting firms and auditors were hired to design the new ports regimeand prepare the dissolution of INP. By the end of 1991, the reform programhad been virtually completed. Its major achievements were:

- the layoff of all 11,000 INP workers2'and the transfer of all cargo handlingand stevedoring activities to privatefirms;

* the introduction of new wharfage anddockage fees in line with competing portsin neighboring countries;

* the establishment of new regional portauthorities in the seven regions with INPports (the eighth INP port is in the

a/ This will require increasing local rates and decreasinginternational rates.

9/ Severance pay was financed from a Restructuring Fund in the FIV.

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Federal District and will continue to bemanaged by the Federal Government);

* the signing of agreements formallytransferring responsibility to the sevenregional governments; and

* submission to Congress of a law formallydissolving the INP.

1.107 Shipoina. Over the past 12 months, the government hasimplemented a number of measures to liberalize shipping and increasecompetition. Numerous restrictions faced by importers and exporters have beeneliminated, including those pertaining to transshipment, opening new routes(and route extensions), and use of CAVN for shipments financed through lettersof credit. A number of regional and bilateral agreements have eliminatedcargo reserve requirements, allowing shippers freedom of choice in selecting acarrier. An Andean Pact agreement, effective July 1991, has eliminated cargoreserve requirements and liberalized shipping tariffs and route extensions forall trade within the Andean region. Bilateral agreements to liberalizeshipping under reciprocal terms have been signed with the United States,Honduras, Costa Rica, Paraguay, and Chile, and are to be signed shortly withArgentina, Mexico, Brazil, and the member countries of the Caricom. Thegovernment is now including shipping liberalization in all bilateral tradeagreements being negotiated and signed. The cumulative impact of all thesemeasures has been to increa3e competition and provide importers and exporterswith greater freedom in selecting shipping companies.

1.108 Water Supplv and Sanitation. In mid-1990, the gove nmentlaunched a far-reaching restructuring strategy aimed at liquidating INOS,establishing autonomous and financially self-sufficient regional watercompanies, and, where feasible, privatizing operations through concessionagreements with private operators. Progress, however, has been slow,particularly in comparison with ports and telecommunications. Ten regionalcompanies have been established but are not yet fully operational. Audits areunderway to facilitate the laying off of INOS staff, the transfer of INOSassets to the regional companies, and the settlement of liabilities. Thisliquidation or transfer process is expected to be completed by late 1992. Adraft water sector law formalizing tne transfer has been prepared and will bepresented to Congress shortly. The original restructuring strategy has beenmodified to retain a small INOS office with limited engineering and projectmanagement functions as a transitional measure. This office will be abolishedonce the regional companies develop full project management capabilities.

1.109 A small tariff increase was recently implemented for industrialand commercial users. The process of privatizing the Caracas water system isnow underway. Sector officials appear committed to the objective ofestablishing a sector regulatory agency.

1.110 Hiahwavs and Interurban Transport. The main objectives are: todecentralize the management of rural roads; and to establish a fund financed

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by new taxes on petroleum products, earmarked for the rehabilitation andmaintenance of the national highway and rural feeder road networ;--;. Themanagement of the rural feeder roads system has recently been transferred fromthe General Directorate for Roads (DGSVT) to a newly created AutonomousService for Agricultural Roads (SAVA). A federal interministerial committeeand regional and local committees with representatives from the state andlocal governments have been authorized to make financial decisions. Thetechnical services have not yet been decentralized, however. The prices ofpetroleum products were being increased on a monthly basis (prior to therecent freeze) and a law to authorize a new tax on petroleum products and theproposed road fund is being presented to Congress.

1.111 An ambitious plan developed under the previous administration forthe construction of an integrated railway system is receiving strong supportfrom various interest groups. The government does not yet have a clear policyfor interurban transport and has made no decision regarding the implementationof the proposed railway projects. The Minister of Transport andCommunications has agreed to the preparation of a comprehensive freighttransport plan that would review the performance of the existing transportindustries and the related institutional and regulatory frameworks beforeproposing appropriate reforms for the short and medium terms. Some economicanalyses of proposed railway and water transport investments have beenundertaken, and a consortium of consultants is being contracted for thefreight transport plan now scheduled to be completed by the end of 1992.

1.112 Urban Transport. In July 1990, a steering group was formed underthe Interministerial Commission on Urban Transport to determine objectives andpriorities, to make recommendations on institutional and regulatoryframeworks, to evaluate policies, and to formulate a strategy for the shortand medium terms. A review of tariffs and subsidies nas been completed, andstudies have been launched on financing mechanisms, institutional arrangements(particularly the roles of the various governmental levels), and options forexpanding urban transport to the poorer areas on the outskirts of Caracas.

1.113 Under the 1990 Decentralization Law, urban transport (excludingthe metro) was transferred to the municipalities. Since they do not have therequisite financial and technical resources, one of the priorities of thegovernment is to equip them for this new responsibility.

Evaluation and Further Reforms

1.114 Telecommunications. The next steps in the reform process are:(i) Congressional approval of the Telecommunications Law; (ii) staffing ofCONATEL and developing appropriate procedures and systems for it; and (iii)approval of proposals for private networks.

1.115 The major issue in the medium term is whether the CANTVprivatization and concession contract includes sufficient incentives to ensurean appropriate balance between competition/efficiency and network expansion.The new operator was granted a nine-year monopoly for basic services (localand long distance) in exchange for commitments to implement a large expansion

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program.2l' Limited competition is permitted through a cellular band (aprivate firm operates the second band), private networks, and value-addedservices. However, granting a monopoly was felt necessary to ensure asufficient cash flow for the new operator to finance an aggressive expansionprogram. To the extent that this monopoly is for a longer period than may benecessary, the government may be trading off some economic efficiency (leadingto higher telephone rates).

1.116 A related issue concerns the adequacy of the incentives for thenew operator to fulfill the expansion program. The concession contract setsout several sanctions for non-compliance to be enforced by CONATEL. But theoptimal method of ensuring compliance is a combination of competitivepressures and an appropriate tariff structure, rather than regulatoryenforcement. It should be in the new operator's best interests to expand thenetwork and ensure reliable service if the tariff rates reward this and thecompetition forces it. It is unclear at this stage whether the CANTVtransaction has sufficient incentives built in, or whether it relies (perhapsunduly) on regulatory enforcement.

1.117 Ports. The dissolution of the INP and transfer of all cargohandling and stevedoring to private firms has already had a dramatic impact onefficiency. Preliminary data show a substantial improvement in several keyproductivity indicators (e.g., tons/man-hour have nearly doubled from 21.16 to40.03).

1.118 Nevertheless, further reforms at the regional level are desirableto maximize economic efficiency and private participation. Specifically, thiswould involve the granting of concessions to private firms, throughcompetitive bidding, for the operation of individual terrmiinals in larger portsor the administration of an entire port where more than one concession wouldbe impractical. Such arrangements would ensure maximum competition bothwithin the larger ports (by allowing terminal concessionaires to compete forbusiness) and between ports (by allowing ports to compete against each otherin terms of rates and service).

1.119 Some of the regional governments are contemplating theintroduction of concession for private operators, though the extent to whichthese will be implemented is unclear. Much depends on the legislation beingprepared.11' Another factor is the uncertainty over which level ofgovernment (national or regional) has the responsibility for granting theconcessions. The national government insists that: (i) it continues to ownthe assets (although the Decentralization Law has transferred responsibilityfor administration and maintenance to the regional governments); (ii) it

10/ By comparison, a similar arrangement in Mexico included a seven-year monopoly and in Argentina a seven-year monopoly with the right to athree-year extension provided certain performance criteria are met.

11/ Each regional government has prepared its own legislation for theoperation of its port authority.

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therefore should retain the right to grant concessions; and (iii) as owner, itshould receive a percentage of port revenues. These issues are currentlybeing discussed by the national and regional governments.

1.120 shi]n,ina. During 1992, the government expects to sign reciprocalagreements with its remaining trading partners to fully liberalize shipping.Consistent with full liberalization, the government should examine theprivatization of the state-owned shipping company, CAVN, since it no longerfulfills a public policy objective.

1.121 Water Supnly and Sanitation. The restructuring of INOS has beendelayed, at least in part due to INOS management interest in maintaining thestatus quo. Over the next 6-12 months, the following actions need to beundertaken:

finalization and enactment of a new water sector lawlegitimizing the new regime and legally dissolving INOS;

development and implementation of a new tariff structure,implementation of substantial increases in water andsewerage rates to enable the new local and regional watercompanies to become financially viable, and adequate rateregulation to ensure sustained viability;

* liquidation of INOS; termination of its employees; transferof all assets to the new regional water companies; andinstitutional, commercial and managerial strengthening ofthese companies;

* formalization of a concession agreement with a privateoperator selected through a public bidding process.

1.122 Several factors will make these actions difficult: (i) legal andpolitical issues concerning the involvement of the municipalities (or regionalgovernments) in the restructuring and privatization processes; (ii) theunwillingness of the national government to increase (primarily) water ratesuntil service has improved (in the interim, the financial viability of thewater companies continues to erode); and (iii) lack of a strong commitment byINOS and the sector ministty (MARNR) to the dissoluticn of INOS and theprivatization (via concessions) of water system operations.

1.123 As was evident in several other SOEs (notably INP, CANTV, andVIASA), resolution of these issues will require new leadership committed tothe dissolution of INOS, privatization and commercialization of water systemoperations, and development of financially viable regional and local watercompanies.

1.124 Highways and Interurban Transport. The decisions to decentralizerural road planning and expenditures and to establish a road fund areimportant first steps in reform. Over the next 12 months, the governmentshould concentrate on:

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* continuing adjustments of domestic petroleum prices topromote efficient resource allocation and transport use;

* redefining the extent of the highway network that is ofnational interest and transferring the rest to the newlycreated decentralized administration;

* formulating a road cost-recovery policy, establishing cost-recovery and funding mechanisms for road maintenance, anddetermining appropriate user charges and toll levels; and

* formulating a concession program for building and operatingexpressways (with an appropriate regulatory framework) andinitiating and granting concessions.

1.125 At the same time, the freight transport plan should be completedto provide a basis for decisions on the rail network.

1.126 Urban Trans2ort. The recommended agenda for further reformsshould focus on:

* liberalization of the bus system regulations (notablyderegulation of fares);

* phased replacement of generalized subsidies with targetedsubsidies linked to affordability;

X progressive adjustment to realistic fuel prices;

X strengthening the agencies involved in urban transport atthe national and local levels, specifically by establishingurban transport policies at the central government level;ensuring that local governments are equipped to undertaketheir responsibilities; and improving the capacity of localgovernment agencies to plan, design, operate, and maintainthe urban transport systems.

* defining the roles of the public and private sectors in theprovision of public transport services within Caracas.Many private bus operators, caught in the squeeze betweenrising operating costs and low regulated fares, are on theverge of bankruptcy, while CAMETRO is expanding itssubsidized bus and rail network..!Y

12/ There is also an equity problem. CAMETRO buses tend to servepredominantly middle-income areas; while transport users from low-incomeareas, using privately operated jeeps and buses, pay higher fares and payseveral times for trips involving interchange.

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Financial Sector

Prior Conditions

1.127 The banking system was based on financial specialization.Commercial banks were to lend for working capital and other short-term needs;finance companies would lend for fixed assets and consumer goods as well asthe development of commercial business; mortgage banks were to borrow throughlong-term instruments and lend for residential construction and home andcommercial property purchase and improvement; savings and loans were also toborrow for the long term and lend for purchases of homes. In practice,however, there is a de facto universal banking system, since financialinstitutions have formed financial groups offering clients a full array ofservices and diversified options. The six largest commercial banks accountfor 63 percent of bank deposits and are part of the six groups that dominatethe financial system. There seems to be a trend towards increasedconcentration.

1.128 Until the reform, interest rates were subject to ceilings. As aresult, real interest rates were mostly low and, particularly with theacceleration of inflation in the second half of the 1980s, often negative.New liquid assets were formed to circumvent the regulations that made realinterest rates on deposits negative (these assets are not subject to reserverequirements).

