Report No. 28911-EC Report No. 28911-EC Ecuador Creating Fiscal Space for Poverty Reduction A Fiscal Management and Public Expenditure Review Public Disclosure Authorized Disclosure Public (In Two Volumes) Volume II: Background Papers
November 17, 2004
cao raigFsa pc o oet euto Volume II Creating Fiscal Space for Poverty Reduction Ecuador Public Disclosure Authorized Disclosure Public Public Disclosure Authorized Disclosure Public
Document of the World Bank and the Inter-American Development Bank Public Disclosure Authorized Disclosure Public
GOE Government of Ecuador PPA Power Purchasing Agreement GTZ German Technical Cooperation Agency PPC Programacidn Peri6dica de Caja (cash balance periodic HDI Human Development Index programming) HW=(s) Highly Indebted Poor Country (ies) PPS Project for Public Spaces ICE lmpuesto a 10s Consumos Especiales (Special Consumption PRADEC Programa de Asistencia y Desarrollo Comunitario (programs Tax) of Aid and Common Development) IDB Inter-American Development Bank PRAGUAS Programa de Agua y Saneamiento para Comunidades IEOS lnstituto Ecuatoriano de Obras Sanitarias (Ecuadorian Rurales y Pequeiios Municipios (Project Appraisal Institute of Sanitary Works) Document, Rural and Small Towns Water Supply and IESS lnstituto Ecuatoriano de Seguridad Social (Ecuadorian Sanitation Project) Social Security Institute) PROBE Public Report on Basic Education IM Infant Mortality PROMEC Proyecto de Modemizacidn de 10s Sectores Elkctrico, IMF International Monetary Fund Telecomunicaciones y Servicios Rurales (Power and INEC (El Instituto Nacional de Estadistica y Censos (Integrated Communications Sectors Modernization and Rural Services System of Household Surveys) Project) INECEL lnstituto Ecuatoriano de Electrifcacidn (Ecuadorian Power PROST Pension Reform Options Stimulation Toolkit - developed by Authority) the World Bank INH lnstituto Nacional de Higiene (National Institute of Hygiene) PRS Poverty Reduction Strategy IPS interbank payment system RER Real Exchange Rate IRS/SRI Internal Revenue Service/Servicio de Rentas Internas RGP Referential Generation Price ISR personal income tax ROSC Reports on the Observance of Standards and Codes ISSFA Military Social Security Institute RUC Registro Onico de Contribuyentes (centralized taxpayers ISSPOL lnstituto de Seguridad Social de la Policia Nacional registry) (Institute of Social Security of the National Police) SAPYSB Subsecretaria de Agua Potable y Saneamiento Bhico m Oil Fields (Ishipingo-Tambococha-Tiputini) (Undersecretary of Drinking Water and Basic Sanitation) ITU International Telecommunications Union SELBEN Sistema de Identi~cacidny Seleccidn de Benejiciarios de 10s NM Internal Value Measurement Programas Sociales (Poverty Mapping and Strengthening JASS Juntas de Agua y Saneamiento (Committee for Water and Database) Disinfection) SENATEL Secretaria Nacional de Telecomunicaciones (National LAC Latin America and The Caribbean Telecommunications Office) LMG Ley de Maternidad Gratuita y Atencidn a la lnfancia (Law of SENRES Secretari'a Nacional Tkcnica de Desarrollo de 'Recursos Free Maternity and Attention to Infancy) Humanos y Remuneraciones del Sector Piblico (National LNG Liquefied Natural Gas Technical Office of Human Resources Development and LOAFYC Ley Orgclnica de Administracidn Financiera y Control Remunerations of the Public Sector) (Organic Law of Financial Management and Control) SIAN Sistema Integrado de Alimentaci6n y Nutrici6n LSMS Living Standards Measurement Study SIEH Sisrema Integrado de Encuestas de Hogares (Integrated MBS/STFS Ministerio de Bienestar Social (Ministry of Social Affairs) Home Survey System) MDGs Millennium Development Goals SIGEF Sistema Integrado de Genercia Econdnica y Financiera MED Ministry of Education (Integrated Financial Management System) MEF Ministerio de Economfa y Finanzas (Finance Ministry) SIGOB Sistema de Gestidn de Gobierno (Government Management MEM Ministerio de Energia y Minas (Ministry of Energy and System) Mines) SINEC Sistema Nacional de Estadisticas y Censos (National System MIDWI Ministerio de Desarrollo Urbano y Vivienda (Ministry of of Statistics and Censuses) Urban Development and Housing) SNEM Servicio de Erradicaci6n de Malaria (Malaria Eradication MNL Multinomial Logit Model Service) MO Mendoza-Oviedo SOTE Sistema de Oleoducto Transecuatoriano (Trans-Ecuadorian MPH Ministry of Public Health Pipeline) MYBF Multiyear Budgeting Framework SPA Subsecretaria de Proteccidn Ambiental (Undersecretariat on NBI Necesidades Bclsicas lnsatisfechns (Unmet Basic Needs) Environmental Protection) NFPS Non Financial Public Sector SPR Strategic Policy Research NWFP North West Frontier Province ssc Seguro Social Campesino (rural social security) OECD Organization for Economic Co-operation and Development sso Seguro Social Obligatorio (obligatory social security) OLS Ordinary Least Squares STFS Secretaria Tkcnica del Frente Social (Technical Secretariat ORDs Regional Development Organizations of the Social Front) OSCIDI Ojicina de Servicio Civil y Desarrollo lnstitucional (Office STFS-SIISE Sistema lntegrado de lndicatores Sociales del Ecuador of Civil Service and Institutional Development) (Integrated System of Social Indicatom of the Social Cabinet) OSINERG Organismo Supervisor de la Inversidn en Energ fa SUFTEL Superintendencia de Telecomunicaciones (Super-intendence (Supervising Agency for Energy Investment) of Telecommunications) OTECEL Bellsouth, Empresa Telefdnica TELECSA Ecuadorian Telecommunications-South America PACIFICTE!L Pacific Telephone-Fixed line telecommunications operator UBN Unsatisfied Basic Needs in the coastal region UDENOR Unidad de Desarrollo del Norte (Northern Development PAE Programa de Alimentacidn Escolar (School Breakfast office) Program) UNDP United Nations Development Programme PAHO Pan-American Health Organization UNE Union Nacional de Educadores del Ecuador (National PA1 Programa Ampliado de lnmunizacidn en las AmCricas Teacher's Union) (Immunization Program) UNESCO United Nations Educational, Scientific and Cultural PA" Programa Nacional de Nutricidn y Alimentacidn (National Organization Nutritional Program for Children) UNICEF United Nations Children's Fund PEM Public Expenditure Management VAT Value-Added Tax PER Public Expenditure Review VOIP Voice-over-IP PGE Presupuesto General de Estado (Central Government WFP World Food Programme Budget) WHO World Health Organization PHRD Public Human Resource Development mm IDB Vice President: David de Ferranti Manager, Regional Operation 111: Ciro de Falco Country Director: Marcel0 M. Giugale Deputy Manager, Regional Operations Dept. 111: Mbimo Jeria Sector Director: Emesto May Chief, Country Division 5: Vladimir Radovic Sector Leader: Mauricio Carrizosa Lead Economist: Vicente Fretes-Cibils Senior Economist, Co-Task Manager Jost R. L6pez-CQix Country Economist, Co-Task Manager: Albert0 Melo Ecuador Public Expenditure Review Volume I1
Table of Contents
ACKNOWLEDGMENTS
PREFACE
Chapter 1. FISCAL SUSTAINABILITY EXERCISES ...... 1 I. Fiscal Sustainability Under Macroeconomic Uncertainty...... 1 11 . Ecuador Analysis Under the Mendoza-Oviedo Model ...... 4 111 . Sudden Stop approach to Fiscal Sustainability ...... 6 IV . Conclusions ...... 10 References ...... 12
Chapter 2 . THE FISCAL RULE ...... 13 I. Oil Stabilization Funds: A Brief Analysis of their Rationale...... 14 I1. Fiscal Rules in Ecuador for Oil Revenues ...... 17 I11. Government Oil Revenues in Ecuador ...... 19 IV. An Analysis of the Fiscal Rules in Ecuador ...... 21 A . The Stabilization Component of FEIREP...... 22 B . The Debt Reduction Component of FEIREP...... 26 C. The 3.5 Percent Target for Growth in Real Primary Expenditures ...... 29 References ...... 30
Chapter 3 . EDUCATION...... 33 I. Education Performance in the 1990s...... 34 11 . Equity in Educational Spending ...... 47 I11. Cost-Effectiveness in Primary Education ...... 51 IV. Education Expenditure Tracking and Budget Scenario Analysis ...... 54 Annex 3.1 Education Cost-Effectiveness Model ...... 62 References ...... 60
Chapter 4 . HEALTH ...... 67 I. Health Status and Access to Health Services ...... 69 11 . Health Policies in the 1990s ...... 80 I11. Trends in Health Expenditures...... 87 IV . Equity in Health Spending ...... 92 V . Access to Health Care and Cost-effectiveness in Health Spending ...... 97 VI. Health Budget Training ...... 108 VI1. Projections for Access to Maternal Care and Infant Mortality ...... 110 References ...... 114
Annex 4.1 Theoretical Underpinnings of Health Demand and Infant Mortality Models ...... 116 Annex.4.2 Methodology of estimating per capita household consumption in the ENDAMAIN (DHS) survey ...... 119 Annex 4.3 Description of Primary Data Sources Used in this Study ...... 124
Chapter 5 . PENSION ...... 125 I. Background and Status Quo ...... 125 I1. The 2001 Reform ...... 127 I11. The Main Problems of the System ...... 129 A . Coverage ...... 130 B. Efficiency. Institutional Arrangements and Transparency ...... 131 C . Central Government Contributions: Distributive and Fiscal Effects...... 132 D. Central Government Debt to IESS...... 133 E. Medium and Long Term Perspectives ...... 134 IV . Conclusions and Recommendations ...... 136 References ...... 138
Chapter 6 . TEACHER ABSENCE ...... 139 I. Literature Review: What Do We Know About Teacher Absence?...... 141 I1. Study Approach and Methodology ...... 143 III . Institutional Context ...... 144 IV . Descriptive Results: What is the Extent of Absence. and Who is Absent? ...... 145 A . Overall Absence Rates. Reasons. and Concentration ...... 145 B . Absence Summary Statistics: Some Simple Correlations ...... 147 V . Regression Results: What Factors May be Causing Teacher Absence? ...... 149 A . Explanatory Variables: Community and School Characteristics ...... 150 B. Explanatory Variables: Teacher Characteristics ...... 157 VI. Conclusions and Policy Implications ...... 159 References ...... 162 Annex 6.1 Survey Methodology and Sample Selection ...... 164
Chapter 7 . WATER AND SANITATION ...... 169 I. Sector Structure and Institutions ...... 169 I1. Coverage and Trends ...... 171 I11. Expenditure Analysis ...... 175 IV . Recommendations ...... 185 References ...... 187
Chapter 8 . ELECTRICITY ...... 189 I. Diagnosis...... 189 I1. The Reality of 2004 ...... 191 I11. Priorities for 2004-2006 and Specific Critical Problems ...... 197 IV . Strategy ...... 199 A . Financial Regularization...... 200 B. Strengthening ofthe Regulatory Agency ...... 202 C . Rate Policy...... 203 D. Utilization of Government Funds to Modify the Rate Level...... 204 E. Management of the Electricity Companies ...... 206 References ...... 208 Annex 8.1 Overview of the Organization of Regulating agencies in some Latin American Countries ...... 209 Annex 8.2 Development of Hydroelectric Projects by the Private Sector ...... 210
Chapter 9 . TELECOM ...... 213 I. Sector Structure and Role of the Public Sector ...... 213 I1. Performance of the Telecommunication Sector ...... 214 A . Access to Telecommunications Infrastructure...... 214 B. Quality and Efficiency of Service ...... 215 I11. Review of Public Expenditures ...... 216 A . Financial Sustainability of Public Enterprises ...... 216 B. Equity and Efficiency of the Tariff Scheme ...... 217 C . Estimation of Implicit Subsidies ...... 219 D. Recommendations ...... 220
Chapter 10 . OIL ...... 223 I. Industry Overview ...... 223 11 . Creation of the FEIREP ...... 225 I11. Fuel Prices and Subsidies ...... 227 IV. A Proposal for a Simplified Tax System...... 231 Boxes. Tables. and Figures in Text
CHAPTER I Figure 1.1 Debt Threshold Sensitivity Analysis ...... 5 Figure 1.2 Number of Periods Before Hitting Debt Threshold ...... 6 Table 1.1 Valuation Effects and Fiscal Sustainability Under a Fall in Oil prices ...... 9 Table 1.2 Fiscal Sustainability Under a Sudden Stop in Capital Flows ...... 10
CHAPTER I1 Box 2.1 The Norwegian Oil Fund ...... 14 Box 2.2 Compliance with the Quantitative Targets of the Fiscal Accountability Law ...... 19 Figure 2.1 Flows Flowing into an Oil Stabilization Fund ...... 25 Figure 2.2 “S-Non Oil Results ...... 26 Table 2.1 Estimates Flows Flowing into FEIREP US$ millions ...... 19 Table 2.2 Composition of Oil Fiscal Revenues .2003 ...... 21 Table 2.3 Revenue Flows into the Stabilization Component of FEIREP Compared to an “Ideal” Stabilization Fund (millions of US$) ...... 25 Table 2.4 Estimate of the Non-Oil Deficit in 2003 ...... 27 Table 2.5 Oil Wealth in Ecuador Millions of US$...... 27 Table 2.6 Flows for Debt Reduction: Ideal Funds vs . FEIREP (Mlns US$) ...... 28 Table 2.7 Budget Execution Ratio of Sectoral Expenditures. Central Government 1/ ...... 29
CHAPTER 111 Box 3.1 Teacher Absence in Primary Schools ...... 40 Figure 3.1 Average Years of Schooling (population 25 years and older) by Region ...... 34 Figure 3.2a. Latin America: Education Gap Between Rich and Poor. Around 1990-2000 ...... 36 Figure 3.2b. Latin America: Change in Education Gap Between Rich and Poor, 1990-2000 ...... 36 Figure 3.3 Education Gap Between Rich and Poor in Urban and Rural Areas, 1995-99 ...... 37 Figure 3.4 Urban Ecuador: Real Monthly Labor Incomes by Education Level of Workers, 1988-2002 (sucres per worker, per month; constant prices of 1988) ...... 41 Figure 3.5 Real Social and Public Education Spending per Capita, 1973-2004 (US$. constant prices of 2000) ...... 45 Figure 3.6 Real Education Spending per Capita. Using Altemative Deflators. 1989-2002 (in constant price dollars of 2000) ...... 45 Figure 3.7 Ecuador: Pupil- Teacher Ratios in Primary and Secondary Education. 1990-2000 ...... 46 Figure 3.8a. Lorenz Curves for Distribution Public Expenditures in Primary and Secondary Education...... 47 Figure 3.8b. Lorenz Curves for Distribution Subsidies to Public and Private Universities ...... 47 Figure 3.9 Lorenz Curves for Distribution Public Spending on Education, 1995 and 1999 ...... 48 Figure 3.10 New and Existing Distribution of (primary and secondary) Education Spending by Provinces ...... 49 Table 3.1 Illiteracy Rate and Years of Schooling of Adult Population (25 years and older), 1990-2001 ...... 34 Table 3.2 Net Enrollment Rates by Educational Level, 1990-2001 ...... 35 Table 3.3 Ecuador: Education Gap Between Rich and Poor, 1995-99 ...... 36 Table 3.4 Urban Ecuador: Education Gap Between Rich and Poor, 1988-2002 ...... 37 Table 3.5 Test Scores for Language and Mathematics Skills, 1996-2000 ...... 37 Table 3.6 Test Scores Fourth-Graders of Primary School in Selected Latin American Countries, 1996 ...... 38 Table 3.7a. Ecuador: Internal Efficiency Indicators for Primary Education, 1995 and 2001 ...... 38 Table 3.7b. Ecuador: Internal Efficiency Indicators for Secondary Education, 1995 and 2001...... 39 Table 3.8 Social Expenditure of Central Government as a Percentage of GDP ...... 45 Table 3.9 Public Transfers and Private Expenditures on Education as a Share of Household Consumption by Deciles, 1999...... 49 Table 3.10. Schooling Determinants in Primary Education...... 51 Table 3.11 Ecuador: Elasticities of Determinants of Net Enrolment in Primary Education ...... 51 Table 3.12. Schooling Determinants in Secondary Education...... 53 Table 3.13 Ecuador: Elasticities of Determinants of Net Enrolment in Secondary Education ...... 53 Table 3.14 Reaching the MDG for Education: Static Budget Projections for Primary Education, 2003-7 ...... 56 Table 3.15 Improving Access to Secondary Education: Static Budget Projections for Secondary Education, 2003-7 ...... 58
CHAPTER N Box 4.1 Decentralization of Health Care in Cotacachi ...... 86 Figure 4.1 Life Expectancy (in years) for Males and Females. 1950-2000 ...... 69 Figure 4.2 Global Mortality Rate. 1960-200 1 ...... 69 Figure 4.3 Infant Mortality. Estimates from Various Sources. 1950-2002 ...... 70 Figure 4.4 Fertility and Infant Mortality. 1950-2000 ...... 70 Figure 4.5 Latin America and the Caribbean: Infant Mortality and GDP per Capita. 1970 and 2001 ...... 72 Figure 4.6 Main Causes of Mortality, 1979-2000 Years (shares of total deaths) ...... 74 Figure 4.7 Distribution of Adjusted Lost Life by Types of Diseases and Age Groups ...... 74 Figure 4.8 Malnutrition (0-5 year olds) and Inequality, 2000 ...... 76 Figure 4.9a. Current, Centralized Financing of Health Care Provided by Ministry of Health ...... 85 Figure 4.9b. Fiscal Decentralization of Health Care Provided by Ministry of Health ...... 85 Figure 4.10 Trends in Real per Capita Health Expenditures and Total Social Expenditures of Central Government. 1973-2004 (in US$ of 2000) ...... 87 Figure 4.11 Real Health Spending per Capita. Using Alternative Deflators. 1982-2002 (in constant price dollars of 2000) ...... 89 Figure 4.12 Health Input Supplies: Number of Hospital Beds (per 100. 000 inhabitants). 1994-2001 ...... 89 Figure 4.13a. Health Input Supplies: Total Coverage of Medical Personnel (per 10. 000 inhabitants) ...... 90 Figure 4.13b. Health Input Supplies: Public Versus Private Coverage of Medical Personnel (per 10.000 inhabitants) ...... 90 Figure 4.14 Public Health Budget by Main Types of Care. 1995 and 2004 (percentage shares of total budget) ...... 91 Figure 4.15a. Incidence of Public Health Expenditures by Type of Public Provider. 1999...... 92 Figure 4.15b. Incidence of Public Health Expenditures by Type of Care. 1999 ...... 92 Figure 4.1%. Incidence of Public and Private Expenditures. 1999...... 93 Figure 4.16 New Formula and Existing Distribution of Public Health Expenditure per Province. 2002 ...... 96 Table 4.1 Reaching the MDG for Child Mortality (projections with unchanged trends of 1990s. per 1. 000 live births)...... 70 Table 4.2 Socio-Demographic Profile of Infant (0-1 years) and Child Mortality (0-5 years) (per 1. 000 live births). 1995-2000 ...... 73 Table 4.3 Ecuador: Social Expenditure of Central Government as a Percentage of GDP ...... 88 Table 4.4 Public Benefits and Out-Of-Pocket Expenses in Health. 1999 (Shares of Total p.c. Household Consumption of Eeach Decile) ...... 94 Table 4.5 Out-of-pocket Health Expenditures of Households by Deciles and Type of Expenditure (expressed as percentages)...... 95 Table 4.6 Out-of-pocket Health Expenditures for Children (aged 0-5 years) of Households by Deciles and Type of Expenditure. 1999 ...... 96 Table 4.7 The Expected Effects of Possible Determinants on the Demand of Maternal Health Services ...... 100 Table 4.8 The Expected Effects of Possible Determinants on Infant Mortality...... 101 Table 4.9a. Effects of Determinants on Access to Health Provision Services (elasticities) ...... 103 Table 4.9b Combined Effect of Poverty and Consumption ...... 104 Table 4.10 Impact Elasticities of Infant Mortality Determinants...... 104 Table 4.1 1 Achieving MDG for Child Mortality and Budget Implications ...... 111 CHAPTER V Figure 5.1 Average Monthly Benefit for Retirees. Under SSO and SSC. in US Dollas. 1994-2003...... 126 Figure 5.2 Revenues. Expenditures and Result of IESS Pension System. 1993-2004 (% GDP) ...... 127 Figure 5.3 Coverage of the Pension System Among Active Workers 1993-2003 ...... 130 Figure 5.4 Population Dependency Ratio. System Dependency Ratio and Ratios Needed to Balance IESS’ Pensions Under Different Assumptions. 1980-2005 ...... 132 Figure 5.5 Population Dependency Ratio and System Dependency Ratio for IESS. 2000-2075 ...... 134 Figure 5.6 Expected Financial Flows for IESS’ Pension System. 2000-2075 ...... 134 Figure 5.7 Expected Financial Flows for IESS Pension System. Assuming No Government Transfers Since 2005 . 2000.2075 ...... 135
CHAPTER VI Table 6.1 Primary-school Teacher Absence. 2002-03 ...... 145 Table 6.2 Reported Reasons for Teacher Absence ...... 146 Table 6.3 Concentration of Teacher Absences: Share of Each Type of Teacher ...... 147 Table 6.4 Teacher Absence Rate and Region ...... 147 Table 6.5 Absence Rates by Significant Correlates ...... 149 Table 6.6 Correlates of Teacher Absence (Random-effects OLS) ...... 151
CHAPTER VII Box 7.1 Household Expenditures in Water. The Case of Machala. El Oro...... 182 Figure 7.1 Urban and Rural Water and Sanitation Coverage in the Region Compared by GDP per Capita...... 173 Figure 7.2 Population Served by Deciles of Consumer Spending In Urban and Rural Areas (%) ...... 173 Figure 7.3 Water Treatment by Expenditure Deciles ...... 174 Figure 7.4 Weighted Water and Sanitation Coverage by Region Intestinal Infectious Diseases. Hospital Reported Cased10. 000 Inhabitants ...... 175 Figure 7.5 Income and Expenses of Water and Sanitation Services (2001) ...... 176 Table 7.1 Type of Service Providers by Population Size ...... 171 Table 7.2 Evolution of Water and Sanitation Service Coverage (population ...... served. millions) ...... 172 Table 7.3 Water and Sanitation Service Coverage by Region. 1999 (percentage of population served) ...... 172 Table 7.4 MIDUVI’s Budgetary Allocation for the Water and Sanitation Sectors 2001-2003 (US$ thousands) ...... 177 Table 7.5 Municipal Expenditures per Capita and by Sector. 2001 ...... 179 Table 7.6 Distribution of ICE and Municipal Expenditures in Water and Sanitation (US$/per capita. 2001) ...... 179 Table 7.7 EMAAP-QUITO Summarized Statement of Results Impact of Subsidies on Results (value in US$) ...... 180 Table 7.8 Operating Income and Operation and Maintenance Costs (US$ million) ...... 181 Table 7.9 Utility Efficiency (use of personnel). 2001 ...... 181 Table 7.10 Tariff Structures and Cross Subsidies - Quito (urban) and Ibarra (urban). 2002 ...... 183 Table 7.11 Water Subsidies to Domestic Users. Quito and Ambato. 2002 ...... 184 Table 7.12 Distribution of Subsidies. 1994 (percent) ...... 184 CHAPTER VIII Table 8.1 Consolidated Cash Flow for the Electricity Sector 2004 (millions US$) ...... 194 Table 8.2. Value of Sector Assets (millions US$) ...... 194 Table 8.3 Cash Flow .Distribution Companies (millions of US$) ...... 195
CHAPTER M Table 9.1 Structure of the Telecommunications Sector in Ecuador ...... 214 Table 9.2 Indicators for Access and Quality of Telecommunications Services in Selected Countries. 2002...... 215 Table 9.3 Operating and Financial Indicators of Public Companies ...... 217 Table 9.4 Classification of Telephone Subscribers ...... 218 Table 9.5 Progress of Tariff Rebalancing Scheme (in US$) ...... 219 Table 9.6. Estimates of Implicit Subsidies (in US$ million) ...... 220
CHAPTER X Table 10.1 FEIREP 2004 ...... 226 Table 10.2 Funding of FEP and FEIREP ...... 227 Table 10.3 Difference in Prices at Terminal ...... 228 Table 10.4 Current Taxes or Subsidies ...... 229 Table 10.5 Crude Oil Consumption ...... 230 Table 10.6 Social and Environment Management Indicators of the Undersecretariat on Environmental Protection ...... 233 BIOGRAPHY ...... 235 ACKNOWLEDGMENTS
This report is a joint effort of the World Bank and the InterAmerican Development Bank. JosC R. Lopez-Cilix (WB) and Alberto Melo (IDB) are the task managers responsible for completing the whole task. Its initial preparation, was coordinated by Sara Calvo (WB) and Carlos Elias (IDB). The report is a collective effort of several authors of chapter sections and background papers presented in two volumes. Volume I.Chapter 1 was prepared by Alberto Melo, with inputs from Jonas Frank (WB-party politics). Chapter 2 was prepared by Alberto Melo, Elaine Tinsley (WB) and Sara Calvo (WB) including inputs from Jorge Shepherd (consultant-Fiscal Trends), Daniel Artana and Cynthia Moskovits (consultant-Fiscal Policy), Carlos Diaz and Alejandro Izquierdo (IDB-Fiscal Sustainability), Jeffrey Rinne (WB-Civil Servive) and Jonas Frank (WB-Tax Revenues). Chapter 3 was prepared by JosC R. L6pez-Cilix based on inputs from Michael Geller (WB-Military Expenditures), Rob Vos, Juan Ponce, Mauricio Le6n (consultants-Social sector). Chapter 4 was prepared by JosC R. L6pez-Cilix with inputs from Elaine Tinsley (WB-Budget Management), Jorge Shepherd (consultant-Social Expenditures), Jonas Frank (WB-Decentralization), and Carolina Sanchez-Piramo (Appendix E-reform of cooking gas subsidy). Vicente Fretes-Cibils (WB), Bruce Fitzgerald (WB) and McDonald Benjamin (WB) provided invaluable oversight and comments on all the chapters. The Statistical Appendix was prepared by Elaine Tinsley with inputs from Jorge Shepherd, Jonas Frank, and Rob Vos. The report also benefited from the useful contributions and complementary analysis on budget management by Diego Mancheno (MEF), Roberto Salazar (MEF), Hugo Muiioz (MEF), Maria de 10s Angeles Rodriguez (MEF), Lenin Parreiio (Banco Central), Fabiin Carrillo (MEF), Javier Game (MEF), Roberto Iturralde (MEF), and Paula Suarez (MEF). The draft also benefited from comments collected during a joint IMF/IDB/WB seminar held in Quito on May 20-21, 2004, and another during a joint MEF/IDB/World Bank workshop held in Quito on November 4-5, 2004 on a preliminary version of this report. More in particular, valuable suggestions were received from Patricia McKenzie (WB), Gonzalo Afcha (IDB), Julio Viiiuela (WIF), Raju Jan Singh (IMF), Trevor Alleyne (IMF) and Esteban Vesperoni (IMF). Peer reviewers were Yasuhiko Matsuda (WB), Amanda Glassman (IDB), and Carlos Elias (IDB), who provided very helpful comments. Valuable contributions were also received from Francesca Castellani (IDB), Rodrigo Suescun, Carolina Sinchez-Piramo, Emmanuel James, Franz Drees, William Doritinsky, Daniel Dulitzky, Emesto May and Mauricio Carrizosa (all WB) during all process. This Volume was edited by Diane Stamm and Chris Humphrey (Executive Summary) and assembled under the general production support by Michael Geller. Volume 11. Contributing authors include: Carlos Diaz and Alejandro Izquierdo (Fiscal Sustainability); Daniel Artana and Cynthia Moskovits (Fiscal Rule and Oil Stabilization Fund); Rob Vos, Juan Ponce, Mauricio Le6n, (IDB-Health, Education); Rafael Rofman (WB-Pensions); F. Halsey Rogers, JosC R. L6pez-Cilix, Nancy Cbrdova, Michael Kremer, Karthik Muralidharan, Jeffrey Hammer, Nazmul Chaudhury (WB, CEDATOS and Harvard University-National Teachers Tracking Survey); Maria AngClica Sotomayor (WB-Water and Sanitation) with support from Franz Drees (WB); Horacio YCpez (Consultant-oil) with support from Eleodoro Mayorga (WB-Oil); Carlos G6mez and Eloy Vidal (WB-Telecom ); and Femando Lecaros (consultant-Electricity) with support from Philippe Durand (WB-Electricity). The Volume was edited by John Moody, and Maria Antonieta Gonzalez and assembled under the general production and editing support by Rosalia Rushton. The report benefited from the overall guidance and support of Marcel0 Giugale (WB-Country Director), Ana Maria Rodriguez (IDB), Vladimir Radovic (IDB), Vicente Fretes-Cibils (WB-Lead Economist), Mauricio Carrizosa (WB-Sector Manager), Ernest0 May (WB- LCSPR Director), Javier Game (consultant-IDB), Margarita Andrade and Alexander Shapleigh (SALTOKJSAID), and David Y uravlivker (IMF). This document also benefited from the excellent administrative and production support of Francisco Irias, and Carolina Torres. Alexandra del Castillo, Ana Maria Vicuiia, Lucy Vargas, Cynthia Guzmin, Vinicio Valdivieso, and Ana Maria Villaquirin provided critical, timely and qualified operational support to field research in Quito. The team would also like to express its sincere gratitude and appreciation for the cooperation and contributions of the Ecuadorian authorities throughout the process. We are particularly grateful to Mauricio Pozo, Gilberto Pazmiiio, and Messrs. Gal0 Viteri, Fernando Sukez, Fausto Herrera, Roberto Salazar, Hugo Muiioz, Mauricio YCpez, Leopoldo Biez, Ramiro Galarza, Ivonne Baki, Christian Espinosa, Diego Martinez, Polibio Cbrdoba, Jenny Guerrero, Paula Sukez, and Liszett Torres. In the same vein, we would like to recognize the valuable inputs provided by the ROSC/CFMER seminar participants held in Quito on May 20-21,2004. Participants at the first seminar included: Mauricio Pozo, Gilberto Pazmiiio, Roberto Salazar, Diego Mancheno, Hugo Muiioz, Fabiin Carrillo, Luis Benalcizar, Maria de 10s hgeles Rodriguez, Jorge Recalde, Stalin Nevfirez, Eduardo Lbpez, Milton Ordbiiez, Fausto Solbrzano, Estuardo Peiiaherrera, Ratil Baca Carbo, Carlos Pblit, Xavier Ledesma, Patricio Acosta, Roberto Passailaigue, Tebfilo Lama, Mauricio Lebn, Genaro Peiia, Elsa de Mena, Leonard0 Viteri, Juan Abel Echevem’a, Jorge Mdn, Jaime Estrada, Mauricio YCpez, Leopoldo Biez, JosC Maria Borja, Luis Palau, Dora Currea, Mauricio Valdez, David Yuravlivker, Lars Klassen, Julio Viiiuela, Gabriel Montalvo, Carlos Pimenta, Javier Game, Paula Suirez, Rick Garland, Maria Lorena Correa, Alexander Shapleigh, Margarita Andrade, Wistano Saez, Rafael Donoso, Victor Acosta, Marco Varea, Esteban Vesperoni, Patricio Rivera, Fausto Herrera, Virginia Velasco, Ivan Leiva, Giovanni Coronel, Singh Raju, Alexandra Lastra, Alicia Guzdn, Juan Garcia, Nelly Molina, Emesto PCrez, JosC Samaniego, Pablo Lucio Paredes, and Alfredo Mzaga. Participants at the second seminar in Quito on November 65,2004 were: Mauricio YCpez, Javier Game, Ramiro Viteri, Renato Valencia, Roberto Iturralde, Fausto Herrera, Patricio Rivera, Jenny Guerrero, Nelly Molina, Verbnica Poveda, Paula Sukez, Verbnica Lojin, Diego Mancheno, Alfredo Astorga, Nelly Molina, Patil Carrillo, Nelson GutiCrrez, Alfonso Tique, and Baudouin Duquesne. PREFACE
The last Public Expenditure Review for Ecuador (PER) was produced in 1993. More than a decade later, the purpose of this report is to provide the Ecuadorian authorities with the World Bank‘s and Inter-American Development Bank‘s joint comprehensive account of their diagnoses and recommendations in the area of fiscal management and public expenditure. As the GutiCrrez Administration moves forward in its second year in office, it is hoped that the content of this PER will be useful for Ecuador both to deal with the formidable fiscal challenges it faces and to take advantage of the existing opportunities in its development agenda. This report consists of two volumes. Volume Iexamines whether, and how, the core goals of public expenditure management, i.e., balanced fiscal aggregates, resource allocations to strategic sectors, and equity and microeconomic efficiency of public spending are met in Ecuador. Volume 11 presents sector studies on fiscal sustainability, the fiscal rules, education, health, pensions, the results of a national teachers tracking survey, water and sanitation, electricity, telecommunications and oil. The report does not provide full coverage of all areas affected by public expenditure. It focuses on the main themes that are critical for Ecuador’s fiscal consolidation and poverty reduction following dollarization. In most cases, it does provide choices to key policy questions that are likely to occupy Ecuadorian policymakers over the remaining of the Government, like defining FEIREP proceedings, budget allocations, or social programs prioritization. Thus, it provides an independent analysis of the selected areas where both Banks are specially involved, and a set of possible recommendations to address them. This report reflects policy developments through May 31,2004. According to the Ecuadorian Authorities, the PER is “an important contribution from the World Bank and the Interamerican Development Bank to public policy. Volume I, in particular, correctly identifies fiscal vulnerabilities in the new context of dollarization, and proposes an adequate fiscal management that increases expenditure flexibility, develops budget management reform, increases public (social) investment, and brings transparency to public expenditure. All this is supported by an implicit proposal for a Fiscal Pact for Poverty Reduction. For its part, Volume 11 deals with sectoral policies, and their link to fiscal management. It identifies the most efficient and cost-effective interventions in the social sectors, while making an optimal use of the reduced and available fiscal space. The study also recognizes the importance of political constraints, and the difficulties of setting steady rules in a non- cooperative game among national political actors that are particularly reflected in budget allocations. It correctly emphasizes the need to bring full transparency of information on the management of public accounts among all domestic actors as starting point for sectoral reform. The report has a global view and suggests positive steps. Somehow, it should contribute to align fiscal and institutional policies in the social and basic infrastructure sectors, and to strengthen them in the context of the ongoing negotiations for a Free Trade Agreement with the US., while preserving difficult domestic equilibria on the development agenda.” CHAPTER 1 FISCAL SUSTAINABILITY EXERCISES'
This note provides an examination of the sustainability of Ecuador's public debt levels using three separate exercises to examine different scenarios. Since the country defaulted on its debt the govemment has worked hard to improve its position. However, this analysis shows the situation is still far from solid. An extemal shock such as a fall in the price of oil could possibly send the country into another debt crisis. Therefore the recommendation is that the government try to further reduce its debt level as a percentage of Gross Domestic Product (GDP) in order to avoid the possibility offurther debt problems.
1.1 These notes serve as accompanying information for three sustainability exercises performed for Ecuador. They describe the models used and their assumptions. These exercises follow the methodology used in Calvo et al. (2003), and Diaz, Izquierdo and Panizza (2004). Two main models were used for the exercises of fiscal sustainability described in these notes. The first model is a simplified version of the probabilistic model of Mendoza and Oviedo (MO) (2003) and it incorporates uncertainty in tax collection into the analysis of public debt sustainability under the condition of incomplete asset markets. Although the original model by Mendoza and Oviedo considers exogenous shocks to income and the world interest rate, given tax and expenditure policies, this simplified version assumes only shocks to tax revenue. We describe the assumptions used for this exercise and its results in section 2. The second model is based on Calvo, Izquierdo and Talvi (2003) who follow the sudden stop in capital flows approach, which basically consists of calculating the required adjustment in the Real Exchange Rate (RER) that is compatible with a closure of the current account gap following a standstill in capital flows, coupled with a standard sustainability analysis that factors in the revaluation effects of the debt/GDP ratio after RER depreciation2. The assumptions used in this model and its results are discussed in Section 3 of these notes. Although these exercises do not take into account several factors, and as such should not be considered as forecast tools, they constitute appropriate benchmarks to be used in a standard sustainability analysis to understand the fiscal position of the Ecuadorian economy. I. Fiscal Sustainability Under Macroeconomic Uncertainty
1.2 Standard models of Fiscal Sustainability usually pick levels for steady state economic growth and interest rates and then use these values to calculate the required level of primary budget surplus that will be consistent with the stabilization of the current debt-to-GDP ratio. In the particular case of Emerging Market Countries (EMS),assessing the sustainability of the fiscal stance is a more challenging task given the much higher macroeconomic volatility facing EMScompared to developed countries, where volatility is not an issue. In this vein, Mendoza and Oviedo (2003) developed a probabilistic model of sustainability that takes into account the volatility of macroeconomic variables, a version of which will be used here as a benchmark,
1 This paper was prepared by Carlos Diaz and revised by Alejandro Izquierdo, IDB research department. 2 For details on methodology and parameters used see Calvo et a1 (2003).
1 focusing on revenue volatility and expenditure inflexibility. The following section describes the main characteristics of this model, while section I1describes its application to Ecuador's case. 1.3 The Mendoza-Oviedo Model. The guiding principle of the Mendoza-Oviedo (MO) model is that of Credible Repayment Commitment (CPC). According to their definition, a commitment to repay is credible only if the government is able (not necessarily willing) to repay its debt in every state of nat~re.~This implies that the government cannot accumulate more debt than the level it could service ifit were to enter a fiscal crisis, defined as the case in which the primary balance remains forever at its lowest possible value. Thus, there will be a debt limit (the debt a country would still be able to pay back even if it were to fall and remain in its crisis state) above which no additional borrowing can take place. With this in mind, Mendoza and Oviedo proceed to develop a complete dynamic stochastic general equilibrium model where the behavior of utility-maximizing individuals and profit-maximizing firms determines government revenues endogenously, all this in a context where tradable and non-tradable goods are produced. The MO model allows for a mismatch in the government's balance sheet since its debt is mostly denominated in tradables while the tax revenues are mostly denominated in non-tradables. Mendoza and Oviedo assume that the volatility in government revenues can be traced back to fundamentals such as changes in TOT, international interest rates or productivity. For this exercise, we follow a much simpler version of the original MO model that still maintains the principal insights of the more complex formulation. In the simplified version of the model used here we focus on the components of the primary balance and their probabilistic dynamics. As pointed out in Diu, Izquierdo and Panizza (2004), the simplified model follows three assumptions4:
0 The path of government revenues is stochastic and exogenously determined.
0 There is no currency mismatch (government revenues and debt are denominated in the same currency).
0 Both the interest rate5 (r) and long-run GDP growth (g) are known with certainty. 1.4 These assumptions lead to a simple formulation of the credible repayment commitment, where the threshold value for the debt-to-GDP ratio satisfies the following condition:6 d 5d"qt"'n-e~)- l+g
r-g (1) Here d * represents the threshold value for the debt to GDP ratio, fh is the lowest possible realization of government revenues over GDP, and chis the minimum level of government expenditure-to-GDP ratio that can be sustained were the country to enter a fiscal crisis in which tax revenue reaches (and stays at) th and pushes d above d * . Heuristically, eh measures a
3 Including the case in which government revenues remain indefinitely at their minimum as a share of GDP. 4 The following paragraphs until the end of this sub-section come from Izquierdo and Panizza (2003). 5 Given that the debt limit can always be repaid (abstracting from willingness to pay arguments), the interest rate under this scenario is the risk-free interest rate. d 2 government’s ability to reduce expenditure in the presence of a prolonged negative shock to revenue. Countries that can sustain larger adjustments will be able to sustain larger debt-to-GDP ratios relative to countries with rigid public expenditure In this version of the model, the - government has a constant desired level of primary expenditure, e. Each period, it observes the realization of revenue, and it finances any gap between revenue and total expenditure (including interest payments) with new debt, as long as the resulting debt does not hit the debt threshold d*. Otherwise, it needs to adjust expenditure in order to meet the debt threshold restriction. Thus, as long as debt is lower than the threshold, the debt-to-GDP ratio evolves according to the following formula: 1.5 Given an initial debt level, and a sequence of revenue realizations based on the stochastic characteristics of the revenue process (mean, standard deviation, and persistence), the model generates a set of relevant results, despite its simplicity. Not only does it determine a threshold debt level, but it also produces estimates for the number of periods it will take to hit the debt threshold, as well as a probability distribution of debt in periods ahead. This probability distribution can then be used to calculate the probability of hitting the debt threshold. 1.6 An important difference between the approach to sustainability of MO and the traditional long-run approach is that the traditional approach defines a policy target (expressed as the primary-balance-to-GDP ratio) aimed at stabilizing the current debt-to-GDP ratio (which is assumed to be the steady state level of debt to GDP). In contrast, in the probabilistic model, only the maximum level of debt to GDP is defined, but this level is not the equilibrium that will necessarily be observed, and is clearly not the optimal level of debt. The task of the government is to strengthen fundamentals so that the probability of hitting the upper limit of government debt remains low. 1.7 An implication of the probabilistic model is that, for any given average revenue-to-GDP ratio, governments that have a less volatile revenue base (for instance, governments that depend less on natural resources) will have higher values of th 7 and hence they will be able to sustain higher levels of debt. Furthermore, what really matters is not the actual value of expenditure adjustment that a country can announce, but the value of that can be credibly announced. Countries that can commit to large adjustments in expenditure can sustain higher debt-to-GDP ratios and may never be asked to act on these commitments.* 1.8 Mendoza (2003) uses equation (1) to compute sustainable debt-to-GDP ratios under different assumptions for the volatility of revenues, the difference between GDP growth and the real interest rate, and the ability to adjust expenditure. He shows that the results are very sensitive to the choice of this last parameter. In particular, he finds that emerging market countries that cannot adjust expenditure by more than 1 percent of GDP will not be able to sustain positive debt. Emerging market countries with a larger capacity to adjust (defined as 7 Where, for example, th is assumed to be equal to the mean minus two standard deviations. 8 Countries could also commit to adjusting their tax rate and, by increasing te ,obtain a similar result. 3 countries that can adjust the expenditure-to-GDP ratio by at least 8 percent) may be able to sustain debt-to-GDP ratios that range between 40 and 150 percent. When he calibrates the results to the “average” emerging market country, he finds a sustainable debt-to-GDP ratio of 60 percent for low risk emerging market countries (low risk is defined as having a small difference between real interest rate and GDP growth) and 30 percent for high risk emerging market countries. Comparable estimations calibrated to industrial countries yield a sustainable debt-to-GDP ratio that can reach up to 350 percent with average values of 85 percent. 1.9 Notice that these large differences in sustainability were obtained by just assuming differences in the volatility of revenues and the capacity to adjust primary expenditure. Hausmann (2003) suggests that valuation effects brought about by liability dollarization and original sin are likely to greatly amplify these differences. In fact, liability dollarization, by making a given country riskier, will affect the difference between real interest rate and GDP growth, and hence play a role in determining which countries are in the high-risk group. 11. Ecuador Analysis Under the Mendoza-Oviedo Model 1.10 The Mendoza-Oviedo (MO) probabilistic model requires information regarding: 1) the volatility of government revenue; 2) average levels of revenue and expenditure; 3) the size of potential adjustment in expenditure were the government to fall into a state of crisis; 4) an estimate of the risk-free interest rate on government debt; and 5) a growth rate for the economy. We first calculate volatility based on a measure of the cyclical component of government revenue (obtained by taking a Hodrick-Prescott filter to the log of revenue) in real terms for the period 1985-20039. Next, we approximate cyclical component behavior to a first-order autoregressive (AR1) process, and take the standard deviation of this process as our measure of volatility, which yields a value of 11.3. It is important to note that this is the standard deviation of the cyclical component of government revenue; this figure can be transformed in order to obtain the standard deviation in terms of GDP, which yields a value of 2.55 percent. Next, we construct measures of average revenue and average non-interest expenditure as a percentage of GDP for the period 1985-2003, obtaining values of 22.6 percent and 19.4 percent, respectively. 1.11 Following Mendoza (2001) and Mendoza and Oviedo (2003), we use their estimate for the risk-free real interest rate paid by the government, set at 6.5 percent. For estimating the average growth rate of the economy we used a similar period as the one used for estimating volatility ( 1985-2003)’0, the resulting growth being 2.5 percent. We used the prevailing level of net public debt at end-2003, equivalent to 54 percent of GDP”, as the initial amount of debt for this exercise. 1.12 Additionally, we need to make assumptions regarding the minimum levels of revenue and public expenditure for determining the levels of tmn and emn used in the model. Consequently, we make the following assumptions: (i)the minimum level of tax revenue lies two standard deviations below the mean (using our estimates of volatility and mean revenue, we find that the 9 We used data on general government (NFPS) for the period 1980-2003; however, given the massive adjustment that the debt crisis of the 1980s brought to Ecuador, we only calculated our volatility measures for the period 1985-2003. 10 GDP data is obtained from the IMF; a geometric average was used. 11 Source: Central Bank of Ecuador. 4 level of tfin is 17.5 percent of GDP); and (ii)the government can reduce non-interest expenditure by close to 30 percent in the event of a fiscal crisis from current expenditure levels. We use this rate of reduction in our estimations to maximize the size of the primary balance in times of crisis, thus providing as much room as possible to keep debt limits relatively high, and above current debt levels. This does not imply that it is expected that the government can realistically reach this level of expenditure reduction. This value of expenditure reduction is chosen mainly to illustrate the usefulness of this approach in analyzing debt sustainability. Lower levels of potential reduction in government spending would lower the size of the debt threshold, thus making crisis much more likely. However, it must be noted that during its 1999 crisis, Ecuador's government expenditures represented around 70 percent of their 2003 value in real terms, providing some indication that Ecuador has been able to live with much lower levels of public expenditure, although amidst an appalling fiscal and financial crisis. 1.13 These two assumptions regarding revenue volatility and the ability to adjust expenditures are crucial for our results and require further explanation, especially because we assume a capacity for adjusting expenditure that seems rather large when compared to other countries. First, we perform a debt threshold Figure 1.1. Debt Threshold Sensitivity Analysis sensitivity analysis that can be seen in Figure 1.1. This debt threshold 120% sensitivity analysis takes the interest and growth rates as given and loo% calculates the different values of the 60% debt thresholds (d*) that would obtain d' 60% for a series of values of volatility and expenditure adjustment levels. We can 20% observe that if we take our estimate of 0% revenue volatility of 2.5 percent and 35 0% 300% 285% 250% 20.0% 0.026 our estimate of expenditure adjustment %of Adjustment In Expendlture Deviation of Revenue (28*5 percent) the debt Source: Diaz, Izquierdo and Panizza (2004) hovers around 54 percent of GDP. Lower values of volatility will give higher debt levels. For instance, reducing volatility to 2 percent, we get a debt threshold of 81.7 percent of GDP for similar values of expenditure adjustment. However, departing from our original measure of volatility, for lower values of expenditure adjustment than the one used in our benchmark exercise, the debt threshold falls to levels that are already lower than the starting value of debt (the current debt-to-GDP ratio), making the exercise less relevant since the initial debt level would already lie above the debt levels suggested by the CPC condition. For this reason, and in order to show the dynamics of the model for illustrative purposes, we assume this large level of adjustment in government expenditure. Once again, and in order to provide some support for this assumption, we notice that the post-adjustment levels of public expenditure implied by this assumption are not that far from 1999 levels when using the 2003 level of government expenditure as a starting point. Of course, there may be new political conditions that can make this assumption unfeasible, in which case existing debt levels would already be past the threshold implied by the model. 1.14 This simple exercise points out that the present fiscal situation of Ecuador is not a lax one. With the current level of debt the government will not encounter a fiscal crisis in the medium term but only if it is correct to assume that the government is capable of high flexibility 5 in expenditure. While the definition of sustainability used here is a conservative one1', we consider that the threshold level obtained using the probabilistic sustainability analysis is a good benchmark for comparison against actual debt levels, particularly for developing countries where uncertainty about the future path of revenue and credibility about debt repayment is always an issue. Furthermore, this exercise has the advantage of highlighting that macroeconomic policies that reduce revenue volatility and increase flexibility in public spending are two key determinants of access to credit markets.13 1.15 Based on the above assumptions, we perform 500 simulations of the model, which implies obtaining 500 possible tax revenue paths, based on mean revenue of 22.6 percent of GDP and the volatility and persistence previously obtained. Assuming that the govemment keeps expenditure constant at its mean level, we can estimate the probability of hitting the debt threshold in the future, given all the above-stated assumptions. Taking as initial debt the level prevailing at end-2003 (54 percent of GDP), we compute the relative frequency distribution of govemment debt n periods Figure 1.2. Probability of Hitting the Debt Threshold n Periods Ahead ahead and then estimate the 80% I I probability of entering a 70% crisis. Figure 1.2 indicates that the probability of 60% entering an adjustment 50% phase within three periods is rather large (34 percent), 40% and it increases after 6 30% periods to almost 50 the 20% percent. One of key advantages of the 10% probabilistic model 0% approach is that it allows 3 6 9 15 30 estimation of future debt Time behavior. This information Source: Diaz, lzquierdo and Panizza (2004) highlights possible negative outcomes with sufficient anticipation, thus offering a chance for the authorities to correct fiscal policy well before hitting debt thresholds. Having discussed the probabilistic model, next we turn our attention to the sudden stop approach to assessing the fiscal sustainability of Ecuador in the following section. 111. Sudden Stop Approach to Fiscal Sustainability 1.16 As described by Calvo, Izquierdo and Talvi (2003), shocks to financing the current account, known as Sudden Stops in Capital Flows, cause stress to fiscal accounts and their sustainability. This type of shock has been relevant for EMS,especially after the Russian crisis of 1998, and they can be interpreted as shocks to credit, or shocks to the capital account. A fall in 12 Because insurance is implicitly taken against a substantial fall in government revenue. 13 So far, we have treated debt thresholds as triggers of an adjustment phase in government expenditure. Alternatively, if authorities could not come up with the necessary adjustment assumed initially to be feasible by lenders, it would be equivalent to a default situation. Thus, hitting the threshold could be interpreted as reaching default. 6 the financing of the current account deficit implies that the country must follow a forced adjustment in its absorption of tradable goods. As Diaz, Izquierdo and Panizza (2004) argue “To the extent that consumption of non-tradable goods is a complement in consumption of tradable goods, a fall in the latter will imply a fall in the former, leading to a decrease in non-tradable prices. Since for a small open economy tradable prices are taken as a given, this implies that the real exchange rate will have to adjust. Adjustment in the real exchange rate will generate valuation effects on the debt-to-GDP ratio, which, in turn, affect fiscal sustainability.” 1.17 The potential of fiscal distress following a sudden stop for a country like Ecuador was much larger in 2002, when its current account deficit reached 5.4 percent of GDP, than in 2003, by which time it had fallen to 1.6 percent of GDP. Still, Ecuador is also exposed to shocks to the current account that could work just like a Sudden Stop. Such is the case of a fall in the price of oill4 that would reduce resources available to finance other items of the current account deficit, generating effects similar to those of a sudden stop in capital flows, particularly because the Ecuadorian government does not have access to international credit markets, and therefore would have no tools available to smooth out the oil price shock. 1.18 For instance, we evaluate a large shock to the international price of oil that would reduce it to US$12 per barrel (close to the real average price of oil in 1998), implying an equivalent fall in real terms of about 50 percent of the average price prevailing at end-2003. Assuming that production of oil stays constant, we compute this percentage price fall as the reduction in the value of oil net exports15. Thus, the financing could fall by slightly over US$1 billion, equivalent to a reduction of approximately 13 percent in total imports. Assuming that the latter represents the needed percentage fall in the absorption of tradable goods, then a similar percentage fall in the demand for non-tradable goods would take place16, and if the relative price elasticity of non- tradable goods has a value similar to that of other developing c~untries’~,this would yield an increase in the real exchange rate of about 33 percent18. 1.19 Next, we need to evaluate the effect of the increase in the real exchange rate on fiscal sustainability. This analysis requires a number of assumptions regarding the currency composition of public debt, output composition, growth rates and interest rates. In the case of the currency composition of the public debt for Ecuador, we observe that given that the country dollarized its economy in 2000 all of its public debt is assumed to be in foreign currency 19. The analysis of debt currency composition vis-&vis output composition (into tradable and non- tradable goods) is key to understanding valuation effects in the debt-to-GDP ratio that will obtain after real exchange rate depreciation. In the Ecuadorian case, debt is fully denominated in dollars (or tradable goods), whereas output has a large non-tradable component. Thus, real exchange rate depreciation (tradable goods become more expensive relative to non-tradable goods) will not change the value of debt in terms of tradable goods, but it will definitely lower 14 Or a decrease in remittances. 15 To measure the net effect of a reduction in the price of oil, we net out oil imports from oil exports. 16 Given that utility functions are assumed to be homothetic. 17 This value is taken to be 0.4. 18 An increase is interpreted as an increase in the price of tradable goods vis-&vis that of non-tradable goods. For a detailed description of this calculation, see Calvo, Izquierdo, and Talvi (2003). 19 Although Ecuador still has some outstanding debt in Sucres, the dollarization of the economy implies a fixed exchange rate for that debt, which will probably be paid in foreign currency at its maturity. Thus, for the present exercise we have assumed that all of Ecuador’s domestic debt is denominated in foreign currency. 7 the value of output in terms of tradable goods, thus leading to an increase in the debt-to-GDP ratio. 1.20 For this exercise we use the geometric average growth rate of GDP between 1985 and 2003 as a proxy for the steady-state growth rate of the Ecuadorian economy. We consider different values for the effective real interest rate paid by the government. Artana, Bour and Navajas (2002) estimate that the average interest rate of the public debt of Ecuador in 2002 was 7.22 percent. However, this interest rate is reduced by the large amount of concessional debt that Ecuador has. Looking into the future, a more realistic rate for this analysis would be the interest rate prevailing in post debt-restructuring Global bonds2', under the assumption that concessional debt will eventually be replaced by market-placed debt. Thus the interest rate used in this exercise is 11 percent, an average of the interest rate of fixed rate Global 2012 bonds and the one that will prevail in the long run for Global 2030 bonds. With this in mind, we build four different scenarios depending on the interest rate used. The assumptions for each case are as follows: (i)Case A: Interest Rate of 7.22 percent which is the average interest rate of public debt for 2002 calculated by Artana et al. (2002); (ii)Case B uses the average interest rate on Global bonds, set at 11 percent; (iii& iv) Cases C and D follow alternative rates used by Artana et al. (2002) of 12 percent and 14 percent, respectively. 1.21 We first consider the required primary surplus (using standard sustainability analysis) that is consistent with Ecuador's projected debt level at end-2003 and find that it lies between 2.5 percent and 6 percent of GDP21depending on the interest rate considered. Given that Ecuador has not been able to place debt in foreign markets, this situation is equivalent to experiencing a high interest rate scenario. Indeed, Ecuador is currently paying not only interest, but, on net terms, it is also paying amortizations to private creditors without receiving new funds. For all these reasons, we lean towards the use of higher interest rates than those used in case A, and prefer instead the use of interest rates as in case B, that point to a required primary surplus of 4.5 percent of GDP. Results for other cases are reported in Table 1.1. These results, when compared with the actual observed Primary Surplus of 4.3 percent of GDP for 2003, show that there could already be a gap between the required primary surplus and the observed one depending on the interest rate case used, even in the absence of an external shock, particularly because the observed primary surplus was obtained under a very favorable external environment, both in terms of the capital account and oil prices. 20 Ecuador has two types of Global Bonds, the Global Bonds 2012, with a fixed interest rate of 12 percent and Global Bonds 2030 with interest rates that start at 4 percent and eventually reach 10 percent. 21 The interest rates and growth rates assumed for this exercise do not take into account the fact that following a sudden stop in capital flows interest rates typically increase and growth prospects decline. Thus, these sustainability calculations are less demanding than those that would obtain had these additional effects been incorporated. We account for this later on. 8 Table 1.1. Valuation Effects and Fiscal Sustainability Under a Fall in Oil Prices Case A B C D Basic Assumptions Debt over GDP 54% Interest rate 7.22% 11% 12% 14% Steady state GDP Growth 2.5% Fall in Oil Net Exports/Imports of G&S 13.15% Real Depreciation 32.9% Observed Primary Surplus (2003) 4.3% Sustainability Analysis Required Primary surplus: a. Base Exercise (no shock) 2.49% 4.48% 5.01% 6.06% b. Change in Relative Prices (valuation effect) 2.91% 5.24% 5.86% 7.09% c. b + Increase in Interest Rate of 200 BPS 4.14% 6.47% 7.09% 8.32% d. c + Decrease in GDP Growth of 1 percent 4.81% 7.16% 7.78% 9.03% e. d + Contingent Liabilities 2.54 percent of GDP 5.03% 7.49% 8.14% 9.45% Source: Diaz, Izquierdo and Panizza (2004). Note: All data refer to 2003. 1.22 Following a shock to oil prices of the magnitude described above, the RER would increase by 33 percent, increasing the debt-to-GDP ratio22 and requiring a new primary balance equivalent to 5.2 percent of GDP (case B), % of a point of GDP higher than the initially required value, and almost 1 point above current levels. Unfortunately, these episodes tend to be accompanied by interest rate increases and lower growth. For example, an increase of 200 basis points in interest rates, coupled with a fall in growth of 1 percent would stretch the required primary balance to 7.2 percent of GDP, placing a lot of stress on fiscal accounts. These results only point at the macroeconomic effects of the negative terms of trade shocks (both on debt valuation and debt servicing) but they do not take into account the direct effect on the government’s budget that lower royalties on oil would entail. It is true that some of the royalties are already earmarked to the oil fund as stated in the fiscal responsibility law, but there would definitely be an additional impact on the primary surplus that we do not account for here. 1.23 A similar exercise can be conducted to analyze the impact of a sudden stop in capital flows. Results are shown in Table 1.2. Given that Ecuador has closed its current account gap between 2002 and 2003 to 1.6 percent of GDP, this shock would be smaller than the oil price shock described above, and a lot smaller than the Sudden Stop experienced by Ecuador in 1998- 99, when the current account deficit represented 11 percent of GDP, and the change in the current account balance from 1998 to 1999 was almost 50 percent of imports. Always focusing on interest rates as described in case Bywe see that a Sudden Stop would increase the required primary surplus by 0.4 percent of GDP following the change in relative prices. Adding on a 200 basis points increase in interest rates, and a 1 percent fall in growth would require a total adjustment of 2.2 points of GDP. 22 This is so because all debt in Ecuador is denominated in terms of tradables, whereas GDP has a large non- tradable component. As long as the the ratio of debt in domestic currency to debt in foreign currency is smaller than the ratio of non-tradable to tradable output, then real exchange rate depreciation will bring along an increase in the debt-to-GDP ratio. See Diaz, Izquierdo and Panizza (2004) for more details. 9 Table 1.2. Fiscal Sustainability Under a Sudden Stop in Capital Flows Case A B C D Basic Assumptions Debt over GDP 54% Interest rate 7.22% 11% 12% 14% Steady state GDP Growth 2.5% Real Depreciation 15.38% Observed Primary Surplus (2003) 4.3% Sustainability Analysis Required Primary surplus: a. Base Exercise (no shock) 2.49% 4.48% 5.01% 6.06% b. Change in Relative Prices (valuation effect) 2.72% 4.90% 5.48% 6.63% c. b + Increase in Interest Rate of 200 BPS 3.88% 6.06% 6.63% 7.79% d. c + Decrease in GDP Growth of 1 percent 4.50% 6.70% 7.28% 8.45% e. d + Contingent Liabilities 2.54 percent of GDP 4.71% 7.01% 7.62% 8.84% Source: Diaz, Izquierdo and Panizza (2004). Note: All data refer to 2003. 1.24 Finally, following the methodology used in Calvo et a1 (2003), or Diaz, Izquierdo and Panizza (2004), we analyze the potential impact that contingent liabilities in the financial sector could have on the government’s stance. As seen in recent crises, governments have stepped in to bail out banks in trouble, particularly because of the emergence of non-performing foreign currency loans handed to non-tradable sectors that go bankrupt after a substantial rise in the RER. Given that Ecuador dollarized its economy, the entire loan portfolio of the banking system is now denominated in foreign currency (or in tradable goods). In order to calculate the loans in foreign currency given to the non-tradable sector, we excluded from the total loan portfolio of the Ecuadorian banking system loans given to the agriculture, mining and manufacture sectors23 weighed by the fraction of output of these sectors that is actually exported24, and considered all remaining loans in foreign currency to be given to non-tradable activities. This remainder represents 12.6 percent of GDP in 2003. Assuming that 20 percent of these loans go bad following a rise in the RER, and that the government incorporates this amount into government liabilities following a bailout, public sector debt would increase by 2.5 points of GDP. This increase in debt would, in turn, require an additional adjustment in the primary surplus of about 0.3 points of GDP. As it can be seen, each of these different elements would add some pressure to the adjustment required taken individually. More importantly, when taken together, they could introduce sizeable stress to the fiscal position, although not as high as that of the oil shock, and much smaller than that faced during the crisis of 1998-99. IV. Conclusions 1.25 These notes cover the results of three fiscal sustainability exercises performed for the Ecuadorian economy at end-2003. Although Ecuador’s fiscal stance has improved substantially when compared to the Sudden Stop crisis it experienced in 1998-99, and the current primary 23 Information provided by the Ecuadorian Banking and Insurance Superintendence. The information used refers to the sectoral portfolio composition as of September 2003. 24 The assumption behind this is that credit allocated to tradable activities within each sector is proportional to the share of exports in that sector’s output. For the construction of these weights we used sectoral GDP and exports as of 2001 from the Ecuadorian Central Bank statistics. 10 surplus is roughly consistent with a no-shock scenario, it is still quite vulnerable to external shocks. The introduction of uncertainty in tax revenue shows that Ecuador is not at all immune to a fiscal crisis, even if it were able to commit to high levels of expenditure adjustment, a commitment that faces substantial political challenges. Indeed, there is a positive probability that the country could enter fiscal crisis in the near future. This is particularly so because there seems to be high inflexibility in government non-interest expenditure, and high volatility in government revenue that leave the country vulnerable to external shocks, as evidenced by two defaults on external debt throughout the 1990s. 1.26 Past experience in Ecuador shows that sudden stops in capital flows can have devastating consequences in terms of fiscal sustainability. The exercises performed here show that oil shocks can also work like Sudden Stops when there is restricted access to capital markets, and that their effects can be substantial for Ecuador, not only because of revaluation of the debt to GDP ratio, but also because these episodes could entail increases in interest rates and a fall in output growth. Although there is an important concessional component that contributes to Ecuador’s relatively low average interest rate, it is true that in case of a crisis, Ecuador will not necessarily have access to this type of credit, and the pressure on sustainability that could follow if market financing were used instead could be substantial. 1.27 Ecuador has recently lowered its current account deficit, thus lowering the potential impact of a sudden stop in capital flows. Yet, the third exercise shows that Ecuador’s position is still vulnerable to this type of shock, although not like it used to be before the onset of the 1998- 99 crisis. Still, Ecuador needs to make further efforts toward fiscal consolidation that accounts for its sources of volatility. This is particularly important because dollarization, while doing away with credibility problems related to poor monetary policy, has left fiscal policy as the sole element to buffer shocks. Therefore, much more flexibility in fiscal policy is required. This can be achieved through a reduction in expenditure entitlements, the consolidation of a reliable oil stabilization fund, as well as by reducing public debt levels. 1.28 These results can be taken as benchmarks to compare against Ecuador’s current fiscal position, and are not the result of a fully calibrated model, but rather a simplification that focuses for each case on the main sources of vulnerability facing Ecuador. Yet, the results of these exercises point to the need for additional efforts in the fiscal accounts if the country is going to successfully improve its shield against negative shocks. The current fiscal position, though tight, does not seem to be out of control. But Ecuador should be showing a much better position given the very positive external environment it is currently facing in terms of oil prices and capital markets. As the exercises imply, negative shocks could quickly add substantial pressure to debt sustainability. 11 References Artana, Daniel; Bour, Juan Luis and Fernando Navajas (2002). “La Problematica Fiscal en Ecuador.” Mimeo: Inter-American Development Bank. Calvo, Guillermo A., Izquierdo, Alejandro, and Ernest0 Talvi (2003). “Sudden Stops and the Real Exchange Rate: Argentina’s Lessons.” NBER Working Paper 9828. Diaz, Carlos, Izquierdo, Alejandro and Ugo Panizza (2004). “Fiscal Sustainability Issues in Emerging Market Countries with an application to Ecuador” Mimeo: Inter-American Development Bank. Hausmann, Ricardo. (2003). “Good Debt Ratios, Bad Credit ratings: The Role of Debt Structure.” Mimeo: Harvard University. Mendoza, Enrique G. and P. Marcelo Oviedo (2003). “Public Debt, Fiscal Solvency, and Macroeconomic Uncertainty in Emerging Markets.’’ Mimeo: Inter-American Development Bank. 12 CHAPTER 2 THE FISCAL RULE' Ecuador has made excellent progress so far in its attempts to avoid the problems of overdependence on oil through the use of a new oil stabilization fund. The fund, FEP, is designed to offset fluctuations in world oil prices by saving when prices are high and enabling the govemment to draw on the fund when prices are low, offsetting the drop in revenue. A subsidiary oil fund, FEIREP, uses some of the oil money to pay down debt. Both funds also finance public investment. Our analysis of the mechanisms designed to force the public sector to save into the finds, however, found some weaknesses the govemment may want to fix. The mechanisms determining how much money flows in and out of the funds may force the govemment to save too much at certain times and not enough at others. The mechanisms, which we analyze in detail, also have too conservative an estimate for how long oil reserves will last, forcing the govemment into a more restrictive fiscal policy than necessary at times, increasing the political temptation to skirt the rules as recently happened. This report makes the following main recommendations for oil-relatedfiscal policy, aimed at maintaining fiscal stability, making optimal use of oil resources and preventing oil price swings from having a negative impact on the economy: (a) lower the public debt target further from the current 40 percent of GDP by 2006, as this level is considered too high by intemational standards and makes the country vulnerable to a debt crisis in the medium term; (b) make the setting of the reference oil price in the budget non-discretional by calculating a long-term price based on market analysis, and end the practice of setting it annually in the budget approved by Congress; (c) improve the mechanisms that determine how much the country should save or use to pay down debt each year. Currently Ecuador saves too much when prices are low and not enough when prices are high, eroding the usefulness of the oil fund as a macroeconomic and fiscal stabilizer; and (d) use the funds mainly to buy back foreign debt. This reduces the debt load (and govemment interest payments) and also offsets the negative effect of a sudden influx of dollars when the price of oil is high. Called Dutch Disease, this situation causes overvaluation of the domestic currency and harms export competitiveness. It also leads to a reallocation of factors of production to the non- tradable sector of the economy, causing deindustrialization. 2.1 The Ecuadorian Congress approved an Oil Stabilization fund aimed at compensating for swings in the world oil price, stabilizing government revenue flows and paying down government debt. 2.2 In Section 1 we look at why this type of fund was created. In Section 2 we review the theory and practice related to oil stabilization funds, and in Section 3 we analyze the Ecuador rules both as a stabilization fund for revenues and as a long-term attempt to reduce govemment debt. 1 This note was prepared by Daniel Artana and Cynthia Moskovits, economists at FIEL, Buenos Aires, Argentina. Juan Luis Bour and Fernando Navajas contributed to parts of this report. Bank Staff also contributed to comments. 13 I. Oil Stabilization Funds: A Brief Analysis of their Rationale 2.3 Several countries or states have adopted fiscal stabilization funds. Their main objective is to reduce the impact of the volatility of government revenues on government expenditures. For example, most US states have adopted fiscal funds as they usually have constitutional mandates for balanced-budgets that force them to reduce expenditures or to raise taxes precisely when the state economy is in a recession. 2.4 In the case of economies where natural resources account for an important share of government revenues, fiscal stabilization funds have been created to self-insure against the volatility of commodity prices.2 The logic is similar to the one described above: when commodity prices are above normal the government saves all (or part) of the “extra” revenues to have them available to finance public expenditures in years of depressed prices. This is the rationale behind Chile’s Copper Fund and other funds created in fuel producing c~untries.~ 2.5 But fuel funds may try to achieve another objective. Given that fuels are exhaustible and that fuel wealth represents an important share of total wealth in fuel-producing countries, some societies might be willing to save part of the proceeds from fuel production for future generations. The Norwegian Oil Fund has both characteristic^.^ Following the rationale of consuming according to one’s permanent income, the country’s Oil Wealth is estimated and the government can have a non-oil deficit equivalent to the real interest rate multiplied by the Oil Wealth. By doing so the government can spend more than it obtains from taxes on non-oil activities, but only an amount that allows it to maintain wealth constant in real terms. This ensures that current and future generations will be able to enjoy the Oil Wealth (see Box 2.1). Box 2.1. The Norwegian Oil Fund According to Bergo (2003), Deputy Governor of the Norges Bank, which is responsible for the administration of the Oil Fund in Norway, the idea is to diversify the oil risk by converting oil proceeds into financial assets that may allow the country to achieve a higher rate of return than betting on one-asset investment; and allow future generations to achieve the consumption level of the current generation given the challenges of an ageing population. The Norwegian Ministry of Finance gives Norges Bank directives so as to maximize the return of the fund (the target is 4 percent real return per annum), subject to constraints that try to limit risk. All oil revenues are deposited in the Fund every year (net of oil investments financed by the government) and the government receives back every year a reverse transfer equivalent to the real return calculated on the Oil Wealth. The Fund is expected to grow from 50 percent of GDP in 2000 to 120.percent in 2010, and fall to about 100 percent of GDP in 2050. The non-fuel deficit is expected to be around 4 percent of GDP during most of the period. Another important characteristic is that assets in the Petroleum Fund are invested abroad to reduce the impact of fluctuations in the price of crude oil on the domestic economy (e.g. Dutch Disease). And the Fund cannot be used as collateral for government or private borrowing because this would undo the countercyclical and long-term objectives. There is also a clear concern about transparency and an attempt to protect the Fund from political temptations. Extra appropriations have to be approved by Parliament. 2 See, for example, Davis et a1 (2001) for a detailed analysis of several Oil Stabilization Funds. 3 Chile has other fiscal rules to ensure macro consistency along the economic cycle. The government is supposed to achieve a structural fiscal surplus of 1% of the GDP. The actual fiscal position may differ from this structural target due to cyclical fluctuations. The Copper Fund is integrated into the long-term fiscal rule so as to cushion the impact of fluctuations in the price of copper on fiscal revenues. Although is unlikely, it might be possible to have flows accumulating in the Copper Fund when prices of copper are high and, at the same time, a fiscal deficit if the output gap is created by other external shocks. European countries have similar fiscal targets, based on a long term sustainable fiscal policy. 14 2.6 In less developed countries there has been an emphasis on trying to improve transparency (e.g. by including members of civil society on the boards that administer the oil funds) and to protect the oil funds from political temptations. The record so far has not been impressive with lots of episodes where the money was spent to finance public projects in the oil industry or other government needs.5 There are some additional points for emerging economies: 2.7 Are Oil Stabilization Funds Necessary. ? Davis et a1 (2001) have questioned whether oil stabilization funds are necessary. The objectives of shielding the budget from revenue uncertainty and volatility as well as avoiding an exhaustion of the wealth can be achieved through the implementation of sound fiscal policy within the context of a medium-term budget plan. Recourse to commodity risk markets may, in some cases, reduce the uncertainty and volatility of the revenue stream. 2.8 The Politics of Oil Stabilization Funds are Also Problematic. In many emerging economies rules are not always obeyed and any funds available in the budget face political spending pressures given the acute needs of the population. 2.9 Although these Concems are Valid, it is not clear that in weak institutional settings a multiyear budget is a credible restriction on fiscal policy. Moreover, emerging countries may have problems participating in commodity markets to insure against the risk of price fluctuations. It also seems to us that Oil Stabilization Funds should be thought of as complements to a well- designed budget process, rather than as a substitute. 2.10 Saving in a Fund when Public Debt is High. Saving for the future is a rational strategy when the public debt is at long-term sustainable ratios. In the case of Ecuador the Gross Public Debt stands at about 55 percent of GDP and the Net Debt is about 49 percent of GDP (when International Reserves and Public Sector Deposits are netted out from Gross Debt). This ratio is not far from the ceiling of 60 percent of GDP agreed by the European countries under the Maastricht Treaty. However, for developing countries a reasonable ceiling is about half of what is sensible for European countries.6 This reflects the narrowness of domestic capital markets, the higher interest rates, and the lower public revenue share in relation to GDP in Latin Ameri~a.~ This reinforces the need to increase public saving and lessen the vulnerability associated with a fragile fiscal position. The rule would also help to avoid an exaggerated expansion of current expenditures and private consumption, which in turn would reinforce private saving. Several factors, including low liquidity, low credibility in the legal framework, and the need to “buy” some confidence after episodes of default on the sovereign debt, suggest that in highly indebted oil-rich emerging countries it may be better to reduce a government liability than to save into a government asset. 4 See for example Bergo (2003). 5 See for example Davis et a1 (2001) and Welch (2002). 6 For more details see Artana, L6pez Murphy and Navajas (2003) or Reinhart, Rogoff and Savastano (2003). 7 The 60 percent of GDP ceiling for European countries, expressed as a fraction of government revenues turns out to be 150 percent. This is similar to a widely used ratio for private companies, which is the debthales ratio. Considering Ecuador Public Sector Revenues are about 25 percent of GDP, a debt ceiling of 150 percent of revenues would yield a “reasonable” debt to GDP ratio of 38 percent. The 30 percent “rule of thumb” ratio takes into account a higher liquidity risk. 15 2.11 How to Use Oil Wealth Wisely. In emerging economies there will always be political pressures to spend a higher fraction of the Oil Wealth in the current generation, and not save for future generations as is done in Norway. Here are some comments about this strategy: 2.12 Norway is a high-income country with an aging population. The idea of having a non-oil deficit equal to the real interest yield on Oil Wealth (that maintains real Oil Wealth constant indefinitely) is easier to understand than in Ecuador. With the aging problem in Ecuador far distant, it may be logical to use part of the fuel wealth to develop the country’s growth potential and the abilities of its inhabitants. However, there are some risks to this strategy: 0 Increasing public expenditures creates a Dutch-Disease effect because government outlays are usually intensive in non-tradable sectors. To avoid the Dutch Disease risk, fuel revenues need to be saved abroad (matching the additional foreign exchange supply with an additional foreign exchange demand); 0 Investing part of the fuel wealth today assumes that the social rate of return on those government outlays is higher than the rate of return that can be achieved in a well- diversified portfolio. The administration of the revenues created in previous oil booms in many emerging economies is not encouraging; the money was mainly used to finance public investments, which turned out to be mainly poor decisions. 2.13 Summing up, there are different alternatives for using the extra revenues a fuels boom generates. The choice depends on the medium-term targets of the government, but also on short- term needs and the history of the economy. One decision is whether to consume or not a higher fraction of the Oil Wealth in the current generation. A developed country like Norway has decided not to do that. Countries with enormous Oil Wealth also have more reasons to spend more of the oil boom today. Neither of these scenarios applies to Ecuador, suggesting the country needs to find the middle ground. 2.14 If the country decides to spend more on the current generation there are several alternatives we outline here, but in any case prudence should be a key element in government decisions because estimates of the Oil Wealth differ widely depending on the assumptions made about future prices and discount rates as well as how long oil reserves will last: Increase current expenditures (e.g. raising public sector wages or transfers to public or private firms). This is the worst alternative because it maximizes the Dutch Disease problem and lacks any professional evaluation about the social return on these spending decisions. 0 If poverty is high, use part of the oil windfall to reduce poverty. Similarly, if the country has a shortage of human capital, invest in education and health. This demands a careful evaluation of projects and the design of incentives so that poverty alleviation does not discourage job creation, and higher outlays on education and health are focused on where the social return on those investments is highest.8 This will also require a high-execution capacity of social programs by the 8 A chronic problem in Latin America has been the use of public money to subsidize tertiary education (mostly for the offspring of rich and middle-class families), even though enrollment in secondary education is still comparatively low. 16 government. In any case, these expenditures have the potential cost of causing a Dutch Disease effect that is difficult to solve through other government policies. 