DOCUMENT OF THE INTER-AMERICAN DEVELOPMENT BANK

PERU

IDB COUNTRY STRATEGY WITH PERU 2007-2011

This document was prepared by the project team consisting of Susan K. Kolodin (SCL/SPH), David Rogers (CAN/CAN), Kim B. Staking (ICF/CMF), Daniela Lpez (CAN/CAN), Rosario Gaggero (INE/RND), Edna Armendariz (CAN/CAN), Gabriela Sylvia Andrade (CCB/CCB), Francesca Castellani (CAN/CAN), and Fidel Jaramillo (CAN/CAN), who was the Project Team Leader, with contributions from CAN/CPE, INE/ENE, INE/TSP, INE/WSA, INE/RND, SCL/EDU, SCL/SPH, SCL/SCT, SCL/GDI, ICF/ICS, ICF/FMM, ICF/CMF, MIF, SCF and IIC.

CONTENTS

EXECUTIVE SUMMARY I. DEVELOPMENT CHALLENGES IN PERU ............................................................................1 A. B. Introduction ...........................................................................................................1 Political, economic, and social outlook ................................................................2 1. The new political landscape in Peru .............................................................2 2. The economic situation .................................................................................2 3. The social setting...........................................................................................6 The governments development agenda ...............................................................8

C. II.

RECENT RELATIONS BETWEEN THE BANK AND PERU ....................................................9 A. B. The 2002-2006 strategy ........................................................................................9 Evaluation and lessons learned ...........................................................................11

III.

THE BANK STRATEGY WITH PERU FOR 2007-2011.......................................................12 A. Foothold in the global economy and competitiveness .......................................12 1. Current situation and principal challenges..................................................13 2. Principal areas of Bank support ..................................................................13 Social development and inclusion ......................................................................22 1. Current situation and principal challenges..................................................22 2. Principal areas of Bank support ..................................................................23 Reform of the State and public management......................................................27 1. Current situation and principal challenges..................................................27 2. Main areas of Bank support ........................................................................27

B.

C.

IV.

IMPLEMENTATION OF THE STRATEGY ...........................................................................30 A. Lending program.................................................................................................30 1. Public sector ................................................................................................31 2. Private sector...............................................................................................36 The new business model .....................................................................................37 The fiduciary situation ........................................................................................37 Risks and mitigating factors................................................................................38 1. Macroeconomic factors...............................................................................39 2. Social, political, and institutional considerations .......................................39 3. Environmental aspects and natural disasters ..............................................40 Agenda for dialogue............................................................................................40

B. C. D.

E.

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ABBREVIATIONS

BCRP CAF CCLIP CGR CONSUCODE EAP FIDECOM FTA IIRSA ILO INEI MAPPE MEF MMF MSME NFPS SCF SNIP TC TFFP WEF

Central Reserve Bank of Peru Andean Development Corporation Conditional credit line for investment projects Contralora General de la Repblica [Comptroller Generals Office] Consejo Superior de Contratacin y Adquisiciones del Estado [National Procurement Council] Economically active population Fondo de Investigacin y Desarrollo para la Competitividad [Competitiveness Research and Development Fund] Free Trade Agreement Initiative for the Integration of South American Regional Infrastructure International Labour Organisation National Statistics Institute Memorandum of Assistance for Project Preparation and Execution Ministry of Economy and Finance Multiyear Macroeconomic Framework Micro, small and medium-sized enterprises Nonfinancial public sector Structured and Corporate Financing Department National Public Investment System Technical-cooperation operation Trade finance facilitation program World Economic Forum

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ANNEXES

Annex A Annex B Annex C Annex D Annex E Annex F Annex G Annex H Annex I Annex J Annex K Annex L Annex M Annex N

Strategy Matrix Financing Scenarios Millennium Development Goal Indicators Public Debt Risks Preliminary Lending Program Energy Sector Operations Matrix Program of Studies Nonfinancial Products Country Financing Parameters Coordination with Other Multilateral Agencies Active Portfolio Balanced Scorecard for COF/CPE, 2006 Recommendations from the Peru 2002-2006 Country Program Evaluation and Management Proposals Bibliography

BOXES

Box 1 Box 2 Box 3 Box 4 Box 5

IIRSA Northern Amazon Hub Water resources, drinking water, and sanitation Financing and development of the private sector Energy sector operations matrix Strengthening the Country Office

EXECUTIVE SUMMARY

Peru is experiencing its most significant period of economic expansion since the middle of the last century: average growth rates have exceeded 5% in the last five years and are forecasted to reach around 7% in the coming years. This performance is the result of prudent macroeconomic management that has contributed to growth stability and sustainability. To a large extent, however, it has been driven by external factors, not based on structural change or economic diversification. The booming formal economy coexists with high levels of poverty, employment insecurity, and economic, social, and political exclusion. Although there has been progress on several social indicators, growth has not trickled down enough to the majority of the population, and nearly 50% of Peruvians still live in poverty, particularly in rural areas. The persistence of underemployment and poverty could significantly weaken the medium and long-term outlook for economic development and impair the countrys governance and economic stability. Given these circumstances, Perus objective is to consolidate the recent pace of growth as a way to improve peoples lives. The challenge is to diversify the economy so as to escape the adverse impacts of external volatility and thereby achieve economic growth that translates into increased formal employment and enhanced well-being for the majority of Peruvians. In response to these challenges, President Alan Garcas administration has based its policies on macroeconomic consolidation, modernization of the productive structure, support for low-income sectors, and reform of the State and decentralization. In line with these objectives, the Inter-American Development Banks country strategy with Peru for the period 2007-2011 seeks to help the country to: (i) strengthen its foothold in the global economy and enhance its competitiveness, (ii) promote social development and inclusion, and (iii) deepen reform of the State and improve public management. To foster competitiveness and productive diversification the Bank will provide support through: (i) greater investment in infrastructure (highways, ports, logistics), especially in water resources, drinking water, and sanitation; (ii) access to capital, in particular direct financing to the private sector; and (iii) support for productive sectors, with the emphasis on sustainable development of hydrocarbons and other extractive industries. Measures to promote social development and inclusion will be designed to: (i) guarantee greater access to basic services; (ii) promote opportunities for formal employment; and (iii) strengthen the social welfare system. In the area of public management, the Banks proposed program will emphasize: (i) decentralization of service delivery; (ii) higher quality in public expenditure; and (iii) strengthening the judicial system. The Banks financial program for the public sector is consistent with the country financing requirements and the public debt management strategy set forth in the 2008 2010 Multiyear Macroeconomic Framework (MMF). It contemplates a base-case scenario of US$1.7 billion, and a high scenario of US$2.5 billion, which would consolidate the Banks position as the principal source of multilateral financing.

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The following conditions would have to be met for the more ambitious scenario to materialize: (i) a commitment to further policy reforms that would justify an increase in the amount of programmatic financing, and (ii) the capacity on the part of the Bank to improve the financial conditions and the availability of financing in nuevos soles. This latter condition depends on the authorities commitment to the reform process and their desire to increase demand for unrestricted funds in local currency, given their interest in reducing the countrys exposure to foreign-currency debt. This possibility, in turn, depends on the capacity of markets to absorb hedging in nuevos soles. Bank support for the private sector and non-sovereign public sector would be primarily for infrastructure (transportation, energy, water and sanitation, with subnational entities or concessionaires), and financial markets (capital market, mortgage securitization, financial institutions, and trade finance facilitation program). The Bank also plans to continue its support to the oil and gas sector, in which it has been a significant player through its financing for the Camisea project and its subsequent phase, Peru LNG. The proposed program takes a comprehensive approach to each strategic area, with a mix of programmatic, investment, and technical cooperation resources, to contribute to the countrys development agenda in terms of knowledge, design and implementation of public policies, and the financing of capital projects in the public and private sectors. The Banks strategy with Peru is being pursued in a context in which country focus is the principal thrust of the Banks new organizational structure. The new model stresses the importance of deepening the Bank-country relationship, and this entails modernizing and strengthening the Banks Country Office. This will be key for reinforcing dialogue and focusing on client needs. The risks facing implementation of the strategy relate to: (i) macroeconomic factors, (ii) social, political, and institutional considerations, and (iii) environmental and natural disaster-related aspects. These risks could compromise the countrys economic, social, and institutional stability and thereby jeopardize its development objectives and implementation of the strategy. Nevertheless, the country and the Bank have incorporated a series of mechanisms to identify, prevent, and mitigate these risks.

I. A. 1.1 Introduction

DEVELOPMENT CHALLENGES IN PERU

Perus economic performance has been encouraging and certainly provides grounds for optimism. In the last year, gross domestic product (GDP) rose by 8%, capping 23 consecutive quarters of economic expansion, and one of the longest periods of sustained growth since the middle of the last century. This dynamic performance has been achieved in a context of rapidly rising exports coupled with macroeconomic stability. Peru is likely to join Chile as one of the two most stable countries, with the lowest sovereign risk in South America. Nevertheless, despite these favorable developments, Peru is facing challenges that argue against complacency. While growth has been substantial, it has been due in large part to external factors that could at some point be reversed, and it is just recovering the pace of growth that prevailed in the late 1970s. Perus productive structure is today nearly as concentrated as it was three decades ago, and remains heavily dependent on primary activities. Moreover, recent growth has been insufficient to create high-quality jobs that would offset the problems of unemployment and employment in the informal economy. Fourteen million Peruvians are still living in poverty, and poverty is especially severe in rural areas and among indigenous populations. It is clear that the countrys sound performance in terms of growth and macroeconomic stability in recent years has not trickled down to the majority of the population. Under these circumstances, Peru faces the challenge of deepening economic growth in a sustainable way, creating more jobs and opportunities that will enhance the well-being of the majority of Peruvians. Success on this front will require: a. Consolidating macroeconomic gains as the basis for developing economic activities and protection mechanisms for confronting adverse shocks relating to the terms of trade, financial conditions, and natural disasters. b. Enhancing competitiveness and diversifying the productive structure, strengthening Perus foothold in the global economy, and guaranteeing an investment climate that will foster development of the private sector, productivity, innovation, and job creation. c. Raising the quantity and quality of investment in human and social capital, and guaranteeing effective delivery of basic public goods and services. d. Improving government management at the national and subnational levels in the delivery of public goods and services, and strengthening the accountability mechanisms needed for a dynamic, competitive and equitable economic system.

1.2

1.3

1.4

1.5

The Banks 2007-2011 country strategy with Peru seeks to support the countrys development agenda as it addresses these challenges. The Bank is in a privileged position to affirm its commitment as an effective development partner for the country, and to consolidate its position as the primary source of multilateral finance

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for the government, and one of the main suppliers of medium and long-term funding for the private sector. B. 1.6 Political, economic, and social outlook 1. The new political landscape in Peru The national and regional elections of 2006 bolstered the process of democratic participation in Peru. President Alan Garca took office with a mandate to lock in growth and stability and to achieve greater equity, transparency and decentralization. President Garcas party, APRA (Partido Aprista Peruano), holds 37 of the 120 seats in the National Congress. While the administration does not have an explicit majority, it has forged working alliances with the Unidad Nacional and the Alianza por el Futuro. Despite progress in making the countrys governance more democratic, the electoral process also revealed a significant degree of political and social fragmentation. Traditional political parties like APRA received most of their support from higher-income urban voters. In contrast, rural and low-income people opted for the party of presidential candidate Ollanta Humala, which took a stance critical of the countrys prevailing economic and political system. That party led the polls in 8 of the 10 poorest departamentos of Peru, and opinion surveys show that Peruvians are increasingly discontent with the results of democracy and the market economy.1 Perus fragmented political landscape poses a potential source of political and social instability, and the risk that the countrys economic direction could be reversed. Consequently, one of the main challenges facing the current administration is to overcome this negative perception, broaden opportunities for the disadvantaged, and promote access to public goods and services for the majority. 2. The economic situation 1.10 Perus economic outlook is positive. On the international front, favorable terms of trade and ample capital inflows have boosted the countrys economic growth and stability. The last five years have produced annual average GDP growth exceeding 5%. Growth in 2006 reached 8%, and the 2008-2011 Multiyear Macroeconomic Framework (MMF) forecasts growth of around 7% for 2007.2 Since 2002, Peru has achieved positive rates of per capita growth, something not seen since the beginning of the last century. This dynamic performance is expected to continue for the rest of the decade.

1.7

1.8

1.9

According to Latinobarmetro, 77% of Peruvians are unhappy with the results of democracy, and 88% are dissatisfied with the market economy. See Informe Latinobarmetro 2005 and 2006. See the 2008-2010 Multiyear Macroeconomic Framework.

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1.11

This growth has been accompanied by substantial macroeconomic stability. Inflation has been below international levels, real interest rates have remained low, and the currency has tended to appreciate. The Central Reserve Bank has successfully applied an independent monetary policy using a model based on inflation targets. As a result, inflation was 1.6% in 2006, at the lower limit of the established band (1.5%-3.5%).3 Table 1 shows trends for the main economic indicators.

In 2007, the Central Banks Board of Directors reduced the target range to 1.0-2.0%.

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Table 1 Main Economic Indicators 2004 Real Sector and Prices Real GDP (growth, %) Unemployment (average, %) Inflation (CPI Dec-Dec, %) Financial Markets Exchange rate (average) Interest rate-Dep < 30 days (annual average) Balance of Payments (US$ billions) Exports Imports Trade balance Current account (% GDP) Direct investment (net) International reserves (end of period) Fiscal Accounts (% GDP) Revenues (CG) Capital spending (CG)* Current expenditures (CG)* Overall balance (NFPS)** Primary balance (NFPS)** Public Debt (% GDP) Total public debt External public debt Domestic public debt Sovereign Risk Ratings S&P EMBI+ (***) Competitiveness Indicators Competitiveness Index GEF (****) Ease of Doing Business IBRD
(*****)

2005 6.4% 9.6% 1.5% 3.36 3.21 17.34 12.08 5.26 1.4% 2.50 14.12 15.9% 2.0% 13.1% -0.51% 1.77% 38.5% 28.9% 9.6% BB 170 77/117 71/155

2006 8.0% 9.0% 1.1% 3.29 4.90 22.73 15.22 7.48 2.6% 2.50 17.20 17.3% 2.0% 12.2% 2.0% 3.9% 32.8% 23.6% 9.2% BB+stable 131 74/125 78/175

2007p 7.2% 7.4% 1.9% 3.18 5.77 26.13 17.79 8.33 1.5% 2.89 20.8 17.4% 2.7% 13.2% 0.3% 2.4% 29.2% 19.2% 9.9% BB+positive 118 n/a 65/175

6.5% 9.4% 3.2% 3.38 2.68 12.81 9.81 3.00 0.0% 1.80 12.65 15.0% 1.8% 12.8% -1.18% 1.03% 41.9% 34.8% 9.0% BB 220 n/a n/a

Source: BCRP, MMF, MEF, Latin Source, (p) Projections. *G: Central Govt ** NFPS: Nonfinancial public-sector ***To 4 May 2007. ****Global Competitiveness Index 2005-2006 and 2006-2007, World Economic Forum. ***** Doing Business Report, World Bank 2006.

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1.12

At the same time, stronger banking supervision within a stable economic setting has kept the financial system sound, and there has been steady improvement in the quality of its assets, capitalization levels and earnings since 2002.4 Financial dollarization has declined in recent years, although it remains high. The public finances have shown continuous strengthening. The deficit of the nonfinancial public sector (NFPS), which exceeded 3% of GDP in the late 1990s, has gradually been eliminated, and a surplus of 2% was posted in 2006. Fiscal discipline and the high growth rates of recent years have helped reduce the balance of the public debt from 45% of GDP in 2000 to 32.8% of GDP in 2006, and its currency, cost and term structure has been improved. Access to international capital markets has improved, with historically low spreads that were only slightly over 100 basis points at the time this paper was prepared. In fact, with this favorable economic and financial performance, Peru could earn a sovereign risk classification that would make it the second country in South America (after Chile) to achieve an investment-grade rating.5 The external sectors performance has been very strong. Exports have more than tripled in value over the last seven years, from US$7 billion in 2000 to US$23 billion in 2006. The external current account shifted from a deficit of more than 1.5% of GDP to a surplus of 2.6% of GDP over the same period. Together with significant capital inflows, this performance boosted the countrys international reserves to US$17.2 billion in 2006, double the level recorded in 2000. Peru is in the final stages of approving a free-trade agreement with the United States, its principal trading partner. The impact of that agreement (and of others now in place or in the process of completion) will help to maintain the dynamism of foreign trade and economic growth. Despite this favorable picture, the country must address a number of vulnerabilities in order to consolidate achievements to date. These weaknesses have to do with the high level of financial dollarization in the Peruvian economy, low tax revenues, and dependence on primary products.6 The favorable economic scenario could also be affected by Perus vulnerability to natural disasters, in particular the El Nio phenomenon. From a medium-term perspective, it must be recognized that, despite the solid performance of the last five years, Peru is just now recovering from a

1.13

1.14

1.15

1.16

1.17

The return on financial system assets rose from 0.8% in 2002 to 2.2% in 2006, and the return on equity jumped from 8.3% to 23.5%. Over the same period, nonperforming loans as a percentage of the total portfolio declined from 7.6% to 1.9%. In the past, Colombia and Uruguay enjoyed investment-grade ratings. See Peru and Investment Grade, Andrew Powell, IDB 2007. Chapter IV examines macroeconomic risks and their mitigating factors in greater detail.

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severe collapse, and has barely reached the levels of per capita income that prevailed in the 1970s (see Figure 1).7 Figure 1
GDP and exports per capita (constant dollars of 2000)
250 0 240 0 230 0 220 0 210 0 200 0 190 0 180 0 170 0 160 0 150 0 1 975 197 6 198 0 198 1 1 983 1 987 198 9 1 991 199 3 1 995 199 7 1 999 2 000 200 1 2 003 200 5 19 79 19 84 19 88 19 92 19 96 20 04 1977 1978 1982 1985 1986 1990 1994 1998 2002 550 500 450 400 350 300 250 200 150

Per capita GDP (left axis)

Per capita exports (right axis)

Source: World Development Indicators, World Bank 2006.