1.129 There are no fixed-term negotiable Treasury bills that can beused to carry out open-market operations. Instead, the Central Bank ofVenezuela (BCV) must issue its own short-term bills at the risk of generatingquasi-fiscal losses. Treasury bills, by law, must be placed through apreferential list of economic agents. In practice, bills are held only by theBCV and commercial banks, the latter holding them as assets to satisfy reserverequirements. The use of Treasury bills as reserves negates the monetaryobjectives of the reserve requirements, which become instead an instrument toforce lending to the government.

1.130 There are numerous public DFIs. Created to provide long-termfinance, several have been used to implement political decisions to financespecial projects at below-market interest rates. They are basically second-tier institutions operating outside the purview of the regulatory authorities.Most of them are controlled by the corresponding ministries and obtain theirfunding from direct transfers of the government, loans from the Fondo deInversiones de Venezuela (FIV), or government-guaranteed external financing.These institutions generate obvious segmentation of financial markets and aremostly unnecessary, even if public funds for long-term finance of certainactivities are considered to be important.

1.131 Beyond the segmentation created by the existence of numerouspublic credit institutions with power to determine rates and conditions ofloans, there are portfolio requirements for private banks. Commercial bankshave been subject to a 22.5 percent lending portfolio requirement foragriculture and agro-industry. Interest rates for these loans are required tobe below market rates.

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1.132 A particularly serious problem is the weak financial position ofsome institutions, which makes insolvency likely. The magnitude of theproblem is difficult to estimate because of poor supervision and widespreadrolling-over of non-performing loans. Registered non-performing creditsincreased approximately 50 percent from May to August 1989 for commercialbanks not under intervention. In August 1989, of 38 banks not underintervention, 12 had non-performing portfolios exceeding their estimatedcapital base. These accounted for 22 percent of the total assets of thesystem and one of them, the Banco Industrial de Venezuela (BIV), a publicbank, held half that share. None of the banks in this group is among the sixlargest private commercial banks, some of which may require capital increaseds,but are not likely to become insolvent. However, the BIV and some of thesmaller banks will have to be heavily recapitalized, merged, or liquidated.

1.133 Mortgage banks and S&Ls are experiencing major financial problemsbecause of the mismatch between the maturity and rate structure of theirassets and liabilities. Multiple government-sponsored programs that financehousing have made most of these institutions highly dependent on subsidies tosurvive.

1.134 Their narrow capital base exposes virtually all S&Ls to rapidinsolvency if subsidies on preferential loan rates are cut. Even withsubsidies, six institutions, holding 31 percent of the assets of thissubsector, had losses greatly exceeding their -apital at the end of June 1989.S&Ls have been losing their share of the market for deposits since 1987.BANAP, a second-tier public institution, has supported them with huge creditsfinanced with external debt as increased interest rates have lured depositorsaway. On average, debts to BANAP are 26.6 percent of the total liabilities ofthe S&Ls, and in five cases have reached more than 40 percent. BANAP itselffaces severe difficulties with US$1.5 billion worth of loans from foreignbanks and is unlikely to have the resources to provide the liquidity that theS&Ls will soon need. This raises doubts about the sustainability of thesavings and loans system.

1.135 Short-term money markets lack depth and long-term capital marketsare minimal. Subsidized rates of interest and easy credit policies havefavored debt over equity financing. A weak regulatory framework has allowednon-transparency :nd discouraged the private investor. Finally, many years ofstate intervention have produced economic concentration in the public sectorand unfavorable conditions for private investors.

1.136 The roles of various institutions involved in bank regulation andsupervision are unclear. Pervasive intervention by the Ministry of Finance(MH) causes delays and politicization of decisions. The BankingSuperintendency (SBIF) lacks autonomy and power. The division of decision-making authority and reporting procedures between the SBIF and the DepositInsurance Fund (FOGADE) is vaguely defined, creating conflicts andinconsistency in policy making.

1.137 The regulations are not effective in ensuring the solvency andfinancial stability of credit institutions. Standards on loan classification,

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provisioning, capital requirements, lending concentration, lending to relatedparties, control mechanisms, and fines and sanctions are weak. Accountingrules are not sufficiently clear, external audits are inadequate, andinformation disclosure by banks and by the SBIF is deficient. Examinationsare not frequent and tend to focus on enforcing specific monetary, fiscal, andother regulations rather than on credit risk analysis and assessment ofoverall solvency.

1.138 The process for handling banking crises is much too long andcostly. FOGADE'S law gives it neither an adequate mandate nor the appropriatemechanisms to rehabilitate or liquidate insolvent banks, and inactionfrequently follows because of the approval requirements. Moreover, becauseFOGADE'S assistance is not made conditional on a change of ownership, it canbe misused to bail out the shareholders and managers of failing banks. Often,the assistance amounts to liquidity support provided at preferential rates andfor unnecessary long maturities.

Policy Reforms

1.139 The objectives of the financial sector reform are: (i) toliberalize the financial policy environment finterest rates, allocation ofcredit, foreign ownership, universal banking, etc.); (ii) to reduce the roleof government in financial intermediation (by privatization and liquidation ofpublic banks, consolidation of DFIs, rationalization of housing financepolicy, etc.); (iii) to limit the role of the BCV to providing liquidity andto monetary management; (iv) to improve the supervision and handling of bankcrises; and (v) to increase competitiveness in banking.

1.140 In April 1990, the BCV issued an order setting the minimumdeposit rate at 10 percent and the maximum lending rate at 60 percent forcommercial and mortgage banks, finance companies, and S&Ls. The spreadbetween these limits allows sufficient scope for market determination ofinterest rates at prevailing inflation rates. The policv is to increase thelending rate ceiling and to decrease the limit on deposit rates as soon asthey become binding. The limits have not yet required further change.

1.141 A new set of preferential rates was instituted in May 1990.Preferential rates for agricultural loans are 85 percent of the average non-preferential credit rates offered by the six largest commercial banks. Ratesfor direct lending by public DFIs for non-agricultural activities were definedat 90 percent of the same reference. There is a commitment gradually toreduce these differentials until they are eliminated. Mortgage relief may beprovided through budgetary allocation as long as the total interest ratereceived by the first-tier financial institution meets the above guidelines.Second-tier institutions will channel funds to first-tier institutions at arate no lower than the remuneration of deposits in the commercial bankingsystem. First-tier institutions absorb the entire credit risk of the finalborrowers.

1.142 The government has reduced the mandatory agricultural loans ofcommercial banks from 22.5 percent to 12 percent of their portfolio andintends to eventually eliminate this constraint on credit allocation.

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1.143 Intervention in the financial system has been reduced. Thegovernment has already privatized three banks previously owned by the CentralBank, has decided to liquidate Bandagro, and has adopted a plan to restructurethe BIV and its four regional banks.

1.144 The Congress has approved amendments to the Public Credit Lawwhich allow the Treasury to issue negotiable fixed-term bills that need not berepaid within the fiscal year in which they are issued. Interest rates onTreasury bills will be market-determined and preferential placement provisionswill be abolished. The BCV will purchase Treasury bills in the secondarymarket or--on a residual basis--in primary auctions at the average clearingprice. The BCV has decided not to purchase any more zero-yield Treasurybills.

1.145 The rediscount window will be used as a temporary liquiditysupport facility. While the BCV is developing its open-market capabilities,rediscounts may be used as instruments of monetary expansion. However, therediscount facility will not be used for sectoral incentives. As part of thispolicy, a resolution of May 1990 provides that all general rediscounts beoffered at a rate linked to the yield on BCV bills auctioned. (Lower ratesfor rediscounts are still maintained as an incentive for agricultural loans.)Also, automatic mecnanisms have been introduced for referring large orfrequent borrowings to the SBIF for review.

1.146 The new BCV law has been recently published. Several other lawshave been sent to Congress to regulate the SBIF, FOGADE, the Industrial CreditFund (FONCREI), and the Agricultural Credit Fund (FCA). If approved, theselaws will provide the required framework to support the objectives of reform.

Evaluation and Further Reforms

1.147 The reforms described above will greatly improve the legal andregulatory framework of financial transactions, but their full effect willtake time and will depend on how soon the required incentives are provided.

1.148 The reforms have been very positive in taking the proper measuresto foster development of a more competitive banking system. They are carryingout very satisfactorily a program that is complex both in nature and intiming. For example, the privatization of banks owned by the BCV took placeahead of schedule, and the proposed Banking Law was sent to Congress earlierthan planned along with the other proposed laws, making for easier definitionof the whole new legal and regulatory framework.

1.149 A very important aspect of the reforms is recognition of the needto properly administer the fiat money system to attain price stability and theconsequent change of the legal environment. The recently published Law givesto the BCV the power and the tools to carry out a sound monetary policy. Ofparticular importance is the elimination of the old arrangement that forcedpublic debt into the banking system.

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1.150 The new rules are designed to strengthen fiscal discipline and

improve the financial condition of the BCV, as well as to allow the use of

Treasury bills as instruments of open-market operations. The introduction ofBCV bills in November 1989 already permitted open-market operations, but it is

expected that the BCV will be able to trade in Treasury bills to avoid the

quasi-fiscal implications of trading in its own.

1.151 By giving the Central Bank much greater independence from the

Treasury, the reforms should create a sound market for public debt,eliminating the difficulties of maintaining monetary targets in the face of

major fiscal shocks. The problem of coordinating monetary and fiscal policywill continue as lonag as public debt is not properly used to isolate public

expenditures from fluctuations in fiscal revenues.

1.152 Closely related to the proper role of the Central Bank is itsauthority to regulate interest rates. For legal reasons this authority wasretained in the BCV Law, although in effect the policy of the monetary

authorities has been not to make the regulation of interest rates a bindingconstraint. It would be desirable for this last remnant of the old regulatory

system to be eliminated as soon as possible.

1.153 The reforms aim at fostering competitiveness by replacingsegmentation with universal banking and opening all kinds of financialinstitutions to foreign investment. Although the proposed new Banking Law

sets a transitory period during which foreign ownership of commercial bankswill be limited to 20 percent of capital, this restriction too is expected to

be removed eventually.

1.154 The most important next step is the approval of the laws nowbefore Congress, which is not expected to pose any serious obstacle to the

reform process. Congress may e'en adopt a more liberal position on foreigninvestment in commercial banks. If, however, it upholds the restrictions now

proposed, the opening of commercial banking to full foreign investment wouldbe left to the discretion of tae authorities.

1.155 An element that badly needs reform is the housing finance system.Among the laws proposed to Congress is the National Savings System Law that

identifies the main problems and suggests remedies.

1.156 As explained earlier, the critical financial situation of bothBANAP and the S&Ls is the result of high market interest rates that could not

be reflected in mortgage loans under the existing regulations. Thisdistortion requires drastic and urgent correction, and is addressed in anotherproposed law before Congress.

1.157 The need for a well-functioning national savings system tofinance housing can hardly be exaggerated. A law passed in 1989 decrees thata monthly mortgage payment greater than 25-30 percent of a borrower's monthlyincome must be subsidized. Up to a price limit, all primary homes are covered

by this protection. The amount of the subsidy in 1990 is estimated to havebeen about 0.7 percent of GDP. The reforms aim at making subsidies to low-income families compatible with the financial stability of the national

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savings system. The proposed new law redefines the functions of BANAP and itsrecapitalization; phases out funding by government, BCV, and any externalsource, and outlines policies for the financial support of S&L,;. The S&Lswill be required to recapitalize and also will be allowed to provide newservices, including credit cards. They will be encouraged to transform intocorporations and will be authorized to issue bonds backed by individualmortgages guaranteed by BANAP. This new function for BANAP aims at developingthe secondary mortgage market. Depositors will not be insured by BANAP but byFOGADE. BANAP will still be a first-tier institution providing finance forspecial housing programs.

1.158 The proposed reform reinforces the control of financialintermediation by eliminating the specialized S&Ls Superintendency and turningover its functions to the Banking Superintendency.

1.159 The reform is ahead of schedule in having privatized all bankspreviously owned by the Central Bank. Reduction of the number and functionsof public DFIs is a process that follows its course. The two main survivinginstitutions are being restructured and will be properly regulated once theproposed laws have been approved by Congress.