0 A supply side response through reductions in the tax burden on non-oil activities. This strategy has some justification in countries with heavy tax burdens. This does not appear to be the case in Ecuador (although the government has used part of the extra oil revenues to reduce non-oil revenues). But even if this decision has a consensus, the government has to be careful in its implementation: it is best to reduce tax rates rather than weakening tax administration or granting incentives; lower tax rates will favor formal activities that have higher productivity than informal activities, or sectors or firms favored by tax breaks. Also, lower tax revenues from the private sector are not as liable to cause Dutch Disease as higher government expenditures because the private sector composition of spending tends to be less biased towards non-tradables than government outlays. However, a reduction in taxes on non-fuel activities increases the fragility of the fiscal position given that fuel revenues are not going to last for ever. 0 Build essential infrastructure. If projects are carefully evaluated this might be a good alternative. 0 Reduce Public Debt. This is a good idea when the debt is relatively high and pays a premium over developed countries’ bonds higher than 150 basis points (the target agreed by European countries in the Maastricht Treaty). With a relatively high debt burden and a higher spread than the European target, a reduction in public debt should top the list of alternatives for Ecuador. A successful strategy will reduce borrowing costs for the government and therefore the fiscal deficit, and reduce real interest rates for the private sector in two ways: lower public borrowing in domestic capital markets (less crowding out by the government) and a lower interest rate in international markets for the sovereign that tends to be a minimum floor and a reference for private sector borrowing costs. 0 Reduce the fiscal deficit. This alternative is especially recommended for countries with high deficits, which has not been the case in Ecuador recently. 11. Fiscal Rules in Ecuador for Oil Revenues’ 2.15 The Ecuadorian economy is highly dependent upon oil. Price volatility has caused major economic imbalances, in particular during periods of low prices. Therefore, the government established an Oil Stabilization Fund (Fondo de Estabilizacibn Petrolera - FEP) and a fund principally aimed at reducing the central government’s indebtedness called the Fund for Stabilization, Social and Productive Investment, and Reduction of Public Debt (Fondo de Estabilizacibn, Znversibn Social y Productiva y Reduccibn de Endeudamiento - FEIREP). 2.16 Oil Stabilization Fund (FEP). Article 58a of the Public Finance Reform Act created the Oil Stabilization Fund (FEP), principally using oil revenues that were not foreseen or that were higher than initially contemplated in the budget. This fund is allocated as follows: 9 This section is based on YCpez (2004). 17 0 45 percent to the Fund for Stabilization, Social and Productive Investment, and Reduction of Public Debt (FEIREP). 0 35 percent to finance the construction of the Amazon Highway. 0 10 percent to finance comprehensive development projects in some provinces of the country. 0 10 percent for the National Police for a period of 5 years, of which half must be spent in the Amazon region. 2.17 Fund for Stabilization, Social and Productive Investment, and Reduction of Public Debt (FEIREP). In June 2002, Article 13 of the Organic Law on Fiscal Accountability, Stabilization, and Transparency created the FEIREP. By law the Fund should receive government revenues generated by crude oil transported over the Heavy Crude Oil Pipeline other than revenues generated on account of reduced use of the Trans-Ecuadorian Oil Pipeline System (Sistema de Oleoducto Transecuatoriano - SOTE) for light crude (in practice the government has amended this). In addition, 45 percent of the FEP revenues should be channeled into this fund. That is to say, the funding sources of the FEIREP are: 0 Government revenues from crude oil transported over the Heavy Crude Oil Pipeline, other than revenues generated on account of reduced use of the Trans-Ecuadorian Oil Pipeline System (SOTE) for light crude. 0 Budget surpluses of the Central Government. 0 45 percent of collections in the Oil Stabilization Fund. FEIREP funds are allocated as follows: 0 70 percent for the repurchasing of external public debt at market value and for paying off the debt of the Ecuadorian Social Security Institute (IESS). 0 20 percent to stabilize oil income up to 2.5 percent of GDP, and to respond to legally declared emergencies. 10 percent to promote human development through health and education. 2.18 The current administration has re-designated the oil revenues to be channeled into the FEIREP. Now all transportation revenue from state-owned oil rated lower than 23" on the API scale (i.e. heavy crude oil) goes to the fund, regardless of the pipeline system used. 2.19 Other Fiscal Targets. The Organic Law on Fiscal Accountability also introduced other targets: 0 Primary Central Government expenditures should not increase by more than 3.5 percent per annum in real terms. This rate of growth is reduced to 2.5 percent for the operating expenses of the Financial Public Sector. 0 The non-oil deficit of the Central Government will be reduced by 0.2 percent of GDP per annum. For this purpose the non-oil deficit is calculated by subtracting oil revenues derived from exports (which is about two thirds of what the government includes as petroleum revenues) from total revenues. 18 0 Public debt has to be reduced permanently until it reaches a ratio of 40 percent of GDP. It has to be reduced at least 16 percentage of GDP points in the period January 2003-December 2006. The 40 percent ratio will be a ceiling for public debt in the future. There are also constraints on the debt of the state governments: any state’s debt cannot be higher than its annual revenues and the service of the debt cannot be higher than 40 percent of the state’s annual revenues. 0 Central Government guarantees on private debt are forbidden, and it can only guarantee state debt issued for infrastructure projects (like the “golden rule” that limits public debt in the United Kingdom). 2.20 In Box 2.2 we summarize the degree of compliance with the Fiscal Accountability Law. It follows from the figures in the Box that so far the government of Ecuador has complied reasonably well with the quantitative targets set in the Law. 2.21 Flows in and out of FEZREP. Recent government estimates about flows into FEIREP are summarized in Table 2.1. Approximately US$SO million was deposited during 2003 and US$450 million is to be deposited during 2004. As of March 2004 the government has used US$41 million to buy back domestic debt. Table 2.1. Estimates Flows Flowing into FEIREP US$millions Dec. Total Jan. Feb. Mar. Apr. May. Jun. Jul. Aug. Sep. Oct. Nov. Dec. Total 2003 2003 2004 2004 2004 2004 2004 2004 2004 2004 2004 2004 2004 2004 2004 FEIREP 80,6 80,6 38,7 33.6 28,8 3,7 46,5 44,l 44,7 43,9 413 43,l 41,l 41,7 451,7 Average 26,49 26,30 28,59 30.73 30,05 28,38 27.57 27,44 27,05 26,63 26,57 25,95 26,Ol 25,74 27,47 Price Ecuador mix Source: MEF estimates. Applifation Measurement 2002 2003 m uoit L&Ch=e Executed Planned Executed Planwd Executed Cenhd Government Primary Expenditure Roforma ys, Initial Budge Real growth 3.5% na 4.3% M na 3.4% na Non-Oil ’ Central Government ~~~~~~ -0.2% M -0.8% na -0.8% -0.d na Deficit public DebVGDP Total Public Debt Reduction 16’046 yearsiaEh 3.8% annuallv 12.0% -. .- ‘Cental Govmmml fmm Fmfcrrm 2004 ’UnuI ~t mchu 40% of GDP Source: MEF 111. Government Oil Revenues in Ecuador 2.22 As a preliminary step in the analysis of fiscal rules in Ecuador, it is important to analyze how the government obtains its share of the value of oil produced in the country. 19 2.23 When the government of an oil-exporting country relies on market forces in the oil industry, private producers of crude oil sell their production in the domestic market to refineries at prices similar to what they can obtain by exporting. The government gets its desired share on the oil at the producer level by different means: a bonus paid in cash at the auction of the oil licenses, royalties, shares in the production and income taxes.” 2.24 In downstream activities, prices of derivatives at the refinery terminal are also aligned with international prices, and the government taxes these products, not trying to capture the rent of the exhaustible resource because this was already solved at the producer level, but to include these products in the general taxation of consumption (through Value-Added Tax (VAT) and to help make consumers pay for the costs to society of the consumption of oil (through special excises designed to address environmental and traffic-congestion externalities). 2.25 In Ecuador oil revenues are obtained partly at the producer level and partly on an ad-hoc basis. In the case of private producers who produce heavy oil, the government gets a share in production or a royalty that varies according to the contract. The average share is approximately 33 percent. In the case of the public company, Petroproduccidn, which produces mostly light oil, the government gets a share of approximately 22 percent of exports. But the government share of, production sold to the public refineries is obtained, indirectly, at the downstream level. Fiscal revenues obtained from sales of derivatives are obtained by taking the value of derivatives sold in the market and subtracting from this amount the value of imported derivatives and the costs of the public agencies responsible for refining and wholesale commercial activities (the “so called” Implicit Transfer from Derivatives). Therefore, these fiscal revenues include what the government should have obtained from the oil processed at the producer level and what it should have obtained at the downstream level through VAT and excises. As the average price of derivatives like gasoline is relatively low in Ecuador, there is practically no tax at the downstream level except VAT. 2.26 Table 2.2 shows an estimate of the government take at the producer level assuming all light oil is subject to the same government take (22 percent), and derives the implicit tax on derivatives. Projections of production by Petroproduccion, private companies and processed oil in domestic refineries were obtained from the World Bank. 2.27 Fiscal revenues for 2003 were estimated at US$1.74 billion, with about US$1.2 billion obtained from the upstream activities and just under US$0.6 billion from the sales of derivatives. In Table 2.2 we allocated an extra US$0.3 billion to upstream activities assuming that the 53.1 million barrels processed in Ecuador would have paid the same 21.6 percent royalty paid by the public company’s exports. Therefore, the fiscal revenue obtained from upstream activities should have been US$1.5 billion and that obtained from downstream activities only US$0.2 billion. As the VAT on derivatives is estimated to yield US$0.2 billion, taxes on fuels are virtually non- existent in Ecuador. 2.28 It is also interesting to mention that if taxes on fuels are specific (which is the most frequent design), tax revenues from these should be independent of the price of crude oil. In the case of Ecuador, analyzing data for the period 1983-2003, we found that fiscal revenues obtained 10 For developed countries economists tend to prefer that the expected rent be captured by bonus paid in cash to distort as little as possible the marginal price received by each producer. When the expropriation risk is higher, it might be better to relate part (or all) the government take to the value of production because the government becomes a silent “partner” in the oil venture. 20 from oil exports have a 76 percent correlation with the international price of oil, while fiscal revenues obtained from sales of derivatives in the domestic market have a negative correlation of 27 percent. This suggests than in periods of high oil prices, taxation on derivatives is reduced, and the opposite is true in periods of high prices. Table 2.2. Composition of Oil Fiscal Revenues - 2003 Million bl US$hl Value at Observ. World Prices (million of - US$) 1 Total Production = 2 + 9 146,O 2352 3.434 1/ 2 Petroproduccion 68,O 26,18 1.780 3 Gov. Take on Upstream 24,3 26,18 636 4 % of Production = 3 12 21,6% 5 Crude Processed in Ecuador 53.1 26,18 1.39 6 Gov. Take on Downstream 567 21 7 Gov. Take If All Were Exported = 5 11,5 26,18 300 8 Implicit tax on derivatives = 6-7 267 3/ 9 Private Production 78,O 21,20 1.654 10 Gov. Take on Upstream from Private 25,5 2 1.20 54 1 11 Percentage = 10 I11 32.7% 12 Total Go;. Take = 3 + 6 + 10 1.744 Source: Based on World Bank figures Notes: 1lProduction is net of losses, but includes a negative net stockbuilding. 2/ Gov. take on downstream is the implicit transfer for derivatives This is a “proxy” for the taxation on domestic sales. 3/201 million come from VAT. IV. An Analysis of the Fiscal Rules in Ecuador 2.29 In this section we analyze the fiscal rules introduced by the Organic Law on Fiscal Accountability. In each case we will try to make the comparison with “best practice,” acknowledging that in some areas there is no consensus among the experts. Our analysis is concentrated on the FEIREP as a means to reduce the burden of the public debt and to create a fiscal stabilization fund. We will not analyze other aspects of the law that improved the budget process. 2.30 Improving Transparency and Reducing Contingent Liabilities. The Law introduced some positive reforms. The Central Government cannot guarantee private debt, and guarantees to State Governments’ debt are limited to investment projects. Although money is fungible and therefore the loan can end up financing current expenditures, this “golden rule” is a reasonable objective. Together with quantitative restrictions on states’ debt, it puts limits on how much debt subnational governments may contract. By doing so it reduces the size of a contingent increase in Central Government debt because of the bailout of subnational governments that is so frequent in the region. 2.31 In the FEIREP’s case, the Law establishes that it cannot be used as collateral in any loan operation. In the absence of this restriction the savings-stabilization functions of the Fund could be undone by expanding the access to credit of public agencies using the financial assets in the Fund as a guarantee. Another point is that transfers and withdrawals from the FEIREP go 21 through the general budget, making for a unified control of fiscal policy." The FEIREP's accounts are expected to be available to the public, also increasing transparency. A. The Stabilization Component of FEIREP 2.32 Ninety percent of FEIREP has two objectives: to create an oil stabilization fund and to reduce public debt (which is similar to building an Oil Wealth available for future generations). The other 10 percent is spent on health and education. In this section we analyze the stabilization function of FEIREP. There are several points to check: Does the Stabilization Fund Provide Full or Partial Insurance ?. The stabilization component of FEIREP has a ceiling of 2.5 percent of GDP and is supposed to provide resources when the price of oil is low or when the country suffers from a natural catastrophe. Both events reduce fiscal revenues, and the second one also raises the demand for public outlays. In Ecuador's case, as we shall show, 2.5 percent is not enough. The necessary amount to provide full insurance for an eventual period of low oil prices is easy to estimate. Low prices would lower the government take on upstream activities. But in the case of Ecuador it is not clear from the data how much was obtained in each period from upstream activities given that part of that revenue is obtained through downstream activities as explained earlier, so we will include downstream revenue for this calculation. The average oil revenues for 1993-2003 were 6.5 percent of GDP (4.15 percent from exports of crude oil and 2.35 percent from sales of derivatives in the domestic market). This is higher than 2.5 percent so there is not full insurance. During 1997-1998 oil revenue was 4.6 percent of GDP lower than the average of 1993-2003 if only exports of crude oil are considered, and 3.7 percent of GDP when all oil revenues are included. The fund is also assumed to provide insurance against losses from natural catastrophes. Although, a priori, the distribution of probabilities of natural catastrophes and low international oil prices should be independent, the 1997-1998 period is an example of bad luck when both negative external shocks were present at the same time. There is no economic justification for purchasing full insurance, but the analysis above should alert the authorities that they only have partial coverage in a worst-case scenario. The Political Economy of Oil Stabilization Funds. The accumulation of funds to ensure a countercyclical fiscal policy leads to political temptations. For example, the current administration has decided in a year of high international prices to tap the 20 percent of the FEIREP earmarked for the stabilization of oil revenue and the 10 percent earmarked to increase expenditures on health and education to partially close the financing gap the government faces. Even in stronger institutional settings this is a problem.12 It might be easier to resist the temptation if the government were able to pay a yearly fee to an insurance company that would provide, in exchange, the gap in fiscal revenues created when negative shocks occur. However, this insurance is not easily available. It is 11 Davis et a1 (2001) underline that these are necessary conditions for a well-designed oil fund. 12 For example, in Chile the amount of money saved in the Copper Fund is not publicly available. 22 very difficult to write a contract to insure the country against natural catastrophes given that it is difficult to measure the damage and agree on what is a “relevant” natural catastrophe. And in the case of oil revenues, although the amount “insured” would be easier to calculate for a given production, some politicians would question a contract like this. 0 The Design ofthe Stabilization Function. In theory the stabilization function of an Oil Fund should be designed so as to save the revenues produced by a positive price shock in order to have resources available when prices are below trend. The first question is what price the government should target as reasonable in the long term. For example, the Copper Fund in Chile assumes the international price follows a mean reverting process, but some analysts have questioned this c~nclusion.’~It is beyond the scope of this paper to provide an analysis of what is the reasonable crude oil price that the government should target, although some past studies by the International Monetary Fund (IMF) suggest that the international price of crude oil follows a random walk. In recent years the government has defined that for the light crude oil the target price is US$ 24hbl and for heavy oil it is US$ 18hbl. In the long run, it would be helpful to get an analysis of the behavior of the international price of crude oil so that the government can define the target in a more precise way. In the short run it is important to introduce a clear rule to calculate the target as it is too easy to finance excess government expenditures by increasing the target price. This discretionality should be eliminated by Law. A second important issue is to analyze the formula by which revenues are accumulated in the stabilization fund. Twenty percent of FEIREP should be used for this purpose. As FEIREP receives 45 percent of the Stabilization Fund (FEP) and any fiscal revenues that are obtained from increases in heavy oil prod~ction,’~revenues that accrue to the stabilization function of FEIREP are equal to: 0.2 X 0.45 [Ag](Pi-pf) QI + Agh (Ph-Ph’) Qh] + 0.2 [Agh Ph (Qh - 56.6)] (1) where: Agl= government take in light oil (currently 32.7 percent) Agh = government take in heavy oil (currently 21.6 percent) P1 and Ph are the actual prices of light and heavy crude oil Pf and Ph’ are the target prices set in the budget (actually US$24 and US$ 18 per barrel) ~1 and Qh are the quantities of light and heavy crude oil produced. 56.6 are the millions of barrel per day per annum that are the base above which fiscal revenues out of extra production must accumulate into the FEIREP (155.000 bbl/day as of August 2003). A well-designed stabilization would be defined as follows: [Agl (Pl-pf) Q1 + Agh (Ph-Ph’) QhI (2) Money will be accumulated in the fund when P1> Pf and Ph > Phot and be used when the opposite happens. 13 See Fiess (2002) for an analysis of the fiscal rules in Chile. 14 The remaining 55 percent of the FEP is earmarked for specific government projects and does not have any stabilization function. 23 Subtracting equation (1) from equation (2) we obtain that the difference between the “ideal” stabilization fund and the Ecuador stabilization fund is equal to: a The second term in expression (3) is negative because Qh is supposed to be higher than 56.6 million barrels per day a year, meaning that the Ecuador Fund will save more than the “ideal” fund, while the sign of the first part of expression (3) will also be negative when actual prices are below target prices, and positive when the opposite holds. Therefore, the Ecuador Fund saves more than desired when crude oil prices are lower than their target, and may save less than desired precisely when there is a boom in prices and P1-Pl0and Ph-Ph’ are positive and high. Table 2.3 and Figure 2.1 illustrate this point. a The first column of Table 2.3 shows the ratio of actual prices compared to target prices, assuming for simplicity that target prices are well defined and that the difference is the same percentage both for heavy and light crude oil. The second column estimates the money that should flow, according to equation (2), into an “ideal” Stabilization Fund. The third column estimates how much money will accumulate into the stabilization component of FEIREP, assuming it includes all the production of light crude oil.” The last two columns repeat the estimates but using the quantities that the World Bank forecasts for 2010. This allows checking for the sensibility of the estimates to higher quantities of Qh that are relevant in expression (3). The calculation leads to the following conclusions: a The stabilization component of the FEIREP will force the government to save resources even in periods of very depressed prices. The amounts increase with increases in the production of heavy oil (see Table 2.3 and Figure 2.1). a The “ideal” Stabilization Fund would require a much higher saving effort when prices are 10 percent or more above the target prices than under the current design. Therefore, the stabilization component of the FEIREP is poorly designed: it forces the government to save even in periods of depressed prices (although this might be offset by a decree authorizing withdrawals from the fund) and also implies much lower savings than desired when prices are slightly higher than target prices.16 a To reduce the disparity between the Ecuador rule and the “ideal” rule the government could earmark for the FEIREP 100 percent of the FEP. In any case, a better design of the Oil Fund will separate the stabilization function from the fiscal solvency function. The first should be independent of the evolution of production, and deal only with the volatility in prices; and the second should be independent of the volatility of the international price of crude oil, and be based on the expected evolution of production and reserves (see below). 15 Money flowing into FEIREP from production of light crude oil counts only exports of crude oil from Petroproduccidn, leaving aside all light crude oil that is refined in the domestic refineries. We show in column 3 of Table 2.3 the estimate including all production of light crude oil to ease the comparison with the “ideal” stabilization fund. Counting only the production of light oil that is exported does not alter the figures much. 16 Prices as of May 2004 are about 30 percent higher than the targets included in the budget. Therefore the revenues flowing into the stabilization component of FEIREP are about US$200 million a year short of what would be desirable. 24 Table 2.3. Revenue Flows into the Stabilization Component of FEIREP Compared to an “Ideal” Stabilization Fund (Millions of US$) Relative Price ratio “Ideal” Fund. Ecuador Fund. “Ideal” Fund. Ecuador Fund. (actual vs. target) for 2004 quantities 2004 quantities 2010 quantities 2010 quantities both heavy and light oil QI = 69.1 Q1= 69.1 Q1= 89.1 QI = 89.1 Qh= 101.1 Qh = 101.1 Qh= 156.5 Qh = 156.5 0.6 -381 -3 -553 21 0.8 -190 25 -277 69 0.9 -95 39 -138 93 1.o 0 52 0 118 1.10 95 66 138 142 1.20 191 80 277 166 1.50 477 121 692 239 Source: Bank staff estimates 0 Moreover, a well designed FEgure 2.1 Flows Flowing into an oil StabiitionFund stabilization fund will also try to offset the macroeconomic consequences of oil price 5m variations (the Dutch Disease problem). This can B only be achieved if the :tm money flowing into the i.,: stabilization fund is saved abroad. l7 Therefore, it follows that the stabilization fund should be invested in the source: ~uthor’~~tinat~ Rrs Wa (mu#w Tapl) 0 But it is not obvious that the entire fund has to be invested in highly liquid assets, which have a low rate of return. As the size of the shock is not uniform, it is more likely that small amounts of the fund might be used than all the fund at any given moment, and this means that part of the stabilization fund should be invested in a diversified portfolio 17 An alternative would be a deposit in a financial institution in Ecuador with 100 percent reserve requirement to avoid lending that money, but this would be exposed to Ecuador risk. 25 containing longer term assets with a higher return but exposed to short-term fluctuations in price. 18 B. The Debt Reduction Component of FEIREP 2.33 The Fiscal Law has three rules related to the long term fiscal solvency of Ecuador: the mandatory use of 70 percent of FEIREP to reduce public debt, to reduce public debt until it becomes less than 40 percent of GDP (this figure then becomes the ceiling for public debt) and the 0.2 percent of GDP yearly reduction in the non-oil deficit, counting only fiscal revenues obtained from exports of crude oil. Here there are several issues to analyze. 2.34 The Long-term Public Debt Ratio. For the reasons detailed in Section 2 of this paper the 40 percent public debt to GDP ratio looks somewhat high. However, to be able to comply with the ceiling every year the government would need to average a lower ratio. As the target is defined by Gross Public Debt, the 40 percent ratio is not unreasonable, although it would be better to modify the target to reduce it or make a rule that, in years when the oil price is not excessively low and there are no natural disasters, it has to be lower than the 40 percent ceiling. Figure 2.2. NFPS Non Oil Results 2.35 Reduction in the Non-oil Deficit. Figure 2.2 tracks the non-oil deficit over the last decade. There is a large decrease compared to the very high levels of the late 1990s. However, the condition of reducing the non-oil deficit by 0.2 percent of GDP every year is too demanding on public finances and not necessary. Starting from a non-oil deficit of 2.4 percent of GDP in 2003 (the government achieved a surplus of 1.7 percent of GDP and oil exports produced 4.1 percent of GDP)19 this assumes that the Oil Wealth of the country will be wholly depleted in 12 years. The “optimal” non-oil deficit becomes zero when the country runs out of its Oil Wealth, and even the most pessimistic outlook assumes that reserves are going to last more than 12 years in Ecuador.*’ Some margin of maneuver is created by the exclusion of some fiscal revenues derived from oil exports in the national accounts, i.e. exclusion of the fraction of the revenues obtained from sales of derivatives in the domestic market that should be attributed to oil production (because no government take is paid at the producer level on the crude refined in Ecuador, this amounts to about US$0.3 billion as calculated in Table 2.2 above). 18 The same suggestion is made for international reserves of the Central Bank in Harberger (2000). 19 In 2003 the non-oil deficit was 3.2 percent of the non-oil GDP. This is the relevant figure that needs to be financed with Oil Wealth. See next section. 20 The pessimistic scenario of the IMF (2003), that assumes that no additional reserves are found in Ecuador shows reserves running out approximately in 2020. In the optimist scenario, where 100 million barrels of reserves are added every year (which is less than half the production rate) reserves are depleted approximately in 2027. 26 Moreover, the reduction in the non-oil deficit might not be binding because the target is set on the budgeted non-oil deficit, and not on the ex-post executed deficit. It is likely that the inclusion of a target for the non-oil deficit attempts to send a “signal” to the non-oil economy that an adjustment is necessary as oil runs out. However this assumes that all the Oil Wealth is spent today, and none is saved for the future. (See Table 2.4). 2.36 Estimate of the Oil Wealth in Table 2.4. Estimate of the Non-oil Dkficit in 2003 Ecuador. Ecuador’s Fiscal Law Millions of US$ % of GDP % of Non-oil mandates that 70 percent of FEIREP GDP should be used for debt reduction. A Revenues 6909 25,5 Oil 1664 6,1 reduction in government debt is similar Exports 1.098 41 to the creation of a government asset. Sales of 572 2,1 When public debt is not a problem, a Non-oil revenues 5811 24,4 well-designed Oil Fund will save Primary 5635 20,8 23,7 through a well-diversified portfolio that Primary Balance 1274 497 Non-oil Primary 176 0,7 finances a non-oil deficit equal to the Interest 820 3 ,O 3,4 real return on this asset. This makes part NFPS Balance 454 1,7 -2,7 of the Oil Wealth available for future Non-oil Balance -644 -2,4 -2.7 generations. This is the case in Norway, Source: Author’s estimates which has one of the better-designed oil Note: GDP in 2003 27,l billion and Non-oil GDP 23.8 billion funds in the world. 2.37 In this case Oil Wealth is the net present value of forecasted government oil revenues at long-term prices (we isolate the impact of fluctuations in the international price of crude oil). Using expression (1) in Annex 1, Ecuador’s Oil Wealth can be estimated using different discount rates. We use three rates for real returns achievable in a well-diversified portfolio, 3 percent, 3.5 percent and 4 percent and use output projections from the World Bank until 2006 and own estimates from 2007 onwards.21 With this production path, oil reserves would be exhausted in year 2020 if no reserves are added to the 4,400 million barrels available today, or in Table 2.5. Oil Wealth in Ecuador Million of US$ year 2027 if 100 million barrels were added 33% 3,0% 4,0% every year from now on (the optimistic Oil Wealth. NPV 18891 19642 18182 scenario of the IMF in 2003). Pessimistic Oil Wealth. NPV 25991 27463 24631 2.38 Table 2.5 shows the estimates of oil Optimistic wealth under both scenarios at the three Non-Oil deficit. 661 589 727 different discount rates. The table also Pessimistic shows the sustainable non-oil deficit that the Source: Author’s estimates country may run without depleting the value of the Oil Wealth under the pessimistic scenario. If Ecuador were able to have a non-oil deficit of US$600 million a year and save the difference in assets yielding a 3.5 percent annual return in real terms, when crude oil reserves are completely depleted the government would have assets equivalent to 35 percent of GDP (as of year 2020 in 21 We assume that private producers add 10 billion barrels a year in 2007 and 2008 and from then on private production increases at an annual rate of 1 percent. Production of light oil is assumed to grow 5 billion barrels a year until 2010 and then at a rate of 4.3 percent per annum. 27 the pessimistic scenario). Alternatively Ecuador would be able to buy back most of its public debt if the money were used for that purpose.22 Ecuador rules do not follow this “ideal” path. Seventy percent of FEIREP should be used to buy back debt, but assuming prices are equal to their long-term levels, the funds available for buyback operations would be equal to: 0,7 [Agh ph (Qh - 56.6)l (4) The only revenues available for buyback operations will come from increases in the production of heavy oil. Table 2.6 compares how much FEIREP would accumulate for debt reduction with the amount that would be saved (or would be available for buybacks of public debt) if Ecuador had an “ideal” rule that tries to maintain constant Oil Wealth. It shows that Ecuador saves “too little”, or in other words, the country is consuming part of the Oil Wealth in the current generation (and implicitly transferring to the future more debt or lower assets than under the ideal rule).23 Table 2.6. Flows for Debt Reduction: Ideal Funds vs. FEIREP (Mlns. US$) 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Ecuador Rule (70 %ofFeirep) 191 249 290 331 373 414 420 427 433 440 447 454 460 467 474 481 489 “Ideal” Debt Reduction 329 411 506 591 676 761 796 828 861 895 930 966 1004 1043 1083 1124 1167 Source: Author’s estimates Note: Prices are forecasted as equal to the long term trend. 2.39 Need to Modifr the Rules. The three rules analyzed so far are contradictory and confusing as they are a combination of restrictions on both spending and debt levels. The 0.2 percent of GDP annual reduction in the non-oil deficit is too restrictive on spending as we showed above, while the rate of accumulation into FEIREP for debt buybacks is lower than would be desirable under a well-designed rule. On the other hand, if the government desires, future production may eliminate all public debt anyway. Sooner or later the law needs to be adapted so that it is more flexible to changes in outlook. However, picking the adequate time to propose the amendments to the Law is critical, since there are populist proposals in Congress attempting to deviate increased FEIREP resources to current spending, which would replicate past history of continuous waste of oil windfalls. 2.40 Which Debt to Buy Back. There is no doubt that the debt ratio remains high and above sustainable levels. Authorities are working hard to reduce it. Therefore, an important point to analyze is what debt the government should buy back, domestic or external. By early 2004, the government has bought back minimal amounts of domestic debt and is trying to take the necessary steps to buy back external debt. 2.41 From a macroeconomic point of view there is no doubt that the government should buy back external debt. This is the only debt operation that will help to moderate the Dutch Disease phenomenon created by high crude oil prices. Using the money available to buy back domestic 22 If the buyback operations are begun now, the total reduction in the public debt would be higher than 35 percent of GDP by 2020 because GDP is assumed to grow at 3.5 percent in real terms per annum. 23 It has to be noted that savings during the first years would be earmarked to reduce public debt; therefore they could not be saved in financial assets. Hence, the Oil Wealth accumulated when reserves are depleted would be lower than 35 percent of the GDP, because part of the Oil Wealth had been used to reduce the public debt to GDP ratio to more sustainable levels. 28 debt will increase aggregate demand unless the holders of domestic debt take the payments out of the country. This is surely not the case with the pension system debt and probable is not the case with other debt held by residents. C. The 3.5 Percent Target for Growth in Real Primary Expenditures 2.42 Rules that constrain the growth in public expenditures are easier to control and more understandable by the public than rules that restrict the deficit or the debt level. Ecuador has the three rules together and this creates some problems. 2.43 In this section we briefly analyze what might be the advantages and disadvantages of using the 3.5 percent rule in growth for primary expenditure in real terms.24 On the one hand, the 3.5 percent rule is easy to understand. This rate is similar to the projected real GDP growth rate for Ecuador during the forecast period.25 But this assumption might be a problem if the actual real GDP growth rate diverges by much from 3.5 percent. One alternative would be to use a weighted average of the rate of growth in the population (as a minimum threshold for the demand for public goods) and a moving average of the growth rate of the economy. This would introduce some flexibility to the yearly rate, but at the cost of introducing more complexity. 2.44 A second problem, which is more urgent, appears because the 3.5 percent rate is calculated on the budgeted real primary expenditures of the previous year, and not on the executed expenditures of that year. This departs from normal rules that restrict the growth rate of executed expenditures. In the particular case of the 2004 budget, it makes the rule very lenient, because the execution in 2003 was about 7 percent below the budget for 2003, implying that the 3.5 percent real growth in 2004 could end up being about 11 percent above than the budget in 2003. 2.45 A third problem appears if the original budget is amended. As the Law establishes that the 3.5 percent rule should be applied to the original budget approved by Congress, major amendments to the original budget may raise conflicts in the future. Table 2.7, elaborated by the World Bank, suggests that this might be a problem. Table 2.7. Budget Execution Ratio of Sectoral Expenditures, Central Government 1/ 1995 1996 1997 1998 1999 2000 2001 2002 1995-2002 1995-99 2000-02 Primary Expenditures 1,13 0,32 1,08 1,12 1,03 0,88 1,06 0,84 0,93 0.94 0,93 Source: Ministry of Finance Note: l/Refer to the difference from the initial planned budget of the year. 24 We excluded from a World Bank original table the line corresponding to Public Debt to estimate the rate of execution of Primary Expenditures. See Volume Iof this Public Expenditure Review. 25 Notice this is not a steady state rate and is above the steady state rate assumed in the previous article. 29 References Alesina A. and T. Bayoumi (1996). “The Costs and Benefits of Fiscal Rules: Evidence from US States.” NBER Working Paper No. 5614. Artana D., Upez Murphy R. and Navajas, F. (2003). “A Fiscal Policy Agenda” in Pedro Pablo Kuckzynski and John Williamson (Eds.) “After the Washington Consensus. Restarting Growth and Reform in Latin America”: Institute for International Economics, Washington DC. Bails, D. and M. Tieslau (2000). “The Impact of Fiscal Constitutions on State and Local Expenditures.” Cat0 Journal, Vol. 20, Fall. Barnett, S. and Ossowski R. (2002). “Operational Aspects of Fiscal Policy in Oil-Producing Countries.” IMF Working Paper WP/02/177. Bayoumi T. and B. Eichengreen (1995). “Restrain Yourself The Implications of Fiscal Rules for Economic Stabilization.” IMF Staff Papers, Vol. 42( l),pp.32-48 Bergo, J. (2003). “The effect of the Petroleum Fund on the Norwegian Economy”. Speech by Deputy Governor of Norges Bank to the Norwegian-Swedish Chamber of Commerce, Stockholm October 22, 2003. www.norges-bank.no/english/speeches/2003-1O-22/speech- 2003- 10-22. html. Bilbue, F. and D. Stasavage (2003). “Incomplete Fiscal Rules with Imperfect Enforcement.” European University Institute and London School of Economics, June. Bohn, H., and R. Inman (1996). “Balanced Budget Rules and Public Deficits: Evidence from the U.S. Status.” NBER WP 5533. Bour, J., Artana, D. and Navajas F. (2002). “La problemdtica fiscal de Ecuador.” Trabajo realizado para el BID, September. Braconier, H. and T. Forsfalt, (2004). “A new method for constructing a cyclically adjusted budget balance: the case of Sweden.” The National Institute of Economic Research, WP90, Stockholm, April. Buchanan, M., MacFarquhar, R. and Nielsen, F. (2003). “Managing Oil Windfalls: Good and Bad in EMEA.” EMEA Economics Analyst, Goldman Sachs, August. Chalk, N. and R. Hemming (1998). “What Should Be Done with a Fiscal Surplus?’’ IMF Paper on Policy Analysis and Assessment 98/10, August. Davis, J., Ossowski, R., Daniel, J. and Barnett, S. (2001). “Stabilization and Savings Funds for Nonrenewable Resources: Experience and Fiscal Policy Implications.” IMF Occasional Paper No. 205. Washington DC. 30 Donders, J. and C. Kollau (2002). “The cyclically adjusted budget balance: the Brussels’ methodology.” CPB Report, 4. Fatiis, A. and I.Mihov (2003). “The case for restricting fiscal policy discretion.” Insead and CEPR, March. Fiess, N. (2002). “Chile’s New Fiscal Rule.” World Bank, May. (Mimeo). Hagemann, R. (1999). “The Structural Budget Balance. The IMF’s Methodology.” IMF Working Paper No. 95. IMF (200 1). World Economic Outlook, Fiscal Policy and Macroeconomic Stability. Washington DC. IMF (2003 a). Country Report No. Ecuador. Selected Issued and Statistical Appendix, April. IMF (2003 b) Country Report No. 03/233. Trinidad and Tobago: Selected Issues and Statistical Appendix. Washington DC, July. Kennedy S. and J. Robbins (2001). “The Role of Fiscal Rules in Determining Fiscal Performance.” Working Paper 2001-16, Department of Finance, Canada. Krol, R. (1997). “A Survey of the Impact of Budget Rules on State Taxation, Spending, and Debt.” Cat0 Journal, Vol. 16 No3, Winter. Lane, P. (2002). “The cyclical behaviour of fiscal policy: Evidence from the OECD.” Institute for International Integration Studies, Trinity College Dublin and CEPR, February. Marcel, M. Tokman, M., ValdCs, R. and Benavides, P. (2001). “Structural budget balance: methodology and estimation for the Chilean Central Government 1987-2001 .” Cepal. Serie Seminarios y Conferencias. Santiago. Marin, J. (2002) “Sustainability of Public Finances and Automatic Stabilization Under a Rule of Budgetary Discipline.” European Central Bank WP 193, November. OECD, (2002). “Fiscal Sustainability: The Contribution of Fiscal Rules.” OECD Economic Outlook 72. Perry, G., (2002). “Can Fiscal Rules Help Reduce Macroeconomic Volatility in LAC?” Presented at the IMF-World Bank Conference on Rules-Based Fiscal Policy in Emerging Market Economies, Oaxaca, Mexico. Poterba J. and J. von Haguen (eds.) (1999). “Fiscal Institutions and Fiscal Performance.y’ Chicago: The University of Chicago Press. Reinhart, C., Roggoff, K. and Savastano, M. “Debt Intolerance.” Brookings Papers on Economic Activity. Spring 2003. 1. pp 1-74. 31 Sobel, R. and R. Holcombe, (1996). “The Impact of State Rainy Day Funds in Easing State Fiscal Crises During the 1990-1991 Recession,” Public Budgeting and Finance, 16,28-48. Talvi, E. and Vegh, C. (2000). “Tax Base Volatility and procyclical fiscal policy.” NBER Working Paper Series. WP 7499. Von Haguen and I.Harden (1995). “Budget Processes and Commitment to Fiscal Discipline.” European Economic Review, 39, pp.771-79. Wagner, G. and E. Elder (2002) Fiscal Policy and Cyclical Fluctuations: An Investigation of U.S. State Budget Stabilization Funds. ” Duquesne University Working Paper. Wagner, G. and J. Gropp (2002). “The Municipal Bond Market and Fiscal Institutions: Have Budget Stabilization Funds Reduced State Borrowing Costs?” Duquesne University Working Paper. Wagner, G., (2003). “Fiscal Stress and State Rainy Day Funds: Are They the Answer for Brighter Days Ahead?” Duquesne University. Welch, C. (2002). “Oil Funds: Answer to the Paradox of Plenty.” Friends of the Earth. November. The World Bank (2003). “Peru: Restoring Fiscal Discipline for Poverty Reduction. A Public Expenditure Review.” Washington DC. -----__--(2004). “Ecuador. Development Policy Review. Sustainable Growth, Social Inclusion and Governance: The Road Ahead.” Washington DC, March. -----_--- (2004). “Initiation Memorandum for a Proposed Fiscal Consolidation and Competitive Growth-I1 Adjustment Loan.” Washington DC, March. YCpez, M. (2004). “Ecuador. Situation of the Oil Industry. Evaluation as of January 2004.” World Bank. Washington DC (mimeo). 32 ChaDter 3 EDUCATION' Education has improved substantially in Ecuador in recent decades, but progress has slowed in recent years and there are signs of deterioration. Of particular concern is that the education gap between the indigenousblack and mestizo (mixed race) population groups appears to be widening, especially after primary school. And as part of this phenomenon, the gap between education levels for the rich and the poor is widening. This paper analyzes the education sector and provides recommendations for a more eflcient use of budgetary resources, especially with regard to the achievement of the Millennium Development Goal (MDG) of universal primary education. The main recommendations, based on studies to determine the factors keeping some children away from school, are: (a) to improve the quality and training of teachers while making efforts to reduce the overall number of teachers as a means to save resources; (b) use these resources to improve school infrastructure and increase subsidies and incentives to the poor; and (c) target cash incentive programs for school attendance towards the urban poor where they appear to have the greatest impact. Here the model suggests the cash transfer (Bono Desarrollo Humano) need not be conditional on school attendance in order to be effective. More decentralized decision-making (e.g. assigning a greater role to local communities in teacher appointments) is expected to promote school enrollment, in particular among urban non-poor and rural poor. 3.1 The Ecuadorian government spends more on education than on any other public sector program. Ecuador has good coverage of primary education, but its quality is poor and transition to secondary education is low. Also inequality in access to education has increased between urban and rural population groups and between rich and poor. However, the gender gap in education appears to have closed. This study assesses the equity, efficiency, and sustainability of educational expenditure, inputs, and results. In section 2 we summarize the performance of Ecuador's education system during the 1990s up to the early 2000s, looking both at education outcome indicators and internal and external efficiency measures. In Section 3 we summarize recent changes in education policies. Section 4 analyzes the causes of the declining trend in education spending since the 1980s, which has reversed since 2000 mainly due to increases in teacher salaries. Section 5 discusses the degree of equity in public spending on education, finding that spending on primary education is pro-poor but spending on secondary and tertiary education is not. In section 6 we analyze the determinants of access to primary and secondary education to help make spending more cost-effective. These findings are subsequently used in Section 7 for a scenario analysis of alternative education budget allocations aiming at reaching the Millennium Development Goals in education. This budget analysis also sets out the parameters for an education budget tracking system that should allow the government to prepare result-oriented, multi-annual budgets. Measuring outputs and outcomes will provide information to fine tune the public quality and effectiveness of provision of education services. 1 This paper was prepared by Rob Vos (Institute of Social Studies, The Hague, Netherlands) and Juan Ponce (IDB Consultant). 33 I. Education Performance in the 1990s 3.2 Education Outcomes. Educational indicators for Ecuador have continued to improve during the 1990s and into the first decade of the new millennium. In Figure 3.1. Average Years of Schooling (population 25 years and comparison to previous decades though, older! by Ftegicm the speed of educational improvement 10 has slowed down and educational 9 .I28 inequality has grown in many respects. SI 2 Figure 3.1 shows continuous growth in u6 the average level of schooling of the $5 Ecuadorian population since the 1970s. According to the population census of glp2 2001, the average Ecuadorian adult had til $0 s~un Ecuador EastAsia South Advanced 7.3 years of schooling completed, up &:zca andthe ~~i~Countries from 6.7 years in 1990. Ecuador's Africa Pacific average schooling level is above that of Source: Population Census data (1974,1982,1990,2001); Other Regions: World the Latin American mean and about the Bank (2003). same as that of East Asia's population. Educational levels for females have risen much faster than for males, so that the gender gap in tUTns of years Of has practically Table 3.1. Illiteracy Rate and Years of Schooling of Adult been closed. It is now 7.5 years for males (25 vears and).1990-2001 against 7.1 years for females (see Table Illiteracy Rate years of Schooling 1990 2001 1990 2001 '3.1). In terms of net enrollment rates, girls By Gender already outperform boys at all educational Men 9.5 7.7 7.1 7.5 10.3 6.3 7.1 levels (see Table 3.2). Total net enrollment Women 13.8 By Area in primary education increased from 88.9 Rural 20.8 15.5 4 4.9 to 90.1 percent between 1990 and 2001. Urban 6.1 5.3 8.3 8.7 By Ethnic Group 3.2 This relatively favorable Indigenous n.a. 28.2 n.a. 3.3 educational performance comes with a Blacks n.a. 11.6 n.a. 5.9 Other n.a. 7.4 n.a. 7.6 number of important qualifications. National Average 11.7 9 6.7 7.3 3.3 First, the speed of educational Source: Population Census, 1990 and 2001. improvements slowed down significantly during the 1990s compared to the 1970s and 1980s. Net primary school enrollment, for instance, increased by 20 percentage points during the 1980s (from 68.6 to 88.9 percent), but only by a meager 1 percentage point during the 1990s. Similarly, during the 1970s and 1980s about 1.5 years were added per decade to the average education level of the population, while between 1990 and 2001 less than one year was added.2 3.4 Second, the transition rates from primary to secondary education and from secondary to tertiary education are low and have not improved much during the 1990s. According to the 2001 population census, net enrollment in primary education is 89 percent, but for secondary education it is just 45 percent, and at the tertiary level it is 12 percent (see Table 3.2). Net secondary school enrollment is well below the Latin American average (including the Caribbean) 2 It should be noted that the data for the 1970s and 1980s refer to eight-year time intervals (1974-82 and 1982-90), whereas the change during the 1990s refers to an eleven-year period, such that the slowdown is in fact even starker than suggested in the text. 34 of 64 percent and also below that of neighboring Andean countries which all have rates well over 50 percent (except for Venezuela which just Scores 50 percent). These numbers Table 3.2. Net Enrollment Rates by Educational Level, 1990 and 2001 suggest that Ecuador has been outpaced Net Enrollment Rates by its neighbors in terms of access to primary Secondary Tertiary education beyond the primary level, and 1990 2001 1990 2001 1990 2001 By Gender therefore may lose its advantage in terms Men 88.6 89.9 42 43.9 10.3 11.1 of years of schooling in the years to Women 89.2 90.4 44.1 45.4 11.3 12.6 By Area come unless there are renewed efforts to Rural 84.4 86.7 23.2 28.8 3.2 4.3 improve educational perf~rmance.~ Urban 92.5 92.7 57.7 55.7 15.4 16.2 By Ethnic Group 3.5 Third, except for the gender gap, Indigenous n.a. 86.1 n.a. 22.7 n.a. 2.9 n.a. 86.2 n.a. 36.9 ma. 6.5 important disparities remain and by ma. 90.8 n.a. 47.1 n.a. 13.2 several measures educational inequality 88.9 90.1 43.1 44.7 10.9 12.3 has been on the rise, The average level Source: *oP'J'ationCe"W 1990md2001. of schooling of the rural population is almost half that of the urban population (4.9 against 8.7 years) and this gap remained about the same during the 1990s. The education gap is even larger for the indigenous and black population, as the averages for these groups are estimated at 3.3 and 4.5 years of schooling in 2001 respectively, well below the national average (7.3 year^).^ Differences in schooling indicators by geographical location correlate strongly with the proportion of the population that is rural and indigenous and with differences in the quality of education inputs, such as the number of students per classroom and teacher qualifications. We analyze these causal relations further in Section 6.5 3 Comparison with Latin America is based on World Bank data (WDI 2003), which are more optimistic for some neighboring countries than UNESCO data, which put Bolivia and Venezuela below Ecuador in secondary school enrollment. Discrepancies also exist between various Ecuadorian data sources. Data from the Ministry of Education (SINEC database) give a more optimistic figure than the population census data, showing a net enrollment rate for secondary education of 48 percent in 2000-2001. The Ministry of Education data also suggest the transition rate from primary to secondary has improved more than the census data would suggest. The SINEC data indicate a rise in the transition rate between 1995 and 2001 from 67 to 73 percent, where the transition rate is defined as the percentage of graduates of primary school continuing to first grade of secondary school. This improvement in the transition rate should lead to faster growth in the net secondary school enrollment rate than suggested by the census data (indicating a rise from 43.1 to 44.6 percent between 1990 and 2001). In the text we assign greater reliability to the population census data in measuring actual school enrollment. 4 Population censuses prior to 2001 do not identify population by ethnicity, so no change in this gap can be reported. Available evidence from household surveys shows improvement from very low levels in educational achievement for the indigenous population and only very slight (if any) catching up with the rest of the population. According to data from the Living Standards Measurement Study (LSMS) surveys the average level of schooling for the indigenous population increased from 2.2 to 2.9 years between 1995 and 1999, while that for the non-indigenous population increased from 7.3 to 7.9 years in the same period. 5 See Statistical Annex Table A42 for educational output indicators at the provincial level. This table shows the results of a simple cross-section model of determinants of years of schooling and net enrollment rates using population census data at the cantonal (district) level for 2001. The shares of rural and indigenous populations are significant in all cases, affecting schooling indicators negatively. Poverty indicators, like the unsatisfied basic needs index are also significant with a negative sign, but are in turn highly correlated with the shares of the rural and indigenous population, and so were not included in the same specification. School infrastructure variables (as measured by student-classroom ratios and the share of single-teacher, uni-docente schools) correlate negatively with education performance indicators by district, while higher availability of trained and experienced teachers has a positive impact. Only in the case of secondary school enrollment was the infrastructure variable not found significant for reasons explained below. These findings are consistent with the cost-effectiveness model analysis 35 3.6 Illiteracy rates are also much higher among the rural, indigenous and black population groups. As shown by Table 3.2, net enrollment rates in primary education do not show such stark differences by ruralhrban and ethnic divides, suggesting some catching up is taking place at this level. In contrast, net enrollment rates for the rural population and for indigenous and black people at secondary and tertiary schooling levels are substantially below that of the rest of the population. Thus, the education gap seems to have widened from secondary school and up. This hypothesis is confirmed when looking at the education gap by income levels. The gap has increased between the poorest and richest quintiles of the income distribution, following a region-wide trend (see Figures 3.2ah). 43;12 I 0 I Table 3.3. Education Gap Between Rich and Poor, 1995-99 (difference in education indicator between first and fifth quintile of distribution of per capita consumption) Change 1995 1999 1995-99 Years of schooling 6.6 7.5 0.8 Males 6.6 7.4 0.8 Females 6.7 7.5 0.9 Net enrollment primary 6.7 9.5 2.8 Males 7.1 8.9 1.8 Females 6.2 10 3.8 Net enrollment secondary 55.4 59.1 3.7 Males 58.7 58.1 -0.6 Females 51.7 60.4 8.7 Net enrollment tertiary 21.1 36 14.9 Males 24.7 36.1 11.4 Females 18.3 35.8 17.5 Source: Calculations based on LSMS (ECV) surveys 1995 and 1999. See Statistical Annex Table A33 and A34 for further detail. Differences for years of schooling are expressed in years and for enrollment rates in percentage points. 3.7 In fact, the increase in Ecuador is the second largest in the region (Argentina shows the largest change). Only five of eighteen countries in the region show a reduction in the education gap during the 1990s (see Figure 3.2b). In Ecuador, the gap between rich and poor increased by 0.8 years of schooling (about equally for men and women) during 1995 and 1999 (Table 3.3). of Section 6. Remarkably though, we could not find a relationship between the same set of determinants and the quality of education as measured by test scores for students at grades 2, 6 and 10 (see Statistical Annex Table A43). 36 3.8 ~~~~~~~~~~~~ nne uality rose faster in mrd than in urban areas (Figure 3.3). between rich and poor in terms of enr~~~mentrates also increase uca~io~levels during" the I 7 ------7 it. using a different data set, but 1995 299 stronger pace for males than ' Source: Calculations based of LSMS (ECV) surveys for 1995 and 999. o~s~stentwith Differcncc in years of schooling is between first and fifth quintile of the above of a per capita consumption d~s~~~u~onfor rural, respectively urban areas. See Statistical Annex Table A33 for additional detail. closing gender gap (see Table 3.4). Males 4.7 4.8 5.6 5.5 6.5 1.6 Females 5.1 6.2 4.2 7.4 6.9 0.7 Soicrce: Calculations based on INEC, Urban ~ouseho~dSurveys, 1988, 1990,2000 and 2002. Difference in years of schooling is for adult p~pu~ationof 25 yeas and older. 3.9 ~~~~~~~,t uality of e~ucat~onis poor. shrpws that stud are on average deficient in able 3.5 gives scores ow a scale of a ~~nim~~pass score. ~~~de~ts in z"~, 6jth and gth clearly score on average s~bs~ant~a~~ybelow the mini for ~at~emat~cs.Test score 10.43 8.24 9.45 9.33 7.21 8.48 11.15 9.31 9.78 7.17 4.86 4.03 12.86 11.17 11.7 7.29 5.35 6.01 Table A%) shows that girls Score S~~ght~ybetter Source: A~~E~~~ jn language skills and ys in~a~~e~atics Notes: Test scores are on a scale of 20 with 13 considered skills, while students in u as the pass grade. Ninth grade refers to third year of secondary those in rural areas, those in th 37 better than their peers in the Costa, and private school enrollees better than those in public schools. For all categories it holds that average scores are below the minimum.6 The little comparable data on test scores in the region sketch a gloomy picture of the quality of Ecuador’s education. Test scores for Ecuadorian students appear at Latin America’s bottom end as (Table 3.6) shows. Table 3.6. Test Scores Fourth-Gradersof Primary School in Selected Latin 3.10 To sum up, education performance in Ecuador has Test Scores Average improved substantially in past ( percent of students scoring in each range) Score decades. However, points of country 0-25 26-50 51-75 76-100 On 100 scale Argentina 2.7 38.5 54.1 4.8 52.8 concern are that progress has Bolivia 4.2 67.4 25.8 2.6 44.2 slowed recently, while education CostaRica 0.7 33.9 49.6 15.7 57.5 gaps between rich and poor, Chile 2.7 39.8 47.5 9.9 53.6 Ecuador 13.6 59.7 25.2 1.5 41.2 between rural and urban, and DoMinican 2.2 60.7 34.9 2.2 46.8 between indigenoushlack and Republic mestizo population groups are Venezuela 0.8 30.7 49.8 18.7 59.1 large and widening, particularly at Average of 4.1 47.2 40.2 8.5 50.8 sample the secondary and tertiary school Source: UNESCOOREALC. Por quC, u5m y para quC mdir la calidad de la educaci6n, level. As we shall discuss further Volunrj I,II, and m. Paris: UNESCO. Note: Test scom refer to internationally comparable tests taken in the indicated counfries. below, these findings are all the Scores are the average for language and rratherrarin skills. In Ecuador the test was taken by a more worrisome in the light of (representative) sample of 3,000 pupils in 159 primry schools across the country. increasing demand for labor with a skill level of at least lower secondary education. 3.11 Zntemal Eficiency. Internal efficiency in education relates educational inputs to outcomes. There are several ways of measuring internal efficiency. The most used indicators refer to repetition and desertion rates. Repetition Table 3.7a. Internal Efficiency Indicators for Primary Education, 1995 and desertion are captured and 2001 simultaneously in the Retention rate Years to complete Efficiency indicator education efficiency indicator (5th grade) % school (5th grade) % defined by UNESCO as the 1995 2001 1995 2001 1995 2001 ratio of the number of By Gender students of a particular cohort Women 84.13 81.5 6.75 6.84 88.90 87.74 that completed a given level Men 84.29 81.37 6.79 6.86 88.36 87.43 of education with respect to By Area the ‘ideal’ number of students Urban 87.69 84.58 6.56 6.68 91.41 89.78 that would have reached that Rural 76.34 74.16 7.32 7.3 81.95 82.14 National level with zero repetition and Average 84.22 81.44 6.77 6.85 88.63 87.59 desertion. Table 3.7a shows Source: SINEC data base. Refers to school years of 1994-5 and 2000-1. that this ratio is about 88 Note: Efficiency indicator as defined by UNESCO stands for the ratio of the number percent for primary education of students of a particular age group which completed a given level of education with after a slight deterioration in respect to the ‘ideal’ number of students that would have reached that level with zero repetition and desertion. 6 The exceptions are for language skills of ninth graders in the Sierra (1996 only) and of students in private schools in sixth and ninth grade (1996 only). In all other cases and observations for these cases in subsequent years scores are below the minimum. 38 the second half of the 1990~.~Other indicators confirm this decline in the internal efficiency of primary education in Ecuador. First, the number of years pupils need to complete primary education increased from 6.77 to 6.85 years between 1995 and 2001, while the survival to grade 5 of primary school has fallen from 84 percent to 81 percent in the same period. 3.12 The internal efficiency in Table 3.7b. Internal Efficiency Indicators for Secondary Education, secondary education also 1995and2001 deteriorated in the second half of Retention rate at Years to Efficiency indicator the 1990s (see Table 3.7b), but 5th grade % complete school at grade 5 % more starkly for girls than boys. 1995 2001 1995 2001 1995 2001 Dropout rates for girls are still By Gender lower than for boys, but data Women 94.2 75.2 6.6 7.6 90.3 76 from the 1999 LSMS show the Men 77.6 70.5 7.6 8.0 76.1 72 stark rise in the dropout rate of National girls could be associated with average 85.6 72.8 7.0 7.8 83.2 74.2 teenage pregnancies and pressure Source: SINEC data base. Refers to school years of 1994-5 and 2000-1. to take on household tasks and Note: Efficiency indicator as defined by UNESCO stands for the ratio of the number of students of a particular cohort which completed a given work in the farm household as level of education with respect to the ‘ideal’ number of students that would the economy moved into crisis. have reached that level with zero reDetition and desertion. The latter hypothesis would be consistent with the observed rise in secondary school dropout in rural areas between 1995 and 2001. The rising dropout rate of boys from secondary school could also be due to economic reasons.* We return to this issue in Section 6. 3.13 Retention rates and education quality are likely negatively affected by the high rate of teacher absenteeism and frequent teacher strikes in Ecuador. No evaluations are available to verify the impact. Nonetheless, the available information does suggest that these are important problems. Box 3.1 gives data on teacher absenteeism in primary schools based on a special survey conducted in 2002-3. Teachers were found absent for unaccounted reasons in 15-19 percent of the cases. Teacher strikes mostly affect both primary and secondary schools at the same time. Over the past 15 years on average one month of education has been lost per year to strikes.’ Rojas (2003) quotes evidence that in poorer areas an average of nine school days per month are lost to strikes and absenteeism. At the end of 2003, all public schools were closed for two months because of a teacher strike over a small salary increase. Earlier in 2003 there was another strike that closed schools for 6 weeks. Despite these problems, it is not obvious that teacher absence is affecting school enrollment, as explained in Box 3.1. The determinants of both phenomena seem to diverge. No doubt, such high rates of absence affect quality of education. 7 See Statistical Annex Table A37 for detail by province and Table A38 for a comparison with other Latin American countries. In comparison with the rest of the region, Ecuador scores relatively well in terms of the internal efficiency of primary education when taking SINEC data based on the records of the Ministry of Education. According to these estimates, Ecuador would have a similar internal efficiency to Argentina, Mexico, Uruguay and Venezuela; and one well above that of Colombia and Dominican Republic. However, UNESCO estimates using the reconstructed cohort method show a lower persistence rate of students in primary education that would put Ecuador in the league of countries with low efficiency. 8 Economic reasons are reported as the main reason, by far, for school non-attendance and dropout at the secondary level among boys in the 1999 LSMS. 9 Estimate based on data from SIISE and Rojas (2003). 39 Coupled with the negative effects of teacher’s strikes, these rates of absence could also be taken into account during political negotiations with Government’s authorities. Box 3.1. Teacher Absence in Primary Schools As part of the Public Expenditure Review (PER) work, and in collaboration with a multicountry study initiated by the World Bank as a background paper for the World Development Report 2004, a pioneer national teacher tracking survey was carried out in Ecuador. (See Rogers et al. 2004 in Volume 11.) It aimed to determine teacher absence rates and their main correlates in Ecuador. During 2002-03, survey teams interviewed a random sample of 720 teachers in 102 primary schools in 51 randomly selected parroquius were surveyed. Each school was visited twice, in December 2002 and again in January- February 2003, to allow two observations of teacher attendance. Of the 670 fulltime teachers who would normally have been teaching at the time of the survey visit, 86.5 percent. On average, teachers were found in the classroom (or accompanying the enumerator) 79 percent of the time, although in a fifth of those occasions the teacher was not teaching at that moment. The overall teacher absence rate, measured as the fraction of teachers who could not be found anywhere in the school, was about 14 percent, with a relatively small number of teachers apparently accounting for a larger share of the absence than in other countries. About half of the overall absences were not accounted for by the school directors. Percentage of time the teacher was found. .. December January- Total 2002 February (both 2003 rounds) In the classroom teaching 59.5 64.8 62.1 In the classroom not teaching 16.0 14.9 15.5 Out of class on scheduled break 0.0 0.0 0.0 Out of class but in school premises 6.0 5.1 5.6 Doing administrativework 2.2 1.6 1.9 Cannot fmdabsent 14.6 12.5 13.5 Accompanying surveyor 1.8 1.1 1.5 Source: Rogers et al. (2004). The study also analyzed the correlates of (and hence possible reasons for) absence, with some notable results. Overall, Bangladesh, India, Indonesia, Papua New Guinea, Uganda, and Zambia all recorded higher teacher absence rates than Ecuador, and only Peru’s absence rate was lower (Chaudhury et a1 2004). Surprisingly, in Ecuador absence is not more likely in remote, rural areas-as is often found in other countries-but rather in urban areas. In fact, teachers in urban schools (outside Quito) are absent at twice the rate of teachers in the most remote rural schools, perhaps because of greater employment opportunities and distractions in the urban areas. Also, one-teacher schools (escuelus unidocentes) are not associated with higher teacher absenteeism, although multi-teacher polidocente schools apparently are; thus as a general matter, the effects of having to teach various grades at the same time are ambiguous. In general, a better community (lower poverty rate) and institutional environment are associated with reduced teacher absence, whereas individual characteristics of teachers (age, tenure, education, union membership) do not seem to make much of a difference. Some factors that might be expected to raise performance through formal monitoring and enforcement of attendance-notably, proximity tc a Ministry of Education office, and the past use of discipline by the school director-are indeed associated with lower absence. On the other hand, active parent committees, per se, do not appear to reduce teacher absence Finally, and perhaps more significant, contract teachers (especially those not hired at the school level) have 2 higher probability of absence than regular teachers, despite the greater leverage that schools and communities might be thought to have over contract teachers. Hence, special contracts may not be the right “quick fix” foi the problem. In the analysis of access to education, no doubt absence will affect the quality of education, but the survey is less clear to what extent it will influence school enrollment. As indicated, rural school enrollment rates are muck lower than enrollment rates in urban areas, and are thus seemingly unrelated to teacher absence. Also, teachei quality does appear to have a positive influence on school enrollment, but does not affect absence. 3.14 Extemal Eficiency. Improved access to education is generally seen to enhance the probability of getting better remunerated work, reducing the likelihood of poverty and social 40 exclusion, and providing positive externalities in terms of higher productivity growth and enhanced health (e.g. by being better informed about health risks). It also leads to improve functioning of institutions and democracy. There is ample evidence that these advantages hold equally for Ecuador. 3.15 A recent study by Vos and Le6n (2003) shows that demand for more educated (skilled) workers increased during the 1990s and associates this with the process of trade liberalization that started around 1990. Skill-intensity increased substantially in all sectors of the economy between 1990 and 2001, except for some parts of the service sector, usually in the informal sector. The increased demand for skilled labor has also come at the cost of less demand for unskilled workers in many sectors. Vos and Le6n take 9 years of schooling as a cut-off point to distinguish between skilled and unskilled workers, but the trend is the same at different cut-off points. The increase in demand is even stronger for those with tertiary education and, given the relative scarcity of highly educated workers, earnings of university-trained workers have risen steeply whereas those with primary education or less have stagnated (see Figure 3.4). Rising skill-intensity and the increased movement of unskilled labor to informal employment explain much of the observed rise in overall labor income inequality and the difficulties for reducing poverty rates, which also affects public perceptions about trade liberalization." This pattern is similar to that found in other parts of Latin America (see Vos, Taylor and Paes de Barros, 2002). In the case of Ecuador, the Vos-Le6n study shows, this shift in employment and remuneration explains why positive aggregate employment and real wage growth due to trade liberalization do not translate into less poverty as workers from poorer households are less likely to be among the winners. 3.16 These findings are consistent with rising rates of return to education. Using a fairly Figure 3.4 . Urban Ecuador: Real Monthly Labor Incomes by Education standard Mincerian function Level of Workers, 1988-2002 (sucres per worker, per month; constant prices of labor earnings, we find of 1988) that the rate of return for each 120,000 additional year of schooling 100,OOO increased from about 6 to 7 h 2 percent for urban workers 80,000 6% between 1990 and 2002, ab whereas the earnings 2 60,OOO premium of having 2 Secondar m completed primary education 5 40,000 v (against having no education) B dropped from 28 to about 19 8 20,000 .- percent, and that of having 6 so- completed tertiary education a (against primary education) 2 1988 1990 1992 1995 1997 1999 2002 increased from about 65 Source: INEC, Urban Labour Force Surveys (Encuestas Urbanas de Empleo y percent to close to 80 percent Desempleo) (see Statistical Annex Table A44 and A45)." Data 10 The Gini coefficient of labor income inequality in urban areas increased from 0.48 in 1992 to 0.54 in 2002 (estimates based on INEC's urban labor force surveys). 11 The basic earnings function that was estimated is specified as: 41 availability for earnings inequality in rural areas is more limited, but the World Bank’s Poverty Assessment (World Bank 2004) shows an average skill premium of about 50 percent for agricultural workers with a permanent labor contract.12 The same study also shows that, as expected, education improves agricultural productivity, with specialized agricultural training having a stronger influence on productivity of small-scale farms and more formal education for the farm operator on that of medium and large-scale farms. 3.17 Putting this evidence of the external efficiency of education together with the evidence of inequality in access to education yields a rather discomforting picture: rising inequality in access to education favoring higher income groups and a rising skill premium associated with the economic growth process is perpetuating ever-rising inequality, and hence limiting the poverty reduction effect of the gains from economic growth. It also suggests that an education policy striving for primary education for all is far from sufficient. Improving transition rates to secondary education and broadening access to tertiary education are necessary conditions for stimulating productivity growth and reducing income inequality. 3.18 Education Policies in the 1990s. Education policies during the 1990s tried to respond to some of the shortcomings in education performance and inequity. At the beginning of the decade Ecuador subscribed to the “Education for All” declaration, striving for universal access to basic education. During the 1990s several education reforms have been set in motion to improve both access to, and the quality of, public education. Following a national dialogue with broad participation from stakeholders from civil society and the education sector, consensus was reached regarding a major reform of the basic education system in 1996: 0 A ten-grade basic education system should be introduced, integrating one year of pre- school education, six years of primary and three years of lower secondary education. 0 Curriculum reform to improve teaching of Spanish and mathematics. 0 Strengthening of bilingual education for indigenous groups. 0 Curriculum reform with greater emphasis on active learning and analytical skills, as well as more attention to social values, multicultural learning and environmental awareness. 3.19 The basic education system should help extend the expected years of schooling beyond the traditional six years of primary schooling, increase coverage of pre-primary schooling and achieve gains in external efficiency. The introduction of the new system has been slow, however. By the end of 2003, the basic education system had still not been introduced throughout the country. The Intercultural Bilingual Education system was created in 1998 and reached about I~[w(s,x,z)]= a. +p,s+pox+p1x2+~z+E where w is hourly earnings per worker, s is schooling level, x is age or work experience and Z is a vector of individual and household attributes. The function has well documented limitations (see Heckman et al., 2003), but the consistency with other empirical findings suggests we are dealing with robust findings. The estimates are after correcting for sample selection bias and controlling for differences in sex, sector of employment, type of occupation and geographic location. 12 Farm-size and labor contracts also influence rural wage inequality, but skilled workers (whether working on small landholdings or not, or whether having a temporary or permanent contract) always earn more than unskilled workers. The premium is substantially higher (about 300 percent) when comparing skilled and unskilled workers with a temporary contract (see World Bank 2004, Table 4.4). 42 90,000 students in almost 2,000 schools by 2003, which corresponds to 4-5 percent of the total, and about 10 percent of rural primary school enrollment in that year. There is no precise estimate of how much of the target group (indigenous families) is reached, but given the proportion of the rural population that still speaks indigenous languages this should be somewhere between two- thirds and three-quarters of the children in that category. Secondary bilingual education is available to 13,700 students in 2003 (about 1 percent of secondary school enrollment). 3.20 The curriculum reforms have been supported by World Bank and IDB-supported programs (EB/PRODEC and Redes Amigas) to improve the quality of basic education in urban and rural areas. These programs have made an important contribution to a more decentralized education system and increased active participation by the communities. The most important experiences include the creation of 120 Education Matrix centers (Centros Educativos Matrices, CEM), with each CEM being made up of 15 to 30 primary schools and kindergartens. Parents and communities have an important say in the management of these networks of schools. The Autonomous School Networks program, known as Redes Amigas, also promotes decentralized school management at the level of a network of again 15 to 30 schools administered through a so-called Education Unit Center (EUC), as compared to the previous system where one administrative unit supervised up to 3,000 schools. After 1999, this was taken a step further, allowing schools belonging to the same EUC to form autonomous school networks, manage their own budget and design their own teacher incentive systems. Currently, the program covers about 140,000 pupils, 2,200 schools and 6,000 teachers operating in 187 networks. This implies coverage of 58 percent of pupils enrolled in public primary schools in rural areas and 40 percent of those living in the poorest areas of Ecuador. About 60 networks (30 percent) are managed by indigenous communities. A third example is the decentralization of approximately 1,800 secondary schools which receive lump sum transfers directly from the Ministry of Economy and Finance and have control as autonomous units to use the resources to pay teachers and cover basic operational costs. As we shall see in Section 6, more decentralized management of schools appears to have a positive influence on school enrollment, particularly in basic education. In Section 5, we discuss additional plans to enhance equity in education spending via a new allocation mechanism of transfers by province. 3.21 The objectives of all these reforms (or at least their intentions) have been confirmed more recently in 2002 with the “Social Contract for Education,” in which the Ecuadorian government subscribes to an initiative from civil society agents. In this declaration, among other things, the importance of an incentive policy based on the implementation of a national evaluation system to improve educational quality is stressed. A system of academic achievement tests (APRENDO) was introduced in 1996. However, it has been without a budget (and thus no further tests were performed) from 2000 onwards. This came about due to resistance from the powerful teachers’ union (UNE), which felt the system would unduly evaluate teacher performance. The result is that the country has no system to monitor education quality, let alone one that provides incentives to enhance the quality of teaching. The social contract does not provide any specific proposal to reintroduce such a system, as it lacks precise guidelines as to how reach the goals. 3.22 In addition to the earlier-mentioned reforms, two social assistance programs have been introduced that have helped promote school enrollment. First, the school meal program (Colacibn Escolar) increased its coverage significantly after the 1999 economic crisis and now reaches about 1.4 million children of primary school age, or about 85 percent of the target group; this coverage is up from 45 percent in 1998 (Parandekar, Vos and Winkler, 2002). The majority 43 of beneficiaries come from the poorest families. However, as analyzed in Vos et al. (2003), the near universal coverage of the program also implies significant leakage of benefits to the non- poor. While there is no impact evaluation as yet available, the program most likely has had a positive influence on school enrollment, as much as it has helped keep children in school during the deep economic crisis of the late 1990s. Second, also as an upshot of the 1999 economic crisis, a conditional cash transfer program, Beca Escolar, was created in 2001 to enhance access of the rural poor to primary education. The program started with a pilot program of 22,000 beneficiaries (children aged 6- 14 years) and reached about 69,000 beneficiaries by September 2003 or 10-15 percent of the rural poor of primary school age. The targeting mechanism involves a combination of geographical targeting based on composite poverty characteristics and individual means testing of potential beneficiaries in poor parroquias selected through the geographical targeting mechanism. Each beneficiary household receives a cash transfer of US$5 per month per child, subject to proof of school attendance. Households may receive benefits for up to two children. The effectiveness of this program to enhance school attendance is discussed further in Section 6, but its focus on the rural poor of primary school age may not be sufficient to make a very large impact in terms of redressing the indicated inequalities in Ecuador's education system. 3.23 In 2003 a new, conditional cash transfer program was introduced, the Bono de Desarrollo Humano, which is to gradually replace existing cash transfer systems, merging the Beca Escolar and the Bono de Desarrollo Humano. This is available to both children attending primary school and mothers with young children attending health ~enters.'~As with the Beca Escolar, the reason to add the conditionality to the cash transfer was that an evaluation of the unconditional cash transfer program (the Bono) showed that it helps to improve school enrollment, but in effect only for those close to the poverty line, whereas no such improvement was observed at the bottom end, i.e. for the extreme poor (Vos and Leon, 2001). This is why the cash transfer program system has been retargeted towards the extreme poor in rural areas. 3.24 Trends in Education Expenditures. Social expenditure levels are low in Ecuador compared to other Latin American countries, both as a share of GDP and on a per-capita basis (see Vos et al., 2003). Real expenditures per capita have fallen more or less continuously over the past two decades. Ecuador spent approximately 4-5 percent of GDP (or on average about US$55 per capita) on social programs during the 1990s, compared to a Latin American average of 12 percent (or US$550 per capita)14. The per-capita figure for Ecuador improves slightly, to approximately US$130 per capita, or around 9 percent of GDP, when social security benefits are included. However, pensions are paid only to those retiring from jobs in the formal sector and mostly do not reach the poorer segments of ~0ciety.l~Real per capita social expenditure has 13 Specifically, the conditions for the target group are that: - in education: the nuclear family has children aged 6-15, who are enrolled in school and are registered to attend at least 90 percent of classes; - in health: the nuclear family has children aged 0-6 years who should be receiving bi-monthly health controls at designated health centers; - for families with children in both age groups, the conditions for education prevail in order to receive the cash transfer. 14 Figures are in constant 1997 US dollars as reported in ECLAC (2001) and, for Ecuador, Vos et al. (2003). Data refer to spending by the central government only and do not include social security spending. 