1.18

The collapse of the Peruvian economy was closely linked to contraction in the export sector, in a context of severe macroeconomic imbalances. The current recovery can be explained to a large extent by the export boom, driven by high international prices. Yet this improvement has not resulted in any major changes in the productive structure: Peru still relies on unsophisticated primary goods with little labor content. 3. The social setting In contrast to the countrys economic performance, progress in its social indicators has not been very encouraging, particularly when it comes to employment. In 2005, nearly 58% of the economically active population (EAP) was unemployed or underemployed. Between 2001 and 2005, most of the new jobs created were in the informal sector, particularly in agriculture and in services. Meanwhile, employment in the formal sector grew by only 6%, less than half the rate of increase in the workforce. As a result, unemployment and underemployment indicators have shown no improvement since 2000.8 The degree of informality in Peru is in fact among the highest in Latin America and the Caribbean.9

1.19

7 8

See Growth Diagnostics, Ricardo Hausmann et al., 2007. See Crecimiento, generacin de nuevas actividades productivas y empleo formal, Carmen Pags, IDB (2007). According to ILO indicators, informal employment in 2002 represented nearly 60% of total employment, the third-highest level in Latin America, after Bolivia and Colombia. See opo et al. 2006.

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1.20

During this time, output per worker grew very little and real wages fell, particularly in the informal sector. Generally speaking, labor market conditions have deteriorated: the number of people working more than 48 hours a week has risen, as has the number of those working without a labor contract and the proportion of employees who have no social security coverage.

Table 2. Employment levels: 2005 (as a percentage of EAP) Geographic spread Urban Rural Total Unemployed 7.5 0.7 5.0 Underemployed 46.5 63.5 52.6 By hours 10.3 8.4 9.6 By earnings 36.2 55.1 43.0 Adequately employed 46.1 35.9 42.4 Percentage 100.0 100.0 100.0 Total EAP 8,800,197 5,007,696 13,807,894 Source: National Statistics Institute (INEI) National Household Survey on Living Conditions and Poverty, ongoing 2005. Prepared by: Ministry of Labor and Job Promotion Labor Statistics and Research Program (PEEL).

1.21

Given the labor situation, it is not surprising that poverty levels remain high. In 2005, 50% of the Peruvian population was living in poverty, and 18% in extreme poverty. In rural areas the poverty rate is nearly double that in the cities, indicating that there is a high incidence of poverty and exclusion among indigenous populations. Inequality, as measured by the Gini coefficient, was estimated at 0.43. Despite progress in social indicators and in meeting the Millennium Development Goals,10 the country still faces challenges in the coverage and quality of basic public services. In some areas coverage remains very low, particularly in the countryside, where one child in two lives in extreme poverty, and more than 40% suffer chronic malnutrition. It is estimated that 25% of the total population has no access to water, and more than half lack adequate sanitation. The quality of education is among the lowest in the hemisphere.11 Slow progress on the labor and social front underscores the difficulty in ensuring that economic growth translates into greater formal employment and well-being for the majority of Peruvians. What is needed is not only to accelerate growth and broaden its basis, but to adopt a social development policy that includes greater investment in human capital, effective social welfare provisions, and creation of opportunities for people who have been excluded from the benefits of growth.

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1.23

10

Maternal-infant mortality, for example, has declined from 75 per 1,000 in 1990 to 28 per 1,000 in 2003. Education coverage has already achieved the goal of universal primary schooling. See Annex B for a status report on achievement of the Millennium Development Goals. IDB, 2006. Nota Tcnica Sector Educacin, Nota Tcnica Sector Agua y Saneamiento; Notas Tcnicas Sector Salud.

11

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C. 1.24

The governments development agenda The Peruvian government has said that its principal challenge is to address the fact that economic growth has not produced significant benefits for the majority of the population.12 To this end, it is pursuing an ambitious development program that seeks to consolidate achievements to date, to accelerate economic growth, and to move forward in terms of opportunities and social welfare. It has proposed a series of initiatives to reduce macroeconomic vulnerabilities and enhance the efficiency of the public sector; to strengthen the countrys foothold in the international economy and foster private initiative; and to promote job creation and efficiency in the delivery of public goods and services. The MMF calls for reinforcing the institutional framework for fiscal policy in ways that will promote public investment and will punish noncompliance with tax rules. Tax reform is also planned, to improve collection and to make the economy more competitive, and budgeting-by-results will be introduced to improve the quality of expenditure. On the international front, Peru is pursuing an active strategy to enhance the quality and diversity of its participation in the global economy. This involves expanding access to the major external markets through the negotiation of free-trade and integration agreements with several other countries, in particular the United States. At the same time, this strategy is promoting a domestic agenda to create capacities for production and trade, including policies and initiatives to foster competitiveness and to promote private investment. The governments social program relies on two pillars: encouraging job creation in the formal sector and guaranteeing greater access to basic services, in particular drinking water, housing, and health. To coordinate its social interventions more effectively, the government has approved the Social Program Reform Plan, which takes a comprehensive long-term approach and includes the reorganization and reorientation of social programs.13 Management by results in budget allocations and geographic targeting are key components of the planned reform. Labor reforms are planned to reduce informality and to foster formal employment. A central point of this strategy is its emphasis on the quality of education. The Bank shares this vision and the objectives of the development program and in this document it sets forth a strategy for the period 2007-2011 to assist the country in implementing this program and achieving its objectives.

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12

Based on documents and presentations from the ministries of labor, economy and trade during the Policy Dialogue meeting in February 2007. Decree 029-2007-PCM, March 2007.

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II. RECENT RELATIONS BETWEEN THE BANK AND PERU A. 2.1 The 2002-2006 strategy The IDB has had a close and very active relationship with Peru. In the first quarter of 2007, the Peruvian portfolio was the Banks fifth-largest,14 accounting for 4% of the total, and Peru had the second-highest number of operations.15 The Banks country strategy with Peru approved for 2002-2006 identified three priority areas for support: (i) raising the economys productivity and competitiveness; (ii) improving the efficiency of social policy; and (iii) creating a modern, decentralized, and efficient State. During this period the Bank approved loan operations with the public and private sectors totaling US$2.284 billion, or 7.3% of total Bank loan approvals, at an annual average of US$457 million, which represented a significant increase over the average of US$346 million from 1990-2000. Technical-cooperation operations amounted to US$27 million, or 3.6% of the Banks total. With respect to the public sector, the IDB accounted for 16.7% of Perus total external debt in 2006, versus 14.6% in 2002, becoming the countrys primary source of multilateral financing, with 47% of its total multilateral debt. Operations with the private sector totaled US$333 million, thereby substantially increasing the nonsovereign portfolio in the country, using innovative financial instruments and involving key sectors for the Peruvian economy. In terms of instruments, policy-based loans represented roughly 57% of approvals, investment operations 28%, and private sector operations 15%. Unrestricted funds covered, on average, 40% of the needs for such financing, in support of the strategy for optimizing the public debt structure and terms. The lending program focused primarily on competitiveness (41% of approved operations), followed by modernization of the State (36%) and the social sector (25%). The emphasis on competitiveness was reinforced by technical-cooperation operations (TCs), financed for the most part by the MIF, with the long-term objective of increasing the potential for economic growth and sustainable social development. With the solid economic trend and the performance of the external sector achieved during implementation of the strategy, the country has moved forward toward its development objectives. Despite problems of attribution, it can be said that the Bank provided timely support for the development of policies to promote trade and competitiveness.

2.2

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2.6

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14 15

After Brazil, Argentina, Mexico and Colombia. After Brazil.

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2.8

With the stepped-up pace of trade negotiations, Bank support was critical for gains in areas that are key to competitiveness, including lowering transportation costs, greater agricultural productivity, the supply of natural gas, the facilitation of business creation, and execution of bank guarantees. Also of great importance was the Banks support for development and investment in the private sector, achieved through the direct financing of projects as well as through innovative instruments that facilitate private participation. Given the private sectors limited access to long-term financing, the Banks catalytic role has been crucial in attracting commercial financing and new investment to the country. The Camisea project, for example, marks a milestone in the Banks support for the countrys energy strategy and private sector development in the energy sector.16 The transportation sector is a central focus of the current portfolio. The IIRSA Northern Amazon Hub project, in particular, represents a double milestone, as the first guarantee project approved by the Bank and the first project financed under a public-private partnership in Peru (Box 1).
Box 1. IIRSA Northern Amazon Hub Innovative Financing in Support of Regional Integration, Private Sector Development, and Competitiveness

2.9

2.10 2.11

In February 2006, the IDB approved a partial credit guarantee of US$60 million to support the Government of Peru in concessioning infrastructure projects through a financing arrangement that would attract private sector participation. The innovative financing structure is based on annual payments for construction issued against certificates of completion, whereby the government undertakes to pay for the works in a series of annual payments defined upon completion of each phase of construction. The Banks involvement generated confidence, increasing the number of firms interested in participating, fostering competition, and reducing financing costs. The concession contract distributes the principal risks among the parties, including the construction and maintenance risks, traffic shortfall risks, and environmental risks (including natural disasters and El Nio). Moreover, the financing arrangement allows the government to account for the costs in the budget, rather than as debt, thereby improving its risk ratings and lowering the countrys borrowing costs in capital markets. The concessioned works relate to the improvement and rehabilitation of 960 kilometers of roads, making this one of the largest concessions in the region, linking areas of great geographic complexity. The new infrastructure will encourage trade and the establishment of new inter- and intraregional production centers, thereby significantly reducing transport costs. It will facilitate ecotourism and the production and marketing of tropical fruits and other products from the area. It is also creating jobs in construction and maintenance of the works, and is providing greater access to social services for local people, particularly those in remote areas. The project was recognized by Project Finance International as Latin American project bond deal of the year in 2006. It has opened up new opportunities for using guarantees to help governments in the region expand their financing options, encouraging new private investments, and promoting greater development.

2.12

In the social sector, the country has made progress in its indicators for social welfare and social expenditure equity and for rural access to education. Yet this progress has not been enough to bring about significant changes in the indicators of

16

See Box 4 for a description of the Camisea project and its second phase, under the Peru LNG project.

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inequality and poverty. This suggests the need to bolster Bank support and to adopt an approach that combines strengthening the social welfare system for the most vulnerable and excluded groups with support for creating opportunities for the majority of the population, emphasizing investment in early childhood, technical and vocational training, and the quality of basic education. 2.13 When it comes to public management and reform of the State, the most significant outcomes were recorded in the support granted by the Bank for managing fiscal policy, the quality of public expenditure, and managing the public debt. The country now has a modern administration system and the public accounts are more transparent. The quality and the transparency of the public information system are particularly noteworthy.17 Bank support has been fundamental in moves to strengthen medium-term economic planning and to achieve orderly and progressive decentralization consistent with fiscal discipline. Yet the State reform process has been spotty, and a greater effort is needed in various areas of government at the national and subnational levels. As a result of this strategy, the current portfolio consists of 27 loan operations totaling US$1.43 billion (see Annex K). Evaluation and lessons learned In general, the evaluation of the previous strategy was favorable. In financial terms, the IDBs share in the multilateral financing market rose significantly. At the same time, direct support to the private sector expanded in key sectors of the Peruvian economy. As to the impact on development objectives, the Bank strategy supported the countrys agenda, particularly in the areas of competitiveness and growth. The Office of Evaluation and Oversight (OVE) conducted an independent evaluation of the strategy and concluded that the Bank was a relevant partner for Peru in addressing the countrys development problems. Annex M describes the recommendations presented by the OVE and the actions taken or planned by Management to address them. The analysis of the Banks work with the country and the OVE evaluation point to the following key recommendations for the design and implementation of the current strategy.18 Optimizing the generation and use of nonfinancial products. Analytic work is an essential element for sharpening the country focus and strengthening: (i) policy dialogue with the country, (ii) priority setting for areas of intervention, (iii) development of the strategy, and (iv) the design of operations. A programmatic approach. The relationship between the countrys achievements and the Banks initiatives indicates that support is most effective when it focuses on

2.14 B. 2.15

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17

Montenegro (2006) highlights Perus achievements in this area and ranks it among the leading countries of the region in terms of the availability and transparency of public information. See Melo (2006), Country Program Evaluation (CPE): Peru: 2002-2006.

18

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a limited number of areas and takes an integral approach which, by strategically combining available instruments (policy-based loans, investments and credit to the private sector) can strengthen results-based orientation. 2.20 Emphasizing the production-based approach to social development and inclusion. The slow progress that has been made in combating poverty and creating jobs demonstrates the need to encourage greater articulation between policies for economic inclusion (i.e. microfinance, production chains) and combating poverty (the social agenda) in order to achieve sustainable structural change. Improving coordination within the Bank. Coordination of public and private sector operations is essential for strengthening the Banks strategic vision of support. Supporting the consultation process. A smooth-flowing dialogue and a consultation policy that includes all stakeholders are key to maximizing the impact of Bank support. Strengthening project preparation and execution. Strengthened analytic work and institutional analysis and effective risk management are important elements for the design and effectiveness of programs. Particularly important in this context is the Banks role in providing project management training, consulting and technical assistance services for executing units. III. THE BANK STRATEGY WITH PERU FOR 2007-2011 3.1 The new 2007-2011 strategy continues the thrust of the Banks work with the country in areas relating to competitiveness, social development, and modernization of the State, taking account of lessons learned and the OVE recommendations set out in the previous chapter. The strategy reflects wide-ranging discussions of policies with the government and with Peruvian society to identify the constraints the country faces in achieving its development objectives, and is designed to support Perus development agenda by deepening the countrys sustainable economic growth and generating greater opportunities for the majority of Peruvians. Bank support is grouped into three strategic pillars: (i) strengthening Perus foothold in the global economy and enhancing competitiveness; (ii) promoting social development and inclusion; and (iii) deepening the reform of the State and improving public management. While each area constitutes an objective in its own right, the programmatic approach adopted ensures that the pillars and their objectives are closely linked. Foothold in the global economy and competitiveness The central objective of this strategic area is to strengthen Perus foothold in the global economy and increase competitiveness as the primary engines of sustained growth and job creation in the Peruvian economy. This will require expanding access to international markets, diversifying the economic structure, and promoting investment and productivity in the private sector.

2.21

2.22

2.23

3.2

A. 3.3

- 13 -

1. Current situation and principal challenges 3.4 The recent performance of Perus external sector has been extraordinary. Growth in the value of goods exports, led by mining exports, has been the highest recorded in the last six decades of Perus history.19 Nontraditional exports, in particular agricultural and textile products, have also shown significant growth.20 Despite this performance, the Peruvian economy remains relatively closed. The degree of openness, measured as the sum of exports and imports as a percentage of GDP, has not changed substantially in the last 40 years,21 and per capita exports remain among the lowest in the hemisphere. Primary products and raw materialintensive manufacturing account for more than 80% of the countrys external sales. The share of manufactures in exports is among the lowest in the region. Empirical evidence suggests that the scant diversification of Perus exports and the countrys dependence on unsophisticated exports of a limited number of natural resources could hold back the countrys long-term growth potential. Moreover, this concentration in capital-intensive goods helps to explain why recent growth has not translated into greater employment gains in the formal sector of the economy. The key problem is that Peru has not gone through a process of discovery of new sectors, of innovation and the emergence of new businesses that would bring greater productive diversification, new exports, and more jobs.22 The competitive climate in Peru has not favored diversification and private sector development. According to the World Economic Forum, Peru ranks 74th among the 125 countries surveyed. Its relative international standing has not changed significantly in recent years, despite its improved performance in terms of growth and exports. Consequently, a strategy for deepening Perus participation in the global economy must go hand-in-hand with efforts to reinforce the countrys competitiveness and productive diversification. The following sections describe the main areas of Bank support for achieving the objectives of this first strategic pillar. 2. Principal areas of Bank support a. Market access 3.8 The government has adopted an active strategy for expanding access to external markets through integration and free-trade agreements with various countries, including the United States, which is the worlds largest market and the main destination of Peruvian exports. Other agreements are being negotiated with the European Union, Chile, Mexico, Thailand and Singapore as part of a strategy to

3.5

3.6

3.7

19

External sales rose from US$5.8 billion in 1998 to US$23.8 billion in 2006. The figure for 2007 is estimated at US$26.4 billion, representing a nearly fivefold increase over the last nine years. Nominal annual growth is estimated at 20% over the period 2003-2007. In 1960 this indicator was 42%, and in 2006 it was 43%. See Growth Diagnostics, Ricardo Hausmann et al., 2007.

20 21 22

- 14 -

boost competition, seek out new markets, and achieve sectoral and geographic diversification. 3.9 3.10 The U.S. and Peruvian governments reached an agreement on the terms of a freetrade agreement, which is now being implemented. The conclusion of the free-trade agreement (FTA) with the U.S. and other trade agreements is only the first step in a long process, one that will demand great effort in terms of legal reforms, new regulations, standards, administrative procedures and institutional changes. According to IDB studies, once the FTA with the U.S. is implemented, the industries that should experience the greatest growth will be textiles and clothing, metal products, and food products.23 Yet, in the absence of parallel policies to open the economy, trade integration with United States will tend to accentuate the concentration of exports, and would not help position the country in high value-added market niches. That outlook highlights the need to accompany trade liberalization with competitiveness policies that will strengthen the dynamic impact of integration. b. Domestic agenda 3.12 While the different scenarios are all favorable, trade agreements by themselves are not a panacea for achieving greater growth and export diversification. To ensure that increased international economic dealings can be an instrument for achieving development objectives, the Peruvian government is at the same time pursuing a domestic competitiveness agenda complementary to its trade initiatives, designed to increase opportunities and minimize risks. The domestic agenda includes promotion of investment and development of the private sector in ways that will reinforce the links between trade and growth and that will also create jobs and promote well-being. Such linkages are essential if all sectors of the population are to participate in the opportunities that greater linkages with the international economy will bring. The Bank has been playing an effective role in articulating public-private dialogue for identifying priority initiatives and policy reforms to address the barriers to competitiveness.24 It is important to deepen the Banks catalytic role by supporting

3.11

3.13

3.14

23

Inter-American Development Bank, INT/ITD, Documento de Discusin sobre Comercio e Integracin, 2006. According to an IDB study, the main barriers have to do with: (i) a weak institutional framework and weak institutions in both public and private sectors, resulting in unstable rules of the game, high levels of corruption, and little cooperation; (ii) the lack of modern business legislation and a judicial system that is slow, uncertain and nontransparent; (iii) a structurally deficient tax system with high levels of evasion; (iv) limited access to credit and financial services, with weak protection of property rights; (v) labor rigidities and an inadequate flow of information in labor markets; (vi) shortcomings in basic public infrastructure, especially ports, transportation and logistics; (vii) the poor quality of public education (basic, technical and university) and weak linkages between technical and vocational training programs and the demands of the productive sector; (viii) poor management of natural resources and the environment; and (ix) a low level of innovation. IDB 2006, Nota Tcnica Desarrollo del Sector Privado.

24

- 15 -

institutions such as the National Competitiveness Council and private sector organizations, and by directly fostering the development of productive clusters. Tourism, in particular, is a sector with great potential. 3.15 While all of these factors are relevant, Bank support will need to focus on the most constraining obstacles that have discouraged private investment and ventures into new sectors and enterprises, where the Bank at the same time has a particular strength or advantage. Three principal areas of concentration have been identified: (i) (ii) (iii) 3.16 Infrastructure (roads, ports, logistics), relating especially to water resources, drinking water and sanitation. Access to capital, in particular direct financing for the private sector. Support for productive sectors, with the emphasis on the sustainable development of hydrocarbons and other extractive industries.