1.160 The BIV will remain a first-tier public commercial bank and berestructured according to the plan already adopted, which will eliminate thesource of past financial difficulties.

1.161 A final pending component of the reform process is theredefinition of the legal and regulatory framework for insurance and capitalmarkets. A first draft of the Capital Markets Law properly identifies theflaws in the present system and proposes remedies.

1.162 The most important shortcoming is the absence of a long-termcapital market, not because of legal obstacles per se, but because of therisks for private long-term lending when there is extensive publicinterventica in capital markets and macroeconomic instability. The success ofthe stabilization program, together with the elimination of distortionarypublic intervention which the reforms already undertaken imply, will allow forboth the development of long-term lending and the introduction of the requiredlegal instruments.

1.163 An important policy change that has obvious implications for thefinancial market is the reform of labor market regulations. If, as planned,Venezuela moves towards a compulsory savings scheme for labor (similar to theone in Chile), the banking industry also would have to be properly regulatedto ensure that savings are allocated efficiently. This policy would beimportant in promoting the development of the long-term capital market.

Social Sectors

Prior Conditions

1.164 Venezuela's per-capita income is amongst the highest in LatinAmerica. But its highly skewed distribution of income leaves large segments

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of the population in poverty. Infant mortality rates have fallensubstantially since 1965 (from 65 per 1,000 to 36 per 1,000 in 1988), butstill remain double those of Jamaica and Costa Rica, which have half the percapita income. Similarly, although school enrollments have increased rapidlyover the same period, gross secondary school enrollment is only two-thirdsthat of Uruguay, Argentina and Chile. The illiteracy rate for adults hasdecreased 65 percent since 1965 but still remains at a relatively high 13percent. The total fertility rate (3.8) is higher than in many other LatinAmerican and Caribbean countries with much lower GDP per capita. Recentestimates show two main trends in selected health indicators during the 1980s:a significant slowdown in improvements in neonatal, postnatal, and maternalmortality; and an increase in undernutrition, child mortality due tomalnutrition, and morbidity due to endemic diseases. Similar trends have beennoted in the education sector, where enrollments have leveled off andrepetition and dropout rates have increased.

1.165 Three major factors have contributed to the persistence ofpoverty and its manifestations: (i) public services have been poorly managed,highly inefficient, and not directed to those most in need; (ii) rapidurbanization and especially the growth of metropolitan Caracas have severelystrained the government's capacity to provide health and education services.Urban dwellers now represent nearly 85 percent of the population, and many ofthem live in large slum communities on the urban periphery, with only limitedbasic services and markedly inferior standards of education, health,nutrition, and hygiene; and (iii) although population growth has declined, therate remains high at 2.8 percent.

1.166 Previous anti-poverty programs attempting to redistribute incomethrough general food subsidies and free social services failed despite highexpenditure. The main beneficiaries of food subsidies have tended to be themiddle- and higher-income groups, who could afford to buy greater quantitiesof subsidized goods. While social services were presumed to be universal andfree of charge, poor management and inefficient investment left manybeneficiaries out of reach of service delivery and obliged others to pay formedicines, bandages, textbooks, and other school materials that were not madeavailable.

Policy Reforms

1.167 In 1989, the government replaced general food subsidies withprograms specifically for lower-income groups and expanded existing programsthat target the most vulnerable members of society. These actions weredesigned to shield the poorer segments of the population from the adverseeffects of structural adjustment and to overcome past deficiencies intargeting, coverage, and administration of selected social services.

1.168 The new strategy emphasizes a shift from highly inefficientgeneral subsidies available to the entire population to programs targetinglower-income groups. Its principal objectives are to: (i) relieve the severehardship resulting from economic decline; (ii) mitigate the impact ofadjustments in the economy necessary to achieve sustainable, long-term growth;

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and (iii) set the basis for human capital development, an essential factor ofgrowth with equity. Other elements of this strategy are to improve theplanning and monitoring capacity of participating ministries and to increasethe efficiency of service delivery.

1.169 To increase the cost effectiveness of social expenditures, thegovernment has emphasized three principles in the selection of projects: (i)increased targeting of the poor; (ii) decentralization of design andmanagement; and (iii) greater participation of the private sector (both for-profit and non-profit) in service delivery.

1.170 Initially, there were four programs at the core of the povertyalleviation strategy: (i) a nutritional grant program consisting of a directcash subsidy to families of school children in low-income areas (BecaAlimentaria); (ii) a maternal-child health care and feeding program aimed atexpanding primary health coverage and improving health service deliverythrough food distribution to vulnerable groups seeking preventive health care(i.e., primarily pregnant and nursing women and children under six years ofage); (iii) Hogares de Cuidado Diario (HCD), a community-based day careprogram directed at children of working mothers in low-income neighborhoods;and (iv) a preschool expansion program targeted to poor rural and urban areas.

1.171 More recently, in an effort to improve nutritional standards forchildren in low-income areas, a cereals bonus (beca de cereales) has beenintroduced. Both the nutritional grant and cereals bonus are beingdistributed through the Ministry of Education, who is also in charge ofproviding textbooks, uniforms, and other school supplies for elementary schoolchildren in low-income areas. These programs are aimed primarily at improvingthe nutritional status of children of preschool and primary school age andpregnant and lactating women.

1.172 The emphasis on social programs is borne out not just by improvedtargeting but also by a very significant increase in budgetary allocations.In 1991, targeted social programs accounted for 7.4 percent of centralgovernment expenditures. In 1992, the resources budgeted for these programssurpassed US$700 million.

1.173 Maternal-Child Health Care. The purpose of this program is toexpand delivery not only of preventive medical care but also of health,education, and nutritional support. Food supplements, especially powderedmilk, are distributed to the targeted population according to socioeconomicand biological risk criteria. The maternal health program aims to improve thequality and service delivery of prenatal and postnatal care, to reducematernal and child mortality, to stimulate breast-feeding, and to reducemortality and morbidity due to uterine and breast cancers. The basicobjective of the program is to provide a nutritional supplement free of chargeto the target population in order to attract the most vulnerable groups tohealth posts for medical care and eventually to improve their nutritionalstatus. In 1988, about 25 percent of pregnant women were receiving prenatalcare and only 5 percent were receiving postnatal care. No more than 16percent of infants under two years old and 10 percent of preschool children

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from two to six years old received health care that year. By 1994, thisprogram is expected to expand coverage to 50 percent of pregnant and postnatalwomen (600,000), 50 percent of infants under two years of age, and 10 percentof preschool children (more than two million). Expansion of coverage will beexclusively for low-income groups.

1.174 Community Day-Care Centers. In 1991, this program expected to

reach about 150,000 children, from about 24,000 children in 1989. This home-based program provides nutrition, health, and childhood development assistancefor poor children and promotes community education and development. Untilrecently, there has been only one type of HCD: about eight children cared forby one community mother in her home for a twelve-hour period. The governmentgives the mother a loan to equip her home and pays her a monthly stipendsupplemented by fees paid by the parents of the children under her care.Three more types are being introduced: (i) part-time HCDs (four-hour shifts);(ii) multi-HCDs, in which three community mothers care for 30 children in a

specially adapted community center; and (iii) natural HCDs focusing on thepoorest of families in which mothers do not (or cannot) work.

1.175 Preschool ExRansion Prouram. Expanded coverage under thisprogram is expected to reach 96,000 children from three to six years of age in

formal preschools, and 16,000 in nonformal preschools throughout the country.The existing program covers only about a third (mostly from middle- andhigher-income families) of about 1.7 million preschool children. To improve

equity and access, the new policy is to allocate all public funds for newpreschool construction exclusively to poor urban and rural areas. The formalpreschools will be assisted by state education budgets, teachers, andsupervision. The nonformal preachools will be served by local-level NGOs andcommunity organizations, and will be given greater future emphasis if they are

successful.

1.176 There are several minor programs, the most important of which are

informal-sector support and other nutritional programs also aimed atstrengthening the institutional social network. Other measures increaseunemployment benefits and modify the social-security system.

Evaluation and Purther Reforms

1.177 The reform program introduced in 1989 was designed to counter thepervasive inefficiency, economic decline, and increased poverty that publicsector economic and social policies had spawned. The strategy for povertyalleviation is to promote sustainable growth and expand social programs,moving from highly inefficient general subsidies available to the entirepopulation to assistance that targets those most in need.

1.178 In this context, the government's poverty alleviation strategyis an innovative approach to moving poverty problems to the forefront, but ithas not yet entirely reversed the misdirection of resources. In 1989, fundsfor poverty alleviation represented approximately 11 percent of social sectorspending; in 1990, they had increased to 16 percent. Maternal-child healthexpenditures grew from 68 percent in 1989 to '.5 percent in 1990. But about

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75 percent of its funds in 1990 were devoted to short-term direct cashtransfers, although it is supposed to cover education, health, and nutrition,as well as better worker protection and the development of microenterprises.While these transfers may have eased the financial burden on the families ofabout 1.8 million poor children, they did not contribute to improving health,education, and nutrition, which have suffered from years of inefficientresource allocation, poor management, and low-quality service. The governmenthas strengthened existing maternal-child health and preventive care systems,but has much more to do in articulating an integrated strategy for socialservices.

1.179 In an effort to improve the planning and management of socialprograms, the government recently announced the Social Megaproject. It is anumbrella project hich covers about 15 ongoing programs and new proposalscovering a broad range of social services, from day-care and nutrition, tohealth and education, and the rehabilitation of social infrastructure. Theseprojects are in various stages of preparation, and some are still in need offinancing. The Social Megaproject would be coordinated by CORDIPLAN, whichwill provide overall guidelines, and executed by the Ministries of Health,Education, Family, Urban Development and Transportation, as well as state andlocal governments.

1.180 The social sector still faces these major problems:

* highly centralized management;

* expenditures skewed to higher-cost, inefficient projects;

* insufficient data to identify target groups;

- insufficient attention to designing appropriate servicesand delivery mechanisms, and to community involvement; and

* inadequate technical skills to plan and manage sustainableprograms.

1.181 Some attempts have been made to decentralige management andimprove service delivery; a survey of living standards will be carried outregularly to improve impact monitoring; and perceptible advances have beenmade to encourage NGO and community participation. But these are merely thefirst small steps.

1.182 The misallocation of resources persists. Higher education, whichaccommodates very few low-income students, receives about 40 percent of theeducation budget. Health resources are oriented towards curative medicine andhospitals, not to preventive care. Programs to improve nutrition do not coversome of the most vulnerable groups. Nonsalaried workers are excluded fromsocial security benefits.

1.183 There is likely to be considerable pressure for a return togeneral subsidies, and it is extremely important that the government stand

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firm. Evidence to date suggests that the reforms will be continued, judgingfrom the seriousness with which the government has embarked on a difficultcourse of social policy reform and the importance it has given to the sectors.The following are specific recommendations:

(a) The government should revise the poverty alleviationstrategy, as to its priorities, costs, and short- andmedium-term objectives so that it focuses not merely on thenew poverty alleviation programs, but on reformingestablished social sector oroarams. The strategy shouldinclude: (i) ongoing social programs with povertyalleviation objectives (e.g., school feeding, healthpromotion, and nonformal preschool education) that couldbenefit from improved efficiency and targeting mechanisms,and political support; and (ii) a second phasri of thepoverty alleviation strategy emphasizing fundamental reformof the health, education, and nutrition sectors. TheMinistry of Family (MINFAM), as the secretariat for thePresidential Commission for Poverty Alleviation (COPEP),should promote the revised strategy among all participatingagencies and the general public to mobilize greater effortsby service providers and greater awareness andparticipation among the beneficiaries.