15 This observation needs some qualification though as, after the 1999 crisis, the real value of pension benefits plunged and the financial assets of pensioners were decimated, turning many elderly into the 'new poor'. 44 fallen staggeringly since the early 1980s, and although there has been a visible recovery since 2000, it currently stands below levels reached a quarter of a century ago (see Table 3.8 and Figure 3.5). Table 3.8. Social Expenditure' of Central Government as a Percentage of GDP 1973 1975 1980 1985 1990 1995 2000 2001 2002 2003 20043 Total Social Expenditure 3.5 3.3 5.3 4.7 4.4 3.6 4.0 4.3 5.1 5.0 4.8 Education 2.9 2.5 4.3 3.5 2.8 2.4 1.9 2.2 2.7 2.6 2.6 Health 0.5 0.7 0.9 1.1 1.3 0.9 0.8 0.8 1.3 1.3 1.2 Social Assistance 0.1 0.1 0.1 0.1 0.3 0.3 1.3 1.3 1.1 1.1 1.0 Cash transfer programs 0.8 0.7 0.5 0.6 0.6 Other 0.1 0.1 0.1 0.1 0.3 0.3 0.5 0.6 0.5 0.5 0.5 Source: Central Bank and Ministry of Finance data. Updated and adjusted series from Vos, et al. (2003). Notes: 1. Social expenditures refer to central govemment budget only. Social expenditures include education, health, social welfare and labor, and cash transfer programs. Cash transfer program refers to Bono Solidario for 1999-2002 and includes Beca Escolar and Bono de Desarrollo Humano thereafter. 2. Social expenditure share in GDP calculated on the basis of constant prices in 2000 dollars . The share at current prices is slightly higher on average (0.3 percent points for the 1990s and 0.1 percent for the whole series), but the trends are the same. The difference between the constant and current price shares is explained by the difference in deflators for government spending and GDP, the former being - on average - slightly higher. 3. Numbers for 2004 refer to the provisional budget for social expenditure and Central Bank projections of GDP growth. Figure 3.6. Real Education Spending Per Capita, Using Figure 3.5. Real Social and Public Education Spending Per Alternative Deflators, 198p2002 (in constantDriee Caoita. 19732004 (US%. constant orices of 2000) ollars of 2000) '-I 50.0 I 45.0 Toll social expenditures - 40.0 35.0 30.0 Education 25.0 20.0 10 * OCCC PZaP 6180S6 kZS 1- 'Real spendq (wage deflator) I ~ -Real spending (implicit NA detlato ) Source: Vos et al. (2003); updated for 2001-3 from Source: Vos et al. (2003); updated for 2001-3 from Ministry of Economy-UNICEF fiscal database. Ministry of Economy-UNICEF fiscal database. Public expenditures include education, health, and Public expenditures include education, health, and social assistance (including cash transfer programs). social assistance (including cash transfer programs). 3.25 The decline in social expenditures has hit education and health spending hardest. During the 1990s, the composition of social spending shifted towards targeted social protection programs (including the introduction of the cash transfer program Bono Solidario) and away from budgets for universal social services in education and health. Between 2001 and 2003, education and health budgets increased significantly, mainly due to various rounds of salary increases for teachers and medical personnel. As a result, the studenuteacher ratio has also decreased (improved), although available data do not allow to measure whether children are also switching toward private schools. Figure 3.5 also shows the dramatic decline in real per capita public spending on education over the past decades. Despite the recovery in recent years, by 2003 the real level of spending was forty percent below that of 1980. In Figure 3.6, education spending has been deflated using, alternatively, a weighted price for public consumption and 45 investment (weighted for their respective importance in education spending)I6 and a nominal wage index for public employees. As much of education spending is on teacher salaries (about 80 percent of the total in 2000) and recent budget increases have been mainly driven by salary adjustments, the wage index should be a good proxy for price changes in education services." Figure 3.6 shows that if one takes the wage deflator, there is no actual recovery in real education spending, confirming the hypothesis that most, if not all, budget increases after 2000 went into rising (nominal) teacher salaries and suggesting that the overall rise in real per capita social expenditures during 2000-2004 is overstated in Figure 3.4. 3.26 How have educational services been affected by the decline in real public spending?.'* The evidence suggests most of the cuts have hit infrastructure spending as there has been no shift away from (more expensive) tertiary education to primary and secondary education and the private sector coverage (23 percent) has not cha ed since 1996. Figure 3.7. Ecuador: Pupil-Teacher Ratios in Primar: 3.27 And studendteacher ratios actually and Secondary Education, 1990-2000 improved in the 1990s: for primary education from 30 to 23 students per 3s'0 Iteacher and secondary from 13 to 11 (see Figure 3.7)'' In other words, the country is spending more, not less, on teachers. In addition, authorities are also developing a spending allocation formula that makes it 20.0 i 1 more suitable geographically (inter- provinces) and pro-poor (see next section). 3.28 It is therefore likely that the burden I 1 ' ' ' ' ' ' ' ' ' of the decline in education expenditure has ro41990 1991 B92 B93 B94 1995 1996 1997 1998 1999 2000 fallen on the availability and quality of Source: SINEC database school infrastructure. While not easy to read from publicly available fiscal data, 16 There are no consistent long data series detailing public expenditures by sector and by expenditure items (e.g. wages, other current expenditures and investment). A national accounts series with disaggregated public sector accounts indicates that originally around 10-15 percent of the education budget was spend on investment in schooling infrastructure, but that this has dropped to below 5 percent in the early 1990s. We use the latter share for weighing the two deflators. 17 Again, no consistent published breakdown exists for public expenditures, let alone social expenditures by ages and other expenditure components. Available breakdowns from a UNICEF-Ministry of Economy and Finance database show a somewhat erratic pattern for 1995-2000 probably due to classification errors. For 1996-98 the share is about 70 percent jumping to over 80 percent in 1999-2000. The national accounts series quoted in the previous footnote would put the share around 75 percent during 1980-1992. This share may be somewhat lower for overall public consumption, but likely the national accounts deflator for government consumption should by and large reflect the trend in the unit cost (wage rate) of public employees. Figure 3. 5 shows this appears to be the case until 2000, but not thereafter. 18 It would have been better to present the trend in education spending per student rather than per capita. However, for the reasons explained in the previous footnotes it is not possible to construct a consistent series for more than a few years in the 1990s and 2000s, given the lack of data by levels of education. 19 These input indicators compare favorably to the rest of the region, particularly for secondary education. In Bolivia, Brazil, Chile, Colombia and Peru, for instance, the ratio is over 20 at this level. The ratio at the primary level is similar to that of neighboring countries with the exception perhaps of Chile, which has a pupilheacher ratio of 3 1 in primary education (comparison based on UNESCO data). 46 there seems to have been a decline in investment in new school infrastructure and provisioning for maintenance of existing schools. Much of school maintenance and operation costs (including electricity and telephone bills) seem to have been passed on to parents. Such 'cost-sharing' has been on the rise as public schools were given greater autonomy. While taking pressure off the government budget, it most likely has negatively influenced school access and performance of children from poor families, as we shall see below. 11. Equity in Educational Spending 3.29 Education Expenditure Incidence. Public spending on primary education is strongly pro- poor; spending on secondary education is distributed fairly evenly across quintiles, while spending on university training mainly benefits the richest segments of society. Vos et al. (2003) provide these findings based on a study of social expenditures in Ecuador. Figures 3.8a and 3.8b summarize the results in the form of Lorenz curves. These show that the poorest quintile receive 35 percent of the 'benefits' of primary education. The curve for secondary education almost Figure 3.8a. Lorenz Curves for Distribution Public Figure 3.8b. Lorenz Curves for Distribution Expenditures in Primary and Secondary Education Subsidies to Public and Private Universities Cumulative share of populalion Cnmuliiivc ahire of popohion coincides with the equity line, making the spending neutral in terms of benefits to the poor. However, the poor hardly share in the benefits of going to universities with less than 3 percent of benefits going to the poorest quintile. Public universities are mainly accessible to the middle and upper income classes so most benefits go the third quintile and up. Subsidies going to private universities almost exclusively benefit the rich. 3.30 These results are obtained using a traditional expenditure incidence analysis inputing the cost of providing education services as benefits to households depending on the number of beneficiaries of subsidized education per household. The estimates have to be. taken with the usual caution associated with the method. We will not spell this out here, but see e.g. Demery (2003) and Vos et al. (2003) for a discussion. The estimates in Vos et al. (2003) take account of differences in unit costs per provinces and in urban and rural areas when assigning benefits.20 Unit costs vary substantially across geographical areas. In primary education, public schooling 20 Benefits are assigned to households as follows: n 7l7 where Xj is the value of the total education subsidy imputed to householdj. Eij represents the number of school enrollments of household j at education level i, and Ei the total number of enrollments (across all households) at that level. Si is government spending on education level i, and i (=I,.. , 3) denotes the level of education (primary, secondary and tertiary). Subscript k denotes the region specified in the unit cost estimate, there being n regions distinguished. 47 costs range from US$61 per student in rural Guayas to US$344 per student in sparsely populated rural GalApagos (1999 figures). In secondary education, the variation is between US$133 in urban Guayas to US$475 per student in rural Napo. It could be questioned whether the cost differential also implies a difference in actual benefit. If we assume that all children in school receive the same type and quality of education, then it might be better to take average unit costs as the proxy for the value of the education benefit. Cost differentials for primary and secondary education are mainly due to differences in population density and average class size, as well as to differences in the share of trained teachers with higher pay. As shown in Section 6, both variables affect access to schooling and education performance. Hence, it seems reasonable to assume that cost differentials are associated with differences in education quality. The tests performed in Section 6 are for national averages though. Data limitations prevent us from testing this at the provincial level and finding out whether it is better to estimate the expenditure incidence using average or regionally differentiated costs. However, despite the substantial differences in unit costs across provinces and regions, we find that the given conclusions about the distribution of public spending on education are not altered in any significant way when imputing the same (average) unit cost to all beneficiaries. Statistical Annex Table A39 shows the comparison. Taking average costs shifts the benefit incidence slightly away from the lowest income groups and towards the richer quintiles. For instance, the poorest quintile would receive 30 percent of social transfers in primary education when using average unit costs, against 35 percent when using regionally differentiated costs. This seems consistent with the earlier observation that unit costs are typically higher in rural areas with a more disperse (and mostly poorer) population. The shift in the distribution curves is very slight though and does not alter the overall conclusion that the benefit distribution for primary education is pro-poor, secondary education close to equi-proportional and tertiary education regressive. 3.3 1 Marginal &nefit Zncidence and Figure 3.9. Lorenz Curves for Distribution Public Spending on Private Expenditures on Education. Education, 1995 and 1999 Taking all the benefits of public education spending together gives a distributive pattern that is close to equi-proportional, with a slight bias in favor of higher - - - Totaledue. 1995 income groups. This is due to the fact that -P.C. cons. 1999 p.c.cons. 1995 these groups benefit most from spending - - - on relatively more expensive tertiary education. On the whole though, education benefits are distributed much more equally 0% 20% 40% 60% 80% 100% than per capita private consumption cumulative share population (Figure 3.9). Available evidence shows that the distribution of education benefits has become somewhat less unequal in the second half of the 1990s. This shift can be ascribed almost entirely to a slight decrease in the benefits the richest households received from public subsidies to private and public universities (see Statistical Annex Table A40). 3.32 Social transfers in education were equivalent to 6.1 percent of per capita consumption, about the same as what households were willing to spend out of their own pockets (Table 3.9). In 1999, private expenditures on education amounted to 6.1 percent of household consumption. This share was 2.4 percent for primary, 2.2 percent for secondary and 1.6 percent for tertiary education. As one would expect, the richer households spend relatively more of their income on 48 education as their children are more likely to get private education and stay longer in the system. However, their relative willingness to Table 3.9. Public Transfers and Private Expenditures on pay for education does not exceed that Education as a Share of Household Consumption by Deciles, of poor households by a wide margin. 1999 Tertiary- Tertiary- The poorest quintile spent about 4.5 Deciles Primary Secondary Public Private Total percent on education compared to 7 Public transfers (%) percent for the richest quintile (see 1 17.9 4.0 0.0 0.0 21.9 Table 3.9). 2 8.9 4.3 1.1 0.0 14.0 3 6.0 5.7 1.2 0.3 13.1 3.33 Decentralization and Equity in 4 5.3 4.7 1.5 0.0 11.6 Education Spending. In 2003 the 5 3.4 4.2 1.9 0.1 9.6 6 2.7 4.0 1.o 0.5 8.1 Ministries of Education and of 7 1.8 3.2 2.7 0.3 8.0 Economy and Finance signed an 8 1.2 2.6 2.5 0.8 7.0 agreement for a new allocation 9 0.6 1.3 2.0 1.6 5.5 10 0.1 0.3 0.9 1.2 2.5 mechanism of central government Total transfers to education service units. Public % 2 2.1 1.5 0.8 6.4 The formula for allocating resources Private spending’ by province (and then on to public 1 3.7 1.1 0.0 4.8 schools or school networks) considers 2 2.9 1.4 0.1 4.4 3 2.7 1.9 0.3 5 .o the following variables: population in 4 2.5 2.0 0.4 4.8 primary and secondary schooling age, 5 2.2 2.0 0.7 4.9 the share of the population with Unmet 6 2.3 2.4 0.6 5.3 7 2.0 2.0 1.1 5.2 Basic Needs (NBI), enrollment rate 8 2.3 2.5 1.3 6.1 targets and type of school. As to the 9 2.2 2.4 2.3 6.9 latter, a larger weight is given to areas 10 2.4 2.2 2.4 7.0 with a larger share of schools with one ‘lotal Private % 2.4 2.2 1.6 6.1 teacher (uni-docentes). Source : 1999 LSMS survey. Note: 1. Share for “Tertiaty” is total for public and private universities 3.34 Through this formula, education Figure 3.10. New and Existing Distribution of spending should become more pro-poor. (primary and secondary) Education Spending by Figure 3.10 shows that the geographic Provinces. distribution of education spending by provinces is already pro-poor for primary and secondary education. The new allocation mechanism does not alter the existing distribution in a major way, but to the extent it does it would make this equi-proportional when the provincial population is ranked by the NBI indicator from poor to rich. The danger of this new initiative is that by looking only at provinces it may miss out on important differences within the provinces themselves and hence make spending less pro-poor. It also does not consider efficiency criteria and 49 could reward ineffective allocation of spending resources. Of course, cost-effectiveness criteria may be imposed in addition to the allocation mechanism across provinces. This issue is taken on in the next section. 3.35 Cost-efectiveness of Education Spending. Improving selected programs in education requires monitoring cost-effectiveness ratios. Ecuador has subscribed to the Millennium Development Goal of ensuring primary education for all by the year 2015. At unchanged population growth, and if school enrollment increases at the same speed as recorded during the 199Os, that target will not be met. In this scenario net primary school enrollment would be 91.7 percent in 2015 and in secondary and tertiary education it would be 46.6 percent and 13.3 percent, respectively. So ‘business as usual’ is not good enough in order to reach the target. Using the Barro-Lee perpetual inventory method to translate enrollment rates into years of school attainment, we find that if net school enrollment rates for primary, secondary and tertiary education remain unchanged, the average number of years of schooling of the population of 12 years and older would show a slight drop by the year 2007 (using 2001 as a base year).21 Should the MDG target of 100 percent net primary school enrollment be achieved, then secondary school enrollment would need to increase to 70 percent (up from 45 percent in 2001) and retention rates would need to increase to 80 percent (up from 74 percent) in order to gain one year in the average level of education of the working population (if tertiary school enrollment remained constant). While the net primary school enrollment target may seem within reach (at least by 2015, but possibly also by 2007), increasing net secondary school enrollment to 70 percent seems a tall order given the past rates of improvement. But the above estimates also suggest that without improving access to higher education (currently at a 12 percent net enrollment rate) it may take a long time to make a substantial impact on the average educational’ level of the work force. Nonetheless, as a working hypothesis, we will set enrollment targets at 100 percent for primary and 70 percent for secondary education and analyze whether it is possible to achieve these by making educational spending more efficient and/or what additional public investment would be required. 3.36 In order to know by how much the education budget would need to increase, or how to make that spending more effective to reach the given goals, we need to analyze in greater detail the determinants of school enrollment. These determinants include the accessibility of schools and the quality of school inputs (such as availability of textbooks, quality of school teachers, and so on). However, problems of access to schooling likely are not merely related to factors on the supply side. Important constraints are also found in the household conditions of the children. The education of their parents typically influences the decision to attend school, as much as the economic situation of the household. If a family is poor and there are significant direct costs to the household for each child attending school (school fees, uniforms, educational material, transportation costs), parents may decide not to enroll (some of) their children. Such circumstances may also lead to a situation where the contribution of children to family income is significant (especially in rural areas) and accordingly the opportunity cost associated with school attendance may be substantial. Attendance will suffer when parents perceive that the return associated with time spent in school does not justify the loss of a child’s economic contribution. 21 See Barro and Lee (2000) for an exposition of the estimation method. Please note that these simulations estimate the average level of schooling for the population 12 years and older. According to the 2001 population census data, the average educational level for the population 12 years and older was 7.2 years, against 7.3 years for that of 24 years and older. 50 Also, parents tend to value the quality of education. That is, if the education is rated to be poor (for instance as measured through test scores), parents may be less likely to send their children to school. Ponce, Bedi and Vos (2003) apply a schooling determinants model for Ecuador identifying the importance of such factors and quantify the impact of changes in such variables on school outcomes. Their model follows that of Gertler and Glewwe (1990) and is described in Annex 3.1. We refer to Ponce, Bedi and Vos (2003) for a detailed description of the quantitative results and estimation procedures. Here we will summarize the main findings relevant for the subsequent education budget analysis and expenditure tracking method developed in Section 7. 3.37 Ponce, Bedi and Vos (2003) analyzed net enrollment determinants for basic22 and secondary education. They find that the relative importance of schooling determinants varies quite substantially between basic and secondary education, and decision-making behavior differs for urban and rural and for poor and non-poor household^.^^ We report their findings here for secondary education, but instead of the results for basic education we re-estimate their model for primary education only, as this provides a better link with the preceding analysis and as the introduction of the basic education system is not fully implemented at the national level yet. 111. Cost-Effectiveness in Primary Education Urban Rural Poor Non-poor Poor Non-poor Demand factors Cost of education (-) Cost of education (+) Cost of education (+) Education of mother (+) Education mother (+) Gender: Female (+) Location: Quito (+) Costa (-) Costa (-) Supply factors Students per class room (-) Share of trained Students per class Share of trained teachers (+) teachers (+) room (-) Centralized teacher Centralized teacher appointment (-) appointment (-) The relevant elasticities for each of these factors are reported in Table 3.1 1. Table 3.11. Elasticities of Determinants of Net Enrollment in Primary Education 3.39 On the demand side, the Urban Rural direct and indirect costs of Total Poor Non- Total Poor Non- education have a weak, but Socio-economic factors (demand) Cost of education -1.32 -0.19 US. 0.06 0.06 0.00002 negative effect on primary Education mother 0.08 0.13 n.s. 0.03 0.06 n.s school enrollment, particularly Sex (males =I) U.S. U.S. US. US. U.S. -lE-06 for poor urban households. For Quito 0.11 0.04 n.s. costa n.s. -0.14 -0.34 n.s. n.s. n.s. each 1 percent increase in cost, Education supply factors net enrollment of children from Students per class room US. 0.08 US. US. -0.07 U.S. Share of trained teachers 0.72 n.s. 1.63 n.s. n.s. n.s. poor urban households is Centralized teacher appointments -0.39 n.s. -0.38 n.s. -0.03 n.s. Source: INEC, Encuesra de Condicionesde Vida (LSMS), 1999 and education input data. See Statistical Annex Table A41 for detailed model estimates 22 Under the new schooling system in Ecuador, basic education comprises pre-primary, primary and lower secondary education. 23 Please note that for urban areas the demand for schooling model is estimated in the form of a multinomial logit specification of household decisions to enroll children in either public or private education. In the results presented in the text we only report on the determinants for enrollment in public schools. 51 expected to fall by 0.2 percent. For the total urban sample the link is much stronger showing a derived elasticity of -1.3.24 For poor rural households the link is weak, but - unexpectedly - positive. It would suggest education is like an inferior good for the rural population. In any case the link is weak, such that costs do not seem decisive in the determination of rural school enrollment. For both urban and rural poor, the education level of the mother has a significant and positive effect on school enrollment. Being a boy or a girl hardly influences the primary schooling decision, consistent with the observations made earlier about the closing gender gap in education in Ecuador. 3.40 On the supply side of primary education, the share of trained teachers has an important influence on the decision of school enrollment in urban areas, particularly among non-poor households, while for rural households the determinant was not found significant. Poor rural households see packed class rooms as a negative sign of education quality and are more likely to enroll children in schools with a lower ratio of pupils per class room. Next to trained teachers, decentralized appointments of teachers (e.g. by parent committees) influence school enrollment favorably. This is reflected by the negative sign for the share of teachers that are centrally appointed, i.e. through the Ministry of Education. However, when splitting the sample into poor and non-poor households, this variable seems to affect schooling decisions of non-poor urban households most and in a weaker sense poor rural households. The education policy implications of these findings would be that: 0 It would appear to be more cost-effective to target the cash transfer program (Bono Desarrollo Humano) towards the urban poor, rather than to the rural poor. Of course, given the fact that the cash transfer program is conditional upon school assistance, it may nonetheless stimulate primary school enrollment in rural areas. For urban areas, the cost-effectiveness model would suggest that the subsidy need not be conditional to stimulate school enrollment. 0 Hiring more trained teachers will positively affect school enrollment in urban areas. Given the earlier conclusions about the quality of education, this may also be a policy priority for rural areas, but according to the cost-effectiveness analysis is not expected to raise primary school enrollment among the rural population. 0 More decentralized decision-making (e.g. assigning greater role of local communities in teacher appointments) is expected to promote school enrollment, in particular among urban non-poor and rural poor. 0 Reducing congestion in classrooms (i.e. ensuring there are sufficient, well-equipped class rooms for a given student intake) will also positively influence school enrollment. While the student-teacher ratio is favorable in Ecuador, infrastructure deficiencies are forcing oversized classes and hampering school enrollment and education quality. These problems are regionally concentrated. For instance, in some municipal areas 24 The model results refer to demand for public education. As a larger share of non-poor are enrolled in private schools the sample for non-poor in primary schooling age is relatively small, which could explain the insignificant estimate for the schooling cost coefficient for this group. The economic interpretation could be that since the non-poor children (or rather their parents) are more likely to prefer private schools, the cost of public schools is less likely to influence their enrollment decision. 52 Urban Rural Poor Non-poor Poor Non-poor Demand factors Cost of education (-) Cost of education (-) Education mother (+) Education mother (+) Education mother (+) Gender: Female (-) Gender: Female (-) Location: Quito (+) Location: Costa (-) Supply factors Studentslclass room (-) Share of teachers with Share of teachers with Share of trained university degree (+)I university degree (+)' teachers (+) The relevant elasticities are reported in Table 3.13. Table 3.13. Elasticities of Determinants of Net Enrollment in Secondary Education 3.42 The direct and indirect Urban Rural costs of education have a strong Total Poor Non- Total Poor Non- negative effect on secondary Socio-economic factors school enrollment, particularly Cost of education US. -0.399 n.s. n.s. -0.201 n.s. Education mother 0.146 0.358 US. 0.635 0.647 0.339 for poor households. For each 1 Sex (males =1) n.s. n.s. 0.109 0.104 0.191 n.s. percent increase in cost, net Quito n.s. 0.054 n.s. -- _- __ enrollment of children from poor Costa U.S. n.s us. us. n.s. -0.101 Education supply factors urban households is expected to Students per class room -0.236 n.s -0.032 n.s US n.s fall by 0.4 percent. For poor rural Share of trained teachers US n.s n.s n.s n.s 0.641 households the implied elasticity Share of teachers with 0.382 n.s n.s US n.s n.s Centralized teacher n.s n.s n.s n.s n.s n.s is also significant, but lower at Source: Ponce, Bedi and Vos (2003: Table 6.14). 0.2 percent. Among other demand factors, the educational level of parents, particularly that of mothers, is an important explanatory variable of secondary school enrollment in both urban and rural areas. Girls are not found to have a significantly higher or lower probability of accessing secondary education. 3.43 The direct and indirect costs of education have a strong negative effect on secondary school enrollment, particularly for poor households. For each 1 percent increase in cost, net enrollment of children from poor urban households is expected to fall by 0.4 percent. For poor rural households the implied elasticity is also significant, but lower at 0.2 percent. Among other demand factors, the educational level of parents, particularly that of mothers, is an important 53 explanatory variable of secondary school enrollment in both urban and rural areas. Girls are not found to have a significantly higher or lower probability of accessing secondary education. 3.44 On the supply side of secondary education, the share of trained teachers has an important influence on the decision of school enrollment in urban areas, particularly among poor households, while for rural households the determinant was only found significant for non-poor households. For each percentage point increase in the share of trained teachers, net enrollment among urban poor and rural non-poor is expected to rise by about 0.6 percent. Class size has a significant negative effect on secondary schooling decisions of urban non-poor households. The education policy implications of these findings would be as follows: 0 It would be cost-effective to increase the coverage of the Beca Escolar (presently, Bono de Desarrollo Humano) program to poor households with children aged 12-18 years. Particularly in rural areas, such a policy would be essential to enhance access of the poor to secondary education. 0 Enhancing the share of teachers with a university degree seems critical to increase enrollment in urban areas, and that of trained teachers (with a teaching qualification) to positively influence enrollment decisions of non-poor households in rural areas. 0 Class size per se, is not a major problem, except for certain urban areas where large class sizes and insufficient schooling infrastructure seem to hamper enr~llment.~~ 3.45 As a long run policy, improvement in the level of female education should help improve access to secondary education. This would require continuous efforts in improving school enrollment in both primary and secondary education. In the short run, literacy campaigns targeted at mothers with young children in rural areas could be effective in this sense. IV. Education Expenditure Tracking and Budget Scenario Analysis 3.46 Ecuador’s government budget system is highly centralized, rule oriented and input based. The education budget forms a prime example. The input-based characteristic has led to incremental allocations (in nominal terms) according to cost changes in the main supply components. The wage bill has been the determining factor for education budget adjustments as rising student numbers led to the hiring of new teachers as well as higher teacher salaries in response to union demands. Government budget rules in Ecuador since the 1970s have included a host of fixed allocations from specified revenues (including the repartition of oil revenues) and fixed-share or growth rules, such as the rule that education should receive at least 30 percent of government expenditures, whereas growth in health expenditures is not allowed to drop below the overall growth in public expenditures. Even though such rules have not been faithfully adhered to in practice and have not been able to prevent real education expenditures from falling, they have imposed rigidities in the spending pattern. Education expenditures have been capped by the 30 percent rule. The biggest problem in practice is that increases have been aimed mostly at teacher’s salaries while cutbacks in lean years have come from maintenance and investment 25 As reported in Ponce, Bedi and Vos (2003), this is not merely a problem in urban public secondary schools. The Same problem is found for enrollment in private schools. 54 budgets. The highly centralized system of budget controls and personnel management took resource allocation further away from performance orientation.26 3.47 However, the government has been making efforts to move towards a more performance- oriented budgeting system in education and is trying to enhance efficiency and equity in education outcomes. The demand subsidies provided through the Bono Desarrollo Humano should improve access to education for the poor. Greater autonomy for decentralized networks of schools should also help a more effective spending of resources, while the new formula to transfer the central education budget across provinces is expected to yield greater equity. However, it cannot be denied that these steps are not a sufficient move towards a more transparent and coherent result-oriented budgeting system. First, the Bono is managed separately from the education budget as a social protection program. Second, the budgets for the CEMs and promotion of Redes Amigas have been heavily dependent on external resources and managed as off-budget activities. Third, as indicated, the new geographical allocation rule for the education budget on a per capita basis does not eliminate the central management of resources, nor - as we have shown - does it increase equity across provinces.27 3.48 A first step towards a more comprehensive result-oriented budgeting system would be to put together all programs and interventions aimed at improving educational outcomes and monitor each for their cost-effectiveness. Increased access to primary and secondary education is a priority target for the government. Therefore, the results of the schooling determinants model of Section 6 may serve as a starting point for the development of a result-oriented expenditure tracking methodology. 3.49 The schooling determinants model serves to establish input-output relationships in education, i.e. between policy interventions and expected educational outcomes measured by net enrollment rates. The relative importance of each determinant discussed in Section 6 may be expressed as an elasticity expressing the impact of a 1 percent change of a given determinant on school enrollment (see Tables 3.10 and 3.11). After linking these to unit costs we obtain a basis for making budget projections for alternative resource allocations. As a first exercise we perform static cost-effectiveness simulations, that is, we change effective inputs such that we approach a given target (say, 100 percent net enrollment) using the given elasticities and unit cost to estimate the costs of the interventions. In this exercise we take account of certain interaction effects. For instance, an expansion in the conditional cash transfer program would lead to higher school enrollment, but also to a higher number of students per classroom which has a negative effect on enrollment for some groups of the population of school-going age unless more is invested in class rooms. In the results reported below, we assume that the pupil-teacher ratio is kept fixed during the simulation period. Simulations are compared to a baseline scenario that keeps all inputs constant (although the number of teachers may rise as a result of the fixed pupil- teacher ratio assumption) and unit costs adjust for projected inflation only. In the baseline (no policy change), the primary education budget remains at 1.3 percent of GDP and that for secondary education at 1.2 percent of GDP, while net enrollment rates do not improve from 2003 levels. 26 See Reid (1997) for a further analysis of this point and incentives to circumvent budget rules and control through off-budget activities and other devices. 27 That is, of course, taking the Rawlsian view of giving higher weight to resource increments for the poor. The new formula would make the distribution more equi-proportional but less pro-poor as discussed in Section 5. 55 3.50 Budget Tracking and Projections for Primary Education. Table 3.14 shows three budget scenarios. Table 3.14. Reaching the MDG for Education: Static Budget Projections for Primary Education, 2003-7 Increase trained teachers Increase school subsidy Combined: trained teachers, program school subsidies and rural school infrastructure Additional Additional Additional Additional Additional Additional costs costs as costs as . costs as costs as costs as as percentage of percentage of percentage of percentage of percentage of percentage of GDP % Education GDP % Education GDP Education budget % budget % budget % 2004 4.1 0.1 3.5 0.0 6.1 0.1 2005 5.4 0.1 4.0 0.1 9.0 0.1 2006 6.2 0.1 4.8 0.1 12.1 0.2 2007 7.1 0.1 6.2 0.1 14.6 0.2 Increase trained teachers Increase school subsidy program Combined: trained teachers, school subsidies and rural school infrastructure Additional budget requirements (in mln US$) 2003 0 0 0 2004 16 14 24 2005 22 16 37 2006 27 21 52 2007 32 28 65 Total 2003-2007 97 78 177 Net enrollment rate by 2007 Urban poor 0.97 1.oo 1.oo Urban non-poor 1.oo 0.94 1.oo Rural poor 0.87 0.86 0.88 Rural non-poor 0.93 0.93 0.93 Nation-wide 0.94 0.93 0.95 Urban total 0.99 0.97 1.oo Rural total 0.88 0.88 0.89 Source: Author’s estimates 3.51 First, we increase the share of trained teachers to 100 percent (up from 90 percent in 2003) and reduce the share of teachers with central appointment to 84 percent (down from 94 percent) by 2007. This scenario works to get all urban non-poor children in school by 2007 and would have induced the urban poor to a net enrollment rate of 97 percent (up from 89 percent in 2003). The policy should also help to increase enrollment among the rural poor, but without additional investment in rural school infrastructure the effect will be more than offset by the ensuing increase in the number of pupils per class room. The budget implications of this policy are minimal. All other things being equal, it would require an increase of about 7 percent in the (nominal) education budget by 2007 or about US$30 million as compared to a baseline of no policy change. This policy can be as effective, and even cost-saving if we would drop the assumption of a fixed pupil-teacher ratio of 23 and allow the ratio to increase to 25, implying a reduction in the number of teachers by 3 percent (or about 3,700 teachers). 56 3.52 Second, we expand the Bono program to cover all urban poor. The analysis of Section 6 suggests school subsidies (or reducing schooling costs) only significantly influence enrollment for this population group. As this group was not targeted initially by the Desarrollo Humano program, this would involve additional budgetary cost; not just from the increase in coverage of the cash transfer program, but also due to rising teacher costs as enrollment increases and the pupil-teacher ratio is kept fixed. In order to have all urban poor in school by 2007, this would involve a slightly smaller additional budget effort of 6 percent over the baseline projection by 2007 or about US$28 million (0.1 percent of GDP). The additional cost may be ‘financed’ through cost savings by allowing for a slight increase in the pupil-teacher ratio as in the first simulation. 3.53 Third, we combine the two policies and also allow for an increase in rural school infrastructure by a sufficient amount such that the rise in the number of pupils per classroom does not have a negative effect on enrollment of the rural poor. Given our model parameters and all other things being equal, we expect this combination of policies to lead to universal access to education for the urban population, but leave the rural population without any visible benefit. The cost would only be marginally higher than for the second budget scenario (an additional 0.2 percent of GDP), mainly due to the extra investment in schooling infrastructure and the rise in demand for teachers as enrollment increases. Again, this policy package could be financed by allowing for a gradual increase in the pupil-teacher ratio to 27.5 by 2007, but requiring a reduction of 9 percent in the number of teachers (i.e. affecting about 11,000 teachers). 3.54 Budget Tracking and Projections for Primary Education. Using the cost-effectiveness analysis as a basic input, Table 3.15 shows three budget scenarios for trying to take an important step towards reaching the target of 70 percent of net secondary enrollment by 2007. 57 Table 3.15. Improving Access to Secondary Education: Static Budget Projections for Secondary Education, 2003-7 Increase trained teachers Increase school subsidy program Combined: trained teachers, school subsidies and rural school infrastructure Additional Additional Additional Additional Additional Additional costs as costs as costs as costs as costs as costs as percent age of percentage of percentage of percent age of percentage of percentage of GDP % Education GDP % Education GDP % Education budget % budget % budget % 2004 2.4 0.0 3.1 0.0 13.1 0.2 2005 4.8 0.1 5.0 0.1 22.6 0.3 2006 7.0 0.1 8.1 0.1 38.2 0.4 2007 8.8 0.1 11.9 0.1 p 53.3 0.6 Increase trained teachers Increase school subsidy program Combined: trained teachers, school subsidies and rural school infrastructure Additional budget requirements (in mln US$) 2003 0 0 6 2004 8 11 46 2005 17 18 83 2006 27 31 146 2007 35 47 212 Total 2003-2007 88 108 493 Net enrollment rate by 2007 Urban poor 0.57 0.70 0.70 Urban non-poor 0.83 0.76 0.79 Rural poor 0.24 0.27 0.27 Rural non-poor 0.60 0.52 0.55 Nationwide 0.56 0.58 0.59 Urban total 0.71 0.73 0.75 Rural total 0.32 0.33 0.34 Source: Author’s estimates 3.55 First, we increase the number of secondary school teachers with a university degree and a teaching qualification to 100 percent (up from about 80 percent in 2003). This scenario would stimulate enrollment in urban areas, except that it would mainly stimulate enrollment for the urban non-poor, leaving the urban poor still at some distance from the target of 70 percent enrollment. The simulation would also predict enrollment of rural non-poor to be up at 60 percent by 2007 (from 52 percent in 2003). The rural poor are not expected to be induced to higher enrollment by such a policy. The policy would imply though that some 27,000 teachers in secondary schools would have to be trained or receive a university degree in a four year time span, which might be a steep order and may have to be spread out over a longer period. We estimate the extra budgetary cost at an annual US$35 million by 2007 or an increase of about 8 percent from the baseline budget for secondary education equivalent to 0.1 percent of GDP. 3.56 Second, we expand the Bono program to cover all urban and rural poor households with children of secondary school age. The analysis of Section 6 suggests school subsidies (or 58 reducing schooling costs) will significantly influence enrollment for poor households. As the Bono program has not been targeted at secondary education, this would involve additional budgetary cost; not just from the increase in coverage of the cash transfer program, but also due to rising teacher costs as enrollment increases and the pupil-teacher ratio is kept fixed. Under the given assumptions, the policy could reach the 70 percent target for the urban poor. However, secondary school enrollment for the rural poor is very low and the impact of the subsidy (of US$5 per student per month) is not large enough to increase enrollment significantly for this population group. As discussed in Section 6, increasing access for the rural poor to secondary education has to be part of a long-term effort of which targeted subsidies are just one element. This would also require better economic conditions for rural households (requiring less child labor), improved achievement at the primary education level and improvements over time in parental education (especially of mothers). The additional budgetary cost of the school subsidy program as simulated would amount to about US$47 million (0.14 percent of GDP) by 2007. 3.57 Third, we combine the two policies and also allow for an increase in school infrastructure by a sufficient amount such that class size (pupils per classroom) remains at 21 and therefore will not impact negatively on urban enrollment (see cost-effectiveness analysis). In this scenario we limit the increase in the share of teachers with a degree to 89 percent, implying about 9,700 teachers would have to be trained during the period. Given our model parameters, we expect this combination of policies to lead to the 70 percent target for both urban poor and non-poor, but the rural poor would still fall short of this target for the reasons mentioned above. The additional infrastructure investment would, however, be substantial at around US$212 million. During 2003-7 about 4,000 new classrooms would have to be constructed to keep the class size at 21. The extra cost would require the secondary education budget to increase by about 50 percent, an annual cost equivalent to 0.6 percent of GDP. 3.58 In sum, there exist (financially) feasible scenarios to reach 100 percent of net primary school enrollment in urban areas in the medium term. Such a target may be reached without additional budget effort, if the additional cost of increasing the quality of teachers and increased coverage of demand subsidies is compensated by a slight reduction in the total number of teachers. Meeting the target for the rural population is more complicated and the budget implications could not be quantified based on the cost-effectiveness model. In secondary education, important progress can be made to reach a target of 70 percent net enrollment (with important expected positive externalities for economic growth). Again, the target is within reach for the poor and non-poor urban population by 2007 at a possible additional cost of between 0.1 and 0.6 percent of GDP. The latter option would also have a visible impact on secondary school enrollment in rural areas, but still off target given the extremely low initial levels of schooling access in those parts of the country. Reaching the 70 percent target for the rural population will require a much longer time period. The required extra budget costs for enhanced secondary school enrollment are thus much more substantial than in the case of primary education. 3.59 In all scenarios, budget neutrality would require finding fiscal space for financing key initiatives. An alternative would be to allow the studenvteacher ratio to increase. Another would be to shift additional resources from the budget within the fical ceiling (Volume I).In any case, the amounts involved are small, when compared to the potential positive outcomes for human capital development. 59 References Bedi, Arjun S. and Jeffery H. Marshall (1999). ‘School attendance and student achievement: Evidence from Rural Honduras’; Economic Development and Cultural Change 47: 657-682. Bedi, Arjun S. and Jeffery H. Marshall (2002). ‘Primary school attendance in Honduras, Journal of Development Economics 69: 129-153. Demery, Lionel (2003). ‘Analyzing the incidence of public spending, in: Franqois Bourguignon and Luiz Pereira da Silva (eds.) The Impact of Economic Policies on Poverty and Income Distribution. Evaluation Techniques and Tools, Oxford and Washington D.C.: Oxford University Press and World Bank, pp.41-68. ECLAC (2001). Panorama Social de Ame‘rica Latina, Santiago: United Nations - Economic Commission for Latin America and the Caribbean. Gertler, Paul and Paul Glewwe (1990). ‘The willingness to pay for education in developing countries: Evidence from Rural Peru, Journal of Public Economics 42: 251-275. Gertler, Paul and Jacques van der Gaag (1988). ‘Measuring the willingness to pay for social services in developing countries, LSMS Working Paper No.45, The World Bank, Washington D.C. Rogers, F. Halsey, JosC L6pez-Calix, Nancy Cbrdoba, Nazmul Chaudhury , Jeffrey Hammer, Michael Kremer, and Karthik Muralidharan (2004). ‘Teacher absence, incentives and service delivery in Ecuadorian primary education: Results from a new national survey, Washington D.C.: World Bank (mimeo). Harbison, R.W. and E.A. Hanushek, 1992. Educational peqormance of the poor: Lessons from Northeast Brazil. The World Bank. Oxford University Press. Heckman, James, Lance Lochner and Petra Todd (2003) ‘Fifty years of Mincer earnings regressions’, NBER WP 9732, Cambridge (MA): National Bureau for Economic Research (htt~:Nwww.nber.ore/Dapers/w9732). Parandekar, Suhas, Rob Vos and Donald Winkler (2002). ‘Ecuador: Crisis, Poverty and Social Protection, en: Paul Beckerman y AndrCs Solimano (comp.) Crisis and Dollarization in Ecuador, Washington D.C.: The World Bank, pp. 127-176. Ponce, Juan, bunBedi and Rob Vos (2003). “LCdmo hacer mds eficiente el gasto educativo?” in: Rob Vos (ed.) 2Quie‘n se beneficia del Gasto Social en el Ecuador? Estudios e Informes del SIISE-STFS No. 4, Quito: Secretm’a TCcnica del Frente Social, Quito: Secretaria TCcnica del Frente Social, pp. 89-1 18. Reid, Gary (1997). ‘Improving micro budgetary performance, Washington D.C.: The World Bank (Mimeo; September). Rojas, Carlos (2003). ‘Education, in: Vicente Fretes-Cibils, Marcel0 M. Giugale, JosC Roberto L6pez-Cilix (ed.) Ecuador: An economic and social agenda in the new millennium, Washington D.C.: The World Bank, pp. 265-292. Vos, Rob (ed.) (2003). ,jQuie‘n se beneficia del Gasto Social en el Ecuador?, Estudios e Informes del SIISE- STFS No. 4, Quito: Secretm’a TCcnica del Frente Social. 60 Vos, Rob, Mauricio Le6n and RenC Ram’rez (2003). “Pobreza, desigualdad y politicas econ6micas y sociales en el Ecuador,” in: Rob Vos (ed.) i Qui& se beneficia del Gasto Social en el Ecuador, ? Estudios e Informes del SIISE-STFS No. 4, Quito: Secretaria TCcnica del Frente Social, Quito: Secretaria TCcnica del Frente Social, pp. 16-30. Vos, Rob and Mauricio Ledn (2003). ‘Tendencias en el gasto social,” in: Rob Vos (ed.) 2Quikn se beneficia del Gasto Social en el Ecuador,? Estudios e Informes del SIISE-STFS No. 4, Quito: Secretaria TCcnica del Frente Social, Quito: Secretm’a TCcnica del Frente Social, pp. 31-46. Vos, Rob and Mauricio Le6n (2003). Dolarizacio’n, didmica de exportaciones y equidad: LCo’mo hacerlos compatibles en el cas0 de Ecuador,? Estudios e Informes del SIISE-STFS No. 5, Quito: Secretm’a TCcnica del Frente Social, Quito: Secretm’a TCcnica del Frente Social. Vos, Rob, Juan Ponce, Mauricio Leh, JosC Cuesta and Wladymir Brborich (2003). “iQuiCn se beneficia del Gasto Social en el Ecuador?,” in: Rob Vos (ed.) iQuikn se beneficia del Gasto Social en el Ecuador, ? Estudios e Informes del SIISE-STFS No. 4, Quito: Secretm’a TCcnica del Frente Social, Quito: Secretm’a Tknica del Frente Social, pp. 46-70. Vos, Rob, Lance Taylor, and Ricardo Paes de Barros (eds.), (2002). Economic Liberalisation, Distribution and Poverty: Latin America in the 1990s, Cheltenham (UK) and Northampton (US): Edward Elgar Publishers. World Bank (2003). Inequality in Latin America and the Caribbean. Breaking with History?, World Bank Latin American and Caribbean Studies, Washington D.C.: World Bank (Advance copy of October 2003).Ecuador: Poverty Report, Washington D.C.: World Bank. 61 Annex 3.1 Education Cost-Effectiveness Model A2.1 Demand for schooling A2.2 Empirical specification A2.3 Costs of attending school A2.4 Benefits of attending school A2.5 Cost analysis and budget projections A2. I Demand for Schooling: enrollment, school attendance and student achievement The first educational outcome that should probably be considered while analyzing the educational sector is school enrollment patterns. In addition there are several other educational outcomes that need to be considered once the enrollment decision has been made. The framework presented here focuses largely on two of these outcomes. In particular, what are the factors that determine school attendance over the school year and what are the determinants of academic achievement? The framework outlined here links both these outcomes. However, it is also possible to analyze these outcomes individually. Also note that while the focus here is on the attendance decision, it is quite straightforward to modify it to suit the enrollment decision. The economic contribution of children to families in developing countries (especially in rural areas) and accordingly the opportunity cost associated with school attendance may be substantial. Attendance will suffer when parents perceive that the return associated with time spent in school does not justify the loss of a child’s economic contribution. Parental perceptions of school inputs may also affect the attendance cost-benefit calculus as low quality teachers or limited availability of teaching materials may attenuate the expected benefits of attending school. A reduction in days attended probably exerts a negative influence on academic achievement and increases the probability of repetition and desertion. The framework presented here, and applied in Section 6, explicitly recognizes the link between primary (and secondary) school attendance and student achievement. It is assumed that parents determine the particular pattern of school attendance for their children on the basis of expected gains and the costs of attending school. It is possible to proceed in two steps. First, estimate the effect of child, family and school characteristics on test scores and obtain predicted test scores. In the second step estimate a school attendance model that includes predicted test scores as a measure of the expected gains of school attendance. School Attendance and Student Achievement - An Analytical Framework School attendance patterns in developing countries vary substantially across households. Some children may never enter school while others may attend only part-time. The degree of part-time schooling may vary from missing a few weeks to missing several months. The variation in attendance patterns suggests that parents evaluate differently the costs and benefits of attending school and that this evaluation for the same household may also vary according to the particular time of the year. For instance, during the harvest season the opportunity costs of attending school 62 may far outweigh the benefits, resulting in temporary withdrawal, while at other times the benefits may outweigh the costs and result in regular school attendance.28 Thus, school attendance over the year may be viewed as the consequence of a daily household decision where a child attends school on a particular day if the expected benefits from attending school on that day are greater than the associated costs. To formalize these notions and to motivate our empirical work this section presents a framework tailored to our needs.29 Consider that the school year consists of n days and it is day i of the school year. We assume that each household has a utility function defined over bi and ci , where bi denotes the benefits associated with attending school on day i, and ci is household consumption on day i. While attending school yields benefits it comes at a cost. Direct and opportunity costs associated with school attendance lower resources available for household consumption. Accordingly, household utility on day i conditional on school attendance (denoted by subscript 1) is given as, Uil=U(b,,cil>. (1) The associated budget constraint is, Yi = Cil+ pi, (2) where yi is household income, and pi represents the total cost associated with school attendance. In a similar fashion the utility associated with not attending school may de defined by, uio = U(C,O) * (3) The budget constraint is yi = CiO . Given the utility associated with both options, households choose the option that yields the highest utility. The solution to the daily unconditional utility maximizing problem is u, * = max (Ui,Y UiO) , (4) where Ui* is the maximum utility. Alternatively, school attendance may be defined in terms of a dichotomous variable, ai, where ai = 1 if a child attends school and 0 otherwise. A child attends school i.e., ai = 1 if Uil> UiO. Summing up the outcomes of these daily decisions, over the school year, leads to the observed pattern of school attendance. A2.2 Empirical Spec @?cation Since our purpose is to empirically explore the role of expected gains and costs on the school attendance decision we proceed by specifying linear forms of the conditional utility function. For the schooling option, uil= P1bi + P2cil+ Eil (5) where the P 's are coefficients to be estimated and 41 is assumed to be a mean zero, normally distributed error term with positive variance. Since Cil = yi -pi, we may rewrite (5) to obtain, ui,=Plbi+P2(yi -~i)+~il (6) The utility function for the non-schooling option is, uio= P2~i+~io (7) 28 This is especially true in rural areas. 29 The framework used here is similar to those in Gertler and Van Der Gaag (1988) and Gertler and Glewwe (1990). 63 Thus, an individual attends school, i.e. ai =1 if P1bi -P2pi + E~,-gi, > 0. The chances of attending school on a particular day may be expressed in terms of a linear probability model that may be written as, where q, is a normally distributed, mean zero, positive variance composite error term.30 Equation (8) depicts the probability of attending school on any particular day. Since we are interested in the yearly pattern of school attendance we may sum up the outcome of the daily attendance decision over the course of the school year, to yield, A = PIB+ P2P + EA, where yearly school attendance A, depends on B, the expected benefits associated with school attendance over the school year and P, the yearly costs of attending school. A2.3 Costs of Attending School The total cost (P) of sending a child to school includes monetary (direct) and indirect or opportunity costs. Since education is largely subsidized the main cost incurred by households is likely to be in the form of opportunity costs. Attending school reduces a child’s availability for work in and outside the home. If a child makes substantial contributions to family income, or plays an important role in supporting other working members, then the opportunity cost of attending school is likely to be high and this may curtail the attractiveness of the schooling option. Both of these cost components are likely to differ across households. For instance, direct costs may vary due to differences in transportation costs. Opportunity costs and the value of a child‘s time may also differ due to personal characteristics of the child (age, sex) and the value that parents place on a child’s time. Since we do not directly observe the costs of attending school we allow P to depend on a vector of child, family and other characteristics that capture the cost of attending school. A2.4 Benefits of Attending School Parents have to ascertain the total benefits (B) associated with school attendance. We consider two types of benefits that may influence parental decision-making. The main benefit associated with attending school is likely to be the expected addition to a child’s human capital. To capture this effect we need a measure of the human capital gains associated with school attendance. For this study we incorporate a measure that is widely used to indicate the benefits derived from education: test scores. However, using actual test scores is obviously incorrect due to the potential endogeneity between test scores and attendance. In order to derive an appropriate 30 In this linear utility specification, income has been differenced out of the decision rule and does not directly affect the school attendance decision. Household endowments are assumed to influence the school attendance decision through opportunity costs. 64 measure of human capital gains we proceed by estimating educational production functions, one for each subject, for those students for whom test score data are available. These test score equations are specified as, H=&+E*, (11) where H is a measure of human capital or in this case test scores, Z is a vector of individual, family and school characteristics that influence H, and EH is an error term. Estimates from the educational production functions are used to predict test sores for each individual. These predicted values ( fi ) are included in equation (10) in order to capture the human capital benefits associated with attending school. In addition to school characteristics that have an impact on test scores, there may be other school characteristics that do not affect academic achievement but do signal the quality (Q) of a school and directly influence the benefits that parents attribute to school attendance. For instance, whether a school has a telephone connection or a sports field may not directly influence academic achievement. However, these are easily observed signals that may be used by parents to judge the quality of a school and in turn may directly influence the benefits that parents associate with school attendance. Thus, some school inputs and facilities may directly influence parental evaluation of the benefits associated with school attendance while others may exert an influence on benefits through their impact on test scores. To account for the different kinds of benefits that parents may associate with school attendance, equation (10) may be adjusted to accommodate both the expected human capital benefits ( fi ) and direct benefits (Q) and may be rewritten as, A=PI,qfi+P2eQ+ P3P + E,, (12) where PIA is a coefficient to be estimated and P2Qand P3 are conformable coefficient vectors to be estimated. As this equation depicts, school attendance is treated as a function of expected human capital benefits, other benefits and costs. A2.5 Cost Analysis and Budget Projections Recent contributions to the school effectiveness literature have emphasized the importance of incorporating cost-effectiveness analysis into school quality research designs. While there is little doubt that the identification of factors that affect learning outcomes is important, its usefulness will be considerably enhanced if accompanied by more information on the costs associated with each intervention. On the basis of the analysis suggested in the previous section it should be possible to identify the most important factors influencing educational outcomes. Combing this information with the cost of each intervention would allow an evaluation of the most efficient method of increasing achievement and attendance. This offers a method of comparing alternative policies that can be ranked in terms of achievement gains per shilling invested in each input. Examples of such static cost-effectiveness analyses are available in e.g. Bedi and Marshall (1999) and Harbison and Hanushek (1992). 65 66 ChaDter 4 HEALTH’ Healthcare in Ecuador has improved substantially over the last 30 years but spending remains low compared to other countries in the region and there are severe inequalities in the system, particularly in access to healthcare for the indigenous population, the poor and those living in rural areas. A series of reforms in the 1990s remain to be implemented, hindered by a series of economic crises. The main focus of this note, however, is on how to reduce infant mortality rates, particularly for marginalized groups. The recommendations aim to help the country achieve the Millennium Development Goal of reducing infant mortality by two-thirds in the period 1990-2015. For many better-off sectors of the population this target is already in sight. The analysis shows that with a series of initiatives that are almost budget-neutral the MDG is almost within reach for the whole population, suggesting more robust measures may be needed in the near fiture. The recommendations that follow, would also go some way to addressing the overall problems in health service delivery, including low access to services, inequalities across population groups and geographical areas, and low quality of services. The recommendations, which analysis shows would have the greatest impact on infant mortality, are to protect the immunization program that has suffered recent budget cuts and expand the Free Matemity program (guaranteeing free access to free pre-natal and delivery to all women). In the long- term the govemment could consider a universal health insurance system as a means of delivering healthcare, especially to the poor. However, current financial constraints make that option impractical at present. The analysis uses a series of econometric and modeling techniques aimed at finding the most cost-effective ways to achieve the desired results. “Soy indigena, vengo de Tigua ... cuando nos enfermamos, nosotros nos curamos con plantas, per0 cuando es una cosa seria, vamos a ver a1 doctor.” “Nosotros nunca vamos a ver a1 mtdico. Cuando hace falta, compramos remedios en la farmacia.” “Si nos enfermamos, tomamos tt de cedr6n. Nunca nos hacemos controlar 10s dientes.” Quechua children, aged 10 to 12, Ecuador (UNICEF, 2004: 14) 4.1 Public health spending in Ecuador is among the lowest in Latin America. Spending amounts to a meager 2 percent of GDP (only Haiti spends less). Yet huge strides have been made in improving health conditions. Since 1970, infant mortality rates have been cut by 70 percent to 34 per 1,000 live births. However, important inequalities remain in the health system, with higher mortality rates and limited access to health care for the indigenous population, the poor and those living in rural areas. 4.2 Health provisioning has shifted towards greater emphasis on primary health care in public provisioning and in-patient hospital care by private health providers. Health policy reforms have included increases in user fees for public services, decentralization, special programs providing free health care for the poor (including the free maternity program), and the introduction of 1 This paper was prepared by Rob Vos (Institute of Social Studies, The Hague). Ruth Lucio, Mauricio Le6n, and Jost Rosero Secretaria Te‘cnica del Frente Social, Ecuador) and Jost Cuesta (Institute of Social Studies, The Hague). We are grateful to Karina Lara and Cesar Amores for valuable research inputs and to Arjun Bedi for advice on the modelling of the demand for health care and infant mortality determinants. 67 demand subsidies for health through the conditional cash transfer program Bono de Desarrollo Humano (Human Development Payment). Policies have not been consistent, though, as the health policy framework has changed a number of times during the 1990s and not all reforms have as yet been fully pushed through (such as the decentralization). The reforms were implemented under tightening budget constraints, as the health budget (in real per capita terms) declined for most of the 1990s. Recent upward budget adjustments have mainly gone into salary increases for health workers. 4.3 All of this has had a mixed outcome on health conditions in Ecuador, but principally the policy reforms as implemented have failed to address the fundamental problems in health service delivery, including low degrees of access to services, inequalities across social population groups and geographical areas, and low quality of services. Inequalities in access to health facilities have increased, partly because of the introduction of user fees and partly because health inputs (particularly drug supplies) have fallen well behind requirements. On the other hand, continued expansion of the immunization program and the introduction of the free maternity program have compensated for this effect, at least for young children and pregnant women, and this is likely part of the explanation for the continued decline in infant mortality during the 1990s. However, the remaining large differences between rich and poor, non-indigenous and indigenous, and urban and rural populations, suggest such specific interventions have not been sufficient to ensure greater equity in health conditions. It is even less clear to what extent Ecuador’s health system is sufficiently prepared to take on the challenge of increasing health demands due to the epidemiological transition towards injuries and chronic and degenerative diseases, which already dominate adult disease prevalence. The main focus of this paper will be on the health risks affecting mothers and young children and finding more cost-effective ways to use the health budget to further reduce infant mortality, particularly for those groups with the least favorable health status. 4.4 We find that improving access to maternal and child care (vaccinations, pre-natal controls, and professionally assisted child delivery) is critical in order to reduce infant mortality to the level of the Millennium Development Goal for all population groups (reduce it by two- thirds in the period 1990-2015). The budget implications should not form any impediment to achieving these targets as these are estimated at just 0.01 percent of GDP per annum. In fact, there would not even be an immediate need to increase the health budget to achieve the target for reducing infant mortality, as there is underutilized capacity in the public health system and the system has a distorted personnel structure with an oversupply of doctors and a shortage of nurses, such that cost-saving adjustments could cover the additional expenditures. In other words, all that is required would be a more adequate priority setting in the public health budget, protecting the immunization program to reach full coverage, a targeted expansion of the Free Maternity program and optimizing use of available resources for personnel and infrastructure. The conditional cash transfer program (Bono de Desarrollo Humano) is also aimed at stimulating use of maternal and child health care services, but at present-we estimate-just about 5 percent of the beneficiaries of the program obtain the cash transfer by making use of such services. While close coordination between the two programs is important, the degree of overlap does not seem very big. Over time, such compensatory schemes should be replaced by an adequate health insurance scheme. But with the current low coverage of health insurance and inadequacies in the supply of health services this seems a more appropriate alternative for the long term. 68 4.5 The remainder of this paper is organized as follows. In Section 2, we describe trends in overall health conditions in Ecuador over the past decades through changes in the mortality and epidemiological profiles of the population. We also present analyses of inequalities in health determinants that most impact child mortality. In Section 3, we describe the major changes in health policies during the 199Os, while in Section 4 we analyze how those changes have impacted on health inputs and trends in public health expenditures. Section 5 addresses equity issues, showing who benefits most from health expenditures in Ecuador. Section 6 looks at the efficiency of health spending, particularly that aimed at improving maternal and infant health status. We do this through a two-stage health production function approach, modeling first the determinants of access to health care and choice among public and private providers. Next, we model the determinants of child survival in the first year after birth and assess which policy variables seem most effective in reducing infant mortality. In Section 7 we assess the budget implications of alternative interventions and spell out a budget tracking methodology that links health inputs to outputs. I. Health Status and Access to Health Services 4.6 Rising Life Expectancy and Declining Infant Mortality. Health conditions for the Ecuadorian population have improved considerably over the past 50 years. Life expectancy increased from 48 to 72 years between 1950 and 2000 (Figure 4.1). This upward trend was sustained during the 1990s with the average Ecuadorian gaining another 5 years of life expectancy. Parallel patterns are found in declining child and infant mortality rates. Figure 4.1. Life Expectancy (in years) for Males and Figure 4.2. Global Mortality Rate, 1960-2001 Females, 1950-2000 25 0" I t20 vB 3 15 2 60 h ,.-* .... * 5s 10 50 t 5t5 0 5 55 60 65 70 75 80 85 90 95 2000 55 60 65 70 75 80 85 90 95 2000 -INEC Populationprojections ....Total +Males -Females . -INECEstadisticas Vitales Source: INEC (2003) and INEC Stadisticas Vitales Source: INEC (2003) and INEC Stadisticas Vitales Note: Estimates from administrative records of Note: Estimates from administrative records of health centers (Estadisticas Vitales) are for the end health centers (Estadfsticas Vitales) are for the end of the period. The estimated projections from INEC of the period. The estimated projections from INEC (2003) are based on mortality tables for 2001 (and (2003) are based on mortality tables for 2001 (and CELADE's life expectancy tables). CELADE's life expectancy tables). 4.7 The overall mortality rate dropped from 13.8 in 1960 to 4.5 per 100,000 inhabitants in 2001 (Figure 4.2). This rate has not changed much during the 1990s. In contrast, the infant mortality rate has continued to fall in an almost linear trend since 1950 reaching 34 per 1,000 live births for 1995-2000 according to the population census based life expectancy tables, down 69 from 140 in 1950-55 (INEC 2003). This impressive trend is consistent across various data sources (see Figure 4.3). Child mortality rates follow similar trends as these mainly reflect infant mortality since most child deaths are concentrated in the first year of life (Table 4.1). Since 1970, the infant mortality rate has fallen by 70 percent in Ecuador, which is as impressive as the achievements in the rest of the Americas where the rate has fallen on average at a similar rate (WHO 2003). Achievements in Chile, Costa Rica, and Cuba have been even more impressive with reductions of over 80 percent. -. 140- 140 a -I 120 - a 120 +Estadsticas vitaleeEndesaEndemam- Population censuses 1 - -Fertility rate-Infant mortality rate Source: INEC (2003); Demographic and Health Source: INEC (2003); Demographic and Health Surveys (Endesa-Endemain) of 1987, 1989, 1994, Surveys (Endesa-Endemain) of 1987, 1989, 1994, and and 1999; INEC Estadisticas Vitales. 1999; INEC Estadisticas Vitales. Note: See also INEC (2003) and WHO Life Tables in Note: See also INEC (2003) and WHO Life Tables in .. L6pez et al. (2002), for a similar compilation L6pez et al. (2002), for a similar compilation including including some additional estimates from the DHS some additional estimates from the DHS surveys. surveys. Table 4.1. Reaching the MDG for Child Mortality (Projections with Unchanged Trends of 1990s, per 1,000 Live Births) 1990 2001 2015 (P) Year of reaching MDG at unchanged trends Males Females Males Females Males Females Males Females 0-1 year olds 56.1 44.0 30.8 22.6 14.4 9.7 2010 2008 1-5 year olds 17.1 15.1 6.1 4.6 1.6 1.o 2002 2000 Source: INEC, Population Censuses 1990 and 2001. Note: MDG target is to cut child mortality by two-thirds between 1990 and 2015. Projections assume continued linear trend as observed during 1990s. 4.8 The drop in infant mortality coincides with a long-term decline in fertility rates as Figure 4.4 shows. Fertility dropped from almost 7 births per woman in the 1950s and 1960s to 2.8 in 2000-05. During the 1990s fertility dropped faster in rural than in urban areas, but the rate is still 1.5 times higher for rural women. Fertility and infant mortality may be mutually dependent, as higher fertility raises the risk of early child birth, whereas infant deaths may induce higher fertility as a replacement effect. In Ecuador it is noteworthy that the decline of the fertility rate has been less pronounced and started later than the decrease in infant mortality. This would suggest that improvements in health services and socio-economic conditions influenced 70 conditions of child delivery and care prior to influencing reproductive health practices at the family level. It would also suggest that the replacement effect is not very strong. 4.9 The Millennium Development Goals for health include a target of reducing child mortality by two-thirds between 1990 and 2015. This target was already reached in 2001 for girls aged 1-5 and with unchanged (linear) trends this should also have been reached for boys aged 1-5. The projections in Table 4.1 suggest that the goal for infant mortality (0-1 year olds) could be reached by 2010 for boys and by 2008 for girls. We want to investigate further whether the trends are in fact linear (Figure 4.3 would suggest as much), to what extent health policies are important in determining the trend and whether the observed improvements are equal for all population groups. 4.10 Taking a comparative perspective for Latin America and the Caribbean, a simple correlation confirms the typical negative, log-linear relationship between per capita income and infant mortality often found in cross-country data sets (see e.g. Hanmer and White 1998). The two panels of Figure 4.5 show further that Ecuador tends to be below the trend line, which might suggest health policies have had a positive effect on its position of having a relatively low infant mortality rate compared to its mean income level, and since 1970 the country has moved further away from the trend line.2 2 The findings in Figure 4. 3 are the same when using GDP at PPP values or when using transformed data (logs, square roots, etc.). The logarithmic specification as shown by the trend line gives the best fit for the data set. 71 Figure 4.5. Latin America and the Caribbean: Infant Mortality and GDP Per Capita, 1970 and 2001 ::I 1970 2001 7 I.1655dLn(x) + 156.92 -I R'= 0.6173 . 4 04 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000 2001 GDP p (caatant 1995 US) , Source: World Bank Development Indicators, 2003 (CD-ROM), 4.1 1 Looking at child mortality by population groups it appears that (see Table 4.2): 0 Boys have a higher probability of dying at an early age than girls, probably largely for biological reasons as such a pattern is found worldwide (WHO, 2003).3 3 Higher child mortality for boys is found with few exceptions around the world. In China, India, Nepal and Pakistan, mortality in girls exceeds that of boys. This disparity is particularly noticeable in China, where girls have a 33 percent higher risk of dying than their male counterparts. These inequities are thought to arise from the preferential treatment of boys in family health care-seeking behaviour and in nutrition. Throughout Latin America child mortality is higher for boys. 72 Table 4.2. Socio-Demographic Profile of Infant (0-1 years) and Child Mortality (0-5 years) (per 1,000 live births), 1995-2000 1985-90 1995-2000 Age groups Age groups 0-1 1-5 0-5 0-1 1-5 0-5 Ethnicity (language) Non-indigenous 53.3 17.8 70.0 35.0 7.5 38.5 Indigenous 98.8 48.0 141.5 66.0 26.0 90.5 Ethnicity (self-definition) Indigenous n.a. n.a. n.a. 66.0 26.0 89.8 Black (Afro) n.a. n.a. n.a. 38.0 10.0 48.3 Mestizo n.a. n.a. n.a. 31.0 7.0 37.8 Caucasian n.a. n.a. n.a. 26.0 5.3 30.8 Other n.a. n.a. n.a. 29.0 6.5 35.3 Area of residence Urban 40.5 11.0 51.0 27.0 5.5 32.3 Rural 71.3 29.3 98.5 44.0 12.8 56.0 Poverty by UBN Extremely poor 66.3 26.3 90.5 42.0 12.0 53.5 Poor 60.5 22.5 81.8 38.0 10.0 47.5 Non-Door 31.5 7.0 38.5 25.0 4.8 29.3 Totai 55.3 19.0 73.3 34.0 8.3 42.3 Source: Estimates based on INEC, Population Censuses of 1990 and 2001, using same estimation method as indicated in note to Figure 4.3. 0 Indigenous children have about double the child mortality rate as non-indigenous children (i.e. 90.5 against 38.5 per 1,000 live births). They form the most disadvantaged group in this sense. As we shall try to analyze later on, this is likely caused by the fact that indigenous mothers tend to have less education, less knowledge of (modem) reproductive health care and limited access to professional pre-natal care and birth delivery assistance. As can also be derived from Table 4.2, the gap in the risk of dying at an early age between indigenous and non-indigenous bom has not narrowed during the 1990s. Child and infant mortality are also significantly higher for Afro-Ecuadorians. The probability of early child death for this population group is 10-15 percent higher than the average, though the difference is much less than that for the indigenous population. 0 The risk of child mortality is significantly higher in rural than in urban areas, even though this difference has narrowed slightly from 1.9 times to 1.7 times during the 1990~.~ 0 Children of poor families are at greater risk than those of non-poor fa mi lie^,^ but here we also observe a reduction in the gap in the 1990s (from 2.1 to 1.6 for child mortality and from 1.9 to 1.5 for infant mortality). 4 For infant mortality this gap fell from 1.75 to 1.63. 5 Poverty is measured here according to the unsatisfied basic needs measure (UBN) as define by SIISE (2003). 73 4.12 The observed differences by socio-demographic groups are more or less expected patterns. The question to be answered later on is to what extent inequalities in access to health services have influenced these patterns. 4.13 Available data also suggest a significant decline in maternal mortality. According to INEC’s health statistics, the maternal mortality rate dropped from 203 per 100,000 live births in 1971 to 117 in 1990 and to 46 in 2002 (SIISE 2003). If these data are correct, a continuation of the declining trend in maternal mortality as observed during the 1990s would be sufficient to reach the MDG target for this health indicator (a cut by 75 percent between 1990 and 2015) by 2008. However, there are strong reasons to believe that the administrative records of maternal deaths as registered by health centers strongly underestimates the actual level. Different estimates are drawn from the Demographic and Health Surveys Encuesta Demografica y de Salud Matemo Infantil (ENDEMAIN). Based on this source, Bortman (2003: 301) maternal mortality was an average of 302 per 100,000 in 1981-87 and 159 during 1988-94, while the WHO database records a rate of 210 for the mid-1990s. The latter rate is relatively high by Latin American standards, well above that in Chile, Colombia, Costa Rica, Mexico and the richer countries in the region, but similar to that of Peru and close to that of Honduras and Nicaragua, the latter being much poorer nations than Ecuador. We must emphasize that all these estimates lack precision, such that it is difficult to infer strong conclusions about the trends and at best it is safe to say that the rate likely fell considerably in recent decades. 4.14 A Shifting Epidemiological Profile. The decline in fertility and increase in life expectancy has changed the demographic profile of the Ecuadorian population towards a higher average age. However, the population is still rather young with 54 percent under the age of 25. This segment of the population was still on the rise during the 1950s and 1960s when fertility rates were still very high. The turning point came around 1965. The share of children under age 5 has dropped from 17.6 percent in 1965 to 11.8 percent in 2000. 4.15 The epidemiological profile (causes of mortality and morbidity) has also changed in past decades, away from traditional “child diseases’’ (malnutrition and communicable respiratory and infectious diseases) towards a greater prevalence of diseases associated with higher levels of figure 46.MainCausesof Mod@,1979-2000 (share figure: 4.7 IXshitulion of AajustedLost IifeYears by of total deaths) Qpes of Diseases and Age Groups, 1995 I 9m Source: INEC, Estadisticas Wales, 1979-2000 and SIISE Source: CEPARPHR(lW), ElPeso de IaEnfermedadenel Ecuador, Quito (Burden ofDisease Study). k%?Preventable death caws include: infectious and respiratory diseases malnurition, atortions and deaths due to inadeguate assistance at bilth. Chronic-degenerative diseases mclude, among other, cancer,cardiovaxular and cerebrovascular diseases, mental diseases, and disorders of the navous system 74 economic well-being and urban lifestyles, such as cancer and cardiovascular health risks. We show this change in health risk patterns for the main causes of death in Figure 4.6. The share of ‘preventable’ diseases declined from over 60 to below 30 percent between 1979 and 2000, while that of ‘chronic-degenerative’ diseases increased from 22.5 to 42.2 percent in the same period. As the administrative records of health services, on which these data are based, tend to understate the prevalence of preventable diseases, the epidemiological transition might have taken place at a somewhat slower pace than suggested by Figure 4.5, but it’s undeniably there. 