Document of The World Bank FOR OFFICIAL USE ONLY Report No: 29508 IMPLEMENTATION COMPLETION REPORT (FSLT-71790) ON A LOAN IN THE AMOUNT OF US$ 404.04 MILLION TO THE FEDERATIVE REPUBLIC OF BRAZIL FOR A SECOND PROGRAMMATIC FISCAL REFORM LOAN (FISCAL RESPONSABILITY AND TAX REFORM) June 24, 2004 Poverty Reduction Economic Management Sector Management Unit Brazil Country Management Unit Latin America and the Caribbean Regional Office This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS (Exchange Rate Effective ) Currency Unit = Real BRL 1 = US$ 0.32 US$ 1 = 3.10 FISCAL YEAR January 1 December 31 ABBREVIATIONS AND ACRONYMS AAA Analytical and Advisory Activities BCB Central Bank of Brazil BMF Brazilian Mercantile & Futures Exchange CAS Country Assistance Strategy CCP Central Clearing Counterpart CDI Interbank Deposit Certificates CEF Caixa Economica Federal CEM Country Economic Memorandum CIDE Gasoline Tax CFAA Country Financial Accountability Assessment CODEX Joint Committee Central Bank and National Treasury for External Debt Management COFINS Financing Contribution for Social Security COGEP Debt Management Middle Office at National Treasury CPMF Federal Tax on Financial Transactions CVM Brazil Securities and Exchange Commission DMC Debt Management Committee DRU De earmarking scheme of Federal Revenues FAT Workers' Support Fund FIF Fixed Income Funds FSAP Financial Sector Assessment Project GDP Gross Domestic Product IBOVESPA São Paulo stock Market Index ICMS Local Value­added Tax ICR Implementation Completion Report IMF International Monetary Fund LDO Budget Guidelines Law LFT Selic Indexed Paper LOA Annual Budget Law LOAS Social Assistance Organic Law LRF Law of Fiscal Responsibility LTN Straight Treasury Bills MPOG Ministry of Planning NTN Notes of the National Treasury PDC Public Debt Council PFRSAL II Second Programmatic Fiscal Reform Loan PEM Public Expenditure Management PFRSAL Programmatic Fiscal Reform Structural Adjustment Loan PGFN Ministry of Finance Legal Department PIS Social Integration Program PDC Public Debt Council PPA Multi-Annual Plan PSBR Public Sector Borrowing Requirement RJU Public Employees' Social Security System ROSC Report on Observance of Standards and Codes SELIC Special System of Custody and Settlement of Federal Securities SIMPLES Sistema Integrado de Pagamento de Impostos e Contribuições das Microempresas e das Empresas de Pequeno Porte SOF Federal Budget Secretariat SRF Federal Tax Revenue Office STN National Treasury TAL Technical Assistance Loan VAT Value-added tax Vice President: David de Ferranti Country Director Vinod Thomas Sector Manager Ernesto May Task Manager: Fernando Blanco BRAZIL 2ND PROGRAMMATIC FISCAL REFORM ADJUSTMENT LOAN CONTENTS Page No. 1. Project Data 1 2. Principal Performance Ratings 1 3. Assessment of Development Objective and Design, and of Quality at Entry 2 4. Achievement of Objective and Outputs 7 5. Major Factors Affecting Implementation and Outcome 24 6. Sustainability 25 7. Bank and Borrower Performance 26 8. Lessons Learned 30 9. Partner Comments 34 10. Additional Information Annex 1. Key Performance Indicators/Log Frame Matrix 35 Annex 2. Project Costs and Financing 37 Annex 3. Economic Costs and Benefits 37 Annex 4. Bank Inputs 37 Annex 5. Ratings for Achievement of Objectives/Outputs of Components 39 Annex 6. Ratings of Bank and Borrower Performance 40 Annex 7. List of Supporting Documents 41 Project ID: P070641 Project Name: 2ND PROGRAMMATIC FISCAL REFORM ADJUSTMENT LOAN Team Leader: Santiago Herrera TL Unit: PRMEP ICR Type: Core ICR Report Date: June 25, 2004 1. Project Data Name: 2ND PROGRAMMATIC FISCAL REFORM L/C/TF Number: FSLT-71790 ADJUSTMENT LOAN Country/Department: BRAZIL Region: Latin America and the Caribbean Region Sector/subsector: Central government administration (75%); Capital markets (15%); Sub-national government administration (10%) Theme: Public expenditure, financial management and procurement (P); Tax policy and administration (P); Debt management and fiscal substainability (P); Administrative and civil service reform (S); Other financial and private sector development (S) KEY DATES Original Revised/Actual PCD: 05/14/2003 Effective: 08/12/2003 08/12/2003 Appraisal: 05/05/2003 MTR: Approval: 06/12/2003 Closing: 12/31/2003 12/31/2003 Borrower/Implementing Agency: FEDERATIVE REPUBLIC OF BRAZIL/MINISTRY OF FINANCE AND MINISTRY OF PLANNING AND BUDGET Other Partners: STAFF Current At Appraisal Vice President: David de Ferranti David de Ferranti Country Director: Vinod Thomas Vinod Thomas Sector Director: Ernesto May Ernesto May Team Leader at ICR: Fernando Blanco Santiago Herrera and Yasuhiko Matsuda ICR Primary Author: Eliana Cardoso and Fernando Blanco 2. Principal Performance Ratings (HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HL=Highly Likely, L=Likely, UN=Unlikely, HUN=Highly Unlikely, HU=Highly Unsatisfactory, H=High, SU=Substantial, M=Modest, N=Negligible) Outcome: S Sustainability: L Institutional Development Impact: SU Bank Performance: S Borrower Performance: S QAG (if available) ICR Quality at Entry: S Project at Risk at Any Time: No 3. Assessment of Development Objective and Design, and of Quality at Entry 3.1 Original Objective: The Second Programmatic Fiscal Reform Loan (the PFRSAL II) formed part of a broader program of Bank support for Brazil's fiscal reform. The Fiscal and Administrative Reform Special Sector Adjustment Loan (the FARL, approved by the Board in March 2000) and the First Programmatic Fiscal Reform Loan (the PFRSAL I, approved by the Board in January 2001), preceded the PFRSAL II. The objective of the Bank's support for Brazil's fiscal reform is to reduce the country's remaining macroeconomic vulnerabilities and thus promote sustainable growth and poverty reduction. Bank support in this area is consistent with the CAS objective of supporting "improvements in fiscal institutions and public sector management for better fiscal performance and incentives for fiscal discipline."1 Policy dialogue with the authorities and analytical work have made a significant contribution to Bank support for fiscal reform. Emerging countries can achieve consistent poverty reduction through high rates of economic growth over extended periods of time and through improvements in income distribution. Growth and poverty reduction depend on stability. Stability requires strengthening fiscal and debt management, which in turn can have a positive impact on market confidence, and lead to a gradual reduction of interest rates, thereby benefiting growth. Moreover, stabilization is a necessary condition for improving income distribution, since inflation primarily affects the poor. The PRFSAL II supports the development of institutional mechanisms in order to ensure better fiscal management. Since 1999, Brazil has made substantial efforts to adjust its fiscal accounts. The idea that institutions definitely have a role to play has reinforced the use of legislation for improving fiscal performance. The country has moved in the direction of credible rules that govern the outcome of the budget process and procedures that contribute to providing incentives and constraints to promote fiscal discipline and increase transparency. The hallmarks of these measures include the Fiscal Responsibility Law and the impressive primary surplus targets achieved between 1999 and 2003. After the successful implementation of the FARL and the PFRSAL I, the PFRSAL II aimed specifically at promoting institutions for responsible fiscal policy and risk management and at reforms to reduce distortions in the tax system. Expected results by the end of the program in 2006 include: a fiscal framework consistent with an economy which is more resilient to shocks; a reduction of the net public debt/GDP ratio to around 50%; a reduction of the risks arising from the public debt composition; a reduction in the weight of distortionary cumulative-cascading in the federal tax structure; and the elimination of inefficient fiscal competition between the Brazilian states. The justification for this operation depended to a significant extent on its broader strategic role rather than on its specific conditionalities. The loan supported the government's macroeconomic policies in broader terms at a particularly critical time. Brazil's new administration was elected on a platform emphasizing economic growth, equity and - 2 - social inclusion. However, the opportunity to address long-standing social and economic issues coincided with an unusually adverse external environment and increasing doubts about Brazil's debt sustainability, which posed acute economic risks. President Lula's administration needed quickly to establish credibility credentials that would enable Brazil to improve its access to international financial markets. Faced initially with low investor confidence, currency depreciation, inflation and economic stagnation, the government chose to adopt tight fiscal and monetary policies to restore credibility and curb inflation. The results were impressive. Sovereign spreads fell from 2,400 basis points in October 2002 to below 500 basis points in December 2003. The exchange rate appreciated from R$ 3.60 to the US dollar to R$ 2.85 over the same period. Inflation and inflationary expectations have been brought into line with Central Bank targets. Finally, economic recovery signs began to appear during the fourth quarter of 2003 and were strongly confirmed in the first quarter of 2004. The new government assumed power amidst doubts about whether it could be able to conduct sound fiscal policy. The loan aimed to bolster confidence and to help consolidate the new government's early commitment to sound macroeconomic policies. This objective still appears to be highly relevant and the design of the operation is appropriate. The operation was strategically focused on a few key macro-fiscal and debt management issues that were critical to restoring Brazil's credibility in the financial markets. The outcomes in these areas were highly satisfactory. -------------------------------------- 1CAS, 6 March, 2000. Report No. 20160-BR, p.31 3.2 Revised Objective: The objective was not revised. 3.3 Original Components: The single-tranche programmatic reform loan had policy components under six main objective groups: (1) macro-fiscal planning; (2) subnational fiscal discipline; (3) fiscal transparency and fiscal risk management; (4) public debt management: governance and capacity; (5) public debt management: market development for government securities; and (6) tax reform. 1. Macro-fiscal planning Sound macro-fiscal policy within a context of high uncertainty is the key factor to restoring credibility. The overall objective was thus to reduce the uncertainty arising from the fiscal situation against a volatile external environment. The importance of macroeconomic stability for growth and poverty reduction is amply recognized. Volatility affects growth mainly through its effect on investment. In Brazil there is a close association between poverty and macroeconomic volatility. Thus, the adoption of sound macroeconomic policies is crucial for achieving the objectives of growth and poverty reduction. Over the past few years, the government has been developing a credible fiscal framework. The Loan supported the achievement of the primary surplus targets in 2001-02 and the adoption of annual primary surplus targets of 4.25% of GDP for 2004-2006 in the Budget Guidelines Law - 3 - (LDO) of 2004. Recent Brazilian experience confirms the relevance of macro-fiscal planning to restoring credibility. Since 1999, the primary surpluses targeted and obtained have served to dissipate doubts about Brazilian debt sustainability and to reduce perceived country risk. 2. Subnational fiscal discipline The overall objective was to maintain the fiscal effort undertaken by subnational governments and to promote more broad-based compliance with the Fiscal Responsibility Law (FRL) and associated legal norms as a way of reinforcing the institutionalization of responsible fiscal policies for the overall public sector. Over the past decade, the fiscal stance of subnational governments contributed decisively to the deterioration of public sector accounts and the ensuing uncertainty regarding fiscal sustainability. With the landmark FRL, Brazil has made great strides toward institutionalizing fiscal discipline at all levels of government. Results were immediate and impressive. Subnational governments have accompanied the adjustment efforts of the federal government to generate primary surpluses, which have in turn contributed to the overall improvement in Brazil's fiscal accounts and lessened debt sustainability-related uncertainty. The objective of strengthening the institutionalization of subnational fiscal discipline called for continuous support for the FRL and for further improvements to be made in this area. The PRFSAL II supported (i) the Senate Resolutions 40 and 43 regulating subnational indebtedness, as required by the FRL, (ii) the National Monetary Council Resolutions No 2827 and 2920 regulating the financial sector's credit supply to the public sector and (iii) the turnaround in subnational behavior represented by effective compliance with key provisions of the FRL. 3. Fiscal transparency and reporting and fiscal risk management The overall objective was to build on already robust government efforts to improve fiscal transparency as a way to bolster fiscal discipline and public sector accountability. Fiscal transparency is a key element of good macroeconomic management: it fosters the accountability of fiscal policy makers and can enhance fiscal management credibility . The Bank's 2002 Country Financial Accountability Assessment (CFAA) and the IMF's Fiscal Transparency Report on the Observance of Standards and Codes (ROSC) in 2001 rated Brazil's fiscal transparency as being of high quality. The government's recognition of contingent liabilities contributed to the 25% increase in federal debt from 1994 - 2001. To minimize unrecognized growth of contingent liabilities in the future the government formally adopted a method of discussing fiscal risks in an LDO Annex. Despite these improvements, there is still room for further progress regarding budgeting for the risk presented in the LDO Fiscal Risk Annex. The Loan supported (i) the issuance since 2001 of consolidated public sector accounts by the Union, all state governments and the majority of municipal governments; (ii) the incorporation of a substantial amount of previously unrecognized liabilities in the LDO Annex on fiscal risks and (iii) the initiation of fiscal statistics-reporting based - 4 - on IMF SDSS methodology. 