At the same time, it is proposed that the Bank support the country in other interrelated areas that are key to improving the countrys competitiveness: (i) (ii) (iii) (iv) The business climate. Labor markets. Innovation and the adoption of technology. Environmental sustainability. (i) Infrastructure

3.17

Public investment in physical infrastructure in Peru has amounted to about 1% of GDP in recent years. Private investment has also been very limited. Consequently, the investment shortfall in physical infrastructure, especially transportation, ports, logistics and water resources management, stands at US$22 billion. To cover this gap, public investment at the national and subnational levels must be increased, and the private sector must be encouraged to participate through concessions and other types of public-private partnership. This investment shortfall has left Peru with serious deficiencies in infrastructure and logistics services, especially in port infrastructure, the efficiency of which, according to WEF indicators, is among the lowest in the region and indeed in the world (105/125).25 The lack of investment in the countrys main port, Callao, means that container handling costs are high: the average charge for a 20 ft. container is 80% higher than in Valparaso and dock times are 50% longer than the international average.26 This is a critical issue for Perus competitiveness, since more than 90% of its exports are shipped by sea. Transport costs constrain the volume and

3.18

25 26

WEF, 2006. UNCTAD, 2005; CAF, 2003.

- 16 -

diversification of exports. Transport operating costs are relatively high in Peru, at US$0.62 per kilometer, compared to US$0.55 in Colombia and US$0.34 in Spain.27 3.19 There are significant shortages of water infrastructure. Access to this resource has become a strategic issue from various standpoints, in particular as a critical factor of competitiveness. Mining, agriculture and energy production account for 80% of water consumption. If Peru aspires to continue growing at the current pace, it will have to ensure access to and sustainable management of this resource. The Bank, together with the Peruvian authorities, has therefore identified the sector as a priority for a long-term programmatic approach. In fact, this is one of the clearest examples of the strategic focus of the Banks activities in the country, as indicated in Box 2.
Box 2. Water resources, drinking water, and sanitation A shared vision and a strategic approach
The IDBs activities in the water sector in Peru demonstrate the strategic support that the Bank can offer the country for achieving its development objectives. A number of aspects are worth noting. On one hand, its approach is based on extensive analytic work and ongoing policy dialogue with the country to identify priorities. On the other hand, it has a flexible programmatic approach that uses various windows and financial and nonfinancial instruments of the Bank, with a medium-term vision that combines public policy reforms in the sector, investment projects, and private sector participation. The Bank will continue to focus its attention and resources on this sector in order to help achieve the objectives of the various programs and ensure that they contribute to Perus development. The first year of this strategy calls for a total of US$450 million in investment loans, programmatic operations in the sector of water resources, drinking water and sanitation, and technical assistance. For the remainder of the strategy, additional operations have been preliminarily identified amounting to between US$600 million and US$800 million, making this the Banks biggest sector of concentration in Peru. The Banks program in the water sector is helping to achieve various objectives of the Banks strategy with Peru: it is providing inputs and basic infrastructure for improving the countrys competitiveness, it is enhancing the delivery of an essential good for the poorest population, and it is modernizing the institutional framework for decentralized resource management. In addition, it is addressing the needs of conservation and sustainable management of natural resources and is consistent with two priority Bank initiatives: the Water and Sanitation Initiative and Opportunities for the Majority. Despite progress in recent years, water resource management in Peru still suffers from problems of scarcity, inefficiency and poor quality. Water demand to satisfy human consumption needs, productive activities and environmental requirements has been growing significantly, and programs in this sector are thus priorities for achieving the countrys development objectives.

(ii) 3.20

Access to capital

The development of financial markets in Peru has helped to improve intermediation, microfinance, and financial services to the private sector. Average interest rates have remained stable, and spreads have dropped to historic lows, thereby facilitating access to external financing for the financial and business sector. According to the Doing Business report, there was a significant improvement in the private sectors perceptions of access to financing from 2002 to 2006.

27

Instituto Peruano de Economa, 2003.

- 17 -

3.21

Nevertheless, access remains limited for low-income sectors (natural and artificial persons). The problem is particularly acute for micro, small and medium-sized enterprises. Only 9% of such firms borrowed from the formal financial system (in contrast to 100% of large companies), and the average interest rate on loans to microenterprises is 38.7% (compared to the banks prime corporate lending rate of 5.2% for their lowest-risk clients). The IDBs different windows for the private sector have the comparative advantage of facilitating access to financing. Box 3 summarizes the strategy for supporting growth of the private sector, and emphasizes the IDBs role both as a direct lender and as a catalyst for financing private productive activities.
Box 3. Financing and development of the private sector

3.22

The strategic pillar supporting a foothold in the global economy and competitiveness is closely related to the development of the private sector. Beyond promoting reforms to improve the business climate and facilitate access to key factors such as infrastructure, the Bank can contribute directly to private sector development through financing and other financial products offered by the private sector window, the Structured and Corporate Financing Department (SCF), the Inter-American Investment Corporation (IIC) and the Multilateral Investment Fund (MIF). The Banks new vision consolidates the different private sector windows and provides a wide variety of financial instruments including direct loans, A/B operations, guarantees, and direct or catalyzing interventions in capital markets (for example, mortgage securitization). Through SCF and the IIC, the Bank has an extensive network of clients in the traditional sectors (financial and corporate). Nevertheless, it could position itself as well in new sectors where it could add value. For its part, the MIF is supporting small-scale interventions to carry out experimental pilot projects that could spark new practices and encourage larger scale reforms. The MIF can provide nonreimbursable technical assistance to the private sector to improve the business climate, build the capacity of the workforce, and expand the economic base for participation by small businesses.

(iii) 3.23

Energy and extractive industries

The central message of the Banks strategy with Peru is the need to foster diversification in the Peruvian economy. Given the wealth and enormous potential of the countrys extractive industries, especially hydrocarbons, however, the Bank should not turn its back on these sectors, and should indeed support the sustainable use of natural resources, innovation and the generation of new activities of greater value added, based on these resources.28 Short-term economic growth prospects will continue to depend on the performance of these sectors. Recent investment in extractive industries has been impressive, with a cumulative total of US$14.3 billion between 1994 and 2005. The share of this sector in GDP in nominal terms rose from 4.4% in 1998 to 11% in 2005. This reflects growth in real output and improved terms of trade for minerals and hydrocarbons, particularly since 2003. Exports in 2005 reached 14% of GDP, representing 66% of the

28

Espinasa, R., 2007.

- 18 -

countrys total exports. Higher levels of production and activity in mining and hydrocarbons has significantly increased their fiscal contribution, in both absolute and relative terms, although that contribution is still one of the lowest among countries that export these goods.29 3.24 According to a survey by the Fraser Institute, reported in its Annual Survey of Mining Companies 2005-2006, Peru ranks first among 64 mining countries and regions around the world in terms of its mining potential. Yet when looked at solely in terms of the policy environment, without taking into account the geological or economic evaluations, Perus ranking drops to 44 out of 64, while Chile stands in fourth place. This indicates that mining exploration and operations are hindered by the uncertainty surrounding government policies and the business climate. Peru has important reserves of natural gas, the exploitation of which, through the Camisea and Peru LNG projects, would allow the country to satisfy its domestic demand and, in future, to become a net exporter. The Bank is supporting development in this sector, and in particular gas production through the Camisea project, as well as its second phase, Peru LNG. Both projects are part of a comprehensive approach in the energy sector, reflected in an operations matrix (see Box 4 and Annex F).

3.25

29

Between 2002 and 2005, domestic taxes paid by the mining and hydrocarbon sectors increased by 450% in nominal terms, rising from 0.5% to 1.7% of GDP, and transfers from shareouts of all kinds (on mining, oil, gas, hydropower, fishing and forestry) to local governments, plus royalties, rose from an average of 0.28% of GDP during 2000-2003 to 0.81% in 2005. Such transfers accounted for 6% of tax burden of the nonfinancial public sector in 2005, compared to 2% during 2000-2002.

- 19 -

Box 4. Energy sector operations matrix Peru has abundant natural resources for producing energy. In recent years, it has established a legal and regulatory framework to promote various sources of energy, and this has sparked greater private investment as well as incentives for research and technological development. In particular, the countrys energy policy supports efforts to develop the natural gas market in order to derive maximum benefit from an energy alternative that is cleaner and more economical than oil, and more stable than hydropower. However, development of the energy sector faces major environmental and social challenges. The Bank has supported Perus efforts to diversify its energy matrix. It financed a portion of the downstream component of the Camisea project (the Camisea deposits are located in the Department of Cuzco). A US$75 million loan from the private sector window is financing construction of dry and liquid gas pipelines (see www.camisea.com.pe for project details). In addition, the Bank supported a further project to reinforce the governments capacity to supervise and control the environmental and social impacts of the Camisea project. The private sector window is now performing due diligence work on the Peru LNG Project, for purchasing and liquifying gas from Camisea for export to markets in the Pacific Basin. The project involves an extension of the Camisea gas pipeline to a liquifaction plant and a sea terminal. The cost of the project is US$3.8 billion, representing the largest private investment in Perus history. The Bank would provide an A loan of US$400 million and a B loan of the same amount. The project is expected to generate revenues of US$800 million annually; it will create around 35,000 jobs, directly and indirectly, during the construction phase, and 2,750 jobs for the life of the operation. The Government of Peru will earn average annual royalties of US$200 million, plus US$150 million in tax revenues during the first 20 years of operation. Peru LNG poses institutional challenges as well as environmental ones, particularly in the Bay of Paracas, and it is important to continue strengthening the governments capacity to monitor and regulate socioeconomic conditions in this area. Based on experience with the Camisea Project, Peru LNG has adopted a policy of consultation and participation with the main stakeholders (the public and private sectors and civil society). An environmental and social impact assessment has been prepared for each component of the Peru LNG Project (see www.perulng.com for details on the environmental and social impact report). The Government of Peru is also seeking Bank support for preparing a medium-term strategy that would establish a policy framework for sustainable development of the hydrocarbons sector. The Bank has begun work on the design of a programmatic loan to identify a new sustainable energy matrix, by creating a new investment framework for the energy sector that will maximize economic benefits from hydrocarbon resources and apply comprehensive environmental and social safeguards. Through technical-cooperation operations, the Bank is assisting in various areas, including a strategy for hydrocarbons development and management, support for the social and economic development of indigenous communities in the Lower Urubamba, and strengthening the governments capacity to regulate and supervise energy efficiency. The sustainable development of the energy sector in Peru is a very complex process that will require a high degree of coordination between sectors, supported by integrated policies. This offers new opportunities for the Bank over the short and medium term, through integrated and coordinated support in four interrelated areas: (i) energy sustainability policies; (ii) financing of private investment; (iii) environmental and social sustainability; and (iv) energy efficiency and the development of renewable sources.

3.26

As noted above, other themes have been identified that are complementary to the areas indicated as priorities, and are fundamental to strengthening the countrys competitiveness. In particular, interventions are being considered to address the business climate, labor markets, innovation, and environmental sustainability. (iv) The business climate The business climate for private investment in Peru has been affected by expropriation risks and uncertainties over legal stability and property rights. In fact, some of the events that contributed to the collapse of exports in the past were sparked by nationalization in the mining and agroindustrial sectors. While such risks have now diminished, transaction costs remain high, and these affect business

3.27

- 20 -

productivity and profitability and explain in part why there is such a large informal sector. 3.28 The International Finance Corporations Doing Business Report (2007)30 has raised the ranking of Perus business climate from 78 to 65 among 175 countries. Nonetheless, businesspeople still perceive excessive licensing requirements and regulations as obstacles to investment, and this perception indeed worsened between 2002 and 2006.31 The report ranks Peru very poorly in terms of the cost of enforcing contracts, which is equal to 35% of the claim, twice the prevailing level in Argentina or Chile. It also highlights difficulties in opening a business or building a warehouse, which is more costly and takes longer than in comparable countries. For example, it takes 72 days to incorporate a company, compared to 44 days in Colombia or 27 days in Chile. The tax burden and labor regulations appear to be the most complex in Latin America. The Bank has been supporting government efforts to improve the investment climate and reduce transaction costs. Following dialogue with the principal government and private-sector stakeholders, a Plan of Action for the Private Sector has been prepared to guide IDB initiatives in this area. (v) 3.30 Labor market Private-sector investment in new economic sectors and businesses will be the basis for broadening growth and creating jobs. To facilitate the latter, however, Peru must adapt its labor market institutions to encourage demand for labor, especially in the formal sector of the economy. To begin with, nonwage costs are among the highest in Latin America, at 66% of the payroll. Firms attempt to boost their productivity by operating with fewer workers, and hiring them without contract. Even the most productive sectors rely on informal workers to reduce labor costs. Given the low productivity of labor, the availability of training is inadequate to meet demand, recognizing that businesses, especially the smaller ones, do not themselves invest in training. The quality of training providers and the instruments adopted varies greatly, and it is often difficult to ascertain the relevance and quality of the training provided. Even in the private sector, where incentives to offer quality services should be stronger, there is still (with a few exceptions) a glaring mismatch between training and private-sector demand. (vi) 3.32 Technological adaptation and innovation Technological innovation is a crucial element for enhancing productivity and boosting competitive development. Peru has increased its investment in research and development (R&D) as a proportion of GDP (from 0.08% in 1997 to 0.11% in 2001), but it remains far below the average for Latin America and the Caribbean

3.29

3.31

30

Peru is continuing to improve its business climate according to the 2008 Doing Business Report, with its ranking rising to 58 of 178 countries. See Carmen Pags, 2007.

31

- 21 -

(0.62% of GDP in 2001). This is one of the lowest levels in the region, similar to that of Ecuador and far below Brazil (1.05%) and Chile (0.57%). The private sector accounts for only a marginal share of R&D spending in Peru. From an institutional viewpoint, there is a lack of articulation between players in the system (government, universities, research centers, and businesses) and resource allocation bears little relationship to sector priorities. 3.33 The National Competitiveness Plan includes the goal of developing a culture for adopting new technologies and innovations, fostering research, specialization and technology transfer as key elements for boosting the countrys competitiveness and its ability to face the challenges of free trade with the United States. Technological innovation has also been identified as one of the key aspects for increasing the share of industry in GDP and in the countrys exports. In this context, the Ministry of Economy and Finance (MEF) recently announced the creation of three funds in support of science, technology and innovation.32 (vii) 3.34 Environmental sustainability Given the projected patterns of future growth, in particular the development of mining, energy and agriculture and of infrastructure projects, it is essential to ensure sustainable use of natural resources and sound environmental management. The economys dependence on natural resources such as minerals, fuels, and fish, has in some cases led to degradation of the environment, of biodiversity, and of human health. These economic activities generate adverse impacts on the state of natural resources, and those impacts must be internalized. The present institutional structure in fact makes it all the more urgent to work closely with the productive sectors. The absence of a strong and independent environmental regulatory agency undermines the effectiveness of the many environmental regulations that have been adopted in Peru. The environmental management strategy should address three major challenges: (i) identifying the specific environmental impacts of each sector, and mechanisms to internalize their costs; (ii) strengthening the institutional structure to ensure independent supervision and regulation; and (iii) reducing the growing cost of environmentally-caused health problems. Recognizing the interrelationship between economic development, the expansion of mining, and the need to remedy mining liabilities, as well as to avoid future

3.35

3.36

3.37

32

The first, for 200 million soles, creates a Competitiveness Research and Development Fund (FIDECOM) to promote research and development for business projects in productive and technological innovation. The second is the Guarantee Fund for agriculture, with 100 million soles, which will become part of the COFIDE trust fund to guarantee bank loans to small and medium-sized producers. The third is the Human Capital Fund, which has 50 million soles to finance university studies abroad for Peruvians who will return to the country to work in the public sector. FIDECOM will be run by the Science and Technology Program Coordination Unit, which has technical and financial support from the Bank.

- 22 -

environmental damage, the Bank is working with the government on a potential loan for a program of comprehensive remediation of mining liabilities. B. 3.38 Social development and inclusion The objective of this pillar is to develop the conditions, capacities and opportunities needed so that the majority of the population can participate effectively in economic growth, so as to improve their well-being and reduce poverty and inequality.33 This will require an increase in the quantity and quality of social investment and the effective delivery of public goods and services, so as to achieve greater inclusion and opportunities for the poorest and most vulnerable population. This pillar is complementary to the support for gaining a foothold in the global economy and competitiveness, and entails efforts in three interrelated areas: (i) long-term investment in human capital (education, health, housing, and basic sanitation), (ii) social welfare and inclusion, and (iii) opportunities for the majority. 1. Current situation and principal challenges 3.40 Peru has a long history of poverty, discrimination and social exclusion. Nearly half of Peruvian society lacks human capital and the essential conditions to subsist in the modern economy. The majority of these people work outside the formal sector in small businesses or microenterprises, or in low-productivity subsistence farming, and they are highly vulnerable to external shocks that affect their capacity to work. Recent economic growth represents an undoubted opportunity to address Perus social challenges. Yet one of the main problems has been that the basis of economic growth has been too narrow, and job creation has been insufficient. This trend is of concern, in light of current demographic patterns. The slow growth of labor demand is at odds with the high growth in the workforce and the increasing participation rate of women. According to estimates of the National Statistics Institute (INEI), the dependency ratio in Peru will reach historically low levels by 2030, when there will be two people working for every child or elderly person. Currently, around 60% of the population is under the age of 29.34 This so-called demographic dividend represents a great opportunity for growth, as the present generation will have to integrate itself into a dynamic economy. Yet that same structure could become a risk if this population remains marginalized. Thus, the first pillar of the strategy will support a broader base for Perus economic growth in order to create job opportunities and capitalize on this demographic dividend. Greater growth and new jobs are essential but not sufficient conditions for improving social welfare in Peru. Concerted government efforts are also needed to ensure greater and better social investment and the delivery of public goods and

3.39

3.41

3.42

33

Conditions and capacities refer to minimum elements of human capital development such as housing and basic sanitation, health, and education. Opportunities are those elements needed for access to the labor market, productive activities, and public goods and services. ECLAC/CELADE, Cambios en la estructura poblacional: Una pirmide que exige nuevas miradas, 2005.