4.16 The main causes of mortality and morbidity in early childhood (0-5 years of age) remain, however, related to preventable, communicable diseases, as one would expect. The burden of disease study by CEPAR/PHR (1999) for 1995 confirms this, showing that more than 70 percent of years of life lost at an early age are due to infectious and respiratory diseases (plus nutritional deficiencies and maternal and perinatal conditions), while in the age group 5-45 the major causes of lost life years are associated with injuries and chronic-degenerative diseases and in those 45 and older the latter type of disease dominates (see Figure 4.7). 4.17 Malnutrition is reported as a direct cause of infant death in less than 5 percent of the cases and, according to INEC’s health statistics, this share has been declining. This figure likely underestimates the impact of malnutrition, as it is a compounding factor in infectious diseases. 4.18 The prevalence of AIDS increased during the 1990s, according to official data from the Ministry of Health.6 Reported cases increased to 764 in 2002, up from 85 in 1990. This implies an increase in the prevalence of AIDS from 0.8 to 6.0 per 100,000 inhabitants. The greatest proportion of cases is clustered in Guayas province (about 60 percent of the total) and heterosexuals account more than half of them. Growth in recent reported cases is especially high among women, particularly sex workers. The impact on child mortality of the rising prevalence of AIDS is not known. 4.19 In recent decades the prevalence of malaria has been closely associated with the El Niiio weather phenomenon. The number of malaria cases increased strongly after the 1982-83 floods, declined after extra malaria eradication efforts were made, resurged in the late 1980s after a light reoccurrence of El Niiio, only to decline steeply during the 1990s until the disaster hit strongly again in 1997-98. Typically it takes several years for the pandemic to subside and eradication measures to take effect. Most recently, the number of malaria cases continued to rise until 2001 when it peaked at 883 per 100,000 inhabitants, up from 103 in 1996 and 686 in 1999. Since 2001 malaria prevalence has declined again. Coastal lowlands and the Amazon region are most at risk. Most cases are clustered in the parts of the Costa region most at risk of flooding (see Vos, Velasco and De Labastida 1999). 4.20 Inequalities in Health Determinants. The indicated differences in the risk of early child death by socio-economic group are also reflected in most indicators of likely determinants of infant mortality. For this we make use of a number of sources, including the 2001 population census, a special module of the Integrated System of Household Surveys of INEC (SIEH) on access to social services of December 2003,7 as well as other recent surveys (the 1999 LSMS and the 2000 EMEDINHO household surveys). Some detailed results are reported in Statistical Annex Tables A46-A53. Some of the salient findings are as follows: 6 Ministry of Health, Epidemiological Statistics, 1990-2002. Also reported in SIISE (2003). 7 The special module was sponsored and designed by the Integrated System of Social Indicators of the Social Cabinet (STFS-SIISE). 75 0 Malnutrition. Data limitations do not allow a longer view of trends in malnutrition in Ecuador, but given economic development trends one should expect a significant decline till the 1980s. Despite recurrent Figure 4.8 Malnutrition (0-5 years old) and Inequality, 2000 economic woes ever 40% - since, the prevalence of Stunting (low height for age) malnutrition also fell in the 1980s and 1990s as suggested by several point estimates. Stunting (low height for age) among children under age ” Underweight (low weight for age) 5 fell from 34 to 26 0% ! percent between 1985 and 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 2000? Underweight Per capita income deciles (low weight for age) declined on average from Source: INEC, EMEDINHO (Special Module of Household Survey), 2000. 17 to 12 percent in that same period. Malnutrition most affects children that live in rural households, in the Sierra region, in poor households and-most particularly- those that are indigenous born. Figure 4.8 shows the link between income distribution and malnutrition, indicating that stunting still affects more than one third of the extreme poor (first three deciles) and underweight about 17 percent of the poorest. Malnutrition (for stunting) is also between 1.5 and 1.9 times higher for the indigenous population, depending on whether it is identified through language or self- definition (Statistical Annex Table A46). 0 Water and Sanitation. Access to drinking water and sewerage systems has greatly improved in past decades. Access to safe drinking water increased from 70 to 81 percent between 1990 and 2001, mainly due to increased coverage in rural areas.’ Inequalities in access run parallel to differences in child mortality rates with indigenous, rural, and poor households showing the larger deficiencies in access to water and sanitation. Coverage of safe drinking water is 58 percent for the rural population against 95 percent for the urban population and about 70 percent for the extreme poor against over 90 percent for the richest household groups at the end of 2003. These data consider all forms of access to drinking water. Piped drinking water to people’s homes has less coverage and shows starker inequalities with 65 percent of urban and 19 percent of rural households served in 2001 (up from respectively 56 percent and 8 percent in 1982). 0 Education. The education of the mother is typically found to be a significant determinant of lower fertility and infant mortality rates. In Ecuador these factors point in the same direction. Female illiteracy has dropped from 19.7 to 10.3 percent 8 SIISE (2002). 9 The coverage in rural areas increased from 44.5 to 63.5 percent, while that in urban areas reached 92 percent by 2001, up from 91 percent in 1990. Data are based on population census data and refer to all sources of safe drinking water. The coverage of piped drinking water in homes has increased more slowly, Le. from 30 percent in 1974 to 38 percent in 1990 and 48 percent in 2001. 76 over the past two decades, and the average level of education of (all) female adults increased from 4.7 to 7.1 years of completed schooling." The 2003 SIEH survey estimates female illiteracy at 11 percent for all women over 15 and at 5.7 percent for women of fertile age (15-49 years). However, the latter rate is significantly higher for poor (12 percent), indigenous (21 percent) and rural (13 percent) women. The mean level of education of women of fertile age (15-49 years) is 9.2 years, but for indigenous women in that age group it is 6.5 years, for rural women 6.4 years and poor women (first three quintiles) 6.7 years. 0 Knowledge of Family Planning and Sexually Transmitted Disease. Knowledge and use of contraceptives has increased. During the 1990s, use of family planning methods increased from 53 to 66 percent of women of reproductive age." This share increased more significantly for women in rural than urban areas, respectively increasing from 40 to 58 percent and from 62 to 71 percent. This no doubt has had a positive impact on declining mortality and fertility rates. Yet again here, remaining differences in use of contraceptives follow the earlier pattern, with women in indigenous, rural, and poorer families showing much less knowledge and use (see Statistical Annex Table A47). Most starkly, 82 percent of indigenous women between 15-45 years report not using any form of contraception. HIV/AIDS does not have a high prevalence in Ecuador, but-as indicated-has been on the rise, particularly among women. Yet, about one third of the population is unaware of the risk that the disease may also be transmitted to the child when giving birth and just over half of the population says it knows how to protect against the risk of HIV/AIDS during sex. Again this awareness varies across population groups showing again the earlier patterns of greater deficiencies among indigenous, rural and poorer families. 0 Access to Health Services. The population groups showing higher disease risk and infant mortality also appear to find greater difficulty seeking professional medical assistance. As shown by Statistical Annex Table A48, cases of diarrhea and respiratory disease have a similar incidence across population groups, but those seeking medical assistance during illness are more likely to be among the non-poor, non-indigenous and urban population.12 Differences in access to qualified medical assistance for pre-natal care and child delivery also follow this socio-demographic pattern (see Statistical Annex Table A49). About 84 percent of child delivery takes place with professional care at health centers and hospitals, but this share is only 64 percent for indigenous women, against almost 88 percent for the non-indigenous 10 Based on population census data for, respectively, 1982 and 2001. 11 Data from SIISE (2003), based on data reported in demographic and health surveys (ENDEMAIN) for 1989 and 1999. Please note that the reported data refer to women that currently use contraceptive methods. Including those who have used contraceptives in the past but not currently would increase the coverage for 1999 to 81 percent. The share of women using modern forms of birth control (i.e. excluding methods such as withdrawal before ejaculation, biorhythm, and other less secure practices) is 75 percent, such that the share of women that are currently using birth control methods considered to be secure was 49.5 percent in 1999 (i.e. 75 percent of 0.66). 12 The reported data in Statistical Annex Table A48 are admittedly crude, as no specific questions were raised regarding the severity of the complaints (Le. a simple cold is reported in the same category as bronchitis or other pulmonary diseases). Nonetheless, assuming the likelihood of a more severe illness is greater among the more vulnerable, the differences in access to health services would be even starker than reported. 77 population. One third of rural births are completed without medical assistance against only 6 percent of urban births. Between 63 and 80 percent of child deliveries of the poorest 30 percent in the income distribution are professionally attended against 90 percent or more for the richest segments, with the latter more typically making use of private health services. Despite the remaining deficiencies, coverage of professionally assisted child delivery has increased in recent decades with likely concomitant effects on falling infant mortality. Access to Targeted Social Assistance Programs. As discussed in the next section, in recent years a variety of health programs have been introduced targeted at women and early childhood protection through nutrition and health care. The free maternity care program (Matemidad Gratuita), introduced in 1998, is one of the more important ones and reached by the end of 2003 about 30 percent of pregnant women (Statistical Annex Table A51).13 The impact in terms of coverage of this program will also be included in the aforementioned data on access to professional birth delivery assistance. It is noteworthy, though, that thus far this program is reaching to a much reduced extent the vulnerable groups, as for instance coverage for indigenous and for rural women is only 19 percent and for the poorest 30 percent it is about 20 percent. Other important programs include several nutritional programs like the National Nutritional Program for Children (PANN 2000), the school breakfast program (PAE) and the cash transfer program Bono de Desarrollo Humano (BDH). PANN has two components: nutritional support for children between 6 and 24 months of age (called Mi Papilla) and nutritional support for pregnant and breastfeeding women (called Mi Bebida). The Mi Papilla program reaches (at the end of 2003) about one third of the children in the age group between 6 and 24 months. The program’s coverage is somewhat higher for the vulnerable groups, i.e. indigenous, rural and poorest segments of the population (see Statistical Annex Table A52). Overall, though, the program’s coverage is rather low as just 39 percent of poor children have access to Mi Papilla and 38 percent of poor, pregnant and breastfeeding mothers receive the benefits of Mi Bebida. Thus, exclusion errors in targeting are big, even though inclusion errors are less severe (10-12 per~ent).’~A recent impact evaluation of the program in one municipality (Santo Domingo) indicated that the program effectively reduced prevalence of underweight (low weight for age) by about 10 percentage points, but could not detect a clear impact on ~tunting.’~A broader impact evaluation would be required in order to know whether these findings could be generalized. The PAE reaches about 20 percent of the total population (and more of the primary school-age population, see Vos and Ponce 2004), but aims at groups over 5 years old and the nutritional value of the provided snacks is relatively 10w.I~ A specific 13 Please note that the data in Statistical Annex Table A51 refer to “knowledge” of the program, i.e. not actual coverage. Nonetheless, information from the program itself estimates beneficiaries at about 1 million women, which also implies coverage of about 30 percent. 14 See Statistical Annex Table A54 for more detailed estimates and Ponce (2004) for a further analysis of the program’s targeting efficiency. 15 See MSP/OPS/ICT (2004). 16 According to information from the Secretaria Te‘cnica del Frente Social (STFS), the school snacks represent about one third and two-thirds of minimum nutritional requirements for, respectively, energy and protein intake for breakfast or lunch. That is, clearly deficient if not supplemented by complementary meals at home. 78 nutritional program covering children in age group 2-5 years is lacking at the moment, although some nutritional support is provided through the early childhood programs. However, these have a rather low coverage (about 12 percent of the target group). The BDH is a conditional cash transfer program and is to replace other existing cash transfer programs (Bono Solidario and Beca Escolar). By the end of 2003, the BDH reached 18 percent of the population. Eligibility for this program relates to a poverty indicator and is conditioned on having a child in primary education or accessing a health care center for maternal and child care. Thus not all beneficiaries of this program will necessarily have accessed maternal care. In fact, only 5 percent of BDH beneficiaries are families with no school-going children and only children under age 5. Given the conditions of the program (see Section 3), this gives us to suspect that the program's impact more likely will be on education than on increasing access to health care. The program overall does benefit our vulnerable groups more than others. Immunization. Ecuador's permanent vaccination campaign has been successful and in most parts of the country parents from all layers of society demand a vaccination card for their children. Data on immunization coverage can sometimes be confusing as much undercoverage may relate to children of less than one year of age not (yet) having received the full doses. Aggregate estimates from the Demographic Health Survey (DHS) and Encuesta Demogrbfica y de Salud Matemo Infantil (ENDEMAIN) show little increase in coverage (for all main vaccinations) during the 1990s (moving from 75 to 77 percent between 1989 and 1999), but this could be an underestimation. The SIEH's health module of December 2003 suggests that of the total number of 2-5 year olds, 87 percent have a vaccination card, 99 percent have received the full doses of BCG and 70 percent the DPT va~cination.'~Coverage of immunizations appears to be rather equitable as there are no significant differences in coverage across social groups (see Statistical Annex Table A50). 0 Health Insurance. Coverage of health insurance in Ecuador is low by any standard. Less than 20 percent of the population has access to any form of health insurance. Those that are insured tend to be part of the public social security system (IESS) and these are mainly urban working families. Private health insurance schemes cover less than 2 percent of the population. The peasant insurance scheme (Seguro Social Campensino) provides some coverage for farmers, but nonetheless reaches just 11 percent of the rural population.'* Access to health insurance is typically lower for the poorer segments and the indigenous population (see Statistical Annex Table A52), hampering their access to health services. 17 Reported coverage of DPT in the SIEH survey of 2003 is much lower than that reported in the 1999 LSMS (ECV) survey. The reasons for this difference are not very clear, but given the permanence of the immunization program (PAI) we do not believe there has been actual reduction in coverage between 1999 and 2003. Rather, the discrepancy reflects differences in measurement and sampling errors. The reported data thus need to be taken with some caution. The general perception is that vaccination coverage is high (over 80 percent), at least for key vaccinations (BCG and DPT). 18 The figure is based on the SIEH survey of 2003. The LSMS of 1999 reports a somewhat higher coverage: 16.8 percent of the rural population. 79 Life Styles. Smoking and alcohol consumption by pregnant women may affect the health of the unborn child, as much as they will increase the prevalence of chronic and degenerative diseases such as cancer and cardiovascular diseases. We have no comparable evidence on how such life styles may have affected the epidemiological profile over time. The Living Standards Measurement Study (LSMS) and Encuesta de Condicionales de Vida (ECV) survey of 1999 suggests, though, that the prevalence of regular cigarette and alcohol consumption is fairly low in Ecuador, with 8 percent of the population of 15 years and older smoking daily and about 25 percent engaging in alcohol consumption. However, tobacco and alcohol may be characterized as luxury and masculine goods as the use increases with income levels and as women hardly consume them (see Statistical Annex Table A53). In other words, these factors affect the more vulnerable groups to a small degree at best, but are not likely a factor of significance in infant mortality. While engaging more in tobacco and alcohol consumption, males and the better off do compensate (on average at least) by doing more sports, but one should add that less than 30 percent of the adult population is engaging in some sporting activity. This may be a sign that the epidemiological transition as observed earlier and rising problems of obesity are likely to continue in the near future. 11. Health Policies in the 1990s 4.21 Ecuador’s public health system has traditionally been centralized and supply-driven. The government funds and subsidizes public health centers, dispensaries and public hospitals from tax revenue. The social security system (IESS) runs its own hospitals and health centers. In recent decades an increasing number of private hospitals and health centers have emerged. In fact, coverage of services per inhabitant has increased for private hospitals and clinics, whereas it has decreased for public in-patient care and remained stable for public primary, outpatient care. The relative reduction in the supply of public health services is partly associated with budgetary restrictions (see next section) and partly with a shift in health policies away from a supply and input-driven system of health provisioning and towards greater incentives to demand for health care and more decentralized delivery. In addition, several targeted health programs have been introduced to repair inequities in the system and put greater emphasis on preventing risk of early child death. Health reform policies have not followed a consistent path in this direction though. Rather, the strategic view underlying reforms has shifted during the decade, such that it is hard to speak of a consistent reform path. 4.22 Ecuador’s health policy reforms since 1990 may be divided into three distinct phases: 0 1991-96: Supply-driven reforms aiming at greater coverage, efficiency and equity. 0 1997-2000: Regulatory and institutional reforms in support of decentralized. delivery of health services and better quality control. 0 2000-04: Decentralization, health insurance reform and demand incentives. 4.23 Supply-Driven Reforms (1991-96). The reforms initiated in this period were aimed at improving coverage of health services, improving the efficiency in delivery and reducing inequalities in access through targeted health interventions. A consensus was sought for these reforms with stakeholders within the health sector itself. FASBASE was the stellar program 80 around which the reforms were to be implemented. The program’s name-Strengthening and Expansion of Health Services (Fortalecimiento y Ampliacibn de Sewicios Bhsicos de Sal@- covers the reform intentions well. FASBASE was financed by the World Bank. Under the program a new system of primary health care provisioning was set up, essentially allowing for a decentralization of planning and decision-making for health providers in newly defined administrative health sector regions. The reform put priority on primary and preventative health care, including an investment program for enhancing the coverage of drinking water and sanitation services and targeted nutritional support for women and young children. The program also established a network of emergency hospital care managed by municipalities and a training program for health workers within the public sector. Finally, the program further aimed at improving the supply of drugs to health centers and strengthened the immunization program (PAI). 4.24 From its inception, the FASBASE program suffered from problems in budget management, encountering tensions between ensuring adequate allocation for the program’s activities and pressures from the Ministry of Health (MoH) to fill gaps in financing its “regular” current expenditures. The progress in enhancing the targeted assistance to young mothers and infants, training of local health workers and strengthening of the PA1 are probably the main achievements of FASBASE, but overall the program’s results are a far cry from the goals set. 4.25 The strengthening of the immunization program can be singled out as a successful improvement of health services that continued during the subsequent periods. The program goes back to 1977 and has had a consistent presence since then. During the 1980s emphasis was on the fast expansion of immunization coverage, but subsequently other elements have been added, including health and childcare education. During the 1990s the program’s capacity to monitor sanitary and environmental conditions for the risk of epidemic diseases and other public health risks has been strengthened. Its success is attributed to its near full emphasis on operations in the field (and reaching beneficiaries often in their homes) and repeated campaigns stressing the importance of vaccinations. Constraints are still found, though, in reaching vulnerable populations in areas of difficult geographical access, and there is some cultural resistance among segments of the indigenous population, particularly in the Amazon region and the Andean highlands. Since 2001, the Law for Immunizations protects the program’s budget. Nonetheless, the draft national government budget for 2004 included a severe cut in the PA1 budget, but efforts are being made to revert this. Growth in vaccination coverage and the eradication of poliomyelitis, neonatal tetanus and measles have made an important contribution to the reduction in infant mortality. 4.26 During this period, fees for the use of public health services were introduced and then increased. This started on the initiative of some public health centers that faced problems in meeting health demands. Initially only small contributions were asked for. In 1998, the practice of cost-recovery was made official through decree 502 (DE-502). However, no proper system of control of the level of fees and use of funds was introduced to regulate cost sharing. DE-502 also regulates self-management of hospitals and health centers. Shortly after introducing the decree, the free maternity law was introduced (see below), which guaranteed access free of charge to infant and maternal health care. Given the lack of proper control, application of DE- 502 or the free maternity law tends to be mostly at the discretion of those in charge at health centers and hospitals, creating much discontent among users. In subsequent years, more incentives have been given for self-management of hospitals allowing for charging of higher user 81 fees in exchange for lower public transfers. As the former in practice have become more secure and easier forms of financing, the trend has been for health centers and hospitals to extent cost- recovery and increase fees. 4.27 Institutional and Regulatory Reforms (1997-2000). This period is characterized by a series of legal changes to the organization of the health system, for which support was sought or pressure was provided by stakeholders outside the health system. The establishment of a National Health and Social Security System was introduced as an article in the constitution. More concretely, a new project-Modersa-was to complement the FASBASE program and overcome some of its difficulties through a modernization of the health delivery system. Modersa, also financed by the World Bank, aimed at initiating a process of decentralization of health decision-making to local governments (provinces, municipalities) and encourage community participation to ensure health services meet local demands. The program would also establish contracts with private and public providers, stimulating greater competition and consumer choice. A new regulatory framework was introduced to deal with problems of adverse selection in the market for private health insurers, as well as a regulatory system to standardize quality control and accreditation of hospitals. There was also an attempt to introduce an ambitious new system of human resource management to provide better career perspectives and incentives to public health sector workers, but this plan proved too ambitious for the MoH to handle. 4.28 To provide a legal framework for equity enhancing measures, Modersa managed to get laws and decrees approved establishing, among others, the autonomy of hospitals in decision- making and health management through DE-520 as mentioned above and mechanisms of social control through social participation committees that monitor the performance of health centers. Congress and the association of municipalities pushed for further decentralization of health care towards municipalities (Ley de Descentralizacibn y Participacibn Popular of 1999), while the National Council of Women (CONAMU) effectively pressured for free maternity care (through the Ley de Matemidad Gratuita y Atencibn Znfantil of 1998). In addition, a law was introduced regulating the supply of generic medicines for the poorer segments of society. 4.29 Yet much of all this is still to be widely implemented. Only five municipalities (Bucay, Cotacachi, Chordeleg, Loja, and Santo Domingo) had obtained decentralized responsibility for health management by early 2004. The law for generic medicines came with a special budget for the MoH to purchase such drugs, but subsequent budget allocations have been irregular and a lack of inventory and storage capacity has caused shortages in supply. Therefore, the stark increase in demand for medicines (which increased by 155 percent between 1988 and 1998) has not been satisfied through this mechanism. 4.30 No precise records exist, but the free maternity health service is assumed to have reached between 1.5 and 2 million beneficiaries annually between 2001 and 2003, consisting in equal shares of pregnant women and the recently born. This represents about 30 percent of the target population (see Statistical Annex Table A52). The budget for the Matemidad Gratuita program was around US$20 million for 2003 and 2004, of which about 80 percent is financed by the Fondo de Solidaridad and the remainder by a fixed share (3 percent) of excise taxes on alcohol and tobacco. In addition, several other public institutions and international organizations (INNFA, MoH, municipalities, PAHO/WHO, UNICEF, GTZ, and CONAMU) have contributed in communicating the program’s benefits to the population. The budget is allocated on a per capita basis to health centers in municipalities (cantons), according to the number of women and 82 young children in the area. An additional 10 percent allocation is given to those municipalities with a poverty incidence higher than 70 percent, with limited access to health services and with above average maternal and infant mortality rates.lg The budget covers only the cost of medicine and basic health equipment for maternal care and no provision is made for health personnel costs or hospital infrastructure. This budget decision is based on the assumption that public health units have such costs already covered and, implicitly, that health units have excess capacity. There is no impact evaluation of the program, but experts in the field say that it has been effective in providing better medical assistance at child delivery and therefore likely has contributed to a reduction in the infant mortality rate. Nonetheless, the program still faces several challenges, particularly in improving access for indigenous and rural women and overcoming implementation problems. Expansion of coverage of the program is hampered by the lack of control of cost-recovery practices at hospitals and health centers as mentioned above and by implementation problems at the municipal level. As to the latter problem, resources for the program are transferred to municipalities, which compensate local health centers on the basis of the number of women and children that have received medical assistance. However, this decentralized operation is very recent and thus far only 42 out of 219 municipalities have opened an account to receive the funds, while most other municipalities still need to overcome administrative hurdles before being able to manage the resource flow. 4.3 1 Towards Universal Health Insurance, Decentralization and Demand Subsidies (2000- 04). During this period, the ambitions of Modersa were toned down in the face of slow progress on several fronts in the modernization of the health sector. New priorities were no longer set with Modersa as the main driving force, but by agents outside the health ministry, including the council for the modernization of the state (CONAM) and the ministry of social affairs (MBS/STFS) that has a lead in the design of social protection programs. Four new priorities were set: (i)renewed priority for expanding coverage of basic infrastructure and equipment of health centers; (ii)health insurance reform; (iii)new impetus to the decentralization process; and (iv) introduction of new forms of demand subsidies. 4.32 Budget allocations during this period were not consistent with the first priority and, as discussed in the next section, most of the health budget increases in this period were for wage adjustments for medical personnel in public health centers, particularly in 2002 and 2003. Strikes of medical personnel were frequent in these years, partly because of delayed payment of salaries and in part also because of complaints of a lack of resources for maintenance, equipment and drugs. Scarcity of drug supplies in public health centers increasingly forced most patients (including social security affiliates) to purchase medicines themselves in private pharmacies, increasing out-of-pocket expenses and likely reducing access to health care for the poor (see below, Section 5). 4.33 Universal coverage of health insurance was launched as a strategic objective for the health sector. Concrete and workable proposals in this direction as yet have to be worked out, but the issue has set much of the tone for health sector reform discussions during 2003. This has included separate initiatives by several municipalities (Guayaquil, Quito, Cotacachi, among others), aiming to develop their own health insurance schemes for their local constituencies. None of these cases have developed into operational schemes. In Guayaquil's case part of the plan is to incorporate IESS affiliates into the municipal plan and for beneficiaries of the Bono de 19. See Executive Decree No. 2704 (article 16) of June 5,2002. 83 Desarrollo Humano (see below) US$1 of their payment would be withheld for insurance coverage of a basic package of services. However, this is not a worked-out plan and there is no clarity on how the insurance plan would lead to universal coverage or what providers it will give access to. The plan of taking US$1 from an already small cash transfer to the poor is being opposed by several central government agencies, as well as international organizations. Quito’s plan has moved to the stage of negotiations with public and private providers about coverage of services and tariffs for treatments. It is far from clear whether the outcomes will be such that the insurance could become universal and affordable and would cover an adequate basic package of services. It is difficult to see how these initiatives will evolve into fully workable schemes without considering simultaneously reform of IESS and public health providers. 4.34 In 2001, Congress approved a new social security law that tries to address some of the fundamental weaknesses of the system and allow for reforms to revert the financial crisis it faces. The law separates the functions of health provisioning and financing and establishes a health inspection to improve regulation and control of the system. Supervision of health financing and insurance is put in the hands of the regulators of the banking system (Superintendencia de Buncos y Seguros). The law is held up, however, in the Constitutional Court because of objections to two of its articles. Nonetheless, a start has been made with separating the functions of provisioning and financing and modest progress has been made to allow coverage of family members (spouses and children) of social security affiliates. None of this, however, has brought a solution to the system’s financial crisis much closer. The number of affiliates and their contributions are simply too low to cover rising health demands and the increasing costs of care. The reform of IESS should become part of the proposed move towards a universal health insurance system, but unfortunately to date these are taken as separate issues. 4.35 In 2003, the national commission on decentralization was established to oversee the implementation of the shift of responsibilities and resources to local governments as established in the Ley de Descentralizacidn y Participacidn Popular (The Law of Decentralization and Popular Participation) of 1997. This should lead to a greater role for municipal and provincial governments in the delivery of health services, as well as to greater autonomy of the health institutions themselves. The main actors in the health sector tend to agree the system should move in this direction, although there is still a stumbling block around the precise areas of responsibility of provincial and municipal governments. In addition, there are a range of implementation problems, including the ones already mentioned related to the transfer of resources to municipalities for the Matemidad Gratuita program, problems in hiring qualified personnel by local governments, and a lack of health monitoring systems in support of health management at the local level and the lack of surveillance of attainment of national and centrally established goals. A new budgetary procedure was introduced in 2003 to transfer funds to local governments (municipalities) that have become part of the decentralized system of health delivery. Municipal health directorates are to administer the resources of public hospitals and health centers and allocate these to the service providers. The municipal health administration is to be monitored by local health councils in charge of consensus building around health plans and monitoring their effective implementation. National public health programs will remain funded centrally. Figures 4.9a and 4.9b give a schematic presentation of the change in the budget transfer mechanism in public health. In practice, however, by early 2004 no decentralized transfers had been effectuated through this new system. 84 Figure 4.9a. Current, Centralized Financing of Health Care Provided by Ministry of Health I CentralGovernment I Ministry of Economy and Financ MOH: Provincial Centers Centers Figure 4.9b. Fiscal Decentralizationof Health Care Provided by Ministry of Health Central Government 4 I Ministrv of &om" and Finance I 1. Local healthpolicies 2. Local regulation and conwol MOH: Nationwide specinlpmgams 3. Monitoring aod evaluation 4. Financing and resource management ...... 5. Local public Mucipal Regional Health Sectiom, a::.:Center ...... DecentralizedProvidersHealth 2. Healthplanning Municipal Health 3. Monitoring and evaluation of plan Hospital Centers 85 Box 4.1. Decentralizationof Health Care in Cotacachi The municipality of Cotachachi in the province of Imbabura has made the most progress in establishing a decentralized health system. The municipality has 40,000 inhabitants comprising (mostly) indigenous people, as well as an Afro-Ecuadorian and Mestizo population. It comprises 9 purroquius (or communities) of which 8 are rural and 1 urban. According to the poverty map for Ecuador, the poverty incidence as measured by the unsatisfied Basic Need (UBN) index in the urban area of Cotacachi is 64 percent, while that for the rural communities ranges between 70 and 95 percent. In 1996, the first municipal general assembly-a democratic practice based on age-old indigenous traditions-established an intersectoral health committee (along with other such committees for education, tourism, environment, municipal governance and production). This committee (CIS) has been institutionalized and develops a municipal health plan for Cotacachi. Based on an integral diagnosis of health risk, it proposed a complete restructuring of health care provisioning and preventive health care. The municipality has 1 hospital, 7 primary health centers and 2 health posts. Equipment and coverage of services at the hospital was still rather basic by the end of the 1990s and is to be restructured to provide medical services that fit the municipality’s epidemiological profile better. In the same way, rrreorganization for the primary health centers is proposed. Most importantly, intercultural medical practices have been designed that combine elements of traditional and modem medicine in an attempt to attract more citizens to the health system and provide care that responds better to their perceived needs and perceptions. The costs of restructuring the health system have been fully detailed according to existing budget procedures. For this, technical teams from the Ministry of Economy and Finance, Ministry of Health, and the municipality of Cotacachi worked together on a joint budget proposal. Local monitoring and evaluation mechanisms are to monitor the proper use of the resources and exercise quality control of health services. On the basis of the draft local health plan and the budget negotiations between the municipality and the Ministry of Health, an agreement was reached-signed by the President-to establish a decentralized health system for Cotacachi according to the locally developed plan in 2003. The flow of the resource has yet to reach Cotacachi’s health system. The effectiveness of this new health care model thus still needs to be proven in practice. 4.36 It seems that matters are stalled at the Ministry of Economy, although as the implementation problems with the Mutemidud Grutuitu program suggest, many municipalities may not yet be capable of operating the new system. On the other hand, there are some municipalities that have successfully reorganized health care even ahead of the new system, such as Cotacachi (see Box 4.1) conditional cash transfer program, Bono de Desurrollo Humano (BDH), was introduced in 2003, which is to gradually replace existing cash transfer systems, specifically the Becu Escolar (School Payment) and the Bono Solidurio (Solidarity Payment). The conditionality consists of the family having either children attending primary school or mothers and young children attending health centers.20 The BDH was set up as part of discussion on improving Ecuador’s social safety net. The idea of introducing direct health demand subsidies was already under earlier consideration as a separate program, but was brought under the BDH as part of an effort to better integrate social policies through the Social Cabinet (Frente Social). While still in the process of absorbing the eligible beneficiaries of the Bono Solidurio program, the BDH reached about 1.2 million beneficiaries in the first quarter of 2004. Preliminary evidence also shows that targeting inefficiencies are also still present in the BDH program, indicating that about 3 1 percent of benefits are leaking to non-poor and undercoverage of eligible poor is about 42 percent.21 Apart from this, two issues emerge regarding health benefits. First, because the BDH has triple objectives (providing social protection, increasing school attendance, and improving access to health care for mothers and young children), it is not immediately clear how much of the program’s impact will serve the health objective directly. It 20 Specifically, the conditions for the target group are that in education: the nuclear family has children in age 6- 15, which are enrolled in school and are registered to attend at least 90 percent of classes; in health: the nuclear family has children in the age group of 0-6 years who should be receiving bi-monthly health controls at designated health centers; for families with children in both age groups, the conditions for education prevail in order to receive the cash transfer. 21 Calculated on the basis of the SIEH survey of December 2003. Eligible poor are defined through the SELBEN composite welfare indicator, which is also used by the program to identify eligible and non-eligible population. (See Statistical Annex Table A54 for details). 86 '200 formal sector and mostly do not reach the poorer H&&h (ds t handsrole) segments of society.23 Real per capita social g 800- loo^. &::1808 -.I61408 0; expenditure has fallen staggeringly since the 5 600- , _.120b early 1980s, and, although there has been a 500- , Totalsortal exp --loo* (left-hand rralef I ,,' visible recovery since 2000, it currently stands '! '0°-+ '-80 I 2 30 0-* --so P below levels reached a quarter of a century ago B -: a il -40 (see Figure 4.10). IO 0- *- 2 0 00,. 3 I I I I I 8. I I I I I I I I. I I I,,. . . r 00 4.38 The decline in social expenditures has 13 75 11 19 81 83 85 87 89 91 93 96 91 99 01 03 22 Figures are in constant US dollars of 1997 as reported in ECLAC (2001) and, for Ecuador, Vos et al. (2003). Data refer to spending by the central government only and do not include social security. 23 This observation needs some qualification though as, after the 1999 crises, the real value of pension benefits plunged and financial assets of pensioners were decimated, turning many elderly into 'new poor'. 87 education and health budgets increased significantly, mainly due to various rounds of salary increases for teachers and medical personnel in public service, as personnel spending carried much of the burden of budget cuts during the 1990s. Figure 4.10 also shows the dramatic decline in real per capita public spending on health services during the 1990s. Per capita health expenditures continued to increase during the 198Os, from US$10 per capita in 1980 to US$17 in 1990. During the 1990s health expenditure fell steeply, to return back to the 1980 level by 2000. During 2001 and 2003, salary adjustments as well as the expansion of special health programs, like the Matemidud Gratuita, led to a significant recovery in spending and back to the level reached in 1990. In any case, the level of public health expenditures is still very low by international standards and in 2003-04 did not surpass a meager 1.2 percent of GDP. No systematic data are available for the health expenditures of the social security system, which not only provides health insurance, but also health care. JESS and the Farmers Insurance scheme (Seguridad Social Campesino, SSC) together add another 0.8 percent of Gross Domestic Product (GDP) (about US$10 per capita) to total public health expenditures. This share appears to have been rather stable since 1995 (Table 4.3). The cost of services provided by the SSC to poor farmers amounts to 0.1 percent of GDP. Table 4.3. Social Expenditure’ of Central Government as a Percentage of GDP 1973 1975 1980 1985 1990 1995 2000 2001 2002 2003 20M3 Total Social Expenditure 3.5 3.3 5.3 4.7 4.4 3.6 4.0 4.3 5.1 5.0 4.8 Education 2.9 2.5 4.3 3.5 2.8 2.4 1.9 2.2 2.7 2.6 2.6 Health 0.5 0.7 0.9 1.1 1.3 0.9 0.8 0.8 1.3 1.3 1.2 Social Assistance 0.1 0.1 0.1 0.1 0.3 0.3 1.3 1.3 1.1 1.1 1.0 - Cash transfer programs 0.8 0.7 0.5 0.6 0.6 Other 0.1 0.1 0.1 0.1 0.3 0.3 0.5 0.6 0.5 0.5 0.5 Memo: Health-related spending of Social 0.8 0.7 0.8 0.8 Security System 0.7 0.6 0.7 0.8 - ESS 0.1 0.1 0.1 - Farmers Insurance (SSC) Source: Central Bank and Ministry of Finance data. Updated and adjusted series from Vos, et al. (2003). Notes: (1) Social expenditures refer to central govemment budget only. Social expenditures include education, health, social welfare and labor, and cash transfer programs. Cash transfer program refers to Bono Solidario for 1999-2002 and includes Beca Escolar and Bono de Desarrollo Humno thereafter. (2) Social expenditure share in GDP calculated on the basis of constant price series in dollars of 2000. The share at current prices is slightly higher on average (0.3 percent points for the 1990s and 0.1 percent for the whole series), but the trends are the same. The difference between the constant and current price shares is explained by the difference in deflators for govemment spending and GDP, the former being411 average- slightly higher. (3) Numbers for 2004 refer to provisional budget for social expenditure data and Central Bank projection of GDP growth. 88 4.39 The measurement of the recovery in real health spending from 2000 onwards is sensitive to the choice of deflator, but this is not so much the case for the years prior to that. Figure 4.11. Real Health Spending per Capita, Using Altern- In Figure 4.11, health spending has been ative Deflators, 1982-2002 (in constant price dollars of 2000) deflated using, alternatively, a weighted 200 price for public consumption and , I investment (weighted for their respective importance in health spending)24 and a nominal wage index for public employees. As much of health spending is on salaries (about 60 percent of the total in 2003) and recent budget increases 1989 1990 1991 1992 1993 1994 1995 19% 1997 1998 1559 2Mx) 2WI 2032 have been mainly driven by salary -- 'Real spending (wage deflator) - adjustments, the wage index should be a Source: Data series used in Vos e al. (2003) and updated for good proxy for price changes in health 2001-2 from Ministry of Economy -UNICEF fiscal data base. services.25 Figure 4.11 shows that if one Deflators are from the Central Bank's national accounts (NA takes the wage deflator, there is no actual deflators and the INEC Urban Household Surveys (for the average wage of public employees). recovery in real health spending, confirming the hypothesis that most, if not all, budget increases after 2000 went into rising (nominal) salaries of medical personnel and suggesting that the overall rise in real per capita social expenditures during 2000-04 is overstated in Figure 4.10. 4.40 How have health services been affected by the decline in real public spending.? First, Figure 4-12. Health Input SUPP~~W:Number of there could have been a shift in the structure of Hospital Beds (per 100,000 inhabitants), 1994-2001 health spending, e.g. from more expensive curative care to cheaper preventative care. No sufficiently detailed health budget data are available to check whether there has been such shift, but the discussion of health policies would suggest no major shift in this sense. Yet in practice, some of this has happened due to a shift in provisioning of hospitals towards the private sector and a shift in the public health -1aCal-* - Less - - Mjp -pnvedOs ---arm sector budget towards cheaper outpatient care Source: INEC, Anuario de recursos y actividades de salud , various years. 24 There are no consistent long data series detailing public expenditures by sector and by expenditure items (e.g. wages, other current expenditures and investment). A national accounts series with disaggregated public sector accounts indicates that historically a bit less than 10 percent of the health budget was spent on investment in health infrastructure but that this increased to about 25 percent in the early OS, declining to about 10 percent by 1995. We use the latter share for weighting the two deflators. 25 Again, no consistent published breakdown exists for public expenditures, let alone social expenditures by ages and other expenditure components. Available breakdowns from a UNICEF-Ministry of Economy and Finance database show a somewhat erratic pattern for 1995-2000 probably due to classification errors. For 1996-98 the share is about 70 percent jumping to over 80 percent in 1999-2000. The national accounts series quoted in the previous footnote would put the share at around 75 percent during the period 1980-92. This share may be somewhat lower for overall public consumption, but likely the national accounts deflator for government consumption should by and large reflect the trend in the unit cost (wage rate) of public employees. Figure 4.5 shows this appears to be the case until 2000, but not thereafter. 89 through health centers. This may be derived from health input data: 0 Coverage of hospital beds fell from 20 to 16 per 100,000 inhabitants between 1974 and 2001 (see Figure 4.12). Most of this decline is due to reduced coverage by public hospitals. Coverage by private clinics almost doubled during this period from 2.4 to 4.7 beds per 100,000 inhabitants. 0 The number of public health institutions doubled between 1980 and 2000, but most of this increase is due to the expansion of out-patient care. The number of public hospitals increased from 144 to 178 in this period, while that of (cheaper) health centers without hospital beds increased from 1,406 to 2,839. The number of private hospitals more than tripled during the period 1980-2000, with 165 new private hospitals emerging in the 1990s. Private agents now run 70 percent of hospitals, though no more than 30 percent of hospital beds, suggesting strong growth of small private clinics. 0 The availability of medical personnel has increased over the past two decades. Most notably, the number of doctors per 10,000 inhabitants increased from 4.8 to 16.0 between 1975 and 2001 and the availability of nurses increased from 1.4 to 5.1 (see Figure 4.13a). The rising trend continued during the 1990s. However, again the increase is entirely due to the expansion of private health providers. As shown in Figure 4.13b, the availability of doctors in public health institutions stagnated around 8 per 10,000 inhabitants during the 1990s, whereas in private clinics it quadrupled from 1.8 in 1990 to 7.9 in 2001. The supply of nurses increased in both private and public segments, respectively from 0.5 to 0.9 and from 3.0 to 4.2 per 10,000 between 1990 and 2001, but the ratio of nurses per doctor increased in the public sector segment (from 0.4 to 0.5), while it decreased in the private segment (from 0.25 to 0.1). The increase in the share of nurses to doctors in public health care implies a shift from a more expensive to a cheaper composition of medical personnel and thereby (given more or less stagnant coverage) explains in part the decline in public health expenditures. Nonetheless, Ecuador’s composition of health workers seems excessively biased towards doctors. Most countries in the world, particularly more developed countries, tend to have more nurses than doctors. Ecuador has the same ratio of doctors per 10,000 inhabitants as Great Britain, but the availability of nurses 18.0 1 90 *I 16.0 - 14.0- *f -k 12.0 - i! I:::: / ak 6.0 - - 1 4.0 - I 0 2.0 - 0 0 -.-----r.------”ll 0.0 ! i 1975 1980 1985 1990 1995 1998 1999 Zoo0 2001 - -Doctors -Nurses -Auxiliary persomll Source: INEC, Anuario de recurms y actividades de salud, various Source: INEC, Anuario de recurms y actividadesde salud, various years. years. 90 is ten times less. The s ift in services to~ardsthe p~va~esector (~ost~ysma~l ~~inics~has e~acer~ated this ~~ba~ance. 4.41 The shift t~wa~dsprivate v~s~on~ngeased ~ressureon the blic health budget, but-as cussed fu~~erin ~ection 6-4 1% I I1 40 also reduced access of the poor to % hea~~hcare. The shift in p~lb~~c30 ~rovis~~ningtowards p~mary % 20 health care is not i~~e~iate~yYO visible In the ~ea~thbudget 10 % structure. The shares of spend~ng 0% for p~~aryhealth care centers and public hosp~talsdecreased ~etween 1995 and 2004, as Figure 4.1 shows. That for pri~~yhea~~h centers decrease from 28 to 23 percent and that for hospita~sfrom 41 to 33 percent. The share of expend~turesfor special ~~b~~c health pro~r~~s( gs su~~~ies,~ate~a~ and child care, ~mmu~iza~~onand other prevent~ve heal~hcare pro~ams~ ped from 22 to 17 pe nt, ~esp~tethe i~t~~~uct~onof the free mate~~ty~~ogra~ (cost about US$21 lion in 2 ) and a prevent~vehe~~th care progra~ or~entedtow~ds the in us population (US$6 ~il~ion~. dec~inein the bu~getfor s~~pl~es.The general wage inc n the increase in the share of general ad~n~strationco e year ~~~~,there was a se~-aut~n~~~usi~stitute( budget in charge of ~rov~ding medica^ ip~entand ~~gsto ~eal~h budget has s~bse~~ent~ybeen abso he genera^ bud~e~of the ava~~a~~e~udgetdec~ine~ from US$ 6 ~il~ionbetween the budget item is fre~u~ntlyused to cover other cu x~e~d~~~resof the ~~~~stry. This has led to the under ~rov~s~~n~~~of pub~~chea~th cente patients hav~ngto purchase their ow^ medic~nesat p~vate~~~~acies, as signaled earlie is a strong ~n~~ca~~onthat the ~~a~~ty of p~~~~~ccenters has d~te~~rated(and this is perce such). As we shall ~isc~ssin ~ection 6, this is a factor of in~~encein access to ~aterna~and child health care. 4.43 ~e~u~arsalary ~a~ents to me ical person~e~have become another factor a~fectingthe ~ualityof pub~ichea~th provis~o~ng. Strikes have a~fectedhealth atte~t~onwith some during recent years, not just to pressure for salary increases, but also because of seriou ent. In ~ddi~io~,in the first arter of ~~04,f~~~-ti~e ~edicalpersonnel ers d~ci~e~to reduce ~or~ngurs (and thus h~ursof at~ention~from 8 to as a form of protest agains~recent salary increases w enefited e~ua~ly(in abso~ute those wor~~ngf~l~-t~~e as those ~or~ng ~n~ypart-ti or ~~~ge~entof b~d~etcas and the low capac~tyof the govern sensus in the he th sector is thus se~ous~y~e~par~~~ing the ~~~ntity 4.44 The ~~ea~ionof the free ~a~e~~ityand chil~care pro and the p~event~vehea rog~~~for the indi~enous pulation could hel in infant mo~a~ityrates for the oor and ~~d~~enouspopul n. ow ever, at t s ~ent~onedin Sect~on 3-the 91 2004 budget has cut resources for the immunization program (PAI) in half (down to US$5 million), which-if maintained-would seriously endanger consolidation of the coverage of this program and affect infant mortality. 4.45 In sum, provisioning of public health inputs has shifted towards primary health facilities and special health programs oriented at vulnerable groups. Also, budgeting restrictions have not prevented some measurable progress in attaining health outcomes like infant mortality. Yet, the signs are not all positive, as availability of public health inputs per head have fallen, replaced by more private health provisioning. This is creating problems of access for the poorer segments of the population, due to the higher cost of private services and the lack of a health insurance system that would allow a choice for the population. Further, drug supplies at public health centers are deficient and important public health programs, like the PAI, suffer budgetary constraints. Finally, as shown in Vos et al. (2003), health expenditures have followed a pro- cyclical pattern over past decades, where the more preferable stance would be counter-cyclical, as health risks may be expected increase as poverty rises during a downturn. As we shall show in section 6, income losses are expected to reduce access to health care and increase likelihood of unattended child delivery and thereby of early child death. 4.46 One could question why infant mortality has been on the decline, despite problems with health sector reforms and falling public health budgets?. We will investigate this further in the subsequent sections, but overall coverage of health services has not declined (though mainly due to an expansion of more expensive private provisioning), the immunization program has been consolidated and expanded, and special programs improving access to maternal care have been introduced. How important these policy interventions likely are as compared to socio-economic conditions, we will analyze in some detail in Section 6. IV. Equity in Health Spending 4.47 Public and Private Health Expenditure Incidence. Public spending on health provided by the Ministry of Health is progressive and nearly equi-proportional, while the subsidies through the Farmers Health Insurance (Seguro Social Campesino) scheme are clearly pro-poor. Public subsidies provided through the services of IESS are anything but pro-poor and close to the distribution of per capita household consumption. The distribution of benefits from public health posts (dispensaries with elementary medical equipment for primary care), which &e the prime ~i~~~4.~5~. Incidence of Public Health Expenditures Figure 4.15b. Incidence of Public Health Expenditures of Public Provider, 1999 by Type of Care, 1999 80% r 40% I uB 20% Source: Vos et al. (2003) Source: Vos et al. (2003) 92 source of primary health care, is progressive and about equi-proportional. Benefits received through public hospitals also show a progressive distribution (that is less unequal than per capita consumption), yet 32 percent of those benefits accrue to the richest 20 percent. Vos et al. (2003) provide these findings based on a detailed analysis of social expenditures in Ecuador based on LSMS data for 1999. Figures 4.15a-c summarize the results in the form of Lorenz curves. The results also show that the aggregate public health expenditures are distributed progressively, but are clearly not pro-poor (Figure 4.15~).~~ 4.48 Special health and nutrition programs (school meals, PANN-Papilla and Bebida), as well as the BDH are pro-poor as the Figure 4.15~.Incidence of Public and Private ESrwnditures, beneficiary incidence estimates based on the 2003 SIEH survey show (see Figure 15b). Around 50 percent of the beneficiaries of these programs belong to the poorest 20 percent by income. Nonetheless, all these programs show important targeting inefficiencies (see Statistical Annex Table A.9). 4.49 Out-of-pocket expenses in health care 0% 20% 404b 60% 80% 100% are four times higher than public expenditures. cumdative '% popllation -Percapia consunption -Equity he The inputed benefits of public health spending -I* Public health exp. --t- Privaa health exp. represent 2.1 percent, while private Source:Vos et al. (2003). expenditures represent 8.6 percent of household consumption (see Table 4.4). Significant efficiency and equity gains could be achieved by merging all centralized interventions, and retargeting them toward meeting the Millenium Development Goals in health. 26 These results are obtained using a traditional expenditure incidence analysis imputing the cost of providing health services as benefits to households depending on the number of beneficiaries of subsidized health care per household. The estimates have to be taken with the usual caution associated with the method. We will not spell these out here, but see e.g. Demery (2003) and Vos et al. (2003) for a discussion. The estimates in Vos et al. (2003) take into account the differences in unit costs per type of provider when assigning benefits. Benefits are assigned to households as follows: where Xj is the value of the total health subsidy inputed to household j. Eij represents the number of medical consultations and other individualized health benefits of household j at education level i, and Ei the total number of consultations (across all households) at that level. Si is government spending on health by type of provider i, and i (=I,.. , 3) denotes the type of provider (by two types of classifications: institutional - IESS, MoH, Farmers Insurance - and level of care - hospitals, primary health centers, health dispensaries). 93 4.50 The poorer segments of the population both receive relatively more benefits (as a share of their income) from public health services and spend relatively more themselves on health care. Table 4.4. Public Benefits and Out-of-pocketExpenses The poorest 2o percent spend 1*5 percent in Health, 1999 (Shares of Total P.C. Household of total household expenditures on health, Consumption of Each Decile) while the richest 20 percent spend more in P.C. Benefit of Public Private Health absolute terms, but this represents 7.3 Consump tion Health Expenditures percent of their total consumption. More Deciles Expenditures 5.5% 12.1% Poorest 10% than half (55 percent) of out-of-pocket 2 4.0% 10.8% health spending is on medicines and this 3 2.4% 9.1% share is somewhat higher for the poorest, 4 4.1% 11.2% who spend more than 60 percent of out-of- 5 3.9% 10.8% pocket expenses on drugs (Table 4.5). The 6 3.2% 10.1% 7 2.6% 11.5% poorest spent no less than 7 percent of total 8 2.4% 10.5% expenditures on medicines in 1999 and this 9 1.9% 8.4% share has increased since 1995. This may Richest 10% 0.9% 6.2% reflect rising costs of medicine due to the --I Total z.1 Yo 8.6 % changing disease pattern and the Source: Vos et al. (2003) and INEC, ECV (WM3)'- 1999. ". demographic change in the population as discussed in Section 2, but given the short time period this &e in private spending on medicine is likely more closely associated with inadequacies in the supplies of medicines at clinics and health centers (and, possibly because of that, rising self-medication). The generic medicine program should have helped reduce costs to households in more recent years, but as discussed in Sections 3 and 4, the program's reduced budget and failing budget execution probably have led to very little relief for poor households. 94 Table 4.5. Out-Of-Pocket Health Expenditures of Households by Deciles and Type of Expenditure (Expressed as Percentages) P.C. Medical Medicines X-rays and Hospitaliz- Glasses Other Total Consumption Consults Laboratory ation and Dental Deciles Tests Prostheses Share of Total Private Consumption Expenditures Poorest 10% 1.4 7.5 0.7 0.9 0.4 1.1 12.1 2 1.2 6.7 0.7 0.1 0.3 1.8 10.8 3 1.o 6.3 0.6 0.1 0.2 0.8 9.1 4 1.1 6.8 0.8 0.7 0.2 1.7 11.2 5 1.o 6.9 0.7 0.4 0.5 1.4 10.8 6 1.3 5.9 0.9 0.2 0.4 1.4 10.1 7 1.o 7.9 1.1 0.1 0.5 0.7 11.5 8 1.3 5.1 1.2 0.3 0.4 2.1 10.5 9 1.2 4.4 0.9 0.2 0.8 1.o 8.4 Richest 10% 1.o 2.8 0.8 0.3 0.6 0.6 6.2 Total 1.1 4.8 0.9 0.3 0.5 1.o 8.6 Share of Out-Of-Pocket Health Expenditure Poorest 10% 11.6 62.2 6.1 7.5 3.0 9.5 100.0 2 11.2 62.3 6.8 0.8 2.6 16.2 100.0 3 10.6 69.5 7.1 1.2 2.7 8.9 100.0 4 9.9 60.3 7.1 6.0 1.7 15.0 100.0 5 8.9 63.5 6.8 3.3 4.8 12.7 100.0 6 12.8 58.2 8.7 2.2 4.4 13.7 100.0 7 9.0 69.0 9.8 1.1 4.6 6.4 100.0 8 12.5 48.8 11.2 3.2 4.1 20.1 100.0 9 13.7 52.4 10.5 2.8 9.2 11.4 100.0 Richest 10% 16.5 45.3 13.8 5.3 9.5 9.7 100.0 Total 12.8 55.1 10.4 3.5 6.1 12.1 100.0 Source: INEC, ECV (LSMS), 1999. 4.51 About 20 percent of private health expenditures are for the treatment of children under the age of 5 (Table 4.6). Again, poorer households tend to spend relatively more than rich households, Le. about 3 percent of total consumption expenditures for the poorest deciles and 1 percent for the richest deciles. This is a pattern that could be expected, as the poorest quintile has about 30 percent of small children against the richest with about 12 percent. Middle-income groups also tend to have fewer small children than the poorest, but their share of expenditures on health care for children is not very different from the poorest, suggesting they have greater access to health services. 95 Table 4.6. Out-of-pocket Health Expenditures for Children (aged 0-5 years) of Households by Deciles and Type of Expenditure, 1999 P.C. Treatment Treatment Other private Total private health % of total consumption costs for costs for health expenditures for 0-5 household deciles diarrhea % respiratory expenditures for year olds % expenditure on diseases % 0-5 year olds % health % Share of Total Private Consumption Expenditures Poorest 10% 0.8 1.4 1.o 3.2 27 2 0.6 0.9 1.4 3.0 27 3 0.8 1.3 0.3 2.3 25 4 0.5% 1.0 0.7 2.2 20 5 0.5 0.8 1.2 2.4 22 6 0.3 0.7 1.3 2.4 23 7 0.2 0.9 2.8 4.0 35 8 0.2 0.4 1.5 2.1 21 9 0.1 0.4 0.6 1.1 13 Richest 10% 0.0 0.2 0.6 0.8 12 Total 0.2 0.5 1 .o 1.7 20 Source: INEC, ECV (LSMS), 1999. 4.52 Decentralization and Distribution of Health Spending per Province. In 2003 the Ministries of Health and of Economy and Finance discussed an agreement for a new allocation mechanism of central government transfers to health services. Unlike the case of education (see Vos and Ponce 2004), the discussion about the allocation of the health budget across provinces and other local governments is at a very preliminary stage and it runs in parallel (rather than being coordinated) with the decentralization process described Figure 4.16. New Formula andExistingDistributim of Public Health in Section 3. The new formula for Expenditures per Province, 2002 allocating resources by province (and then on to municipalities and public health providers) would possibly consider a poverty indicator (Unsatisfied Basic Needs) as the main criterion. Through this formula, health spending should become more pro-poor. Figure 4.16 shows that the geographic distribution of health spending by province is currently more or less -Equity line - - 'Existing budget allocation (equi-) proportional to the -PIC-poor allocation distribution of the population. The new formula would effectively make health spending pro-poor, while allocation based on population shares (capitation) would make the distribution fully egalitarian. A pro-poor allocation mechanism would address the equity issue in health spending, but to do so at the provincial level may miss out important differences in inequality within provinces, particularly inequalities in health needs. It also does not consider efficiency criteria and therefore could reward ineffective allocation of spending resources. Of course, cost-effectiveness criteria may be imposed in addition to the allocation mechanism across provinces. This issue is taken on in the next section. 96 V. Access to Health Care and Cost-Effectiveness in Health Spending 4.53 In Section 2, we concluded that infant mortality has decreased substantially in recent decades and that Ecuador seems well on track to reach this MDG target well before 2015. However, we also concluded that large differences in the risk of child death persist across socio- economic groups. In order to reduce such differences (and speed up the reduction in infant mortality) it would be useful to know what interventions would be most cost-effective. For that we will first model determinants of access to health care and those of the risk of early child death, Subsequently, we will relate the determinants that can be linked to policy interventions to the cost of such interventions and simulate the budget implications of alternative policy options aimed at reaching the MDG for child mortality. It is important to notice the close interaction among health and non-health variables in determinants found. This points to the need to consider factors that go beyond health sector spending and institutional capacity. 4.54 Joint Modeling of Access to Health Services During Delivery and Infant Mortality. The socioeconomic profile of infant mortality above concludes that wide gaps by socioeconomic categories, geographical location and vulnerability groups prevail in Ecuador. The critical question to ask is what proportion of these differences is explained by unequal access to health provision, specifically among the poor vis-&vis the non-poor; and the indigenous population vis- &vis non-indigenous peoples. 4.55 The present analysis connects access to health services during birth with the phenomenon of infant mortality. Traditionally, the health demand literature has focused on separating the effects of price-related and socioeconomic-related variables shaping access to services (see e.g. Gertler, Locay and Sanderson, 1987; Gertler and van der Gaag, 1990). In addition, most previous infant mortality studies have emphasized the likely mutual causation between infant mortality and fertility decisions (Hanmer and White, 1998). However, a combined specification of infant mortality and the choice of health service has not been attempted before. 4.56 The new approach explores first what motivates Ecuadorian individuals when selecting among different health services (either public or private or no service at all). Once these determinants are known, the effects of access to health services on infant mortality are analyzed. As a result, public health policy strategies are linked to the key development goal of infant mortality reduction. This link is two-fold: one shows the effects of private and public interventions on infant mortality directly; the other shows the impact on infant mortality through its induced change to health demand. 4.57 The traditional emphasis in the previous literature is not completely overlooked, though. Price considerations are not directly included although controlling for affiliation (if any) to different health provision categories may well convey price differences faced by health users. The relation between fertility and infant mortality is taken into account implicitly since many of the determinants of fertility are also factors affecting mortality. In addition, interesting behavioral relationships such as replacement and/or resource-competition among household members are controlled for in the proposed infant mortality specification. This is believed to capture the consequences of an intertwined relation between fertility and mortality. 4.58 Data. The database for both models comes from the demographic and health survey (ENDEMAIN) of 1999 that investigated in a exhaustive manner the birth history of every single child born alive in a period of six year before this survey, as well as the use of reproductive 97 health services by mothers and sanitary conditions of the household. In this sense, ENDEMAIN stands out from other surveys such as the LSMS and the population census of 2001 that ask information of mortality just for the last child born and also do not find out the age at which the children died. The sample size of the 1999 ENDEMAIN is representative at the national, regional and provincial levels. The data set for the CPH modeling is composed of 9,391 children born alive since January 1994, of which 301 died before the first year and 9,090 survived. For the health demand model, the number of observations for pregnant women that gave birth is 8,789. See Annex 4.3 for further details on the data sources. 4.59 Modeling Strategy. We apply two techniques to estimate the demand for health services for peri- and post-natal maternal care and the determinants of infant mortality: a multinomial logit model of demand for health care and the Cox Proportional Hazard model to estimate the probability of child survival at early age. The general specifications of these models may be summarized as follows: Estimation Estimation technique Model function Specification Demand for Multinomial Logit -B,z, PS, : health provider ‘i’ (none, public, r“’ health services (MNL) Prob(PSi = j)= - [I] private); during child zi: determinants of health care demand for delivery ,Sk zi child delivery. k=O Infant mortality Cox Proportional Hazard Hit):risk of infant ‘j‘to die in period (t) C Sjxi determinants W‘H) survival model H (t) = e ij Ho(t) before reaching one year of age; [21 Hdt): risk of infant of reference group to die in period (t) before reaching one year of age; xi: determinants of infant mortality. Source: Author’s estimate 4.60 The Multinomial Logit Model (MNL) is an appropriate method to analyze multiple, discrete decisions where the dependent variable may take at least three different values. In the demand for maternal health care we distinguish three options: no access to health care, public and private providers. The MNL specification is further appropriate if we assume that the alternatives for choice of provider are independent. That is, the probability of choosing one or the other option does not depend on the existence of other option(s). In the case of the choice for health care for child delivery, this hypothesis implies that a pregnant woman who is making a choice between receiving maternal health care or not, or between a public and private provider, is not influenced by the presence of an alternative care option. This assumption is likely to be valid as long as the differences in cost or quality between the options are sufficiently large. The assumption may not be true if, for instance, there would be little difference in cost between private and public services, or if the quality of public health care were perceived to be so poor that potential users think they might be equally well off receiving no care at all. Should such conditions hold, the preferred method would be a conditional Zogit or ordered probit model, which would allow interdependence in the ordering of alternative choices. In Ecuador, there is no a priori reason for any user to first try a public service before soliciting private service. Hence, we assume the MNL assumption is valid for our case. The model specification is based on consumption theory as applicable to health care demand. The theoretical foundations are spelled out in Annex 4.1. 4.61 ‘Hazard.’ models estimate the relative probability of a particular group incurring a particular risk as compared to another reference group. For instance, one could estimate the probability of infant death of girls relative to that of boys. Similarly, survival models estimate the 98 same type of probability but take as the dependent variable the time (number of months) it takes for the event (death) to occur or not to occur within a given time frame (one year, in case of infant mortality). Probit or logit models have often been used to estimate determinants of infant mortality, but this requires defining a binary or discretionary dependent variable (death or no death). In the case of the Cox Proportional Hazard (CPH) or survival model, we are allowed to consider all observed cases of children under age one, whereas a logit or probit specification (when properly estimated) would require considering only relevant cases that have actually reached age one to determine survival or non-survival. As a consequence, the CPH model does not require scrutinizing the sample of infants first and avoids possible biases in the estimators. Such a bias will necessarily be present in probit or logit estimations to the extent that the probability of dying in the first year of life is concentrated during specific months (say the first) after birth.27 Models using a binary or discrete dependent variable would thus considerably overestimate the impact of the given set of determinants on infant mortality, as the number of non-survivors per month lived would be incorrectly weighted. 4.62 Duration models have been extensively used in socioeconomic analysis in issues such as unemployment spells, education enrolment or social benefit schemes (see e.g. Nickel1 et al., 1991). There is also a rather extensive epidemiological literature on the duration of health conditions including, infant, child and adult mortality (Masset and White, 2003). We spell out the theoretical foundations of the CPH model in greater detail in Annex 4.1. 4.63 Model Specification and Specification Problems. The existing literature suggests a large number of possible determinants of access to health services and infant mortality. Tables 4.7 and 4.8 summarize the expected effects of a wide possible range of determinants, including the ones analyzed in Section 2. 4.64 It is widely recognized that the estimation of health production functions is subject to problems of interdependence and endogeneity. Many of the likely determinants, such as family income and parents’ education are interrelated, such that having both as determinants could give biased estimators. In addition, there tend to exist mutual relationships between health inputs (supply variables) and health outputs (illness incidence) causing endogeneity in the estimation of health production functions (see e.g. Deolalikar, 1996). In particular, there is a potential case for health supply variables at a regional or municipal level to be endogenously determined by the magnitude of infant mortality. If so, higher infant mortality rates would be driving a higher provision of health services. 4.65 The traditional econometric solution to the endogeneity problem is the use of instruments for endogenous variables (Greene, 200 1). Obvious candidates for current health supply variables are lagged health supply, based on the assumptions that health policy changes require time both to articulate and to generate expected outcomes. In Ecuador, a practical constraint prevents a satisfactory use of instruments for contemporary supply variables. Statistical sources on supply variables at district (parroquia) level only permit the construction of lagged variables for 1998 and these variables are limited to per capita in-patient hospital services. While this rules out a strategy based on instrumental estimation, the virtually identical significance, size and sign of the infant mortality coefficients with contemporaneous and lagged supply variables confirm that endogeneity may not be a serious problem after all. The hypothesis of no serious endogeneity is 27 In Ecuador, the evidence shows that most child deaths occur within the first five months after birth, thus reducing considerably the risk of death after having survived the first five months. 99 further confirmed by the very low explanatory power of infant mortality averages on averages of public health expenditures per municipality. In other words, differences in the incidence of infant mortality do not appear to explain much of the distribution of public health provision. 4.66 With respect to the interdependence issue, non-economic variables such as education or geographical location are not entirely independent from economic variables such as consumption levels or poverty status. For instance, education may not only affect infant mortality because it is closely and positively linked to consumption levels (its economic effect) but also because it affects preferences and skills referring to infant care (non-economic effects). All these effects from education are expected to affect infant mortality, and the inclusion of consumption in the infant mortality function acts as a control variable for the economic effects of education. A similar issue may arise with access to drinking water and other sanitation conditions which are likely linked to consumption levels and poverty status, not in the least also because sanitary conditions were used as explanatory variables in the construction of the consumption variable for the ENDEMAIN survey (see Appendix A.3). Apart from checking the relevance of such different dimensions, we also test for multicollinearity and drop variables causing such problems. Table 4.7. The Expected Effects of Possible Determinants on the Demand of Maternal Health Services Variable Expected effect Hypotheses on demand for medical services Personal characteristics: Mother’s age Ambiguous Effect will depend on the magnitudes of two conflicting effects: increased demand with age as risk increases vs. decreased demand for professional attention as mother’s experience rises. Mother’s education Increase in Partly this effect captures an economic relation (higher education is associated demand for with higher economic status), while it may also capture different preferences professional between educated and non-educated women. If there are important differences of services quality in favor of private health services, one could expect better educated women (with better access to information) to prefer such services. Mother’s ethnic Decrease in Individuals of ethnic background may prefer traditional delivery practices background demand for attended by individuals other than professional medical staff professional services Household characteristics: Urban location Increase in Residence in urban areas typically implies better access to medical facilities for demand for delivery and other health-relatedpractices. professional services Sierra / Costa location Increase in Residence in highlands or coastal locations increases access to medical facilities demand for with respect to forest and jungle areas (Amazonia). This variable may well professional capture therefore differences in public infrastructure that make health services services more accessible in certain areas. Socioeconomic status: Increase in The higher the economic status of the household broxied by either consumDtion (i)per capita demand for levels or poverty status), the more likely that a mother is bok willing to usd and consumption level; professional able to afford available medical services offered to her at the time of delivery. (ii)per capita services Similarly, if there are important perceived differences in quality between public consumption separated and private services favoring the latter, higher income groups likely will prefer by poverty status using private health services. Health inputs and medical conditions: Personal: Affiliation to public Increase in Affiliation to health systems makes it more likely that mothers use the services social security scheme demand for covered by their affiliation and those affiliated with the social security system or private health professional will be expected to use public health services. insurance services Premature delivery Increase in Complications in the delivery typically increase the demand for professional staff demand for attention. 