4. Public debt management: governance and capacity The overall objective was to strengthen the governance structure needed for implementing the benchmark developed by the Middle Office of the National Treasury Secretariat's Debt Management Office. The centralization of the domestic debt functions already achieved in the STN is important for rendering debt managers accountable for public debt risk levels. The Brazilian government has implemented an agenda for the institutional reform of internal governance arrangements for federal public debt management and for strengthening the debt management capacities in the (STN). Considerable and steady progress has been achieved in building up the STN's debt management capacity. The STN currently publishes high-quality annual borrowing plans including portfolio benchmarks. It also produces internal medium-term strategy documents and monthly reports on the debt portfolio and STN operations. Improved governance is a necessary condition for implementing borrowing plans. In this respect, the government planned decisive action to clarify the roles of the agencies involved in debt management - the main objectives being to unify debt management operations at the STN and to develop a coordination mechanism between the STN and the Central Bank. The Loan supported (i) issuance of Annual Borrowing Plans; (ii) the consolidation of domestic debt issuance responsibilities under the STN; (iii) the strengthening of the analytical capacity of the Middle Office; and (iv) the completion of an exercise to map STN procedures for controlling debt management operational risks. The strengthening of STN debt management capacity and enhanced coordination between the STN and the Central Bank were responsible for the improvements in debt management as evidenced by the extension of debt maturity and the duration and improvement of debt composition, all of which alleviated debt vulnerability and helped to dispel doubts about debt sustainability. - 5 - 5. Public debt management: market development for government securities Besides developing a governance structure more suited to maintaining a long-term debt management strategy, the development of a market for government securities is another necessary condition for a successful debt management policy. Activities to complement the government debt market development objective would enable the risk from the government debt portfolio to be transferred prudently to market participants. Meeting this objective would necessarily call for improvements to be made in the structure and buoyancy of the end investor base and for a clear definition of fund types, together with an increased readiness by institutional investors to disclose and manage risk. The overall objective of this component was to develop a domestic market for different types of securities leading to the implementation of the associated benchmark (i.e., the possibility of issuing long-term securities, fixed rate nominal debt, etc.) The Loan supports (i) introducing the sale of public bonds through the internet; (ii) issuing regulations concerning new criteria for the selection of primary dealers and specialists; (iii) improving the methods for issuing government securities; (iv) transferring the regulation and supervision of collective investment schemes in fixed income securities and (v) establishing formal cooperation between the Central Bank and the Securities and Exchange Comission (CVM) on market regulation. 6. Tax reform Tax reform constitutes another critical area for sustaining fiscal adjustment and for eliminating the distortions affecting the Brazilian economy. Fiscal adjustment since 1999 has been based on revenue increases (the tax burden increased from 30% in 1999 to 34% in 2002). The main problem was that the increases were not the result of levying broad­based and efficient taxes, but from increases in the most distortionary tax instruments. In reality, increased indirect cascading taxes (called in Brazil Social Contributions as they finance social security and assistance) had a negative effect on the quality of the entire tax system and led to constraints on growth. Improvements in the quality of the tax system are needed in order to maintain the current fiscal effort without undermining the efficiency of the economy. It follows that tax reform is a step on the long road towards making the tax system more compatible with economic growth strategy as well as simultaneously safeguarding the sustainability of fiscal accounts. The Loan supported recent efforts to introduce changes in tax policy, including: (i) the transformation of the Contribuição para o Programa de Integração Social (PIS) turnover tax into a value added tax and (ii) the submission of a tax reform bill to Congress in April 2003. The main component of the tax reform bill embraced the `unification' of the ICMS (States' VAT) tax rates, conversion of the Contribuição para o Financiamento da Seguridade Social (COFINS) tax base from turnover to value-added and flexibility to set the CPMF tax rate at between 0.38% and 0.08%. 3.4 Revised Components: - 6 - N/A 3.5 Quality at Entry: The Quality at Entry of this operation was rated satisfactory, based on the following observations by the QAG Quality at Entry Assessment. The panel rated this operation as Satisfactory overall and in all its aspects, with the exception of Strategic Relevance -rated as Highly Satisfactory. This is a very important operation in a major client country. It shows the Bank in a very good light in terms of: (a) the Bank's ability to respond quickly to an emerging crisis with a well-designed operation, owing to good analytical work in the country program and the Bank's well-established dialogue with the Brazilian authorities; and (b) management's willingness to take calculated risks, with large potential pay-offs- i.e. averting economic and social collapse and seizing the moment to reinforce a new government's reforming zeal. Although the amount of the Loan ($404 million) is not large in relation to the Brazilian economy or to the Fund's Stand-By of $30 billion, the agreement reached between the Bank and Brazil (together with the Fund's program) sent out an invaluable signal to the financial markets. The operation proved to be very timely. It focused strategically on a limited number of fiscal and debt management issues critical to the stability and growth of the Brazilian economy and to restoring Brazil's credibility in the financial markets. While some of these areas are traditionally associated with the IMF, the Bank's presence in the operation added value by: (a) delving into subnational fiscal issues; (b) delving deeper into fiscal transparency and contingent liability issues; (c) bringing Bank debt management expertise, which is not available in the Fund; and (d) engaging the government in a dialogue on pensions. The technical quality of the analysis underpinning the reform recommendations is very high. The close working relationship with Brazilian officials in design and implementation is a further noteworthy feature. The country's new President, despite his campaign rhetoric, has emerged as a strong champion of reform. 4. Achievement of Objective and Outputs 4.1 Outcome/achievement of objective: While the achievement of objectives under the PRFSAL II was satisfactory overall (eg: highly satisfactory on macro-fiscal planning, debt management, subnational fiscal discipline and fiscal transparency and risk management components) the tax reform objectives were nevertheless not fully achieved. These ratings are based on the excellent performance of macro-fiscal policy, the substantial progress made on debt management, the consolidation of the institutional framework for subnational fiscal responsibility and continued improvement in the transparency of fiscal accounts. The sound fiscal policy adopted by the new government (elected in October 2002) has been the key element responsible for restoring Brazil's credibility. In the course of 2003, the new administration unequivocally confirmed its staunch commitment to fiscal discipline and debt sustainability. Fiscal tightening deepened with the higher primary surpluses achieved, together the rapid approval of the Social Security Reform for public sector employees. The latter will reduce - 7 - the pressure of the social security system deficit on federal, state and municipal accounts. The effects on market perceptions were strong and immediate, leading to a reversal of the pessimistic expectations regarding Brazil's debt sustainability. Spreads fell from 2,400 b.p in September 2002 to under 500 b.p in January 20042. The exchange rate appreciated from R$ 3.50 to R$ 2.85 (to one US$) over the same period. The restoration of credibility enabled the government to improve the public debt composition in terms of longer maturities and lower vulnerability to exchange rate and short-term interest rates, thereby making the Brazilian economy more resilient to adverse shocks. The efforts made by the authorities to reduce the volume of indexed debt have been particularly significant. Exchange indexed debt and the related BCB issues foreign exchange swaps have fallen from a peak of 41 % of total debt in September 2002 to 17 % as from May 2004. Interest rate indexation via the use of LFT has also been reduced and the issuance of LTN (plain vanilla non-indexed debt--or pre-fixed) has substantially increased. LFT have fallen from approximately 67 % of outstanding debt in April 2003 to around 57 % in May 2004. LTN increased from a low of 2% in April 2003 to over 16% in April 2004. To date, the policies in these areas have been well coordinated between the Central Bank and the STN, eg: the Central Bank has been reducing the outstanding foreign exchange swaps at the same time as the STN has ceased issuing exchange indexed bonds (together with the BCB). As for interest rate indexed debt, the STN and the Central Bank have been coordinating a plan to reduce the proportion of total debt taking the form of LFT as established in the STN Annual Borrowing Plan for 2004. The only area where coordination continues to be complicated concerns monetary policy and debt issuance, where slippage could occur. The tight fiscal policy enabled monetary policy to be eased in line with the marked reduction in inflation and inflationary expectations. After raising the interest rate to 26.5%, the Central Bank began a process of interest rate cuts. In April 2004 the interest rate was down to 16% and further reductions are likely as inflation prospects improve. Consolidating the institutional framework in order to improve fiscal discipline also contributed to the objective of reducing uncertainty regarding the administration's fiscal policy stance. The strict observance of the Fiscal Responsibility Law, respect for the 1997 debt renegotiation contracts and the National Monetary Council resolutions ensured that subnational governments made a positive contribution to the overall public sector fiscal adjustment effort. Despite the negative impact of economic stagnation on fiscal revenues, state and municipal primary surpluses increased overall from 0.8% of GDP to 0.9% of GDP. The primary surplus of the states increased from 0.64% to 0.78% while the municipal primary surplus decreased from 0.15% to 0.13%. The number of individual states with negative results has tended to decrease over the past few years. 