34

- 23 -

services to the poorest population, as proposed in this second strategic pillar. Various studies show that social expenditure in Peru has frequently been inefficient and regressive, despite the rising amounts involved.35 3.43 In addition to traditional social problems, Peru faces a serious situation of social exclusion for indigenous and Afro-Peruvian populations. Recent studies have shown that these people are poorer and have less access to education, health and credit than the nonindigenous population.36 The geographic location, educational level, gender and ethnic background of a person will for the most part determine whether that person is poor or not. A woman with four years of schooling, living in the Sierra and speaking a native language, has a very high probability of being poor or very poor. The lack of social mobility virtually condemns her daughter to the same fate. Thus, generalized efforts to improve living conditions and enhance opportunities for the majority must include a special focus on the social, political and economic inclusion of these populations. 2. Principal areas of Bank support 3.45 The governments social platform is three-pronged: (i) guaranteeing greater access to basic services, (ii) promoting opportunities for formal employment, and (iii) strengthening the social welfare system.37 Key to the strategy is the emphasis on the quality of education, reflecting the consensus achieved in the National Accord. a. Access to basic public services 3.46 The governments plan emphasizes access to education, health, drinking water and sanitation, and housing for the most vulnerable groups, through coordinated interventions. The Bank will continue to support the achievement of long-term objectives in these areas. (i) 3.47 Education The net enrollment rate is 93% for compulsory primary education, and 70% for secondary education, with lower coverage (53%) in rural areas. While Peruvians have among the highest mean education levels in Latin America, in terms of years of schooling (Barro and Lee, 2000), there are problems with the quality of education, and Peru ranks last in this regard, well below countries at similar levels

3.44

35 36

Carranza et al., 2007. opo, Hugo; Saavedra, Jaime, and Mximo Torero (2004) Ethnicity and Earnings in Urban Peru, in Social Inclusion and Economic Development in Latin America; IDB (2004) Mayra Buvinic and Jacqueline Mazza, eds. Measures to reduce informality and promote the creation of formal employment also include reforms to reduce nonwage labor costs.

37

- 24 -

of development.38 Public spending on education fell from an annual average of 3% of GDP in the 1970s to 1.6% in 1990. It has recovered in recent years to 3%, but still falls short of international standards in education, as measured by cumulative outlays (on a PPP39 basis) to 15 years of age. This indicator stands at US$3,479 for Peru, compared with US$41,627 for Spain, US$18,893 for Argentina, US$17,820 for Chile, and US$12,189 for Mexico. 3.48 The Banks proposal is to support the extension of early education with the objective of: (i) universalizing it for children aged 4 and 5, (ii) expanding opportunities for early childhood stimulation and integral service for children up to age 3, and their mothers, and (iii) considering an integrated package of interventions in nutrition, education and health in the program targeted at children under 6. (ii) 3.49 Health The same pattern can be seen in health expenditure (3% of GDP). Despite progress in reducing child mortality and malnutrition, there are disparities in access to services, reflecting the unequal distribution of available medical infrastructure. As a result, 60% of Peruvian provinces have no local hospitals, meaning that: (i) approximately 4.3 million people have no access to hospital care, and (ii) those who do have such access face high costs in terms of travel and time. The governments priority goal is to increase the use of institutional services to reduce maternal-infant mortality. The IDB and the World Bank are providing joint support to the country in modernizing and reforming its health system, with a view to improving health conditions for low-income mothers and children by expanding access to effective, efficient, and high-quality health services. Future efforts will maintain their focus on reducing maternal-infant mortality, combining this with the strategy to promote integral care and service for children under 3. (iii) 3.51 Water and sanitation There is still a critical lack of drinking water and sanitation services. Water service coverage averages 74%, and sanitation 56%. Household water connections reach only 66% of the population, while 8% rely on public standposts; 49% of the population has household sewer connections, and 7% use latrines. In 1999, sewage treatment coverage was estimated at 16% nationwide. To reduce the service deficit, particularly for the poorest people and those in rural areas, the government has launched a program, Water for All. The Banks approach in this area is described in Box 2.

3.50

38

Obviously, there is some circularity to this argument. In effect, the problems observed in the education system could be endogenously derived from the lack of effective demand for improvement. Purchasing Power Parity.

39

- 25 -

(iv) 3.52

Housing and neighborhood improvement

With 75% of its people living in cities, Peru is highly urbanized, and this means growing demand for housing, particularly for low-income families. It is estimated that 68% of urban dwellers are living in substandard homes without basic services. The lack of funds for building even the simplest dwellings,40 and difficulties in arranging mortgages, has led the government to launch programs called My Home and My Neighborhood (Mi Vivienda and Mi Barrio), to encourage the purchase of basic housing and improve conditions in urban settlements. The Bank has long experience with the country in this sector, and is working in accordance with guidelines provided by the authorities on a proposal to strengthen the low-cost housing market, through: (i) creation of a Family Housing Bond for the purchase and upgrade of basic housing; (ii) mortgage financing; (iii) servicing of lots for low-income housing in high-quality urban developments; and (iv) integral neighborhood improvement, including road access and the establishment of neighborhood councils. b. Promotion of opportunities To achieve a sustainable impact on social development, the authorities have adopted a strategy to boost job creation in labor-intensive activities, and to support the development of rural businesses through initiatives to provide clear land ownership rights. This approach complements and reinforces the objectives of the competitiveness pillar. (i) Fostering rural exports The program conceived by the government for integral development of the Sierra proposes initiatives to expand its productive potential by developing competitive export activities (in farming, agroindustry, livestock, aquaculture, handicrafts, textiles, jewelry, forestry and tourism), and to enhance their commercial value. The objective is to link small producers in the Sierra with regional and international markets, and thereby to diversify the rural economy and promote the sustainable management of natural resources, improve standards of living, and preserve the environment. To develop and consolidate local and international markets for specific products from the Sierra, the Bank is supporting design work on this program, by financing a study to categorize investmentand and technical cooperation opportunities that combines: (i) promotion and strengthening of production chains; (ii) formulation and implementation of rural business plans for selected production chains, using competitive procedures based on social and economic criteria that will have a clear impact on reducing poverty in rural communities (competition-based funds); and (iii) decentralized planning of regional development, to help generate an appropriate climate for rural businesses to flourish.

3.53

3.54

3.55

40

World Bank, 2006, Per: Oportunidad de un pas diferente, page 354.

- 26 -

(ii) 3.56

Land titling

Rural development in Peru has been held back by difficulties in defining land ownership rights, regularizing landholding, and registering properties. Lack of title precludes access to financing for rehabilitation or reconstruction and discourages productive investment. All of this depresses incomes and encourages informal activities. The government intends to move forward with the certification of land titles, which so far has covered 53% of individual properties, and to strengthen local and regional land survey and registry services. The Bank has already played a role in this process, supporting ownership regularization of around a million properties along the coast, and proposes to pursue cooperation with the government to revitalize the land market. (iii) Microfinance There are some 3.1 million microenterprises and small businesses in Peru, constituting 97.7% of all entrepreneurial units, employing 70% of the economically active population, and generating around 42% of GDP. Despite the widespread presence of financial institutions serving microenterprises, a significant portion of the low-income population has no access to financial services that meet their needs. It is estimated that the commercial banking system covers fewer than 30% of microenterprises and small businesses, and coverage is even lower in rural areas and in smaller cities. Rural credit is generally seen as entailing high risks and low returns. Among the obstacles to increased coverage are the limited range of specific products offered, and collateral requirements that are inappropriate for the rural sector. With its experience in this sector, the instruments available (i.e. MIF), and the work already done in the country, the Bank is in a position to help the authorities improve access to high-quality financial services for segments that use bank services very little. In this context, future activities will be designed to strengthen financial institutions in their capacity to manage risks, develop new products, and enhance corporate governance, with particular attention to the cajas rurales (rural banking cooperatives) and EDPYMEs (small business and microenterprise development agencies), so that they can expand and consolidate their operations and penetrate new markets. c. Social welfare Social spending rose from 3.9% of GDP in 1990 to 7.3% in 2005. Yet poverty has not declined, and this points to problems of efficiency. Social programs produce limited results because of lack of targeting and institutional weaknesses in the social welfare system. When it comes to social security, coverage is very limited: in 2000, 72% of salaried workers and 83% of all workers were in the social security system. The government is preparing a plan to rationalize and target social welfare programs so as to enhance their impact, reduce administrative costs, generate economies of scale, cut service delivery costs, and foster accountability.

3.57

3.58

3.59

- 27 -

3.60

The Bank has been supporting the countrys efforts to target and consolidate the allocation of funds to regional social programs. These efforts could be enhanced through support for integrating the programs in the context of the Social Program Reform Plan, with emphasis on rationalizing resource use and developing the coordination and supervisory capacities essential to operation of an integrated system, and the design of policies to expand social security coverage. Reform of the State and public management This strategic area is essential to strengthening democratic governance in Peru, and critical for putting the Banks strategy with the country into effect. The central objective is to support Perus efforts to enhance government management of public goods and services at the national and subnational levels and to strengthen accountability mechanisms needed to maintain a dynamic, competitive and equitable economic system. 1. Current situation and principal challenges Public administration in Peru has made progress, particularly in terms of macroeconomic management, including fiscal policy, and in certain regulatory areas where the State has performed well. Yet overall efficiency is still low when it comes to the delivery of goods and services, and especially the provision of infrastructure and social services. This is reflected in the indicators of confidence in public institutions, and more particularly in perceptions of institutional quality and corruption, where Peru ranks in the 85th and 75th percentiles respectively, according to the World Economic Forum.41 The governments capacity to lock in economic growth and strengthen the public finances, promote development of the private sector, and create opportunities depends on strengthening democratic governance, including: (i) creating an efficient, flexible public administration that will contribute to a favorable business climate while achieving social equity and inclusion; (ii) a decentralization plan that will align responsibilities, build capacity to enhance access to basic services and public investment, and foster local competitiveness; and (iii) better budgetary management, particularly for public expenditure. 2. Main areas of Bank support The cross-cutting nature of institutional issues emerges clearly from the governments plan, which stresses reform of the State as a way of improving macroeconomic management, enhancing the quality of social expenditure, and promoting private sector development. The planned reforms call for rationalizing social welfare programs, with emphasis on decentralizing the provision of services to improve the quality of public expenditure and strengthening the judicial system.

C. 3.61

3.62

3.63

3.64

41

For a detailed institutional analysis, see Alonso et al. 2007, Per: Evaluacin de la gobernabilidad democrtica.

- 28 -

a. Decentralization and improved management in subnational governments 3.65 Peru is one of the most highly centralized countries in Latin America. In 2003, the central government accounted for 86% of public revenues after transfers, compared to an average of 65% for the regions medium-sized and large countries, and 54% for developed countries. Public spending shows a similar pattern: in 2003, subnational governments were responsible for 12% of total spending, compared to 35% in Latin America and 43% in developed countries. Moreover, the bulk of economic activity is concentrated in Lima: 57% of industry, 62% of commerce, 46% of the EAP, and 53% of GDP. This situation means that the capital city absorbs 86% of tax revenues. Since the beginning of the transition government in 2001, the decentralization process has been revived, in accordance with the following principles: (i) the creation of regional governments with elected authorities, based on the countrys historical departamentos, and incentives for voluntary merger (via referendum) into macro-regions; (ii) a clear definition of powers and responsibilities for the different levels of government; (iii) fiscal neutrality and responsibility; (iv) the gradual transfer of services; and (v) the transparency of the process. The plan for the distribution of services is consistent with the principles of subsidiarity and externalities, with respect to the powers reserved to the national government, but it is rather vague with respect to the powers transferred. Financial transfers are not congruent with expenditure responsibilities. The legislation explicitly calls for a gradual process of decentralization, with balanced transfers of expenditures and revenues. In particular, it is essential to have a plan for decentralization and the devolution of expenditure responsibilities that is consistent with institutional capacities, in order to create a system that will improve the quality of public services and strengthen the public finances. The Banks proposed support agenda includes: (i) reform of the system for financial transfers from the central government to the regions and municipalities, to optimize its mechanisms and its regional distributive effects, and to equip the country with tools for implementing policy and investment objectives of mutual benefit to all levels of government; (ii) development of a regional and municipal tax system consistent with the decentralization process; (iii) an orderly and comprehensive system for transferring services to subnational governments, coordinated with the transfer of funds; (iv) an effective and orderly system for transferring human resources to subnational governments; and (v) strengthening institutional management capacities and accountability mechanisms at the central as well as the regional and municipal government levels. b. Modernization of the national government 3.69 Perus public administration is not considered very efficient. According to WEF indicators, for example, Peru ranks 96th among 125 countries in terms of efficient public management. The main weaknesses have to do with low fiscal capacity to

3.66

3.67

3.68

- 29 -

support public accounts, excessive budgetary rigidity, and the limited capacity for strategic planning. Despite the efforts of recent years, shortcomings persist, reflecting: (i) inadequate stakeholder involvement (by line ministries, Congress, citizens, etc.) in expenditure decisions; (ii) lack of overall strategic direction for improving public management; (iii) the weakness of the agencies making the expenditures, particularly the local governments; (iv) budgetary inertia and inadequate results-based performance incentives; and (v) weaknesses in the government procurement system. 3.70 In terms of transparency and accountability, Peru has improved its oversight systems, for example by broadening public access to information on government affairs and improving information systems generally. However, there are still obstacles to horizontal control (i.e. oversight by other branches of government: the judiciary, the legislature and the Comptroller Generals Office CGR).42 The Bank can support the government in modernizing the State in the following key aspects among others: (i) strengthening the national governments capacities for policy and strategy formulation; (ii) modernizing the civil service to make it more effective and efficient; (iii) consolidating the fiduciary and management systems; (iv) reforming the structure and financing of the executive branch; (v) improving intergovernmental coordination mechanisms; and (vi) establishing modules for service to the public. c. Justice and security 3.72 There is a widespread perception that the justice system is not independent of the other branches of government, and is easily influenced. The legislative and political changes since 2001 have helped reinforce the external independence of the judiciary and the Attorney Generals office (Ministerio Pblico), but doubts persist over the transparency of the National Council of Magistrates. The internal independence of the judicial system (for example, the ability of judges to issue rulings without reference to their superiors) has improved. There is still however a lack of transparency in the nomination, confirmation and removal of judges. Finally, the institutional weakness of the bodies responsible for the administration of justice in general, and of the judiciary in particular, creates an atmosphere conducive to corruption and tends to undermine the supposed independence of the judge vis--vis the parties to a case. Judicial independence and security are perceived as among the lowest in the world: Peru ranks 119th and 109th, respectively, among 125 countries (WEF, 2006). The systems ineffectiveness stems from a number of factors including weaknesses in the regulatory framework (these include excessive bureaucracy, obsolete organization and structures, inadequate management of human resources, outdated

3.71

3.73

42

The Peruvian government has addressed this situation with a new program to modernize the CGR and to consolidate and deconcentrate the National Control System (SNC). The Bank is supporting this effort (IDB 2004).

- 30 -

systems for generating and managing information, geographic, cultural and economic barriers impeding access to justice, insufficient infrastructure, inadequate training in the legal profession). In addition, the institutions that prepare and implement public safety policies need to be strengthened to deal with growing problems of violence and insecurity in the country. The reliability of the police is rated low.43 3.74 The Bank is working with Peru on the initial stages of implementing the judiciary modernization plan developed by CERIAJUS (the justice reform commission), focused on the following areas: (i) access to justice, (ii) anticorruption policies, (iii) modernization of prosecution and judicial offices, (iv) human resources, (v) government and budget, (vi) predictability and jurisprudence, (vii) penal reform, and (viii) regulatory adaptation. In the area of security, Bank support seeks to improve the services of the Ministry of the Interior and the National Public Safety System, to make the National Police more professional, and to support local prevention initiatives to reduce violence and crime. IV. IMPLEMENTATION OF THE STRATEGY 4.1 The lending program is one of the main instruments through which the Bank can support the country in implementing its strategy and achieving its development objectives. Clearly, this program must be accompanied by nonfinancial products as basic input for generating knowledge about the country, policy dialogue and project preparation. Given the Banks track record in Peru and the weight of its portfolio in the countrys total multilateral financing, the Bank is well-placed to be an effective partner in financing and implementing Perus development programs and public policy reforms. The following sections describe the lending program for the Banks country strategy with Peru, and its operational features. Lending program The program proposed in this strategy will allow the Bank to consolidate its position as the principal source of multilateral financing and of innovative products for the government, and one of the main suppliers of medium and long-term funds for the private sector. The Banks lending program for the public sector (sovereign) is consistent with the country financing requirements and its debt management strategy. In terms of direct financing to the private sector (non-sovereign), the plan is to support traditional clients in the areas of infrastructure and financial markets, and to venture into innovative operations with other sectors where the Bank has competitive advantages. In percentage terms, the greatest share of Bank financing for the period 2007-2011 will go to the public sector (sovereign risk). However, operations with the private

A. 4.2

4.3

4.4

43

According to WEF (2006) indicators, Peru stands 96th among 125 countries.

- 31 -

sector are expected to take on increasing importance, because of their high impact and their catalytic effect on the countrys development. 1. Public sector44 4.5 Peru aims to reduce gradually the ratio of external public debt to GDP from its current level of 23.6% to around 13% by 2011. At the same time, it hopes to reduce the proportion of debt in foreign currency and improve the term and cost structure. Consistent with this strategy, the countrys financing needs, possible sources, and the resources that could be offered by the IDB have been identified. According to the MMF targets for the main macroeconomic variables, and the repayment profile of the different fiscal obligations, it is estimated that Peru will face gross financing needs of US$14.2 billion over the period 2007-2011, or an annual average of US$2.8 billion. Of this amount, US$7.8 billion (52% of the total) would come from external sources (multilateral institutions, external bonds, bilateral agencies and others) and US$6.4 billion (48% of the total) from domestic sources. The Ministry of Economy and Finance has established formal guidelines for coordinating external debt transactions.45 The following sections describe the financing scenarios that could serve as a framework for the Banks relationship with the country in the coming years. a. Base-case scenario 4.8 In the base-case scenario, the Bank would cover a significant portion of Perus financing needs and would consolidate its position as the principal supplier of multilateral finance. Specifically, the lending program calls for disbursements of US$1.9 billion over the period 2007-2011, amounting to 14% of the countrys total financing requirements. This would raise the outstanding IDB debt, as a proportion of total multilateral debt, from 47% to 54% by 2011.

4.6

4.7

44 45

This refers to public sector operations with sovereign guarantee. Lineamientos para Orientar la Concertacin de Operaciones de Endeudamiento Externo para Financiar Proyectos de Inversin Publica [Guidelines for Coordinating External Debt Transactions to Finance Public Investment Projects]. Ministry of Economy and Finance, August 2006.