(b) Targeting mechanisms and sectoral resource allocationshould be directed to achieve greater efficiency andequity. Poverty maps should be updated to includemunicipal, barrio-level, and health and nutritionindicators to identify those most in need. MINFAM shouldensure that the revised indicators are incorporated intoall poverty alleviation programs. School feeding andmaternal-child health programs should be consolidated.Allocations should be revised to correct: (i)disproportionately high expenditures at the cost ofoperations and maintenance expenditures in both health andeducation; (ii) bias towards higher education at the costof basic education; (iii) bias towards tertiary/curativehealth care at the cost of primary/preventive health care;and (iv) remaining untargeted food subsidies for schoolchildren. In general, primary school education and primaryhealth care offer higher social rates of return and thusrepresent a more efficient use of public resources. Thegovernment should begin exploring mechanisms for selectivecost recovery to include: public-university fees, combinedwith a student loan program and scholarships for low-incomestudents; and health care fees based on ability to pay, orin conjunction with subsidized health insurance for thepoor.

(c) Both for-profit and non-profit private sector agenciesshould be used for greater efficiency in delivery services.In health, some options to consider are: contracting for

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hospital management or the provision of select services;encouraging competition in the distribution ofpharmaceuticals; and establishing a compensatory schemeunder which patients treated in private clinics are coveredby some form of public (or private) health insurance. Ineducation, increased private sector university andpreschool services for those who can afford to pay wouldfree up public resources for higher priority areas, such asbasic and secondary education, textbooks, and othermaterials for those who cannot afford them. In nutrition,local companies, which often buy and distribute goods morecheaply than the public sector, could improve efficiency.NGOs often are more effective in delivering services to thepoor because of their location, commitment, and communityorientation. They also promote local participation andresource mobilization at a relatively low cost. A surveyof NGOs should be completed to determine their strengths,weaknesses, and needs for coordination with the publicsector.

(d) The overall management of programs to alleviate povertyshould be strengthened by better coordination of policydevelopment, project formulation, monitoring, andevaluation. The transformation of the MINFAM into theMinistry of Social Development should be completed, placingparticular emphasis on establishing working links with allagencies involved in poverty alleviation. Each agencyshould provide MINFAM with accurate cost estimates ofsocial programs and in turn receive technical assistance inproject design, targeting, monitoring, and evaluation.Reforms are badly needed to correct problems of weakmanagement, unqualified personnel, low salaries, poorproject formulation, unintegrated planning and budgeting,and low quality of service.

(e) The new Decentralization Law has many implications for thesocial sector. Since the state governments are expected torequest the decentralization of education and health first,these ministries should prepare an implementation strategythat determines: which services could be more effectivelydelivered at the local level or by the private sector; thecosts and personnel involved; the best way to maintain orimprove quality of service; and the capacity of the statesto assume their new responsibilities. Central funds couldbe used as matching grants for priority programs and as ameans of redressing social or regional inequalities. Localauthorities have little, if any, experience in planning anddelivering social services, a deiiciency that must becorrected by urgent technical assistance in all phases ofthe work.

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II. MACROECONOMIC REFORMS

2.1 This section of the report discusses Venezuela's macroeconomic issues

under two headings: the 1989 stabilization policy, and the country's inherent

macroeconomic problems. The first concerns a specific event of prime

importance to Venezuela's recent economic life; the second embraces features

of a more permanent nature--some of which are clearly demonstrated by the

stabilization experience. The analysis does not intend to provide an up-to-

date assessment of Venezuela's macroeconomic performance.

A. The Stabilization Policy

Prior Conditions

2.2 Venezuela has had continuous inflation since the first major oil-priceincrease of 1974. Until the late 1980s, however, inflation was moderate and

rather stable, with an average annual rate of 11 percent from 1974-86 and not

much variation except for a jump following the second oil-price increase of

1979 (Table 3).

Table 3: RATE OF INFLATION AND THE FOREIGN EXCHANGE RATE, 1970-91

Pertentage Increase of Nominal Rate ofCoinsumer Price Index Exchange, End Year

Year (Annual Averages) (Bs per USS)(1) (2)

1970 2.5 4.571 3.2 4.572 2.9 4.473 4.1 4.374 8.3 4.375 10.2 4.376 7.7 4.377 7.8 4.378 7.2 4.379 12.3 4.3

1980 21.6 4.381 16.2 4.382 9.6 4.383 6.3 4.384 12.8 7.585 11.4 7.586 11.6 14.587 28.1 14.588 29.5 14.589 84.5 43.1

1990 36.5 50.491 '0.7 61.6

Source: Banco Central de Venezuela (BCV); and I.M.F. International Financial Statistics (I.F.S.), various issues.

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2.3 From 1986-88, however, economic policy became heavilyexpansionary. Public-sector investment jumped from 7.7 percent to around 12percent of GDP in 1987-88. By 1988, the budgetary deficit was 7.2 percent ofGDP. By early 1988, the inflationary process had gathered momentum to reachlevels unknown in Venezuela but still fairly moderate relative to many otherLatin American countries. During the second half of 1988 and early 1989, therate of inflation (increase in the consumer-price index) was roughly 4 percentper month, or some 60 percent per year, which still understated the intensityof the inflationary pressure because of the existence of price controls.

2.4 Throughout these changes, the nominal exchange rate remained fixedat 14.5 Bs per USS for the principal rate, the level since 1986. A rapidappreciation of the real exchange rate thus took place, with a consequentdeterioration in the balance of payments: the current-account deficit reachedalmost 10 percernt of GDP in 1988. Oil prices in the short run are the majordeterminant of the value of Venezuela's exports, since oil yields 70 to 80percent of total export revenues and the volume of oil exported changes onlyslowly (and, in any case, is independent of the exchange rate). Oil pricesdeclined significantly in 1988, reinforcing expectations of devaluation which,together with the actual real appreciation, led to a substantial increase inthe import bill, partly reflected in the accumulation of inventories. The netresult was a sharp fall in Venezuela's foreign-exchange reserves, whose grosslevel declined from US$11.0 billion at the end of 1987 to US$7.1 billion bythe end of 1988 (the level of net reserves was then only about US$4.0bill ion).

2.5 Nominal interest rates, too, remained constant (by decree)throughout the process. At the level of 13 percent per year (banks' lendingrate), the real interest rate thus assumed a high-negative value--a factorthat further encouraged the inflationary process.

2.6 The rapid acceleration of inflation and the loss of foreign-exchange reserves created a perception of crisis, heightened by capital flightand the foreign-debt burden. It was the recognition of this crisis that ledthe new Administration to make stabilization the cornerstone of its reformpolicy in February 1989.

Maior Elements of the Stabilization Plan

2.7 The three major and closely interrelated elements of thestabilization plan were: a new foreign-exchange rate, fiscal policy, andmonetary policy.

The Foreign-Exchange Rate

2.8 The change in the foreign-exchange system was clearly the key tothe stabilization plan. Under the existing multiple exchange rate system, theprincipal (official) rate, applying to most transactions and especially to oilexports by PDVSA, had been maintained at a constant nominal value of 14.5 Bsper US$ since December 1986. Two lower rates applied to the official debt andto minor transactions, and a higher, "free-market" rate served for non-traditional exports (predominantly of goods such as steel and aluminum bypublic-sector enterprises). The stabilization plan unified the exchange rateand left it free to float. It increased immediately to 39.3 Bs per USS by theend of February 1989.

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2.9 The devaluation continued throughout 1989, by the end of which theexchange rate reached 43 Bo per US$--three times its level on the eve of theplan (Table 4). The immediate nominal devaluation implied a substantial realdevaluation. From then until the summer of 1990, the real exchange rateremained stable, with only slight fluctuations. The real exchange ratefollowing the plan was thus much higher than prior to it.

Table 4: NOMINAL AND REAL EXCHANGE RATES, 1988-91

Nominal Exchange Real ExchangeRate v Rate

End Quarter Quarter Average(Bs per USS) (I 1988 = 100)

Quarter (1) (2)

1988: I 14.5 100.0II 14.5 99.9III 14.5 90.3IV 14.5 83.8

1989: I 36.9 85.8II 37.1 124.5III 38.3 115.2IV 43.1 120.6

1990: I 43.6 119.9II 46.8 122.0

III 48.5 124.7IV 50.4 119.2

1991: I 54.0 117.2II 55.3 113.5III 59.2 113.4IV 61.6 111.6

For 1988, this is the official rate.

Source: Based on I.F.S., various issues.

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Fiscal Policy

2.10 Table 5 presents the annual budgetary performance from 1988through 1991. Between 1988 and 1989, approximately the first year followingthe new policy, several changes in the principal fiscal components wereevident:

(i) An increase in the PDVSA surplus was the predominantelement of fiscal change and of the stabilization packageas a whole, closely related to the change in the foreign-exchange regime. Most of PDVSA's income is surplus (thatis, an excess over the cost of production), and most ofthis surplus constitutes a source of government budgetaryrevenues through taxes. An increase in the real exchangerate thus raises real public-sector revenues. In theevert, this increase was dramatic: PDVSA's surplusincreased from 11.4 percent of GDP in 1988 to 20.5 percentin 1989. Contributing to this large increase was a 24percent increase in the dollar value of Venezuela's oilexports.

Table 5: PUBLIC SECTOR FISCAL ACCOUNTS, 1988-91 (ANNUAL)(in percentage of GDP)

1988 1989 1990 1991±'

(1) Ordinary Revenues, total 24.4 30-4 34.0 34.0Principal conmponents:

PDVSA suiplus 11.4 20.5 25.9 24.5Other SOEs surplus 2.5 3.0 1.9 2.3Taxes 8.6 5.5 4.9 6.8

() Ordinary expenditures,total 20.1 203 206 20.2Principal components:

Wage payments S.1 4.6 4.4 4.7Purchase of goods

and services 1.3 1.1 1.3 1.3Interest on externa debt 2.6 4.7 4.0 3.7Transfers 6.2 6.7 7.4 7.0Exchange losses 2.5 2.1 2.3 1.0

(3) Capital expenditures,total 13.9 11.4 12.5 13.7Principal components:

Central government 3.2 1 .7 1.5PDVSA 2.7 3.4 3.9 4.3Other SOEs 4.7 4.9 4.1 4.6

(4) Surplus (+) or Deficit (-)- (1)-X(2)+(3)j -9.6 -1.4 1.0 3L

(5) Change in deficit from -1.1 -3.0 -1.6previous year excludinePDVSA surplus (minus signindicates an increasein deficit)

11 Preliminary.F ITis figure reflects some adjustments and is thus not fully consistent

with the rest of the table.-sotirceD BCV, Inforne Economico, 1989 and 1990; 1991 data provided by ECV.

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(ii) Reduction of canital expenditures. This component was ofsome substance. Public-sector investment declined from13.9 percent of GDP in 1988 to 11.4 percent in 1989. Thebrunt of the reduction was carried by the centralgovernment, whose investment virtually disappearedfalling from 3.2 percent of GDP in 1988 to .1 percent in1989. PDVSA and other public-sector enterprises, on theother hand, increased their capital expenditures in 1989.

(iii) Changes in current expenditures. Total governmentexpenditures on current account increased slightly from1988 to 1989 due to a significant increase in the domesticvalue of external debt payments--from 2.6 to 4.7 percentof GDP--resulting from the real devaluation. Domesticcurrent government expenditures remained practicallyconstant: 12.6 percent of GDP in 1988 and 12.4 percent in1989. For purposes of analyzing the impact of thebudgetary changes on domestic demand and money creation--and thus on inflation--it is domestic expenditures thatare relevant. We may thus infer that reduction of currentgovernment expenditures was not used to support thestabilization effort. Even the reduction of thegovernment's real wage bill by .5 percent of GDP, or 10percent of its 1988 level, was due more to a fall of realwages in the *ublic sector than to a decline of realactivity.

(iv) Reduction of the cuasi-fiscal deficit. Following thedevaluation of February 1989, Central Bank exchange-rateguarantees on private import letters of credit and on theservice of private external debt reached some 10 percentof GDP. Through negotiations, however, the Central Bankmanaged to lower this iurden to a mere 4 percent of GDP.