10 states generated primary deficits in 2000, 7 in 2001, 3 in 2002 and only 1 state generated a negative primary balance in 2003. The Brazilian government has continued to improve the transparency of fiscal accounts and to - 8 - broaden the coverage of fiscal risks affecting government accounts. Since the introduction of the Fiscal Responsibility Law in 2000, Brazil has continuously improved the quality of its fiscal accounts information, reducing reporting delays and expanding the number of government entities (especially municipalities) that send fiscal reports for inclusion in the consolidated public accounts. Progress has also been made in the standardization of norms and accounting procedures used in the reports of fiscal management and budget execution by the federal, state and municipal governments. In the tax reform area, the quality of achievements is more debatable. The uncertainty surrounding the effect of tax reform on revenues in a tough fiscal adjustment environment and the complex federal fiscal structure effectively restricted the breadth and depth of the reform. The Loan achieved limited progress towards reducing distortions inherent in the tax system. The government failed to maintain the single main component of the tax reform bill submitted to Congress - the unification of the ICMS (States' VAT) rates. On the other hand, converting the COFINS into a value added tax could be considered a positive achievement since, given the importance of COFINS to the federal tax revenue, this will reduce the amount of indirect cumulative taxes in the overall tax burden. In fact, the share of cumulative tax in the federal revenue fell from 28% in 2002/03 to 12% in May 2004. Nevertheless, problems of rate calibration and definition of the rules governing its application to specific sectors and to imports need to be appropriately resolved in order to produce the full benefits of this change and to avoid increasing the tax burden. Other measures approved concerned tax relief for exports and capital goods, the CIDE revenue-sharing arrangement, further simplification of small businesses taxation, the eventual partial replacement of payroll taxes with turnover taxes, extensions to the DRU, the CPMF and the Manaus Free Zone. While the extensions of the DRU and the CPMF up to 2007 were indispensable for meeting current primary balance targets, they cannot be considered genuine structural reform measures. ------------------------------------------------- 2Since February 2004, external volatility fostered by worries of US interest rate increases and rising oil prices, increased spreads to the 600-700 b.p level. Exchange rate depreciated to R$ 3.10 per dollar. 4.2 Outputs by components: Expected versus actual outcomes in each component are recorded below and summarized in Table 1. (1) Macro-fiscal planning Under the program supported by the PRFSAL II, the Brazilian government aimed to ensure public debt sustainability, to attenuate uncertainty regarding its future stance on fiscal policy and to reduce the pro-cyclical bias of fiscal policy. Achieving these objectives was intended to ensure the reduction of country risk. So far in 2003, the government has continued to use the primary surplus as a device to assure Brazil's credibility in financial markets and to guarantee the sustainability of public debt. The new - 9 - administration has repeatedly demonstrated its commitment to fiscal discipline by announcing and achieving high primary surpluses. In February 2003, in order to accelerate the reduction of the debt-to-GDP ratio and to show commitment to debt sustainability, the government announced an increase in the primary balance target for 2003 to 4.25% of GDP, higher than the 3.9% of GDP which had been agreed in the September 2002 Stand-By Arrangement with the IMF. In April 2003, the 2004-2006 Budgetary Guidelines Law (LDO) was submitted to Congress, formalizing the primary surplus target of 4.25% of GDP for this three-year period. The Congress approved the LDO and ratified the primary surplus of 4.25% of GDP, thereby demonstrating the broad commitment of Brazilian society and political actors to responsible fiscal policies. The primary surplus for 2003 was even higher - 4.37% of GDP. The intermediate quarterly targets were also reached, thus successfully completing seven reviews up to May 2004 in accordance with the IMF Stand-By Arrangement. The aftermath of the 2002 crisis and the high interest rates employed to reduce inflationary pressures in the first semester of 2003 resulted in negative growth in 2003 and in higher debt to GDP ratio. Despite the substantial primary surplus obtained in 2003, net public debt grew from 55.5% of GDP in December 2002 to 58.7% of GDP in December 20033. In 2004, the tight fiscal stance continued. Monthly primary surpluses reached consecutive record levels and by April the accumulated fiscal results already complied with the IMF targets set for the first semester of 2004 (up to May primary surplus achieved 5.9% of GDP). The interest rate reduction since the third quarter of 2003 and the recovery of economic activity during the last quarter of 2003 and first quarter of 2004 guaranteed a reduction to 56.6%. of the net public debt to GDP ratio. The continued trend towards decreasing interest rates and the better prospects for growth should favor the government primary accounts effort to reduce debt to GDP ratio. In April 2004, the government submitted the LDO for 2005-07, renewing the primary surplus target of 4.25% for the period with the aim of ensuring the continuity of the administration's responsible fiscal stance. Regarding the reduction of the pro-cyclical bias of fiscal policy, the government has begun to analyze the viability and adequacy of fiscal rules to reduce the pro-cyclical bias of fiscal policy. Internal discussion papers circulated in the National Treasury, Central Bank and Planning Ministry present the options for counter-cyclical fiscal devices while preserving the primary surplus target of 4.25% of GDP. In view of the negative reaction of the financial markets, which could interpret it as a sign of fiscal laxity, the government will continue to study implementation of the rules for some time in the future. The sound macro- fiscal policy was, and continues to be, the main factor responsible for the impressive improvement of market sentiment with regard to the sustainability of the Brazilian economy. Spreads fell from 2,400 b.p in September 2002 to under 500 b.p in January 2004. In 2003, the exchange rate improved from 3.54 R$/US$ to 2.85 R$/US$ and the - 10 - stock market index (IBOVESPA) appreciated by 90%. The reduction of country risk enabled the government and private sector to reestablish access to the international credit market. The tight fiscal policy also contributed to the success of the anti-inflationary monetary policy. The monthly inflation rate fell from 2.8% in December 2004 to an average of 0.4% in the second half of 2003. In addition, the realignment of inflationary expectations to the Central Bank target zone heralded a substantial reduction of the interest rate from 26.5% in February 2003 to 16% in April 2004. The downward trend of future interest rates should result from the better prospects regarding inflation and the increased confidence in the continuity of the government's responsible fiscal stance. (2) Subnational fiscal discipline The consolidation of the institutional framework for fiscal discipline at the subnational government level ensured the adoption of prudent fiscal stances by states and municipalities in accordance with the federal government's fiscal adjustment effort. As a result of the tight fiscal stance of the subnational governments and the reduction of macroeconomic volatility, the Fiscal Responsibility Law key indicators improved in 2003. Net consolidated debt to net current revenue of Brazilian state governments decreased from 1.95 in 2002 to 1.79 in 2003. The number of individual state governments with the ratio above the FRL ceiling of 2.0 was stable in 8 of the 27 Brazilian states. However, the net consolidated debt to net current revenue ratio fell in 6 of the 8 states that are above the FRL ceiling and this indicator decreased in 19 of the 27 states. The other key FRL indicator - personnel expenditures to net current revenue ratio - slightly improved on average, decreasing from 45.5% to 45.3%. Nevertheless, the number of individual state governments above the LRF ceiling on personnel expenditures increased from 3 to 44. Given the credit supply constraints imposed by the National Monetary Council in accordance with resolutions 2827 (March 2001), 2920 (December 2001), 3049 (November 2002), and subsequent resolutions 2954, 3049 and 3153 - all issued in 2003 - credit operations to net current revenue ratios continued to remain well below the 16% FRL ceiling In 2002, this indicator was 2.6% for state governments. Preliminary figures for 2003 show an even lower indicator. Figure 1 - 11 - State LRF Compliance 2002-03 Personnel Expenditures* Debt to Net Current Revenue (NCR) Ratio to NCR Ratio (Cannot Exceed 2.00) (Cannot Exceed 49%) State 2002 2003 2002 2003 MS 3.10 2.67 2.67 35.0 37.5 RS 2.79 2.63 2.63 48.8 48.7 MG 2.63 2.43 2.43 61.7 57.7 GO 2.77 2.40 2.40 43.8 45.2 AL 2.36 2.26 2.26 46.9 48.3 SP 2.27 2.24 2.24 48.0 46.5 MA 2.73 2.23 2.23 40.8 47.0 RJ 2.35 2.03 2.03 37.6 39.3 SC 1.95 1.69 1.69 49.4 44.1 PI 1.64 1.68 1.68 48.5 52.5 BA 1.82 1.63 1.63 41.6 44.2 PE 1.25 1.19 1.19 47.0 46.5 PB 1.42 1.17 1.17 48.2 52.6 RO 0.79 1.14 1.14 31.2 38.0 CE 1.18 1.09 1.09 39.4 41.8 ES 1.16 0.97 0.97 41.5 36.7 PR 1.24 0.97 0.97 44.5 46.2 MT 1.59 0.87 0.87 36.7 37.4 SE 0.73 0.70 0.70 46.1 47.5 AC 0.73 0.68 0.68 45.1 49.0 PA 0.67 0.61 0.61 43.1 45.0 RN 0.65 0.53 0.49 0.53 49.0 48.2 AM 0.67 0.36 0.49 39.9 40.7 DF 0.40 0.26 0.36 32.4 33.6 AP 0.09 0.26 0.26 35.7 37.2 TO 0.28 -0.01 0.26 39.9 40.7 RR 0.35 1.79 -0.01 31.2 25.0 AVERAGE 1.95 1.79 45.5 45.3 * Executive Branch - Source STN Web Site In 2003, the 1997 debt renegotiation contracts were strictly observed in terms of the achievements of the fiscal targets established in the Fiscal Adjustment Programs, agreed between each of the 25 states and the National Treasury (STN), and in terms of honoring the debt service obligations of states with the National Treasury and other creditors. The National Treasury continued to follow-up closely the public finances of state governments, with regular technical missions dispatched to verify their specific multi- annual fiscal adjustment programs - subject to annual review as mandated by Law 9496/97. These checks include verification of targets achieved and the definition of new targets and actions that the state should take over the subsequent three years. The increased aggregate primary surpluses for states and municipalities reflect strict compliance with the fiscal programs, as established under the 1997 debt renegotiation agreements. The number of individual states generating primary deficits decreased from seven in 2001 to three in 2002 and to only one in 2003. As a result, states are regularly meeting their debt service obligations to the National Treasury and the latter continues to apply penalties to any states that fail to comply. In January 2003, for example, constitutional federal transfers were blocked when the state of Rio de Janeiro failed to meet its debt obligations. That state responded by restarting its scheduled payments. - 12 - The technical assistance made available to subnational governments, especially to municipalities, also contributed to good fiscal performance in terms of the quality of the fiscal information that they are obligated to submit. The National Treasury provides technical support as required to the different units of government on the basis of an electronic registration system at the STN site. This ongoing technical support has substantially reduced reporting delays over the past few years. The number of subnational entities that now send reports in accordance with STN norms has also continued to increase. Further improvements would result from the establishment of a Fiscal Management Council ( Conselho de Gestão Fiscal). This Council would be required (under the provisions of the FRL) to develop a set of uniform standards for elaborating subnational Budgetary Guidelines (LDOs). Operational problems, together with the lack of an appropriate institutional mechanism to represent the 5,500 municipalities, have delayed this initiative. The federal government is now concerned with redefining the organizational structure of the Council. Meanwhile, the National Treasury continues to define accounting rules, as required to do so by the FRL. (3) Fiscal transparency and risk management Under the PRFSAL II, improved transparency of public accounts and the inclusion of a broader set of budgetary risks that affect the government balance sheet and fiscal situation are objectives, which enhance fiscal discipline and public sector accountability and strengthen the credibility of fiscal management. In 2003, the Brazilian government continued to improve both (i) transparency and (ii) the risk management of fiscal accounts. As regards (i), the Budget Guidelines Law (LDO) for 2005-2007 submitted to Congress in April 2004, complies with the Fiscal Responsibility Law requirement to include separate annexes setting out the actuarial projections of the public employees' Social Security System (RJU) and projected benefits under the Social Assistance Organic Law (LOAS), together with details of fiscal benefits awarded by the government and the financial position