- 32 -

Figure 2 IDB share of the financing market for Peru (base-case scenario)
60.0% 50.0% 42.8% 40.0% 30.0% 21.7% 20.0% 10.0% 0.0% 2002 % Total debt 2006 % External debt 2011 % Multilateral debt 14.6% 11.4% 16.7% 12.1% 13.0% 46.9% 54.1%

Source: IDB, 2007

4.9

This lending program entails new approvals totaling US$1.7 billion. This means an annual average of US$340 million, of which US$145 million (43% of the total) would be in investment projects and US$195 million (57% of the total) in programmatic loans.
Table 3 Approvals and net flow of funds (base-case scenario) 2007 2008 4,078 315 165 150 455 205 250 264 191 6.3 184.7 198.0 -13.3 150 2009 4,140 300 150 150 348 173 175 286 62 5.0 57.0 195.0 -138.0 150 2010 4,125 300 150 150 292 142 150 307 -15 5.0 -20.0 188.0 -208.0 150 2011 4,166 300 150 150 360 210 150 319 41 5.0 36.3 178.0 -141.8 150 Average 2007-2011 4,079 340 145 195 383 168 215 286 97 5.4 92.1 191.2 -99.1 220 Total 2007-2011 1,700 725 975 1,917 842 1,075 1,430 487 26.9 460.4 956.0 -496 1,100

Balance of IDB debt Approvals Investment PBL Disbursements Investment PBL Amortization Net flow of lending* Subscriptions and contributions Net capital flow Interest and fees Net cash flow Private sector Approvals

3,887 485 110 375 462 112 350 254 208 5.6 202.4 197.0 5.4 500

Source: IDB, 2007 * Net flow of lending is based on MMF 2008-2010 projections.

- 33 -

4.10

Investment and programmatic operations alike would be geared to supporting the development agenda, the strategic pillars, and the key areas of Bank intervention. The programmatic operations identified preliminarily would support reforms in the areas of water resources, drinking water, and sanitation; quality of public expenditure; competitiveness and local development; and justice. Investment loans would go primarily to developing economic infrastructure (water, transportation, and energy) and social infrastructure (housing, education, and health). This program takes a comprehensive approach to each strategic area, combining programmatic and investment funds, so as to address public policy and investment issues simultaneously. Fulfillment of this lending program will depend on some critical factors: a. Maintenance of the government program and reform agenda. b. The countrys institutional and management capacity. c. Operational flexibility and agility on the part of the Bank. d. The Banks operational capacity to provide substantive support for the reform agenda. e. Ongoing, effective dialogue with principal stakeholders. f. Bank competitiveness in terms of loan costs and funding in local currency. It is hoped that the Bank will be able to convert US$200 million to soles each year.

4.11

4.12

4.13

Country Financing Parameters consistent with this program have been agreed with the authorities and are shown in Annex I. b. High scenario A more ambitious scenario for Bank support to the country would depend on two key factors: (i) a commitment to substantial policy reforms that would justify an increase in the amount of programmatic financing; and (ii) the Banks capacity to increase significantly the amount of possible conversions to soles. The latter appears feasible, in that the authorities have demonstrated their commitment to the reform process and their desire to increased demand for unrestricted resources, provided they are in local currency, reflecting the interest in reducing the countrys exposure to foreign-currency debt. This possibility, in turn, depends on the markets capacity to absorb hedging in nuevos soles. For 2007, the Bank has worked out with the government a preliminary lending program of US$488 million, comprising US$113 million in investment funds and US$375 million in programmatic loans, in addition to US$525 million in operations with the private sector (see Table 4).

4.14

4.15

4.16

- 34 -

Table 4 Lending program 2007 Name PBL Water Resource Policies I PBL Sanitation Sector Policies I PBL Public Expenditure Management Quality III Subtotal: PBL approvals Plant & Animal Health SENASA (CCLIP) Technical assistance - Water Resources Consolidating Democracy and Public Safety MAPEP Modernization of the Judiciary Sierra Exports - Phase I Land Titling and Registration Phase III Water for All SEDAPAL Subtotal: Investment loan approvals Total Sovereign Sector Banco Interamericano de Finanzas-TFFP (PRI) Guarantee for Banco Continental (PRI) BBVA Banco Continental S.A.-TFFP (PRI) Peru LNG (PRI) Total Non-Sovereign Sector TOTAL Source: IDB, October 2007.

US$ millions 200.0 100.0 75.0 375.0 25.0 1.5 10.0 1.2 15.0 10.0 50.0 112.7 487.7 10.0 100.0 15.0 400.0 525.0 1,012.7

4.17

In the high scenario, the lending program would see disbursements rise to US$2.4 billion over the period 2007-2011, amounting to 17% of Perus total financing requirements. As a result, the outstanding IDB debt as a proportion of the total multilateral debt would rise from 47% at present to 60% by 2011.

- 35 -

Figure 3 IDB share of the financing market for Peru (high scenario)
70.0% 60.4% 60.0% 46.9% 50.0% 40.0% 24.2% 30.0% 14.6% 20.0% 11.4% 10.0% 0.0% 2002 % Total debt 2006 % External debt 2011 % Multilateral debt 12.1% 16.7% 14.5% 42.8%

4.18

This lending program entails new approvals totaling US$2.5 billion, or an annual average of US$500 million, of which US$150 million (30% of the total) would be in investment projects and US$350 million (70% of the total) in programmatic loans.
Table 5 Approvals and net flow of funds (high scenario) 2007 2008 4,121 500 150 350 480 130 350 264 216.0 6.3 209.7 185.4 24.3 400 2009 4,315 500 150 350 480 130 350 286 193.8 5.0 188.8 194.2 -5.4 400 2010 4,488 500 150 350 480 130 350 307 173.5 5.0 168.5 202.0 -33.5 400 2011 4,649 500 150 350 480 130 350 319 160.9 5.0 155.9 209.2 -53.4 400 Average 2007-2011 4,296 500 150 350 480 130 350 286 194.0 5.4 188.6 193.3 -4.7 420 Total 2007-2011 2,500 750 1,750 2,400 650 1,750 1,430 970.1 26.9 943.2 967 -23 2,100

Balance of IDB debt Approvals Investment PBL Disbursements Investment PBL Amortization Net flow of lending Subscriptions and contributions Net capital flow Interest and fees Net cash flow Private sector Approvals Source: IDB 2007.

3,905 500 150 350 480 130 350 254 226.0 5.6 220.4 175.7 44.7 500

- 36 -

4.19

A critical aspect of this scenario relates to fiscal headroom: more aggressive financing by the Bank would have to be offset by a reduction in financing from other sources, so as to meet the debt reduction and liabilities management targets. Authorities have signaled their preference to issue fewer external bonds and to reduce borrowing from multilateral agencies that offer more costly products, thereby confirming their commitment to gradually reduce the amount of debt and to improve its structure. Nevertheless, if Peru were to achieve an investment grade rating and obtain market access on terms similar to IDB financing, the Banks competitiveness in terms of costs, operating flexibility and possibilities of converting its loans to local currency would become even more critical. 2. Private sector46 Consistent with the Banks expanded mandate to engage in operations with the private sector and without sovereign guarantees, the Bank strategy includes projects with traditional clients involving infrastructure and financial markets as well as projects in nontraditional sectors where the Bank could have an impact over the longer term. The Banks new vision consolidates its various private sector windows and includes a wide variety of financial instruments such as direct lending, A/B operations, guarantees, and direct interventions in capital markets. The Bank already has a network of clients in the traditional sectors, but it will take a learning period before the Bank can position itself in the new sectors. Bank activities with the private sector will relate primarily to area 1 of the strategy, strengthening competitiveness and developing the private sector. Clearly, to the extent this contributes to growth and job creation, it will also support the other strategic areas. The sectors identified relate to infrastructure (transportation, energy, water and sanitation, with subnational entities or concessionaires), and financial markets (capital market, mortgage securitization, financial institutions, and the trade finance facilitation program). In the productive sectors, the Bank plans to continue its support to the oil and gas sector, in which it has been a significant player through its financing for the Camisea project and its subsequent phase, Peru LNG. Other sectors that have been identified in a preliminary manner include agroindustry, biofuels, mining and metallurgy, petrochemicals, forestry, fisheries, and textiles. The mandate to work with productive sectors includes the flexibility needed to adjust the Banks participation to market conditions, and in this way to tailor financing to the needs of the sectors and projects in which the Bank would be involved. In addition, the Bank will continue to support SMEs through IIC and MIF instruments.

4.20

4.21

4.22

4.23

4.24

46

Includes non-sovereign guaranteed public-sector operations.

- 37 -

B. 4.25

The new business model This strategy is being pursued in a context in which the country focus is the principal thrust of the Banks new organizational structure, and the country departments define the fundamental parameters for shaping the corporate program. The new model stresses the importance of deepening the Bank-country relationship, strengthening dialogue, and focusing on client needs. From the operating viewpoint, the Banks Country Office will be organized to respond flexibly and provide better service to clients, depending on their characteristics, and it will have a key role in promoting the country agenda, identifying the countrys needs, and formulating an adequate response. Its work will focus on: (i) guiding the dialogue and developing relations with the country; (ii) leading the preparation and implementation of the strategy; (iii) originating programs and projects; (iv) preparing and executing projects with the active participation of sector specialists; (v) strengthening the countrys systems of financial management, procurement, and monitoring and evaluation; and (vi) promoting the Banks image in the country (see Box 5). This focus complements the New Lending Framework strategy, which offers new instruments for enhancing service to clients (see Annex L).
Box 5. Strengthening the Country Office Reducing transaction costs, sharpening the client focus, and management by results

4.26

Through the realignment process, the Bank is seeking to optimize its efficiency so it can respond to borrowing countries needs within shorter time frames and in ways that add value. The Banks Country Office in Peru has been in the vanguard of this movement, making comprehensive improvements in aspects relating both to its internal administration and operations and its development effectiveness. The process calls for: (i) a new supervisory and coaching role for the Bank in the processes agreed with executing agencies; and (ii) institutional strengthening in fiduciary aspects, ranging from multiyear operational, financial, and procurement planning to training for officials working in the executing units in procurement processes and procedures. This process will shift the Banks emphasis from administrative control, which does not add much value, to management and supervision by results. This includes a process of risk analysis, with planning and management based on that analysis, and ongoing supervision and coaching for achievement of the planned goals. At the same time, a smooth working relation has been established with the MEF, through regular tripartite meetings (MEF, executing agencies, and IDB) to review the portfolio, identify particular problems and strategic issues, resolve them, and ensure follow-up where necessary, thereby establishing a shared vision of the problems and, most importantly, of solutions.

C. 4.27

The fiduciary situation Government procurement systems. The evaluation of procurement systems conducted jointly by the IDB and the World Bank in 2005 highlighted progress in implementing the recommendations from the 2001 evaluation, and in reforming those systems.47 In particular, it noted the strengthening of the National Procurement Council (CONSUCODE), the first steps toward developing an electronic procurement system, and revisions to the regulatory framework. It is also

47

Country Procurement Assessment Report (CPAR), 2005.

- 38 -

important to note the improvements that have been made in terms of transparency, through the online availability of information on all government agencies. 4.28 Nevertheless, the system still betrays weaknesses due to fragmentation, which impedes the development of a common vision and the enforcement of uniform standards of administration. Given this situation, a program has been launched to build the capacities of public officials to meet the formal requirements and conditions, and to make procurement management efficient across the board. Future reforms will include creation of a workable interface between the financial management system and the new e-procurement system. Financial management. The 2001 assessment48 examined the countrys regulatory framework and fiduciary management instruments, stressing the standards of accountability and information and financial management (i.e. planning, control and supervision of financial operations). The conclusions highlight the importance of strengthening: (i) Congressional oversight of the budget process; (ii) enforcement of appropriate accounting standards and more frequent expenditure reports; and (iii) oversight of the executive branch by the Auditor General. The government has succeeded in strengthening the legal and regulatory framework for public expenditure supervision, and the independence of the Comptroller Generals Office, and with support from the IDB and the World Bank is taking further steps to bolster national management systems. In this context, a comprehensive review of progress against the recommendations from the 2001 evaluation is crucial. The Banks recent support for the country in this sector has involved programmatic loans to improve public-sector expenditure and management. The Public Expenditure Review49 proposed a plan to reform public expenditure management, stressing the restoration of fiscal discipline, a reorientation of the budget towards pro-poor spending, and greater efficiency in public spending. The government has made progress in restoring fiscal discipline and improving certain aspects of the public expenditure process. Further initiatives are now awaited in politically sensitive areas involving reform of the public administration, the efficient use of natural resource royalties, and the taxation system, within the context of decentralization. Risks and mitigating factors The economic, social and political outlook for Peru is favorable for successful implementation of the Bank strategy with the country. Nevertheless, there are a number of risks that could jeopardize fulfillment of the planned objectives. Those risks have to do primarily with (i) macroeconomic factors, (ii) social, political, and institutional considerations, and (iii) environmental aspects and natural disasters.

4.29

4.30

4.31 4.32

D. 4.33

48 49

Country Financial Accountability Assessment (CFAA), 2001. PeruRestoring Fiscal Discipline for Poverty Reduction: A Public Expenditure Review, 2002.

- 39 -

1. Macroeconomic factors 4.34 Despite improved macroeconomic management, the country remains dependent on a small number of primary products, and is vulnerable to adverse shocks to its terms of trade. A downturn in mineral prices, for example, could severely alter the external and fiscal balances. According to IDB calculations, if the current account is considered against the terms of trade prevailing in 2002, the present surplus would become a deficit of nearly 4% of GDP. This risk could be amplified by problems in ratifying the free trade agreement with the United States, a key element in the governments proposed economic diversification strategy. The high degree of financial dollarization in the Peruvian economy, while declining, also amplifies macroeconomic vulnerability and reduces the effectiveness of monetary policy. Currency mismatches also affect the structure of the public debt, 82% of which is denominated in foreign currencies. This represents a weakness, in the sense that shocks to the exchange rate, economic growth, and the primary balance could jeopardize the sustainability of the debt. Annex D presents an analysis of these vulnerabilities, showing that the historic volatility of Perus growth constitutes the major risk, as it could raise the debt path far above its current level, thereby canceling all the progress achieved to date. Lastly, on the fiscal front, one of the weaknesses noted is the low level of tax collection, which reflects not so much the tax rate (which is relatively high) but rather the array of tax exemptions, the tax stability pacts in the mining sector, and the persistence of a large informal sector that goes untaxed. The national government is addressing these vulnerabilities across-the-board, and this country strategy seeks precisely to help Peru address some of these structural weaknesses, in particular by strengthening competitiveness and diversifying production. In addition, the government is striving to ensure macroeconomic stability primarily by maintaining high external liquidity, a conservative monetary policy, and fiscal discipline. In this context, reforms to improve tax collection and public debt management (which this strategy is supporting) represent the mainstay of efforts to reinforce the public finances, ensure fiscal sustainability, and reduce vulnerability to external shocks. The Banks competitiveness could be at risk if Peru is awarded an investment-grade rating and gains access to markets under conditions similar to IDB financing. 2. Social, political, and institutional considerations 4.39 The scant progress that has been made in living conditions in the country and the persistence of sharp social, regional and political fragmentation in Peru could pose a threat to institutional stability and continuity in implementing economic reforms and the growth model based on trade liberalization. These tensions could spark changes in government policies and could cloud the outlook for growth, thereby aggravating social divisions. Indeed, the possibility of policy reversals has been

4.35

4.36

4.37

4.38

- 40 -

noted by risk-rating agencies as one of the factors standing between Peru and an investment-grade rating.50 4.40 The likelihood of this scenario is mitigated by the current administrations effort to promote an agenda of social inclusion. The government program calls for increased public investment to address the needs of the poorest groups and people living farthest from urban centers. To mitigate the problems of fragmentation, the authorities have also reiterated their commitment to continue efforts to improve the presence of government at both the national and subnational levels and its capacity to generate opportunities and meet peoples basic needs. The present Bank strategy with Peru seeks to support the country in achieving these objectives as well. 3. Environmental aspects and natural disasters 4.42 Peru is vulnerable to natural disasters, particularly the El Nio phenomenon that periodically assails the country and has exacted costs in terms of human lives, lost output, and destruction of infrastructure. It has had adverse impacts not only on economic growth and on the fiscal and external balances, but more especially on the poverty situation. The national government is developing a strategy to mitigate the impact of natural disasters: it combines planning, prevention and preparedness, and incorporates mechanisms of insurance against catastrophic risks. Steps are also being taken to strengthen environmental management capacities, to ensure sustainable use of natural resources. Agenda for dialogue This strategy sets forth the pillars on which the Bank-country relationship would be developed over the period 2007-2011. These have been worked out in close collaboration with the government since it took office, through an inclusive process of consultation with all key stakeholders and multiple interactions with the government, inaugurated by the Economic and Social Policy Dialogue organized with President Garcias transition team in July 2006, with input from the Banks analytic work on the country. In the future, the dialogue will serve to specify the forms that support will take in the agreed areas, with particular stress on issues involved in implementing the trade agreements and the domestic agenda, which could be refined following wrap-up of the negotiations and signature of the treaties. Through its nonfinancial products, the Bank will also continue to consolidate its position as an interlocutor with the government in the design of policies for the countrys medium-term development

4.41

E. 4.43

4.44

50

While the consensus on the direction of macroeconomic policies is deepening in Peru, the existence of polarizing social, ethnic, and economic divisions, as well as a highly discredited political class, still more closely resemble the characteristics of its Andean neighbors. See Standard and Poors. http://www2.standardandpoors.com/spf/pdf/products/SRS_Americas_2006_Low_Res_Book.pdf?vregion= us&vlang=en.

- 41 -

agenda. In particular, preparation of the Economic and Social Progress Report for 2008 on the The Faces of Exclusion and related studies offer the opportunity to deepen the dialogue on one of the most important issues for Peru.