100 professional services Prenatal visits Increase in Prenatal visits may indicate a mother’s higher preference for professional demand for attention throughout pregnancy. These visits indicate also the existence of professional institutional facilities providing such attentions. services Community health services: District (parroqufa) Increase in Larger public health supply indicators at district level reflect a wider access to average availability of demand for public services, which may lead to higher demand for these services in detriment hospital beds professional to no-care or private care. There is however a potential problem of endogeneity District (parroqufa) services. associated with the fact that the level of public provision can be targeted to average availability of communities with lower health supply indicators. Altematively, the wealthiest medical personnel communities might also capture more per capita public with political leverage. Note: These variables refer to zi in the estimation model [ 11 Table 4.8. The Expected Effects of Possible Determinants on Infant Mortality Variable Expected effect on Comments infant mortality Personal and biological characteristics: Infant’s sex Larger probability Male infants are reported to survive less frequently than females in the first year of of male infant life (WHO 2003) mortality (IM) Infant’s ethnic Ambiguous Once controlled for education, consumption, behavioral, household composition background and community-wide health supply differences among different ethnic groups, it is not clear whether ethnicity-driven aspects have additional impacts on the probability of IM. Multiple delivery Increase in Multiple delivery increases the probability of less healthy infants. (twins, etc.) probability of IM Premature delivery Increase in Premature delivery increases the probability of less healthy infants. probability of IM Birth order Decrease in Under the hypothesis of intra-household competition, higher-ordered infants (first probability of IM bom) are more likely to capture available resources (food, care) in the household Behavioral characteristics of mother: Type of attention Professional Professional attention should reduce the probability of delivery problems causing received during attention decreases infant mortality. It is, however, an open question whether the impact on infant delivery probability of IM mortality is significantly different between private and public health care and most likely will be associated with differences in quality of service. Prenatal visits Ambiguous More prenatal control visits may indicate a higher preference and larger opportunities for professional attention, thus reducing health risks for the fetus and the infant. It may also indicate, however, that fetus complications exist and that the infant when bom is more prone to illness or physical deformation. Breastfeeding Decreased Biologically, it has been shown that breast feeding improves the nutritional and probability of IM immunological conditions of the infant. Also, it may indicate the mother is around to personally take care of the infant. Further, breastfeeding provides a natural form of contraceptive, which may help spread the interval between births and reduce risk of early child death. Contraceptiveuse Ambiguous Use of contraceptives may indicate that mothers are more aware of - and more willing to use - available medical services regarding infant care as well as other health issues. It will also reduce the number of children bom to the mother (fertility) and may help spread the interval between births, reducing the risk of early child death. However, though less likely, it may also increase health risks for mothers if their use is uncontrolled or protracted. It is, however, unlikely that this variable properly captures mother’s health status. Household characteristics: Socioeconomic: 101 Variable Expected effect on Comments infant mortality Mother’s age Ambiguous Effect will depend on the interaction of two conflicting effects: older age at birth increases health risks for newborn infants but also increases the experience of maternal and infant health care. There might also be a non-linear relation between mother’s age and IM. This kind of argument (hypothesis) is tested by introducing the square of the variable of mother’s age. Mother’s education Decreased Again, this variable captures an economic relation that implies that better educated probability of IM parents devote more resources to the benefit of infant’s health. It also accounts for a presumably better use of available child caring technology, which should also positively affect infant health status. Finally, higher education of the mother implies a higher opportunity cost of personally taking care of her infant. This should lead to less time devoted to infant health care. There is, therefore, a possible trade-off between the quality and quantity of time mothers devote to infant care. Household size Ambiguous Two potential conflicting effects: more individuals in the household may mean higher fertility rates (thus higher health risk) and tougher competition for resources available to infants. But, it may indicate that other household members may take care of infant welfare in case of need. Socioeconomic Decreased A higher economic status (captured either through levels of consumption or poverty status: probability of IM conditions) is related to a lower probability of IM. However, the socioeconomic (i)Poverty status effect may be already captured by other variables such as parental education, basic (ii)Per capita infrastructure in the household or geographical location. consumption Basic social Decreased Better sanitation and drinking water access for the household should improve infrastructure: probability of IM hygienic and health conditions for all members. However, this effect may be Water already captured by socioeconomic status or education variables, as the distribution Sanitation of social infrastructure within households is correlated with socioeconomic status (and geographical location). Geographical: Urban residence Decreased The effects of urban location on IM that are not already captured by economic or probability of IM educational variables may be due to wider access to health facilities in urban areas with respect to rural areas. Sierra I Costa Decreased Residence in highlands or coastal areas implies more favorable living conditions residence probabilityofIM for infants (and other individuals) with respect to forest and jungle areas (Amazonia), so it should be associated with decreases in IM Community characteristics: District @arroquiu) Likely decreased On the one hand, higher immunization rates at the community level indicate wider immunization rate probability of IM access and use of public health facilities that should lead to improved health status (might be of infants. But, they may also indicate that unfavorable community conditions ambiguous) attract targeted policy intervention. The underlying health performance at community level should then be responsible for higher individual IM rates. Note: These variables refer to xiin the estimation model [2] 4.67 A final specification problem refers to omitted variables. While trying to test for as many likely determinants as possible, data limitations did not allow for the inclusion of some. For instance; it was not possible to include indicators of mother’s health status during delivery, as these are not reported in the demographic and health survey (ENDEMAIN). Instruments for mothers’ health status (and life style) such as alcoholic or smoking habits are not reported either. The use (abuse) of contraceptives or pre-natal visits can be considered to be imperfect instruments only. The expected relation between mothers’ health and socioeconomic conditions may partially offset this omission. Further, the model does not consider the price of health services, as these are not reported in the ENDEMAIN survey. The consumption variable is also not part of the survey, but could be imputed using an indirect method (see Annex 4.2 for the estimation method). Per capita consumption is used to pick up both the income and cost differential effect on demand for health services, which is of course an imperfect approximation. 102 4.68 Results of the Access to Health Care Model. Tables 4.9a and 4.9b present the results of the demand for health services model in the form of elasticities. More detailed estimation results are in Statistical Annex Table A54a and A54b. 4.69 Personal. characteristics of the mother seem not to have a consistent significant effect on the choice of medical attention. However: 0 Indigenous mothers seem not to prefer deliveries attended by professional medical personnel. Being an indigenous mother increases the probability of unattended delivery by 27 percent (marginal effect; Table A. loa). Being non-indigenous increases both the probability of demanding public and private delivery services, roughly by the same amount each (around 13-14 percent). 0 Mother’s education is highly significant and the simultaneous significance of per capita consumption indicates that there are non-economic effects underlying this relationship. In fact, the magnitude of the impact of each additional year of education is relatively modest. Each 1 percent increase in the education level decreases the probability of child delivery without professional care by 0.7 percent, while it is expected to increase private service demand by 0.4 percent and public service demand by 0.15 percent. Table 4.9a. Effects of Determinants on Access to Health Provision Services (Elasticities) Effect on the Effect on the Effect on the probability of no probability of probability of professional public maternity private maternity care care during maternity care during delivery delivery during delivery (percent) (percent) (percent) Personal characteristics Mother’s age motherage 1.162 -0.111 -0.877* Mother’s age squared motheragesq -0.636 0.049 0.504** Mother’s ethnic background ethnic 0.043*** -0.010*** -0.020*** Mother’s education (years of school) motherschool -0.745*** 0.147*** 0.404*** Medical variables (reference: no aflliation to health system) Affiliation to IESS Segiess -0.013*** 0.025*** -0.040** Affiliation to other health insurance system Segother 0.025*** -0.015*** 0.007 Premature delivery Premature -0.020*** 0.005*** 0.010*** Pre-natal visits Prenatal -0.675*** 0.242*** 0.139*** District @arroqufa) average supply of tasin99 -0.065 0.092*** -0.130*** inpatient hospital services District @arroqufa) average supply of tasper99 -0.010 0.008*** -0.006*** medical personnel Household characteristics Urban residence Urban -0.264*** 0.005*** 0.241*** (reference: Ammonia) Costa coast -0.356*** -0.131*** 0.613*** Sierra Sierra -0.291*** 0.053*** 0.167*** Per capita consumption (log) Logcons -0.832*** 0.010*** 0.773*** Source: Multinomial logit model estimates based on 1999 Demographic and Health Survey for Ecuador (ENDEMAIN). See Statistical Annex Table A54a for detailed estimation results. Notes: * significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent 4.70 Estimates for health inputs and medical condition variables confirm the hypotheses of Table 4.7 with some qualifications: 103 0 Given the difficulty of using the instruments, the magnitude of estimated coefficients for average availability of in-patient hospital sewices at the parroquia level confirms the existence of some degree of endogeneity bias. Table 4.9b. Combined Effect of Poverty and Consumption Effect on the probability Effect on the Effect on the of no professional care probability of public probability of private during child delivery care during child care during child (%o) delivery (%) delivery (%) Per capita consumption of Povertycons -0.143 *** -0.059 0.25 8* ** the poor Per capita consumption of Nopovertycons -0.192 *** -0.050 0.284*** the non poor Source: Multinomial Logit Model (MNL) estimates based on 1999 Demographic and Health Survey for Ecuador (ENDEMAIN). See Statistical Annex Table A54b for detailed estimation results. Note: *significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent. Table 4.10. Impact Elasticities of Infant Mortality Determinants Variable Effect (percent) Personal and biological characteristics Sex (male=l) sexh 0.168 ** Ethnic background etnia 0.003 Multiple delivery multi 0.006 Premature birth prematu 0.133 *** First born primo -0.149 *** Behavioral factors (reference: no medical assistance) Private health care private -0.175 *** Public health care public -0.116 * Pre-natal controls prenatal -0.461 *** Breastfeeding breast -18.496 *** Use of contraceptives anticon -0.002 Household characteristics Mother’s age motherage -0.714 Mother’s age squared motheragesq 0.352 Mother’s education (years of schooling) motherschool -0.460 ** Household size hhsize -0.993 *** Poor household (dummy times per capita consumption) poverty 0.130 Access to safe drinking water water 0.134 Access to sewerage sanitation 0.225 Urban residence urban 0.042 Costa location coast -0.140 Sierra location sierra -0.188 * (reference: Amazonia) District (parroquia) has a satisfactory immunization record immune -1.102 *** Birth in 1994 b1994 -0.050 Birth in 1995 b1995 -0.060 Birth in 1996 b1996 0.016 Birth in 1997 b 1997 -0.044 Birth in 1998 b1998 -0.002 (reference: 1999) Source: Cox Proportional Hazard model of infant survival. Estimates based on 1999 Demographic and Health Survey for Ecuador (ENDEMAIN). See Statistical Annex Table A55 for detailed estimation results. Notes: * significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent. 104 0 In contrast, average availability of medical personnel at public health services may capture quality considerations of health provisioning well. The quantitative effect is rather small though. Each 1 percent increase in the supply of health workers (per 100,000) increases the demand for public provisioning by a meager 0.01 percent, while it decreases the demand for private services by 0.01 percent and that of no use of services equally by 0.01 percent. These particular estimates need to be taken with some caution, but it seems safe to conclude that improvements in the supply of health workers will have a very limited impact on the demand for maternal health care. 0 Affiliation to the social security system (IESS, SSS) increases, as expected, the probability of choosing public provision. The effect is rather small and in addition it appears to be (partly) offset by a lower demand for private services. Hence expanding public health insurance per se will not have a big impact on the demand for professional maternity care. 0 Premature delivery decreases the probability of unattended delivery, resulting in a very similar increase in private and public intervention. As a premature case appears, mothers may want to take no chances and ask for professional assistance. 0 Pre-natal controls decrease the probability of unattended delivery by almost 20 percent (marginal effect). As a result, there is an increase in the demand for public provision of 15 percent and 4 percent for private provision, reflecting that most prenatal control schemes are public and targeted to the poor. 4.71 Effects on the choice of delivery services from household characteristics are as expected: 0 Residence in Urban Areas and Regions. Other than the Ammonia decreases the probability of unattended delivery (by 11 percent in the case of urban residence; 18 percent for Costa; and 14 percent for Sierra), and results typically in increases in public and private provisions. Interestingly, the resulting increase in demand for professional care is stronger for private than public institutions. 0 Each 1 percent increase in per capita consumption increases the demand for private services nearly proportionally (0.7 percent) to the detriment of unattended deliveries, and no substantial change in demand for publicly provided care. This key result may indicate that Ecuadorians are willing to immediately shift to private rather than to public services. This might be attributed to a lack of confidence in the perceived quality of public health care. Also, it is worth noting that the impact of a higher consumption level only differs slightly between poor and non-poor, as Table 9b indicates. An important policy implication would be that an unconditional cash transfer program (such as the Bono Solidario) would be expected to enhance demand for private health care. In contrast, a conditional cash transfer (such as BDH) would increase access to public health care services because of its conditionality and not because the additional income would induce such demand. 105 4.72 Results of the Znfant Mortality Model. Estimates from the survival model are reported in Tables A.10 and A.11 and mostly confirm the expected determinants of infant mortality. 4.73 Regarding Personal and Biological Factors: 0 Being born as a male or prematurely both increase the probability of infant mortality. Although the impacts are statistically quite significant, their magnitudes are rather low (elasticities are 0.17 and 0.13, respectively). 0 Being a first born (with or without other siblings) implies having a lower probability of dying in the first year of age. This is taken as evidence that if there is competition for resources within the household, older siblings have a better chance of capturing resources for survival. Higher risk associated with multiple delivery does not seem to have significant effects. 0 More interestingly, indigenous infants aie not more prone to infant mortality than non-indigenous for reasons unrelated to socio-economic, household or behavioral factors (controlled for by a different set of variables). What matters more, it seems, are the factors associated with a lack of access to medical assistance for birth delivery. 4.74 Behavioral and Health Policy. Variables seem in general to have significant bearings on infant mortality. 0 Professional Medical Care reduces the probability of infant mortality, but the significance and magnitude of this effect varies somewhat by category of service. That is, the effect on infant mortality of private care is larger than the effect of public health care. The elasticities do not differ widely, but it is perhaps of importance that the statistical significance of public attention 'only passes confidence intervals of 10 percent while the significance of private attention is accepted at 1 percent. Prenatal visits-when conducted-reduce infant mortality, indicating the effectiveness of this intervention in preventing future infant deaths. These findings point out the rising demand for and effectiveness of private over public services, which should be a guiding criteria in future sector reforms. 0 Breastfeeding also significantly reduces infant mortality, its effect being the largest among both behavioral and non-behavioral factors. If all women giving birth breastfeed their children, this is expected to reduce infant mortality by 18 percent. 0 Coverage of immunization is also very significantly related to lower prevalence of infant mortality. For each 1 percent increase in the coverage of immunization, infant mortality goes down by about 1.1 percent. Once again, the effectiveness of this preventative action stands out. 0 Access to safe drinking water and sewerage is not found to have a significant impact on infant mortality. As indicated, this result may well be due to problems of multicollinearity with other determinants, such as education and area of residence. However, we also do not find a very high simple correlation between infant mortality and sanitary conditions, such that the latter might be a conditioning or compounding factor rather than a direct determinant. 106 4.75 Socio-economic characteristics present a mixed combination of effects, substantiating the relations between some of these variables. 0 Mother’s age does not affect infant’s survival possibilities, probably indicating the offsetting effects of more experience and more biological risk as age rises. 0 However, higher levels of matemal education reduce infant mortality: each percentage increase in the average level of maternal education reduces the probability of infant mortality by 0.5 percent.28 0 In contrast, the poverty status of the household does not seem to affect infant mortality. This is not so surprising as maternal education is related to consumption levels and socioeconomic status of the household. The same explanation may underlie the statistical insignificance of water and sanitation services. Although it is difficult to disentangle the possible different effects of education on infant mortality, the fact that this variable strips the significance of other socioeconomic variables may point to the importance of the economic determinants of infant mortality. 0 Of the remaining significant determinants of infant mortality, household size affects the probability of infant mortality. As discussed in Table 4.8, we might expect an ambiguous effect, as a larger household size could reflect higher fertility and thus greater health risk, as well as reflecting greater competition for household resources. The alternative hypothesis is that it increases the likelihood that other household members take care of infants. Apparently, this latter effect outweighs the former. 0 Geographical Location does not seem to have a substantial impact on infant mortality on its own. Urban residence per se does not reduce infant mortality having already controlled for factors related to geography, such as access to services, or socioeconomic patterns. Residence in the Costa or Sierra does not affect significantly the probability of infant mortality, although there is some weak effect attributed to living in the highlands (Sierra). This may be related to better transport and health infrastructure as compared to Amazonian areas, but this kind of effect is neither substantial nor systematic across non-Amazonian areas. 0 Finally, the regression equation includes an additional variable for the year in which the child was born. The latter allows us to check for an unexplained progress over time in reducing infant mortality which remains after controlling for all other microeconomic and non-economic factors. However, the time dummies are not significantly different from zero (not even at a 10 percent confidence interval). Therefore, we can conclude there is no apparent unexplained trend in infant mortality. 28 Several specifications including paternal education and differences in parental education did not prove significant, though. 107 VI. Health Budget Training 4.76 Ecuador’s government budget system has long been highly centralized, rule oriented and input based. The health budget has been no exception. The input-based characteristic has led to incremental allocations (in nominal terms) according to the cost changes of health supply components. Government budget rules in Ecuador since the 1970s have included a host of fixed allocations from specified revenues (including the repartition of oil revenues) and fixed-share or growth rules, such as the rule that health spending should increase at least as fast as aggregate public spending. Even though this has not been adhered to in practice and has not been able to prevent real health expenditures from falling for a prolonged period of time, it has imposed rigidities in the spending pattern and made the health budget adjust pro-cyclically at least until 1995, as analyzed in a study by Vos et al. (2003). In recent years, as discussed in Section 4, expenditure trends have been dominated by salary adjustments and the expansion of special health programs, leaving investment in health infrastructure and maintenance as well as resources for drugs supplies as the first items cut when budget adjustments are required. Attempts at a system of more decentralized budget allocation and performance-based budgets have been part of the health policy reforms of the 1990s. Implementation of these reforms has been difficult, as explained in Section 4, leaving much of the traditional health budgeting system still in place. 4.77 A first step towards a more comprehensive result-oriented budgeting system would be to put together all (central and decentralized) programs and interventions aimed at improving health outcomes and monitor each for their cost-effectiveness. In line with the MDGs, further reduction of infant mortality is a priority target for the Ecuadorian government. In that vein, the results of the health demand and child survival models of Section 6 may serve as a starting point for the development of a result-oriented expenditure tracking methodology. 4.78 The two models serve to establish input-output relationships in health, i.e. between policy interventions, access to health services and expected health outcomes measured by infant mortality. The relative importance of each determinant discussed in Section 6 may be expressed as an elasticity expressing the impact of a 1 percent change of a given determinant on, respectively, the probability of professionally assisted child delivery and child survival (see Tables 9a/b and 10). After linking these to unit costs we obtain a basis for making budget projections for alternative resource allocations. We perform this analysis in three related steps: 4.79 The Impact on Access to Health Services. In our case the specification is for the probability of professionally assisted childbirth and pre-natal controls. For this we use the relevant elasticities from Tables 4.9a and 4.9b for the likelihood of receiving no medical assistance during child delivery. The key policy variables are access to health insurance and availability of health services and medical personnel. In addition, we assume that expansion of the free maternity program will increase professionally assisted childbirth commensurately. Household determinants include the educational level of the mother and per capita household consumption. The averages of the latter two variables are assumed to change at fixed rates of 1.5 percent per annum, thus imposing a trend in rising access to health services due to improving 108 socio-economic condition^.^^ We assume further that use of pre-natal controls has similar determinants and impacts as the probability of medically assisted child delivery. 4.80 Impact on Infant Mortality. Results of policy simulations on the demand for maternal care (at child delivery and pre-natal controls) are subsequently used in the health “production function” for child survival. The survival model further suggested that breastfeeding has a strong positive effect on avoiding early child death. We did not model the determinants of breastfeeding practices. We checked whether having access to pre-natal maternal care increases the likelihood of breastfeeding, but this does not appear to be the case as there is no significant difference in such practice between those that do and those that do not have access. Moreover, since breastfeeding practices are already widespread (over 90 percent) we do not consider increases in the budget simulations. According to the model findings, this then leaves the coverage of the immunization program as the policy variable with the most important expected effect on reduction of infant mortality. Ethnicity and female education variables are considered as the most relevant household variables in determining infant mortality. 4.81 Budget Implications. We add unit cost estimates for the relevant public health input variables, such as salaries of health workers, construction and maintenance of hospitals and health centers, as well as of the special programs, specifically the immunization and free maternity program^.^' In addition, we considered the possibility of increasing access to health services through a subsidy to the health insurance premium and thereby broaden coverage of health insurance, but this has been dropped from the results reported below as increasing health insurance coverage has very little direct impact on infant mortality. We did not consider expansion of the BDH to enlarge its impact on the use of health services. As discussed in Section 4, this program currently mainly has a (direct) impact on access to education. By changing the relevant health input variables, the required health budget will adjust according to the change in coverage of services times the corresponding unit cost parameter. In the simulation results presented below we use two alternative scenarios. One assumes that if demand for maternal health care increases there will have to be a related increase in the supply of doctors, nurses, and health infrastructure to meet that demand.31 The second assumes, as the free maternity program does, that the additional demand for health care can be met using existing resources, assuming slack capacity.32 We assume further that the nominal health budget (for all items) is adjusted for a given inflation rate (3 percent per year) to account for changes in input costs. Also nominal salaries of health workers are adjusted over time this way. In the budget simulations presented below, we assume constant real wages for doctors and nurses. 4.82 The models presented in Section 6, did not detect structural differences across population groups in the impact of the mentioned determinants, except for the income (consumption) variable. The gaps in health status (as measured by infant mortality and access to health 29 The growth in years of schooling of females thereby is assumed follow the trend of the 199Os, while economic growth is-albeit modest-more optimistic (and clearly more stable) than that achieved during the 1990s. 30 See Statistical Annex Table A56 for a summary of the unit cost estimates as used in the budget projections. 31 As we make a projection of the total public health budget and focus only on demand for maternal and child care, we assume in the reported simulations this affects 20 percent of the overall health budget. So a 10 percent increase in spending on this area would lead to a 2 percent increase in the overall budget. 32 This has not been investigated systematically, but there is some evidence suggesting substantial underutilization of public health resources. Using health input indicators provided by INEC’s Vital Statistics and Data on Human Resources in Hospitals and Health Centers, the average number of medical consults (of any kind) per hour in public health services is less than one. 109 services) between poor and non-poor and indigenous and non-indigenous thus are explained essentially by differences in initial conditions. The objective of the budget simulations is to see what would be cost-effective ways to achieve both the MDG in child mortality and reduce inequality in health status across population groups. The latter can be achieved by targeting interventions at the (extreme) poor and indigenous pop~lation.~~ VII. Projections for Access to Maternal Care and Infant Mortality 4.83 Table 4.11 shows the results for three budget scenarios under the assumption that there is a 0.2 percent endogenous increase in medical personnel and infrastructure for each 1 percent increase in demand for public maternity care: 0 Reaching full coverage of the vaccination program for all. This would require an annual growth in the number of beneficiaries of the program of about 3 percent per year until 2015 (particularly to cope with the current undercoverage of DPT vaccinations). 0 Expansion of the Free Matemity program targeted at the poor and indigenous population, such that these target groups get unrestrained access to maternal and childcare by 2015. For this, the program’s expansion would amount to about 2 percent per annum for the (non-indigenous) poor and 3 percent for the indigenous population. 0 Combination of the first two scenarios. 4.84 Our target is to reduce overall infant mortality from 34 to 18 per 1,000 live births between 2004 and 2015. For the poor the reduction should be from 42 to 22 and for the indigenous population from 66 to 33. Our baseline simulation projects improvements in education and per capita consumption forward to 2015 under the assumptions indicated above, but assumes that health programs show no further expansion from the coverage reached in 2003. The baseline then projects that without health input improvements infant mortality would reach 30.5 per 1,000 live births by 2015. 4.85 The simulations presented in Table 4.11 show that neither reaching full coverage of the immunization program nor the expansion of the free maternity program targeted at the poor are sufficient to reach the MDG targets for infant mortality. The expansion of the immunization program would reduce infant mortality to 20.1 per 1,000 live births by 2015. As the immunization program is universal and initial coverage does not differ much across population groups, this policy would reduce infant mortality for all, but would not narrow differences between poor and non-poor or indigenous and non-indigenous. 33 In the reported budget simulations, the “poor” refers to the “extreme poor” as identified by the UBN index. 110 Table 4.11. Achieving MDG for Child Mortality and Budget Implications Baseline MDG Baseline Simulated Additional projection for for projection impact budget cost IMR IMR for assisted (over baseline) child (annual delivery average 2004- 2015) IMR Access US$ % of to million GDP maternal care 2000 2015 2015 2003 2015 2015 2015 Full coverage immunization program by 2015 3.5 0.01% Total population 34.1 30.5 18.2 84% 82% 20.1 81% Poor 42.0 37.4 21.9 78% 76% 24.9 74% Non-Poor 28.9 25.8 10.4 87% 86% 16.8 85% Indigenous 66.0 58.7 32.6 65% 63% 39.6 62% Non-indigenous 30.2 27.0 15.2 86% 83% 17.6 83% Full coverage free maternity program for poor and indigenous by 2015 3.8 0.01% Total population 34.1 30.5 18.2 84% 81% 28.0 91% Poor 42.0 37.4 21.9 78% 74% 31.1 100% Non-Poor 28.9 25.8 10.4 87% 85% 25.8 86% Indigenous 66.0 58.7 32.6 65% 62% 43.3 100% Non-indigenous 30.2 27.0 15.2 86% 91% 26.1 91% Combination of expansion immunization, and free maternity 7.2 0.02% Total population 34.1 30.5 18.2 84% 81% 18.2 91% Poor 42.0 37:4 21.9 78% 74% 20.6 100% Non-Poor 28.9 25.8 10.4 87% 85% 16.8 86% Indigenous 66.0 58.7 32.6 65% 62% 28.9 100% Non-indigenous 30.2 27.0 15.2 86% 91% 17.0 91%. - .. Source: Author’s estimates based on health budget tracking model. (Scenario assumes that each 1 percent increase in the demand for matemal care leads to an endogenous 0.2 percent increase in supply of public health inputs. See text for implications of dropping this assumption.) 4.86 A targeted expansion of the free maternity care program would narrow such gaps. Generating unrestricted access to medically assisted child delivery and maternal care for the poor and indigenous population would reduce the overall infant mortality rate to 28 per 1,000 live births, but also narrow the health status gaps between population groups. The higher probability of early child deaths among the poor as compared to the non-poor would fall from 45 percent around 2000 to 21 percent in 2015, and the gap between the indigenous and non-indigenous population would be almost halved from 118 to 67 percent. 4.87 The additional budgetary cost of the expansion of these programs as simulated would be about the same for each: between US$3 and US$4 million per year (or 0.01 percent of GDP), 111 which would seem quite affordable. Combining the two would lead to an annual cost of US$7.2 million over the baseline budget (or 0.02 percent of GDP). The combination of these two policies would be sufficient to reach the MDG targets for the poor and indigenous population groups, but would still fall slightly short for the non-poor. 4.88 As discussed in Section 3 and under the budget scenario assumptions (see footnote 32), there is some reason to believe that there is slack capacity in the public health system (at least in relation to executing its present tasks). In fact, the design of the Free Maternity Program assumes the existence of such slack capacity. Dropping the assumption that supply of medical personnel and infrastructure adjusts automatically in response to increased demand for maternity care reduces the budgetary requirements of the expansion of both programs to US$5.7 million per year. 4.89 If the health ministry decides to change the somewhat distorted proportion of doctors to nurses, it could “finance” the indicated extra budget requirements through cost-savings, if gradually (over the 11-year time span of the simulations) it reduces the number of doctors (by 40 a year) and increases the number of nurses (by about 50 a year). This would slightly raise the share of nurses to doctors in public health centers from 0.5 to 0.56. Bringing this proportion to 1:l could imply an annual cost saving of US$29 million or about 8 percent of the total public health budget.34 4.90 Further fine-tuning of these budget scenarios will be needed to guide actual policy decision-making. Of course, the relatively low cost estimates are influenced by the assumption of a stable macroeconomic environment in the coming decade with low inflation and a steady rise in real per capita incomes. Actual conditions may be more volatile, for which the budget tracking methodology may help keep a focus on the health outcomes and make the health budget much more anti-cyclical than now. Such a budget strategy would comprise the protection of full immunization coverage and possibly a much stronger move towards wider coverage of health insurance. The latter is where the future of health financing should lie, but the country is still a long way from universal health insurance. A targeted expansion of the Free Maternity Program would be an effective option for the short to medium term. At present, as analyzed, this program does not overlap much with the benefits of the Bono de Desarrollo Humano cash transfer program, even though potentially such overlap may become important with the possible expansion of the BDH. All of this would require appropriate coordination for which the health budget-tracking model might provide meaningful input. “These proposed measures would increase the demand for public health services. The infant mortality model suggested that birth delivery attended by private health providers would increase the probability of child survival in the first year more than if delivery takes place in a public health center. As indicated, the difference in effectiveness is not very large though. Nonetheless, if the BDH and Free Maternity programs would give the poor equal access to private health centers, the impact on infant mortality could be enhanced by more. Yet, availability of private clinics typically is at greater distance from the homes of poor families, such that the expected additional impact likely will be very small indeed. The additional consideration is that the quality of public health care is in need of improvement to meet at least the apparently better standards at private health centers. 34. Such a scenario, leaving all other things equal, would require firing some 2,500 medical doctors and hiring some 2,600 nurses in the period 2004-2015. 112 4.91 These policy directions can be fully consistent with the envisaged decentralized budget allocation mechanisms. The main requirement is that decentralized budgeting incorporates a focus on health outcomes, rather than on health inputs. 4.92 In conclusion, we found the somewhat paradoxical outcome that infant mortality rates have come down steadily, despite low public health expenditures, an apparently poorly functioning health system and a persisting high incidence of malnutrition in Ecuador. Much of the answer is to be found in the continued improvement of education levels and the urbanization of the population with associated improvements in sanitary conditions and knowledge of adequate reproductive health conditions. The same factors likely also have contributed to the strong reduction in fertility rates that has further pushed down infant mortality in a mutually reinforcing trend. Health interventions have mattered, particularly the expanded coverage of the immunization program and the program’s related contribution to improving environmental conditions for disease control. During the 1990s this role of the program has been strengthened along with specific interventions trying to ensure sufficient access for the poor to maternity care (among others through the Free Maternity program). Such policies seem effective at low cost. Obviously, more specific implementation issues will require additional attention, such as reaching the indigenous population with (culturally) adequate health services, quality control of health delivery and avoiding absenteeism of health workers. Overall rising health costs need to be taken into account as well since the country’s epidemiological profile is shifting towards a predominance of cancer and cardio-vascular diseases. Ecuador’s challenges in improving health delivery systems are large, but resource constraints cannot be an excuse for not achieving the MDG targets for infant mortality. 113 References Bortman, Martin. 2003. ‘Health,’ Vicente Fretes-Cibils, Marcel0 M. Giugale, JosC Roberto L6pez-CBlix (ed.). “Ecuador: An Economic and Social Agenda in the New Millennium. ” Washington D.C.: The World Bank. CEPAWHR. 1999. “El Peso de la Enfermedad en el Ecuador.” Collett, D. 1994. “Modelling Survival Time in Medical Research. ” London: Chapman and Hall. Cox, D. R. and D. Oakes. 1984. “Analysis of Survival Data. London.”: Chapman and Hall. Demery, Lionel. 2003. “Analyzing the incidence of public spending”. Francois Bourguignon and Luiz Pereira da Silva (eds.) The Impact of Economic Policies on Poverty and Zncome Distribution. Evaluation Techniques and Tools, Oxford and Washington D.C.: Oxford University Press and World Bank, pp.41-68. Deolalikar, Ani1 B. 1996. ‘‘Government health spending in Indonesia: Impact on children in different economic groups.” in Dominique van der Walle and Kimberly Nead (eds.) Public Spending and the Poor. Theory and Evidence, Baltimore: Johns Hopkins University Press (for World Bank), pp. 259-289. ECLAC. 2001. “Panorama Social de Ame‘rica Latina.” Santiago: United Nations - Economic Commission for Latin America and the Caribbean. Gertler, P., L. Locay and W. Sanderson. 1987. “Are User Fees Regressive? The Welfare Implications of Health Care Financing Proposals in Peru.”: Journal of Econometrics 36( 1/2) pp 67-80. Gertler, P. and J. van der Gaag. 1990. “The Willingness to Pay for Medical Care: Evidence from two Developing Countries.” Baltimore: Johns Hopkins University Press. Greene, W.H. 2001. “Econometric Analysis.’’ 3rd Edition, Englewood Cliffs, N.J.: Prentice-Hall. Hanmer, Lucia and Howard White. 1998. “Under-five mortality in Sub-Saharan Africa.”: ISS, The Hague. INEC. 2003. “Ecuador: Estimaciones y proyecciones de poblacibn 1950-2025.”: INEC. Jenkins, Stephen P. 1995. “Easy Estimation Methods for Discrete-Time Duration Models.” Oxford Bulletin of Economics and Statistics, Vol. 57 (1): 129-38. Lbpez, A.D., O.B. Ahmed, M. Guillot, B.D. Ferguson, J.A. Salomon, C.J.L. 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SIISE. 2003. “Sistema Integrado de Indicadores Sociales.” Versi6n 3.5, CD-ROM database, Quito: STFS. UNICEF. 2004. “Ensuring the Rights of Indigenous Children.” Unicef Innocenti Research Centre, Innocenti Digest 11, Florence: UNICEF. Vos, Rob, Margarita Velasco, and Edgar de Labastida. 1999. ‘Los efectos econdmicos y sociales del fendmeno de El Niiio, 1997-98’, in: Enrico Gasparri, Carlo Tassara and Margarita Velasco (eds.) “El fenbmeno de El Nifio en el Ecuador, 1997-1999. Del desastre a la prevencibn.” Quito: CISP-SEDEH-SIISE. Vos, Rob (ed.) et al. 2003. iQuie‘n se beneficia del Gasto Social en el Ecuador?, Estudios e Informes del SIISE-STFS No. 4, Quito: Secretm’a TCcnica del Frente Social. WHO 2003. World Health Report 2003, Geneva: World Health Organization. 115 Annex 4.1 Theoretical Underpinnings of Health Demand and Infant Mortality Models Demand for Health Care Given data limitations, the use of health care is not measured in tems of the quantity of health care consumed but in terms of choices among alternative health care providers or the probability of choosing a particular health care provider. The framework that we propose to use is a standard framework that has been employed in several papers that have estimated the use of health care (see Gertler, Locay and Sanderson, 1987; Mwabu, Ainsworth and Nyamete, 1993). The framework is a short-run static model with a utility function defined by health status and the consumption of all other goods. Consider an individual confronted with an illness. This individual has to choose among alternative health care providers (including self-care). Health care providers offer different levels of service at varying costs. An individual has to make a discrete choice amongst these providers. Conditional on an individual's health status, the type of illness, availability of information, and income an individual chooses the alternative that yields the highest utility. This description of the manner in which an individual may make a choice concerning health care provision may be formalized by considering utility conditional on receiving care from health care provider (HCP) j. Utility conditional on choosing providerj is given by, u, = ~(H,9C1,9T,) (1) Where HIJis the expected health status of the individual conditional on receiving treatment from provider j, C, is the consumption of all other goods except those associated with health care, T, represents the non- monetary costs of access to provider j. The expected improvement in health care status is unobservable but is assumed to depend on the characteristics of an individual (health status, habits, etc.) and the quality of health care received by the individual. This allows us to write a health production function defined over X,, the attributes of an individual and Z,, the attributes of the provider j. Hence, =H(X, ,'J> (2) Turning to the second argument in the utility function, the level of consumption that is possible depends on the income of the individual and the costs associated with buying health care. If the user fee associated with providerj is PJ and Y is an individual's income then, c, = Y, - Py (3) Substituting 3 into 1 yields, u, = U(H,,? -PJ,qj.> (4) i.e., utility is a function of the expected health status of an individual, the level of consumption and the non-monetary costs associated with using providerj. To guide empirical work it is suitable to substitute 3 and 2 into 1. This yields a function where utility is given as, u, = u(xi,zj,y,PJ,qj) (5) Thus, the benefits from visiting a particular health care provider depend on individual characteristics, the attributes of the provider, individual income, user fees faced with provider j and non-monetary costs associated with visiting provider j. 116 In order to empirically determine the probability of choosing a provider we need to choose a particular form for the conditional utility function and to introduce a stochastic disturbance. There are several possible choices for the form of the utility function. What is required is a form for the utility function that is consistent with well-ordered preferences. As shown in Gertler, Locay and Sanderson (1987) a suitable form for the utility function is the semi-translog where health and non-price access costs enter in log form and consumption enters in both log and log-squared forms. Other suitable forms for the utility function include parameterizations that are log-linear in heath status and consumption or a utility function that is linear in health status but log-linear in consumption (see Mwabu et al., 1993 for a discussion). The exact form of the utility function that will form the basis for our analysis will be determined at a later stage. For the time being consider a utility function which may be written as follows: Where, Vu is the systematic part of the utility function and depends on individual characteristics and provider attributes. The idiosyncratic part is represented by cii. An explicit form of the empirical utility function may be written as, Where, Wi = [Xi,Yi]and Kj = [Z, Pj, T,]. Estimates of c1 differ across alternatives while estimates of p are J: equal across the various altemat~ves.~~ An individual's health care provider choice may now be expressed as: HCPi = j if Uij>max{Uik}, j =1 ... J, k # j, (8) Where HCPi is a health care provider indicator. The parameters of (7) and the probability that individual i chooses health care provider j may be obtained by estimating a multinomial discrete choice model. The selection rule (8), combined with the assumption that the stochastic error term follows a Weibull distribution, defines a multinomial logit model where: Estimates of the required parameters may be obtained by maximum-likelihood estimation of (9). The results of the multinomial logit model may be used to compute the welfare costs associated with the imposition of user fees. These welfare costs may be measured in terms of compensating variations. Finally, as discussed above, choosing a particular health care provider depends on individual characteristics as well as the attributes of the choice and, accordingly, it is better to view (9) as a reduced form relationship rather than as a demand function. Survival Analysis Duration models have been extensively used in socioeconomic analysis in issues such as unemployment periods, education enrollment and social benefit schemes (Nickel1 et al, 1991, Meyer, 1990). There is also a rather extensive epidemiological literature on the duration of health conditions, among then infant, child and adult mortality (Masset and White, 2003). Theoretically, a survival function is first constructed as a reduced-form equation relating a set of determinants, xi, with the probability of observing an event, for example the death of an infant in a period or interval 't'. Interestingly, a survival function estimates 35 For simplicity the utility function is depicted as a linear function of the explanatory variables. At the time of empirical implementation appropriate alternative forms will be examined. 117 conditional probabilities that a particular event does not take place in a given period given that it has not occurred in previous periods. Also, survival models (such as the Cox Proportional Hazard model used in this study) typically assume that determinants of the survival process are time invariant throughout the analyzed period.36 Following Greene’s (2001) notation, let ‘T’ be a random continuous variable with a probability function f. This probability function indicates the number of periods elapsed until the studied event takes place in a period ‘t’. This probability function is dependant on a set of variables, xi, capturing anything from socioeconomic conditions to individual characteristics to any other factor that affects the duration of the studied event. Let F( ) be the cumulative probability of the duration variable, T. The probability that an event takes place in a period ‘t’ is given by: t F(t)= f,f(x)dx = Prob(T It) (10) Conversely, an underlying survival function indicates the probability that the duration of the process unfolding in the observed event takes ‘t’ periods to materialize is given by: S, (t) = 1- F(t)= Pr ob(T 1 t) (11) The survival function in (11) indicates that each period is independent of the previous as far as the probability of observing the event is concerned. This is typically not true in the kind of socioeconomic events like infant mortality or unemployment periods. More appropriately, a survival function can be expressed as a process of intertwined relations of xi upon F(t) conditional on survival in previous periods: S,(t) = (T = tlT 2 t) (12) In the case of infant mortality, ‘t’ typically represents the number of successive months within the first year after birth that the infant remains alive. Thus, the survival probability of remaining alive in the fourth month of life for an infant is the conditional probability that the infant survived the first, second and third month after birth. This (conditional) survival function in (12) can be expressed conveniently in the form of a hazard rate, that is, the ratio between the probability of failure (death), and success (survival) of an event taking place. As Jenkins (1995) shows, (12) can be re-arranged in the following way: I-1 h(t) S,(t) =Prob(T =tT >t) =h(t)-n(l-h(k))=-n(l-h(k))‘ k=l 1-h(t) k=l Cox and Oakes (1984), parameterized this conditional probability in the form of proportional hazards with respect to a baseline individual leading to the Cox Proportional Hazard model (CPH) explained below. Using maximum likelihood estimation, the CPH can estimate the unknown coefficients, pi, of a set of determinants, xi, on infant mortality. 36 This assumption can be easily relaxed, however. 118 Annex 4.2 Methodology of Estimating Per Capita Household Consumption in the ENDAMAIN (DHS) Survey The procedure to calculate per capita household consumption was developed by SIISE as part of the derivation of a Human Development Index (HDI) at the provincial level (UNDP 2001). The income variable of the HDI was proxied by per capita consumption as the consumption measure is considered to be more reliable than income estimates in household surveys. No existing survey provides representative data at the provincial level for this variable. For this reason two sets of survey data were combined: the 1998 LSMS, Encuestu de Condiciones de Vidu (ECV) and the 1999 Demographic and Health Survey (DHS). The former reports consumption data, but not at the provincial level; the latter has representative socio-economic data at the provincial level, but does not report consumption. The 1998 LSMS was used instead of the more recent 1999 LSMS, because the latter did not cover the Amazon region of the country. Observed consumption data from the 1998 LSMS survey were imputed to the households of the ENDEMAIN simple using a simulation exercise. The procedure is as follows: A set of categorical variables (XI, XZ,... , X, ) related to the quality of housing and other living conditions indicators was selected using an optimal scaling technique (principal components analysis). These variables were subsequently used as explanatory variables in a multiple regression analysis. Two regression models were specified, one for urban areas and one for rural areas using data from the 1998 LSMS survey. Monthly per capita consumption was taken as a dependent variable in a linear regression in the following general format: y = a, + a1 *XI + u2*X2 +... + u,*Xn, where y is per capita consumption, ai are the regression coefficients and Xi the selected qualitative variables. After validating and testing the regression models, the corresponding parameters were used against the corresponding values for the explanatory variables as measured in the 1999 ENDEMAIN survey to impute per capita consumption for each of the household members. Principal Components Analysis Valuation of categorical variables through the optimal scaling method is obtained by maximizing linear correlations between a given set of variables. This way qualitative variables are quantified and the optimal combination of variables is sought for use in regression models (that assume linear relationships). Figure A4.1, demonstrates the advantage of constructing an index of this sort, using statistical procedures. The arbitrary assignation of scores or weights to categorical variables (e.g. through policy evaluators) would not adequately discriminate between the different elements (Part Iin the Figure). For instance, if we had categorized the quality of housing with values 1, 2 and 3 to identify homes constructed with bricks and cement, wood, and “adobe,” respectively, we would not value the distances in quality as such. Instead, using optimal scaling, we obtain statistically derived weights that consider the distance between the units of observation based on maximum linear correlations (see part 11 of Figure A2). The first step in the procedure implies selecting and comparing common variables in both surveys. Variables were selected if they showed similar frequency distributions and those 119 showing very different frequencies were excluded. Valuation of the selected categorical variables was done on the basis of the 1998 LSMS survey using (non-linear) principal components analysis, which is part of the family of multivariate factor analysis. The objective of the procedure is to maximize linear correlation between two variables, to increase in this way the distance between observation units (in our case: households). It also allows one to distinguish ambiguous cases better. Figure A4.1 Assigning optimal scales to components of categorical variables. I Variable B I variables ajier applying optimal scaling model. / Element 2 after Element 1 after ODtilllidOn / Element 1 before ontimization I I 120 Table A4.1. Common Variables of 1998 LSMS and 1999 ENDEMAIN Surveys and Optimal Scaling of Categorical Variables. Variables Weights Variables Weights (score) (score) Type of housing (CEP-VIVI) Education household head (NIV-JEF) 1 Other -3,35 1 None -1,34 2 Shedl’choza” -3,35 2 Literacy campaign - 1,06 3 Mediagua -0,89 3 Primary -0,6 4 Rented room 0,39 4 Secondary 0,58 5 Apartment 0,39 5 Superior / university 1,91 6 House 0,39 6 Post-graduate 2,95 Tenancy of housing (CEP-TENE) Education spouse (NIV-CON) 1 Other -1,35 1 None -1,51 2 Tenancy in exchange for services -1,35 2 Literacy campaign -1,19 3 “Cedida” -1,35 3 Primary -0,7 4 Rented -1,35 4 Secondary 0,93 5 Own housing 0,74 5 Superior / university 2,44 Roof construction (CEPTECH) 6 Post-graduate 2,78 1 Other -1,71 7 No spouse -0,11 2 Palm leaves / “paja” -1,71 Area of residence (CEP-REG) 3 Teja -0,76 1 Rural Sierra -1,12 4 Zinc -0,57 2 Rural Costa -1,12 5 Etemit 0,85 3 Rural Amazonia -1,12 6 Hormig6n / bloque / ladrillo 1,62 4 Urban Amazonia 0,67 Floor construction of housing 5 Urban Costa 0,67 (CEPTECH) 1 Other -1,41 6 Urban Sierra 1,13 2 Dirt -1,41 Persons per bedroom (HACINA2) 3 Wooden -0,73 1 More than 4 persons -1,44 4 Cement / stones 0,19 2 3-4persons -0,79 5 Parquet / ceramic tiles 1,55 3 0-2persons 0,95 Wall construction of housing Sound equipment (EQUIPO) (CEP-PARE) 1 Other -1,74 1 Does not have -0,88 2 Bahareque -1,57 2 Has 1,14 3 Wood -1,29 Refrigerator (REFR) 4 Adobe -0,98 1 No -1,14 5 Bricks 0,73 2 Yes 0,87 Type of toilet (CEP-SSHH) Telephone connection (TELEFO) 1None -1,64 1 No -0,54 2 Latrine -1,35 2 Yes 1,85 3 Toilet and septic tank -0,20 Washing machine (LAVADO) 4 Toilet and sewerage connection 0,96 1 No -0,29 Electricity (CEPLUZ) 2 Yes 3,49 1No -3,23 Car (CARRO) 2 Yes 0,3 1 1 No -0,42 Energy for cooking CEP-COMB) 2 Yes 274 1 Other -2,36 Computer (COMP) 2 Electricity -2,36 1 No -0,22 121 Variables Weights Variables Weights (score) (score) 4,52 4 Gas 0,43 Television (TELEVI) Drinking water supply (CEP-AGUA) 1 No -2,03 1 River I lake / stream -1,94 2Yes 0,49 2 Open well -1,04 3 Piped water (shared access) -0,87 ,141. 3 Wood I carbon -2,36 2 Yes -0,48 6 Drinking water supply by truck 0,06 7 Piped drinking water in home 1,08 Sources: INEC, ECV, 1998; CEPAR, ENDEMAIN, 1999. Note: In parentheses is the label of the variable as used in the linear regression models. This table lists the selected variables with their corresponding values. The order and magnitude of the derived weights are as expected, that is higher scores (weights) reflect better living conditions. Regression Models Alter valuating the categorical variables, these were subsequently inserted into the consumption model, taking logarithms of observed per capita household consumption. The estimhtion results for urban and rural areas are, respectively: Rural areas (Adjusted R2= 0.832): Per capita consumption = exp( 13.570 13682)*exp(A-AGUA*O.O 19 1595822347977 + A-CARR0*0.20438937 1615797+ A-COMB"0. 1545491562636985 + A-CONY*0.0497950918830602 + A-EQUIPO*O.O426059807807566 + A-HACI*0.077 1703896456 176 + A-JEFE*O.116035513892694 + A-PISO*O. 10665 102293 1832 + A-REFR*O. 223 1434433 59268 + A-SSHH"0.037320867780 1488 + A-TECH"O.05 17787473764033 + A-TELEFO"O.05 17069259231406 + A-VIVI*O.O148335861089794 - A-MIEM"O.369007006249754) Urban areas (Adjusted R2= 0.765): Per capita consumption = exp( 13.8124792990525)" exp(A-AGUA*0.0469161683673776 + A-CARRO*O. 178953644054217 + A-CONY"0.035 1708061398845 + A-EQUIP0*0.063425 1606620911 + A-HACI*0.0725 197379069467 + A-JEFE"0.06604 13752052221 + A-PISO"O.03974 109 10875448 + A-REFR"0.0829802496 104904 + A-SSHH"0.05835 10687 159971 + A-TELEFO*O.O997 1696 14546676 + A-VIVI"0.03261474343 1203 - A-MIEM"0.526590305558633 + A-LAVA"0.0778544004268 161 + COSTA*0.058 106499 1569207 + ACOMB"0.0682568 172266 199) 122 The results were subsequently validated by reproducing the poverty incidence and average consumption levels between observed values of the 1998 LSMS and the imputed values of the 1999 ENDEMAIN surveys (see Table A4.2). Actual values are reproduced with great precision. Only in the case of Urban Costa is there a discrepancy of about 5 percent between the two estimates. In all other cases the difference is less than 2 percent. Table A4.2. Poverty Incidence and per Capita Consumption, According to Observed Values of the 1998 LSMS Survey and Imputed Values of ENDEMAIN Survey of 1999 Region Urban Areas Rural Areas Total Imputed Imputed Imputed (ENDEMAIN (ENDEMA Observed (ENDEMA Observed 1999) Observed IN 1999) (ECV 1998) IN 1999) Poverty Incidence (consumption) ( percent) costa 34.9 30 70 71.6 46.7 41.7 Sierra 22 20 69.1 69.8 45.5 46.6 Amazonia 27.7 27 58.6 59.1 52.6 49.6 Country 30.2 26 68.8 69.5 46.4 44.4 Per capita Household Consumption (1998 sucres) costa 455,610 4 16,9 19 246,183 215,711 384,878 358,842 Sierra 640,430 522,848 233,261 251,724 442,005 379,081 Amazonia 4473 11 413,795 277,594 284,947 310,928 322,573 Country 522,906 458,574 241,752 242,774 406,465 366,917 Sources: INEC, ECV, 1998; CEPAR, ENDEMAIN, 1999. In the demand for health services model, we use the consumption estimates for each household and individual. 123 2 B h o\ p: ce c t ti o\ x w I P aw: 5(I .IS ac c 8 ! i U n ec e ..f b% C ..i ..C w m 6 9 c 8 3 cr 0 Chapter 5 PENSION SYSTEM’ The pension system in Ecuador has several problems that prevent it from delivering adequate old age income security to the population. The coverage rate is one of the lowest in the region, as only one in seven individuals older than the minimum retirement age receive a benefit. Also, the system has a strong bias towards covering middle and high-income workers, as coverage of active workers in the highest quintile is five times larger than in the lowest quintile. However, the system imposes a significant cost to society, since the govemment is required by law to finance 40 percent of all benefits from general revenue, or about US$200 million in 2003. Given the low and skewed coverage, and the large subsidy, the system operates in a clearly regressive way. Also, the legal framework of the system is weak, and the institutional organization ineflcient. If govemment transfers are maintained, the system will have no sustainability problems for approximately 50 years, but if the scheme is reformed and the subsidy eliminated, financial problems will appear much sooner. To avoid these problems and redefine the role of the pension system in Ecuador, the govemment should: (a) review the legal framework of the system to create a simpler, more transparent model, and increase transparency in the system management; (b) expand coverage beyond formal sector employees, providing non-contributive benefits in a fiscally sustainable manner; (c) review the autonomous status of the Ecuadorian Institute of Social Security (IESS) to avoid political interference in the daily operations and transfer all policy design authority to a new instance within the central administration in charge of designing and implementing social security policies; and (d) eliminate the govemment contribution to IESS benefits, adjusting the parameters of the system to achieve actuarial sustainability in the medium and long term. I. Background and Status Quo 5.1 The pension system in Ecuador was created early last century, when some groups of civil servants gained the right to receive pensions after retirement. In the following decades the coverage of the system expanded to include other civil servant groups as well as private sector employees. Also, health, accidents and severance benefits were included in the program. In the last 30 years, a rural workers insurance (“Seguro Social Campesin0”- SSC) was created, and the programs for the police and the military were separated and new autonomous agencies (“INSSPOL” and “INSSFA”) were created. 5.2 The Ecuadorian Institute of Social Security (IESS) was created in the early 1970s, and currently manages both the “Seguro Social Obligatorio” - SSO (covering all civil servants and private employees) and the SSC. The programs are financed with employer and employee contributions, as well as contributions from the Treasury. Cross subsidies are an important element of the programs. SSO includes protection against disability, old age and death (IVM), 1 This paper was prepared by Rafael P. Rofman. 125 health (only for affiliated workers), maternity, work-related accidents and severance. SSC provides health coverage for the family group and retirement for the head of household. 5.3 Until November 2001, the system operated under a law originally approved in 1942, with many modifications. The Social Security system (including health, pensions, labor accidents, funeral expenses, severance, and other programs) was financed by contributions from employees, employers and the state. Although assets and accounting of the different programs were not separated, the regulations implied that contributions to the pension system amounted to approximately 8.4 percent of taxable wages, made up of employers (2.4 percent) and employees (6 percent), plus a state contribution of 40 percent of benefits. 5.4 Both contribution rates and benefits were defined as a percentage of the “basic wage.” Workers receive additional payments that are not included in the contribution calculations such as thirteenth, fourteenth, fifteenth, and sixteenth monthly wages, cost of living compensation, and other bonuses. As of late 1999, more than 90 percent of actual wages were defined as one of these special categories and, consequently, actual contributions are made on less than 10 percent of total wages. A law passed in early 2000 established that wages in the private sector should be “unified,” setting an implementation schedule that should be completed by January 2005. Also, a law simplifying the structure of civil servants wages was approved in early 2004. 5.5 Workers could retire with 30 years of contributions at 55 years of age for a “normal” retirement benefit, with some provisions to retire later if fewer contributions had been made. Benefits were proportional to the average of the best five years of earnings, and replacement rates ranged from 75 percent for those retiring with the minimum requirement to 100 percent for those retiring with at least 40 years of contributions. Under special circumstances, workers could receive a reduced benefit at age 45, with 25 years of contributions. 5.6 As with other economic variables, the Figure 5.1. Average Monthly Benefit for Retirees, in value of benefits the pension system had under SSO and SSC, in US dollars. 1994-2003 been strongly reduced by the late 1990s crisis and the dollarization in 2000. Average benefits s200, were around US$lOO in the mid 199Os, but declined to about a third of that value by 1999. However, beginning in 2000 benefits began to recover and, after strong increases in 2002 and 2003, the average reached US$l85 per month, :jS40 Ldi almost twice the average of the mid nineties. In the case of the SSC, the benefit amounted to so 1994 1995 1596 1997 1598 1999 2wo mol 2w2 mo3 2w around US$23 in the mid nineties, or 25 percent of the average old age benefit for SSO. The Source: IESS decline in the late nineties was equally sharp, and the benefit was set at US$3 per month after the dollarization in 2000. In a departure from the policy applied to retirees under the contributory scheme, this value has not been increased, and by 2003 the old age beneficiaries of SSC were receiving a benefit worth 1.6 percent of the average in SSO. (See Figure 5.1). 5.7 The wide variations in the real value of wages and benefits resulted in equally wide variations in the financial status of the pension system managed by IESS. The flows of revenue and expenditures during the 1990s produced a sustained surplus. After a decline in 1998 and 126 1999, a rapid increase in revenue and expenditures began in 2000, due to the dollarization, wage unification and increases in benefits. The system has maintained a surplus of around 0.2 percent- 0.4 percent of GDP for most of the 1990s, and had a rapid growth after 2000. The surplus reached 0.8 percent of GDP in 2002, to decline later. The expected result for 2004 is a surplus of 0.5 percent of GDP. (See Figure 5.2). 5.8 Instituto de Seguridad Social de las Fuerzas Armadas (ISSFA) and Instituto de Seguridad Social de la Policia Nacional (ISSPOL), the army and police systems, have large Figure 5.2. Revenues, Expenditures and Result of deficits and require continuous subsidies ESS Pension System, 1993-2004 (% GDP) from the government, as is the case in most systems dedicated to provide retirement to 2.5 I I the military and police forces around the 2.0 world. The contributions to the retirement system for the military covers less than 40 1.5 percent of expenditures, and government transfers were US$65 million in 2003. In the 1 .o case of the police forces, the percentage of expenditures financed by contributions is 0.5 close to 50 percent, and annual transfers from the government are around US$25 1993 1994 1995 1996 1997 1530 1999 2wo 2W1 MM 2W3 2004' million. 'ote: ( *) Projected 5.9 The origin of the deficits can be Source: IESS found in the design of these systems. While contribution compliance is 100 percent, individuals are forced to retire young, due to the particular characteristics of their activity. As a result, more than 90 percent of the new retirees in ISSFA in 2002 were younger than 50, while 75 percent of new retirees at ISSPOL were in the same age group. Given this tendency, the system dependency ratio (that is, the number of retirees that must be supported by each active contributor) is very high for both systems. In 2003, there were 82 beneficiaries per 100 contributors at Instituto de Seguridad Social de las Fuerzas Armadas (ISSFA) and 57 beneficiaries per 100 contributors at Instituto de Seguridad Social de la Policia Nacional (IS SPOL). 5.10 The difficult financial situation of these funds does not necessarily imply that a reform is needed. As mentioned before, this situation is common in pension funds serving these populations in many countries, and it is unavoidable as retirement is compulsory in many cases. 11. The 2001 Reform 5.11 After several years of debate, Congress approved a new Social Security law in November 2001. This law introduced parametric and structural reforms to the system. The most relevant parametric changes included an increase in the minimum retirement age to 60 years (to be fully implemented in 2006), and the decision to revise the minimum retirement age every five years, in order to maintain a life expectancy of 15 years after retirement. Enrollment in the system continued to be compulsory for all employees, in both the public and private sectors, and the requirement was extended to the self-employed. 127 5.12 The new law mandated complete segregation of assets and accounts between the different programs, an2 and established the total contribution rate for the pension system at 8.5 percent, of which employees would contribute 5 percent (if private employees), 7 percent (if civil servants) or 8.5 percent (if self employed), and employers would contribute the rest. Also, the “reserve fund,” into which employers are required to deposit one monthly salary per year, would be paid to the worker only ifhe gets fired, becomes disabled or retires, or to the family if the worker dies. By blocking the possibility of withdrawing the balance of this fund every few years, the law aimed at associating this reserve with the accumulated retirement funds. 5.13 The new law created a multipillar system, with private participation in management and individual accounts for accumulating contributions. The design was a variation of the model implemented in Uruguay in the mid 1990s, where all workers are required to participate in a PAYG scheme (called “Regimen de Jubilacion por Solidaridad Zntergeneracional”). Employees must make contributions from their salaries, but only on the first US$165 a month of salary. In the case of employers, the maximum would be US$500 a month (plus a 5 percent contribution on wages over US$500 a month). A second scheme, based on individual accounts, was called “Regimen de Jubilaci6n por Ahorro Individual Obligatorio.” Employees’ contributions on the portion of wages that exceed US$165 but are below US$500 would be directed to this scheme. These contributions would be managed by specialized managers (“Entidades Depositarias del Ahorro Previsional-EDAP”) and on retirement, an actuarially fair benefit would be calculated and paid in monthly installments. Workers earning less than $165 a month had the opportunity to join the funded scheme on a voluntary basis, splitting their contributions in equal parts among the two schemes, and those earning more than US$500 a month may voluntarily contribute on the amount that exceeds US$500. 5.14 For the transition period, the law established that workers older than 50 years of age at the time of the reform would not join the funded scheme (regardless of their wages), and that all workers younger than forty would be required to join. For those aged 40 to 50 years old, they would have a one-time option to join the new scheme or stay with the old PAYG model. No transitional benefits (such as compensatory benefits or recognition bonds) were considered. 5.15 The Government has not published official estimates of the fiscal cost of the reform or how it would be financed. Independent estimations indicate that around 10 percent of IESS contributors (that is, 2 percent of the labor force) would qualify to contribute to the funded scheme. The wage unification process should increase this percentage, but even so the magnitude of the new private system and the fiscal cost of its implementation should be minor. 5.16 Several aspects of the law have been strongly criticized. Many articles appear to be contradictory, although that could be solved through an adequate regulatory decree. Also, the law has been considered to be too vague in some aspects. For example, it gives a major role in the investment process to the Technical Investments Commission (“CTI”), an autonomous office within IESS, but this role is not clear. According to the law, assets from the funded scheme will be invested following policies defined by CTI, which will hire EDAPs to manage the funds. These “investment policies” are not defined, and they could be anything from general guidelines regarding security and prudence to actual portfolio strategies. Most of the supervisory authority corresponds to the Superintendency of Banks, but there are some gaps in responsibilities that 2 The law also established a 0.8 percent contribution to finance administrative expenses, to be paid by employers or the self employed. 128 should be clarified. Also, a minimum return guarantee may be offered by the EDAPs, but the conditions of this minimum are not established and left open to be defined by each EDAP independently. 5.17 A few weeks after Congress approved the new Social Security Law, several deputies and other political groups challenged it in the Constitutional Court. The court ruled that several articles (including those that defined the distribution of contributions among IESS and EDAPs) were unconstitutional but, due to technicalities, the decision was never published in the Official Registry. As a consequence, a legal void was created and there are several interpretations of the legal status of the system. 5.18 A first interpretation is that, given that the Court ruling was never published, it has no force. Thus, JESS should proceed to prepare the regulatory decree and, once approved, implement the new system as defined in the law. Others believe that a corrective law, modifying a few articles should be approved in Congress and then the legal problems would be solved, while a third sector considers that the law is inapplicable and that a new, complete draft should be prepared and discussed. 5.19 TESS began applying some articles of the new law, in particular those that are not disputed. However, the discussion regarding the constitutional status of the new multipillar system has not progressed and, more than two years after the law was originally approved, there has been no decision regarding its future. The controversy has been as much technical as political, and a solution will require a consensus that has been difficult to reach in the past. 111. The Main Problems of the System 5.20 The main problems of the pension system in Ecuador can be identified by considering its basic goal and comparing it with actual performance. Any pension system should aim at providing income security for the elderly in an efficient and sustainable way, avoiding undesired intragenerational and intergenerational transfers or negative effects on the labor markets. Ecuador’s system has serious problems regarding its performance as provider of adequate income for the elderly, its distributive effects and its effects on the fiscal situation. First, coverage is so low that it can hardly claim to be providing income security to the elderly. In fact, only one in seven individuals old enough to retire receive a benefit, and most of them live in middle and high-income households. A second problem goes to the efficiency, institutional arrangements and transparency, as some operative procedures of IESS have been questioned, the legal and institutional frameworks conspire to limit the effectiveness of the system and the access to information is limited. Third, the pension system in Ecuador is one of the most important redistributive tools in the economy, although this is not explicit. Forty percent of benefits are financed by the government with general revenues, representing close to US$175 million in 2003. As this subsidy reaches only those receiving benefits, the low coverage produces undesired redistribution within and across generations. While required by law, the government did not made these contributions during a 15-year period (from 1985 to 2000), generating a significant debt whose payment has been the subject of controversy. A final problem is the medium and long-term sustainability of the system. The existing projections indicate that the system may be sustainable as it is today for more than 50 years, as long as the government transfers continue, but any change in this provision would require a more careful assessment of policy options. 129 A. Coverage 5.21 The pension system coverage in Ecuador is very low. Slightly over one in four workers contribute to the national pension system, or one in three if participants in the SSC and the military and police systems are considered. The low participation rate is directly linked to the extended informality in the economy. While participation slowly grew during the last few decades of the last century, a steady decline began in 1995, as the turmoil in the economy reduced the job creation rate in the formal sector and the population searching for a job continued to grow steadily. (See Figure 5.3). 5*22 The situation among the is Figure 5.3. Coverage of the Pension System Among critical. According to data from EsS, Only Active Workers 1993-2003 one in seven individuals older than 55 receives a benefit from the national pension system. This ratio grows to one in four for those older than 65 and one in three for those older than 75, but it still is much lower than in other countries in the region. Low access to benefits among the elderly is a consequence of the combination of two factors; first, the high prevalence of informality at younger ages, as workers reach retirement age without enough 1965 1970 1975 1980 1985 1990 1995 2000 2005 contributions to qualify for benefits; and Source: IESS second, the contributive character of the pension system, which is designed to protect only those in the formal sector. As most workers in Ecuador do not participate in the formal economy, they cannot receive benefits from IESS. 5.23 The benefit is low (US$3 per month), and the number of beneficiaries is approximately 20,000, less than one tenth of the number of retirees under SSO. This low figure can be explained by the relative youth of the rural system (a couple of decades), and the limited coverage of the system (it covers 200,000 families, approximately 25 percent of the rural population). 5.24 Aiming to address the low coverage problem, the 2001 Social Security Law created a new benefit, called “Non contributive universal benefit.” Individuals older than 70 could qualify to receive it if their total income is below 50 percent of the minimum contributory wage, approximately US$60 per month as of 2003, and they do not receive any other public subsidy. The benefit would be equivalent to the amount necessary to bring the individual total income to US$60 and would be financed by the federal government. While this new program could be a significant step to increase old age income protection in Ecuador, neither the Ministry of Finance nor IESS have prepared, or are planning to prepare, an analysis of its fiscal impact or the technical requirements to implement it. 5.25 Also, in 1998 the government created a program called “Bono Solidario,” to replace energy consumption subsidies (which were reinstated a few months later). The program benefited mothers of small children and the elderly. By early 2003, nearly 230,000 individuals older than 65 were receiving a US$7 monthly benefit. This program was replaced by a new, family based conditional cash transfer scheme called “Bono de Desarrollo Humano” in July 2003, and benefits for the elderly were increased to US$11.50 per month. 130 B. Efficiency, Institutional Arrangements and Transparency 5.26 The pension system has several efficiency problems that need to be addressed. While there are no formal evaluations of client satisfaction, it is common to see complaints in the media and in informal conversations with workers and beneficiaries regarding quality of services, including delays in obtaining benefits and other administrative procedures. As the Banks and Insurance Superintendency began to control IESS operations with regard to financial transactions, several problems have surfaced. For example, the Superintendency has noted that IESS does not have a system in place to identify and assess arrears on payments of personal credits from affiliates. Also, problems in the collection process have been detected, in particular with the mechanisms to recover contribution arrears from private employers. 5.27 The institutional arrangement of the pension system in Ecuador differs from the situation in other countries in the region, as there is no government dependency in charge of planning and policy development in the area of Social Security. IESS is an autonomous institution with constitutional status, as a section of the Constitution defines the basic design of the social security system and establishes that IESS is responsible for managing it. The Constitution also prescribes that the Institute be headed by a tripartite committee (employers, affiliates and government), with political independence. IESS interpretation of its autonomous status has led it to operate as a non-governmental agency, with little coordination with Ministries or other government agencies. 5.28 Given that no Ministry or other dependency in the central government is formally responsible for developing and implementing social security policies, there is no clear counterpart for IESS with regard to policy decisions. The Ministry of Finance has an active role discussing problems from a fiscal perspective, but little attention has been paid to the social protection aspects of the system, including its effects on equity and its role in poverty alleviation strategies. With support from the World Bank, an inter-institutional commission for Social Security was created in 2003. This commission is made up of representatives from the Ministry of Finance, the Central Bank, Superintendency of Banks and Insurance, IESS, ISSFA, and ISSPOL. The commission has provided a useful venue for discussing problems and approaches, and is preparing a document detailing a fiscally sustainable strategy to expand coverage and improve efficiency in the system in the medium and long run. If this goal is achieved, the commission could be empowered and transformed into a stronger institution in charge of developing social security policies in Ecuador. 5.29 Following the 2001 law, IESS has separated the accounting systems for the four insurance schemes it manages (pensions, labor accidents, health, and SSC) and a fifth program to finance administrative expenses. Budgets are prepared for each program independently, and their execution is processed monthly. While the budget for each scheme includes administrative expenditures (the pension system expects to spend US$5.3 million on personnel and other expenses, or 1 percent of expected benefits, in 2004), the general administration budget for personnel and supplies is close to US$40 million. 