Monetary Policy

2.11 Table 6 presents monetary aggregates for 1988 and 1989. Monetarydevelopments largely reflect the change in the fiscal stance and its impact onthe monetary base. They also reflect a policy of contracting private-sectorcredit. Having earlier exhibited a very rapid increase, the nominal supply ofmoney (M1) declined by 3.5 percent in the first quarter of 1989, and fellfurther by 1.4 percent and 2.9 percent, respectively, in the following twoquarters. Thus, by the end of the third quarter of 1989, nominal money supplywas about 8 percent below its level at the end of 1988. The decline would beeven sharper if comparison were made not with December 1988 but with February1989, the eve of the stabilization pPlicy.

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Table 6: MONEY SUPPLY, 1988-91

Real Nominal Real

Nominal Quarterly Money Money Quarterly Money

Money Percentage (M1) (M2) Percentage (M2)

Quarter (b.Bs) Change (I 1988=100) (b.Bs) Change (I 1988=100)

(End) (1) (2) (3) (4) (5) (6)

1988: I 109 - 100.0 290 - 100.0

II 118 8.2 104.5 304 4.8 96.4

III 124 5.0 98.5 307 1.0 89.0

IV 145 16.9 103.0 335 9.1 83.7

1989: I 140 -3.5 84.8 348 3.9 68.9

II 138 -1.4 60.6 353 1.4 56.1

III 134 -2.9 54.5 397 11.3 58.2

IV 169 26.1 63.6 464 11.7 64.1

1990: I 175 3.5 62.1 513 11.1 66.7

II 181 3.4 59.1 540 5.3 65.0

III 191 5.5 57.6 625 11.6 69.1

IV 241 26.1 66.7 747 12.0 75.5

1991: I 247 2.5 63.6 786 5.2 75.1

II 294 19.0 70.7 899 14.4 80.1

III 329 11.9 73.6 983 9.3 81.4

IV 322 -2.1 67.1 995 1.2 76.8

Source: BCV, Boletin de Indicadores Semanales, various issues.

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2.12 Combined with this change in nominal balances, a very sharpinitial increase in prices practically halved real money balances: from theend of 1988 to the end of the third quarter of 1989, real money supply (M1)fell by 47 percent (once more, the fall would be even sharper in comparisonwith February 1989). For MH, the decline is less dramatic but, at about 30percent, still substantial.]/ It would be impossible to explain thisreduction of real balances by a fall in the dgmand for money. If anything,the deceleration of inflation, which will be discussed later, should have ledto increased demand for money balances. The drastic fall of the latter mustthus indicate the creation of excess demand for money which, through the needto rebuild money inventories, led to a decline of demand for goods andservices.

2.13 Interest rates, freed by the plan, increased sharply. Thecontrolled lending nominal interest rate of 13 percent per year turned into afree rate hovering at around 32 to 40 percent throughout 1989. During most ofthe year, this implied a slightly negative real interest rate; but itrepresented, nevertheless, a very sharp increase of the real rate from minus20 to minus 40 nercent prior to the reform.

Impact of the Stabilization Policy

2.14 The higher exchange rate translated into higher prices oftradable goods; combined with the increase in public-sector prices, theeliminat on of subsidies, and the removal of price controls, this led to amassive increase in the price level. This one-time jump in prices should notbe confused with an acceleration of inflation. The process of inflationclearly had been checked. Overlooking the substantial price increase ofMarch-April 1989, the rate of inflation from May-June 1989 onward was muchlower than prior to the plan and kept decelerating throughout 1989 (Table 7).While the monthly increase in consumer prices averaged around 5 percent duringthe last quarter of 1988, it was only about 2 percent in the last quarter of1989. In terms of annual inflation rates, this is a reduction from about 80percent to 27 percent.

1/ M2 includes M1 (cash and sight deposits) and term deposits, savingdeposits and a form of CDs.

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Table 7: THE RATE OF INFLATION, 1988-92(Percentage monthly change of the

Consumer-Price Index)

Monthly Average Monthly

1988: I -.53 1989: 1 1.11

II 2.80 2 3.15

III 3.05 3 21.26

IV 5.05 4 13.50

1989: I 8.51 5 6.35

II 7.68 6 3.20

III 2.64 7 2.47

IV 2.03 8 2.17

1990: I 2.02 9 3.28

II 2.63 10 3.01

III 2.86 11 1.33

IV 2.99 12 1.74

1991: I 1.90

II 2.37

III 2.43

IV 2.33

Source: BCV, Boletin de Indicadores Semanales, various issues.

2.15 This major moderation of inflation was due to the large reductionin the private sector's real disposable income, the sharp decline in realmoney balances and the need to rebuild them, and the higher (though stillmostly negative) real interest rates, all of which led to a substantialdecline in the demand for goods and services. Not surprisingly, these alsoled to a sharp decline in real activity (Table 8).

Table 8: GDP AND ITS MAIN COMPONENTS, 1988-91

Billions of Bolivars. 1984 Prices % Change

1988 1989 1990 1991 1989/88 1990/89 1991/90 1991/88

Total GDP 491.4 449.3 473.0 516.5 -8.6 5.3 9.2 5.1

Petroleum 93.9 93.6 106.3 116.8 -1.4 13.6 9.9 24.4

Crude & Nat. 70.2 70.7 82.6 94.2 0 17.6 14.0 34.2Gas

Refining 23.7 23.3 23.7 23.7 -1.6 1.6 0 0

Non-Petroleum 386.8 350.3 363.2 394.4 -9.4 3.7 8.6 2.0

Agriculture 27.3 25.9 25.8 27.3 -5.1 0.3 6.0 0

Mining 3.9 3.8 3.9 3.7 -4.3 3.9 -4.1 -5.1

Manufacturing 87.0 74.3 77.9 82.1 -14.6 4.9 5.4 -5.6

Electricity 6.8 6.9 7.1 8.0 1.3 2.5 12.3 17.6

Water 0.8 0.8 0.8 0.9 3.0 2.6 12.5 12.5

Construction 30.0 21.9 23.3 31.2 -27.1 6.7 33.9 4.0

Commerce G 70.6 57.9 59.0 65.4 -17.9 1.8 10.8 -7.4Transport

Restaurant & 16.0 14.9 14.8 16.4 -7.3 -0.2 10.5 2.5Hotels

Trans., 15.9 16.1 16.2 16.9 1.2 1.3 4.3 6.3Storage &Communication

General Gov't 39.1 40.7 43.9 48.1 4.1 7.8 9.6 23.0

Other 89.1 87.1 90.3 94.4 -2.3 3.7 4.3 5.6

Source: BCV, Informe Economico, 1989 and 1990; 1991 data provided by BCV.

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2.16 GDP fell by 8.6 percent (9.4 percent if the petroleum sector isexcluded) from 1988 to 1989. As might be expected, the largest decline was inthe construction sector, whose product fell by 27 percent. There were alsolarge declines in manufacturing and in commerce And transportation--about 15percent and 18 percent, respectively. The only major sector that expanded wasgovernment services, which increased by 4 percent, further illustrating thepoint that stabilization was not achieved by a cut in the government's currentaccount spending.

The Policy Chanes

2.17 Towards the end of 1989, and clearly by early 1990--roughly a yearafter the introduction of the stabilization package--the restrictivemacroeconomic policy came to its end.

2.18 A reversal appears in the fiscal stance, although the raw data donot reveal it: cn intrinsic budgetary deficit is hidden by the swelling ofgovernment revenues from oil taxation, resulting from the substantial increaseof world oil prices following the Persian Gulf crisis. Thus, an apparentcontinuing improvement of fiscal performance is shown: a change of the publicsector balance from a deficit of 1.4 percent of GDP in 1989 to a surplus of1.0 percent in 1990. But when the change in oil-tax revenues (resulting fromits increased world price) is abstracted from, a reverse impression emerges:rather than an improvement, a deterioration of the fiscal stance from 1989 to1990, of the order of 3 percent of GDP, is seen to have taken place. In 1991,the dollar value of oil exports changed only little from 1990, so that thisimpact on the budgetary performance was not of much significance.?l

2/ A distinction should be made between increased oil-tax revenueresulting from a higher exchange rate (that is, an increase of the domesticvalue of oil exports at given world prices), and an increase resulting from achanged dollar value of the exports (whether due to change in oil prices or inthe volume of exports - with fluctuations of prices being usually the majorsource). In the former case, when oil revenues increase as a result of anincrease in the foreign exchange rate, this change is identical in its impactto increased revenues from non-oil taxes, and should hence be regarded as partof a genuine change in the government's fiscal stance: since the government isthe major supplier of foreign exchange, real exchange rate depreciation worksvery much like the imposition of a uniform tariff on imports of goods andservices. This was primarily the source of changes in government oil revenuesin 1989, although the impact of the devaluation was reinforced that year by a24 per cent increase of the dollar value of oil exports. The case in whichgovernment oil revenues increase as a result of change in the dollar value ofoil exports - as happened in 1990 - is quite different. In its short termmacroeconomic impact, financina government expenditures out of such anincrease is equivalent to financing them by borrowing from the central bank orby an external capital inflow: the impact on money creation, or on the privatesector's disposable income, would be the same.

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2.19 Table 9 shows the auarterly budgetary outcome (surplus ordeficit)from 1989-91. Though these estimates are less accurate than theannual data, they nevertheless provide a clear indication of the nature andtiming of the chanae in the fiscal stance: from a recorded surplus in 1989 toa deficit starting in early 1990. (The substantial improvement in the lastquarter of 1990, reflecting the jump in oil revenues, should be ignored.)

Table 9: FISCAL SURPLUS (+) OR DEFICIT (-) 1989-91 (QUARTERLY)

In Bitlions Bs., In percentageCunrnt Price of GDP

(1) (2)

1989: 1 -7.0 -1.8II 25.7 6.4III 1.7 .4IV 40.7 8.9

1990: 1 -4.1 -.8il -1.8 -.3If -22.0 -3.4IV 51.9 8.6

1991: 1 19.2 2.9II -42.8 -6.2III 2.7 .4IV 27.1 2.6

Source: Provided by BCV.

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2.20 The trend in the nominal money supply (M1), also changed. In thelast quarter of 1989, money increased by about 26 percent (an annual rate of152 percent), partly in response to a seasonal increase in demand. (In thelast quarter of 19A) the increase in the money supply was exactly the same asa year earlier, and much above "normal".) But even allowing for the seasonalvariation, a change in trend is apparent. During 1990 as a whole, MIincreased by 43 percent, in contrast with a fall of some 8 percent during thefirst three quarters of 1989. In 1991, the rate of expansion declinedsomewhat to about 34 percent. For M2, the rates of increase were: 18 percentin the first three quarters of 1989 (an annual rate of about 25 percent); 61percent in 1990; and 33 percent in 1991.

2.21 The real interest rate peaked in the last quarter of 1989 and thefirst quarter of 1990--the only extended period in which its level wasgenerally positive (within a range of 5-10 percent per year). From then on,nominal interest rates have declined while inflation has not, so that realinterest rates generally have been negative and declining.

2.22 Nominal devaluation proceeded all throughout; but the realexchange rate, having been roughly stable for a year and a half, startedfalling in the fall of 1990. From then to the end of 1991, the realappreciation amounted to some 10-15 percent.

2.23 The impact of the policy change was almost immediate. Inflation,which had been weakening, stabilized at an average monthly rate of around 2percent during the last quarter of 1989 and the first quarter of 1990. Thenit accelerated moderately, to an average monthly level of around 3 percentthroughout the second half of 1990. During 1991, it was in the range of 2.5-3.0 percent, or somewhat over 30 percent for the year.

2.24 Since the end of 1989 money supply, in its strictest definition(MI), has increased at about the same rate as the price level, and thus, realmoney balances have been almost constant from 1990-91. If a broaderdefinition of money (M2) is used, however, real money balances have increasedsince the end of 1989 (that is, prices have increased less than nominal moneysupply). Following their drastic contraction, real money br.lances must havebeen particularly low by the fall of 1989, and some replenishment has beentaking place since. Whether these balances are still below their equilibrium

3/ This is a somewhat uncommon pattern. In most recent stabilizationexperiences, exchange-rate appreciation followed almost immediately theintroduction of the stabilization package. In these episodes, tight monetarypolicy (and often less than complete fiscal adjustment) led to high interestrates and, in turn, to capital inflow and currency appreciation. Jn Venezuelathe interest rate was much above its pre-stabilization level but stillnegative, in real terms, or barely positive - at a level, that is, not highenough to attract capital from abroad. Indeed, no large-scale capital inflowaccompanied Venezuela's stabilization. Currency appreciation started, inVenezuela's experience, only with the massive increase of proceeds from oilexports following ths Gulf crisis.