of the Workers' Support Fund (FAT). As for (ii), the quality of the LDO fiscal risk annex has improved marginally with the inclusion of an increasing number of fiscal risks. Better integration between the Fiscal Risk Annex of the LDO and the Annual Budget Law, through the creation of a contingency fund to reflect the fiscal risks identified, was not however possible because this would lead to a further increase in budget rigidity (already high). Notwithstanding the detailed description of the risks impinging on public debt and the estimated effects of exchange rate and interest rate movements on debt, the debt-related risk indicators displayed in the National Treasury Annual Borrowing Plan are not yet part of the LDO Fiscal Risk Annex. (4) Debt management: governance and capacity Under the PRFSAL II, the main objectives of the debt management component were to reduce - 13 - the exposure of public debt to exchange rate, interest rate and rollover risk. The Brazilian government's performance on debt management was highly satisfactory. The authorities have taken advantage of the improved macroeconomic scenario to make substantial progress in the debt composition. The efforts made by the authorities to reduce the volume of indexed debt have been particularly significant. Exchange indexed debt and the related BCB issues foreign exchange swaps have fallen from a peak of 41% of total debt in September 2002 to 17 % as from May 2004. Interest rate indexation via the use of LFT has also been marginally reduced and the issuance of LTN (plain vanilla non-indexed debt--or pre-fixed) has substantially increased. LFT have fallen from approximately 67 % of outstanding debt in April 2003 to around 57 % in May 2004. LTN increased from a low of 2% in April 2003 to over 16% in May 2004. Some of the achievements can be explained by the progress made in the public debt management governance and capacity areas that were implemented following the PRFSAL I and strengthened during the PRFSAL II. Over the past 4 years the government has developed an agenda for institutional reform of the internal governance arrangements for federal public debt management and for strengthening debt management capacities in the STN. Considerable and steady progress has been achieved in building up the STN's debt management capacities. The creation of the Middle Office, the regular release of high quality reports on the debt portfolio and STN operations, the publication of Annual Borrowing Plans and the upgrading of the information technology system were the most important accomplishments supported by the Bank through the PRFSAL I and PRFSAL II. In 2003, the STN complied satisfactorily with the short-term developmental actions proposed in the policy matrix. The project achieved its stated objectives, which were to: (i) improve Treasury governance arrangements, (ii) review the procedure for formulating debt management strategies, and (iii) create a mechanism for verifying compliance with operational risk. The Middle Office (COGEP) prepared the documentation required for establishing the Public Debt Committee (PDC) and the Debt Management Council (DMC). This was subsequently reviewed and approved by the Ministry of Finance Legal Department (PGFN) in April 2004. The draft decree concerning the PDC requires clearance by the Ministry before it is submitted to the President's Office for final approval. The whole process could take up to one month. The creation of the PDC and DMC will help to institutionalize the decision-making process, to encourage closer involvement by senior officials and to ensure the long-term continuity and consistency of the debt management process. An agreement signed by the BCB and STN defining procedures for transferring the management of the marketable external debt to STN was published in the Official Gazette in January 2004. The agreement includes details of the modus operandi for the transitional phase and sets the end of 2004 as the deadline for completion of the transfer. The document also provides for the creation of a Joint Committee (CODEX) to comprise two members from each entity. This committee will be responsible for strategic decisions during the transition period, and will work to a detailed timeline for the staff and file transfer from the BCB to STN. As for capacity building, the Middle Office continued work on the formulation of a long-term - 14 - strategy resilient enough to apply to a range of different scenarios and resist major periodic changes. Various macro-structural and financial models (the latter based on stochastic analysis) are being tested to ensure that different approaches do not result in widely divergent benchmarks. It is estimated that the benchmark and the long-term borrowing plan will be completed within 2-4 months, and that approval will take a further 6 months. The PDC will be responsible for approving the benchmark, the long-term borrowing plan and the Annual Borrowing Plan, ensuring that the Annual Borrowing Plan is consistent with the benchmark and the debt management objectives. In the event of a major shift in the macroeconomic or market situation warranting a change in the debt management strategy, the Debt Management Committee will study the merits of such a change and recommend the PDC to approve the change. The establishment of the PDC and the formal approval procedure for long-term borrowing strategy will enhance control over the strategy and render the policy less susceptible to speculative changes in response to short-term movements in the macro/market scenario. Finally, the STN prepared a pilot project to create a unit to oversee operational risk in the Debt Management Office. This project was approved as part of the Treasury semiannual plan. Consultants employed to advise on the establishment of the new unit submitted a business plan in February 2004. The new unit has not yet been awarded formal status but it is already staffed and initially tasked with reviewing the auction process. Formal recognition will depend on the evaluation of the pilot program. This will be implemented throughout the Treasury, if approved. (5) Debt Management: Debt Market Development The efforts to improve the governance structure were complemented by a set of measures focused on developing the local market for government securities. In 2003, initiatives undertaken by the authorities in this area enhanced the efficiency of public debt markets and contributed to better debt composition. The measures apply to three areas: (i) further refinement/development of the mechanism for issuing securities by the STN that was introduced with the regular issuance of Treasury Bills (LTN), (ii) improvement in the size and diversity of the end investor base by expanding the Treasury Direct program and (iii) regulation of the collective investment schemes and measures aimed at increasing liquidity in the public debt secondary market. In (i) above, the strategy of reducing debt linked to exchange and interest rates benefited from issuance of Treasury Bills (LTN) and Treasury Notes (NTN-F), both fixed rate bonds, as a first step towards developing a medium term domestic debt issuance program. Efforts have been made via buy- backs, exchange offers and re-openings successfully to develop liquid T-bill benchmarks at the short end of the yield curve. These nominally pre-fixed instruments now account for around 14% of the outstanding stock. At present, the LTN (due in January 05) is one of the more liquid benchmarks where average trading volume in May 2004 has been about US$ 1.8 billion with a bid ask spread of 16.7 b.p . While the authorities have done much to institute a regular T-bill program - publishing an auction calendar, defining benchmarks, etc - the program is still overly susceptible to external shocks. The - 15 - efforts by the STN and the Central Bank to coordinate the primary issuance of the STN and the open market operations of the Central Bank will be vital for ensuring that the operations can be managed in a way that will not undermine the targets contained in the STN Annual Borrowing Plan. In the event of coordination problems a procedure is now being implemented to provide opportunities for submitting differences of approach regarding issuance coordination to high levels within the government. Ensuring proper coordination between the BCB and STN with respect to the use of LTNs, together with the further development of repurchase agreements as a true monetary policy instrument, are both keys to the short and medium term development of a vigorous T-bill program. As regards (ii) broadening the end investor base, the authorities have succeeded in expanding the Treasury Direct system. Public awareness of the program was raised through a radio/newspaper/flyer campaign. This increased the number of investors to 25,024 by May 2004. Although falling short of the target of 50,000 registered investors, it nevertheless represents a boost to investor numbers (from 2,400 in January 2002). Accumulated investments through Treasury Direct now exceed R$ 500 million, with each transaction averaging approximately R$ 9,000. The government also has taken action to increase the size of the end- investor base by improving regulation of collective investment schemes. The authorities have submitted for comment a general instruction concerning a range of open and closed collective investment schemes covering different types of fixed income funds5. This regulation enhances the fixed income fund schemes (FIFs) issued by the Central Bank and approximately 40 types of funds under the aegis of the National Association of Investment Banks (ANBID). This new regulation makes a clear distinction between 9 types of collective investment funds. The regulations improve protection for all investors in such funds, including small retail investors (a significant concern at the end of 2002). In order to reduce the widespread predominance of "collective investment funds" through the use of exclusive and other funds by corporations, pension funds (and even insurance funds) as a tax avoidance device, the authorities have issued regulations creating "investment accounts" that will come into force in October. These accounts will ensure that individuals and companies pay the CPMF tax only once - at the time of purchasing an investment and not when transferring or re-allocating the portfolio. In this way, economic agents will have less incentive to invest through exclusive funds, and a start can be made to rectify the current imbalance where some 50% of Brazilian local debt is rolled over through the use of a variety of collective investment funds. In addition, the Securities and Exchange Comission (CVM) has taken a number of initiatives to improve protection for investors in government or private securities. These initiatives are included in the new instruction on collective investment schemes, which is designed to improve the disclosures made by fund administrators eg: subjecting them to daily disclosure of the value of all units (or quotas under Brazilian law) in different types of funds. Initiatives taken by the CVM to ensure proper disclosure of investment policies by fund administrators, thereby enhancing the rights of quota holders, are a significant step in the right direction. Finally, implementation of a new off-site surveillance system to allow better monitoring and compliance with the new regulations will be put in place over the coming months. This will be play a major role in bolstering credible enforcement of the above-mentioned instruction on collective investment - 16 - schemes. Progress in the area of valuation has not been significant. The authorities appear to have decided to eschew changes for the time being even in the mark- to-market methodology. Repurchase agreements or short-term assets are currently still not subject to true mark- to-market accounting - even in the case of holdings by mutual funds. Furthermore, there still no uniform method for valuation in reference to like instruments. Although these drawbacks remain, the authorities have started to make improvements with the issuance of instructions 365, 375 and 405. The latter of these instructions obliges all fund administrators to disclose the portfolios in their funds (including exclusive funds) and the value of the units therein. An important private initiative involving the roll-out of the Sisbex trading system and its central clearing counterpart (CCP) being offered by BMF for all government securities and related RPs traded could lead to more transparency on the prices front, better registration of OTC trading and more accurate pricing of such contracts ­ affording improved valuations of such transactions. These initiatives, together with the proposed introduction of even better systems for monitoring designated specialists in securities (tracking impact rather than simply volume- traded costs), can be expected to have an important impact on the secondary market liquidity of government securities and on repurchase agreements. To increase liquidity in public debt markets, the STN and BCB established (in March 2003) a two-tier primary dealer regime, introducing "specialists" and primary dealers in the government debt market. The