5.30 The pension system in Ecuador has a serious transparency problem. IESS does not publish any report describing the current status of the programs it manages or the expected evolution in the medium and long term. IESS’ web page (www.iess.gov.ec) presents some financial and actuarial information, but there are no regular updates or detailed data. While IESS has an actuarial division, it does not have any regular analytical program to assess the evolution 131 of the financial and actuarial status of the system. The Superintendency of Banks, in its role as regulator, has recently begun to require information on a regular basis, but has published no data. The lack of public information is critical, as IESS operates as a “black box” for most of the population, and some data officially provided has been considered inconsistent. C. Central Government Contributions: Distributive and Fiscal Effects 5.31 As the pension system confronted some medium and long-term financial problems in the mid 1950s, a reform to the Social Security law established that the government would finance 40 percent of the benefits on a current basis, assigning funds from the federal budget. This contribution was meant to avoid an actuarial imbalance, although current flows generated surpluses at that time. The government has paid the contribution since then, with the exception of a fifteen-year period (1985 to 2000) when a significant debt accumulated. In 2000 payments were resumed, although some delays have been reported during 2003. 5.32 The goal of this contribution is to avoid an actuarial imbalance in the system. As total contributions were around 8.4 percent and benefits were expected to average 55 percent3 of previous wages, the implicit dependency ratio (that is, the number of retirees per hundred active contributors to maintain a financial balance) was close to 15 percent. Thanks to the government transfer, this ratio was increased to 25 percent, meaning that as long as there are less than 25 retirees per hundred contributors in the system, there will be a financial surplus. Given the relative youth of Ecuador’s population, reaching these goals has been possible, as the population dependency ratio (that is, the ratio of population aged 60 and more to the population aged 20 to Figure 5.4. Population Dependency Ratio, System 59) has been around 14 percent for the last Dependency Ratio and Ratios Needed to Balance IESS’ couple of decades. Pensions Under Different Assumptions,1980-2005 30% 5.33 Because not all young adults contribute to the system, not all older 26% adults receive a benefit, and some young 22% adults receive a benefit, the actual system 18% dependency ratio (that is, the ratio of 14% actual retirees to actual contributors in the 10% 1980 1965 1990 1995 2000 2005 system) is not the same as the ratio for the +Population dependency ratio population as a whole. In Ecuador the -+-Ratio necessary to balance IESS pension mthout system ratio has been higher than the 40% +Ratio necessary to balance IESS pension mth 40% population’s, especially since the mid- .. 1990s when the number of contributors stagnated and beneficiaries continued to Source: CELADE and IESS grow. The ratio has been significantly higher than the 15 percent mark since the mid-l990s, indicating that if benefits had been paid at the 55 percent average replacement rate, the system would have been dependent on government contributions and other revenues to avoid current deficits. As actual benefits have been lower (the average replacement rate in 2002 was 26.5 percent), the system was close to equilibrium even before the 40 percent government contribution was considered, but the increases in benefits of 2003 (which brought the average replacement rate to 39 percent) affected the balance sheet of 3 This is the average replacement rate considering old age, survivors, and disability benefits. 132 the pension system, and the government contribution became necessary to avoid a deficit. (See Figure 5.4). 5.34 Avoiding actuarial imbalances has had a significant cost, both in fiscal and equity terms. Since current balances have surpluses, the 40 percent transfer has represented an effort by the government to pre-finance future deficits. Given the fiscal problems of Ecuador’s government, this approach to solve the medium and long term problem is too costly in the short run, especially considering that part of the surpluses of IESS are lent back to the government. As of 2003, approximately US$175 million should have been transferred to IESS to cover these benefits, or 0.65 percent of GDP. This figure has been growing since 2001, when the transfer was only 0.2 percent of GDP, and given the increases in benefit levels, is expected to reach 0.75 percent of GDP in 2004. 5.35 The government transfer creates not only fiscal problems, but it also raises a question of equity that should be considered. The 40 percent contribution represents a subsidy from society as a whole to the relatively small group that participates in the pension system. The population covered by the system is mostly middle income, but a significant part of their benefits is financed by all Ecuadorians, including the poorest. The magnitude of this subsidy is very similar to the total budget of the main social assistance program in Ecuador, the “Bono de Desarrollo Humano,” although, in that case, the program is targeted and the number of beneficiaries is four times larger than the number of retirees in the pension system. D. Central Government Debt to IESS 5.36 The government contribution to finance pension expenditures was established in 1956, aiming to reduce a long-term fiscal sustainability problem. However, fiscal restrictions prompted governments to stop payments in 1985, which were then resumed in 2000. During this period, a significant debt accumulated, and its magnitude and payment has been subject of controversy in recent years. 5.37 The 1998 Constitution addressed this problem, stating that the debt should be paid in ten annual installments. From 1999 to 2001 a working group integrated by representatives of IESS and the Ministry of Finance collected information and produced a report indicating the total debt as of December 2001 was 9.8 million sucres and US$90 million. While there was agreement on these figures, the criteria to convert the debt to US dollars were never agreed. While IESS considered that it should be converted into US dollars using the exchange rate prevalent at the time the debt was originated, MEF proposed that the total debt should be converted to dollars at the 1/25000 rate used to dollarize the economy. The first approach resulted in a total debt of US$2.05 billion, while the second produced a debt of US$392.5 million. These figures were later increased, and the estimates as of late 2003 were around US$2.2 billion and US$450 million. 5.38 The argument between the government and IESS has become one of the most controversial aspects of the system. IESS officials have argued that the lack of payments is a serious cause for instability, since the interest payments should be used to pay benefits and they are not being collected. Also (as discussed in the next section) the magnitude of the actual debt is critical to define the medium and long-term sustainability of the system, as the difference between the two figures has a significant effect on the actuarial balance. In February 2004, the Minister of Finance announced that an agreement has been reached, and the total debt was determined to be US$549 million. The form of payment remains to be settled in the near future. 133 E. Medium and Long Term Perspectives 5.39 In the context of a technical training project, the World Bank Figure 5.5. Population DepenQncy Ratio and System Dependency Ratio for IESS, 2000 2075 prepared a simulati on of the medium llo% - and long-term perspectives of the pension system in Ecuador, using Pension Reform Options Stimulation 70% Toolkit (PROST), a pension 50% simulation software developed by 30% Bank staff and applied in more than 80 10% countries around the These 2000- 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060 2065 2070 2075 simulations, as in any other case, are --t kpulation dependency ratio -t- Ratio necessary to balance IESpension w ithout 40% not predictions but Only the expected +Ratio necessary to balance lsspensionwith 40% outcome given a set of assumptions -System Dependency Ratio about the future. Given the history of Source: CEMDE and IESS the volatility of rules and parameters in recent years (for example, the real value of benefits declined by 70 percent from 1995 to 2000 and then grew by 500 percent), it is clear that the results of the simulations must be considered possible scenarios and not predicted outcomes. 5.40 Assuming that the coverage level does not change, the system dependency ratio will continue to grow, partly due to the overall population aging process, but also because of the maturation process within the system. After a small decline in the next few years (due to increases in retirement age), the ratio should reach 30 percent by 2028, 50 percent by 2042, and over 90 percent by 2075. Of course, such a dependency ratio is unsustainable, as contribution rates to balance the system would have to be over 50 percent. Consequently, the system parameters will have to be adjusted in the future. 5.41 Pension expenditures in IESS should slightly decline in the next few years and then start rising, as the effect of increases in retirement age is offset by the larger number of workers reaching the minimum required age. As revenue will exceed expenditures for several decades, fund reserves should reach approximately 18 percent of GDP by 2035, assuming a real return of 2 percent. However, the sustained increase in the number of beneficiaries will start to affect the finances, as total expenditures should Figure 5.6. Expected fiiancial flows for IESS’ pension reach 3 percent of GDP by 2033 and system, 2000-2075 over 5 percent by 2050. Since revenue I from contributions, government transfers, and other sources (including returns from investing reserves), will increase at a much lower rate, cash flow will become negative by 2044, and reserves will be completely exhausted by 2057. 5.42 Figure 5.6 shows that the pension system run by IESS can be I MM 2005 2010 2015 2020 2025 m30 2035 2040 ZMS zoso 2055 2050 2065 2070 financed under the current conditions 2ws Source: PROST 134 for approximately fifty years, as long as government transfers continue to grow with expenditures. However, this assumption implies that the subsidy to the pension system will reach 3 percent of GDP, a rather expensive policy considering that it will still only reach one quarter of the population. Policy makers should question whether the current model should be maintained, given its regressive effect. If the government contribution is eliminated beginning in 2005, the cash flow would become negative by 2025, and reserves would accumulate up to a maximum of 3.6 percent of GDP by 2020, and be completely spent by 203 1. 5.43 In either case (with or without government transfers), the implementation of some reforms to make the system sustainable Figure 5.7. EKpected Financial Flows for IESS’ Pension Sgtem, is unavoidable, although the time frame Assuming no Government Transfers Sine 2005-2000-2075 in which they must be adopted changes. I Corrections to age of retirement, I contribution rates andor expected replacement rates will be necessary, and the government must begin % 4% L analyzing options to develop and 8 056 implement them progressively. Otherwise, the risk of creating an -4% additional source of fiscal stress with no significant welfare outcome is high, -6% 2ooo 2035 2010 2015 Xeo Xe5 p30 2035 2040 .?W5 253 2035 203l 2035 20x) M75 with the obvious negative consequences for the country’s Source: Bank staff using, PROST development prospects. (See Figure 5.7). 5.44 Changes in the assumptions used to prepare these simulations may yield different results, especially with regard to: a) the rate of participation in the system (increasing coverage would result in better finances in the short and medium term, and larger deficits in the long term); and b) the returns obtained by investing accumulated assets which, if larger than assumed, would result in a delay of the date when reserves become exhausted. 5.45 In July 2003, the Major of Guayaquil presented a proposal to decentralize the Social Security system, creating a municipal system in Guayaquil that would replace the national scheme for workers living or working within city limits. According to his estimates, the new municipal system would cover 220,000 workers, or 20 percent of those currently covered by IESS. 5.46 The proposal specified that the new municipal insurance scheme would cover the programs currently managed by IESS, including health, pensions, work-related accidents, and the rural workers insurance (SSC). IESS would transfer all active workers covered by these programs, as well as the corresponding assets from the financial reserves, to a new administrative agency at the municipal level. The pension system would continue to be ruled by the national Social Security Law, and all benefits would be defined and adjusted in coordination with IESS. 5.47 Guayaquil’s proposal did not introduce important changes to the existing system. While some differences are to be found regarding health insurance (mostly, the possibility of contracting out services), the pension system would continue to be managed as before. Since only active workers would be transferred, the new system would have a significant surplus for 135 several years, until maturation, while the decentralization would produce financial problems for IESS. 5.48 Authorities at IESS rejected the decentralization idea. However, they also proposed the implementation of a decentralization process in the investment of assets. In this model, the Municipality of Guayaquil would manage part of the system’s reserves, focusing on investment in housing through individual mortgages. Further discussions, as reported in the media, included the idea of creating a municipal EDAP, to manage assets in the funded pillar of the new pension system. 5.49 The public debate regarding this proposal has been strongly affected by political interests, and the technical analysis of advantages and negative effects has been limited. The main argument in favor of decentralizing all or part of the system is that, having shown a strong proactive attitude with regard to other areas in recent years, the Municipality of Guayaquil might have the strength to develop a more modem and efficient administration system. Also, the proponents have made references to a “better management of contributions,” that would result in higher economic growth and general welfare. 5.50 However, there are many problems and risks that must be considered. First, even if Guayaquil proves to be an efficient administrator, there is a significant probability that other municipalities with a weaker record will follow its example, and the system could rapidly become fragmented. The existence of several independent social security agencies with a level of autonomy similar to the current one for IESS would most likely result in divergent pension systems, with problems of inequity, portability of acquired rights and supervision. Also, the fragmentation process could result in serious sustainability problems for the national system, as it would lose the contribution flow corresponding to relatively better paid workers in richer, more dynamic municipalities, while it would have to continue paying benefits to all retirees. To prevent these risks, technical studies should be developed. IV. Conclusions And Recommendations 5.51 The pension system in Ecuador is currently in a legal limbo, as the existing legal framework cannot be applied and the political climate has not been favorable to discussing and adopting a new one. The managing institution applies some rules as defined by the old law and others following the 2001 law, creating a dangerous level of instability that affects the credibility and efficiency of the system. While the system does not face immediate financial risk, a rigorous evaluation indicates that it is not performing as it should. Low coverage, inadequate institutional arrangements, costly and inequitable subsidies, and long term sustainability risks are some of the most critical problems that the system has to solve. The Government should develop and implement several policies aiming to solve or reduce the effect of these problems. Some of the most urgent recommendations are: Adopt an inclusive approach in the design of the pension system to expand it toward a social protection system and provide income security to groups with little or no coverage but great needs, in a fiscally sustainable manner (for example, using part of the current subsidy to the pension system to finance a non contributive scheme). 136 0 Revise the institutional design of the sector, creating a leading agency (ente rector) within the central administration in charge of designing and implementing social security policies. Review the autonomous status of IESS to avoid political interference in daily operations and transfer all policy design authority to the instance mentioned in the previous point. 0 Increase transparency, by adopting a permanent program to prepare, disseminate and evaluate information on the status of IESS and the different programs. 0 Solve the government’s debt with IESS, by setting a payment program. Explore whether it is possible to gradually reduce the government’s contribution to IESS benefits, adjusting the parameters of the system to achieve actuarial sustainability in the medium and long term. 0 Review the legal framework of the system to create a simpler, more transparent model. A structural reform (including the creation of individual accounts and private management) may be an option, but only if it can be implemented with a reasonable social and political consensus and in a fiscally sustainable way. 5.52 None of these proposals can be easily implemented in the short term, and their fiscal cost easily estimated. Factors like salary verification, government’s contribution, review of minimum pensions and financial sustainability in the medium-term affect them. Applying reforms they will require strong political support from the highest levels of the government and civil society. However, the alternative is to maintain the current status quo, where the system is becoming increasingly costly and inefficient, and plays a minimal role in social protection policy . 137 References Banco Central del Ecuador (varios aiios) Boletin Estadistico Mensual. Centro Latinoamericano de Demografia (CELADE) (200 1). Amtrica Latina. Tablas de Mortalidad. Santiago de Chile. Centro Latinoamericano de Demografia (CELADE) (2004). Estimaciones y Proyecciones de Poblacibn, 1950-2050. Santiago de Chile. Comisi6n Interventora del Instituto Ecuatoriano de Seguridad Social (2003), Rendicidn de Cuentas de las Actividades Realizadas y 10s Resultados Alcanzados. Agosto- 1998; Marzo 2003. Quito .~ Consejo Nacional de Desarrollo (CONADE) (1992), Ecuador Siglo XXI. El Desarrollo del Seguro Social en el context0 Socioecondmico. CONADE-GTZ, Quito. Lo Vuolo, Rubtn y Mesa Lago, Carmelo (1998). Social Security in Ecuador. En Cruz Saco, Maria y Mesa Lago, Carmelo (eds) “Do Options Exist?” University of Pittsburgh Press, Pittsburgh. Logaritmo Consultores (2001) Estudio Actuarial del Instituto Ecuatoriano de Seguridad Social, Quito. Mesa Lago, Carmelo (1989). Ascent to Bankruptcy: Financing Social Security in Latin America. University of Pittsburgh Press, Pittsburgh. Mesa Lago, Carmelo (1991) Social Security and Prospects for Equity in Latin America. World Bank discussion paper #140. Washington, DC. Ojeda, Gal0 Abril (1991). “El Sistema Previsional Ecuatoriano.” En Uthoff, A. y Szalachman, ’ R. Sistema de Pensiones en America Latina. CEPAL-PNUD, Santiago de Chile. Pallares-Miralles, Montserrat (2003). A Brief Simulation Analysis of the Public Pension Systems in Ecuador. Preliminary Draft for Discussion. Washington, DC. PNUD, Indicadores de Desarrollo Humano, Ecuador 1999. Rofman, Rafael (2003) “The Pension System” en Fretes-Cibils, V., Giugale, M. y Lopez-Calix, J. Ecuador. An Economic and Social Agenda in the New Millennium. The World Bank, Washington, DC. 138 CHAPTER 6 TEACHERABSENCEAND INCENTIVES IN PRIMARY EDUCATION:12 RESULTS FROM A NATIONAL TEACHER TRACKING SURVEY IN ECUADOR High rates of absence of teachers from their posts is a serious obstacle to delivery of education in many developing countries, but hard evidence on the problem has been scarce. This study, carried out as part of a new multi-country survey project in health and education, is the first systematic investigation in Ecuador into the extent and causes of employee absence from primary schools. Data from our nationally representative survey reveals that teachers in Ecuador are absent from their posts nearly 14 percent of the time. While this overall absence rate is relatively low compared with those of other survey countries, it remains high enough that it is likely to impede leaming. Moreover, it is higher in particular areas, with the absence rate exceeding 16 percent in urban areas other than Quito, and appears to be concentrated in particular teachers. We identify several important variables that are associated with increased absence: community characteristics, such as poverty and urbanization; and poor monitoring and discipline, including infrequent use of discipline by the school director, low rates of school inspections, and distance from the nearest Ministry of Education ofice. By contrast, we do not find strong or unambiguous efSects of variables proving for working conditions at the school, nor of monitoring of teachers by communities and parents. Finally, the findings do not support the idea that moving to non-fomal or contract teachers will solve the problem of teacher absence by creating a more “incentivized ” teaching force. 6.1 Ecuador is one of the 189 countries that have pledged to meet the Millennium Development Goals (MDGs), which aim at eradicating extreme poverty and improving the living conditions of poor people. Education figures prominently in these goals: one goal is to achieve universal primary education for all children by 2015, while another is to eliminate the gender gap in basic schooling. 6.2 Ecuador is on track to meet both goals, as well as other desirable educational outcomes. It has already achieved high net enrollment rates in primary education 1 This paper was prepared by F. Halsey Rogers, Jose Lopez-Calix, Nazmul Chaudhury and Jeffrey Hammer (all World Bank), Nancy C6rdoba (CEDATOS), and Michael Kremer and Karthik Muralidharan (Harvard University). A preliminary version served as contribution to the World Development Report 2004. 2 The Latin America and the Caribbean Region of the World Bank (LC6) funded the survey on which this study was based, and the UK Department for International Trade and Development also provided funding for the study through its generous support for the World Development Report 2004’s “Provider Absence in Education and Health” research project. We are grateful to the dedicated and professional survey enumerators at CEDATOS for their work collecting the data for this paper, and to Mona Steffen for her assistance in cleaning and preparing the survey data for this paper. 139 (probably well above 90 percent), and has achieved a higher average of years of schooling (7.3) than the mean for the Latin American countries. Literacy rates are also relatively high, at above 90 percent on average. Finally, Ecuador has essentially eliminated the education gender gap, with educational outcomes of the female population rising faster than that of males (Vos and Ponce, 2004). 6.3 Nevertheless, attaining the goal of universal basic education is not guaranteed. Ecuador’s educational system continues to face serious problems in several areas. Access to secondary education is low, with net enrollment well below the LAC average at only 50 percent. Inequalities in access to education between urban and rural and between rich and poor are significant. Ethnic inequalities loom large, with the literacy rate for indigenous groups estimated at below 72 percent. Ecuador does spend more on education than on other social sectors, with budgeted education outlays (2.6 percent of GDP) in 2004 represented more than half of total social spending (4.8 percent of GDP); nevertheless, education expenditures are low compared to LAC average close to 5 percent of GDP. They are also on a long decreasing time trend it appears that spending on education has dropped from 4.3 percent of GDP in 1980 (Vos and Ponce, 2004). As a result of spending cuts, needed investments in education are not being made, school maintenance is minimal and teachers’ salaries have been reduced in real terms. It has been argued that these changes have contributed to a higher turnover rate among teachers and absenteeism (Rojas, 2003). 6.4 Problems in the educational system go beyond limited access and limited resources. The system also features important shortcomings in its internal efficiency indicators, which relate educational inputs to outputs. The most commonly used indicators refer to repetition and desertion rates. If we compute the ratio of the number of students that completed a given level of education to the ideal number of students that would have reached that level with zero repetition and desertion, we find that it is only 88 percent; worryingly, that ratio deteriorated slightly in the 1990s. The decline in primary schooling efficiency appears to be concentrated in urban schools (Vos, 2004); surprisingly, as the analysis below will show, so does the problem of teacher absence. 6.5 Efficiency indicators like retention rates and education quality are likely to be affected by teacher absence. The little information available on absence in Ecuador suggests this is a problem, but few studies have explored it carefully. For instance, Rojas (2003) cites evidence that during the past 15 years an estimated one month per year on average has been lost because of teacher strikes, and in poorer areas an average3 of nine school days per month is lost because of teachers’ strikes and absenteeism. The last long school strike in Ecuador, which took place in early 2003, closed public schools for six weeks. Thus, exploring the determinants of teacher absence is a pressing subject for research. 3 Unlike our estimates in this paper, this one was not based on direct observation of absence, nor on a representative sample of schools. 140 I. Literature Review: What Do We Know About Teacher Ab~ence?~ 6.6 The problem of high levels of absence among teachers- extent, causes, and effects - has not been widely studied in a development context. Even in Organization for Economic Co-operation and Development (OECD) countries, the literature on provider absence is relatively small and has failed to produce many robust conclusions. 6.7 For the case of developing countries, there are some limited findings on the extent of absence from primary schools, but until recently, they have been based on nonrepresentative surveys or surveys that are representative only of particular regions. For example, Glewwe, Kremer, and Moulin (1999) found that teachers in one area of Kenya were absent from school 28.4 percent of the time, and in school but absent from their class an additional 12.4 percent of the time. The 1999 Public Report on Basic Education for India found that one-third of head teachers were absent when Public Report on Basic Education (PROBE) investigators visited, sparking considerable public debate on the issue in India (PROBE Team 1999). In addition to those studies, a recent survey of primary schools in the states of Uttar Pradesh and Madhya Pradesh found that 17 percent of teachers were absent from school, and another 20 percent were at the schools but absent from their classrooms (Rao 1999; World Bank 2001). In a sample of schools in West Bengal, Amartya Sen found absence rates of 20 percent among primary school teachers (Sen 2002). In a large sample of public and private schools in the North West Frontier Province of Pakistan, the rate of teacher absence averaged 18 percent (Ali and Reed 1994; King, Orazem, and Paterno 1999). Another survey of primary schools in Pakistan found absence rates of about 10 percent in the surveyed schools (Reimers 1993). And a World Bank report on Bangladesh in the mid-1990s noted that “often 50 percent of teachers are absent, and cases where schools are functioning with only one teacher present for over a hundred children at different grade levels are not uncomrnon~’(World Bank 1995). Overall, the problem appears from past research to be particularly serious in South Asia; new data collected in the global absence survey reported below confirms this impression. 6.8 But what these surveys lacked was an ability to assess how representative their estimates were. Before the project that produced this paper, there were very few nationally representative surveys of absence; these included most notably a survey estimating teacher absence at 15 percent in primary schools in Papua New Guinea (World Bank 2004), and another that set the rate at 17 percent for Zambian primary schools (Habyarimana et al. 2003). 6.9 On the cauxes of provider absence, a recent study on Nicaraguan schools (King and Ozler 2001) suggested that a lack of local control over schools may sometimes be responsible. Specifically, it concluded that Nicaragua’s program expanding school-level 4 The term “absenteeism” is sometimes used to refer to the problem of high levels of absence among teachers and health care workers. We will generally use the term “absence” instead, because absenteeism typically implies that providers are irresponsible or derelict in their duties. While this implication is sometimes correct, we recognize that absence is often caused by exogenous circumstances, such as illness, or by official duties that take the provider out of the facility. What we are interested in investigating is the extent and causes of excessive absence, at least some of which seem likely to involve incentive structures. 141 administrative autonomy and parental involvement had led to sharp increases in attendance by teachers, with the largest improvements coming in schools in poor rural areas. Illness appears to be another major cause of teacher absence, with research indicating that teachers with HIV/AIDS are often repeatedly absent even before they reach the terminal stage of the disease (World Bank 2002). A Department for International Development (DFTD) study on teacher resource centers (Fairhurst et al. 1999) notes that teacher training can itself be a cause of absence, when it removes teachers from the classroom for up to a month of training at a time, with no substitutes to cover for the teachers. In some cases, gender may play a role, as when competing demands of home and workplace contribute to high rates of absence among female teachers (El-S anabiy 1989). 6.10 The effects of absenteeism in developing countries have not been well studied either. The analysis of North West Frontier Province (NWFP) schools finds that higher rates of teacher absence increase student promotion rates for a given level of test scores but reduces student continuation rates. The authors hypothesize that this is because teachers that are absent more often are less able to make accurate assessments of student progress (King, Orazem, and Patemo 1999). This study does not appear to test for the effects of teacher absenteeism on improvements in test scores. The other cited survey of primary schools in Pakistan did test for such an association, but failed to find any correlation between teacher absence and achievement levels (Reimers 1993). However, as the study looked at simple correlations without any control variables, the finding remains open to question. Clearly, there is a need for more research in this area, but the presumption should be that while merely having a teacher in place is not sufficient for students to learn, it is probably necessary. 6.1 1 The problem of teacher absence has received somewhat greater attention in developed countries-paradoxically, given that absent teachers are usually replaced by substitutes in rich-country schools, and thus the instructional costs of absence may be lower than in poorer countries. Nevertheless, even here the literature is sparse. On the causes of absence, one study found that more generous school district leave policies led to higher rates of absence, while more generous leave buyback provisions reduced absence (Ehrenberg, Rees, and Ehrenberg 1991). A study of teacher absence in one large school district suggests that there is persistence over time in absence - that is, the teachers who have been absent most often in the past are those who account for the most absences today - and that school employees with poorer performance ratings were absent significantly more often than average (Pitkoff 1993). A recent survey of the available studies on teacher absence concludes that there are few robust findings on its causes (Norton 1998). 6.12 In short, before this project, little was known from systematic studies based on nationally representative data about the extent and possible causes of teacher absence. If ensuring that teachers are present on the job is at least necessary for educational progress - even if it is not sufficient - then gaining a better understanding why so many are absent seems essential to meeting multilateral development goals in these sectors. This study aims to help fill these gaps in the case of Ecuador. 142 11. Study Approach and Methodology 6.13 To begin to fill these gaps in our understanding of the extent and causes of provider absence, the World Bank, in collaboration with the Global Development Network, initiated in 2002 a multi-country survey of service delivery facilities in basic health and education (Chaudhury et al. 2004). This survey encompassed seven countries-Peru, Bangladesh, Ecuador, Ethiopia, India, Indonesia, and Uganda - and the methods that were used paralleled a similar approach taken by recent studies in Papua New Guinea (World Bank 2004) and Zambia (Habyarimana et al. 2003). The objective was to gather data on absence using a common (and hence cross-nationally comparable) facility survey instrument in a representative national sample of education and health facilities in each country. (For more details on the global study, see Chaudhury et al. 2004.) 6.14 The Ecuador survey was carried out by staff of Centro de Estudios y Datos (CEDATOS), a leading Ecuadorian pubic opinion and market research firm. The firm’s staff implemented a survey that had been designed by the World Bank’s global absenteeism study team and modified by the joint team to fit the Ecuadorian context. The primary survey instrument was an extensive survey to be administered at the level of the individual randomly selected primary school. Annex 6.1 describes in detail the survey instrument, sampling methodology, and related issues. The most important points to note here are the following: 0 Sampling. The survey was administered to a randomly selected national sample of primary schools. Schools were clustered in parishes and municipalities randomly selected from a national sampling frame, stratified by region and by rurayurban status. 0 Survey Instrument. The survey gathered extensive data on the schools and teachers, using a survey instrument that is comparable across countries. Information was collected through interviews with both the head teacher and the individual teachers, as well as through interviews and testing of a sample of students. 0 Survey Methodology. Survey visits to schools were unannounced, to allow the enumerators to get an accurate assessment of typical absence rates. Enumerators did not rely on administrative records or head-teacher reports of absence, but instead observed all teachers and verified their presence or absence. 6.15 As a result, this Ecuador survey is part of a unique cross-national dataset that has allowed estimation of comparable teacher absence rates in six countries. Along with the companion study of Peru, it is producing the first national teacher-absence rates produced to date for South American countries. 6.16 Beyond the careful nationally representative survey of schools and teachers, we also carried out a smaller-scale survey of a nonrepresentative sample of education experts and officials to sketch out key features of the national institutional context for teacher absence. Before we proceed to the results of the school survey, Section 3 briefly summarizes the information on the institutions. 143 111. Institutional Context 6.1’7 Teacher absence can take root in a context of institutional disarray, and the institutional interviews carried out for this study (described in Annex 6.1) confirmed substantial deficiencies in the organization of the Ecuadorian education sector. No reliable registry of regular primary-school teachers exists, nor does the central government hold reliable and complete records of the contract teachers employed in the system. In part, the poor records may be a result of the circumscribed responsibilities of the Ministry of Education (MED). Although MED is also in theory entitled to administer the education budget, in practice it is confined to formulating policies and administering cultural affairs. The Ministry of Economy and Finance (MEF) is the agency charged with actually making decisions about payments to teachers (when they are not decentralized) and about transfers to decentralized schools. But MEF in turn, has little effect on decision-making at local levels, and on the non transparent system by which teachers are appointed. 6.18 A poorly planned process of decentralization has contributed to this disarray. For instance, in the 1990~~the experience of Redes Amigas granted autonomy to about 2,400 schools (about 20 percent of all rural schools) in the management of their resources. In the same vein, about 1,800 secondary schools became managed as decentralized units and receive funds directly from MEF. These schools hardly consult with MED about their decision to hire teachers. Barely 10 percent of teachers are actually employed by MED at the provincial level, and data from the most recent teacher census indicate that more than 1000 public schools teachers are paid with community funds (Rojas, 2003). 6.19 Nevertheless, it is MED that formally makes teacher appointments, typically with little participation of the parents’ committees. The result in an uncontrolled process of teacher appointment and transfers, as well as, a relatively high level of transfers, with about 400 regular teachers transferred in 2003. Becoming a rural teacher and then transferring to an urban school, sometimes within a few months, is reportedly the simplest way to become indefinitely appointed as teacher. Our interviews confirmed indeed that most transfers were due to the teacher’s own desire to get a better posting, rather than being transfers used as disciplinary devices. 6.20 Knowledge about salary levels is also poor in the education sector, making it difficult to assess the role of salaries in teacher absence. Only formally appointed teachers have a base reference salary that is known. Our interviews found that no such information is available on contract teachers, although it is believed that their total level of compensation approximately matches that of regular teachers. This is due to the myriad of bonuses and extra-salary benefits, including a frontier “bonus” of up to 25 percent of the base salary, on which little is known because of a lack of record^.^ 6.21 In this disarray, our interviews also found that official records on teachers’ attendance are poor, sanctions against absent teachers generally very lenient, and supervisory visits to schools irregular. Although the Education Law requires a daily 5 Interestingly enough, teachers were excluded from the 2003 new civil service reform law, which would have made more transparent and unified their benefits into a renewed base salary. 144 attendance record from principals in each school, maintenance of such records is generally considered to be poor. Our interviews found that teachers’ absenteeism from class was the main reason for teacher dismissal in the schools surveyed in this study. In 2003, among 50 severe disciplinary actions taken, there were 12 dismissals, which is a high number considering the low level of inspections. As there is no incentive to have school inspectors perform their duties well, in a way that is free of corruption, school visits by MED inspectors are irregular, infrequent, and brief they are estimated to take place only about 2-3 times a year, at an average duration of 1-2 hours each. IV. Descriptive Results: What is the Extent of Absence, and Who is Absent? 6.22 In calculating teacher absence rates, we of course need to ensure that we are using the right sub-sample of the data. In the analyses below, we exclude various observations. First, we exclude an observation when the teacher is reported by the head teacher to have retired or been transferred, or to be assigned to another shift (that is, not on the current shift). Because there is no way of verifying these claims using the school-visit approach, this choice will make the overall absence estimates more conservative. Second, we further restrict the analysis to only those teachers who were reported to be working full time. Because we have already omitted teachers reported as being “on another shift,” this step should be superfluous. Nevertheless, it should remove any doubt about whether shift workers are counted as absent when they are not supposed to be on duty. A. Overall Absence Rates, Reasons, and Concentration 6.23 In calculating absence rates, we code as absent any teacher who could not be found in the school at the time of the random visit. Restricting the sample as described above gives us a database of 1,340 observations. Each observation is a teacherhound pair, meaning that in total we have about 720 fulltime teachers, observed twice each.6 6*24 With this the Overall Table 6.1. Primary-school Teacher Absence. 2002-03 teacher absence rate for 14.6 Absence Rate (%) percent in the first round, and 12.5 Bangladesh 16 percent in the second, for an Ecuador 14 overall avera e absence rate of India 25 Indonesia 19 13.5 percent.F To place these Peru 11 figures in a comparative context, Papua New 15 Table 6.1 gives the primary-teacher Uganda 27 absence rates for the countries in ia 17 the global pro,ect and those for E:Chaudhury, Hammer, aemer, Muralidharan, and Rogers 2004 for most countries; NRI and World Bank 2003 for Papua New which we have parallel surveys’ Guinea; Habyarimana, Das, Dercon, and Krishman 2003 for Zambia. Ecuador has the second lowest rate Note: Absent staff are fulltime teachers on current shift who were in this sample of countries, trailing not at the school at the time of an unannounced visit (see text for only Peru. Cross-country analysis details.) 6 The exact number varies by round, since a teacher may be excluded from one round but not the other, if his employment status has changed between the two rounds. 7 The sample means in this section are adjusted using the appropriate sampling weights, to reflect differences in the probability of being selected. 145 suggests that absence declines with per-capita income, however; given that Ecuador has the second-highest income level in the sample, its low absence rate is expected (Chaudhury et al. 2004). 6.25 What reported reasons are Table 6.2. Reported Reasons for Teacher Absence given for these teachers’ absence? Share of absent teachers (%) Table 6.2 shows that of the Official duties 18.2 Teaching-related duty 8.2 teachers who were recorded as Non-teaching-related duty 10 absent by our survey enumerators, Sick or personal leave 29.1 about 29 percent were out of Sick 12.9 school for reasons that would Authorized leave 9.9 generate a leave record of some Leave for Administrative 6.3 kind-that is, authorized leave and No Reason given 52.7 Expected to arrive later 8.5 sickness. Another 18 percent were Left early 0.8 reported as being away from the Don’t Know 14.2 school on some official duty, either Unauthorized absence 2.7 teaching- or non-teaching-related. No reason given absence 26.5 not acknowledged 6.26 Thus even if we take the Total absent 100 “official duties” and leave reports Source: Ecuador Survey at face value, we are left with over half of the absent teachers who are out of school for other reasons. This remainder - 53 percent of the sample, to be precise - was absent without any valid reason given at all. Half of this group (26 percent of the total absences) were acknowledged to be absent by the director or acting director, but without any valid reason given. The other half (27 percent of the total absences) were reported by the director to be present at the time of the visit, but could not be located in the school by the enumerators. 6.27 This list of reasons suggests how important it his to make direct observations of absence and attendance. Ifwe were to rely on official ex post reports of absence, the calculated rate would be misleadingly low. Even if we assume that all the sick teachers fill out sick leave requests, and that those taking personal and administrative leave also fill out the necessary paperwork, it is possible that as few as 29 percent of teachers’ absences would be picked up in any kind of retroactive assessment of absence rates based on administrative records. To put it another way, our calculated ex post absence rate would be 3.9 percent, far lower than the actual rate of 13.5 percent.* 8 By contrast, ifone calculated absence based on the official attendance logbook, the result would be to overstate absence rates. More than 17 percent of teachers were reported as not having signed the logbook on the day of the visit, and in another 2 percent of cases no logbook existed. Of those who failed to sign the logbook, 48 percent were actually present that day, which would make it hard to analyze the causes and correlates of absence using logbook records. 146 6.28 Another way to look at the Table 6.3. Concentration of Teacher Absences: Share of overall absence rates is to analyze Each Type Of Teacher (%) the degree to which absence is Number of times absent in 2 visits concentrated in particular teachers. Primary-school teachers in: 0 1 2 Are absences scattered among all Bangladesh 73.4 23.5 3.2 of the teachers, or are they mostly Ecuador 82.8 6.9 10.4 concentrated in a small minority of hhx~ia 67.7 27.5 4.8 teachers? The figures in Table 6.3 Peru 81.0 17.3 1.7 anda 63.0 29.6 7.4 suggest that the latteris more Sfurce: Chaudhury et at (2004) and Ecuador Survey likely. If all teachers had an equal probability of being absent, then far more teachers would be absent during one visit than during both visits. And indeed, this is the pattern seen in the other countries in the study. But in Ecuador, uniquely, the pattern is reversed, suggesting that a small minority of teachers is absent at much higher rates than their colleagues (Chaudhury et al., 2004). We lack the data to analyze this concentration of absences in detail in the analysis below, because only actual absences, and not underling probabilities, are captured by the survey. Nevertheless, Table 6.3 suggests that policies to reduce absence will need to distinguish between the large majority of teachers who attend at high rates and the small minority who account for much of the absence. B. Absence Summary Statistics: Some Simple Correlations 6.29 Before turning to multivariate analysis, we review briefly the simple correlations between teacher absence and certain geographic, individual, school, and institutional variables. Tables 6.4 and 6.5 show the mean absence rates for different categories of schools and teachers. 6.30 Table 6.4 shows the absence rates by Table 6.4. TeacherAbsence Rate and region covered in the survey. The most striking Region feature of the table is the low rate of absence in Absence N the Oriente region, which is explored in the Rate (%) analysis in the next section. Contrary to the %ma 14.1 650 patterns described in a companion study of Peru Costa 15.9 540 (Alciizar et al. 2004), these data do not suggest a Oriente 3.6 168 Ecuador Total 13.5 1358 priori that the problem of teacher absence is Source: Ecuador Survey concentrated in remote areas of the country. 6.31 Table 6.5 lists several characteristics for which the differences in means are statistically significant. Because Section 5 discusses these factors in more detail, we review them only briefly here, to point out several intriguing relationships: 6.32 First, Table 6.5 supports the view that the problem of teacher absence in Ecuador is not one of remoteness. Teachers at rural schools have marginally lower absence rates than do those at urban schools, and teachers at the most remote schools (far from a paved road) have much lower absence rates. 6.33 Second, these correlations suggest that the supervision of teachers may matter. Despite the remoteness result, teachers working at schools that are farther from the nearest Ministry of Education office do have somewhat higher absence rates. It seems likely that distance from (and presumably reduced intensity of) supervision may be a type 147 of remoteness that actually raises absence. Also, teachers in poor areas have higher absence rates, perhaps because poor communities lack the resources to supervise and enforce teacher attendance. And surprisingly, teachers at schools with higher pupil- teacher ratios-who might be expected to find work more arduous and hence miss work more often-actually have relatively low absence rates. One possible explanation is that where absence would affect more students, the students’ parents and even fellow teachers monitor and punish absence more intensively. 6.34 Third, problems are concentrated in a particular class of schools. Ecuadorian schools are classified according to the number of teachers they have as either unidocente (single-teacher), polidocente (roughly, multiteacher but with multigrade teaching), or polidocente completu (larger schools, with at least one teacher per grade). Absence rates in the polidocente completu schools are far lower than in the polidocente schools. (Unidocente schools actually appear to have relatively low absence rates.) 6.35 Fourth, if we turn to look at the teacher characteristics in Table 6.5, we find few characteristics that are correlated with absence-a result that will appear also in the regression results of section 5. The largest difference is between civil servants and contract teachers,’ with the latter much more often absent than the former. In addition, having a local origin and having received recent in-service training are associated with lower absence. Union members are absent more often than non-members. Other individual variables, such as gender, age, and commuting distance, are uncorrelated with absence. 6.36 Fifth, time and survey variables correlate strongly with absence. Among days of the week, absence rates are surprisingly highest on Wednesdays, rather than on Monday or Friday as one might expect. And in terms of survey rounds, enumerators found far fewer teachers absent the second time they visited a school. 6.37 These relationships are far from definitive, given that the correlations control for no other variables. But Section 5, to which we turn now, will show that many of these relationships hold up well in a multivariate setting. 9 Contract teachers are defined as those either listed as contract teachers by school directors or identify themselves as not having a civil-service rank. 148 Table 6.5. Absence Rates by Significant Correlates Absence Number Rate of (%o) Teachers School and Community Characteristics Urban area 15.0 820 Rural area 13.1 520 Near paved road (< 15 km away) 7.8 1199 Far from paved road (> 15 km away) 15.0 141 Lower-poverty area (< 60% poverty) 12.3 765 Higher-poverty area (> 60% poverty) 16.9 575 School near Ministry of Education office (< 15 km) 12.5 794 Farther from Ministry office (> 15 km) 16.9 546 School has good infrastructure and equipment 11.8 459 Poor infrastructure and equipment 15.6 881 School is polidocente completa 12.4 959 School is unidocente or polidocente 20.3 355 School has low pupil-teacher ratio 17.9 688 High pupil-teacher ratio 10.4 652 Teacher Characteristics Civil servant 13.4 1147 Contract teacher 19.1 193 Born in this canton 11.3 617 Born in another canton 16.7 723 Received training recently (< 1 year ago) 13.0 1072 No recent training 18.3 262 Union member 15.4 923 Non-member 11.8 417 Survey Characteristics Teacher observed on a Wednesday 19.6 286 Observed on other weekdays 12.8 1054 First-round survey visit 15.7 670 Second-round survey visit 12.8 670 Note: All differences are significant at the 5 percent level or better. Absence rates apply to full-time teachers who would regularly have been on duty at the time of the survey visit. Averages are not weighted by sampling probability; note, however, that the differences between weighted and unweighted are small. V. Regression Results: What Factors May Be Causing Teachers Absence? 6.38 Many factors are likely to affect absence rates of teachers. In the description of the institutional setting for education above, we have focused on the institutional and management factors. But other factors beyond these formal incentive structures could 149 plausibly affect attendance, including community characteristics and individual characteristics of the teachers. In this section, we analyze the data collected in the provider absence surveys to assess which factors have the greatest explanatory power. We examine each in turn, presenting the hypothesis and then discussing the evidence. As an econometric specification in the analyses in this section, we use a random-effects ordinary least squares for what is in effect a two-visit panel, with each individual teacher serving as the i variable." A. Explanatory Variables: Community and School Characteristics 6.39 In assessing the causes of provider absence, we start with the factors at the community and school levels -that is, the environment in which the teacher makes his or her attendance decisions, rather than the teacher's own characteristics. These regressors are included in column (1) of Table 6.6 below. 6.40 Community Characteristics. Remoteness and Poverty. The characteristics of the community where the school is located may be important determinants of absence. Here, we focus on whether the community is remote, rural, or poor. These characteristics may affect absence through various conduits, including the desirability of the posting and the teachers' opportunity cost of attendance. 6.41 Rural and Remote Schools. Worldwide, the problem of provider absence in health and education is often thought to be concentrated in remote rural areas, as in the case of primary school teachers in neighboring Peru (Alchar et al. 2004) or in Papua New Guinea (World Bank 2004). Teachers and medical personnel in developing countries tend to have characteristics-such as relatively high education levels and an urban background-that might lead them to prefer urban life, both for the amenities that such areas offer and for the opportunities for outside income." 10 One alternative would be to use ordered probit; under this alternative, the dependent variable would be the number of times a teacher had been absent over the two visits (0, 1, or 2). Our specification has the advantage of making use of the information for teachers who are in the dataset for only one of the two visits-for example, those who were on staff at the time of the first visit, but had been transferred before the second visit. A second alternative would be random-effects probit. While that alternative makes sense, given that the dependent variable (whether the provider is absent) is a 0,l variable, the random-effects Ordinary Least Squares (OLS) has the advantage that coefficients are immediately interpretable as the marginal effects of a one-unit change in the regressor. And significance results are highly robust to the approach used: the probit results closely track the OLS estimates, generally giving similar coefficients with much higher precision. 11 In the popular imagination in many countries, the archetypal absent provider is probably the teacher or doctor who rarely shows up at his rural post, so great is his urban orientation and his disdain for the uneducated rural populations. 150 Table 6.6. Correlates of Teacher Absence (Random-effects OLS) (1) (2) Community & School (= (1) + Teacher Characteristics Characteristics) Urban area 0.1695** 0.1 803** (0.0389) (0.0386) Paved road > 15 kms away -0.1248* -0.1207* (0.0494) (0.0492) Poverty rate (for parroquia where school is located) 0.0024** 0.0026** (O.Ooo9) (0.0009) Discipline: Index of past actions (weighted) -0.0187** -0.0197** (0.0044) (0.0043) Min Educ office > 15 kms away 0.1677** 0.1813** (0.0339) (0.0334) PTAs: Share of schools in district with recent meeting -0.0478 - -0.0562 (0.0829) (0.0826) Infrastructure: School has toilet facilities -0.0493 -0.0519 (0.0725) (0.0721) Infrastructure: Good score (top one-third of schools) 0.0706** 0.0621* (0.0264) (0.0262) Multigrade (reported) -0.2634** -0.2673** (0.0448) (0.0443) School is 'polidocente completo' -0.2054** -0.1822** (0.0388) (0.0385) Pupil-teacher ratio -0.0053** -0.005 1** (0.0014) (0.0014) Observed on Tuesday 0.0703** 0.0700** (0.0202) (0.0205) Observed on Wednesday 0.0839** 0.0901** (0.0225) (0.0227) Observed on Thursday 0.0405+ 0.0418+ (0.0227) (0.0230) Observed on Friday -0.0107 -0.0089 (0.0238) (0.0241) Dumyfor second round of observations -0.0443** -0.0472** (0.0103) (0.0105) Female -0.0032 (0.0164) Teacher holds educational certification (titulado) 0.0613 (0.0440) Age -0.0095 (0.0058) Age squared 0.0001+ (0.Oool) Tenure -0.0036 (0.0028) Tenure squared 0.0001 (0.0001) Contract teacher (non-civil-servant or lacking CS rank) 0.0780* (0.0363) Local ties: Teacher was born in this canton -0.0274+ (0.0159) Education: Instituto superior graduate only 0.0341 (0.0292) Education: Bachelor's graduate or higher 0.0069 (0.0231) Long commute (>30 minutes) -0.0126 (0.0194) 151 Training: 'Teacher received training in past 12 mos. 0.0511 (0.0578) Training: Teacher received training more than 12 mos. ago 0.0539 (0.0607) Teacher holds outside employment -0.0158 (0.0167) Union member 0.0315+ (0.0185) Constant 0.2440* 0.2947+ (0.1240) (0,1756) Day-of-week dummies included? Yes Yes Teacher age and tenure variables included? Yes Yes Observations 1314 1308 Number of teachers 663 659 Wald chi2 144.1123 167.3302 Standard errors in parentheses + significant at 10%; * significant at 5%; ** significant at 1% 6.42 There are at least two major reasons why rurality and remoteness might increase absence rates-one logistical, the other motivational. First, from a logistical perspective, it may simply be more difficult for teachers in remote locations to make it to school on time, even if they fully intend to do so, because of the unpredictability of transportation or the need to travel farther to reach facilities such as banks and post offices. Second, from the perspective of teacher motivation, urban-educated teachers may find remote posts less attractive-because those posts are farther from friends and relatives, because they lack cultural and other amenities, or because they offer few outside earning opportunities (such as private tutoring). Teachers in these remote locations may spend more time away from their postings, for example heading to urban areas for long weekends and extended holidays. 6.43 On the other hand, remoteness could in theory reduce provider absence. If the area around the school offers few temptations for alternative pursuits-whether leisure or alternative employment-the teacher may decide that teaching school is the best use of his or her time during school hours. 6.44 As it turns out, in Ecuador absence is at least as much an urban problem as a rural one. The cross-tabulations in Table 6.1 showed that rural teachers are actually slightly less likely to be absent than their urban counterparts, and the multivariate regressions in Table 6.5 strengthen this conclusion. After we control for other variables - most notably poverty, which is lower in urban areas - we find that for a teacher in an urban school, the predicted absence rate is 16 to 18 percentage points higher than for a teacher in an otherwise similar urban school. 6.45 A more explicit way of checking the remoteness hypothesis is to measure the actual distance of the school from amenities of interest.12 We used as a summary measure of remoteness the distance to the nearest paved road, since having a paved road nearby will lessen the effective distance to most of the other facilities. In Table 6.6, the measure used is a dummy variable that takes the value of 1 when the school is at least 15 km from the 12 Because the area around the school could be officially designated as rural and yet be near a major city, the remoteness variable is worth including for its effects beyond the official rural status of a village. 152 nearest paved road. Again, we see that remoteness is not associated with higher absence rates. In fact, the opposite is true: more remote schools have absence rates that are 12 percentage points lower than other schools. 6.46 These results support the hypothesis that in Ecuador, the primary force driving absence is not likely to teacher’s antipathy to rural areas. Instead, they suggest that the culprit may be nearby amenities and employment may be causing teacher absence-the “pull factors” that lure the teacher away from school. 6.47 Poverty Rate. Like remoteness, the level of poverty in the school’s community could conceivably be associated with either higher or lower absence. Higher poverty could mean poorer supervision and monitoring by less educated parents; it could mean greater social distance between well-educated teachers and poor students and families, reducing the possibility of social sanctions against absenteeism; and it could reduce the teacher’s willingness to live in the community fulltime. Each of these factors would tend to increase teacher absence. On the other hand, a poorer community may offer the teacher fewer opportunities for outside income-earning, making him or her less inclined to skip work for outside employment. 6.48 Table 6.6 includes as a regressor the poverty rate for the parroquia (sub-provincial geographical unit) in which the school is located. Poverty is associated with much higher rates of absence: increasing the poverty rate by just one standard deviation increases the predicted probability of absence by more than 5 percentage points. 6.49 Monitoring and Discipline. One possible deterrent to opportunistic teacher absenteeism is monitoring and discipline, whether carried out by the school director, the Ministry of Education, or the community. This section assesses each of those in turn. 6.50 School-level Discipline. First, attendance may depend on the management style of the school director, including his or her willingness to use disciplinary measures when necessary. In the school survey, head teachers were presented with a list of disciplinary measures, and asked in turn whether they had ever used each of the measures to discipline teachers. From this survey data, we have constructed a severity-weighted index of the disciplinary intensity of the school dire~tor.’~Table 6.6 shows that this measure is highly significant: teachers at schools whose directors have used more discipline in the past are considerably less likely to be absent. An increase of just one standard deviation in the discipline index is associated with a reduction in absence of 6 percentage points.14 This result suggests that monitoring by school directors, if it is accompanied by disciplinary action, may be able to reduce absence. 6.5 1 OfJicial Inspections. Another second possible mechanism for inducing higher effort levels by teachers is frequent inspections by district or Ministry of Education officials. If there are any sanctions associated with poor performance, exercised on either the teachers 13 The index is weighted as follows: six points are given for dismissal of a teacher, five points for suspension of a teacher or withholding of pay, and so on, down to one point for an oral warning to an offending teacher. While in theory it could range from 0 to 23, in the data it ranges only up to 13. 14 We might assume that the actual effect of discipline is even larger, given that the discipline index could suffer from the same offsetting reverse causality problem as the inspections measure: at a school that has had severe attendance and other behavioral problems in the past, the director is more likely to have had to use severe disciplinary measures. 153 themselves or the school director, then the possibility of unforeseen monitoring could induce higher attendance. 6.52 Gauging the effect of inspections is not straightforward, however. If we were to include the frequency of school-level inspections as a regressor, that might not be a good test of whether inspections have an effect, because there may be an opposing, reverse causation. If serious attendance problems at a school may induce inspectors to visit the school more often, that would dampen or even reverse the expected relationship between inspections and absence. 6.53 To get around this problem, in Table 6.6 we include as a regressor the distance to the nearest Ministry of Education office. The theory here is that, once we control for other measures of remoteness, schools that are farther from external supervisors will be inspected less often and therefore will have higher absence rates-for reasons unrelated to the level of absence at the school. In Table 6.6, the expected correlation comes through strongly: teachers at schools more than 15 km away from Ministry offices have predicted absence rates 16 to 18 percentage points higher than schools close to Ministry 0ffi~es.l~We take this as evidence that inspections are associated with lower absence. 6.54 Parental Involvement. As discussed in the literature survey, an emerging strain of the education service-delivery literature emphasizes the positive role that community involvement can play in school management. Studies from El Salvador and Nicaragua, to mention just two examples, suggest that giving greater discretion to parents and communities can reduce teacher absence and improve student test scores. The most obvious vehicle for parental involvement in the management of Ecuadorian primary schools is the parents’ association (Comite de Padres de Familia, or CPF). As with inspections, we created a dummy variable indicating whether that association had met recently (defined as either “this month” or “last month”). l6 6.55 The results do not support a community-monitoring story. More active parents’ committees are actually associated with higher teacher absence, probably because high levels of absenteeism spur a parents’ committee to become more active. Again, to circumvent this problem of school-level reverse causality, we include in Table 6.6 an alternative measure of parents’ committee activity: the share of the province’s schools that have had recent CPF meetings. However, the estimated coefficient is not significantly different from zero. 6.56 Frequency of CPF meetings may not fully capture the effectiveness of the parental efforts to influence school management. What may be most important is having informed and influential parents, who have the knowledge and connections necessary to 15 An alternative approach to estimation is to include the average inspection intensity for other schools in the province. This intensity should not be affected by the absenteeism at the teacher’s own school, but may well capture how carefully the Ministry supervises schools in the area. When we include this variable, we find that provinces with greater inspection intensity have lower absence, even controlling for the distance to Ministry offices. (That result is not shown here, because it limits the sample slightly.) 16 Because virtually all of the teachers in the sample teach at schools reported to have an CPF, merely entering a CPF dummy variable will not be fruitful. Instead, we need to measure the activity level of the CPF, to distinguish those that are moribund from those that are active enough to influence the school director. 154 discipline a school director or individual teachers if their behavior is unsatisfactory. This pressure might be channeled through the CPF, but there may well be other mechanisms, including direct appeals to government officials and social pressure. 6.57 What is the best measure of parents’ ability to influence the school? One obvious candidate is parents’ education level, since more educated parents are likely to have both higher expectations of schools and greater resources to enforce those expectations. Another candidate is the size of the financial contributions that parents are required to make to the CPF. However, neither variable enters significantly in these multivariate regressions (and both are omitted from the Table 6.6 specification). Taken together, the evidence in this subsection does not suggest that parental involvement is a powerful force for reducing teacher absence in Ecuador. 6.58 Working Conditions at the School. Another set of factors that may influence teacher absence is the quality of the workplace and of the work. The previous subsection focused on external rewards for attendance, in that monitoring and discipline hold the threat of salary losses for absent employees, or perhaps social sanctions levied by the community. But non-pecuniary factors at the school may also be important in reducing absence; this section assesses that possibility. 6.59 School Facilities and Infrastructure. First, like other employees, teachers are likely to prefer a workplace that has more amenities and comforts, as well as better school supplies. In the survey, we collected information on a variety of aspects of school facilities and types of supplies and equipment. For this regression, we use as a summary measure a dummy variable indicating whether the school has toilets of any kind. l7 Here, the results are ambiguous; the coefficient is negative but not significant in the regressions reported in Table 6.6, but it is highly significant in the alternative probit specification. 6.60 But this result, even if it does hold, applies only to the small percentage of schools that lack toilet facilities. On the broader question of infrastructure quality, the result clearly runs in the opposite direction: the schools that score highest on an index of infrastructure and equipment have absence rates 6 to 7 percentage points higher than other schools. We do not interpret this to mean that better infrastructure deters teachers from attending, but it does suggest that, beyond some minimal level of acceptability, facility quality plays little role in absence. 6.6 1 Multigrade Teaching. Another measure of working conditions is multigrade teaching. Reviews of multigrade teaching point out that this system can be frustrating and alienating for teachers, particularly if they are not assisted in developing approaches tailored to the multigrade setting (Little 1995; UNESCO/APEID 1989). In some other countries, multigrade teaching appears to be strongly associated with absence, and Table 6.6 showed that in Ecuador, schools with multigrade teaching had higher absence rates. 17 At first blush, we might want want to use a dummy for “functioning latrines,” rather than simply latrines, since non-functioning toilets are unlikely to help morale. But “functioning latrines” may be endogenous-if fewer teachers show up at school, there will be fewer staff members around to make sure the latrines work properly. We had two indicators of types of toilet facilities - letrinas and cubiculos sanitarios. We chose to use the latter indicator (translated here as bathrooms), which fewer schools had. If instead we use a “no toilet facilities” dummy, we get roughly similar results (with the opposite sign, of course). 155 6.62 In Ecuador, however, the results on multigrade teaching are ambiguous. Teachers at schools that were self-identified as using multigrade teaching actually had a vastly lower predicted rate of absence (26 percentage points lower) than those at other schools. But the next variable in Table 6.6, indicating whether the school is polidocente completo, points the other way. As noted in Section 4, Ecuadorian schools are categorized as either unidocente (single-teacher), polidocente (multi-teacher, but with fewer class teachers than grades), and polidocente completo (multi-teacher and “complete”, in the sense of having more teachers than grades). Here, the teachers at polidocente completo schools have predicted absence rates 18 to 20 percentage points lower than those at other ostensibly multigrade schools. Because the unidocente and polidocente schools often have more teachers than implied by their official categories, however, the interpretation is not straightforward. Detailed analysis suggests that absence is concentrated in the larger polidocente schools (those that have more than seven teachers, and hence are not likely to use multigrade teaching). 6.63 Pupil-teacher Ratio. A third, related measure of working conditions is the school’s pupil-teacher ratio. We might hypothesize that teachers at schools with higher pupil- teacher ratios will be absent more often, if the heavy workload reduces the teacher’s motivation. Conversely, a higher pupil-teacher ratio might mean that a teacher is under greater pressure to avoid being absent: there are more parents to monitor the teacher’s presence, and other teachers may be more resentful of having to double up large classes when a colleague is absent. Here, the latter effect appears to dominate: higher pupil- teacher ratios are associated with lower absence. Moreover, the effect is large: increasing the ratio by one standard deviation reduces predicted absence by 5 percentage points. At a minimum, this result does not support the working conditions hypothesis. As hypothesized in Section 4, it may instead support the notion that supervision is important. If being monitored by a larger number of parents discourages absence, then this could lend some support for the community-monitoring hypothesis dismissed in the previous sub-section. 6.64 Competition from Private Schooling. Another possible source of performance pressure on school directors and teachers is competition from private schools in the local area. If at least some students have a credible exit option, the public schools may feel pressured to improve their performance.’* But threat of losing students is not the only channel through which a private alternative could affect performance. Private schools may also serve as a benchmark for performance, by showing parents what quality of education is attainable under local conditions with a given level of resources. If either of these effects is at work, then the availability of private schooling in the area should be associated with lower teacher absence. Results of this analysis are not shown in Table 5.1, because of problems of missing observations. Teachers at schools in communities 18 It is not clear at first glance why public-school teachers should feel threatened by loss of students. After all, if their jobs are secure, doesn’t this simply reduce their workload? But according to Indian government officials at a recent multicountry workshop on absenteeism organized by the authors, there are incentives here. First, they argued, the school director and teachers lose social standing if they are not able to attract and keep students. Second, there is at least theoretically a risk that the school could be closed or consolidated with another if it loses too many students, perhaps resulting in a disruptive transfer for the teacher. 156 where private competition is reported have a predicted absence rate 7 percentage points below those where there is reportedly no private school. B. Explanatory Variables: Teacher Characteristics 6.65 Beyond the community characteristics, the characteristics of the individual teacher-training, background, age, gender, marital status, level-may affect attendance. Teachers are heterogeneous in their motivation and circumstances, and this heterogeneity may both affect absence and be correlated with exogenous characteristics. 6.66 Column 2 of Table 6.6 adds teacher characteristics to the regression, but the effect of these additional variables is minor. Only one of the teacher-level variables is significant at the 5 percent level, and that variable is the one most closely related to institutional structures: the teacher’s contract status. Nor does the inclusion of teacher- level variables have any material effect on the estimated coefficients reported in Column 1. These results suggest that in Ecuador, absence is driven substantially by community and school-level factors rather than by teacher characteristics. 6.67 Gender. One obvious characteristic to explore is the gender of the teacher. As with some other characteristics, being a woman could have offsetting effects on absence. We might expect that working women will have more family responsibilities that are likely to keep them away from the workplace, as noted above; in this case, women will have higher absence rates than men. Altematively, it could be that women have fewer outside work opportunities, are less likely to be assigned administrative non-teaching tasks that take them away from the school, or are simply more concerned with the welfare of the children. Any of these factors could lower their absence level compared with that of men, Table 6.6 suggests that in the case of Ecuador, gender is uncorrelated with absence. This result is consistent with the cross-tabs of Section 4, which showed little difference between women and men. 6.68 Zntrinsic Motivation. Where monitoring and discipline are ineffective, the teacher’s attendance may be determined largely by his or her level of non-pecuniary motivation. Notably, a teacher may be motivated by professionalism. One possible proxy for motivation is educational specialization, in that a teacher trained in pedagogy may be more professionally motivated than a teacher who studied another subject. We have included in this regression a dummy indicating whether the teacher is titulado-that is, whether he or she has a certification in education. A second measure of professional motivation is past exposure to in-service training, in that good training may increase a teacher’s desire to perform well. Third, if teachers enter the profession highly motivated, but “bum out” after a number of years of service, then motivation and attendance may decline with age. As Table 6.6 shows, these potential professional motivation variables--certification, training, and age-do not enter significantly in predicting absence rates. (Age is not shown here, because it is not significant at 5 percent, nor does it have the predicted sign.) While underlying professional motivation may matter for attendance, the proxies tested here do not pick it up. 6.69 A second set of possible non-pecuniary motivations concems attachment to the local community. If local social pressure and intrinsic orientation toward service to the community are important, then we might expect teachers who come from the area near the school to have lower absence rates. (Conversely, if local teachers’ greater attachment 157 to the area translates into better out-of-school income-earning opportunities or weightier family responsibilities, there may be more factors pulling the teacher out of school.) Table 6.6 shows that a teacher is bom in the canton where the school is located does have a lower predicted probability of absence, but the effect is small and not very significant. Another, more physical measure of ties to the area-the length of the commute faced by the teacher-has no effect at all. Nor does a third measure of local ties, the teacher’s tenure at the school. 6.70 Pecuniary Incentives-Contract Status. A basic model of incentives would suggest that the teacher’s contract status might affect his or her incentives. Regular (civil- service) teachers have tenure and face few salary incentives for good performance; by contrast, one might expect that contract teachers would be willing to exert more effort on the job, at least ifthey have some possibility of a reward at the end of the contract period. If their performance affects the probability of this reward, then contract teachers may have lower absence rates than regular teachers. 6.71 To test this hypothesis, we include in Column 2 a dummy variable for contract teachers, defined as those who were identified as contract teachers by the school respondent or who self-identified as not having a civil-service rank. Table 5.1 offers no evidence for the hypothesis that contract teachers will have an incentive to exert greater effort than regular teachers do. In fact, contract teachers are predicted to have absence rates 8 percentage points than civil servants do. Further investigation shows that for the largest class of contract teachers-those not hired by the school-the predicted absence rate is higher still. 6.72 What might account for this perverse effect of contract status, which is also found in Peru and Indonesia? There are various possibilities, which are explored in the companion project paper on Peru (Alcfizar et al. 2004). Contract teachers could face greater logistical challenges or be required to carry out more non-teaching duties, but it is also possible that they feel less attachment to the teaching force and hence have to spend more time exploring or engaging in alternative employment. Whatever the motivation, these results suggest that from the perspective of attendance, reducing the security of teacher tenure may not lead to higher-quality service delivery in education. l9 6.73 Opportunity Costs of Attendance: Outside Employment. In the absence of effective monitoring and discipline, the teacher’s attendance decision will depend in part on the opportunity cost of her time. If she has other income-earning work outside the school, her financial opportunity cost is likely to be higher, perhaps increasing her absence rate. But Table 5.1 provides no direct support for the outside-income story, as the coefficient is small and insignificant. 19 Of course, an assessment of the efficiency of contract teachers depends not only on their performance-measured by attendance, as well as by other measures of quality and effort-but also on their cost. Ifcontract teachers are much less expensive than regular teachers, school systems may gain by employing more of them, even if they perform less well. This analysis suggests only that contrary to what might be expected, contract teachers may not exhibit perform better on the key metric of attendance. 158 6.74 Union Membership. Finally, we test the effect of union membership. Union members might be expected to be more aware of the shortcomings of teachers’ working conditions and rewards than other teachers, assuming that the union is an activist one. In fact, the union led a national teachers’ strike in May 2003, a few months after these data were gathered. In Table 6.6, the teacher’s union membership does appear, but it is small and only mildly significant, suggesting that unions are not a major factor in absence. I VI. Conclusions and Policy Implications 6.75 The analysis of the correlates of absence in the previous section suggests several conclusions that may have implications for policy. It is essential to point out that none of these statistical associations establishes a casual relationship, so they should be taken as pointing the way for more in-depth investigation of the causes of absence. However, in this concluding section we lay out some of the policy implications that may follow, if these results are borne out by future research: 0 Teacher absence in Ecuador appears to be driven primarily by features of the school, community, and institutional environment-some of which should be amenable to policy-rather than by individual characteristics. Age, tenure, education, region of origin, union membership, commuting time, even outside employment-none of these is strongly correlated with absence rates. The only individual characteristic that matters much is an institutional one, the contract status of the teacher (see below). In a sense, this should be encouraging: it means that reducing absence will depend in part on addressing systemic teachers incentive weaknesses, rather than targeting classes of teachers whose characteristics might not be easy to change. However, it also suggests that it will not be enough simply to hire the right teachers and hope that they do their jobs. At the community level, the poverty level is a strong predictor of absence, suggesting that poverty mitigating approaches, like school breakfast or cash- transfers programs, might have the effect of reducing absence. 0 The “sticks” of inspections and discipline may be important in reducing absence. Both the province-level inspection intensity and the record of past discipline are strong predictors of lower absence, suggesting that these “sticks” may have a role in reducing absence further. The importance of inspections is perhaps unexpected, given that Ecuadorian education experts report that inspectors generally do not make frequent surprise visits. But the importance of inspections is reinforced by the strong effect of distance from a Ministry of Education office. Schools that are farther away from a ministry office (and thus presumably inspected less often) have higher absence rates-even though remote schools in general have lower absence rates. 