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level, so that prices can be expected to rise less than money expansion (minuschanges in real activi-.y) is a matter of conjecture.

2.25 Real activity, too, responded fast to the policy change. GDP,particularly its private-sector component, started increasing in the secondquarter of 1990, rising in 1990 by 5.3 percent (3.7 percent without the oilsector) from 1989 (see Table 8). Construction and manufacturing, two of the3ectors hit hardest in the recession of 1989, expanded most in 1990 but stillnot to their 1988 levels. In 1991, the national product increased even more--by 9.2 percent, or 8.6 percent in the non-oil economy. Once more, theconstruction sector registered the highest growth. Throughout, the general-government sector kept increasing, so that by 1991 its product exceeded thatof 1988 by almost one quarter. The only major activity that had not reboundedby the fall of 1991 was private-sector investment, which between 1988 and 1989fell from about 20 billion to 8 billion Es and in 1990 was negative in netterms. In part, this reflacted a large inventory accumulation prior to thewidely expected 1989 devaluation and a decumulation following it.Unemployment, which increased from 6.9 percent of the labor force in thesecond half of 1989 to 10.9 percent in the first half of 1990, declined to 9percent by the end of 1991.

Evaluation of the Stabilization Policy

2.26 The stabilization program enjoyed immediate success, lowering theannual inflaticn rate of some 60 percent prevailing in the second half of 1988to about 34 percent in the first year following the program. (The periodMarch-May 1989, when a one-time increase in the price level occurred as aninstrument of stabilization, should be ignored.) The balance-of-paymentssituation changed dramatically, even before the oil-market bonus of 1990: a50 percent drop in net foreign-exchange reserves, from US$4 to US$2 billion,in the last 10 months preceding the program turned into an increase of US$4billion during the period March 1989-July 1990 (after which the increaseaccelerated due to the oil-price increase).

2.27 Long-term stabilization, however, has not been achieved. During1990 and 1991 and up to the present (Fall 1992), the rate of inflation hascontinued in the range of 30 percent per year. This is much higher thanVenezuela's traditional inflation: it is higher than in any year prior to theprogram save the last two (1987 and 1988), when it was at about this level.The level _f inflation is also substantially higher than in countries such asChile, Mexico, or Israel duzing the first few years following the introductionof similar programs. In most countries, an inflation level of 30 percent peryear would be judged as unstable, likely to lead within a shcrt time toincreased inflationary expectations and to accelerated inflation. Venezuelamay be benefiting now from its long experience of relatively stable prices, atradition in which accelerated inflation is not perceived as an imminentthreat. It is also possible that the conclusion, in December 1990, of a debtand debt-service ("Brady Plan") agreement with foreign commercial banks hasgiven the government's stabilization plan a measure of credibility. But evenso, it is unlikely that such a level of inflation cculd be sustained foryears: if it does not go down, it is likely to go up, given the presentcondition of the fundamental determinants of the macroeconomic situation.

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2.28 The most important of these determinants is the budget. After aninitial substantial improvement, the fiscal stance deteriorated in 1990 and1991. Monetary policy, by and large, has accommodated the inflationaryprocess. The deterioration has originated primarily from two sources: a realexchange rate appreciation and increased public-sector investment. Anappreciation of 10 percent in the exchange rate--the actual size since mid-1990--can be expected to lead to an increased budgetary deficit in the rangeof 1.5 percent of GDP; and the increase in public-sector investment from 1989to 1991 was of the order of over 2 percent of GDP.

2.29 An improved fiscal stance, of the proportions necessary fordurable stabilization, would require a reversal of recent trends that wouldeffect a real exchange rate depreciation and a significant reduction inpublic-sector investment. This will become clearer from the discussion of thelonger-term major macroeconomic issues that follows and that also points outthe possibilitiea of increased taxation as a source of additional avenue to beuned partly to improve the fiscal stance. Even abstracting from longer-termconsiderations, real exchange rate depreciation is called for. The present(fall 1992) level of the rate is maintained through a substantial reduction ofthe foreign-exchange reserves of the Central Bank, since the fall of 1991; andthe low level of the rate muat be at least partly responsible for a poorperformance of the country's non-traditional exports, as well as to graduallyincreasing budgetary deficit.4/

2.30 Developments in the last three years illustrate two importantelements of macroeconomic performarce--both intimately related, as so muchelse in the Venezuelan economy, to the exports of oil. One iB the impact ofshort-term fluctuations in oil revenues on the government's budget and on theeconomy; the other is the exchange-rate policy and the impact of the real rateof foreign exchange on economic performance. These are among the issuesdiscussed in the following analysis of major elements in the formulation ofmacroeconomic policy in Venezuela.

B. Inherent Macroeconemic Problems

2.31 Four long-term elements in Venezuela's macroeconomic policy willbe discussed here: (i) fiscal issues; (ii) the short-term impact offluctuations in oil revenues; (iii) the targets and instruments of monetarypolicy; and (iv) the foreign-exchange rate policy. These are closely andinevitably related, and some fundamental phenomena cut across these categoriesof issues.

4/ A substantial nominal devaluation in September-October 1992, ofsome 12-13 per cent, was followed by nominal stability, so that by the end of1992 the real rate was still roughly at its level before this devaluation.

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Fiscal Issues

Government Revenues

2.32 Aside from oil revenues derived from the tax on the PDVSA surplus,government revenues are amongsz the lowest in the world, about 5-6 percent ofGDP. Essentially, oil revenues have replaced domestic taxation as a source offinancing both current and capital government expenditures. Several argumentsmay be advanced for a substantial increase of non-oil tax revenues.

2.33 First, at present levels of oil exports (volume and price), and ofgovernment expenditures, a substantial gap exists between revenues andexpenditures - an excess of the latter over the former of some 4-5 percent ofGDP. Closing any part of this gap with an increase of oil taxation, which isalready at the level of roughly 80 percent (of the profit, or "surplus"), isboth impractical (in view of the size of the gap) and undesirable: it wouldreduce sharply, or eliminate, PDVSA's incentive for efficient operation. Infact, the government plans to lower, in the near future, the oil tax rate. Achange of the exchange rate would have an impact on oil revenues, as will bediscussed later. But even with it, increased non-oil t&xation would berequired to close the gap.

2.34 Beyond it, even if at present tax revenues were equal toexpenditures, a gap may be expected in the future. The volume of oil exports,given the world constraints on it, may not be expected to rise at the desired,and expected, rate of growth of Venezuela's economy. Since governmentservices may be assumed to maintain roughly a given proportion of GDP, as theeconomy grows, tax revenues would then increase less than governmentexpenditures.

2.35 A case may also be made to the effect that oil revenues, whichconstitute rent income for Venezuela, should have been used to increase theeconomy's capital stock, that is, to boost investment; whereas publicconsumption services should be financed, as almost anywhere else and inVenezuela prior to the appearance of oil, through taxation. To the extentthat this argument is acknowledged, it would call for increased taxation alongwith increased capital outldys. This should not be confused, though, with anincrease in the government's investment in state enterprises: as will beargued shortly, the capital outlays (whether increased or not) should keundertaken by the private sector.

2.36 Finally, an argument for raising more non-oil tax revenues couldbe mnade - and very often is - on the grounds that virtual dependence on oilmakes the government hostage to a single, volatile revenue source: thediversification of revenue sources would eliminate, or greatly reduce, thefluctuations of aggregate revenues and expenditures. This argument holds trueunder Present circumstances. But, as will be seen later it would have novalidity once an oil-stabilization fund is established.

2.37 There is ample evidence that the existing tax structure couldyield substantial additional revenue through improved tax administration, theclosing of loopholes, and the reduction of exer,ptions. Beyond this, there are

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three main candidates for raising the level of net taxation (i.e., increasedtaxation or lower subsidization).

a. Domestic oil -rices. Even after being raised in early 1989,domestic oil prices are still among the world's loweet andcontain a large implicit subsidy. The price of gasoline isthe equivalent of US$.30 per gallon, roughly one-half of theexport price, compared with, say, US$2.68 in Germany, $1.15in the U.S., US$1.44 in Chile, and US$.90 in Mexico.Eliminating this subsidy by raising the domestic price tothe international price level (at the going foreign-exchangerate) would raise net revenues by 2.4 percent of GDP, and byroughly 3 percent if PDVSA's retained profits are added. Itwould also reduce the problems of heavy pollution andexcessive highway maintenance which are induced by thesubsidy. About 87 percent of the additional revenue wouldcome from gasoline and diesel prices.

b. Other vublic-sector Prices. Prices of the most importanttradable products like steel, aluminum, and petrochemical.have been increased significantly. But there are stilllarge implicit subsidies in water and electricity tariffs.Water tariffs have hardly risen since 1981, ana' the smallincreases in 1991 did not apply to most residential users.Electricity tariffs have been adjusted gradually since 1989,but there is still a large subsidy provided mostly toresidential users. Increasing electricity tariffs to theirlong-run marginal cost would provide an additional netbudgetary revenue of about 1.2 percent of GDP.

C. Value-added tax IVATI. The introduction of a VAT has been amajor government objective during the last two years and thesubject of lengthy discussion in Congress, butimplementation before late 1993 seems unlikely. Thegovernment intends to start with a modest rate of around 4-5percent, with muchs higher rates for some "luxury" goods andtotal exemptions for "basic" goods. Even at this low level,the tax would yield a revenue of some 1.8 percent of GDP.

2.38 These three changes would yield an aggregate revenue of over 5percent of GDP. With improvements in tax legislation (such as the eliminationof various exemptions from income-tax already passed by Congress), they wouldbe of quantitative significance.

Government Exoenditures

2.39 In Venezuela, more than in most other countries, capitalexpenditures are a major component of public-sector expenditures, most of themon public-sector enterprises led by PDVSA and CVG (see Table 5). This, again,is a reflection of the role of oil revenues in the economy and in thegovernment's budget. Part of these revenues finances current expenditures,but a large part finances investment, to a much greater degree than a

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government depending solely on taxes would normally be able to do. Theallocation of funds for capital expenditures is done partly by allowing PDVSAto retain a fraction of its surplus for investment (the tax rate on thissurplus is 80 percent, rather than 100 percent). In other cases, funds areexplicitly assigned--primarily to finance CVG investments.

2.40 This pattern of expenditures has made the public sector inVenezuela a much more important actor than in most other countries, certainlyin terms of its share of GDP though not perhaps in aggregate employment. Theimportant implication of the unique budgetary structure of Venezuela is thatchanges in expenditures are accomplished more through changes in capital thancurrent expenditures--as was the case with the 1989 stabilization package.Investment expenditures are generally more malleable and subject todiscretionary control by the government, and thus, the conduct ofmacroeconomic policy to achieve economic stability should be easier inVenezuela than in most other countries.

2.41 The decision of the Government of Venezuela to privatize the stateenterprises has not yet been reflected in privatizing CVG corporations (withminor exceptions) or PDVSA. Reaching this stage will, and should, take time -particularly in reference to PDVSA; and the process would inevitably begradual. But there is no need to continue the model of government investmentas it has been pursued hitherto. Thus, we recommend that a graduallyincreasing portion of the resources presently invested in public-sectorenterprises should be placed at the disposal of the Private sector, notinvested by the government itself. This could be done through a capitalbudget providing long-term loans to private enterprises at non-subsidizedinterest rates (beyo:a the fact that access to such facility would imply anelement of subsidy). The rate of interest would be at a level at which noquantitative rationing of this credit would be required. As long as public-sector enterprises are not privatized, they would have the same access to thefuilds as private-sector enterprises, with no preferential conditions ortreatment.21

2.42 A part of the capital budget, though not the major part, could beinvested directly by the government in foreign exchange reserves. This wouldbe required if, as will be suggested shortly, a need is perceived to encourageeconomic diversification, and, specifically, non-oil tradable activities,through an increase in the real rate of foreign exchange. Supporting such anincrease would require the creation of a budgetary surplus and an equivalentinvestment in foreign exchange. Indeed, this accumulation of foreign exchangeby the government would be the instrument through which real devaluation isproduced. Such an investment could conceivably be combined with the operationof an oil stabilization fund. From its annual allocation of revenues to thegovernment, this fund could subtract an amount equivalent to the annualaccumulation of foreign exchange required to raise the real exchange rate to agiven level above what would otherwise be its equilibrium level. Like all

5/ Since conventional accounting rules do not regard such lending asgovernment expenditure (on goods and services), the practice suggested herewould lead to the appearance of a large budgetary surplus.