primary dealer system was set up with the twin-objective of ensuring minimum stable demand in the primary market and to support liquidity in the secondary market for government debt. To achieve these objectives, the specialist and primary dealers were given well-defined roles in the market on the basis of a combination of rights and obligations focusing on secondary and primary market activities respectively. The authorities have established a framework to assess the performance of primary and specialist dealers. Performance evaluations of the individual participants as well as of the effectiveness of the regime as a whole have inspired a number of changes in the regulations with a view to enhancing the impact of the regime on both the primary and secondary markets. The authorities have progressed quicker than foreseen at the time of the loan and have now implemented all their short and medium term policies in this area. Finally, it is important to note that when the Loan was being negotiated the authorities were recommended to work together formally to address some of the critical issues related to debt management governance and debt market development. Progress is being made, but the speed of implementation and the overall design of the reforms could be undermined by the continued lack of cooperation over the reforms at the working level. The reactivation of the capital markets group that now meets weekly at very senior level points to better review and inter-agency coordination and could well be an excellent vehicle for meeting the need for coordination identified during the process of policy formulation. (6) Tax Reform The objective to reduce the distortions inherent in the tax system by rationalizing subnational - 17 - value-add taxation and reducing cumulative indirect taxes was not satisfactorily achieved. After an intensive period of negotiation initiated during the first half of 2003, the Chamber of Deputies approved in September 2003 a watered-down version of the original bill submitted by the government to Congress in April 2003. In December 2003, as the result of a political agreement between the federal government, the Senate and the state governors, it was decided to split the reform proposal into two sections. The less controversial section was approved by the Senate and promulgated in mid-December. The most difficult and important measures, including the complex question of renewal of the ICMS, were left to a second phase. In view of the looming difficulties, the whole subject was split into separate `modules', to be phased in over a period of up to four years, thereby providing an opportunity for postponing decisions on controversial details: (i) unification of the ICMS would not materialize until 2005; (ii) the number of permitted tax rates would be reduced to five; (iii) the Senate would fix the rates and then attempt to obtain the agreement by the states on how the rates should be applied to goods and services; (iv) in the first year of the next presidential term ( 2007) the ICMS would be replaced by a broad-based national value-added tax, with the rate to be defined in the future. The second part of the reform, basically predicating a complete overhaul of the ICMS and its eventual transformation into a broad-based VAT, was approved by the Senate in December 2003, but this has yet to be ratified by the Chamber of Deputies. The conversion of the Contribuição para o Financiamento da Seguridade Social (COFINS) into a non-cumulative tax was the most notable result of over 8 months of intense negotiations on tax-reform. The new COFINS legislation permits tax payers to use credits from previous transactions in the supply chain, thus transforming the actual tax base from turnover to value-added. The government in effect applied to the COFINS the same solution already adopted at the end of 2002 by the Cardoso Administration with another cascading tax, the Programa de Integração Social (PIS), which was also converted into a non-cumulative tax. The conversion of the COFINS tax base to value added was a positive achievement. Given the importance of COFINS, its conversion reduced the share revenues of cumulative taxes on total federal tax revenue from 28% in 2002 and 2003 to 12% in May 2004. However, establishing the new rate generated harsh criticism. In order for the government to retain the same revenue, the previously applied 3 % rate was raised to 7.6 %. Since announcement of the new rate, questions have been raised as to whether 7.6 % would increase the COFINS tax burden. It is noteworthy that the COFINS nominal revenue in April 2004 was 21.25 % higher than the value collected in April 2003, which would appear to provide evidence of a calibration error. There has also been considerable outcry over the inclusion of imports in the tax base of both the PIS and the COFINS. For many years the concept was favored by the domestic manufacturing industry, which alleged that it was unfair to impose the two taxes on domestically-produced goods and services but not on competing imports. Now that Congress has finally voted the new arrangements, many industrialists are not convinced that it was a good idea. Higher costs of imported parts and intermediary goods could lead to an ill-timed combination of squeezed margins and shrinking sales. Other approved measures involved tax relief for exports and capital goods, the CIDE revenue-sharing arrangement, further simplification of the taxation on small businesses - 18 - (SIMPLES), the eventual partial replacement of payroll taxes with turnover taxes and extensions of the DRU, the CPMF and the Manaus Free Zone. The extensions of the DRU and the CPMF up to 2007 had become indispensable. Without this important revenue the current primary-balance targets would not be feasible. The extensions have undoubtedly given some leeway to the government's fiscal policy, and the DRU/CPMF have once again proved invaluable for keeping public indebtedness on a sustainable path. From a broader perspective, however, these measures cannot be considered structural improvements to the tax system. Conversely, they highlight the urgent need for deeper fiscal reform. Finally, the objective of increasing the progressive nature of the tax system was postponed, since the Senate did not approve of measures that could be grouped under the "taxing the rich" heading. Table 1: Summary of Goals and Actual Outcomes Program Area ­ Goals Outcomes in 2003/04 Macro-fiscal planning · Ensure public debt sustainability · Debt to GDP ratio of 55.5% in December 2002, 58.7% · Reduce uncertainty regarding future stance of fiscal in December 2003 and 56.6% percent to GDP in April policy. 2004 with a declining trend. · Reduce pro-cyclical bias of fiscal policy. · Primary balance surplus of 3.9 percent of GDP in · Reduce perceived country risk. 2002, 4.37 percent of GDP in 2003 and 5.9 percent of GDP up to May 2004. Primary surplus targets of 4.25 for 2004-2006. · Government produced a proposal for the adoption of counter-cyclical fiscal policy rules to be implemented in 2005. Market reactions postponed their implementation. · Country risk fell from 1,400 b.p in January 2003 to around 700 b.p in May 2004. Sub-national fiscal discipline · Ensure that all governments in the federation maintain · Aggregate Debt to Net Current Revenue Ratio for states prudent fiscal policies. fell from 1.94% in 2003 to 1.78% in 20036. · Prevent future bailouts of sub-nationals by the federal · Number of states exceeding the debt ­to-net revenue government. ratio ceilings of the FRL, was maintained but ratio fell for the states above the FRL ceiling. · Contracts under the Law 9496/97 of debt renegotiation were strictly observed. Fiscal transparency and risk management · Improve accountability for fiscal management. · Continuous improvement of the quality of the Fiscal · Raise awareness of risks in fiscal process. Risk Annex of the LDO with the incorporation of new risk factors and their better treatment. · Debt risk indicators in Fiscal Risk Annex of LDO were not yet included. Public debt management: Governance and capacity - 19 - · Reduce exposure of public debt to interest, refinancing · Share of public debt linked to short term interest rate and exchange rate risk. fell from 67% in April 2003 to 57% in May 2004. Share · Increase transparency and accountability in the of debt linked to exchange rate fell from 40% to 17%. management of government debt. Fixed instruments (LTN) share increased from 2% in · Reduce operational risk in debt management April 2003 to 16% in May 2004. · The Middle Office at STN prepared the documentation required for establishing the Public Debt Committee (PDC) and the Debt Management Council (DMC). Expected approval in October 2004. · Agreement signed by the BCB and STN defining procedures for transferring the management of the marketable external debt to STN until 2005. · Benchmark and the long-term borrowing plan will be completed by the end of 2004. · STN prepared a pilot project to create a unit to oversee operational risk in the Debt Management Office. Public debt management: Market development for government securities · Broaden access of retail investors to government · Number of participants in the Treasury Direct rose securities. from 2,400 in January 2002 to 25,000 in May 2004. · Diversify investor base to reduce costs, and mitigate Accumulated investment of R$ 500 million. risks related to concentration of debt holdings. · The Brazilian authorities issued an overall instruction · Increase spot trading (liquidity) in the secondary to be reviewed by agents dealing with various forms of markets closed and open collective investment schemes that · Improve competition in the markets for government includes various categories of fixed income funds. securities. Expected approval in June 2004. · Develop a yield curve in benchmark government · LTN Jan 05 is one of the more liquid benchmarks. securities. Average trade of R$ 1,8 billion with a bid ask spread of · Increase efficiency of the primary and secondary 16.7 b.p. market for government securities. · The STN and BCB established in March 2003 a · Increase transparency and predictability of government two-tier primary dealer regime, introducing "specialists" securities issuance. and primary dealers to improve efficiency in the · Strengthen the final investor base. government debt market. · Increase resilience of the economy to interest rate · The overall instruction for collective investment shocks. schemes (see above) improves the disclosures provided by fund administrators and also will force the disclosure daily of the value of all units of various types of funds. · Low progress on the valuation of similar government securities used across different collective investment schemes. Tax reform · Reduce allocative distortions by eliminating · Conversion of the COFINS (most important cumulative geographical competition based on taxes and reducing tax) into a non-cumulative tax. Share of cumulative taxes different effects of taxation among firms in federal tax revenue fell from 28% in 2002 and 2003 to · Improve sub-national revenue collection 12% in April/May 2004. · Improve equity of tax system. · ICMS unifications and simplification postponed to · Reduce labor costs and incentives for informal 2005. employment · Enhancing-progressivity measures contained in the government proposal Bill were rejected by Congress. - 20 - -------------------------------- 3In October 2002 debt to GDP ratio reached 63%. For the 3.2% increase in debt to GDP ratio in 2003, interest payments contributed with 9.3% and the negative growth effect with 1.2 % for the increase in debt to GDP ratio. In the opposite direction (Conversely), primary surpluses reduced debt to GDP ratio by 4.3 % and exchange rate appreciation by 3 %. (Central Bank, Fiscal Policy Press Release, April 2004). 4Data for Year 2003 expenditure on personnel by the consolidated government branches (Executive, Legislative and Judiciary) is not yet available. For the purposes of this report, the figure for the Executive Branch is used ­limited to under 49% by the FRL. 5The deadline for comments expired in April 2004 and a new final instruction should be issued before the end of May 2004. 6Municipal data for 2003 is not yet available. 