Annex A Page 1 of 5

IDB COUNTRY STRATEGY WITH PERU: 2007-2011 STRATEGY MATRIX

Fundamental Targets Annual growth rate of GDP of 7% on average for the period 2008-20101 Reduction of poverty from 50% in 2005 to 30% in 20112 Principal programs, studies, and loans Country objectives and indicators Areas of support In execution Loans Program Technical cooperation and studies In execution Program

Foothold in the global economy and competitiveness Objective To consolidate outcomes to date and accelerate economic growth, reducing macroeconomic vulnerabilities, enhancing the country's place in the global economy, and strengthening private initiative. Indicators Growth in total exports will be 10% on average for the period 2007-2010 3 Trade deficit will fall approximately US$1.15 billion per year through import substitution and increased exports of Camisea gas. Base year (2007p): US$9.198 billion.4 By 2011 Peru will have improved its ranking on the World Economic Forums Global Competitiveness Index, breaking into the top 30 countries, with improvements each year. Market access - International negotiations - Implementation of agreements - Trade promotion Domestic agenda - Infrastructure - Access to capital - Extractive industry Complementary support in - Business climate - Labor market - Technological adaptation and innovation - Environmental sustainability - Road rehabilitation and improvement - Rural transportation infrastructure II - Lima Urban Transportation - Departmental roads program - Guarantee Program for the IIRSA Northern Amazon Hub - Decentralized rural transportation - National highway system serviceability improvement - Border crossings - Sanitation sector development program - Water resources policy PBL - Comprehensive water resources management PBL - Urban transportation for mid-sized cities - National highway system serviceability improvement II - Guarantee for BBVA Banco Continental - Banco Interamericano de Finanzas - TFFP - Liquified natural gas (LNG) - Competitiveness PBL - TC: Knowledge and development of exports under the FTA - TC: Pilot program for information technologies - TC: Support for the Andean integration process - TC: Sustainable development of agroforestry resources - TC: Youth employment and corporate social responsibility - TC: Sustainable energy efficiency services - TC: Rural global microcredit program - TC: National strategic tourism plan, Phase 2 - TC: Prioritizing investments in the Peruvian Sierra - TC: IIRSA border crossing - TC: Operation and maintenance of the Olmos irrigation system - TC: Arequipa public transportation - MIF: Logistical capacities and ICTs in SMEs in agroindustry - MIF: Strengthening risk management in the financial system - MIF: Sustainable production chains in protected natural areas - MIF: Competitiveness of ecological producers - MIF: Index-based agricultural insurance - MIF: Corporate governance in familyowned companies - TC: Country environmental analysis - TC: Port security - Phase II - TC: Logistical platform in southern Peru

Annex A Page 2 of 5

Principal programs, studies, and loans Country objectives and indicators Base year (2005): 77/117. Number of basins with watershed management agencies and integrated water management plans in place. 6 Baseline: 0 Year 5: 4
5

Areas of support In execution - Financing for BBVA Banco Continental - Youth job training program

Loans Program

Technical cooperation and studies In execution - MIF: Training in small business management - MIF: Promoting youth entrepreneurship - MIF: Promoting youth start-ups - MIF: Support for the competitiveness of the software industry - MIF: Development of business networks in tourism clusters - MIF: Support for microfinance in credit unions outside of Lima - MIF: Cluster promotion program - MIF: Assistance for small and mediumsized enterprises on technical requirements for market access under the FTA - MIF: Consolidation of private microfinance institutions - MIF: Support for the development of capital markets in Peru, with emphasis on promoting venture capital - S: Quality of employment and work productivity in Peru - S: Assessment of economic growth and new exports in Peru Program - TC: Technological platform for patent information - TC: Technological innovation in SMEs - TC: Labor and environmental standards under the FTA - TC: Opportunities to open up trade for the poor - TC: Rules of origin and customs procedures - TC: Mapping clusters in regions - TC: Sustainable energy strategy - TC: Investment in regional infrastructure and financial capacity - TC: Lima-Callao logistics - TC: Trade integration - TC: Public-private partnerships - TC: Energy matrix and development of the hydrocarbon sector - TC: Electric power sector - National water resources plan

Annex A Page 3 of 5

Principal programs, studies, and loans Country objectives and indicators Areas of support In execution Loans Program Technical cooperation and studies In execution Program - S: Assessment of growth and new export activities - S: Assessment of the private sector - S: Labor legislation legal framework - S: IPES 2008: Social inclusion Social development and inclusion Objective Improve social opportunities and well-being, promoting job creation and efficiency of the provision of public goods and services. Indicators By 2011, early education for children ages 4 and 5 will reach 80% of boys and girls in that age bracket in the poorest provinces. Base year (2003): 66% of boys and girls ages 4 and 5 were served by early education.7 By 2011, 85% of rural youth will have completed secondary school or be enrolled in the final cycle. Base year (2003): 24% of persons ages 16 to 18 and 37% of persons ages 19 to 21 completed secondary school in rural areas.8 By 2010 coverage of institutional childbirth will reach 90% of pregnant women and in no Access to public services - Education - Health - Water and sanitation - Housing Promotion of opportunities - Sierra exports - Land titling - Microfinance Social welfare - Improving the quality of secondary education - National Social Compensation and Development Fund (FONCODES) III - Support for the Housing Sector, Phase I - Fruit fly control and eradication - Environmental institutional strengthening - Support services for rural markets - Support for social sector reform - Reform of poverty alleviation and development programs - Childhood education and development - Basic education - Health sector reform (PARSALUD) Phase II - Sanitation sector (PBL) - Water for All SEDAPAL I-II - Fast-impact water expansion program - Agricultural health and food safety - Sierra exports - Microfinance - Sustainable development of the Lower Urubamba - Land titling and registration program III - TC: Financing best practices in child labor prevention - TC: Social and labor reintegration of the youth population - TC: Youth employment and corporate social responsibility - TC: Reducing child labor in gold mines - TC: Creating work opportunities for the disabled - MIF: Promoting entrepreneurship at the base of the pyramid - TC: Institutionalizing the gender perspective in the rural transportation program - S: Creating steady jobs and overcoming poverty: Review of successful experiences in Peru - MIF: Consolidation of private microfinance institutions - MIF: Support for developing the capital market in Peru, with emphasis on promoting venture capital - TC: Empowerment of vulnerable youth - TC: Expanding social welfare coverage in Peru - TC: Integral child development: Nutrition Education Health - TC: Contingent family transfers - S: IPES 2008: Social inclusion - A Panorama of the Peruvian Labor Markets in 2006 - Job quality and work productivity in Peru - Quality of education in Latin America and the Caribbean: the case of Peru

Annex A Page 4 of 5

Principal programs, studies, and loans Country objectives and indicators province in each excluded area will it fall below 50%. Base year (2001): coverage of institutional childbirth is 58%.9 By 2010 the maternal mortality rate will be reduced to no more than 80 per 100,000 live births, and infant mortality will be reduced to no more than 20 per 1,000 live births. Base year (2001): the maternal mortality rate is 185 per 100,000 live births and the infant mortality rate is 33 per 1,000 live births.10 By 2011, there will be a rise of 20 percentage points in rural water supply coverage. Base year (2006): 36.8% have access to water supply in rural areas.11 Areas of support In execution Loans Program - Contingent family transfers Technical cooperation and studies In execution Program

Reform of the State and public management (crosscutting theme) Objectives To pursue further decentralization to achieve greater efficiency in the provision of public goods and services; to strengthen public management and administration of justice. Indicators Improvement in the following WEF indicators (2006): - Efficiency of public administration (current ranking 96/125) Modernization of national and local government Justice and security Decentralization - Modernization of the State and decentralization - Institutional support for the Peruvian congress - Modernization and strengthening of tax administration - Modernization of the Comptroller Generals Office and deconcentration of - Water resources policy - PBL - Sanitation sector PBL - Comprehensive water resources management - Improving public expenditure and management III PBL - Modernizing the judicial sector - TC: Fiscal equity in Andean Development Community countries - TC: Design and implementation of labor policies in Latin America and the Caribbean - TC: Conditional cash transfer program - TC: Evaluation tool for financial institutions - TC: Support for aligning common standards in the Andean countries - TC: Support for the Andean integration process - TC: Support for sanitation sector reform - TC: Citizen services - TC: Support for civil society to fight corruption - TC: Local government fiduciary policies - TC: Strengthening subnational management - TC: Justice administration - TC: Climate change (early warning)

Annex A Page 5 of 5

Principal programs, studies, and loans Country objectives and indicators - Independence of the judiciary (current ranking 119/125) - Perception of security (current ranking 109/125) Areas of support In execution the national control system - Sector facility to improve expenditure quality - Decentralized rural transportation - Modernization and strengthening of tax administration Loans Program PROPEF - Modernizing the justice sector PBL - Modernizing justice administration - Consolidating public safety - Decentralization PBL Technical cooperation and studies In execution - TC: Design and implementation of the social and fiscal reform program - TC: Development of a water services rate framework - TC: Strategy and plan of action for development effectiveness - TC: Code of Ethics for the Ministry of Health - TC: Support for PARSALUD, Phase II - S: IPES 2006. The politics of policies - S: The political economy of the budget process in Peru - S: Changes in the ground rules and information problems in two economies experiencing natural resources booms. The case of Peru - S: IPES 2007. Living with debt Program - TC: Mining liabilities - TC: Financial rating of subnational entities - S: Debt sustainability study - S: Evaluation of democratic governance

TC: Technical-cooperation operation; S: Study; MIF: Multilateral Investment Fund.

Sources:
1 2

Multiyear Macroeconomic Framework (2008-2010). Means of verification. MEF, BCRP. National address by President Alan Garca (July 2007). Means of verification, INEI. 3 Multiyear Macroeconomic Framework (2008-2010). Means of verification. BCRP. 4 Loan 1472/OC-PE for the Camisea project. Means of verification; BCRP. 5 National competitiveness plan. Means of verification: World Economic Forum. 6 INRENA. Means of verification. INRENA. 7 Proposed National Education Project through 2021, Ministry of Education. Means of verification: Ministry of Education, INEI. 8 Proposed National Education Project through 2021, Ministry of Education. Means of verification: Ministry of Education, INEI. 9 National plan of action for children and adolescents 2002-2010. Means of verification: Ministry of Health, INEI. 10 National plan of action for children and adolescents 2002-2010. Means of verification: Ministry of Health, INEI. 11 Multiyear Macroeconomic Framework (2008-2010). Means of verification. Ministry of Housing, Construction, and Sanitation.

Annex B Page 1 of 2

FINANCING SCENARIOS Base-case scenario Nonfinancial public sector (NFPS): financing requirements and sources (US$ millions)
2007 Requirements Amortizations - Domestic - External IDB share Fiscal deficit Total gross requirements Sources - Domestic - External IDB share Total financing sources Financing flows Domestic - Disbursements - Amortizations - Net flows External - Disbursements - Amortizations ** - Net flows 2008 2009 2010 2011* Average 2007-2011 2,664 629 2,035 286 169 2,833 1,272 1,561 383 2,833 Total 2007-2011 13,321 3,147 10,173 1,430 845 14,165 6,362 7,803 1,917 14,165

6,510 1,173 5,337 254 (271) 6,239 2,420 3,819 462 6,239

2,005 520 1,485 264 324 2,329 1,149 1,180 455 2,329

1,311 310 1,001 286 653 1,964 853 1,111 348 1,964

1,492 339 1,152 307 371 1,863 759 1,104 292 1,863

2,003 805 1,198 319 (232) 1,771 1,181 590 360 1,771

3,207 1,173 2,034 3,730 5,337 (1,607)

900 520 380 1,140 1,485 (345)

800 310 490 1,084 1,001 83

900 339 561 1,100 1,152 (52)

1,381 805 576 590 1,198 (608)

1,438 629 808 1,529 2,035 (506)

7,188 3,147 4,041 7,644 10,173 (2,529)

Source: Updated Multiyear Macroeconomic Framework 2008-2010, IDB. * IDB projection for some items. ** For 2007, amortizations include prepayment to the Paris Club, financed through domestic and external bond issues.

Total public debt of the NFPS (US$ millions)

Domestic (% total debt) External (% total debt) Multilateral IDB share Bonds Others Total debt Total debt (% GDP) External debt (% GDP) 2007 10,487 34% 20,318 66% 7,938 3,887 8,476 3,904 30,805 29% 19% 2008 10,907 35% 19,948 65% 8,137 4,078 7,932 3,879 30,855 27% 17% 2009 11,558 37% 19,948 63% 8,093 4,140 7,884 3,971 13,506 26% 16% 2010 12,252 38% 19,850 62% 7,870 4,125 7,831 4,149 32,102 24% 15% 2011* 12,828 40% 19,242 60% 7,700 4,166 7,760 3,782 32,070 22% 13%

Source: Updated Multiyear Macroeconomic Framework 2008-2010, IDB. *IDB projection for some items.

Annex B Page 2 of 2

High scenario Nonfinancial public sector: financing requirements and sources (US$ millions)
2007 Requirements Amortizations - Domestic - External IDB share Fiscal deficit Total gross requirements Sources - Domestic - External IDB share Total financing sources Financing flows Domestic - Disbursements - Amortizations - Net flows External - Disbursements - Amortizations ** - Net flows 2008 2009 2010 2011* Average 2007-2011 2,664 629 2,035 286 169 2,833 1,272 1,561 480 2,833 Total 2007-2011 13,321 3,147 10,173 1,430 845 14,165 6,362 7,803 2,400 14,165

6,510 1,173 5,337 254 (271) 6,239 2,420 3,819 480 6,239

2,005 520 1,485 264 324 2,329 1,149 1,180 480 2,329

1,311 310 1,001 286 653 1,964 853 1,111 480 1,964

1,492 339 1,152 307 371 1,862 759 1,104 480 1,863

2,003 805 1,198 319 (232) 1,771 1,181 590 480 1,771

3,207 1,173 2,034 3,730 5,337 (1,607)

900 520 380 1,140 1,485 (345)

800 310 490 1,084 1,001 83

900 339 561 1,100 1,152 (52)

1,381 805 576 590 1,198 (608)

1,438 629 808 1,529 2,035 (506)

7,188 3,147 4,041 7,644 10,173 (2,529)

Source: Updated Multiyear Macroeconomic Framework 2008-2010, IDB. * IDB projection for some items. ** For 2007, amortizations include prepayment to the Paris Club, financed through domestic and external bond issues.

Total public debt of the NFPS (US$ millions)

Domestic (% total debt) External (% total debt) Multilateral IDB share Bonds Others Total debt Total debt (% GDP) External debt (% GDP) 2007 10,487 34% 20,318 66% 7,938 3,098 8,476 3,904 30,805 29% 19% 2008 10,907 35% 19,948 65% 8,137 4,125 7,932 3,879 30,855 27% 17% 2009 11,558 37% 19,948 63% 8,093 4,319 7,884 3,971 13,506 26% 16% 2010 12,252 38% 19,850 62% 7,870 4,492 7,831 4,149 32,102 24% 15% 2011* 12,828 40% 19,242 60% 7,700 4,653 7,760 3,782 32,070 22% 13%

Source: Updated Multiyear Macroeconomic Framework 2008-2010, IDB. *IDB projection for some items.

Annex C Page 1 of 2

MILLENNIUM DEVELOPMENT GOAL INDICATORS

Peru's Progress against the Millennium Development Goals Goals 1. Eradicate extreme poverty and hunger a. Halve, between 1990 and 2015, the proportion of people whose income is less than US$1 a day b. Halve, between 1990 and 2015, the proportion of people who suffer from hunger. In 2003, 24.4% of the population had incomes of less than one dollar a day. In 2004, the proportion was 21.6%. Extreme poverty has declined in recent years, but it will be difficult to achieve this goal (7.8%). Peru is on track to achieving this goal. Country performance Evaluation

In 1990, the prevalence of malnutrition among children under 5 years was 10.7%. In 1995 this figure had fallen to 7.8%.

2. Achieve universal primary education Ensure that, by 2015, children everywhere, boys and girls alike, will be able to complete a full course of primary schooling. The net enrollment ratio in primary school rose from 90.8% in 1995 to 103.1% in 1999. Peru has already achieved the goal.

3. Promote gender equality and empower women Eliminate gender disparity in primary and secondary education, preferably by 2005, and in all levels of education no later than 2015. a. The ratio of girls to boys in primary and secondary education rose from 93.4% in 1990 to 94.3% in 1999. b. The ratio of literate women to men, 15-24 years old, rose from 95.1% in 1990 to 97% in 2000. c. The share of women employed in the non-agricultural sector rose from 38.8% in 1990 to 46% in 1999. d. The proportion of parliamentary seats held by women rose from 6.7% in 1990 to 10.8% in 1995. 4. Reduce child mortality Reduce by two-thirds, between 1990 and 2015, the under-five mortality rate. 5. Improve maternal health Reduce by three-quarters, between 1990 and 2015, the maternal mortality rate. In 1995, the maternal mortality rate was 240 per 100,000 live births. In 2003 it had declined to 180. Peru has made progress, but there is a long way to go. The under-five mortality rate was 75 per 1,000 in 1990 and declined to 28 per 1,000 in 2003. Peru is on track to achieving the goal. Peru is on track to achieving the goal.

6. Combat HIV/AIDS, malaria, and other diseases a. Have halted by 2015 and begun to reverse the spread of HIV/AIDS. b. Have halted by 2015 and begun to reverse the incidence of malaria and other major diseases. HIV prevalence among women ages 15-24 was 0.2% in 1999. There are no more recent data. In 2000 there were 68,321 cases of malaria reported. The incidence of tuberculosis per 100,000 inhabitants was 95 in 1999. There are no more recent data for either malaria or tuberculosis. There is not enough information to evaluate There is not enough information to evaluate

Annex C Page 2 of 2

Goals 7. Ensure environmental sustainability a. Integrate the principles of sustainable development into country policies and programs and reverse the loss of environmental resources

Country performance

Evaluation

a. The proportion of the national land area covered by forest declined from 53.0% in 1990 to 50.9% in 2000. b. The proportion of the national territory protected to maintain biological diversity was 2.7% in 1995, and was the same in 1999. c. GDP per energy unit used rose from US$6.3 per kg oil equivalent in 1990 to US$8.9 in 1999. d. Carbon dioxide emissions per capita rose from 1.0 metric tons in 1990 to 1.1 metric tons in 1999.

Peru is backsliding

b. Halve, by 2015, the proportion of people without sustainable access to safe drinking water.

a. The proportion of population with access to drinking water rose from 72% in 1990 to 77% in 2003. b. The proportion of population with access to improved sanitation services rose from 64% in 1990 to 76% in 2000.

The country is on track to achieving the goals.