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surpluses of the stabilization fund, this would automatically be invested inforeign exchange.W Disregarding the potential benefits of diversification,such investment would involve a loss, since its yield must be lower than theexpected return from investment in domestic physical (or human) capital. Onlyif the perceived fruits of diversification are higher than this loss shouldthe investment in foreign financial assets be contemplated.

2.43 A specific issue to be faced now is whether PDVSA should adopt alarge-scale investident plan for the next few years financed partly by foreignborrowing. PDVSA presumably is able to raise funds abroad at a reasonableprice and, from the investment of these funds, to generate enough additionalforeign-exchange receipts to service and eventually repay the debt. But suchborrowing and expenditure would be inconsistent with the need for Venezuela toactually export capital in order to change some basic features of its economicstructure.

The Budgetary Process

2.44 The design and implementation of Venezuela's budget containseveral elements likely to contribute to instability.

a. Ex-arte deficit. The budget usually is constructed to allowfor a deficit. It is presumably "balanced", by law, but bycounting proceeds from borrowing as "revenue" it in fact bydefinition creates a budgetary deficit.

b. Biased proiection of revenues. The Budget Office (OCEPRE)starts designing the annual budget by estimating expectedrevenues, both oil and non-oil, in ways that can lead towide margins of error. Projections of oil revenues, whichmake up some 7C percent of total government revenues, tendto follow past high prices. Projections of non-oil revenuesconsistently exceed the proceeds realized by an average of10 percent (or 3 percent of total revenues). The BudgetOffice believes it has changed this procedure now bychoosing to underestimate revenues. Should this indeed bythe new practice, an important source of budgetary deficitsand inflation will have been eliminated.

c. Incomplete follow-up of budgetarv nerformance. The BudgetOffice is expected to make adjustments, as the yearproceeds, to match actual revenue performance. But it isdoubtful whether it receives continuous and timelyinformation to do this accurately. It appears to have anup-to-date record of revenues, but its information on

6/ In the aforementioned study by Sebastian Edwards (Report 0148'-VE), it is estimated that a permanent reduction of government expenditlures by10 percent (not offset by increased expenditure due to the interest revenue onthe accumulated foreign investment) would lead to a permanent increase of thereal exchange rate by about 6 percent (mostly reached within two years).

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expenditures and, hence, on the deficit is incompletebecause of a significant lag.

d. Incomplete control of public enteroriLes. The businessplans of public enterprises are determined as part of thegeneral design of the budget. But once determined, the onlycontrol exercised is through the transfers from the centralgovernment to the enterprises. (This obviously does notapply to PDVSA.) The enterprises can in fact vary the sizeof their investments by changing the amounts they borrowfrom non-government sources.

e. Variability of oil revenues. Last, but certainly not least,is the impact on the budget and on the economy of variationsin oil revenues (mainly oil prices), both expected andunexpected. This element is important enough to merit themore extensive discussion that follows.

Fluctuations in Oil Revenues

2.45 Oil revenues are highly volatile, primarily because of changes inoil prices. The fluctuations in revenues since mid 1990 are obviously higherthan average, but illustrate the potential for disruption by this factor.

2.46 Oil revenues are the major source of income for the government,which ideally should adjust its spending to changes in oenmanent income ratherthan to transitory changes. The latter would affect the permanent income onlythrough variations in the size of accumulated capital--of the government, inthis case--and the consequent variations in net interest on this capital.

2.47 The complete or partial failure to behave according to thispattern would lead to two complementary scenarios. In the first, thegovernment continually adjusts to the fluctuations in revenues, opening theway to domestic cycles of inflation and recession. The other is the well-known "ratchet" effect, where the government fully matches increased oilrevenues by increasing expenditures and maintains this higher level ofspending even when oil revenues fall, thereby creating a fiscal deficit orreinforcing an existing one. Both responses are evident in the experience ofVenezuela since the first oil shock of 1974, and bott, needizes to say, tendto frustrate macroeconomic stability.

2.48 In December 1990, following the jump in oil prices shortly afterthe Gulf crisis erupted, Venezuela established a mechanism to neutralizefluctuations in oil revenues, in accord with the IMF. The mechanismstipulated a baseline of gross export revenues equal to an annual volume of1.9 million barrels at an export price of US$19 per barrel. Of oil revenuedexceeding this baseline, only 25 percent would be spent and 75 percent wouldbe frozen. In fact, while the central government did deposit 75 percent of

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its oil windfall, PDVSA mostly did not.ZJ Moreover, the whole scheme appliedonly as of the end of 1990, after a major part of the extraordinary revenuehad already been received. Altogether, this Ad hoc sterilization scheme is oflittle significance to the present discussion.

2.49 An oil stabilization fund should thus be of prime importance foreconomic policy and a vital condition for the long-term maintenance ofmacroeconomic stabilitypi--even though it may be of little operationalconsequence in the imm9ALJtt future. There is no intention here to suggest aspecific design for such a fund, which already has received much attention.VOnly some salient features it should have are described below.

(i) The fund should be a separate entity, independent of theorgans of the central government. Oil revenues (that is,the tax of PDVSA profits, or "surplus") should be paid tothe fund, rather than to the gover-ment.

(ii) The fund should establish a formula to determine permanentoil revenues in any given year, and modify this formula (asdistinct from the derived level of income) onlyinfrequently and in response to major changes in thebehavior of the oil market.

(iii) Each year the fund should transfer to the government anamount equal to the "permanent" level of oil revenues, asdetermined by the formula. This amount should be knownwell in advance of the annual budgetary preparations andshould not change during the year.

(lv) Any excess after the transfer to the government should beinvested in foreign exchange, and any deficit should bemade up by drawing on the fund's foreign assets. Profitson its foreign investments should be considered part of the

2/ PDVSA maintained that its obligation was offset by a separateclaim it had on a transfer of money from the central government.

a/ Stabilization, or smoothing out, of government expenditures is notidentical with stabilization of the real exchange rate; but the two areLntimately related. In the study by Sebastian Edwards (Report 0181-VE) asimulation exercise demonstrates that fluctuations of the real exchange ratein the last 15 years would have been drastically lowered had an oilstabilLzation fund been operating. In addition, the lflvel of the exchangerate would have been hlgher--an outcome relevant to the following discussionof the real exchange rate.

2/ See Ricardo Nausmann, Andrew Powell, and Roberto Rigobon, "FacingOil Income Uncertainty in Venezuela: An optimal Spending Rule with LiquidityConstraints and Adjustment Costs." Mimeo., Instituto de Estudios Superioresde Administraci6n, Caracas, December 1991.

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fund's permanent revenues for the purpose of determiningthe size of the transfer to the government.

Taruets and Instruments of Monetary Policy

2.50 There are several basic problems in the way the Central Bankoperates.

(i) Inconsistency of Targets. The Central Bank has a number oftargets, and the set of targets and instruments ispotentially inconsistent. The targets are: the level offoreign-exchange reserves; the rate of expansion of moneysupply; and (less clearly or emphatically) the real rate ofexchange. It also seems that, less systematically, boththe nominal and real rates of interest are considered astargets.

(ii) Money Supol. Of particular concern is the Central Bank'shandling of money supply. In principle, supply is targetedto match expected demand which, in turn, in the absence ofa fundamental real change, is expected to increase at therate at which prices and nominal income rise. Hence, moneysupply is targeted to increase by some expected inflation,which is assumed to be exogenous and independent of therate of monetary expansion. In this way money supplyaccommodates, and validates the expected rate of inflation.

(iii) Control Instruments. Until recently, the Central Bankattempted to control the monetary base, not money supply.In the absence of a portfolio of government bonds, theCentral Bank does not conduct open-market transactions ingovernment paper. The monetary base is thus determined asfollows: A net acquisition of foreign exchange is offsetto the desired degree by an open-market sale of the CentralBank's own short-term paper (the zero-coupon bond). On twooccasions recently, the Bank has changed the minimumreserve ratios for commercial banks. In May 1991, reserverequirements on qovernment deposits (which usually resultfrom lags between payments to the banks for thegovernment's account and the transfer of money to thegovernment) were increased from 15 to 80 percent. InAugust 1991, in stages lasting through December 1991, thegeneral minimum-reserve ratio was raised from 15 to 25percent. As we Lnall note, the use of this instrument isan improvement. Rediscounting at the Central Bank,although recognized in principle, rarely has beenpracticed. As a rule the discount rate greatly exceeds themarket interest rate. Only once recently, have discountoperationo been conducted at the Central Bank.

(iv) Cr ation of Near Money. The practice of offsetting theim_ ct of accumulated foreign-exchange reserves by open-

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(i) If the Central Bank sells bonds to the commercial banks,the use of the two alternative instruments would leave themoney supply unchanged. The use of the reserve-ratiolnstrument would result in a higher monetary base but theholding of Central Bank bonds by the commercial banks wouldbe lower.

(ii) Another course, the one most common in Venezuela, is thesale of Central Bank bonds to sectors other than thefinancial sector. Here the same conclusion holds as beforeregarding the levels of the monetary base and the stock ofCentral Bank bonds. The difference would be in the size ofmoney. The money supply, strictly defined (M1 or M2) issmaller when open-market operations are used, but the stockof Central Bank paper held by the public is larger by thesame amount. Since the Central Bank's paper is extremelyliquid, it qualifies as a component of mc;.ey supply. Usinga broader definition of money, the inference is thus thatmoney supply is affected to the same extent by eitheralternative.

Thus, in the final outcome, using reserve-ratio changesrather than open-market operations results in the samelevel of money supply, a higher level of the monetary base(primarily commercial bank deposits in the Central Bank),and a lower outstanding level of the Central Bank's short-term paper. Since the paper bears interest, whereas themonetary base does not, the shift towards the use ofreserve ratios reduces the quasi-fiscal deficit. Inessence, this undoubtedly is a benefit; but it is notwithout cost. The government's saving through lowerborrowing is the other side of an implicit tax on thecommercial banking system--a tax that in turn creates aspread between the banks' borrowing and lending rates.Like all taxes, this tax conceptually has an optimum level;but, noting that the distortive loss from a tax incrŽasesexponentially with the tax rate, this level cannot be zero.Thus, without citing precise ratios or ranges, it can beassumed that at least some use of changes in minimum-reserve ratios as an instrument of controlling money supplywould be beneficial. It would be an inadequate instrumentfor fine-tuning--for continually effecting gradual changesin monetary aggregates, but its use for discrete changes isrecommended.

2.59 The discount window. Rediscount3.., or a similar device forshort-term lending by the Central Bank to the commercial banka, is certainlyan effective instrument for continuous control of the monetary base and moneysupply. Its recent use offers hope that it will be perceived as an avenue tobe regularly pursued by the Central Bank.

, m mu.. . mN .. m M

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The Real Exchange Rate

2.60 Whether or not the government should intervene to manage the real

exchange rate is a central, long-term issue of macroeconomic policy in

Venezuela, at the heart of much of the economic debate in the country. It

concerns basic issues of the country's economic structure, of the government's

finance, and of fundamental policy guidelines.

2.61 There is a sound argument for allowing the rate of exchange to be

determined strictly by market forces. Through the exchange rate, the market

would establish a relative price which would ensure maximum levels of

efficiency and production and the highest rate of growth. Tampering with the

exchange rate, to fix it at other than its equilibrium level, would only

introduce distortions and lower welfare.