4.3 Net Present Value/Economic rate of return: N.A. 4.4 Financial rate of return: N.A. 4.5 Institutional development impact: Most importantly, the Loan has supported the continuing consolidation and institutionalization of sound fiscal policies in Brazil. The clearest evidence of this was the continuation of such policies across Brazil's political spectrum during a period of government transition. President Luiz Inácio Lula da Silva's election victory represented a significant shift within the Brazilian political system. While President Lula's administration won the election on a platform emphasizing increased social equity and faster growth, it assumed power in the midst of growing market uncertainty about his commitment to fiscal responsibility. In addition to political uncertainty, the market was concerned about Brazil's external financing requirements, high domestic debt and inflationary pressures. In the course of 2003, the new government successfully passed a very difficult credibility test by deepening responsible fiscal policy and maintaining the inflation targeting and floating exchange rate regimes introduced by the previous administration. Acknowledging that neither sustainable growth nor lasting social progress is possible without deep reforms, the new government began to construct the political and social support needed for such reforms. The establishment of the Council for Economic and Social Development (to discuss reforms with civil society organizations), the President's periodic meetings with the 27 state governors and the participatory nature of the drafting of the Multi-Annual Plan (PPA/Plano Plurianual), allowed the government to build consensus and support in Congress and among the general public for a negotiated broad agenda of reforms for 2003. The PFRSAL II is one of the Bank's programmatic loans, which will be continued in the future. Given the long-term nature of institutional development, it would be premature to consider the Loan's final impact. But the evidence of improved fiscal responsibility at the federal and subnational levels, together with improved transparency, is encouraging. In the debt management - 21 - area the project improved Treasury governance arrangements. Better institutional coordination between the Treasury and Central Bank was an important factor favoring the improvement in public debt composition. The agreement for transferring the management of external debt from the Central Bank to the Treasury is another important institutional development in the area of public debt management. On the other hand, the launching of the tax reform process in a tough fiscal environment at all levels of government brought into sharp relief the complexities of Brazil's complex federal fiscal structure. State governors perceived the tax reform as an opportunity to slacken the tight fiscal restrictions they faced. With the simultaneous negotiation of social security and tax reforms, the governors' bargaining power seemed to be on the rise. As a consequence, discussions were dominated by proposals of changes in revenue-sharing rules to give states and municipalities a more generous share of aggregate tax revenue, relegating the discussions on the improvement of the tax system to second place. 5. Major Factors Affecting Implementation and Outcome 5.1 Factors outside the control of government or implementing agency: External factors worked in Brazil's favor during 2003. The combination of increasing international liquidity during the year and the upsurge in confidence arising from the domestic austerity measures caused country risk, as measured by EMBI, to decline. Financial variables in Brazil - exchange rate, inflation, inflation expectations, and interest rates involved in swaps of fixed interest rate bonds and indexed government bonds - all fluctuate in line with the EMBI spread. The reduced country risk in 2003 led to exchange rate appreciation and a rapid decline in inflation. Retaining sound fiscal policies despite strong public and political pressures for expansionary fiscal policies - to generate short term (but unsustainable) social and growth results- has been an important achievement. 5.2 Factors generally subject to government control: Tight fiscal and monetary policies were the government's response to the credibility crisis during early 2003, resulting from uncertainties generated by the election. The situation did not begin to improve until April-June, with the reduction in country risk and the appreciation in the exchange rate as a result of the impressive improvement in external accounts and the consequent lessening of external vulnerability. As inflation declined, the real interest rate increased sharply and the Central Bank retained nominal interest rates at a high level until it felt confident that inflation was converging with the inflation target zone. The rapid launching of the social security and tax reforms and the broadening of the government's political support helped to restore credibility. While the cost of this adjustment was a reduction in economic activity during 2003 (GDP fell by 0.3%), this cost could be considered on the low side when compared with other country adjustment experiences. 5.3 Factors generally subject to implementing agency control: The implementing agencies have shown commitment and technical leadership. The deepening of the fiscal adjustment and progress made on debt management capacity- building was highly - 22 - satisfactory and could be attributable to the good performance of the National Treasury (STN) and the Central Bank. The process of institutional development in a large public sector such as Brazil's is inevitably slow. 5.4 Costs and financing: There were no changes in the original financing arrangements. The loan was approved in June 2003 and disbursed in August 2003. 6. Sustainability 6.1 Rationale for sustainability rating: The overall sustainability of the fiscal adjustment supported by the PFRSAL II is likely. Brazil's program for 2004 continues to center on fiscal consolidation. The achievements discussed in section 4 point to the sustainability of the progress achieved under both PFRSAL I and PFRSAL II. Developments in the public finances in the year to date have been encouraging. The primary surplus during the first quarter of 2004 was in excess of projections, with strong performances at all levels of government. The Debt Renegotiation Agreements and the Fiscal Responsibility Law will continue to have a positive impact on subnational fiscal discipline over the coming years. With restricted access to finance, states and municipalities will be obliged to keep fiscal adjustment in place while they bring their debt stocks down to manageable levels. The government acknowledges that continued fiscal consolidation is essential for ensuring the gradual reduction of public debt in relation to GDP and it is determined to continue to effect the necessary structural reforms. However, at least until 2002, adjustment has been based excessively on increased tax revenues. From 2004 onwards, these tax hikes appear to have risen well ahead of nominal GDP. If the country is hit by another external shock, the government will have to be prepared to deep the fiscal adjustment effort through expenditure cuts rather than increasing tax revenues. For the near future, responding to deterioration of the external scenario which could arise from tighter international liquidity and higher oil prices will require further adjustments in macroeconomic policies. In the recent past Brazil has demonstrated its ability to weather external volatility episodes by employing appropriate policy responses. In this respect, institutionalization of responsible fiscal policy will continue to be essential in order to build up the country's ability to respond robustly to an adverse external environment. The improvement in economic fundamentals as the result of continuing sound macroeconomic policies has placed the Brazilian economy in a better position to absorb external shocks. Fiscal discipline, strong external sector performance, controlled inflation and improved debt composition indicates that the Brazilian economy should henceforth be less negatively affected by external shocks. The most probable scenario consists of the government maintaining or even increasing primary - 23 - surpluses and accommodating external shocks through monetary easing and higher inflation. The government would also be likely to try and approve the pending structural reforms in Congress in order to reinforce the positive effects of its macroeconomic policy. In this respect it is important to note that government is likely to secure Congressional approval of the Bankruptcy Law, the Public Private Partnership framework, the Innovation Law and other microeconomic reforms, all of which form part of the medium term development program. 6.2 Transition arrangement to regular operations: N.A. 7. Bank and Borrower Performance Bank 7.1 Lending: The Bank's performance in the identification, preparation assistance and appraisal of the project was highly satisfactory. The Bank demonstrated ability to respond quickly to a very difficult macroeconomic context, preparing a well-designed operation in the space of three months that contributed positively to restoring Brazil's credibility in the financial markets. The Bank grasped the strategic opportunity to support the emerging consolidation of sound fiscal policies and their importance for reversing the adverse economic situation in 2003. Previous analytical work was fundamental to the rapid preparation of the project., The Country Economic Memorandum (CEM), the Financial Sector Assessment Project (FSAP) and the Brazil Policy Notes in particular provided an extremely solid analytical basis enabling the identification of key fiscal and debt management areas - crucial to improving market perceptions of Brazil's fiscal sustainability. The above-mentioned high quality ESW was also a useful mechanism for establishing a highly constructive and permanent policy dialogue with the authorities engaged in the preparation of the project. Since the analytical work concentrated on fiscal policy and public debt management and the effects of these on vulnerability, the project focused on a limited number of key areas. Given the modest progress in other areas covered by the PRFSAL I (such as expenditure management), it was decided to scale down the size of the Loan and to exclude public expenditure management from this operation. Thus, with a few key areas and a selection of solid analytical material immediately available, it was possible to prepare the project quickly. Given the substantial track record of reforms that Brazil has implemented over the past few years and the new administration's commitment to structural reforms (tax and social security reforms were already submitted to the Congress at the time of the PRFSAL II preparation), the PSAL instrument was adequate. The tough fiscal constraints of the Brazilian government favored the choice of an adjustment loan since this does not affect the government's fiscal primary balance and provides support to the country's balance of payments position. The PRFSAL II complemented the Brazil-IMF U$ 30 billion Stand-By Agreement of September 2002. Although considered relatively small for Brazil and in comparison with the IMF support, the Bank operation underpinned the impact of the IMF agreement by bolstering Brazil's - 24 - credibility. In terms of content, the Bank's program deepened the commitment of the government in the macro-fiscal policy and debt management areas by employing a range of actions to help achieve the targets laid down in the Stand-By Agreement. The type of instrument used and the strategy of concentrating on a few key areas sent out powerful signals to the markets regarding the Brazilian government's commitment to tight fiscal policy and sound debt management for restoring the sustainability of the Brazilian public sector fiscal accounts. The inclusion of tax reform also signaled the administration's commitment to long-term structural reform. In short, the Bank adequately balanced the risks and potential rewards of the operation. Preventing financial collapse through well-timed support for Brazil more than compensated for the risks related to the slippage of the fiscal reform agenda due to lack of political support and negative shocks. As both risks failed to materialize and the actions proposed under the Loan were reasonably accomplished, the decision to support the new Brazilian administration with the loan could be considered to have been correct. In addition to the Bank's financial support (relatively small in comparison to the IMF program), the Bank's activities under the PRFSAL II added value to the overall Brazilian fiscal adjustment program in areas not covered by the IMF program, such as subnational fiscal issues, fiscal transparency and contingent liability issues. Moreover, the Bank was able to offer its particular expertise on debt management and succeeded in establishing a permanent policy dialogue with the Brazilian authorities resulting in progress being made on debt management governance and capacity, as well as in the area of debt market development. The recognition by the Brazilian government of the importance of the improvement of the quality of public expenditures for the structural fiscal reform agenda and continuity of the current fiscal effort resulted from the permanent dialogue established between the Bank and the authorities. 