0 More generally, there are indications that “pull” factors-perhaps including cultural amenities and alternative employment-may increase absence in urban areas. Contrary to the experience in many other countries, teachers at urban schools in Ecuador have much higher absence rates (15 percent) than those at remote rural schools (7.8 percent), with particularly high rates in urban areas outside Quito (16.2 percent). This urban absence effect holds up strongly in multivariate analysis. This is the reverse of the pattern often found in other countries, where less desirable rural posts suffer higher absence rates. A possible explanation is that less isolated areas 159 offer more amenities or employment that can lure a teacher away from school. While detailed policy implications of this conclusion are not obvious, it does suggest that in Ecuador-unlike many other countries-efforts to combat teacher absence should start in urban areas. Urban polidocente schools in particular merit further investigation: their 27.6 percent absence rate is double the national average. 0 Community involvement in the schools does not have clear effects in reducing absence. Schools in provinces with more active parents’ committees do not have lower absence rates, in contrast to what might have been expected from studies in other countries. Nor do other indicators of potential parental influence, such as parental literacy levels or financial contributions, predict lower absence rates. This does not imply that parental or community involvement in school management is a bad idea, but merely that it may not help on the absence front as might be expected. 0 Nor are contract teachers-that is, teachers who presumably face a greater threat of punishment for non-performance-a simple fix for absenteeism. The major teacher- specific characteristic highly correlated with absence is the teacher’s contract status. Notwithstanding expectations that they might have greater incentives for at, contract teachers who have not been hired at the school level are absent at much higher rates than are regular civil-service teachers. Contract teachers hired by the school, while they do not suffer from the same absence problem, also fail to attend at any higher rates than do regular teachers. Governments may want to hire contract teachers for other reasons than budgetary savings, since salary levels are similar to those of regular teachers, once fringe benefits are included. Reasons like high turnover rates, especially in poorest rural schools, or the need to fill the gaps left by transferred teachers might explain this decision. But our findings show that, in any case, authorities should not presume greater teaching effort from contract employees. 0 How much does it matter whether the government can lower teacher absence? This analysis has been based on the assumption that excessive teacher absence will have costs. One way to assess the magnitude of these costs would be to attempt to measure the student learning forgone as a result of teacher absence; a subsequent study will do this. But a second approach would be to calculate the budgetary waste from absence-the amount of salary expenditures that go to teachers who are absent without good reason. To make a rough calculation of these magnitudes, take as a baseline the half of absent teachers (or 6 to 7 percent of all teachers) whose absence is not reported or excused by school directors. According to our companion institutional survey, the salary costs for a teacher might be at least US$200 per month, including monetary and non-monetary fringe benefits and multiplying over 86,000 primary-school teachers, this suggests a rough absence cost of about 1 million a month, or about US$12 million per year. Alternatively, a cost can be calculated based on the $300 million per year that Ecuador spends on primary education. About 84 percent of this goes for teacher salaries, meaning that the budgetary cost of excessive teacher absence might be some $18 million per year. This would add to a budgetary cost ranging between $12-18 million. (about 2 percent of the overall budget for the education sector). It should be underlined that these back-of-the- envelope estimates are merely suggestive, and that most teachers appear to be attending well. Nevertheless, the estimates suggest that modest programs to reduce 160 absence, such as targeted inspections and increased discipline in urban schools, could pay off substantially through reduced waste. The data on concentration of absence rates are sketchy, since they are based on only two visits, but they suggest that in the Ecuadorian case, it might be particularly fruitful to try to improve the attendance of the relatively small fraction of teachers who are often absent. 161 References Alciizar, Lorena, F. Halsey Rogers, Nazmul Chaudhury, Jeffrey Hammer, Michael Kremer, and Karthik Muralidharan. 2004. "Why Are Teachers Absent? Probing Service Delivery in Peruvian Primary Schools." World Bank and GRADE. Ali, Murad and Tony Reed. 1994. "A School and Parental Survey of Book Provision Issues in NWFP." International Book Development, Ltd. Chaudhury, Nazmul, Jeffrey Hammer, Michael Kremer, Karthik Muralidharan, and F. Halsey Rogers. 2004. "Teacher and Health Care Provider Absenteeism: A Multi- Country Study." World Bank: Washington, DC. Ehrenberg, Ronald G., Daniel I.Rees, and Eric L. Ehrenberg. 1991. "School District Leave Policies, Teacher Absenteeism, and Student Achievement." Journal of Human Resources, 26:1, pp. 72-105. El-Sanabiy, Nagat. 1989. "Determinants of Women's Education in the Middle East and North Africa: Illustrations from Seven Countries." World Bank: Washington, DC. Fairhurst, Genevieve, William Gibbs, Pankaj Jain, David Khatete, Gary Knamiller, Geoff Welford, and Patrick Wiegand. 1999. "The Effectiveness of Teacher Resource Centre Strategy." pp. 259. Department for International Development: United Kingdom. Habyarimana, James, Jishnu Das, Stefan Dercon, and Pramila Krishnan. 2003. "Sense and Absence: Absenteeism and Learning in Zambian Schools." World Bank: Washington, DC. King, Elizabeth M. and Berk Ozler. 2001. "What's Decentralization Got To Do With Learning? Endogenous School Quality and Student Performance in Nicaragua." World Bank. King, Elizabeth M., Peter F. Orazem, and Elizabeth M. Paterno. 1999. "Promotion with and without Learning: Effects on Student Dropout." World Bank: Washington, DC. Little, A. 1995. "Multigrade Teaching: A Review of Practice and Research, Serial No. 12." Overseas Development Administration: London. Norton, M. Scott. 1998. "Teacher Absenteeism: A Growing Dilemma in Education." Contemporary Education, 69:2, pp. 95-99. Pitkoff, Evan. 1993. "Teacher Absenteeism: What Administrators Can Do." NASSP Bulletin, 77551, pp. 39-45. PROBE Team. 1999. "Public Report on Basic Education in India." New Delhi: Oxford University Press. Rao, G. V. L. Narasimha. 1999. "Teachers Absenteeism in Primary School: A Field Study in Select Districts of Madhya Pradesh and Uttar Pradesh." District Primary Education Programme: New Delhi. Reimers, Fernando. 1993. "Time and Opportunity to Learn in Pakistan's Schools: Some Lessons on the Links between Research and Policy." Comparative Education, 29~2,pp. 201-12. Sen, Amartya. 2002. "Pratichi Education Report: An Introduction." UNESCO/APEID. 1989. "Multigrade Teaching in Single Teacher Primary Schools." UNESCO Principal Regional Office for Asia and the Pacific: Bangkok. 162 World Bank. 1995. "Labor Market Policies for Higher Employment." World Bank, Bangladesh Country Team: Washington, DC. World Bank. 2001. "Expanding and Improving Upper Primary Education in India." pp. 104. World Bank: Washington, DC. World Bank. 2002. "Education and HIV/AIDS: A Window of Hope." World Bank: Washington, DC. World Bank. 2004. "Papua New Guinea: Public Expenditure and Service Delivery (Discussion Draft)." World Bank: Washington, DC. 163 Annex 6.1 Survey Methodology and Sample Selection This annex describes the survey and sampling approach used in gathering the data on school service delivery, discussed briefly in Section 3. School Survey Procedures and Instrument Data were gathered primarily through surveys of school directors and individual providers, carried out during unannounced visits to a random sample of schools. The survey instrument used in these school visits was intended first and foremost to establish a good estimate of the absence rate of providers at the school. To avoid contaminating the responses, the instrument and survey methodology were designed in such a way that they did not focus too heavily on attendance and absence questions. Instead, they collected a broad range of variables on the school and individual providers. In filling out the survey, the enumerator met first with the school director in order to collect school information. If the director was absent, the enumerator met instead with the acting director or, failing that, any staff member who was willing to answer questions about the school. From the director, the enumerators obtained a list of the personnel (teachers or medical personnel) who were supposed to be working in the school, as well as their work schedules; this list served as the sampling frame for the observation of attendance and the surveys of providers. But in addition, the enumerator collected the following data on the school from the director: staffing and attendance: size of school and number and names of teachers assigned to it; presence or absence of each worker on the day of the visit, as well as the reasons for any absences school hours, services, and usage: the hours that schools are supposed to be in operation; usage by students remoteness of the school, measured by distance to (for example) the provincial capital or the nearest paved road or bank community characteristics, such as primary languages of students parental, community, and employee involvement in school management monitoring and supervision (frequency and type) disciplinary procedures used at the school and in the region school finances, including sources and uses of funds characteristics of the school After obtaining a list of the personnel who were supposed to be at the school on the day of the visit, the enumerator selected a sample of providers to be interviewed. Where there 164 were 15 or fewer teachers or medical personnel in the school, all were included in the school sample; where the total exceeded that number, then 15 were selected randomly for interviews. The enumerator then worked his or her way through that list twice. The first circuit was the direct observation of attendance, aimed at verifying directly the presence or absence of each provider on the list; these direct observations provide the basis for the calculations of absence later in this paper. The goal of this first circuit of provider visits was to ensure that the measure of provider absence was as uncontaminated by the enumerator’s presence as possible. If instead the enumerator had stopped in each room long enough to interview the provider before verifying the presence of the other providers on the list, it is possible that the director would have had time to get word to absent providers that they should return to the school in time to be enumerated. Once the enumerator had recorded the attendance of each of the sampled providers, he or she then made a second circuit to carry out detailed provider interviews. Like the school- level interviews with the director, these interviews aimed to collect information on all of the correlates that seemed most plausibly related to absence and its effects: e provider activity at the time of the visit e demographic characteristics e rank of the teacher e educational background of each teacher e job tenure and work history e ethnic group and mother language of the teacher e training and preparation for the job e marital status and number of children e commuting logistics e ties to the local community e outside income-earning opportunities e information on the logistics of the teacher’s pay e motivations for career choice and current level of job satisfaction Finally, there was a third module of the school survey instrument, administered to a sample of students. Specifically, enumerators selected a random sample of fourth-grade students during the second visit. Their teachers answered a very brief survey about the family backgrounds of these students (with help from the students if necessary), and the students were then asked to take a simple mathematics and language test. This test was intended to provide at least a crude metric of the educational outcomes that teacher absence would be presumed to impede. Following the survey design, every school in the sample was visited twice by enumerators. Having multiple observations over time was aimed in part at helping us determine whether absences are concentrated among a few teachers, or are more spread 165 out. This information could help shape policy. For example, a 10 percent absence rate could arise because all workers are absent 10 percent of the time, or because 5 percent of workers never show up while the majority are rarely absent. In this case, policies targeted at the latter group would not threaten the majority of teachers. On the other hand, if all workers are absent 10 percent of the time, improving service delivery will require different measures. Repeat visits will help us understand which approach to solving the problem will be most promising. Probably more important, the second visit also allowed collection of detailed individual- level data from teachers who were absent at the time of the first visit. This data allowed us to obtain much richer insights into the question of who is absent and why- detail that would be lacking had we surveyed only the teachers who were never absent. Without the second visit, all individual data on absent teachers would have had to come from directors or co-workers, increasing the noise of the responses. Sampling Methodology The sample for the school survey consisted of 102 primary schools, with two schools surveyed in each of 51 parroquias (or town) selected randomly.20 To reduce fieldwork costs, the sample was selected using multi-stage clustering, as follows: 0 First, the sample was stratified geographically into the three regions described above - Costa, Sierra, and Oriente. Within each region, a given number of parroquias were chosen randomly on a probability-proportionate-to-population (PPS) basis. The number chosen was based on the relative population of the three regions, so as to yield the following number of parroquias in each region: 23 in Costa, 22 in Sierra, and 6 in Oriente. 0 Municipios and parroquias were chosen as follows, with stratification by ruralhrban status: In the Sierra region, 14 rural and 8 urban parroquias were chosen, reflecting the ruralhrban breakdown in that region. To do this, CEDATOS first selected 14 municipios, on a randomized PPS basis (with replacement). From the list of urban parroquias in those 14 municipios, 14 were chosen on a PPS basis; similarly, from the list of rural parroquias in those 14 municipios, 8 were chosen on a PPS basis. 0 In the Costa region, 11 rural and 12 urban parroquias were chosen in the same way (Le., first 12 municipios will be chosen, and then the rural and urban parroquias were selected from those municipios). 0 In the Oriente (Amazon) region, 4 rural and 2 urban parroquias were chosen in a similar procedure. In this region only, because of the inaccessibility of many villages, some parroquias were chosen using PPS sampling with an additional sampling weight given by a pre-defined accessibility parameter. This diminished the probability of selecting very 20 Because the parroquias were selected with replacement - i.e., a parroquia could be selected more than once if it came up randomly multiple times-the actual survey included 41 distinct parroquias. 166 inaccessible parroquias (for cost reasons), without eliminating such them from the sampling frame altogether. In calculating the overall mean absence rate for Ecuador, the observations were therefore reweighted to reflect this intentional undersampling of the most remote locations. Once the 51 parroquias were selected, two schools were chosen randomly from each parroquia. The randomization was carried out on a PPS basis, using as population weights the official school enrollments. Note that while the school sample selection process was centralized, the sampling of individual teachers occurred at the facilities during the field visits, as described above. The sampling frame at this level was the list of employees provided by the school director; the enumerator then either interviewed all of the teachers, or-for larger schools-interviewed 15 randomly chosen teachers. (We adopted this cutoff to keep the survey a manageable size and cost.) Companion National Institutions Survey To complement the data collected through questionnaires at the school and individual level, we carried out a parallel effort to gather information on the national institutional environment for the education and health sectors. This institutional survey drew primarily on central govemment sources to illuminate such topics as: provider types, numbers, and qualifications; provider work hours and excused absences; provider salaries and benefits; recruitment, assignment, and transfer policies; provider participation in school management; private providers and the institutional environment; discipline and dismissal procedures; local involvement in personnel decisions; incentive schemes for attendance; and unionization. To illuminate these topics, we drew both on codified information about the formal institutions and subjective assessments of how these institutions work in practice. We collected this information by drawing on existing sources and by surveying higher-level education and health officials, non-government experts, and a subsample of providers during school-level survey work. Many of the results of this institutional survey are presented in Section 3 below. 167 168 Chapter 7 WATER AND SANITATION' The water supply and sanitation sector in Ecuador is characterized by: (i) low coverage levels, specially in rural areas; (ii) poor and ineficient service provision; (iii) low cost recovery from tariffs and high dependence on transfers from central and municipal governments; and (iv) a poor and incomplete institutional, legal and regulatory framework with overlapping responsibilities and a lack of accountability at different levels of government. These problems have led to policies that have left the sector in a financial crisis, unable to find needed investments to increase coverage levels and access to services for the poor. Subsidies continue to favor higher income groups as they are the heaviest users, and the tariffs charged do not distinguish between high and low income groups on the whole. Commercial and industrial users, on the other hand, face much higher tariffs and subsidize the residential sector, weakening the economy. This note makes the following recommendations to give policy a pro-poor focus and financial sustainability: (a) provide subsidies to invest in extending access for poor users instead of trying to keep tariffs below the cost of providing the service; (b) raise prices to cost levels and target consumption subsidies to poorer areas while increasing operational eficiency at the utilities to help keep prices in check; (c) refom the legal framework to provide transparency in decision-making and increase accountability at all level; and overlapping responsibilities at different levels of government; and (d) consider allowing local private companies to provide services, especially in smaller markets, to improve eficiency and increase investment, thus extending coverage. I. Sector Structure and Institutions 7.1 From 1965 to its abolishment in the 199Os, the Ecuadorian Institute of Sanitary Works Znstituto Ecuatoriano de Obras Sanitarias, (IEOS) was the central agency responsible for sector planning, construction, operation and maintenance. IEOS was financed completely by transfers from the Government, mostly oil revenues. In 1990, in the midst of a decentralization process and hampered financially by low oil prices, the Government decided to transfer the systems and the responsibility for service provision to the municipalities. The IEOS structure was drastically reduced from about 2,500 employees to less than 200 and transferred to the Sub-secretariat of Potable Water and Basic Sanitation (SAPYSB) at the Ministry of Urban Development and Housing (MTDUVI). In 1999, with the advice of international consultants, the SAPYSB began a process of institutional reform to change its role from an executing agency to a regulating one responsible for: (i)sector planning; (ii)policy making; (iii)setting sector norms and regulations; (iv) providing technical assistance to municipalities, communities and service operators; and (v) design and maintenance of a sector information system. 1 This paper was written by Maria AngBlica Sotomayor, Economist (World Bank). 169 7.2 Although SAPYSB has the sector’s leading role, many other agencies at the central, regional and municipal level participate in the sector, many times with overlapping functions and responsibilities leading to a lack of accountability. Other sector agencies at the national level are: The Ministry of Public Health, responsible for regulating water quality (responsibility for overseeing and controlling water quality is not clearly defined). The Ministry of Environment, responsible for environmental protection and pollution control, including the control of water resources. The Ecuadorian Development Bank Banco Ecuatoriano de DesarroZZo, (BED@, the main source of financing for the municipalities. 0 At the regional level there are 8 regional development corporations responsible to the National Council of Water Resources Consejo NacionaZ de Recursos Hidricos, CNRH) that includes the Ministries of Environment and Agriculture, and these are responsible for allocating water rights. 7.3 The legal and regulatory frameworks for the sector are incomplete. There is a national policy formed in 2002 called Politica Nacional de Agua y Saneamiento (National Water and Sanitation Policy). It provides guidelines and basic principles for service provision with the objectives of increasing coverage and service quality, ensuring efficient use of water resources and opening a space to private sector and community participation. However, there is no clear position on sector financing, tariffs and subsidies or on criteria for resource allocation. Although the responsibility for service provision is at the municipal level, the roles and accountability of the municipal and central governments are not clearly defined. 7.4 As a consequence of the decentralization process there are several water service providers Entidades Prestadoras de Sewicios, (EPS) at the municipal level. Most of these are a department within the municipal government structure (some share the same personnel and financial administration, some are autonomous or semi-autonomous entities of the municipality, and in the larger cities, they are independent water utilities). Although service provision in rural areas is also the responsibility of the municipalities, water, and in some cases sanitation services, are provided by users associations Juntas de Agua y Saneamiento, (JASS) with limited support from the municipalities. Table 7.1 shows the composition of the service providers in Ecuador. 170 Table 7.1. Type of Service Providers by Population Size Population Size No. of Type of ES Population Population (thousands) Municipalities (&lions) Growth Rate 9‘0 More than 1,000 Guayaquil (1.7 m) 30 year concession with 3.35 +2.3 Interagua Quito (1.6 m) Public W&S utility (EMAAP) 100 to 300 12 11 public utilities +Imunicipal 1.92 +7.8 department (Loja) 30 to 100 37 8 public utilities + 29 municipal 0.80 -2.2 departments Less than 30 169 Municipal departments* 1.30 +3.5 Rural areas Approx. 2,000 JASS 4.72 +0.9 TOTAL 220 12.09 +2.1 * There are a few exceptions. MIDUVI’s PRAGUAS project has a pilot component to provide technical assistance and financing to municipalities that delegate service provision to public, private or mixed companies or cooperatives. To date at least 6 small municipalities have delegated the provision of water and sanitation services. There is a growing demand for this. It is expected that at least 20 municipalities will take advantage of this arrangement by the end of 2004. Source: “Plan Nacional de Desarrollo del Sector de Agua Potable y Saneamiento Brisico”, (National Development Plan for Potable Water and Sanitation) G. Yepes, B. G6mez y E. Carvajal, October, 2002; and the Project ImplementationUnit of PRAGUAS. 11. Coverage and Trends 7.5 Water. During the last two decades service coverage has increased significantly. The population with a water connection increased more than overall population growth during the period 1980-1999. Total population increased by 3.9 million and the population with access to a water connection increased by 4.1 million (see Table 7.2). However, at the end of 1999, there were still 4 million people without access to an adequate water supply. In Ecuador, as in many other countries in the region, having a water connection does not necessarily mean access to safe drinking water. MIDUVI reported that in 47 percent of the municipalities service provision is intermittent and in 5 1 percent the service quality is poor or bad. A study by Asociacibn Znteramericana de Ingenieria Sanitaria y Ambiental (AIDIS) reported that only 70 percent of the water from surface sources received some kind of treatment.’ 7.6 Sanitation. During the same period, the population with access to sanitation increased by 3.3 million, while the country’s population increased by 4.1 million, leading to a growing gap in service coverage in absolute terms. At the end of 1999, there were more than 5 million Ecuadorians without access to sanitation services. As in the case of water, sanitation services are of poor quality. MIDUVI reports that in 74 percent of the municipalities the service is poor or bad, and only 10 percent of the systems had a wastewater treatment facility, but none of those were treating 100 percent of the discharge. ’ AIDISIAEISA. Revista de Ingenieria Sanitaria y Ambiental. Quito, August, 2000. 17 1 7.7 Urban and Rural Table 7.2. Evolution of Water and Sanitation Service Disparities.* Despite efforts to Coverage (population served, millions) increase coverage during the past decades, coverage levels for water Year Total Safe Water Sanitation and sanitation in rural areas are well Population (%o) (%) below those in urban areas, (water3: 82 percent in urban areas and 39 l980 8.1 3.9 (48) 3.5 (43) percent in rural areas, and 1990 10.3 6.4 (62) 5.4 (52) sanitation4: 73 percent in urban areas and 29 percen; in rural areas). And lgg912.0 8.0 (67) 6.8 (57) except for urban Ecuador Sources: OPS (PAHO) Sene Informes Ttcnicos No. 5 (Technical Report Series) and MIDUVI, Anaisis del sector de still reports one of the lowest agua potable y saneamiento en el Ecuador - Sene Anilisis coverage rates in the Andean region, Sectoriales No. 1, 1999. (Analysis of the drinking water and sanitation service in Ecuador - Sectoral Analysis Series No. 1, even after adjusting for income 1999) levels, as shown in Figure 7.1. 7.8 Regional Disparities. As shown in Table 7.3, the Coastal and Eastern regions have the lowest coverage rates in the country. Table 7.3. Water and Sanitation Service Coverage by Region, 1999 (percentage ofpopulation population served) Service Total Region Highlands Costal Eastern Insular Potable Water 67 Urban a/ 82 90 98 Rural 39 56 48 Sanitation 57 Urban af Rural a/ Coverage includes only house connection; Shaded: those below national average. Source: MIDUVI “Plan Nacional de Desarrollo del Sector de Agua Potable y Saneamiento Bdsico” (National Plan for the Development of Potable Water and Basic Sanitation Sector), G. Yepes, B. G6mez y E. Carvajal, December, 2002; p. 11-14 3 Water service available through house connections or through protected easy access water sources (wells, stand posts, manantiales, rain water catchments) 4 Sanitation service through a sewerage system (without treatment) or individual solutions in situ (latrines with or without water runoff) 172 Urban water ...... 120.00 100.00 co 5 100.00 En N mookEce PE * @MX a000 0 60.0 0 60.00 3 4000 2000 @ PY 000 0 2,000 4,000 6,WO 8,000 10,00012,000~~,000 GDP per ea plta ~a~~~s~e~for p~~c~~~~power, 2 a 80.00 p 60.00 I Source: ~n~~~uc~~i~ePolicy Notes for Ecuador, The W~~ldBank, Was~ing~om,January 2003. 7.9 ~~~~~. o~se~oldaccess to wa~er and san~tat~o~s ices also differs based on ~ncomelevel. In both urban and rural areas the Areas (%) poorest se~~entsof the ~opulati~~are less likely to have access to services. Figure 7.2 Urban shows the ~~e~~a~i~iesin access to water services by deciles of ~o~s~~ers tJrban the ~o~~i~at~onin urban and Spending i~~ere~cesare larger in urban than in rural areas, Rural Spending 7.20 There are also acute d~~erenc~sin uaIity of service by ~~co~elevel of the 12345678910 ~~~~la~~o~served. Abo~~5 percent of urban Deciles of Consumer Spending - average of 12 hours per day in the south and center of the city), and low pressure in the same areas and in peri-urban areas. In Guayaquil, however, a concession contract with a specialized private operator, InterAgua, establishes clear targets and conditions for service provision.6 That is not the case for the other 12 intermediate cities (with a population of between 100,000 and 300,000), or smaller municipalities. In these cities only 45 percent of those with a household connection receive continual service and only 40 percent receive adequately disinfected water. The problems of unreliable and poor service and water quality create additional problems for users, Figure 7.3. Water Treatment by Expenditure especially for poorer segments of the Deciles population, as additional %Families that treat the water expenditures are required to cover the costs of treating the water at I 1001 home. If they do not regularly treat the water they are at higher risk of incurring medical expenses and suffering time losses due to waterborne diseases. Figure 7.3 1 2 3 4 5 6 7 8 910 illustrates the impact on the poor of d ."An bad water quality, as at a national Source: PAHO. 2000. level only 40 percent of the families in the lowest deciles treat the water at home in comparison with 90 percent of families in the highest decile.' 7.1 1 The inequality is higher when one considers that water and sanitation services are highly subsidized for those with access to a household connection (the richer segments) and the services to those without a connection are not. As a consequence, service to the poorest segments of the population end up being of higher cost and lower quality. 7.12 The poor service quality also has a negative impact on health. Although there are no good statistics on the incidence of water-borne diseases at the community level or by neighborhood to compare against access to potable water and sanitation services, Figure 7.4 shows a strong correlation between coverage and reported cases of intestinal infectious diseases by region. 6 "Proceso de Modernizacidn de 10s Servicios Pliblicos de Agua Potable y Saneamiento de Guayaquil", (Modernization of the Public Services of Water and Sanitation in Guayaquil) ECAPAG, 2001. I "Desigualdades en el acceso, us0 y gasto con el agua potable en Ame'rica Latina y el Caribe" (Inequality in access, use and spending with regard to potable water in Latin America), Ecuador, Serie Informe Ttcnico No. 5, Organizaci6n Panamericana de Salud (Panamerican Health Organization (OPS)), Washington DC, February, 2001. 174 e= ~~~~~~ ~@~i~~;E= ~as~er~~~~i~~; I=~~~~~~; S= Sierra testinal Infectious Diseases per ~~.~~~inhabitants (2,000) yslis 7.13 The water and san~ta~~onsector ~epen~s~eav~~y on transfers from central a riffs are well below cost ~ecoverylevels. In the absence of e trans~ersand Ioans to the water and sa~~ta~ionsector have s in the last decade. In many cases these sources act ~nd~pe~dently, w~tho~t clearly define^ ~eve~op~en~o~~e~tives and often with a negative impact on the sector as subsidies from centra1 gove~mentbenefit mainly those with access to the services-and not the poorest s~g~gntsof the ~o~~1ation. 7.14 At the national level ~gg~egate~income from tariffs (~p~ro~.US$74 ~~~I~onin 2o0l) covered 67 percent of operation and ~~inten~ncecosts (approx. ~$$1~~ ion for existing systems~.If debt service is cons~dered(approx. US$18 ~i~~~~nper year) then coverage goes down to 58 percent. The gap is closed by transfers from the central gove~~e~~(approx. US$114 ~il~jonin ~0o1~ and ~u~~cipa~gove~~ents (approx. $30 m~~~~~nin 2001) as shown in Figure 7.5. After covering current costs, about ~$$9~~ill~~n re~a~ned for ~~v~stments in 2001. 175 Figure 7.5. Income and Expenses of Water and Sanitation Services (2001) H Investment 250 0 Debtservice 200 Adequate O&M 150 0 Telephonetax 100 0 MrDwItransfm 3 CIa s 50 Municipal transfers 0 0 Tariffs Source: Infrastructure Policy Notes for Ecuador, The World Bank, Washington, January 2003. 7.15 Central Govemment Expenditures. The water and sanitation sector is partially financed by transfers from the Government through: (i)MIDUVI, including the Fondo de Solidaridad Social, multilateral and bilateral credits, and its own budget; and (ii) transfers from the telephone tax pre-assigned to the water sector, transferred directly to the utility or municipality for investment purposes only’. Of the US$114 million of central government transfers in 2001, about US$64 million were assigned through MIDUVI (US$6 million from the Fondo de Solidaridad and US$58 million from its own budget) and about US$50 million came from the telephone tax. 7.16 Transfersfrum MIDUVI. The transfers from MlDuVI to the sector are direct transfers to the utilities or municipalities for the execution of investment projects. These may be contracted by the municipality or directly by MDUVI. This includes resources from multilateral, bilateral and domestic lending sources that are earmarked for investments in the water and sanitation sector. These transfers are allocated without any specific conditionality or incentive to improve efficiency or cost recovery. Table 7.4 shows that since 2002 MIDUVI’s own resources for investment have been drastically reduced from US$52 million to US$5 million for “transfers for investment” and from US$44.6 million to US$1.5 million for direct investment in public works. During 2003 the resources from the “Solidarity Fund” were also reduced from US$6 million to US$420,000. In 2003, MIDUVI’s budget was maintained at the lower investment levels of 2002, with only US$22.5 million for investment, including the resources from the Solidarity Fund for water and sanitation. 8 The special tax is 15 percent of telephone charges, and it is distributed between the water (10 percent) and sports (5 percent) sectors. Resources to the water sector are only for investments in drinking water supply. 176 Table 7.4. MIDUVI's Budgetary Allocation for the Water and Sanitation Sectorsg 2001-2003 (US$ thousands) Item 2002 a/ 2003 Initial Available Initial Available Allocation Codified Allocation Codified Income Income b/ Operating expenses (including personnel) 1,026 1,956 1,026 1,860 Investment Direct Investments in Public works 44,630 1,468 6,146 970 Fondo de Solidaridad Social 6,050 6,050 6,050 419 External Credits (e.g. PRAGUAS) 3,360 3,224 3,224 3,525 Domestic Credits (e.g. BEDE) 1,418 1,418 1,418 7,700 Counterpart Funds 376 322 322 200 Earmarked Funds (e.g. FONASA) 77 77 77 26 Transfers to Municipalities & "Donations" 52,164 5,184 3,395 9,650 TOTAL c/ 109,102 19,698 2 1,659 24,35 1 Source: MIDUVI, SABYSPY, Estado de Ejecuci6n Presupuestaria (Budget Report) 2002 and 2003. a/ Reported data at closing date, December 3 1,2002. b/ Reported data as of September 30,2003. c/ Total may not exactly add up due to rounding. 7.17 ICE, Telephone Tax. The Special Consumption Tax, a tax on telephone services, has been one of the main sources of funds for the sector during the last 40 years. These transfers are highly controversial because of the distortions generated in both sectors. Historically,. the resources have been collected by the telephone company, passed onto the government and then distributed by the Central Bank to utilities or municipalities in the area where the money was generated in the first place.'' 7.18 A direct result of the current interpretation of the law is that the resources from the telephone tax have not contributed to reducing the regional inequalities in service provision, or inequalities between urban and rural areas. On the contrary, it contributes to increase the disparities as the resources are highly concentrated in Quito and Guayaquil. The two largest municipalities have 27 percent of the population and in 2002 received 70 percent of the total resources distributed (Quito and Guayaquil received a total of US$32 million out of a total of US$46 million"). In that same year 25 municipalities received less than US$l,OOO (15 percent of the municipalities) and 84 municipalities received less than US$lO,OOO (50 percent of the municipalities). Data available as of September 30, 2003, confirmed the tendency as 75 percent of the resources transferred so far in 2003, had gone to Quito and Guayaquil. 7.19 The development impact of these transfers is not significant. They are not used as an incentive for improving efficiency or increasing access to the services. They only 9 The definition that MIDUVI uses for sanitation includes solid waste. 10 Ley de Refomza del Rigimen Tributario Intemo de Mayo del 2001, Articulo 38, el cual aiiade luego del Articulo 84 del RCgimen Tributario el Articulo 84", 10s recursos se destinaran para proyectos de agua en todos 10s cantones del pais. (Reform Law to Internal Tax Regime, May 2001, Article 38, adding Article 38') Source: Registro Oficial No. 325. 11 Banco Central del Ecuador, Direcci6n de Servicios Bancarios Nacionales, Distribucih de Impuesto Consumos Espaciales, 10 percent Agua Potable, AAo 2002 y 2003 ( data as of September 30,2003). 177 reduce the pressure on the utility to cover its costs via tariffs.12 The ICE, as currently applied, is not necessarily benefiting the poorest segments of the population, as it is not always used for investments in additional water connections. It is important to note that in the case of Quito transfers from the central government (ICEE) and the municipality represented 32 percent of total income in 2002, and 30 percent of total income in 2001. It is also clear that, at least in the 56 municipalities receiving less than US$5,000/year, it is not likely that the resources are being used to finance investment projects because of the small size of the transfers. 7.20 Loans and Credits. Domestic financing to the sector is available to utilities and municipalities mainly from the Ecuadorian Development Bank (BEDE), which lends on resources from multilateral and bilateral credits. The larger utilities (Quito, Guayaquil and Cuenca) have received multilateral loans for specific projects, mainly from the Inter- American Development Bank (IDB). MIDUVI also finances some of its investments with multilateral and bilateral loans. Historically, the amount lent to the sector has been relatively small, with an average of US$32million a year over the last 20 years, of which about US$20 million correspond to loans from the IDB to Quito, Guayaquil and Cuenca and US$12 million to BEDE, which has at least been distributed to most of the municipalities in the ~ountry'~.Recently the World Bank has been more active in the sector, lending to MlDUVI for water and sanitation in rural areas and small towns. The Corporacibn Andina de Foment0 (Andean Development Corporation or CAF) and the World Bank have also lent to specific projects in the sector, although in smaller amounts. It is important to note that most multilateral credits include components of institutional strengthening, and some even impose conditions directed at improving cost recovery. In some cases those credits are not repaid by the utility and end up being absorbed by the Government, increasing once again the subsidies to the sector. In 2002, Quito's Water Utility Company (EMAAP-Q) had long-term debt of US$187 million with the IDB, US$1.5 million with BEDE, and other debt of US$1 million. 7.21 Municipal Transfers. The fiscal resources of municipalities are extremely limited (0.4 percent of GDP) when compared with other countries of the region. In countries like Argentina, Brazil, Chile and Colombia the percentages are above 2 percent of GDP14. Of 2001 total fiscal income, the central government generated about 96 percent while municipalities generated about 3 percent. Generation by the provinces is even lower at less than 1 percent of total fiscal income. Since 1977, the central government has had to transfer a percentage of its budget to the municipalities. The initial amount of 15 percent had increased to 33 percent of its budget, by law, in 2001. However, in practice, the central government transferred 12 percent of its budget to the municipalities in 2001. The low levels of tax income for the municipalities translate into low levels of expenditure. Available resources are usually not enough to cover operating expenses, let alone invest in services under municipal responsibility like water, sanitation, solid waste 12 The tax does not take into account that financial resources are fungible so the transfers are not necessarily a source of fresh resources for investment but just maintain the status quo, as the transfers cover the financial gap. 13 Yepes, Gomez y Carvajal, 2002. 14 Wiesner, Eduardo. Ecuador: La Descentralizacidn, el Ajuste Fiscal y el Desarrollo Municipal. Serie de Estudios Econdmicos y Sectoriales (Ecuador: Decentralization, Fiscal Adjustment and Municipal Development). IBD. Washington, DC, February, 2000. 178 collection and disposal, roads, slaughterhouses, and cemeteries. Table 7.5 shows the total municipal expenditure on water, sanitation and solid waste sectors, on a per capita basis. Table 7.5. Municipal Expenditures per Capita and by Sector, 2001 Per capita expenditures Cities Total Water Sanitation Solid waste Other Guayaquil 63.80 0.00 0.18 0.00 63.60 100,000 to 300,000 inhabitants 56.50 1.00 1.80 0.13 53.50 30,000 to 100,000 inhabitants 68.40 1.90 6.00 1.oo 59.50 Less than 30,000 inhabitants 91.10 6.20 3.40 0.60 80.90 Weighted average (per capita) 62.00 1.00 1.50 0.17 60.30 Source: BEDE, Sistema de informaci6n fiscal, 2002. (Sample of municipalities excluding Quito, information as of December 31,2002). 7.22 The municipal transfers in Table 7.5 to the water, sanitation and solid waste sectors, represent a net aggregate of about US$32 million per year for 200115 and are not enough to cover the operational deficit of the services. Table 7.6 shows how those smaller municipalities, with a reduced amount of participation in the overall distribution of the ICE tax, are investing a much larger proportion of their income in the water and sanitation (W&S) sectors, while larger cities spend a much smaller share of their own resources on the sector. Table 7.6. Distribution of ICE and Municipal Expenditures in Water and Sanitation (US$/per capita, 2001) City by Size ICE (Tel. Total municipal Municipal W&S as percent of total tax expenditure expenditure W&S municipal expenditure Quito 8.4 31.8 0.03 0.09 Guayaquil 4.69 63.8 0.18 0.2 100,000 to 300,000 2.27 56.5 2.8 5 30,000 to 100,000 2.52 68.4 7.9 12 Less than 30,000 1.91 91.1 9.6 11 Source : World Bank, Ecuador Policy Notes, Infrastructure, 2003. 7.23 Utilities’ Operating Income. Considering that subsidies and loans available to the sector are formally for investment only, income generated from operations should cover at least operation, administration, maintenance and debt service costs. The reality is different, and is reflected in the financial statements, in the quality of the service provision and the maintenance of the infrastructure. A detailed study based on a sample of eight utilities in medium-sized cities shows that the billed amount for service provision is less than total operating costs, even without depreciation and finance charges. The operating deficit of these utilities is much higher when considering that the collection ratio is on average 83 percent of the billing. In the case of Guayaquil, the utility reported a negative result even before depreciation in 2001. 15 Estimation based on an average of $2.50 per capita and a total population of 12 million. Source: Yepes, Gomez, Carvajal, 2002. 179 7.24 Quito’s water utility, EMAAP-Q, has increased tariffs since 2000, and has reported a positive result ever since. However, as can be seen in Table 7.7, even after the considerable price increases between 2001 and 2002, income generated by tariffs represents about 60 percent of total income. As Quito is the richest utility, it means all the analyzed utilities are not covering costs with income from tariffs. The transfers received from telephone charges are clearly covering that deficit. EMAAP-Q, with an estimated operating deficit of about US$10.6 million in 2001, reported a surplus of about US$7.3 million; and for 2002 the utility had an operating deficit of about US$5.3 million but reported a surplus of US$24.4 million. And the administration costs increased considerably in the same period. Table 7.7. EMAAP -QUITO Summarized Statement of Results Impact of Subsidies on Results (values in US$ ) 2002 2001 Income: Water sold 4 1,724 25,547 Other operating income 15,600 11,268 Energy sold 3,481 4,055 Income from taxes (subsidies) 29,644 17,892 - ICE (Tel. Tax- Central government) 26,619 15,465 - 5 percent predial (municipal property tax) 2,363 2,004 - 1 percent alcabalas (municipal tax) 662 423 Total Income (A) 90,449 58,762 Total Income excluding subsidies (B) b/ 60,805 40,870 Expenses: (does not include financial costs) Operating costs 56,811 45,600 Administration and general costs 9,268 5,869 Total Expenses (including depreciation) (C) 66,079 5 1,469 Result from Operation (B-C ) b/ -5,2 74 -I0,599 Reported Operational Result (A-C) 24,370 7,293 Source: Deloitte and Touche, Estados financieros por 10s aiios terminados el 31 de diciembre de 2002 y 2001 e Informe de 10s Auditores Independientes. (Audited Financial Statements for 2002 and 2001) Quito, April 25,2003. b/ Own calculations. 7.25 Operating Expenses of Utilities. It is evident that the tariffs charged are insufficient to generate enough resources to provide efficient and high quality services while adequately maintaining the infrastructure. The study by Yepes, Gomez and Carvajal estimated an aggregated shortfall of about US$54 million per year, taking into account adequate operation and maintenance of the systems and debt service. Table 7.8 shows that even with the current levels of maintenance, operating income is insufficient. 180 7.26 Eflciency. Based on Table 7.8. Operating Income and Operation and Maintenance available data on the efficiency (us$ of water and sanitation service Item Actual Adjusted Operating Income (from tariffs) 74 74 provision in large and medium Operation and maintenance costs 83 110 sized cities in Ecuador, the Debt service 18 18 situation is also worrisome. (DEFICIT) OFTHE SECTOR (27) (54) The INXTlber of staff per Source: Yepes Gomez and Carvaial, 2002. thousand connections in Quito and most medium cities is well above efficient benchmarks from the region. Guayquilflnteragua is the exception, as can be seen in Table 7.9. Table 7.9. Utility Efficiency (use of personnel), 2001 Water connections No. of Staff (N) per 1,000 Utility (total) Employees (N) water connections Cities with more than 1 million inhabitants Quito (EMAAP-Q) 318,000 2,060 6.5 Guayaquil (INTERAGUA) a/ 266,000 900 3.4 Cities with population between 100,0000 and 300,000 inhabitants b/ Santo Doming0 de 10s Colorados 20,375 196 9.6 Machala 29,685 173 5.8 Manta 29,000 220 7.6 Portoviejo 24,05 1 340 14.1 Dum 27,369 195 7.1 Ambato 34,741 300 8.6 Riobamba 30,122 180 6.0 Milagro 16,351 69 4.2 Ibarra 23,866 205 8.6 Esmeraldas 22,387 167 7.5 Benchmarks from two of the best performing utilities in the region Santiago (Chile) 1,200,000 1.2 SANEPAR-Paran6(Brasil) 1,914,OoO 2.6 Source: Ecuador Policy Notes- lnfrastructure (MIDUVI and World Bank calculations). 2003. a/ Data for Guayaquil estimated. b/ Sample of 10 utilities. 7.27 Such large inefficiency levels have a large impact on expenses, making it harder to cover costs and reducing the possibility of investing own resources. In smaller utilities, a lack of economies of scale is a burden that increases operating costs, as most of the service providers in small towns are the municipalities. However, there is not enough information to analyze the financial results in detail. 181 Box 7.1. Household Expenditures in Water. The Case of Machala, El Oro. Information on average spending on water for families with and without connections in Machala, a city with 90 percent coverage. As those not covered are the poorest segments of the population, it illustrates the differences in price and consumption for the poor, and the impact in terms of monthly expenditures on water and sanitation as a percentage of family income. The table shows that an average family served by a water connection consumes 3 times more than an average family without access to the network. Those households without a connection spend about 9 percent of their monthly income for a service of lower quality, while those with access to the network spend less than 1 percent of their monthly income on water. Machala. Monthly Expenditure on Water of Households with and without a Connection to the Water Network User Concept With water Served by connection tankers Estimated average monthly consumption of a poor family 15 4to5 a/ (in m3) Estimated average monthly 1.20 bl 29.00 payment (in US$) Monthly expenditure in water as a percentage of monthly 0.4 9.0 family income Source: Yepes, Gomez and Carvajal, 2002. a/ Estimated by Yepes and Gomez based on average consumption of approx. 30 liters/person/day. b/ Tariff depends on house characteristics. The indicated value is based on the lowest tariff. 7.28 Cross Subsidies. Utilities also subsidize consumption through cross subsidies. In Ecuador, this practice has become widespread. Usually the utilities charge higher tariffs to commercial and industrial costumers to subsidize domestic users. The impact of this mechanism on the water and sanitation sector in Ecuador is not clear. Since the average tariff does not cover costs (usually not even operation and maintenance costs) there is another embedded subsidy in the price structure that most of the time is not recognized as such16, and greater distortions are generated. There is a negative impact of these cross subsidies on the financial health of the utilities, due to the effect of price elasticity of water demand, as the lower tariffs charged to residential users result in increased consumption, with associated incremental production costs. And on the other hand, the smaller number of larger consumers are penalized by a surcharge that in most cases is not enough to compensate financially for the subsidies given to the residential users. If coverage levels were at 100 percent, it could be argued that the poor would benefit from the cross subsidies to consumption. However, with existing coverage rates it is clear that cross subsidies do not achieve a distributive objective, as the poorer segments are those lacking access to services. It could be argued that the low tariff levels have such a negative impact on utility finances that they prevent the utilities from investing to increase coverage. Box 7.1 (above) illustrates the case of Machala. 16 This subsidy can be measured with respect to the average tariff that covers all costs. 182 7.29 Table 7.10 shows the tariff structures for Quito and Ibarra, number of users and consumption by user group. It shows that more than 90 percent of the users, who consume about 75 percent of the total water supply, only pay 66 percent and 53 percent of billing revenue respectively. In these examples the tariff is also well below cost recovery levels. On the other hand, commercial and industrial users, that represent between 5.5 and 7.5 percent of users, consumed about 11.5 percent of total water and represented 18 and 28 percent of total billing, respectively. In the case of Ibarra, industrial users get charged 5 times more than the average tariff. Many utilities have noticed that industrial users are lowering their consumption as some are developing their own water sources such as wells, andor are implementing systems to reuse water to avoid the high water charges. This situation also generates a negative impact as it reduces revenue, and in many cities the situation is becoming financially unsustainable. If other utility sectors were also charging such high tariffs to industrial and commercial users it could potentially prevent expansion or establishment of new industries in the country, and it is a topic that should be further explored. Table 7.10. Tariff Structure and Cross subsidies - Quito (urban) and Ibarra (urban), 2002 No. Users ConsumDtion Billing Average tariff (thousands) (thousal;ds of (US$ millioimonth) ($ /;n3) User group (percent) &/month) (percent) Commercial 4.9 7.4 11.5 11.7 17.9 27.7 0.44 0.55 Industrial 0.5 0.1 4.1 0.9 6.4 4.8 0.44 1.26 Public sector, other 0.8 1.o 8.3 9.1 9.5 15.2 0.33 0.39 Total: As a percent 100 100 100 100 100 100 Absolute Value 244.1 29.1 7,071 619 2.02 0.14 0.29 0.23 Source: Yepes, Gomez and Carvajal, 2002. (Commercial Department of the utilities). The number of users and volumes subsidized are higher as the average tariff for both utilities is below cost recovery levels. For Quito it is estimated to be US$0.40/m3,detailed cost information for Ibarra was not available. 7.30 In absolute terms the estimated value of the subsidies is considerable. In the case of Quito, the amount of subsidies to domestic costumers is estimated at about US$10 million a year, which represents about 27 percent of total billing. In the case of Ambato this subsidy is about US$2 million a year, which is above yearly billing. Table 7.11 shows the distribution of subsidies for residential users in Quito and Ambato. As can be seen, subsidies increase with consumption in absolute terms. If consumption is a function of income, those with higher income levels consume more water and will be receiving a higher share of the cross subsidy than the poorest consumers with a connection, because, even with an increasing average tariff per block, the average consumption per block increases at a higher rate. 183 Table 7.11. Water Subsidies to Domestic Users, Quito and Ambato, 2002 Consumption Quito (urban) Ambato Block m3/dmonth Average Subsidy m3/dmonth Average Subsidy (&/month) tariff $/dmonth tariff $/dmonth $/m3 a/ $/m3 a/ 0- 10 6.0 0.18 1.30 4.4 0.39 0.50 11 -20 15.5 0.18 3.40 16.3 0.18 5.20 21 -50 32.9 0.19 6.90 32.8 0.22 9.20 51 - 100 63.5 0.29 7.00 67.6 0.30 13.50 101 - 300 149.6 0.32 12.00 138.8 0.38 16.70 Over 300 607.9 0.27 79.00 368.3 0.38 44.20 Average 39.2 0.25 5.90 25.0 0.25 6.30 Source: Yepes, Gomez and Carvajal, 2002. al With respect to tariff that will cover costs; estimated as US$0.40/m3 for Quito and $OSO/m3 for Ambato. 7.31 The cross subsidy system is based on the theory that all domestic users require subsidies. However, there is no evidence Table 7.12. Distribution of Subsidies, 1994 supporting that argument. The poorest (oercentl\ ~--~~ segments of the population, without a Quintile Subsidy household connection, usually end up Water Total servicios 1/ paying a larger proportion of their First 7.9 9.5 income in water and sanitation services Second 12.0 13.6 than those with a water connection. And Third 15.2 17.4 Fourth 23.6 23.6 of those connected, the richer segments Fifth 41.3 35.8 of the population are receiving the larger Total 100.0 100.0 subsidies in absolute terms. Source: Ecuador Poverty Report. The World Bank 1996. Unfortunately, not enough information 1/ Electricity, water, andurban transport services. was available to update the results presented in a 1996 World Bank report 17, which compared the distribution of subsidies from the utility sectors. The report showed that the implicit subsidy in water services was the most unequally distributed among the different subsidies analyzed (electricity, water, gas and urban transport) in Ecuador, as can be seen in Table 7.12. 17 The World Bank. Ecuador Povertv Report. Washington, DC, 1996, page 226. 184 IV. Recommendations 7.32 The current institutional, financial and legal framework for the sector provides insufficient incentives for public utilities to improve their performance and extend services to the poor. Resolving these issues will require sustained action on a number of fronts. 7.33 Improve the institutional and financial framework for the sector to reduce the needs of continuous subsidization to the sector: Use transfers and other central govemment resources as an incentive to improve utility eficiency. Given that water and sanitation services are a municipal responsibility, the central government should use the financial transfers to the sector as a mechanism to provide incentives to improve corporate performance of the water utilities. This could be done by using transparent mechanisms for the allocation of funds linking the amount of transfers received to operational and financial performance and requiring the municipalities to invest a proportion of their resources in the sector as a matching grant mechanism. The amount of subsidy to be allocated per connection could be defined considering the size and income level of the population. This would avoid existing disparities in central transfers that benefit mostly the large and richer utilities and better target the poor. This strategy would work if the central government avoids transferring resources through a parallel window without conditionality. Improve Operational Eficiency of Public Utilities and Increase Cost Recovery Levels. Financially sustainable utilities will reduce the need of constant subsidization from the central govemment and the municipalities to the sector. The main obstacles preventing the sector from being self-sustained are; (i)high cost of services due to inefficiencies; and (ii)inadequate tariff levels and subsidy policies. (i)Operating efficiency in public utilities in Ecuador is inadequate. The majority of the public utilities seem to be overstaffed, with inefficient commercial and financial systems. Levels of commercial and physical losses also remain high. Ideally, the operating costs of the public utilities should reflect cost of efficiency. Public utilities should make an effort to reduce costs, improve their operational efficiency and show results to their customers. (ii)Current tariff levels are in large insufficient to cover operation and adequate maintenance costs. The existing tariff structures are inadequate and existing cross subsidies only mask more distortions and have a negative impact on the utility and the poor that remain unserved. More detailed studies on the impact of cost recovery tariffs on the poor should be further analyzed. Furthermore, better targeting mechanisms should be developed, as the current situation is financially unsustainable. Private Sector Participation and Specialized Provision. Given the benefits it can offer, private sector participation should be further pursued. The local private sector should be attracted to the provision of services in small and medium cities, reducing the need of constant subsidization to operations. The water and sanitation sector utilities should generate cash, but this is not the case in Ecuador. Experiences from other countries of the region (such as Colombia and Paraguay) with minimum subsidy concession and output based aid could be of interest and 185 impact in Ecuador. At the very least, the government should require that services be provided by a specialized entity (public, private, mixed, communal), with separate accounts from those of the municipality, as otherwise it is extremely difficult to assess service provision, identify inefficiencies and provide assistance or resources to improve performance. This will be especially important for small cities. 7.34 Support the Sector’s Legal Reform. MIDWI and Council for Modernization of the State (CONAM), with the support of international consultants, are working on the development of a Water and Sanitation Law. The proposed law will be based on the existing water and sanitation policy and is expected to address many unresolved issues within the sector. The main objective of the law is to establish basic norms for an efficient provision of water supply, sanitation and drainage. The main principles of this new law are efficiency in the service provision, institutional accountability, universal access, service quality and continuity, cost recovery reflecting the economic value of the service provision, social equity, preservation of the water resources and the environment, and consumer protection. The WB and the IDB are actively participating in the review of this law and consider it as a high priority. 7.35 Increase Coverage. Given the large disparities in access to water and sanitation services and that those without access are the poorest segments of the population, better targeting mechanisms for the subsidies provided by central and municipal governments to the sector should favor access versus consumption. In rural areas of Ecuador, there is evidence that the poor have the capacity and willingness to pay for services that meet their own demands. For example, in the MIDWI’s PRAGUAS projectl8, in rural areas beneficiaries are paying tariffs that cover all administration, operation and maintenance costs and some cash generation for replacement costs, as well as, an upfront contribution in cash and labor during construction. A similar mechanism could be established to serve the poor peri-urban areas of medium and large cities. 18 Partially financed by the World Bank. 186 References Infrastructure Policy Notes for Ecuador, The World Bank, Washington, January 2003. “Desigualdades en el acceso, us0 y gasto con el agua potable en Ame‘rica Latina y el Caribe”, Ecuador, Serie Informe Te‘cnico No. 5, Organizacidn Pana- mericana de Salud (PAHO), Washington, D.C, February, 2001. Deloitte and Touche, Estadosfinancieros por 10s aiios terminados el 31 de diciembre de 2002 y 2001 e Informe de 10s Auditores Independientes. Quito, April 25,2003. “ Decentralization Reform Agenda in Ecuador,” The World Bank, May, 2001. “Project Appraisal Document, Rural and Small Towns Water Supply and Sanitation Project (PRAGUAS),” World Bank, September, 2000. “Proceso de Modernizacidn de 10s Servicios P6blicos de Agua Potable y Saneamiento de Guayaqui,” ECAPAG, 2001. World Development Indicators (WDI), The World Bank, Washington, 2002. Ecuador Poverty Report, The World Bank, Washington, 1996. BEDE, Sistema de Informacidn Fiscal, Quito, 2002. Banco Central del Ecuador, Direccidn de Sewicios Bancarios Nacionales, Distribucicin de Impuesto Consumos Espaciales, 10% Agua Potable, AAo 2002 y 2003, Quito, 2003. MIDUVI (SAPYSB), Estado de Ejecuci6n Presupuestaria 2002 y 2003, Quito, 2003. INEC. Anuario Estadisticas Hospitalarias, 2000. Registro Oficial No. 325. Ley de Reforma del Re‘gimen Tributario Intemo de Mayo del 2001, Articulo 38, Quito, Ecuador, 2001. Creacidn del Fondo Nacional de Incentivos, (Proyecto para Discusidn), MIDUVI- SAPYSB, Quito, 2003. Wiesner, Eduardo. Ecuador: La Descentralizacidn, el Ajuste Fiscal y el Desarrollo Municipal. Serie de Estudios Econdmicos y Sectoriales. Banco Interamericano de Desarrollo. Washington, D.C, February, 2000. Yepes, B. Gdmez y E. Carvajal, December, 2002. “Plan Nacional de Desarrollo del Sector de Agua Potable y Saneamiento Bdsico. ” 187 ChaDter 8 ELECTRICITY Ecuador’s electricity sector is facing a financial crisis that will require political will to fix or the government may have to find extra public money to keep the industry going. The reforms of 1999, which opened generation to private companies while maintaining government monopolies in transmission and distribution, are taking the blame. However, reforms themselves were not the problem, the execution of the reforms is. Among the biggest dificulties facing the sector are a pricing system that is unfair to distributors by forcing them to make a loss on much of the electricity they sell; political interjlerence in the setting of prices to consumers; and the failure of many customers, including public agencies, to pay for the electricity they use. Without firther reform it may be dificult to attract the necessary private capital needed to expand the system’s capacity and keep up with demand growth. The main recommendations, which have been agreed in consultation with both private and public participants, include to: (a) regularize the financial situation of the industry and put in place a system to ensure payment of bills, including cut-08s to non-payers; (b) strengthen the regulator and insulate it better from political interjlerence. Give it budgetary freedom, perhaps by finding @om industry sources; (c) improve management with a system of incentives and penalties to ensure more eficient companies, perhaps hiring private management; (d) a transparent policy for setting rates that encourages investors while also providing incentives to cut costs and thus sell electricity more cheaply; and (e) study new ways to attract private financing, especially for hydroelectric projects that produce cheaper electricity in the long run. This may include some government guarantees forfinancing risks. 8.1 The Ecuadorian electricity sector is facing a crisis whose symptoms include financial chaos. This situation has led to dissatisfaction among service providers, and led to calls from various sectors to reform the industry’s structure. This calls for deep reflection about the fundamental causes of the problems now being seen with the aim of developing a long-term approach to the industry. This document diagnoses the problems facing the industry and suggests a strategy for its development. The first section, which presents an analysis of the sector, was discussed at a meeting held on January 26, 2004. Meeting participants included authorities from the electricity sector, government representatives, and market players. The conclusions of that meeting provided a foundation upon which to structure Part Two of the document, which outlines a long-term strategy. I. Diagnosis 8.2 The Reform’s Expectations. The current structure of the electricity sector is based on changes introduced by the 1996 Electricity Law. This provided a basis for institutional reforms, culminating in 1999 with the industry’s current mode of organization. The reform came about 1 This paper was written by Fernando Lecaros (World Bank Consultant), and reviewed by Philippe Durand (World Bank). 189 because of the persistent failures of the previous industry structure and aimed to alleviate the government’s financial burden. 8.3 The reforms instituted sought to create an organizational framework for business relations among the players, such that incentives and financial results (as opposed to political concerns) would guide their performance. It was hoped that these incentives would also motivate the players to correct the administrative and operating inefficiencies affecting the industry. This was to be achieved through competition in the generating sector where markets are viable, and regulation in transmission and distribution where free competition is less viable. To that end, the law created an independent regulatory agency, which would set rules and conditions aimed at benefiting consumers and improving efficiency. The objectives of the reform are summarized as follows: (a) increased efficiency and reduced costs; (b) bringing electricity prices in line with costs; (c) improved quality of service; (d) attract private investment; and (e) financial relief for the government. 8.4 The Model Chosen. The organizational model chosen has been adopted in many countries throughout the world (for which reason it is now becoming known as the “standard model”). Its basic structure has the following elements: 0 A wholesale market with multiple generating companies, remunerated in accordance with a spot price determined by the lowest marginal cost of production at that particular time of the day. 0 A contracts market involving generating companies, distributors, and large consumers, which establishes prices for heavy users and provides them with protection against fluctuation in the spot market. A regulated market served by distribution companies at prices set by a regulating entity. The regulating entity determines rate formulas, bearing in mind the costs associated with supplying customers, looking at generation, transmission and distribution. 8.5 With respect to the wholesale market, it should be.noted that remuneration in accordance with marginal cost seeks to mirror the behavior of competitive markets for goods and services where the price is a reflection of marginal cost. Economic theory postulates that if the marginal cost rises, more producers will be attracted to a market showing signs of insufficient demand. If the price falls, the opposite signal is sent to producers. 8.6 Conditions for Efectiveness of the Model. In order for the chosen model to function properly, the following conditions are necessary: 0 Participation by multiple generating companies on the wholesale market, such that there is no room for manipulation of the spot price or of the contracts market (so that the assumptions of competition are present, on which the model is based). 0 Freedom for new generating companies to enter the wholesale market. 0 Multiple distributors and large consumers, so that there will be no room for manipulation of the contracts market. 0 A remunerated and regulated transmission organization, which maintains the transmission infrastructure and thus facilitates market operations. 190 0 A regulatory agency that sets stable rules for the markets, reflecting the economic costs of service. 8.7 A question with respect to the model is whether or not private participation is needed. The problem here is that public companies never face financial consequences for operating inefficiencies as the costs are passed on to the government. Lack of consequences prevents the market from working. Private companies are also necessary in order to provide financial relief to the government by freeing up resources for other uses. This does not imply the need for complete privatization but suggests the need for private generating companies. 8.8 The Structure of the Industry as Implemented. Ecuador implemented the structural elements of the standard model. Generating, the sub-sector considered to be susceptible to responding to competition, was organized through a wholesale energy market, and new companies were organized around the existing power plants. Transmission was organized around a regulated company, and the multiple distribution companies essentially continued as they had been in the past. For the dispatching function, CENACE (Corporacibn Centro Nacional de Control de Energia) was set up, to take charge of administering the wholesale market. 8.9 Regulation and Rates. This function was entrusted to the National Electricity Council, CONELEC (Consejo Nacional de Electricidad), a body comprised of a board whose members, in their majority, are directly or indirectly appointed by the country’s president. One of CONELEC’s primary functions is the setting of rates, according to pre-established principles. 8.10 Attracting Investment, Fiscal Efsects, and Private Participation. One of the reform’s fundamental objectives, in addition to introducing incentives to improve the performance of the players, was to create conditions to attract new capital, especially for the generation of electricity, through private participation. This was intended to have the beneficial effect of relieving the government from its investment burden, making it possible to channel government funds into social services. It was hoped that market mechanisms and rate rules would attract funds, thereby contributing to the sustainability of the electricity sector, which would no longer be a fiscal burden for the State. 11. The Reality of 2004 8.1 1 The results of the reforms have not met expectations. Symptoms of distress in an industry generally manifest themselves as financial decay, and the electricity sector is no exception. 8.12 The Wholesale Market. From a technical point of view, the wholesale market has operated satisfactorily. A contracts market has developed, along with a spot market, which generates a pricing signal serving as an incentive for the installation of new power plants. From a commercial point of view, the wholesale energy market has been characterized by an unsustainable debt accrual due to failure on the part of energy distribution companies to make payments. The current debt of these companies with the generating companies is approximately US$700 million. The debt is principally concentrated in EMELEC (Empresa Ele‘ctrica del Ecuador). 8.13 Debts Accrued among Players. The debt with the wholesale market is simply a manifestation of the financial chaos that characterizes the sector. Some of the most alarming debts among players include: 191 0 Debts of generating companies with Petrocomercial for supplies of fuel: US$106 million.2 Debts of distribution companies with the wholesale market: US$700 million. 3 2 0 Debts of distribution companies with financial entities: US$176 million. 0 Debt of the government with the distribution companies: US$193 milli~n.~ 2 0 Debt of generating companies with the government: US$510 million. 8.14 In addition to debts among players, it should be stressed that government agencies are among the distribution companies’ largest debt01-s.~ 8.15 Rates. Electricity prices have been riding a rough road since the reforms of 1999. CONELEC’ s calculations have called for rate levels consistently higher than the rates actually applied. In 1998 the gap was approximately 3.7 US$/kWh, which increased to some 6 US$/kWh due to the economic crisis of 1999-2000. The government assumed the difference between the cost-basis rate calculation and the rate applied (“rate deficit”), thus establishing a subsidy for consumers. Between April 1999 and June 2001 the subsidy amounted to US$279 million, but it was not officially extended to 2002 or to 2003. In May 2000 the rate increased from 2.5 US$/kWh to 4.2 US$/kWh, and a 4 percent per month adjustment plan was implemented, with a view to reaching cost levels by the end of 2003. In April 2002 the rate was frozen. In October of 2002, CONELEC approved a rate for the period of November 2002 - October 2003, with monthly increases of 5 percent as of January 2003 until it reached a level of 10.38 US$/kWh. Nonetheless, in January 2003 the plan was discontinued, and the increase was reduced to 1.6 percent per month. 8.16 This obvious instability in managing the rate is explained by the periodic accumulation of pressure at the producer level (when the rate freezes without compensation), at the consumer level (when rate increases are considered excessive), and at the level of the government itself (when it grants subsidies that become unsustainable over time). The periodic intervention in the rates of the electricity sector thus forms a cycle, illustrated below: 2 Solidarity Fund, December 2003 3 CENACE, September 2003 4 Undersecretariat of Public Credit, CONELEC and CENACE 5 Solidarity Fund 192 Unsustanability of Temporary financial subsidies relief 8.17 The target rate objective was reduced to 9.16 US$/kWh in October of 2003, based on the following factors: Increase in the useful life of certain transmission and distribution assets; Non-inclusion of VAT in determining the marginal cost of generation; Elimination of the floor previously in place for fuel prices, allowing fuel prices to fluctuate freely, in accordance with international prices; Modifications in the way of calculating purchasing power; Elimination of payments to the generating companies for power during maintenance periods, even in the case of scheduled maintenance; and Different discount rates for different elements of the electrical infrastructure. 8.18 The problems stem from a random application of the rules and constant political interference. This hardly generates confidence in the regulatory entity. What is more, it creates undesirable precedents, discouraging the entry of private investors. Currently, rates have reached a level that has provoked protests by electrical workers unions and business associations, and a new reduction has been announced. 8.19 Sustainability of the Sector. It is fundamental to be aware of the capacity of the sector, as a whole, to cover its costs and contribute to its own expansion. For said purpose, the cash flow of the public electricity sector illustrates the current situation, as is seen in the following table (Table 8.1). 193 Table 8.1. Consolidated Cash Flow for the Electricity Sector 2004 (Millions US$) Billing ’ 800 Expected collections 720 Payments to private generating companies (1,000 GWh) 57 Payments for interconnection (1,800 GWh) 75 Balance: Sector income 588 Operations and maintenance costs of public thermal generating companies (2,300 GWh) 150 Operations and maintenance costs of public hydropower generating companies 22 Operations and maintenance costs of transmission 20 Operations and maintenance costs of distribution 180 Balance: Internal generation of funds of the public electricity sector 216 Source: 1 Excludes large consumers; At a market price of 4.14$/kWh + capacity (CENACE-Plan 2004); At market price (4.14$/kWh); Corresponds to the public sector, including distribution in Guayaquil; Average variable cost 5.4$/kWh and fixed cost US$20/kW-year; Fixed cost US$lS/kW-year; Equal to the 2003 estimate (Solidarity Fund). 8.20 The effective overall cash flow shows a generation of funds of US$216 million, which should be used to remunerate the capital invested in the public sector, and would be earmarked to cover: (a) service of debt; (b) contribution to investment; and (c) increases in working capital. This balance is highly sensitive to variations both in costs and in rates. For example, a rate reduction of only 5 percent (reduction in billing of US$40 million) translates into a 17 percent reduction in the intemal generation of funds (dropping from US$216 million to US$l80 million). One measure of soundness in the generation of funds is the sector’s retum on assets. The sector’s assets have the following approximate values (see Table 8.2). 8.21 Using these values, a modest retum on assets is calculated, at between 4 percent and 5 percent. These Table 8.2. Value of Sector Assets values are insufficient if one seeks to attract private (Millions US$) investment. The prime generators of cash for the sector Generation 1,600 to 2,500 are the distribution companies and their financial health has repercussion throughout the industry so what follows Transmission 872 is an analysis of distribution. Distribution 1,862 8.22 Distribution. The distribution companies are the “cashier” that collects revenues for the sector and pass Total 4,300 to 5,200 some on to transmission and generation companies. To the extent that any of these functions fail, inefficiencies ’ Can vary between 2,000 MW at US$8OO/kW arise and conditions are created that threaten the and 2,500 MW at US$1,000kW. CONELEC - Cost study 2003 - 2004 sustainability of the sector. 8.23 At the level of the distribution companies, faults are seen in two functions: 0 Faults in the “cash register.” With only a few exceptions, the companies are billing too low a proportion of the energy they acquire (77 percent), and similarly, are receiving too little of the actual amounts billed (90 percent). 0 Faults in payments to other players. It was necessary to establish trusts to manage the funds received by distributors in order to make sure that billing faults and collection faults would not affect the sustainability of transmission and generation. 194 8.24 Out of 19 distribution companies in the interconnected system, nine -including (Corporacibn para la Administracibn Temporal Ele‘ctrica de Guayaquil (CATEG), the country’s largest distribution company- show losses greater than 25 percent of the energy they acquire, and only five show losses of less than 15 percent. Losses beyond technical losses (8 to 9 percent) are associated with energy that is not recorded, either due to meter faults, inexistence of meters, or fraud. Average loss in the system is approximately 23 percent, and therefore commercial losses due to fraud and measurement errors could be as high as 14 percent or 15 percent. 8.25 Beyond the problems associated with administrative faults that result in the losses noted above, there are also distribution problems inherent to the rates themselves. The projected cash flow for 2004 of the distribution companies has the following approximate values (See Table 8.3). Table 8.3. Cash Flow - Distribution Companies (Millions US$) Total Billing 800 Collections 720 Purchases from Generating Companies and Spot Market Purchases ’ 620 Payments for Transmission 80 Sub-total, Upstream Payments 700 Operations and Maintenance Costs of Distribution 180 Deficit (160) ’ CENACE data and author’s calculations 0.7qkWh Labor, materials, and other expenses (Solidarity Fund data) 8.26 Therefore, even though the sector as a whole generates a profit, projected results for the distribution companies are negative. These results could be considerably better if some of the distribution companies were to improve their management. If the losses, rather than being 23-24 percent, could be reduced to 15 percent for the entire sector, if billing would increase by approximately US$SO to 90 million; and if collections were to increase to 97 percent, then funds would be generated in the amount of US$140 to 150 million, with which the deficit would go down to between’US$lO and 20 million. 8.27 In addition to the management problems associated with energy losses and collection shortfalls, the deficit is also associated with the manner of conceptualizing the rate formula, which uses a “referential generation price” (RGP) to reflect the costs of generation. The RGP is calculated by CENACE on the basis of a multi-year plan. The RGP does not necessarily coincide with the actual costs of the distribution companies’ energy purchases, which are determined by term contract prices, or with the spot market price. As such, the rate formula shifts the risk onto the distribution companies, creating a situation where the price they pay is higher than the price they are allowed to charge. For example, in 2004, purchases (12,000 GWh) are expected to have a mean cost of 5.2@/kWh, compared to an RGP of 4.7$/kWh,6 with an associated loss of US$60 million. If improved management were combined with a rate formula through which the costs of purchasing energy were recovered, the distribution companies would show a positive result of approximately US$40 to 50 million. 8.28 Finally, part of the distribution companies’ rate corresponds to the Added Value of Distribution, calculated by the electricity companies and annually reviewed and approved by the National Electricity Council, CONELEC (Consejo Nacional de Electricidad), based on the 6 Stabilized value of the RGP for energy (332) and the cost of capacity (1.2~) 195 principle of reflecting efficient costs of the distribution sector. Accepted efficient cost levels for the distribution companies are approximately US$120 million, compared to actual costs of US$l80 million. 8.29 All this indicates that there is an enormous potential for efficiency improvements in the distribution companies. This should provide an incentive to modernize the companies, reduce losses, improve collections, and reduce operation and maintenance costs. Nonetheless, together with management improvements, investments are required, and the negative cash flow keeps that from happening. The outlook is therefore one of continued deterioration for many of these companies, unless drastic measures are taken to rehabilitate them. 8.30 Source of Internally Generated Funds. The results of the distribution companies’ cash flow makes it possible to identify the source of the internal generation of funds in the amount of US$216 million, estimated for the sector as a whole. The source is the generating sector, where companies are expected to make a profit in 2004. This is because the marginal cost of generation is so high it is signaling that new investments are needed in the sector and until these are made producers operating under the margin, such as hydroelectric companies, are doing very well. In theory, the contracts market should protect the distribution companies from price fluctuations that cannot be transferred to their users. Under normal conditions, the contracts’ value should reflect a stabilized generation cost, but contracts can be ill-conceived. As such, it would be desirable to make a more detailed examination of their structure and of the contracted price levels, as it would appear the distribution companies are being forced to pay more than they can charge for some of the electricity. 