2.62 The only factor that might justify intervention is the predominant

role played by oil exports. Dependence on oil expo-'s has two distinctly

different components. The first concerns the stability of oil revenues, and

has, in turn, also two aspects. One is the potential short-term fluctuations

of these revenues; that, indeed, would require intervention. in the way

discussed earlier when the stabilization fund was suggested. But over the

long run, this intervention would not be intended to establish a level of the

real exchange rate different from what the market would. The other aspect is

the potential disappearance, complete or partial, of the oil revenues some

time in the proximate future. This is an unlikely eventuality for Venezuela.

But even if it were not, it might be argued that the market would anticipate

the change and make the most efficient adjustment over time.

2.63 The other, more serious component of dependence on oil exports is

their impact on the economic structure. It is conceivable that because of it

the maximization of present efficiency, or the allocation of resources to

maximize present production, is not necessarily compatible with the

achievement of maximum growth over a longer period. This would be the case--

and such a possibility may well warrant consideration--if the "enclave" nature

of the oil industry denies the country the benefits ("externalities") of an

industrialized economy in general, and of the externalities presumably

generated by tradable activities in particular. This is the so-called "Dutch

Disease," which may be caused by permanent large-scale capital inflows (as in

colonial Spain) or by "enclave" exports in wh;ch rent is dominant - oil

exports are today's prime example - and which are equivalent to foreign

capital inflow for the purpose on hand.1 01 The presumed externalities stenm

from a strong learning-by-doing element in activities that compete

continuously in an outside market. This hypothesis is supported, though by no

means proved, by empirical studies of production functions which conclude that

the size of exports, as such, is an element that increases production (beyond

10/ An empirical investigation of the channels through which oil

revenues in Venezuela have led to a real appreciation of the exchange rate

(hence to the contraction of other tradable activities) may be found in the

report by Sebastian Edwards (Ibid.). Oil revenues are indeed found there to

be the most important determinant of changes in the real exchange rate.

I

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market sales of Central Bank bonds has serious monetaryimplications. To the enttent that the rate of interest onthe paper (deflated by the rate of devaluation) is higherthan the rate of interest earned on the foreign-exchangeholdings, a fiscal liability is ct-.ated. Even moreimportant is that the short-term paper acquired by thepublic through these sales is liquid enough to be a verygood substitute for money. Thus, while this practicedetermines the stock of the monetary base presumably at itstargeted level, the effective supply of money increasesbeyond that. Since this increase is not fully recognizedas such by the government, there is some illusion about thesize of money supply. The money involved is an interest-bearing asset roughly indexed, through the level ofinterest rates, to the rate of inflation. Thus it escapesthe imposition of an inflation tax, thereby increasing therate of inflation resulting from any given level of suchtax.

(v) The Monetary Implications of the Budcet. The fiscal stancehas an obvious and important impact on the money market.Although no direct government borrowing from the CentralBank takes place to finance a deficit, the monetaryimplications of a deficit do not thus disappear. TheTreasury, short of cash when presented with a payment orderauthorized by the Ministry of Finance's Controller forservice to the government, has one of three courses ofaction:

1. It can refuse to honor the order--and in consequencecreate a deficit on an accrual basis financed byinvoluntary supplier credit.

2. It can raise money for the payment through the sale oflong-term (over one year) Treasury notes in thecommercial money market.

3. It can raise the money through the market sale ofshort-term Treasury notes, which are recognized aspart of commercial-bank reserves for maintainingminimum-reserve ratios. In its impact on the monetarybase, this operation would be similar to borrowingfrom the Central Bank.

2.51 The three alternatives for financing a government deficit haveentirely different implications for the money market. It is not clear thatthese are taken into account by the Central Bank in its targeting of monetaryaggregates, or that Treasury financing of the deficit is coordinat-d with theCentral Bank.

2.52 In the light of this evaluation of the major issues affectingmonetary policy, the following recommendations are made:

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2.53 Targets. There should be just one target for monetary policysthe money supnly. Further research is required to determine (in line with ourearlier exposition) which definition of money is more appropriate; but tostart with, M1 may be targeted. Using money supply as the system's anchorwould, after some transition, ensure a atable and low rate of inflation, givenappropriate targeting. Needless to say, a stable and low rate of expansion ofmoney would presuppose that the government had no budgetary need to borrow.Since there are various instruments that affect the money multiplier, as willbe suggested shortly, maintaining a stable expansion of money would imply thatthe monetary base did not necessarily require a similar expansion.

2.54 The present policy targets that should be abandoned are the level(or rate of expansion) of foreign-exchange reserves, the nominal interestrate, and the real interest rate. These would be determined by the monetaryexpansion target.

2.55 Instruments. Two factors affecting money supply are beyond thecontrol of the Central Bank: government borrowing, whether directly from theCentral Bank or through the sale of Treasury notes to the public; and theacquisition of foreign-exchange reserves as a government investment (see thefollowing discussion of fiscal policy and the real exchange rate). But theCentral Bank does have three instruments that can affect the monetary base orthe money multiplier: open-market operations; changes in minimum-reserveratios; and the discount window. In principle, the number of such instrumentsis not limited: others may be added as institutions develop.

2.56 Open-market ogerations. In conducting open-market operations, theCentral Bank could add transaftions in securities other than its own zero-coupon bonds; specifically, . SA bonds might be introduced. A stock of PDVSAbonds will be created gradually as it turns progressively from long-termborrowing abroad to long-term borrowing in the domestLc capital market. (To alarge extent, this would actually establish such a market.) The sale of thesebonds would lower domestic liquidity if, indeed, there was a reasonableguarantee that they were replacing, not adding to, borrowing fron abroad. Intime, the accumulated stock of PDVSA bonds would be used by the Central Bankin its open-market transactLons.

2.57 Chanaes in minimum-reserve ratios. These have been used recentlyfor the first time. They do not affect the size of the monetary base but ofthe money multiplier (that is, the credit-supply capacity of the bankingsystem, given the level of the monetary base).

2.58 Assume the two instruments, open-market operations and changes inthe reserve ratio, are employed alternatively to counter an increase inforeign-exchange reserves of the Central Bank (which, in turn, implies aregime in which the government intervenes in the foreign-exchange market). Inone instance, the Central Bank sells bonds to equal the increase in foreign-exchange reserves, so that in the end the monetary base is unchanged. In theother case, the monetary base is allowed to increase, but reserve ratios areraised to prevent any increase of domestic credit from the banking system.The difference between the two alternatives would be as follows:

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its function as a source of finance of imports). An important presumption -as yet uncontested in empirical studies - is that the effect of externalitiesis uniform over the factors of production that participate in expandableactivities. Were the beneficial effect due to the enhanced quality of justone identifiable factor, a less costly policy might have been thesubsidization of that factor in the production of exports rather than theuniform promotion of all exports implied by a higher level of the realexchange rate.

2.64 An economic structure in which oil plays a smaller role and otherexport activities are established may thus be preferable even when, at themargin, the benefits to economic agents from these activities are smaller thanthe cost of foregoing the immediate use of some of the oil revenue. Whetherthis is the case is not easy to establish. The government will have to make apolicy decision on this matter, based more on speculation than on informationand quantitative analysis, and we do not make a reconmendation on this matter.Bu% the important point is that if the principle of diversifying exportactivities is adopted, the real exchanoe rate would be the best instrument ofpolicy implementation. In fact, the government, through its directinvestments as well as other policy instruments, seems to have implic, 'vadopted the diversification principle; but to have gone about policyimplementation by way of ad hoc, discretionary (hence discriminatory)decisions, such as non-uniform export premiums or the government's own large-scale investment in (often unprofitable) "non-traditional" export industries.The use of an exchange-rate policy would uniformly encourage export (as wellas import-competing) activities, thus ensuring maximum efficiency. While achange of the real exchange rate is a change of the relative price of alltradables to non-tradables, it does not serve as a discretionary instrumentselectively affecting only specific tradable activities.

2.65 The real exchange rate in any economy depends on many factors,most of which are outside the government's control. These include theeconomy's productive endowments, consumers' tastes, technology (in the senseor the set of production possibilities), or world prices for the country'sexportables and importables. But other factors, namely domestic saving andinvestment, are determined partly by government policy; and manipulating themwould enable, and be a prior condition for, changing the real exchange rate.Specifically, starting from equilibrium, raising the real exchange rate wouldrequire the creation (or increase) of an excess of saving over domesticinvestment through the creation (or increase) of the government budgetarvsurplus. This surplus would finance an accumulation of foreign-exchangereserves, which in turn would reflect a current-account surplus created by theincreased real exchange rate. Without such an accompanying budgetary surplius,any government attempt to increase the exchange rate through intervention inthe foreign-exchAnge market would lead to a rise in the nominal exchange rate,followed shortly by a nearly equivalent rise in domestic prices, with only avery limited impact on the real rate of exchange.1 11 The instrument through

1-/ Thib impact would be "limited" rather than nil due to a real-balinr-e affect: if money supply is not expanded vari oassu with the rate of

(continued...)

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which the government would change the real exchange rate is, thus, the

creation of a budgetary surplus and its use to finance the acquisition of

foreign exchange.

2.66 The unique position of oil revenues in Venezuela's economy leadsautomatically to the creation of a budgetary surplue by an increase in the

real exchange rate. This is the essence of our earlier discussion of the

nature of the stabilization policy of 1989. Since the government, throughPDVSA, is the major supplier of foreign exchange, an increase in the relative

price of foreign exchange yields increased government revenues (through larger

transfers from PDVSA) and an increased surplus. 'his automatic impact partly

obviates the need for any further action to increase the budgetary

surplus.IV It is estimated that, with Venezuela's present attributes, a

one percent increase in the real exchange rate would yield additionalgovernment revenues (net of increased expenditure on the government's own use

of foreign exchange) of US$80-100 million dollars. Thus, for example, a 10percent increase in the real rate would automatically create a budgetary

surplus of some 1.5 percent of GDP, which, in turn, would amount to a ratio of

20-25 percent of non-oil exports.

2.67 It is essential for the government to realize that the increase in

revenues should not be a signal for increasing expenditures. The increasemust be devoted to the creation of a budgetary surplus, if the real-exchange

rate depreciation is to be sustained. Moreover, this surplus should not be atempora.Ly phenomenon bst a permanent feature of the budget. One possible

mechanism conducive to such behavior, suggested earlier, is the proposed oil

stabilization fund, which would transfer annually to the government's budget

ll/( ... continued)

nominal devaluation, real money balances would decline, thus enabling some

increase of th. real exchange rate. The trade (current-account) surplus wouldthen be made possible by increased saving, required to re-establish real money

balances; and a reduction of domestic investment due to higher real interest

rates.

la/ Assume that all foreign exchange in the econor.y is supplied by the

government (and demanded by private agents). When the Central Bank introduces

its own demand, to raise the exchange rate, it accumulates reserves and pays

with domestic monrey. If the elasticity of demand for foreign exchange is

unity, the amount of money paid is identical ts the size of additional

revenues flowing to the government, and thus to the increase in the budgetary

surplus. No net injection of money takes place, and no need exists for any

further government or Central Bank action. If demand elasticity is below

unity, the budgetary surplus would exceed the size of payments for acquired

reserves; whereas the relationship would be reversed with an above-unityelasticity. The concrete case of Venezuela is not so extreme, although the

deviation from the hypothetical case is not overwhelming (oil exports being 70to 80 per cent of total exports, and not much below this as a fraction of

total foreign-exchange supply). The deviation would become bigger, of course,

the more the increase of the foreign-exchange rate raises private-sectorexports.

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not the perceived value of permanent oil revenues, but that amount minus theaoumulation of foreign exchange zequired for thq desired increase in theforeign-exchange rate.

2.68 At the end of thiu process, the structural changes introduced byit would be a higher real exchange rate leading to a higher share, anddiversification, of non-oil tradable activities, and the creation of acurrent-account surplus. This surplus would be reflected in the accumulationof foreign-exchange reserves; that is, in an investment abroad. This, inturn, would be offset by a reduction of domestic consumption and investment,with investment being directed in a pattern quite different from what it wouldhave been without a change in the real-exchange rate.