7.2 Supervision: Supervision performance has been satisfactory. Given the structural programmatic nature of the loan and the short interval between the loan effectiveness and preparation of the Implementation Completion Report, only two supervision missions were mounted to monitor progress on debt management and to assess the prospects for a future operation on public expenditure management. Based on the PRFSAL II operation and solid analytical work, the Bank was able to establish a fluid and high quality policy dialogue with government authorities on fiscal policy follow-up, debt management and the broad fiscal reform agenda. Three activities developed as a result. The ESW Fiscal Policy for Reduced Vulnerability set the scene for a valuable exchange of views at the Ministry of Finance and the Central Bank between World Bank staff, top international academics7 contracted by the Bank and senior staff from government departments on a range of relevant topics, including a diagnosis of the fiscal challenges facing Brazil. The issues discussed included fiscal rules and institutions, optimal debt management, fiscal and monetary policy mix and the effectiveness of monetary policy in a context - 25 - of high indebtedness. All these topics are closely related to the institutionalization of responsible fiscal policy and risk and public debt management - key areas covered by the PRFSAL II. Debt management was the second area for intensive discussion between the Bank and government authorities. Brazilian officials paid particular attention to the Bank's contributions on debt management, in which it possesses acknowledged expertise. In addition to following up the progress on governance and capacity, together with market development for government securities, the policy dialogue with debt authorities proved to be extremely fluid and many of the actions taken by the government in these areas were suggested, discussed in depth and agreed by the Bank team and the authorities. The results were satisfactory in both areas. The Bank contracted a fiscal economist specialized in subnational finances. This initiative facilitated permanent follow-up of the Fiscal Responsibility Law indicators and the general evolution of the initiatives developed under the subnational fiscal discipline component of the PRFSAL II. The expenditure management area was also included in the policy dialogue (although not on the PRFSAL II agenda). Since the PAD called for the continuity of a policy dialogue on expenditure issues for possible inclusion in a future operation, the Bank is now developing a programmatic AAA aimed at addressing concerns about the quality of public expenditures in Brazil. In terms of supervision, a mission was organized in March 2003 to discuss PEM issues, which the Bank is interested in supporting through various instruments including (i) a Programmatic Fiscal Reform Loan (IV) that is expected to focus on expenditure issues, (ii) a possible TA Loan to strengthen federal PEM (primarily for the MPOG), and (iii) the ongoing AAA on the quality of public expenditures. As for Social Security Reform (also excluded from the PRFSAL II) the Bank followed up and continued the dialogue on this topic with the government, closely examining the progress of the social security reform process and gauging the effects of the different options available and the amendments made to the original proposal. While the reform was being debated in Congress, the Bank produced an ESW ("Policies to Sustain Equitable Income Security for Old Age"), discussed with government officials. In October 2003, the Bank mounted a preparatory mission with a view to a future operation on Social Security Reform. Finally, supervision and policy dialogue on Tax Reform was limited on account of its constitutional nature and the fact that once submitted to Congress, the government itself had little control over the process. --------------------------------------------- 7Olivier Blanchard, Francesco Giavazzi, Carlo Favero, Alessandro Missale and Charles Wyplosz were contracted to produce research documents in close collaboration with Brazilian authorities and Bank staff. 7.3 Overall Bank performance: Based on the above, overall Bank performance is rated satisfactory. Borrower - 26 - 7.4 Preparation: The borrower's performance in the preparation of the loan was satisfactory. The government recognized the importance of the operation for the recovery of its credibility and displayed strong commitment to the operation, accurately identified the areas of substantive progress in the past and areas where further progress was likely. The latter favored focusing on a limited number of key areas. The technical support given to the Bank staff by the various departments responsible for the areas covered by the loan facilitated its rapid preparation. 7.5 Government implementation performance: The implementation performance of the government was highly satisfactory. Macro-fiscal planning and debt management were two areas of successful implementation of actions and reforms. Regardless of the legislative difficulties and the new government's lack of a solid majority in Congress, it was able to negotiate and to obtain support for the approval of the social security and tax reform in a short period of time. 7.6 Implementing Agency: The performance of the implementation agency was highly satisfactory in the debt management and fiscal policy areas, but less than satisfactory in the tax reform area. The implementation agency for the technical components was basically the National Treasury (STN) at the Ministry of Finance. Since the operation concentrated on a few areas and public expenditure management was excluded, the participation of the Planning Ministry was limited to the joint work undertaken by the National Treasury (STN) and the Federal Budget Secretary (SOF) in the elaboration of the Budget Guidelines Laws (LDOs) for 2004 and 2005. The Treasury (especially the debt management office) demonstrated consistent commitment with the reform package and a high technical capacity to implement it. Since the function of the Federal Tax Revenue Office (SRF) is tax administration, its role in the tax reform process focused on providing inputs to the government regarding the effects on tax revenues of the different options and modifications proposed by the Congress. This being the case, the SRF could not be considered to have a relevant role as an implementation agency of the tax reform component of the PRFSALII. 7.7 Overall Borrower performance: Based on the above description, the overall borrower performance was satisfactory. 8. Lessons Learned Structural fiscal loans are complex operations that teach policy makers and the Bank many lessons. This section outlines some of them. 1. Strategic timing and support to government in a critical situation can be at least as important as its specific technical content. The ability of the government to respond quickly to a credibility crisis was fundamental to overcoming the crisis. The new Brazilian administration was able to recover credibility through the deepening of fiscal adjustment. The Bank accompanied this effort through the PRFSAL II, which derived its importance from its broader strategic role rather than from the negotiation of - 27 - specific conditionalities (that could have delayed the operation). The need for urgency favored focusing on a few key fiscal and debt management issues that were critical for successfully turning around the macroeconomic scenario. 2. Complex reforms, such as those supported, are liable to require mid-course adjustments and can thus be best supported with the Bank's programmatic instrument. Since 1998, Brazil has experienced a process of fiscal reform that coincided with a period of high external volatility. This has influenced the course of fiscal reform in two contrasting ways. On the positive side, the adverse macroeconomic scenario stimulated bolder and deeper fiscal responses. At the same time the high external volatility and resultant adverse shocks experienced by the Brazilian economy undermined the reform efforts, neutralizing many of the positive effects of the reforms and reducing the political support required to guarantee the passage of reforms. The constraints faced by the reform process conditioned its progress and strengthened the option of employing a programmatic approach. Without neglecting the need for medium and long-term structural reform, the flexibility of the Bank's programmatic instrument allowed for the adjustment of the content and the sequence of reforms included in the overall fiscal reform agenda. The flexibility of the programmatic approach enabled the Bank to provide efficient support in a context where the significance and viability of specific policy actions tended to vary in response to the macroeconomic scenario and to the degree of political support for the reforms. Furthermore, the opportunity to identify desirable and feasible future steps creates a permanent channel of policy dialogue with authorities that other types of instruments cannot provide. The identification of key reform actions to confront contemporary difficulties within a broad structural reform highlights the importance of prior analytical work, which should provide an appropriate assessment of the suitability and sequence of the actions supported by the program. The previous analytical work also allows to construct more accurately different scenarios in which the required policy actions will take place. These scenarios should be crucial for the definition of the policy matrices as they permit more flexibility in the policy action requirements. 3.The design of tax reforms in federalist countries requires careful political economy analysis regarding winners and losers and adjustment to design to make reforms politically viable. Given the complexity of the political economy of tax reforms, an analysis of the forces and interests that are affected by changes to the tax system is needed in order to be in a position to evaluate the difficulties to be faced by a tax reform. In addition to the distributional impact of changes in the tax code that creates resistance to tax reform, fiscal federalism arrangements could put additional difficulties in the path of the reform process. Despite general agreement on the need to reform the Brazilian tax system, the idea that it would be possible to redesign a large part of the tax system through the reform process ­ for example resorting to problematic constitutional amendments without discussing the distribution of the - 28 - aggregate tax revenue among the three government-levels - proved to be over- optimistic. The initial consensus disappeared as soon as generalities were abandoned and the detailed discussion on the reform commenced. During the bulk of the negotiation period, state governors hotly disputed whether the new ICMS should be collected in the state of origin or in the state of destination. The camp thus divided into "exporting" and "importing" states. There was also much boisterous discussion about how the states should be compensated in the event of losing a "tax war" among themselves in cut-throat competition for footloose investment projects. Finally, discussions were dominated by proposals for changes in revenue-sharing rules to give states and municipalities a more generous piece of the aggregate tax revenue. The structural tax changes were relegated to second place. 4. Economic adjustments in economies with high indexed debt requires careful coordination of fiscal, monetary and debt management policies. High-indexed debt requires a significant degree of coordination between fiscal, monetary and debt management policies. Fiscal policy should be flexible enough to react to adverse shocks that undermine debt indicators. Otherwise, the government's budget restriction has to be balanced either through inflation or by a fall in the prices of government securities. Both options are inconsistent with stable prices. Both were obstacles affecting the Central Bank's anti-inflationary policy. When fiscal policy is able to react adequately to shocks, (eg: when the primary surplus can increased and commitment to future fiscal prudence is certain), the Central Bank is free to raise interest rates and the economy is stabilized as a result. The Brazilian experience shows that the combination of fiscal adjustment deepening and tight monetary policy adopted by the new administration in 2003 led to a rapid recovery of confidence and much improved economic conditions. The need for coordination between fiscal, debt management and monetary and financial policies is also essential for the success of an anti-inflationary policy. In an environment of rising debt levels combined with an unresponsive fiscal policy and highly indexed debt, raising interest rates to curb inflation could have inflationary effects. The higher cost of debt service (with an unresponsive primary surplus) could lead to a higher probability of default. This in turn can accelerate capital outflows, thereby increasing pressure on the currency to depreciate and, as a result, increasing inflation. Also, the coordination between debt management and financial policy proved to be essential in the Brazilian context. Efforts to improve the debt composition and risk management need to be complemented by the development of public debt markets. The adequacy of the supervision and regulatory functions of the Central Bank plays a central role in this. The Central Bank and the capital market regulators have to be aware of three issues regarding the protection of holders of public debt: (i) the importance of possessing balance sheets that adequately reflect the value of intermediaries' assets and hence a mark-to-market regulation; (ii) financial regulators should have timely and realistic information about the risks assumed by agents trading public securities, and (iii) the natural tendency of financial intermediaries to concentrate public bond holdings should not be accentuated by regulations such as those allowing public bonds to compute as reserve - 29 - requirement holdings. Finally, the separation of public debt management objectives from monetary and financial policy objectives is crucial. The Brazilian experience of 2001-2002 shows that issuing dollar-linked public bonds to curb inflationary pressures fostered by exchange rate devaluation and to provide the markets with instruments to hedge exchange rate risk while attaining inflation targets is a strategy that may succeed only temporarily. Additionally, the objective of dampening the asset prices volatility to reduce financial system risks through debt exchanges and cash debt buybacks shortened the maturity of public debt held by the market and provoked a significant expansion of the monetary base with adverse effects on debt composition and inflation. In the long-run, the risk underwritten by the public sector will be reflected in higher debt and higher inflation levels. 