8. Within the overall goal of developing a global partnership for development: (i) implement strategies to assure decent and productive work for youth and (ii) in cooperation with the private sector, make available the benefits of new technologies, especially information and communication technologies. a. Youth employment The unemployment rate for young people ages 14-24 rose from 11.4% in 1995 to 15.4% in December 2002. a. The number of fixed and mobile telephone lines per 1,000 inhabitants rose from 26.2 in 1990 to 111.3 in 2000. b. The number of personal computers per 1,000 inhabitants rose from 14.9 in 1995 to 40.9 in 2000. The country is not making progress toward the goal. The country is on track to achieving the goal.

b. Access to new technologies

Annex D Page 1 of 3

PUBLIC DEBT RISKS1 The public finances of Peru have been steadily consolidated over recent years. The performance of the nonfinancial public-sector improved from a deficit of 3% of GDP in 1999 to a surplus of 2.1% in 2006. Together with sustained economic growth and an active government strategy for managing the public debt, this fiscal consolidation has allowed the public debt to be cut from 45% of GDP in 2000 to 32.6% in 2006. Efforts to re-profile the debt have also improved its structure in terms of currency composition, costs, and maturities. At the end of 2006, however, the external debt still represented 77% of the total, and 82% of the total debt was denominated in foreign currency, as a portion of the domestic debt is in dollars.2 In 2006, 57% of the debt carried fixed rates, with an average life to maturity of 8.4 years. The government's principal objective is to improve the currency composition further so as to limit the country's high vulnerability to exchange risks. Given the characteristics of the Peruvian economy and its vulnerability to deteriorating conditions abroad, the Bank recently conducted a study to consider the impact of adverse shocks on the public debt. In evaluating these risks, the study considered the behavior of the debt in the face of various configurations of shocks to the exchange rate, to growth, and to the primary balance. Rather than projecting a single scenario, the study subjected these variables to probabilistic shocks, calibrated in light of their historic volatility, to obtain a complete distribution of probability of the debt/GDP ratio that can be used to verify (with a confidence interval of 90%) the impact and the risk to sustainability associated with each event.3 Exchange risks Figure 1 shows that, with a devaluation of the nuevo sol/dollar exchange rate, the debt-GDP ratio would remain above 30% over the medium-term, in 90% of cases.4

Andrade, G. Sostenibildad de la deuda en Per, in preparation. The proportion of total debt in nuevos soles was 18%. Stochastic shocks are based on historic volatility (i.e. variance) of the relative series. The methodology used is simplified version of the "Fan Charts" proposed by Celasun, Debrun, and Ostry (2006). This exercise assumes that the entire debt is denominated in foreign currency.

Annex D Page 2 of 3

0.6

Figure 1. Total Public Debt/GDP Shock a la tasa de cambio Choqueto the exchange rate

0.5

0.4

0.3

0.2

0.1

0.0 20 00 200 1 200 2 2 003 2 004 20 05 20 06 200 7 200 8 2 009 2 010 20 11 20 12 201 3 201 4 2 01 5

The currency matching indicator, an alternative measure of the debt's vulnerability to devaluation, estimated at 0.17 in 2006, suggests that a significant devaluation could have a considerable impact on the public debt and its sustainability.5 Implementation of the government's planned strategy for managing the public debt, the objective of which is to have 34% of the debt in local currency, could raise the matching indicator to 0.4 in 2009. Shock to growth While future forecasts are favorable, Peru's growth in recent decades has betrayed great volatility, highlighting the importance of analyzing the consequences of a growth shock.6 As Figure 2 shows, this would represent a more significant risk than would a devaluation, as the debt would be much higher than its current level.

This indicator is defined as MI= (B/eB*)/(Y/eY*) where B= non-tradable debt, B*= tradable debt, Y= tradable output, and Y*= nontradable output. When MI=0, real depreciation would fully affect sustainability of the debt. The matching indicators estimated at 0.05 in 1998. Between 1980 and 2006, the standard deviation of real growth in Peru was approximately 6%.

Annex D Page 3 of 3

Figure 2. Total Public Debt/GDP Shock to the real growth rate Choque a la tasa real de crecimiento
0. 6

0. 5

0. 4

0. 3

0. 2

0. 1

0. 0

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

Vulnerability in primary fiscal balances Given the low level of public revenues and the uncertainties in the level of expenditures that have characterized Peru, Figure 3 analyzes the impact of a potential shock to the primary balance. The comparison with the shocks analyzed above suggests that this would have a lesser impact and would not pose a risk to debt sustainability. This result is corroborated by fiscal projections in the annual macroeconomic plan which, under the fiscal responsibility law, calls for primary balances of around 1% of GDP over the medium term.
Figure 3. Total Public Debt/GDP Shocks al resultado primario Choque to the primary balance
0.6

0.5

0.4

0.3

0.2

0.1

0.0 2 00 0 2 001 2 002 2 003 2 004 20 05 20 06 20 07 20 08 20 09 201 0 201 1 201 2 2 01 3 2 014 2 015

Annex E Page 1 of 1

PRELIMINARY LENDING PROGRAM

No. Project Name Amount US$ millions 200.0 100.0 75.0 375.0 25.0 1.5 10.0 1.2 15.0 10.0 50.0 112.7 75.0 75.0 150.0 25.0 10.0 30.0 50.0 25.0 25.0 165.0 50.0 50.0 50.0 150.0 50.0 50.0 50.0 150.0 50.0 50.0 50.0 150.0 15.0 100.0 35.0 150.0

Operations Program 2007 L-1024 PBL Water resource policies I L-1025 PBL Sanitation sector policies I L-1027 PBL Public expenditure management quality III Subtotal policy-based loans approved in 2007 L-1023 Plant and animal health SENASA (CCLIP) L-1030 Water resources: technical assistance PE-0240 Consolidation of democracy and public safety PE-1028 MAPPE Modernization of the judiciary L-1035 Sierra Exports Phase I L-1026 Land titling and registration Phase III L-1020 Water for All SEDAPAL Subtotal investment loans approved in 2007 Operations Program 2008 L-1040 PBL Water resource policies II PBL New sustainable energy matrix Subtotal sector loans approved 2008 Early childhood development and education L-1021 Sustainable development of the Lower Urubamba L-1005 Health sector reform Phase II Housing sectorneighborhood development Olmos irrigation infrastructure Olmos irrigation infrastructure (contingent loan/concession) Subtotal investment loans 2008 Operations Program 2009 Water resources III Sanitation sector II New sustainable energy matrix II Subtotal sector loans 2009 L-1031 Modernization of justice administration Quick impact and expansion of drinking water Sanitation sector development Phase II Subtotal investment loans 2009 Operations Program 2010 Sanitation sector III New sustainable energy matrix III To be determined Subtotal sector loans 2010 Sierra Exports Phase II National Highway System II To be determined Subtotal investment loans 2010

Annex F Page 1 of 2

ENERGY SECTOR OPERATIONS MATRIX

1 Title Objective Counterpart OC loans 2 Title Energy Policy Programmatic Loan To help the government formulate a policy framework for energy development that is economically efficient and ecologically and socially sustainable. To lay the basis for broader dialogue with the government on many facets of energy development. Ministry of Economy and Finance (MEF), Ministry of Energy and Mines (MEM) To be determined Peru LNG (PE-L1016) The Peru LNG project will liquefy 4.45 million tons annually of gas from Camisea and sell all the resulting LNG to Repsol, for export to Mexico, Chile and the United States. This will add 0.5% annually to Peru's GDP. It includes (i) construction of the natural gas liquefaction plant at Pampa Melchorita, (ii) the marine loading terminal, (iii) a breakwater on the open coast, and (iv) extension of the 34 inch gas pipeline beginning at km 211 of the existing Camisea pipeline. Hunt Oil Co. Total project cost is US$3.8 billion including financing. Hunt Oil Co. (50%), SK of South Korea (30%), Repsol-YPF of Spain (30%) Financing plan: (i) IDB A loan of US$400 million and commercial B loan of US$400 million, (ii) other debt of US$1.5 billion, and (iii) US$1.5 billion in sponsors equity. Sustainable development of the Lower Urubamba (PE-T1053 and PE-L1021) The TC and a possible "innovation" loan will support the economic and social development of native communities and consolidate the capacity of local governments to improve access to basic services and to make use of Camisea Fund/royalty resources. Presidencia del Consejo de Ministros (PCM) Technical cooperation of US$750,000 JSF and OC loan of US$10 million Camisea project (loan 1472/OC-PE) Partial financing of the downstream component of the gas and LNG pipeline. Transportadora de Gas de Camisea US$75 million to the TGP consortium Environmental and social institutional strengthening of the Camisea project (loan 1441/OC-PE) To consolidate the Peruvian government's capacity to supervise and control the social and environmental impacts of the Camisea project. Ministry of Energy and Mines (MEM) US$5 million Communications strategy for Camisea and Peru LNG Special attention to communication requirements during due diligence and beyond in support of the Bank's two principal operations in the sector. IDB internal Approximately US$80,000 is still available in the telecommunications budget. Hydrocarbons management and development strategy To develop a national energy matrix from the hydrocarbons viewpoint. Components:: (i) economic advantages of hydro versus thermal power generation; (ii) prepare a hydrocarbons management strategy; (iii) feasibility of a new gas pipeline in southern Peru; (iv) analysis of the environmental, social, and cultural risks as well as the opportunities offered by the southern pipeline. Ministry of Energy and Mines (MEM) InfraFund, US$490,000

Objective

Sponsor Structure

Title Objective Counterpart Resources

Title Objective Sponsor Loans Title Objective Counterpart OC loans

Title Objective Budget

Title Objective Counterpart TC

Annex F Page 2 of 2

Title Objective Counterpart Resources

Social and environmental initiative for sustainable hydrocarbons development in Peru S&EI To harmonize current and future investment in the hydrocarbons sector in the Amazon basin, within a framework of environmental and social safeguards negotiated with the public and private sectors and related stakeholders. The focus will be on the concessioned lots and the overlap between protected communities and biological reserves. The Bank will have a catalytic role only. To be determined The first US$50,000 of the Hydrocarbons Management and Development Strategy TC would be used. Sustainable Energy and Strategic Plan for Biofuels Assist the Ministry of Energy and Mines in defining a Strategic Plan for Sustainable Energy and Biofuels Development. Ministry of Energy and Mines (MEM) To be determined Power Generation Initially, a TC to finance pre-investment studies for the rural electrification program (potentially 30 projects valued at US$80 billion). This is an important local development initiative, associated with a broader energy matrix and policy. Ministry of Energy and Mines (MEM) To be determined Regional TC Communities living in voluntary isolation Ministry of Womens Affairs and Social Development (MIMDES) To be determined Sustainable Energy Efficiency Services (ATN/JF-7040-PE) To consolidate the government's regulatory and oversight functions relating to energy efficiency. To identify policies and standards that will contribute to the efficient energy market. Ministry of Energy and Mines (MEM) US$750,000 Promotion of clean energy market opportunities and energy efficiency (PE-M1038) To increase market opportunities for small and medium-sized enterprises by improving their competitiveness through the development of clean energy. To promote clean energy and energy efficiency to facilitate SME access to economic incentives that support competitiveness and the use of clean technology. Fondo Nacional del Ambiente (FONAM) To be determined.

Title Objective Counterpart TC

10

Title Objective Counterpart TC

11

Title Objective Counterpart TC Title Objective Counterpart TC

12

13

Title Objective Counterpart TC

Annex G Page 1 of 1

PROGRAM OF STUDIES
Name IPES 2006. The Politics of Policies The economic policy underlying the budget process in Peru Per: Evaluacin de la gobernabilidad democrtica [Evaluation of democratic governance in Peru] Cambio en las reglas de juego y problemas de informacin en dos economas con bonanzas de recursos naturales. El caso de Per [Shifting rules of the game and information problems in two economies experiencing natural resource booms. The case of Peru.] A Panorama of the Peruvian Labor Markets in 2006 Generacin de empleo no precario y superacin de la pobreza: Revisin de experiencias exitosas en el Per [Generating stable employment and overcoming poverty: review of successful experiments in Peru] IPES 2007. Living with Debt Calidad del Empleo y productividad del trabajo en Per [Job quality and the productivity of labor in Peru] The Educational Gender Gap in Latin America and the Caribbean One Size Does Not Fit All Returns to Private Education in Peru Does the Quality of Training Programs Matter? Evidence from Bidding Processes Data Diagnostico del crecimiento econmico y nuevas exportaciones en Per [Analysis of economic growth and new exports in Peru] Estudios de sostenibilidad fiscal [Fiscal sustainability studies] Final Report 2006 2006 2006

2006 2006

2006 2006 2007 2007 2007 2007 2007 2007 2007

Annex H Page 1 of 3

NONFINANCIAL PRODUCTS1 A. Program

A. Competitiveness TC: Country Environmental Analysis TC: Port Security-Phase II TC: Pilot program on "orientation by demand" in Cerro Azul TC: Logistics platform in the south of Peru TC: Navigability of the Amazon waterway system TC: Technical platform for patent information TC: Experimental economy for water resource management TC: Technological innovation in SMEs TC: Sustainable development of the Lower Urubamba TC: Water resources management plan for the Mashcon and Chonta basins MIF: Logistical and ICT capacities in agroindustrial SMEs MIF: Strengthening risk management in the financial system MIF: Promoting clean energy market opportunities and energy efficiency MIF: Sustainable production chains in protected natural areas MIF: Competitiveness of ecological producers MIF: Index-based farm insurance MIF: Corporate governance in family enterprises B. Social development and inclusion TC: Empowering vulnerable youth TC: Expanding the coverage of Peru's social welfare system C. Modernization of the State TC: Support for the Sanitation Sector Reform

B.

In execution

A. Competitiveness TC: Knowledge and export development under the free trade agreement TC: Information technologies pilot program TC: Support for monitoring the Andean integration process TC: Qhapac an Development Action Plan TC: Integration and cross-border development: project bank TC: Support for the Andean integration process TC: Sustainable development of agroforestry resources TC: Youth employment and corporate social responsibility TC: Sustainable energy use services TC: Olmos Irrigation Project: water conveyance and distribution works TC: Global rural microcredit program TC: Biodiversity Strategy in Andean Countries: Project Formulation TC: Emergency assistance following eruption of the Ubinas volcano
1

TC: Technical-cooperation operation; MIF: Multilateral Investment Fund; SP: Small project.

Annex H Page 2 of 3

TC: Strengthening the industrial processing of cacao TC: Responsible production and marketing for small coffee growers TC: National Strategic Plan for Tourism, Phase 2 TC: Setting investment priorities in the Peruvian Sierra TC: Support for preparation of the Sierra Exports program TC: Conversion to natural gas and air-quality effects in urban areas TC: Preparation of the Science and Technology Program MIF: INDECOPI: SME quality control MIF: Strengthening airport security MIF: Small business management training MIF: MSB: Municipal System for improving productivity and working conditions MIF: Promotion of youth entrepreneurship MIF: Promotion of youth startups MIF: Business linkages and competitiveness in the alpaca textile sector MIF: Enhancing the competitiveness of small and medium-scale producers of artichokes MIF: Expanded support for cleaner production in the South Region MIF: Competitiveness support for the software industry MIF: Developing business networks in tourism clusters MIF: Support for returning entrepreneurs MIF: Consolidating development in the Northeastern Tourist Circuit to enhance MSME competitiveness MIF: Competitiveness of rice growing in Alto Mayo MIF: Enhancing the impact of Peruvian workers' remittances from Japan MIF: Government e-Procurement Support for SMEs MIF: Support for microfinance at credit unions outside Lima MIF: Conversion to organic cultivation of mangoes MIF: Good farming practices for mangoes MIF: Conversion to the organic cultivation of cacao MIF: Promoting entrepreneurship at the base of the pyramid MIF: Environmental adaptation for SMEs in the tanning industry MIF: Cluster Promotion Program MIF: Crear Arequipa: small business and microenterprise development MIF: Support for SMEs in meeting technical requirements for market access under the FTA MIF: Competitiveness of hearts of palm growing and marketing MIF: Consolidation of private microfinance companies MIF: Institutional strengthening of Banco Internacional MIF: Support for the exchange of knowledge among development banks in Latin America and the Caribbean MIF: Support for capital market development in Peru, emphasizing venture capital MIF: Economic development of Jan MIF: MiCasita -the first full-service mortgage company in Peru MIF: Mobilizing capital market financing for SMEs through factoring SP: Expanding microcredit and savings facilities for women SP: Outsourcing and marketing for microenterprises and small businesses SP: Product expansion and diversification for small coffee growers B. Social development and inclusion TC: Financing best practices to prevent child labor TC: Social and occupational integration for youth TC: Youth employment and corporate social responsibility TC: Reducing child labor in gold mines TC: Creating work opportunities for the disabled TC: Mainstreaming the gender perspective in rural transport TC: Rural Telemedicine

Annex H Page 3 of 3

MIF: Promoting youth entrepreneurship MIF: Support for returning entrepreneurs MIF: Promoting entrepreneurship at the base of the pyramid C. Modernization of the State TC: Fiscal equity in Andean Community countries TC: Support for monitoring the Andean integration process TC: Design and implementation of labor policies in Latin America and the Caribbean TC: Conditional Cash Transfers Program TC: Instrument for evaluating financial institutions TC: Support for the adaptation of common standards in Andean countries TC: Integration and cross-border development: project bank TC: Support for the Andean integration process TC: Introducing framework contracts in government procurement TC: Design and implementation of the Social and Fiscal Reform Program TC: Development of a water service rates framework TC: Strategy and Plan of Action for Development Effectiveness TC: Code of Ethics for the Health Ministry TC: Support for PARSALUD, Phase II TC: National Strategic Plan for Tourism, Phase 2 TC: Public bus transit system in Arequipa

Annex I Page 1 of 1

COUNTRY FINANCING PARAMETERS

Item Cost sharing and local cost financing. Limits on the proportion of the total cost and local costs of a project that the Bank may finance.

Parameter Up to 100%

Remarks/Explanation The Bank may finance up to 100 percent of project costs. The actual cost-sharing percentage would be determined during the preparation of each new project. The use of the increased flexibility on eligible expenditures will be managed in such a way as to lessen the impact on the amount assigned to new operations, since the new policy does not provide additional fiscal space. The Peruvian Constitutions limits the financing of recurrent costs that are considered permanent.

Expected World Bank Parameter Up to 100%

Recurrent cost financing. Any limits that would apply to the overall amount of recurrent expenditures that the Bank may finance. Taxes and duties. Are there any taxes and duties that the Bank would not finance?

Not applicable

Not applicable

None

The Bank may finance the costs of taxes and duties associated with project expenditures. Peru has a moderate level of taxation. Bank financed projects/activities are taxed at the same rate as the countrys normal tax rates. As of July 2005, there are no taxes or duties that are identified as unreasonable or discriminatory.

None

Annex J Page 1 of 3

COORDINATION WITH OTHER MULTILATERAL AGENCIES The Bank has close working relations with the World Bank, the Andean Development Corporation (CAF), the International Monetary Fund (IMF), and other donors. In addition to smooth and ongoing dialogue among the institutions, the following also takes place: a. Collaboration on policy and reform programs. The IMF, the World Bank and the IDB have made an effort to coordinate their sector policies and macroeconomic reforms. b. Cofinancing. In the case of investment loans, the IDB in the World Bank are cofinancing transportation programs (e.g. Lima Urban Transit, Rural Transport Infrastructure), and are coordinating activities in education and in reform of the State. The IDB is working with the CAF on an institutional strengthening program for public management in local governments. c. Collaboration in the program of studies. There is very active dialogue between the IMF, the World Bank and the IDB on policy issues for the country, through collaboration on their evaluations of fiduciary management, public expenditure and government procurement systems. They also take joint part in seminars and encerronas. World Bank. In 2006, the World Bank approved four loans, totaling US$325 million. The active loan portfolio has 19 operations, totaling US$749 million, of which 21% has been disbursed to date. The 2007 lending program consists of five operations, amounting to US$385 million, and includes two sector loans for a total of US$300 million. Andean Development Corporation. The CAF approved sovereign loans totaling US$425 million in 2006. Its project portfolio is concentrated in infrastructure, social development, SME competitiveness, and structural and macroeconomic reforms. International donors. Peru receives support from a great many countries, international agencies and NGOs.1 The largest bilateral donors are Germany and Japan, which are supporting the country in the areas of economic growth and competitiveness, poverty reduction and social inclusion, and governance.

There are 617 NGOs registered with the Peruvian International Cooperation Agency that are working in the country.

Annex J Page 2 of 3

Stock of medium and long-term external public debt (US$ millions) 2003 7,359 8,658 5,630 1,121 22,768 2004 7,875 8,508 6,944 1,139 24,466 2005 7,983 5,696 8,393 207 22,279 2006 7,843 5,629 8,392 108 21,972

International agencies Paris Club Bonds Other Total

10,000 8,000 6,000 4,000 2,000 2003

2004

2005 Paris Club Other

2006

International agencies Bonds

Disbursements of medium and long-term external public debt (US$ millions) 2003 699 210 1,250 2,159 2004 1,049 190 1,299 2,538 2005 788 186 1,650 2,624 2006 484 125 609

International agencies Paris Club Bonds Other Total 2,000 1,500 1,000 500 2003

2004

2005 Paris Club Other

2006

International agencies Bonds

Annex J Page 3 of 3

Creditors: Disbursements of external public debt (US$ millions) 2003 112 345 29 238 2004 434 234 18 378 2005 454 191 26 138 2006 417 36 50 81

IDB World Bank JBIC CAF

500 400 300 200 100 2003 IDB 2004 World Bank 2005 JBIC 2006 CAF

IDB active portfolio versus other multilateral agencies (US$ millions) 2003 1,960 885 574 517 2004 2,144 838 424 187 2005 1,999 823 424 567 2006 1,904 599 476 308

IDB World Bank JBIC CAF

2,500 2,000 1,500 1,000 500 2003 IDB 2004 World Bank 2005 JBIC 2006 CAF

Annex K

Active Portfolio *

Fulfillment of basic assumptions

Execution progress (PPMR))

Loan number

Project name

Strategic area I: Competitiveness through a foothold in the global economy and public and private investment 12 operations totaling US$583 million (40.8% of the portfolio value) 1150/OC-PE 1328/OC-PE 1501/OC-PE 1534/OC-PE 1586/OC-PE 1647/OC-PE 1657/OC-PE 1663/OC-PE 1717/OC-PE 1810/OC-PE 1827/OC-PE 1836/OC-PE 197 Highway Rehabilitation and Improvement Program 140 National Rural Transportation Infrastructure Program. Stage Two 187 Lima's Urban Transportation Program 241 Youth Training Program 234 Program of Support Services to Gain Access to Rural Markets 1007 Fruit Fly (Ceratitis Capitata) Control and Eradication Project in Coastal Areas of Peru 236 Departmental Roads Program 203 Science and Technology Program 1010 Guarantee Program for the IIRSA Northern Amazon Hub 1011 Decentralized Rural Transportation Program 1006 National Highway System Serviceability Improvement Program 1003 Peru Border Crossings 150.0 50.0 45.0 18.0 15.0 15.0 50.0 25.0 60.0 50.0 100.0 5.0 149.6 49.3 4.9 2.9 1.2 7.8 0.5 0.0 0.0 0.0 0.0 0.0 99.8 98.5 10.9 15.9 8.0 52.1 1.1 0.0 0.0 0.0 0.0 0.0 31-Aug-07 30-Sep-07 25-Aug-08 26-Mar-08 15-Mar-09 21-Dec-09 2-Apr-11 19-Jul-13 19-Jul-26 16-Apr-12 0-Jan-00 0-Jan-00 Satisfactory Satisfactory Unsatisfactory Unsatisfactory Unsatisfactory Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Probable Probable Probable Probable Probable Probable Probable Probable Probable Probable Probable Probable High High High High High High High High High High High High Normal Normal Alert Alert Alert Normal Normal Normal Normal Normal Normal Normal

Strategic area II: Reform of the State and delivery of decentralized public services 6 operations totaling US$59.4 million (4.2% of the portfolio value) 1437/OC-PE 1442/OC-PE 1458/OC-PE 1482/OC-PE 1591/OC-PE 217 State Modernization and Decentralization Program 219 Foreign Trade Policy Development Program 220 Institutional Strengthening Program for the Peruvian Congress 223 Program for the Modernization and Strengthening of Tax Administration 1002 Program for Modernization of the Office of the Comptroller General of the Republic and Deconcentration of the National Control System 1013 Institutional Sector Facility to Improve the Quality of Public Expenditure and Management 28.0 5.0 7.0 3.6 12.0 3.1 4.9 1.2 0.7 2.1 11.0 98.5 17.3 19.2 17.6 12-Sep-08 15-Aug-07 22-Nov-07 23-Sep-08 28-Feb-10 Unsatisfactory Satisfactory Unsatisfactory Unsatisfactory Satisfactory Probable Probable Unlikely Probable Probable High High High High High Alert Normal Problem Alert Normal

1696/OC-PE

3.8

0.3

9.0

8-Jun-08

Satisfactory

Probable

High

Normal

Strategic area III: Building opportunities through social investment 9 operations totaling US$788.1 million (55.1% of the portfolio's value) 1237/OC-PE 1421/OC-PE 1441/OC-PE 1461/OC-PE 1539/OC-PE 1600/OC-PE 1601/OC-PE 1697/OC-PE 1878/OC-PE 170 Program to Improve the Quality of Secondary Education 193 Foncodes III 233 Program for Institutional Strengthening and Environmental and Social Management Support for the Camisea Gas Project 218 Program to Support the Housing Sector First Phase 1001 PROPEF: PE0142 Program to Support Development of the Sanitation Sector 247 Reform of Poverty Alleviation and Human Capital Development Programs 1009 Support for Reform of Poverty Alleviation and Human Capital Development Programs 142 Program to Support Development of the Sanitation Sector 1024 Water Resources Reform Program I TOTALS 87.0 80.0 5.0 60.0 0.8 300.0 5.3 50.0 200.0 1,430.5 86.2 67.2 4.1 18.6 0.0 150.0 0.9 0.0 0.0 555.6 99.1 84.0 82.1 31.1 0.0 50.0 17.6 0.0 0.0 38.8 14-May-07 11-Dec-07 27-Dec-07 21-Jan-08 28-Feb-08 15-Dec-07 20-Jul-08 0-Jan-00 0-Jan-00 Satisfactory Satisfactory Satisfactory Unsatisfactory Satisfactory Satisfactory Satisfactory Satisfactory Satisfactory Probable Probable Probable Probable Probable Probable Probable Probable Probable High High High High High High High High High Alert Normal Normal Alert Normal Normal Normal Alert Normal

* Updated as of 11 July 2007.

Performance rating (PAIS)

Fulfillment of development objectives (PPMR)

Current contract amount

Project Number

Cumulative disbursements

Date of final disbursement

% disbursed

Annex L Page 1 of 1

Balanced Scorecard
INDICATOR
BALANCED SCORECARD (BSC) FOR COF/CPE, 2006

Dec. 2005 Sept. 2006

Dec. 2006

RANGE

WEIGHT ASSIGNED TO PARAMETERS

BSC DECEMBER 2005

BSC SEPTEMBER 2006

BSC DECEMBER 2006

PARAMETERS Fi Cl Pr Kn Substantive 44 23.13 20.85 37.82

Annual % of portfolio disbursements (loans)

11.55

9.99

16.8

<10%=0, >20%=100

10

1.6

0.0

6.8

Annual % of portfolio disbursements (TCs and MIF)

11.50

13.98

20.7

<8%=0, >12%=100

4.4

2.1 Annual % of portfolio disbursements (only MIF)

13.46

13.47

19.3

<8%=0, >12%=100

2.2 Annual % of portfolio disbursements (only TCs)

3.51

15.84

25.4

<8%=0, >12%=100

Market share compared to the other multilaterals (approvals)

38

41.0

48.8

<30%=0,>40%=100,

4.0

5.00

Average extension of disbursement period compared to original contract

months

13.6

8.6

10.0

>15=0, <8=100

1.2

5.5

4.27

Total amount of loans approved under the New Lending Framework (NLF)

US$

200,000

20,000.00

300,000,000

<50,000=0, >150,000=100

6.0

6.00

Total value of approved operations (US$ million) (Loan pipeline)

US$

140,000

90,000

415,000,000

<150=0, >250,000=100

0.0

2.0

6.1 Percentage of loans approved (# loans)

67

40

100

Average time between signature of contract and months eligibility for disbursements

9.8

3.6

3.3

>6=0, <3=100

0.0

2.4

2.75

Approval of critical projects

no=0, yes=100

3.0

3.0

Percentage of the portfolio amount above the satisfactory level - Loans

95

91

91

<70%=0, >85%=100

3.0

3.0

Percentage of the portfolio amount above the satisfactory level - TCs

84

72

67

<70%=0, >85%=100

0.9

0.13

9.1 Percentage of the number of operations in the portfolio above the satisfactory level (in # of loans) 9.1 Percentage of the number of operations in the portfolio above the satisfactory level (in # of TCs)

87

78

77

<70%=0, >85%=100

82

74

71

<70%=0, >85%=100

Annex M Page 1 of 4

RECOMMENDATIONS FROM THE PERU 2002-2006 COUNTRY PROGRAM EVALUATION AND MANAGEMENT PROPOSALS
Recommendations Management comments/actions

Recommendation 1: The process of reflection on the country's development problems The Bank should help the country reflect on how to: (i) expand its production and export base; (ii) increase tax revenue and streamline the collection process; (iii) increase infrastructure spending; (iv) enhance the quality of education; (v) lower poverty levels; (vi) reduce inequity; (vii) expand and improve healthcare; (viii) improve natural resource management; (ix) help the government strengthen its public institutions, including regulatory agencies and the SNIP; (x) ensure an orderly, efficient decentralization process; and (xi) strengthen the management of public funds and the proceeds of international cooperation loans by substantially reducing the administrative burden. Above all, when the Bank raises these questions, it should reflect on the system of incentives and the decision-making process that give rise to public policies in Peru. This process of reflection, which should help the Bank and the country to agree upon a strategy that is consistent with current challenges, takes a different approach than that pursued previously on the basis of sector notes reflecting the Bank's structure rather than the country's fundamental development issues. Recent experience with the Country Studies Initiative can offer guidance on how to structure the analysis of problems with an eye to the future. Moreover, this process can also help the Bank identify its own knowledge needs and thus feed into its training and human resources policy. The Bank should help the country in its effort to increase investments at both the national and the regional levels while maintaining fiscal discipline and making efficient use of its resources. It should therefore encourage the process of expanding the SNIP to reach the regions rapidly and thus ensure higher-quality investments. In addition, the Bank needs to support the SNIP's work by collaborating in the designs and feasibility studies for Bank-financed projects. Successful experiences currently unfolding in some sectors (particularly highway infrastructure) could be extended to the other areas. There is general agreement on the importance of the development themes recommended, including that relating to the energy sector. The Bank will step up its dialogue with the country through regular exercises for assessing and analyzing options for action in different areas, with a view to ensuring continuity, through short, medium and long-term approaches and comparison with international experience. The assessment takes account of the Country Studies Initiative. The strategy has used the country studies and sector notes as key inputs for thinking about and informing the process of balancing the country's needs with the Bank's strengths. This has sparked an iterative and interactive process with the MEF and other key ministries and stakeholders, including the multilateral banks. Management agrees on the importance and relevance of the SNIP for enhancing the quality of investment projects financed with public funds. The government has reviewed and simplified the SNIP to reduce the bureaucratic burden and to adapt the system for use by regional and local governments. The project for Modernization of the State and Decentralization (loan 1437/OC-PE) will provide further support for strengthening the executing and fiduciary capacity of subnational institutions. The possibility of programming with regional governments and the larger municipal governments is an element of the ongoing dialogue with the authorities, and poses a significant challenge for the near future.

Annex M Page 2 of 4

Recommendations Recommendation 2: The programming process Specify the composition of the program, prioritizing actions according to their expected benefits, based on the risks faced and the importance of the weaknesses to be addressed. For that purpose, it is essential to make an in-depth analysis of the causes of existing weaknesses in the areanot merely list the problemsand provide a complete, meaningful risk analysis. Focus activity, insofar as possible, on a smaller group of areas of intervention based on the Banks comparative advantages. One of the criteria for this could be given by past results, which have proven a good predictor of future success. Expand the Bank's activity beyond the sectors identified in the foregoing point, but only on the basis of clearly defined lending scenarios determined by the most relevant triggers according to the risks identified and execution capacity. The expansion of business lines therefore needs to be preceded by an increase in the Bank's knowledge and in the country's capacities. Conduct an adequate risk analysis that factors the weaknesses of executing agencies into the programming process, along with problems of institutional capacity, coordination, and the incentives for actors to move the program forward. Accompany risk analysis with mitigation measures, but above all with risk management that makes it possible to head off problems with specific actions and adapt the programming process efficiently. Ensure better coordination, both with other donors and within the Bank, in order to capitalize on the synergies of work in certain specific areas. Expand the identification of lessons learned that could be useful for determining action areas and modalities, and also for utilizing and designing Bank tools. For example, the Country Office should draw lessons learned from the use of disbursement triggersa mechanism included in a number of technical-cooperation programsas they could serve as an input for the Bank at times when it intends to increase the use of tools that incorporate this mechanism, such as performance-driven loans (PDLs).

Management comments/actions

The strategy will be implemented in a context in which the country focus is the principal thrust of the Bank's new organizational structure, and the country departments define the fundamental parameters for shaping the corporate program. Future programming will respond to the pillars on which the Bank-country relationship will be developed over the period 2007-2011, identified in close cooperation with the government through an inclusive process of consultation with all stakeholders, and in multiple opportunities for interaction. The strategy calls for establishing a new business model with the country in order to: (i) maintain a smooth and high-quality dialogue on selected issues; (ii) identify and move promptly to seize windows of opportunity as they open; and (iii) reduce transaction costs for the country with the Bank. With the prospect that Peru may receive an "investment grade" rating and obtain access to international financial markets under conditions comparable with those of IDB financing, the Bank's competitiveness in terms of costs, operating flexibility and other financial services will become more critical. While the thrust of the recommendations on risk analysis and program targeting are relevant, it must be noted that the Bank does not operate in the country independently. The government prepares a periodic Multiyear Macroeconomic Framework, which consolidates economic policy and sector strategies and forms the basis for programming with all multilateral agencies. The size of the program with the public sector and its thematic focus will depend on the needs expressed by the government, consistent with the country financing requirements and the public debt management strategy. When it comes to financing the private sector, the Bank plans to support traditional clients in infrastructure and financial markets, as well as other, innovative sectors.

Annex M Page 3 of 4

Recommendations Recommendation 3: The strategy document It is recommended that the next country strategy include an adequate system of outcome indicators, complete with targets and baselines, to make it possible to assess whether the strategy's development objectives have been met. This system of indicators should be accompanied by the implementation of information, monitoring, and evaluation systems that allow for continuous tracking of the effectiveness of the Bank's work in the country. The potential for identifying indicators is not independent of programming. The better the diagnostic study and the stronger the targeting, the greater the chances of finding suitable indicators, with baselines, of the Bank's work in the country. Correlating indicators with lending scenarios and triggers could be an additional virtue.

Management comments/actions

The strategy contains a limited number of indicators reflecting the programmatic pillars. As to the recommendation that the strategy should contain a system of outcome indicators, with targets, baselines, and information, monitoring and evaluation systems, its practical applicability will depend on the priority accorded this kind of focus in the realignment context. With the approach in the strategy, the issue of indicators, their relevance and their attribution will have to be addressed in the individual projects.

Recommendation 4: Project design, approval and execution Diagnostic studies should clearly identify the causes of the reality to be addressed. Diagnostic studies should properly analyze the particular characteristics of each executing agency so as to determine the best way of working in the respective sector. Project design should take into account the incentives facing the actors involved, along with their capacity and the viability and long-term sustainability of the actions. During the design process, account should be taken of any necessary measures to strengthen the executing agency, bearing in mind the details of cases involving successful executing units and the lessons learned from implementation of action plans to strengthen other such units. The design and approval process should take into account SNIP requirements for declaring project viability, and, during the design phase, Bank specialists should work together with the government officials responsible for declaring viability. Risk management should be improved, using evaluation matrices to allow for preventive measures to be adopted at an early stage, and using mechanisms to ensure that those preventive measures are channeled through the right agencies. Generally speaking, these recommendations are relevant. Many have already been incorporated, while others pose implementation problems. There is total agreement on the need to deepen the assessments and improve the project design and approval process, as well as the need to work jointly with the executing agencies to improve their implementation. This entails establishing operating policies to: (i) identify the principal indicators during the design phase, include adequate baselines, and create monitoring systems; (ii) establish a management practice of analyzing risk in the executing agencies and the MEF; and (iii) include multiyear planning of project activities, focused on the desired outcomes.

Annex M Page 4 of 4

Recommendations Indicators need to be better designed and baselines more effectively compiled (in due time and form). Information and monitoring systems should be generated for Bank projects and adopted by the beneficiary institutions once execution has concluded.

Management comments/actions

Recommendation 5: The Bank/Country relationship The Country Office should continue to move forward with its reengineering process, paying special attention to early identification of weaknesses among executing agencies, providing training and adequate support for project management by the country. It is essential that it maintain support for executing agencies in planning the execution of their projects and for the work of the SNIP in its internal portfolio review process. The Country Office should design a systematic support plan for the General Administration Offices (both those executing Bank projects and those that have yet to do so), this being one of the key examples of value added by the Bank recognized by the country, and thus one of the mechanisms for ensuring that Peru will continue to request Bank financing. Headquarters should also act accordingly, not only in terms of the changes needed during the design phase, but also during execution. For example, the Bank could play a crucial role in providing training, consulting, and technical-assistance services, given State weaknesses in terms of regulation, the administration of bidding processes, service provider management, etc. To a large extent, the reengineering achieved by the Country Office reflects the growing sophistication and accountability of the government. In this context, the Bank will continue to support institutional strengthening, the improvement of internal systems, and expansion of the services menu. In the new business model, the Bank's technical capacity, both at headquarters and in the Country Office, takes on particular importance for improving support to the executing agencies.

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