5. Other specific lessons a) The adoption of counter-cyclical fiscal policies should take into account the indebtedness level. The high indebtedness of the public sector is the most relevant obstacle to reduce pro-cyclical bias of fiscal policy. If it is broadly accepted that a sound fiscal policy should combine some short run flexibility with a long run commitment to debt sustainability. In the case of countries with higher debt levels that cause credibility problems, the prime objective of fiscal policy should be the reduction the debt to GDP ratio and the objective of smoothing economic activity fluctuations should come second. The Brazilian experience confirms the difficulties of the establishment of counter-cyclical fiscal stances. The government informally announced the implementation of counter-cyclical fiscal policy devices to be adopted in 2005. Financial markets interpreted the announcement as a signal of relaxation of fiscal policy and the government had to postpone the adoption of counter-cyclical rules. In summary, despite the impressive achievements of fiscal policy, doubts persist about debt sustainability. A good reputation frequently takes time to be established. At this moment in time, the reduction of the pro-cyclical bias of fiscal policy could affect credibility in a negative way. Moreover, counter-cyclical policies cannot be achieved as long as constitutional earmarking of revenues schemes links expenditures to the level of revenues collected by the national government, avoiding the increase of public savings in good periods. b) The speed of the reduction of exposure of public debt to risk is conditioned by debt market development. In addition to the macroeconomic scenario and an adequate governance structure for debt management, the achievement of the objective of reducing the exposure of public debt to rollover, interest, and exchange rate risks is conditioned by the development of public debt markets. In the case of Brazil, the concentrated market structures and certain shortcomings in the fund industry limit the speed at which risks can be prudently transferred from the government balance. - 30 - c) Tax reform processes are more difficult in an environment of tough fiscal effort and economic stagnation. Together with the political economy difficulties faced by the Tax Reform, the need to maintain the high current level of tax revenues, at least in the short term, was another important constraint affecting Tax Reform. The constraint represented by the need to maintain revenues is likely to acquire more weight against a backdrop of economic stagnation. Any change in the tax system generates effects on fiscal revenues that are difficult to assess. The uncertainty about the revenue impact of the Tax Reform favored a natural tendency to adopt a more conservative approach to the depth of the proposed changes in the tax system. The need to obtain high fiscal surplus and the stagnation of the Brazilian economy strengthened the option for gradual and smooth changes in the tax code. 9. Partner Comments (a) Borrower/implementing agency: The Government's comments addressed the following issues: (1) Borrower's rating of the World Bank's assistance in formulating the program, policy options and technical assistance. The PFRSAL II has confirmed the adequacy of the World Bank's approach to assistance since it brought relief to the balance of payments financing needs and also provided useful technical support for the successful implementation of fiscal reforms. It is important to acknowledge the high-quality professionalism of both staff and consultants. This contributed to a more productive and cooperative environment. (2) Borrower's assessment of the Programmatic Loans programs. The programmatic loan has been an appropriate way of adjusting planned actions or policies in line with current evolving atmosphere, especially in areas that require participation by many different segments and the Congress. From this point of view, it could be considered to be a more flexible and results-focused instrument for benefiting both the borrower and the Bank itself. (3) Borrower's rating of Bank's procedures. As mentioned in the completion report of the early phase of the Programmatic Fiscal Reform, it would be advisable for the Bank to make some improvements regarding the format of such an evaluation in order to reflect the style of this kind of operation, or even to examine the real need for such a report which in the borrower's opinion, is more in keeping with a traditional investment program. (4) Borrower's assessment of this ICR. The ICR was considered by the implementing units as generally balanced and reflecting the status - 31 - of the different actions or policies contemplated. Some comments were made for data updates and clarification on specific topics related to Brazilian fiscal policy. (b) Cofinanciers: (c) Other partners (NGOs/private sector): 10. Additional Information - 32 - Annex 1. Key Performance Indicators/Log Frame Matrix Outcome / Impact Indicators: 1 Indicator/Matrix Projected in last PSR Actual/Latest Estimate Net Debt Around 50% of GDP 56.6% of GDP PSBR 4.4% of GDP 5.2% of GDP Brazil EMBI - Spreads Reduction from 1,400 b.p 700 b.p Exchange Rate Redcution from 3,54 R$/US$ 2.85 RS/US$ Aggregate State Debt 1.5 of Net Current Revenue 1.78 Share of Exchange rate linked bonds in Reduction from 2002 figure of 40% 17% domestic debt Share of Exchange rate linked bonds in Reduction from 2002 figure of 67% 57% domestic debt Share of fixed bonds in domestic debt Increase from the 2002 figure of 2% 17% Number of Participants in the Treasury Direct Increase from 2,300 25,000 Program Reduction of distortionary taxation Reduction of share of cumulative taxes on Share of cumulative taxes in May 2004: 12%. federal tax revenue from the 2002 figure of 28% Simplification of subnational Value Added Unification of ICMS and reduction of the Not met Taxation number of ICMS rates to five Output Indicators: 1 Indicator/Matrix Projected in last PSR Actual/Latest Estimate Public Sector Primary Surplus 4.25% of GDP 4.37% of GDP Subnational Primary Surplus Higher than 0.78% of GDP 0.91% of GDP Comply with LRF indicators Observance of the Fiscal Responsibility Law Fully met Comply with Debt Renegotiation Contracts Observance of the Debt Renegotiation Fully met under the 9496/97 Law Contracts of 1997 Limit credit operations by subnational Observance of Resolutions of the National Fully met governments Monetary Council Incorporation into the Fiscal Risk Annex Incorporation in the LDO 2005-2007 Not met quantitative debt risk indicators No of States above Debt FRL Ceiling Reduction from 2002 figure of 8 8 No of States generating primary deficits Reduction from 2001 figure of 7 1 Debt management coordination Transferring the external debt issuance Agreement between STN and BCB was responsibilities from BCB to STN signed for a transition period. Reduce operational risk in debt management Creation of a function to verify compliance STN created a pilot program to be approved with operational risk safeguards in 2004 Regulation strengthening the protection of Collective investment schemes regulated and New Regulation on Investment Funds to be investors trading government and other supervised pursuant to a unified regulatory approved in 2004. securities framework. 1End of project - 33 - Annex 2. Project Costs and Financing N.A. - 34 - Annex 3. Economic Costs and Benefits N.A. - 35 - Annex 4. Bank Inputs (a) Missions: Stage of Project Cycle No. of Persons and Specialty Performance Rating (e.g. 2 Economists, 1 FMS, etc.) Implementation Development Month/Year Count Specialty Progress Objective Identification/Preparation March, 2002 3 1 Economist and 2 Public Sector S S Specialist Appraisal/Negotiation March and May, 9 3 FMS, 1 Public Debt S S 2003 Management Specialist, 2 Economists, 1 PS Specialist, 1 Operations Officer and 1 YPA Supervision March, 2004 2 2 PS Specialists S S ICR April, 2004 5 2 FMS and 3 Economists S S (b) Staff: Stage of Project Cycle Actual/Latest Estimate No. Staff weeks US$ ('000) Identification/Preparation 57.4 209,289.05 Appraisal/Negotiation Supervision 1 3,500 ICR 11.20 34,130.85 Total 69.20 248,919.90 - 36 - Annex 5. Ratings for Achievement of Objectives/Outputs of Components (H=High, SU=Substantial, M=Modest, N=Negligible, NA=Not Applicable) Rating Macro policies H SU M N NA Sector Policies H SU M N NA Physical H SU M N NA Financial H SU M N NA Institutional Development H SU M N NA Environmental H SU M N NA Social Poverty Reduction H SU M N NA Gender H SU M N NA Other (Please specify) H SU M N NA Private sector development H SU M N NA Public sector management H SU M N NA Other (Please specify) H SU M N NA - 37 - Annex 6. Ratings of Bank and Borrower Performance (HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HU=Highly Unsatisfactory) 6.1 Bank performance Rating Lending HS S U HU Supervision HS S U HU Overall HS S U HU 6.2 Borrower performance Rating Preparation HS S U HU Government implementation performance HS S U HU Implementation agency performance HS S U HU Overall HS S U HU - 38 - Annex 7. List of Supporting Documents 1. Brazil ­ Country Assistance Strategy ­ Report No 20160-BR, The World Bank, March 2000. 2. Brazil ­ Country Assistance Strategy 2003-2007: A More Equitable, Sustainable and Competitive Brazil, Report 27043-BR, The World Bank, November 2003. 3. Brazil ­ Stability for Growth and Poverty Reduction - Country Economic Memorandum, The World Bank, January 2003. 4. Brazil ­ Stability for Growth and Poverty Reduction - Country Economic Memorandum: Signaling Effect of Primary Surplus, The World Bank, Background Paper, 2002. 5. Brazil ­ Stability for Growth and Poverty Reduction - Country Economic Memorandum: The Quality of Fiscal Adjustment, The World Bank, Background Paper, 2002. 6. Brazil ­ Stability for Growth and Poverty Reduction - Country Economic Memorandum: Public Finance in Brazil: Policy Issues and Projections, The World Bank, Background Paper, 2002. 7. Brazil ­ Fiscal Policy for Reduced Vulnerability, The World Bank,, March 2004. 8. Brazil ­ Fiscal Policy for Reduced Vulnerability: Inflation Targeting and Debt: Lessons from Brazil, The World Bank, by Favero, Carlo and Francesco Giavazzi, March 2004. 9. Brazil ­ Fiscal Policy for Reduced Vulnerability: Fiscal Dominance and Inflation Targeting. Lessons from Brazil, The World Bank, by Olivier Blanchard, March 2004. 10. Brazil ­ Fiscal Policy for Reduced Vulnerability: Public Debt Management in Brazil, The World Bank, by Alessandro Missale, March 2004. 11. Brazil ­ Fiscal Policy for Reduced Vulnerability: Institutions for Debt Sustainability in Brazil, The World Bank, by Charles Wyplosz, March 2004. 12. Brazil ­ An evaluation of the Recent Tax Reform Effort, by Rogério Werneck, The World Bank, mimeo prepared for the ICR of PRFSAL II, May 2004. 13. Brazil ­ Country Financial Accountability Assessment, The World Bank, June 2002. 14. Brazil ­ Critical Issues in Social Security, Country Study, World Bank Report #22513-BR, May 2001. 15. Brazil - Policies to Sustain Equitable Income Security for Old Age, The World Bank, Mimeo, January 2004. 16. Brazil ­ Issues in Fiscal Federalism, World Bank Report #22523-BR, October 2001. 17. IMF, July 2001. 18. Brazil ­ Structural Reform for Fiscal Sustainability, World Bank Report #19593-BR, June 2000. 19. Brazil's State Debt's Crisis: Lessons Learned, The World Bank, Country Economic Dept. I, Economic Notes #14, September 1997. 20. Brazil ­ Equitable, Competitive and Sustainable: Contributions for Debate - Policy Notes, Fiscal Sustainability, The World Bank, December 2003. 21. Brazil ­ Equitable, Competitive and Sustainable: Contributions for Debate - Policy Notes, Macroeconomic Stability, The World Bank, December 2003. 22. Brazil ­ Equitable, Competitive and Sustainable: Contributions for Debate - Policy Notes, Public Sector, The World Bank, December 2003. 23. Brazil ­ Proposed Second Programmatic Fiscal reform Loan (Fiscal Responsibility and - 39 - Tax Reform), The World Bank, Project Document, May 2003. - 40 - - 41 -