8.3 1 Attracting Private Capital. The electricity sector is not attracting private capital even though the market is sending out signals that investing in generation will provide attractive returns right now. This is happening despite government payment guarantees to private investors. Some of the possible explanations include: 0 The dominance of hydroelectric projects in the expansion of the sector. For a variety of reasons, private investors tend to prefer thermal projects. Some of those reasons include the hydroelectric projects’ greater investment costs, extended construction periods, and long financing periods, as well as environmental considerations (whether justified or not), on account of which the multilateral credit entities are financing fewer and fewer hydroelectric projects. The alarming debt accrual with the wholesale market, which would send a negative signal to potential investors in the sector, despite the incentives of prices and payments, given that investors can see they may not get paid. 0 The history of CONELEC’s decisions, particularly regarding the sensitive issue of rate policies, as indicated above, as well as CONELEC’S lack of political independence. 196 0 The reforms in Ecuador coincided with the worldwide recession that started in 2000 and with general disillusion over the results of investments in the electricity sector in developing countrie~.~ 8.32 It is worth noting that hydroelectric projects have been promoted on account of being the lowest cost energy sources in the sector, bearing in mind their long useful life and their low operating costs. It is for that reason that their construction is desirable. The private sector’s weak appetite for these projects is due to the financing they require and the risks they entail (geological risk, environmental risk, and market risk, for example). This poses the challenge of finding financing mechanisms and risk mitigation mechanisms that make it attractive for private investors to participate in hydropower plants. 111. Priorities for 2004-2006 and Specific Critical Problems 8.33 Users’ complaints regarding high electricity rates cannot be ignored, and have a major impact on the industry. Nonetheless, the solution to this problem should be based upon an effective reduction of costs and not on temporary measures that feed the cycle of rationalization leading to price freezes leading to subsidies as illustrated above. We shall next examine the most important features related to this issue, starting with doubts over the chosen model. 8.34 Validity and Conditions for Functionality of the Chosen Model. The model for the sector is valid with respect to its capacity to generate economic signals that motivate efficient behavior among the players. Nonetheless, it is also a demanding model, which requires a number of conditions -enumerated at the beginning of this document- in order to function satisfactorily. In other words, the model per se does not solve fundamental problems such as how to manage the distribution companies. Rather, those problems must be solved so that the model can function properly. The Ecuadorian case shows that implementing a model, in and of itself, is not sufficient. One must also meet the conditions that make the model viable. Likewise, it is insufficient to establish the rules that govern the model. One must also establish the mechanisms under which the rules work. What is needed is the political will to ensure the rules are implemented and thus avoid major changes to the existing structure. 8.35 Looking Back. As part of this evaluation exercise, it is a good idea to examine the situation as it existed prior to the reform and implementation of the current model. On doing so, we discover that the financial and management weaknesses were already in place and the industry was reaching a crisis point just before the reforms were instituted. The difference is that under the old system the weakness was hidden in the government budget and not evident as it is now. Now, action can be taken whereas under the previous system these problems just kept growing undetected. 8.36 Eficiency of the Distribution Companies. The current level of losses for distributors threatens the sector’s financial sustainability. A solution is therefore required in the short term. Currently, a procurement process is underway to put the 13 distribution companies under private management, although this has been delayed. If new management can reduce costs, it would be possible to attempt to rectify the financial and administrative situation. 7 Lamech, Ranjit and Saeed, Kazim “Private Power Investors in Developing Countries - Survey 2002,” World Bank. 2002 197 8.37 The Problem of EMELECKATEG. The largest distribution company has had the most acute operating problems. It is the principal debtor to the wholesale market and has sustained considerable losses. A temporary administrator designated by CONELEC ran the company, but that did not resolve the problems of untimely payments and losses. The new administration seems to have partially solved the company’s untimely payment problems. Just as in the case of the trusts of the other distribution companies, the regularization of the company’s business relations with the sector’s other players has met with partial success, but the company’s management problems have yet to be solved. 8.38 Future Supplies. The expansion of the generation system for 2004-2013 is essentially based on the San Francisco, Mazar, Termoriente, and Bajo Alto (Machala Power) projects, which total approximately 1,000 MW, the expected growth in demand for the period. Nonetheless, some of the system’s existing thermal generating units are now reaching the limit of their useful life, and economic incentives are required for their replacement. Otherwise, the spot market price will continue to reflect the high cost of these plants. The generation system requires greater investment, and mechanisms must be explored for attracting participation from the private sector. 8.39 Zntellectual Property. The debt accruals and the commercial losses are, among other things, manifestations of intellectual property rights violations. It is urgent that individuals and legal entities face effective consequences for their acts in order to help bring the situation under control. At present, no one is held accountable when government-owned companies commit violations of intellectual property rights. So long as this situation persists, the possibility of solving the underlying problems will become increasingly difficult. 8.40 Impunity and Sanctions. The lack of consequences for technically or commercially inefficient management (associated with the vacuum in terms of intellectual property rights) must be resolved through measures that can and should be applied automatically. Currently, there is an obvious unfairness at the user level, since the majority of users are financing those who are not paying their bills. This unfairness is also reflected at the level of companies, with a few distribution companies subsidizing transmission and generation companies. 8.41 Impunity for non-payment is also seen at the government level. Distribution companies must have the will (and the political backing) to cut electricity services not only to private parties but also to public sector institutions that fail to pay.8 8.42 Stability and Predictability of the Regulator. The regulator is comprised of officials who report directly to the executive branch, depriving them of independence. Thus CONELEC’s decisions are subject to political interference, leading to inconsistent decisions with regard to rates in particular. This has led to a lack of confidence in the regulator, especially from private sector participants, and is likely to negatively affect their willingness to invest in the future unless this changes. 8.43 Rate Rules. The problem consists of setting rules so that the costs of the service will be reflected in electricity prices. The generating component is the most significant element in the cost of service, and is therefore the most important. A review is needed of the rules governing the rate structure, possibly establishing the principle of “pass through,’’ or of handing costs down 8 Article 83 of the Superceding Regulations (Principle of non-gratuitousness). 198 to the user, when the distributor has no control over them. Implementation of this principle would provide financial relief to the distribution companies. 8.44 There are several alternative methods for achieving this objective. The most direct one would be to allow the cost of energy purchases to be directly transferred to users. Such an approach discourages the distribution company from establishing favorable purchasing contracts, and could result in undesirable rate fluctuations. Another possibility would be for the government to pay the difference as a subsidy to consumers when the RGP is higher than the distribution company’s purchasing costs. Other formulas for establishing the RGP could consist of calculating the generating component in the rate as an average of the purchasing prices for all the companies in the market, including contract purchases and purchases on the spot market. 8.45 An agreement to confront this fundamental problem should form one element of the strategy to be followed in order to achieve viability for the distribution companies. This requires a careful analysis to ensure the objective-of financial stability without introducing distortions to rates. 8.46 With respect to other rate rules, it would be best to codify them with the aim of contributing to the stability and predictability of the regulating agency. 8.47 Setting a Path. This short evaluation has uncovered a series of problems that need to be addressed. The electricity sector’s current situation is tied to a model that could yield great benefits if it were fully implemented. The essential decisions require solid political support, since the deficiencies have been building up for some time now. A new change of model or new reform of the sector’s legal framework will not resolve these problems. IV. Strategy 8.48 Conclusions of the a National Forum on Electricity Zssues of January 26, 2004. The results of the forum (see details in Annex 1) focused on: (a) the validity of the model adopted in reforming the sector; (b) distortions that need to be corrected for the sector to function properly; and (c) attracting financing in order to expand generation. 8.49 It was agreed that the model adopted has the potential to yield the reform’s intended results, but that its functionality has been hindered due to the absence of certain basic conditions, such as legal security, economic and financial incentives, rate equilibrium, and efficiency in business management. The forum agreed upon the need for additional reforms in order to attain efficient management of the electricity companies, sound development from an economic and financial point of view, and regulatory stability, as well as to provide signals that will help attract private capital. 8.50 With respect to specific distortions in the functionality of the sector, there was a consensus upon: The need to address problems in the rate structure associated with the lack of correlation between the cost of generation and the end user’s rate. The need to establish an appropriate regulatory framework for developing the contracts market. 199 0 The need to reward or penalize the results of good or bad management. This would be supplemented with a clear policy of incentives for efficient management of the companies in the form of government capital. 0 A position needs to be adopted with respect to laws and ordinances that affect the sector’s financial stability and contribute to making the service more expensive, which in turn encourages non-payment. 0 The government should pay the companies in the sector the money it owes them to help lead the way to financial stability. 8.51 Finally, with respect to the attraction of capital to expand generation, it was noted that the best way to expand supply is through new hydroelectric plants, and only to a lesser extent plants that depend on heavy crude oil and natural gas. Under these circumstances, it was recommended that mechanisms and incentives be explored to promote investment in hydroelectric projects. 8.52 Key Elements of a Mid-Teim Strategy. The proposed strategy consists of seeking solutions to the faults identified in the model’s functionality, within political limitations. Lasting institutional foundations are sought-in contrast to ad hoc measures-to attain the reform’s objectives. The strategy will focus on the following elements: 0 Financial recovery of the electricity sector. 0 Attraction of private sector funds. 0 Institutional strengthening. 0 Legal reform. Areas where further analysis is proposed include: 0 Financial regularization of the sector. 0 Strengthening of the regulatory agency. 0 Rate policy setting. 0 Decentralized mobilization of funds and financing for expansion, while using renewable resources that could return resources to municipal governments. 0 Improvement of management. A. Financial Regularization 8.54 The current situation is characterized not only by considerable debts among players, but also by a lack of clarity with respect to the amounts actually owed. In order to understand the origin of the problems, it is useful to summarize the events that have led to the current crisis: 0 In 1998, the government assumed responsibility for INECEL’s pre-existing debt to international financial entities. The corresponding obligations were to be covered through agreements between the government and the entities newly created under the reform. 0 The government assumed the “rate deficit” resulting from the difference between the applied rate and the objective rate from April 1999 to December 2001. This amounted 200 to approximately US$780 million, but included the companies’ unrealized gains; if those “paper profits’’ were not included in the rate deficit, the amount of the deficit would go down by US$166 million, to US$614 million. It has not yet been established which of the two values is the “correct” one. 0 Since the distribution companies were receiving subsidies through the contracts with the generating companies, estimated at US$220 million, this value could be subtracted from distribution companies’ rate deficit. 0 The rate deficit as of December 2001 has not been regulated and could rise to more than US$1 billion by the end of 2003. 0 The distribution companies’ debts in the wholesale market amount to US$656 million as of September 2003, more than 50 percent of which is attributable to EMELEC/CATEG. This value does not include accrued interest. 0 It has not been determined whether the rate deficit has generated interest to which the distribution companies could be entitled. 8.55 The debt situation between generating companies and distributors, the wholesale market, and the government, is troublesome for a number of reasons: 0 It forms an obstacle for attracting private investment, both in generation and in distribution, given that potential investors will negatively view investment in a sector that lacks clarity regarding the participants’ financial responsibilities. 0 The more time goes by, the greater the uncertainty with respect to overdue accounts, especially as regards penalties and accrued interest. Government action is therefore required that: 0 Sets guidelines for the settlement of debts. 0 Organizes a commission to quantify and negotiate the settlement of those debts. 0 Establishes agreements with each of the participants, including the government, to define the obligations resulting from the debt settlement, while also placing a value on eventual contingencies (interest and penalties) should parties renege on the agreement. 8.56 Finally, it is necessary to confront the problem of accounts receivable from government agencies. For this, the following is proposed: 0 To quantify the debts of these entities with the various electricity companies. To develop payment agreements between the government agencies and the electricity companies for the debts, if necessary through direct payments charged against the budget of the debtor agency. 0 To explore alternatives and agree upon mechanisms that will ensure future payments. 8.57 Among the measures to ensure payment among the sector’s players, it is indispensable to impose service cut offs for non-payment, both at the transmission level (to ensure the payment of 20 1 debts with the wholesale market) and at the level of the electricity companies’ government customers. B. Strengthening of the Regulatory Agency 8.58 Functions and Structure. One of the aspects that should be examined in the context of reforming the sector and its institutional strengthening is the possibility of strengthening the National Electricity Council, CONELEC (Consejo Nacional de Electricidad). Some specific questions that arise in this context include: The multiple functions of policy setting for the sector, regulation, supervision, and enforcement of penalties, which are concentrated into one and the same organization. 0 Procedures to ensure transparency in decision-making. CONELEC’s independence in decision making with respect to other government entities, and the balance between independence and accountability. 8.59 As a point of reference, Annex 2 summarizes the various approaches adopted in countries of the region. There is a broad spectrum with respect to the regulating agency’s role. Nonetheless, a common element is the development of sectoral policy in an independent entity associated with the government. In Ecuador, although national energy policy is a primary responsibility of the Ministry of Energy and Mines, CONELEC’s role, by law, includes certain policy-making functions for the electricity sector. For example, CONELEC proposes and implements policies for the electricity sector, submits legislative bills, develops the Master Electrification Plan, and oversees compliance by the public sector. This responsibility is uncommon among regulatory entities, particularly because it creates commitments with the players, potentially compromising the regulatory entity’s impartiality. Furthermore, there is an inevitable shift of expectations onto the regulating agency, and pressure from the executive branch to implement given policies is considerably greater, as compared to a situation in which such a responsibility falls upon another institution. CONELEC is also responsible for granting concessions. This role is not strictly a function of a regulatory agency (which could, on the other hand, review the bidding specifications and oversee the procurement process). 8.60 The challenge consists of grouping these responsibilities into policy making and execution. Assigning the entire responsibility to the Ministry of Energy and Mines is not a practical alternative, given the ministry’s limited resources. It is therefore necessary to distribute these functions, taking advantage of the analytical and informational resources of CONELEC and of CENACE without involving them in the implementation of the plans. 8.61 The issue of independence of the regulating agency is probably the principal problem faced when forming regulatory commissions. No commission can be totally independent, since it is created by the government. Thus, independence should be understood as the agency’s authority to raise or lower rates without the need to obtain approval from the executive branch. As such, a conscious policy decision must be made to delegate certain decisions to the regulating agency. That does not mean, however, that the regulating agency’s accountability is sacrificed. The regulating agency is simply accountable for implementing the rate-setting principles established in the law, rather than answering to the executive branch. 8.62 In order to ensure the independence of the regulating agency, the laws of various countries incorporate safeguard measures such as: 202 0 Have a law mandating the existence of the agency, which is not subject to approval by the executive ministries. 0 Minimum professional qualifications in order to hold a position in the regulating agency. 0 Participation from other organizations, in addition to the executive branch, in appointing the regulators (for example, selections can be made by the legislative branch from a list of candidates drawn up by the executive branch, as occurs in Argentina -with the possibility of direct appointments when the legislative branch fails to announce its decision within a predetermined term). 0 Appointments for fixed terms and protection against arbitrary removal. 0 Staggered terms in office (where officials are not all replaced at the same time) to provide continuity, which do not coincide with the electoral cycle. 0 Budgetary freedom, not subject to the civil service salary rules. 0 Assured funding sources, generally through user contributions. 8.63 Decision-Making Entities. In some countries, the Executive Director can make regulatory decisions without need for approval from the Board of Directors. In the case of CONELEC, it would be beneficial to determine when the Executive Director can make technical decisions, and when he requires approval from the Board of Directors. This would lessen the volume of decisions taken to the Board of Directors and would also grant more autonomy to the institution itself, in particular to its technical team. 8.64 Technical Reports of the Regulating Agency. Decisions for regulating the electricity sector should be periodically published in technical reports. That would create discipline in making the decisions by documenting their rationale. C. Rates Tariff Policy 8.65 Tariff Rate-policy decisions are one of the principal reasons why the regulating agency exists, and have various facets: Financial Consistency: the tariff-rate rules should ensure the financial sustainability of the companies while also generating funds to contribute to their expansion. Incentives: Tariff rates, as far as possible, should reflect costs, in order to encourage rational energy usage. Rates for industrial use are high by regional standards and need to be revised. Deviations from the economic tariff rate: the issue of subsidies is common to the majority of electricity systems, but this is a social policy matter over which the government should take charge. 8.66 Below, an analysis is made of aspects related to the RGP, to energy purchasing contracts, and to subsidies. 8.67 Costs of Purchasing Energy and Rates to End Consumers. As illustrated in the first section, the problems associated with the pricing policy originate in the weak relationship between the component that determines the rates charged to end consumers and the cost actually 203 incurred by the distribution companies to acquire the energy. A new approach to rate rules, aimed at overcoming this weakness, could take several different forms: 0 In some rate formulas, such as in Chile and Peru, purchases by the distribution companies are made at regulated prices (called knot prices), which are directly reflected in the rates (with adjustments for acceptable energy losses). As such, the distribution companies never lose, provided that they are able to keep their sub- transmission and distribution losses under control. 0 In other rate formulas, such as in Colombia, the component determining the end rate is calculated using energy purchase prices incurred by the company and all distribution companies as a reference (with adjustments for losses). This creates a strong link between the distribution company’s energy purchase prices and the end rate. In this case, the distributor can have a profit or loss not only as a function of its ability to control losses, but also as a function of its ability to negotiate on the contracts market. 8.68 Under the first approach, the distribution companies are fully protected against variations in wholesale prices; the risk of cost variations is assumed by the generating companies, and therefore a regulating agency is required that rapidly responds to variations in the costs that comprise the knot price. In fact, the regulatory provisions regarding rates in these cases state that the knot price varies (together with the rate to end user) when industry costs vary (for example the cost of inputs such as natural gas or in the case of a drought affecting water supplies to hydroelectric plants). The formula in question is attractive in systems where there is some stability in the price of supplies. In systems with significant volatility, it appears to be less adaptable. 8.69 Under the second approach, the distribution companies are partially protected against variations in the wholesale price, given that their purchase costs are reflected, but they are exposed to comparison with the overall contracts market, and with purchases being made on the spot market. Clearly, this appears to be a more compatible alternative with a system with a contracts market in place since the start of operations of the wholesale market. 8.70 In any case, the formulae establish a link between the distribution companies’ purchase prices and the recovery of those costs through rates to end consumers. It is indispensable to strike a balance in this sense, given the magnitude of the losses for the distribution companies. D. Utilization of Government Funds to Modify the Rate Level 8.71 Two mechanisms have been proposed with the aim of reducing rates. One of them is the creation of an “electric fuel,” favoring thermal generation with lower-cost fuels. The other consists of reducing contracted prices between the government’s hydropower plants and the distribution companies. There are three considerations to bear in mind when evaluating these options: the effect on wholesale market signals, the effect on rates to end consumers, and the financial effect on the sector’s players. 0 Electric Fuel. This is a mixture of residual fuel oil (“mazout”) and diesel. Residual fuel oil lacks a market and has practically no value, which means that the price of the resulting mixture could be very low. As long as the price of this product reflects its cost, use of electric fuel would have an impact no different from a reduction in production costs, with the resulting benefits for the system. The effect on the rate to 204 end consumers depends upon the impact these fuels could have on the RGP. To the extent that the marginal cost of dispatching goes down, either because these fuels replace marginal high-cost resources, or because the fuel in question is the one that establishes the marginal cost, the rate’s generating component will go down -under the rate formula in effect- and the prices to end consumers will also go down. However, if the fuel is used to feed infra-marginal plants (whose cost is consistently less than the marginal cost) it will not have an impact on the end rate, at least not under the current rate formula. If the price of fuel is reflected in the contracts with the distribution companies, those companies will have lower energy purchasing costs. Depending upon the effect on the RGP, the net financial effect could be positive (if the RGP does not change because the fuel is infra-marginal) or neutral (because the price reduction is reflected in a lower RGP). Reduction of Contracted Prices of the Paute and Agoycin Hydroelectric Plants with the Distribution Companies. The other mechanism consists of reducing contracted prices between government-owned generating companies (such as Paute and AgoyBn) and the electricity companies. That would reduce energy purchasing costs and facilitate a rate reduction. It should be noted that the use of government funds in relation to such contracts can be seen in other countries (Guatemala, Dominican Republic). Contracts between generating companies and distributors have no effect on dispatching. Therefore, marginal costs and wholesale market signals are unaltered. For the same reason, the rates to end consumers under the current rate formula would not change, because the measures would have no effect on the RGP. There would be a significant financial effect for the distribution companies, because their energy purchasing costs would go down, without affecting sales prices. Nonetheless, for the generating companies, the financial effect could be significant, since available funds for investing in new projects would diminish. It would be necessary to calibrate the amount of the reduction to ensure that Paute and Agoyiin can develop the Mazar and San Francisco projects, respectively. A quantification of the effect of using Paute to balance the sector’s finances yields the following values: Cost of reducing the rate by 5 percent (5 percent of US$40million US$800 million) Cost of offsetting the amount of the RGP US$60 million Total cost of offsetting using hydroelectric plants US$ 100 million Price reduction: Paute + Agoyin (5,600 GWh sold) US 1.8$/kWh As can be seen, the cost of offsetting through Paute and AgoyBn could be considerable, equivalent to approximately 45 percent to 50 percent of their profits for 2004, with the resulting effect on the financing of new generation technology. 8.72 Subsidies. The government should formulate the subsidy policy. The law explicitly authorizes cross subsidies in Article 53, but does not contemplate “deficit” subsidies, that is, subsidies that impact the overall equilibrium of the companies. Nonetheless, in practice, certain measures, under statutes such as the Law on the Elderly or the Law on Sports, are not offset in the rate. Even though such measures do not necessarily have a severe impact on the electricity companies, these extra-sectorial laws create a negative precedent for financial recovery or for attracting private investment. In this sense, the strategy of the sector should be to create conditions in which provisions applicable to the electricity companies are strictly those set forth 205 in the law on the sector, with the possibility of filing suit against other discriminatory provisions. Finally, a positive outcome has been the publication of the electricity subsidies in the 2005 draft budget. E. Management of the Electricity Companies 8.73 As was noted in the section on diagnosis, the discouraging financial results of the distribution sub-sector are related in part to management problems and a lack of accountability for executives. Likewise, it was indicated that improvements in management have the potential to generate considerable cash, thereby reinforcing the financial sustainability of the electricity sector. Iflosses were reduced to 15 percent and the collections rate rose to 97 percent, that would generate US$140 to US$l50 million annually. The internal generation of funds in the sector would go up from US$216 million to approximately US$360 million, equivalent to an increase of 67 percent. Efficient management ought to reduce the distribution companies’ current costs by an additional sum of approximately US$60 million, which would make these companies profitable. 8.74 The key is to introduce incentives. Ideally, this would be achieved through private investment. Under the current circumstances, after the failed attempt at privatization, the possibility of reinitiating such a process is remote. It is proposed that measures be explored to improve the financial situation of power companies and provide incentives for management accountability, along with alternatives for creating regional companies with greater commercial strength. It is also suggested that private investment be explored on a reduced scale, with a view towards demonstrating its feasibility. These actions should be implemented well before even considering their privatization. 8.75 Corporate Objectives, Management Accountability, and Improvements in Management. These three elements complement one another. To the extent that corporate objectives exist it becomes possible to demand concrete results, and it becomes feasible to justify responses to good and bad performance. 8.76 Among the management alternatives for public companies, an approach that has been adopted in some countries is to establish a contract between the government and the company, setting forth quantitative objectives in operational as well as financial terms. For example, Electricit6 de France, possibly the world’s largest electricity company, has a contract (the “Contrat Plan”) that designates specific financial goals. In the Ecuadorian case the contract in question should be entered into by the Solidarity Fund, as the majority shareholder and representative of the government’s business interests in the electricity sector, with each of the companies it oversees. The contracts (not to be confused with the current concession contracts) would have specific goals in terms of operational efficiency (control of energy losses, collection rate) and financial results (for example specific cash flow objectives). 8.77 Management Accountability. The consequence of whether a contractual objective is attained should be borne by a company’s executives. Part of the poor performance seen in the companies lies in an administration with no accountability for results. Nonetheless, emphasis should also be placed on the fact that the past history of some companies was good until a relatively short time ago. For example, EMELGUR (Empresa Ele‘ctrica Regional Guayas Los Rios, S.A.) had losses of 16 percent in 1996, which doubled in a lapse of only five years, reaching 34 percent in 2001, one of the worst rates in the country. The problem, therefore, is how to recover from an accelerated deterioration, which requires a commitment on the part of the 206 Solidarity Fund, the other shareholders, and the executives. These executives, as depositaries of the responsibility, should lose their jobs if they fail to attain the agreed-upon goals. Similarly, a uniform system of incentives should be sought that rewards executives when goals are attained. 8.78 Maintaining Financial Discipline. Various measures could be conceived to deal with the situation of non-payment on the part of some companies in relation to the wholesale market, such as is the imposition of penalties, the charging of interest, or administrative takeovers of the companies. These types of sanctions are efficient to the extent that they create foreseeable consequences for those who break the commercial rules of the market, but become ineffectual if there is no real possibility of making radical changes in their operations. An indispensable measure, if not used indiscriminately, is to cut off energy (partially and in steps) to companies that repeatedly fail to pay; this includes cutting off energy to entities whose default has been protected by their official status. Such an approach shifts the consequences to the users, who will exert an influence at the local level, through political means, when they see themselves harmed by the inefficiency of the companies. That should create conditions for earnest, responsible management. Proof that this is feasible is seen in the example of some of the distribution companies that are displaying acceptable indicators. Likewise, a commitment should be demanded from sectorial entities that currently share ownership of the distribution companies, such as the municipal and provincial governments, that they will support the measures required for financial recovery. 8.79 Private Administration or Delegated Administration. The process of contracting a private administrator for some electricity companies, if it were to take place, would set a precedent of enormous significance, which could serve to demonstrate the worth of a management system based on specific goals and rational incentives. Other less ambitious alternatives, but with the potential to have a strong effect, include contracting the administration of one or two companies in need of recovery to some of the companies that have demonstrated good management. 8.80 Restructuring of Markets. A proliferation of small markets is not economical, since small markets cannot leverage economies of scale of potential significance in the distribution phase. A merging of weak companies with companies with a track record of competent management could have a similar effect to the contracting of administration mentioned in the previous point, but with more permanent effects. 8.81 A Pilot Privatization Project. The sale of shares of all the electricity companies attempted in the past was a very ambitious project. It generated an opposition that in the end led to failure. A new attempt at privatization on a lesser scale, carefully prepared with the support of local authorities and a firm legal basis, could set a precedent with a view to being replicated in the long term for other companies. 8.82 Attraction of Funds for Expansion. Ecuador has a tremendous inventory of hydroelectric resources that are competitive in terms of costs, bearing in mind, above all, the high opportunity cost of fuels. As mentioned in the diagnosis section, there are a number of reasons why private investors have not taken an interest in developing hydropower plants. Annex 8.2 provides a more detailed analysis of the obstacles encountered. Below, some principles are set forth, along with alternative solutions. 207 References Head, Chris. “Financing of Private Hydropower Projects.” World Bank Discussion Paper No. 420. 208 Annex 8.1 Overview of the Organization of Regulating Agencies in some Latin American Countries Chile: Policy is determined by the National Energy Commission, which is comprised of six ministers and a technical team. Regulation corresponds to the Superintendency of Electricity and Fuels, which is headed up by a Superintendent appointed by the President of the Republic without a fixed term. The Superintendency grants provisional concessions and recommends definitive concessions. Bolivia: Policy is the responsibility of the Secretariat of Energy, which comes under the Ministry of the Treasury. Regulation corresponds to a Superintendency that covers several public utilities with sectoral Superintendents. The General Superintendent is appointed by the President from a list of candidates nominated by the legislature, and has a fixed term of seven years. The sectoral Superintendents are appointed for five-year terms. The Superintendency is in charge of granting concessions for the service. Peru: The Ministry of Energy and Mines formulates policy guidelines and grants concessions for the service. Regulation is concentrated in OSINERG (Supervising Entity for Energy Investments - Organism0 Supervisor de la Znversibn en Energia), whose board of directors has five members: two proposed by the President of the Council of Ministers, one by the Ministry of Energy and Mines, one by the Ministry of the Economy and Finances and one by the Institute for the Defense of Competition and Property. The appointments are for five-year terms and are staggered. Colombia: The Ministry of Mines and Energy formulates policy for the sector. Regulation corresponds to CREG (Regulating Commission for Energy and Gas - Comisibn Reguladora de Energia y Gas), comprised of three ministers and four experts with a voice and a vote; terms are for four years and are staggered; the concessions are granted by the Ministry or by the states, depending upon the service granted. CREG does not oversee compliance or impose sanctions. The Superintendency of Public Utilities exercises that function. Brazil: As in the cases described above, sectoral policy is the responsibility of the Ministry of Mines and Energy, while ANEEL (National Electric Energy Agency - Agencia Nacional de Energia Ele'ctrica) provides regulatory functions. ANEEL has a General Director and four directors appointed by the President of the Republic, with approval from the Senate. The directors are appointed for staggered, four-year terms. ANEEL is responsible for authorizing public electricity utility concessions. Argentina: The Secretariat of Energy establishes sector policy and ENRE, (National Electricity Regulating Entity - Ente Nacional Regulador de la Electricidad) exercises the regulatory functions for the sector. ENRE is comprised of five full-time members appointed by the executive branch. Two of them are appointed based on a nomination from the Federal Electrical Energy Council. Their terms are for five years (staggered), and can be renewed indefinitely. ENRE oversees the conditions for awards of concessions, exercises oversight, and is authorized to impose sanctions. 209 Annex 8.2 Development of Hydroelectric Projects by the Private Sector Background A significant reduction is being seen in the development of new hydropower plants. Ironically, this reduction has coincided with structural reforms of the electricity sector in many countries aimed at attracting private financing to expand generating capacity. This situation is not due to any change in the fundamental economic benefits of hydroelectric power. Rather, it is attributable to new priorities that have arisen in the context of private financing. Currently the private sector is favoring low-risk, non capital-intensive projects, with short construction periods and rapid returns on investment. These criteria ideally correspond to thermal projects, preferably combined-cycle natural gas plants, or power plants based on low or moderate-speed engines burning bunker fuels. The bunker fuel plants, despite a high cost of investment per kW, have comparative advantages in terms of installation times and modularity. The following is a brief summary of problems and questions that have arisen in the development of hydropower plants. Financing of Generating Projects The development of power plants by the private sector has been characterized by the “project finance” mode, in which loans for development of a project are secured by the cash flow of the project itself, and the banks are unable to take action against the developer’s headquarters in the event of non-payment. This requires that the projects be “bankable.” In other words, that the developer be able to submit an economically attractive project, with known risks and suitable measures to mitigate those risks. In addition, project financing is facilitated if the construction periods are short, which reduces interest rates during construction, and if the investment recovery periods are equally short. Hydroelectric projects have special characteristics that make it difficult to find financing of the “project finance” type, such as: The specificity of the projects, associated with their geographic, geological, and hydrological conditions, which do not allow for duplication. The construction risk associated with uncertain geological conditions and extended construction periods. Capital-intensive developments, with a high component of local costs. Uncertainty in production due to hydrological fluctuations or restrictions in the management of the hydraulic resources. Social and environmental risk, particularly when large reservoirs are created that require resettlement of the population or that significantly impact the local fauna. High initial costs, associated with pre-feasibility studies, feasibility studies, and design. 210 Market Risk. In order to obtain bank loans, a developer generally has to demonstrate that the plant’s production has a secure market at a rate that guarantees the repayment of the debt. This is achieved through contracts that guarantee energy purchases with pre-established volumes. These PPA (Power Purchase Agreements) are feasible when an entity exists that can guarantee the corresponding purchase. In a market scenario such as Ecuador’s, the contracts would have to be established with several purchasers depending upon the size of the development. The feasibility of obtaining financing for the plant would depend upon the credibility of the contracts so established. Typically, in order to submit a project to the financial entities, the contracts must allow the developer to perform its obligations during the repayment period for the acquired debts, which implies the need to establish contracts with a term of ten to twelve years, that is, five years of construction and five to seven years of repayment. Hydrological Risk. The production of a hydroelectric project depends upon the hydrology and, unless the reservoir is large enough, energy supplies for which the project was designed cannot be guaranteed. This risk is particularly real in the case of power plants without a reservoir, which are precisely those that in many cases are attractive in terms of costs and pose fewer environmental risks. Hydrological risk can be partially mitigated by contracting contingency supplies with thermal power plants. Yet such an approach complicates the financial package that must be submitted to the banks. Construction Risk. A developer can transfer part of the construction risk to the contractor or contractors of the project’s civil works. Nonetheless, this could have a significant cost (it has been estimated that this could add 10 to 20 percent to the cost of the project). With private financing, there has been a trend towards what are called EPC contracts (Engineering, Procurement, and Construction) in which various contracts for the project are broken down and procured at more or less fixed prices. In practice, the transfer of risk to the contractor will have a limit, and the tendency is towards sharing risks, particularly geological risks. Role of the Government There is still no standard for the process of attracting private investment to hydroelectric projects. Nonetheless, governments could promote projects by partially assuming part of the risk. Some of the contributions that could be contemplated include: 0 Preparation of the project. The marketing of a hydroelectric project requires careful preparation, generally including preliminary studies and the first stage of design. The better prepared the project is, the higher the likelihood of creating an interest among potential developers. 0 The first stage of design and conceptualization for a hydroelectric project should be an approach that optimizes the catchment area and the possibilities offered by the site. If these activities are left to the developer’s judgment, a configuration could result that would be undesirable in the long term. 0 Given the current situation of Ecuador’s electricity sector, market risk requires government support because (a) if long-term contracts are signed, they would be entered into with distribution companies now owned by the Solidarity Fund, and (b) the business history alone of those purchasers would not be acceptable for financing a project, and a reliable guarantee would be required, probably from the government. 21 1 0 Environmental and Social Risk: a critical part of many projects might be associated with these factors, and their mitigation should be contemplated in the project’s preparation stage, as an integral part of the design. To ensure that these risks are under control, it is desirable to prepare environmental and social management plans in advance, including any necessary resettlement to be implemented by the developer. Direct Negotiations or Bidding Competition? This is a question that arises with a certain frequency when a developer is interested in a project and offers to carry it out. Generally, the developer requires an exclusivity arrangement, on account of which the government would give up a good part of the control over the project, especially in terms of its conceptualization and design. This is undesirable. It is thus preferable, even though it takes a greater effort, to promote projects in an advanced state of preparation, attracting developers through bidding competitions in which there is a wide range of offers. That ensures greater transparency and better implementation conditions. Role of Multilateral Entities Development banks play an important role in the development of projects that require government support as guarantor. Some of the instruments worth mentioning include: 0 Insurance for political risk and fortuitous political circumstances, which provides security to the developer with respect to certain unforeseen circumstances and acts of expropriation. 0 Partial risk guarantees. Liquidity mechanisms for refinancing the developer’s debt (bridge loans). 212 ChaDter 9 TELECOM’ Ecuador’s telecom industry is almost unique in the region in that it is still dominated by two regional public sector companies ANDINATEL and PACIFICTEL in the fixed-line business following unsuccessful attempts to privatize them. Legislation permits private companies to enter the business but few have chosen to do so given the incumbents’ dominance. Access to phone services is comparable to other countries with similar income levels in the region. However, rural areas are poorly served. Both major telephone companies are unprofitable as a result of poor operating eficiency and subsidies to residential users. This is a load that costs the govemment money it can ill-afsord (US$121 million in 2003) on transfers that do not target the poor specifically and benefit high-income users as well. lntemational calling rates are far above intemational standards in an attempt to recover this income, leading to higher costs for companies. The poor pellformance of the state companies is shown by the quality of service indicators where Ecuador is worse than every country in the region except for Colombia. To address these problems this note recommends to: (a) eliminate subsidies by raising call rates for residential users; (b) lower intemational calling rates to make business more eficient and increase the country’s attractiveness to foreign investors; (c) privatize the companies if politically possible. Otherwise contract their management out to the private sector; (d) lower rates for public telephones as a way to help the poor; and (e) extend access to telephones in poor and rural areas either by installing more public telephones or by giving subsidies to cellular companies to operate in otherwise unprofitable areas. I. Sector Structure and Role of the Public Sector 9.1 The public sector continues to dominate the telecommunications sector in Ecuador. Whereas in the majority of countries in Latin America, the role of the state is limited to policymaking and regulation, state-owned enterprises in Ecuador continue to provide all telecommunications services, generating about 90 percent of the sector revenues in 2002. Private participation and competition is limited to a few market segments, even though legislation permits it. Many factors are constraining the development of the sector, but the weak regulatory and institutional framework remains the main bottleneck. 9.2 There are four state-owned ente rises in Ecuador. ANDINATEL and PACIFICTEL, the regional incumbent fixed-line operator? ETAPA, which offers fixed-line service exclusively in the Cuenca municipality; and TELECSA, the cellular operator jointly owned by ANDINATEL and PACIFICTEL. With the exception of ETAPA, all other companies are fully owned by the Fondo de Solidaridad (FS), a fund created by the Government to manage the privatization process of all its public companies. The main private operators are OTECEL (Bellsouth) and CONECEL (America Movil), the largest cellular service providers. 1 This paper was written by Carlos R. Gdmez (World Bank) with inputs from Eloy Vidal(Wor1d Bank). 2 ANDINATEL operates in the northern region and PACIFICTEL in the southern region 213 9.3 The Government has unsuccessfully tried to attract private participation. In 2002, it deregulated the market by allowing the entry of private operators to compete with the state- owned enterprises. However, few private companies have entered, and those that have mainly provide leased lines and value-added services such as Internet services. The Government tried to privatize ANDINATEL and PACIFICTEL in 1998 but was not successful. In September 2003, it initiated a tender process to temporarily contract an experienced international private operator to manage PACIFICTEL and ANDINATEL. In February 2004, the process was suspended apparently because the management contract was so badly designed it failed to attract any interest. 9.4 As a result, the Government continues to undertake most of the investments in the sector. For the period 2003-2007, ANDINATEL and PACIFICTEL, have plans to invest US$500 million, and TELECSA, plans to spend more than $100 million on developing its cellular network2. 9.5 The sector’s institutional framework is headed by the Consejo Nacional de Telecomunicaciones (National Telecommunications Council or CONATEL), which is in charge of policymaking functions, issuing interconnection arrangements and establishing the terms of the concessions. Secretaria Nucionul de Telecomunicaciones (National Telecommunications Secretariat or SENATEL) is the executing agency and elaborates the National Development Telecommunications Plan. Superintendencia de Telecomunicaciones (Telecommunications Superintendency or SUPTEL) is the regulator. The main legislation that governs the sector is the Ley Especial de Telecomunicaciones (Special Telecommunications Law) from 1992, which has been amended many times. The government is currently working on new legislation to address the current needs of the sector (See Table 9.1). Table 9.1 Structure of the Telecommunications Sector in Ecuador Policymaking Regulation Fixed Cellular Leased lines3 Internet Public Conatel Suptel Andinatel Telecsa Andinatel Andinatel Senate1 Pacifictel Pacifictel Pacifictel Etapa Etapa Etapa Private Conecel Conecel Conecel Otecel Otecel Otecel Others (8) Others (36) Source: CONATEL 11. Performance of the Telecommunication Sector A. Access to Telecommunications Infrastructure 9.6 Access to telecommunications services in Ecuador is comparable to other countries with the same income level in the region (refer to Table 9.2.) According to SUPTEL, Ecuador had 1.55 million fixed telephone lines in service at the end of 2003, or 12.2 lines per 100 inhabitants. Cellular operators reported 2.39 million subscribers, the equivalent of 18.9 subscribers per 100 inhabitants. There were about 18,600 public phones, including 10,600 public cellular terminals, 2 Fondo de Solidaridad, 2003 3 Leased line operators offer transmission capacity between network points with international and national coverage. 214 the equivalent of 0.14 public telephones per 100 inhabitants. Lastly, there is less than one Internet subscriber per 100 inhabitants. Table 9.2. Indicators for Access and Quality of Telecommunication Services in Selected Countries, 2002 Access (users per 100 inhabitants) Quality Fixed Public Cellular Internet Faults per 100 fixed lines lines telephones Guatemala 7.1 0.32 13.2 Paraguay 4.7 0.14 28.8 0.43 3.4 Ecuador 11.0 0.04 12.1 0.78 35.3 El Salvador 10.3 0.29 13.8 1.47 14.5 Dom. Rep 11.0 0.14 20.7 0.74 Colombia 17.9 0.14 10.6 1.20 45.6 Peru 6.6 0.4 1 8.6 0.67 Source: ITU (2003) 9.7 The lack of competition and private investment in the fixed telephone line sector has constrained its growth. The number of fixed telephone lines has increased at an average of 8 percent per year since 1997.4 ANDINATEL and PACIFICTEL, the incumbent fixed-line operators, satisfy only 71 percent and 48 percent of the demand from their respective geographical service region.5 9.8 In comparison, the number of subscribers per 100 inhabitants in the more competitive and private-led cellular market has grown at an average annual rate of 59 percent during the same period. Since October 2002, the number of cellular subscribers has been higher than the number of fixed telephone line subscribers. 9.9 The increase in access to the telecommunications network has been mostly limited to urban areas. According to CONATEL, more than half of all fixed telephone lines are concentrated in Guayaquil and Quito. Only 5.6 percent of the rural population had telephone service in 19996. Until recently, the Government did not promote the extension of the telephone network to rural and low-income areas. The public telephone network is among the smallest in Latin America, with only 0.04 public telephones per 100 inhabitants in 2002. Recently, the Government established the Telecommunications Development Fund (FONDETEL) to finance the expansion of access to telecommunications services where no service is currently available. All operators are expected to contribute with one percent of their gross annual revenues. However, that funding requirement is included in the concessions and not in the legislation, and thus has not been enforced actively. CONATEL currently allows ANDINATEL and PACIFICTEL to waive their contribution if they install telephone lines in rural areas. B. Quality and Efficiency of Service 9.10 The quality of telephone service in Ecuador suffers from the inefficiencies of the state- owned operators and is considered to be among the lowest in the region. According to the 4 In 1997, EMETEL, the former incumbent fixed-line operator was divided regionally, creating ANDINATEL and PACIFICTEL. 5 Demand Study, 2003 (SENATEL) 6 INEC, http://www.inec.gov.ec 215 International Telecommunications Union (ITU), Ecuador has a very high number of faults per line, with an average of 35 faults per 100 telephone lines in 2002, better only than Colombia (refer to Table 9.2.) A sample of manufacturing firms showed on average about one interruption per month, which results in more than 200 hours without service per year7. To ensure an acceptable quality of telecommunications services, SUPTEL established minimum levels of quality in all concessions. These parameters are very lenient and are below the standards of quality of most telecommunications companies in the region. According to ANDINATEL, it met all quality of service goals for 2002. It reported only 30.7 faults per 100 lines and completed 53.1 percent of local calls, 58.7 percent of national calls, and 47.2 percent of international calls’. There is no information about PACIFICTEL but its quality of service has always been considered lower than ANDINATEL’S. Firms located in the province of Guayas constantly express their dissatisfaction with PACIFICTEL’s quality of service. They reported an average of 25 interruptions per year, the highest among all provinces. PACIFICTEL was fined in February 2003 for its constant service interruptions in the town of Jipijapa’. 111. Review of Public Expenditures A. Financial Sustainability of Public Enterprises 9.11 The financial situation of the state-owned companies is complex and their prospects will depend on restructuring their management operations and changing their tariff scheme”. PACIFICTEL is the company that faces the most challenges. It has been struggling with a high level of bad debts and internal inefficiencies that have caused negative financial results. PACIFICTEL estimates it has US$56 million in bad debts, mainly from international carriers. In 2002, it set aside 13 percent of operating revenues to cover outstanding debts. Despite the fact that PACIFICTEL has a market monopoly, it has problems covering its operating expenses and suffers from low profitability. The company reported a loss of US$56 million in 2002, although it estimates a profit of US$3 million in 2003. It has more than 3,000 employees, which is equivalent to 195 lines per employee, less than half that of other regional operators such as Telefbnica (Peru) or Compaiiia de Telkfonos de Chile (CTC). The operation of the company has been very deficient compared with ANDINATEL. Both companies come from the split of the former operator EMETEL and have similar market sizes and potential. After five years on its own, PACIFICTEL’s debt level is three times higher, but has about 30 percent fewer lines in operation. 9.12 On the contrary, ANDINATEL is more efficient and its financial results have been positive in recent years. It reported a net profit of US$54 million in 2002, and estimates a profit of US$80 million in 2003. Even though it has more lines installed than PACIFICTEL, it has fewer employees, achieving an efficiency level of 332 lines per employee in 2002. It reported a rate of return on its assets of 10.4 percent in 2002. 7 Investment Climate Survey, World Bank (2003) 8 According to SUPTEL, the quality indicators for 2002 were the following: 52 percent of local and national calls and 47 percent of international calls completed, and a yearly maximum of 44 faults per 100 lines. 9 SUPTEL 10 ETAPA is not considered in the analysis 216 9.13 The main challenge both companies face is the current tariff regime. Despite the fact that they are required under their concession to rebalance their tariffs, they have not done so. They remain highly dependant on their lucrative monopoly in international traffic, which accounted for almost 30 percent of revenues in 2002. This dependence is risky as the market for international long distance will no longer be as profitable due to the emergence of new technologies such as Voice-over-IP (VoIP) and increased competition from other carriers. On the other hand, ANDINATEL and PACIFICTEL have ambitious investment programs, estimated at US$397 million for the period 2003-2007, and US$190 million for the period 2003-2008, respectively.(See Table 9.3). The unbalanced tariff scheme will not allow these investments to generate a financial return. Most lines to be installed are expected to be to the less profitable customers, who pay subsidized tariffs below cost recovery level. Excluding international traffic, more than 80 percent of the lines do not generate the revenues needed to cover their costs (refer to Table 9.6.) Table 9.3. Operating and Financial Indicators of Public Companies December 31,2002, US$ million ANDINA TEL PACIFICTEL OPERATING PERFORMANCE Operating revenues $229 $182 Operating margin 38% (22%) EBITDA margin 59% 0.06% Net profit $54 (56) Operating revenues per line $31 1 $309 Rate of return over assets 10.3% (7.7%) EFFICIENCY MEASURES Total employees (') 2,222 3,029 Lines per employee 332 195 Operating revenue per employee 0.10 0.06 Digitalization rate 99.9% 97.2% INVESTMENT Investment $74.21 $49.2 Investment as % of operating revenues 32.4% 27% Total fixed lines (2003) 822,420 632,036 Line growth (CAGR 1999-2003) 12.4% 5.1% Investment Program, 2003-2007 $397m $190m LEVERAGE Long term debt $59 $183 Long term debt / total equity 8.6% 44% Long term debt / total assets 7% 25 % Nore: (1) Includes subcontracted employees Source: PACIFICTEL, ANDINATEL, Fondo de Solidaridad. B. Equity and Efficiency of the Tariff Scheme 9.14 Maintaining the implicit subsidy in the current tariff scheme is costing the government millions of dollars. It is estimated that in 2003, approximately US$120 million was transferred 217 from commercial users and international traffic as a cross subsidy to mostly residential users (see section below.) 9.15 In 1995, the Government changed the tariff regime to include categories based on the characteristics of the users and their consumption level (refer to Table 9.4.) The tariff regime implicitly subsidizes low-income and rural users by charging higher tariffs for commercial users. The problem with the current tariff regime is that it is not effective in targeting the intended groups and is not financially sustainable. Table 9.4. Classification of Telephone Subscribers Categories Characteristics Consumption Percentage of total fmed lines Popular (A) 0 Low-income urban households < 6000 minutes per year 8% 0 Rural households Located in Eastern, Galapagos and Frontier regions Residential (B) 0 Up to 3 telephone lines per household > 6000 minutes per year 76% Government, military, public education, and religious entities Commercial (C) All others 15% Source: CONATEL 9.16 The problems and challenges of using blanket subsidies are well documented”. Firstly, they are not effective in targeting resources to the economically disadvantaged. By definition, poor and rural users are less likely to have fixed-line telephones. Not only because most cannot afford to obtain one, but also because they reside in communities that do not have access to the telephone network. Only 5.6 percent of the rural population was estimated to have telephone service in 199912. In addition, many users that can afford to pay unsubsidized tariffs benefit as they reside in eligible areas. It is also very easy to have leakage between categories as many users find a way to get around the scheme and pay lower tariffs. It requires continuous and costly enforcement to gather information about users and reduce the risks of leakage and fraud. 9.17 Secondly, targeted subsidies require substantial financial capacity, which most Governments cannot afford. The financial burden of the current subsidy scheme is very high and unsustainable, as it gives subsidies to all residential consumers, regardless of their income level. Although it could be justified to provide lower tariffs to low-income users, there is no rationale for the Government to be subsidizing all residential users. A consequence of the artificially low tariffs is a significant unsatisfied demand for fixed telephone lines, which is estimated at more than 50 percent according to SENATEL13.The companies do not have the capacity to satisfy that artificially high level of demand. 11 For more detailed information see Estache, Foster and Wodon (2002) “Accounting for Poverty in Infrastructure Reform” World Bank 12 INEC, http://www .inec. gov.ec 13 Demand Study, 2003 (SENATEL) 218 Table 9.5. Progress of Tariff Rebalancing Scheme (in US$) Categories 2000 As of September Target Progress 2003 Monthly subscription (Included 0.8 0.95 6.9 2% minutes) (300) (200) (0) Local call 0.2 0.3 1.7 20% Residential (B) Installation charge 88 88(P), 60(A) 88 100% (P) 0% (A) Monthly subscription 6.2 7 8.6 33% (Included minutes) (200) (150) (0) Local call (centdminute) 1.4 1.3 1.7 0% Commercial (C) Installation charge 200 120(P),60(A) 200 0% Monthly subscription (included 12 12 12 100% minutes) (0) (0) (0) Source: ITU, CONATEL Notes: (P) Pacifictel, (A) Andinatel 9.18 In 2000, the firm Strategic Policy Research (SPR) prepared a tariff and cost study for the Consejo Nucionul de Modemizucih del Estudo (National Council for the Modernization of the State or CONAM) that proposed various changes to the current tariff scheme and outlined the potential benefits to the companies and the consumer^'^. In October 2000, CONATEL approved a tariff-rebalancing schedule included in ANDINATEL and PACIFICTEL’s concessions. By 2003, both companies had to increase their local rates to at least match their incremental costs and reduce international tariffs by half. In spite of this, the President of the Republic rejected the proposed tariff increase and both ANDINATEL and PACIFICTEL have not applied it, even though it is in their best interest (refer to Table 9.5). ANDINATEL estimates its net profits in 2006 would be 43 ercent higher if the Government allowed it to implement the tariff- rebalancing process. 15 C. Estimation of Implicit Subsidies 9.19 The implicit subsidies to the popular and residential categories are estimated at US$20 million and US$101 million respectively, a total of US$121 million during 2003 (see Table 9.6). The amount of the subsidies is higher than the profits of both companies combined during 2003. The results are based on a set of assumptions and cost data from SPR, and only provide a raw estimate of the implicit subsidies. To reduce or eliminate the size of the subsidy, the government could continue the pending tariff-rebalancing process. The estimated change in profits for the companies and additional tax receipts for the Government, if it were to balance the tariff scheme, is shown in Table 9.6. The specific actions considered are: (1) eliminating included free minutes 14 “Study of Costs and Tariff Policies in Ecuador” Strategic Policy Research (2000) 15 “Parimetros de Gesti6n Proyectados a1 2006,” ANDINATEL (2002) 219 in categories A and B, (2) eliminating all subsidies by setting residential tariffs at cost-level; and (3) reducing international tariffs by half. Table 9.6. Estimates of Implicit Subsidies (in US$ million) Categories Current (1) (2) (3) (2003) Eliminate free (1) + Eliminate (2) + Reduce minutes subsidies international tariffs Category A (20) (18) Category B (101) (62) Category C 55 55 55 55 International 104 104 104 89 Operating profits 38 79 159 144 Income Tax 8 17 34 31 Source: CONATEL, SPR (2000). 9.20 Eliminating the free minutes would reduce the cross-subsidy to US$SO million and provide the companies with additional operating profits of US$79 million and the Government with US$17 million in tax receipts. Moreover, if all tariffs are set to at least cover the incremental cost, the cross-subsidy would be eliminated and the companies would make an additional US$159 million in operating profits and the Government US$34 million in tax receipts. Lastly, if international tariffs were reduced to US$0.25 and subsidies eliminated, the companies would increase their operating profits by US$144 million and provide US$31 million in tax receipts for the Government. Although reducing international tariffs would likely reduce revenues for the companies, it would eliminate their historic dependency on revenues from international traffic. Also, lower international tariffs would have significant benefits for consumers and increase the competitiveness of the country. The cost of international communications is a key element when multinational firms choose where to locate. 16 D. Recommendations 9.21 If the Government wishes to increase the financial sustainability of ANDINATEL and PACIFICTEL, and have a more equitable tariff scheme that effectively addresses the real needs of the population, it needs to continue with the tariff-rebalancing process and eliminate the cross- subsidy. 9.22 The Government is facing a deteriorating fiscal situation and cannot afford to be operating companies at a loss. Its various efforts to privatize the companies in the past have not been successful and thus it faces the challenge of how to improve the operations of these companies. Privatizing both enterprises would be the most favorable option. However, if this is not currently possible due to political and economic factors, transferring management of the companies to an experienced private operator is a possible response that would increase their efficiency and profitability. But unless the Government continues with the tariff rebalancing process and eliminates the cross-subsidy, the companies’ financial situation and attractiveness to potential investors will remain poor. 9.23 Taking these actions will naturally have economic consequences for the affected groups, and might also have political repercussions. However, the cost of continuing to provide service below cost recovery levels is much higher. The Government can take cost-effective measures to 16. For more detailed analysis, refer to “Competition in International Voice Communications,” World Bank (2004) 220 provide telephone services to the economically disadvantaged groups. Indeed, low service quality, non-equitable rates, low coverage of poorest groups are all equity issues that need to be addressed. Poor need to have access to a telephone, and they do value telecommunications services and are willing to pay for them.17 The Government should reduce the tariffs for public telephones, which currently are ten times higher than tariffs for residential users1’. Public telephones are the only way of making a call for those users who cannot afford to have a telephone connection, mostly low-income and rural inhabitants. The current tariff scheme is indirectly hurting the population it supposedly intends to benefit. 9.24 The Government should focus its efforts on extending access to telecommunications services to the poor and rural areas. Alternative means of providing telephone service to low- income and rural households in Latin America have proven to be effective in reducing the access gap. Public telephones have been used in Chile to provide access to a telephone, which reduced the percentage of households without access to a telephone to 3 percent”. Supporting the expansion of the cellular network to rural areas by private operators could be another option. In 2003, Bolivia issued rural licenses to cellular operators that are to receive subsidies from the telecommunications development fund. Making the FONDETEL operational is a priority to start supporting private operators, expanding the access network to low-income and rural areas. 17 The lowest income decile in Chile spends about 4 percent on telecommunications services (Source: De Melo (2000), “Telecommunications and the Poor,” World Bank Internal Report). 18 Tariffs per minute for public telephones are U$$O.lO for a local call, US$0.135 for a regional call, US$0.20 for a national call, and US$1.25 for an international call. Source: CONATEL (2003). 19 SUBTEL, based on CASEN (2002). 22 1 222 Chanter 10 OIL Ecuador’s economy is highly dependent on oil both to keep its trade deficit in check and to finance government spending. The outlook for the oil industry is very unfavorable as investment is falling while legal and political uncertainties are hampering the country’s ability to attract more investment. The political situation is also making it dificult to make any changes. As such oil production is likely to remain below the potential offered by its large reserves. This note offers an analysis of the problems together with a few recommendations for possible improvements. The main problems are (i) in 2004, production in the areas operated by Petroecuador will most likely continue to diminish, with production by private companies being far lower than the potential offered by the contracted areas’ reserves; (ii) problems remain in defining the legal/contractual model to attract badly needed private investment to the oil industry; (iii) ineficiencies in refining and wholesale distribution operations, which are exclusively Petroecuador’s responsibility, have not been abated; (iv) price increases on fuels, decided upon when the new administration took ofice, are no longer eflective, due to a decision to maintain the price freeze in 2004. As such, subsidies have increased, making market liberalization even more dificult; (v) increased eficiency in managing the accounts of the oil industry has not been achieved. Subsidies are still managed through Petroecuador ’s budget, and transparency is still lacking in the industry’s collection and allocation of revenues. I. Industry Overview 10.1 Areas Operated by Petroecuador. The government has announced cuts in Petroecuador’s budget, which will impact production in the areas with the greatest proven reserves. Nonetheless, bidding competitions have been launched to receive tenders from private investors on some fields. These bidding competitions are likely to face difficulties so long as the political debate continues regarding the legalkontractual framework to be applied. Despite reports in the press of a significant reduction to Petroecuador’ s projected budget, in practice the investment budget for 2004 will remain at a level of approximately US$250 million.2 Nonetheless, known difficulties in the procurement and awards process for Petroecuador’s projects have yet to be resolved. An example of this can be seen in what happened with the procurement of drilling towers. The standstill in that process is in part attributable to the Office of the Attorney General and in part to regulatory and logistical issues in the customs service. As a result, fewer wells are being drilled than originally planned. This note was prepared by Horacio Yepez (World Bank, Consultant) with inputs from Eleodoro Mayorga (World Bank). 2 In 2003, US$200 million was cut from Petroecuador’s projected budget. In 2004, Congress cut US$50 million earmarked to pay for transporting Petroecuador’s crude oil through the Heavy Crude Oil Pipeline, that is to say, the cut was made in Petroecuador’s operating budget, which is about US$900 million. 223 10.2 In order to counteract Petroecuador’s deficiencies and facilitate private investment, the government issued a decree regulating joint ventures. That decree calls for bidding competitions to solicit tenders from the private sector. Nonetheless, a debate has opened in Congress regarding the constitutionality of this measure and the need for a new law3 and that debate is still going on. 10.3 The bidding competitions underway are in two areas: 0 A bidding competition for blocks on the coast, both onshore and offshore, reopened in March, 2004. Seven companies have expressed an interest, three of which are already operating in Ecuador. The minimum required programs solely contemplate seismic studies. If the results were positive, the incorporation of these blocks into production would take place within six years. 0 The bidding competition for the Culebra, Auca, Lago Agrio, and Shushufindi fields will end on March 23rd. The bidding has attracted twelve companies, under a joint venture model. The signing of these contracts, and above all the receipt of significant investments, is to some extent dependent upon the result of the congressional debate. Instability in the legal framework and problems of environmental liability are reflected in the quality of the companies submitting proposals. 10.4 Other bidding competitions are also in preparation, although they would not have an impact on production in the coming years. Among them are a bidding competition on marginal fields, which is now in a consultation stage, and a bidding competition for the Ishipingo- Tambococha-Tiputini (ITT) fields, where studies are not yet finished. 10.5 Petroecuador’s current production is approximately 205,000 barrels per day. However, given the difficulties noted, it is likely that average annual production will be less than 200,000 barrels per day for the current year.4, 2004. 10.6 Private Companies. The average estimated production of private companies is 271,000 barrels per day for the current year. Private production in 2003 was 204,000 barrels per day. An argument over VAT reimbursements is becoming increasingly complicated. The government even went so far as to seize the accounts of an oil company, despite the fact that an arbitration process was underway. As a result, hesitation among foreign investors has increased. 10.7 Adding in public sector output, a production rate of 470,000 barrels per day is expected for 2004, as compared to a rate of 420,000 barrels per day for 2003. 3 It should be noted that the current administration has not introduced any of its own reforms to the Hydrocarbons Act. Reforms now under discussion have emanated from Congress itself, although they are backed by the administration. The core reform would give legal status to Joint Ventures, as at present these arrangements have no legal status. 4 According to production data, taken for a few days during January of this year, Petroecuador’s production has ranged between 190,000 and 200,000 barrels per day. 224 11. Creation of the FEIREP 10.8 The Ecuadorian economy is highly dependent upon oil. Price volatility has caused major economic unbalance, in particular during periods of low prices. As such, the government has established two funds to correct this. The first is an Oil Stabilization Fund (Fondo de Estabilizacibn Petrolera - FEP), and the second is a fund principally aimed at reducing the central government’s indebtedness called the Fund for Stabilization, Social and Productive Investment, and Reduction of Public Debt (Fondo de Estabilizacibn, Znversibn Social y Productiva y Reduccibn de Endeudamiento - FEIREP). 10.9 Oil Stabilization Fund (FEP). Article 58a of the Public Finance Reform Act created the Oil Stabilization Fund (FEP), principally using oil revenues that were not foreseen or were higher than initially contemplated in the federal budget. This fund is allocated as follows: 0 45 percent to the Fund for Stabilization, Social and Productive Investment, and Reduction of Public Debt (FEIREP). 0 35 percent to finance the construction of the Amazon Highway. 0 10 percent to finance comprehensive development projects in the provinces of Esmeraldas, Loja, Carchi, El Oro, and Galhpagos. 30 percent of this allocation, in turn, is earmarked for the Emergency Social Investment Fund (Fondo de Znversibn Social de Emergencia - FISE). 0 10 percent for the National Police for a period of 5 years. 10.10 Fund for Stabilization, Social and Productive Investment, and Reduction of Public Debt (FEZREP). In June 2002, Article 13 of the Organic Law on Fiscal Accountability, Stabilization, and Transparency created the FEIREP, to be administered as a trust. This Fund would principally capture government revenues generated by crude oil transported through the Heavy Crude Oil Pipeline, except where those revenues are due to reduced use of the Trans-Ecuadorian Oil Pipeline System (Sistema de Oleoducto Transecuatoriano - SOTE) for light crude. In addition, 45 percent of the FEP revenues would be channeled into this fund. That is to say, the funding sources of the FEIREP are: 0 Government revenues from crude oil transported over the Heavy Crude Oil Pipeline, other than revenues generated on account of reduced use of the Trans-Ecuadorian Oil Pipeline System (SOTE) for light crude. 0 Budget surpluses. 0 45 percent of the Oil Stabilization Fund. FEIREP funds are allocated as follows: 0 70 percent for the repurchasing of external public debt and for paying off the debt of the Ecuadorian Social Security Institute (IESS). 0 20 percent to stabilize oil income up to 2.5 percent of GDP, and to respond to declared emergencies. 0 10 percent to promote human development through health and education. 225 10.11 There has been debate and concern over using revenue from the Heavy Crude Oil Pipeline where the money is generated by the transportation of government-owned crude oil. A temporary solution was reached whereby the government does not channel this revenue to the fund. Instead the government has succeeded in designating as revenue to be channeled into the FEIREP all government participation in oil rated lower than 23" on the API, in other words only heavy crude oil. 10.12 The following table illustrates the estimated production of companies whose oil is rated lower than 23" API for the current year and their corresponding contribution to the FEIREP. It is assumed that the price of heavy Nap0 crude is 20 $/bbl. (See Table 10.1). Table 10.1. FEIREP 2004 Millions Companies Areas Quality Production Percent of Price Participation of or API bllday participation $hbl Mbbl $/year PERENCO Block 21 17.5 19,827 16.62 20 1,203 21.0 PERENCO Block 7 21.5 4,000 19.22 20 281 4.9 ENCANECUADOR Block 14 18.9 4,000 12.5 20 183 3.2 ENCANECUADOR Block 17 18.4 4,000 12.5 20 183 3.2 OCCIDENTAL Block 15 18.8 28,156 16.85 20 1,732 30.3 OCCIDENTAL Limoncocha 22.4 5,304 58.8 20 1,138 19.9 OCCIDENTAL Eden Yuturi 20.8 50,000 2 1.55 20 3,933 68.8 REPSOL Block 16 15 70,000 23.49 20 6,002 105.0 Bogui REPSOL Capiron 18.3 6,376 14.73 20 343 6.0 AEC Tarapoa 22.3 59,045 30.21 20 6,s 11 113.9 TOTAL 21,506 376 Source: Author's estimates 10.13 The following table shows estimated FEP and FEIREP revenues for the period of 2004 - 2007, under two scenarios. The first scenario contemplates a drop in Petroecuador's production, with moderate investments from private companies. The second scenario does not contemplate a reduction in Petroecuador's current production, and contemplates increased private investment. 10.14 Out of the total contributions to the treasury during the year 2003, the Oil Stabilization Fund should have received at least US$253 million, due to the extra income generated by higher than expected oil prices. In fact the government did not accumulate fiscal reserves through the Oil Stabilization Fund during the year of 2003. Rather, it liquidated the Fund's entire existing deficit, accrued since 1999. (See Table 10.2). 226 Table 10.2. Funding of FEP and FEIREP 2003 2004 2005 2006 2007 TOTAL National Production (bbyday) Scenario 1 396,636 514,239 501,318 508,058 517,058 Scenario 2 396,636 530,527 554,132 584,028 588,028 Price of Oriente Crude (US$/bbl) 24 24.00 24.00 24.00 24.00 Price of Nap0 Crude (US$/bbl) 20.00 20.00 20.00 20.00 Government participation, API lower than 23" (bbyday) Scenario 1 58,921 59,459 59,867 61,087 Scenario 2 58,921 62,187 63,187 63,737 FEP (Millions US$) Scenario 1 0 27 1 240 246 255 1,012 Scenario 2 0 307 325 372 373 1,377 FEIREP CALCULATION (Millions US$) Scenario 1(*) nodata 376.4 379.8 382.4 390.2 1,528.7 Scenario 2(*) no data 376.4 397.2 403.6 407.1 1,584.3 Total FEIREP(**) Scenario 1 498.5 487.7 493.3 504.7 1,984.2 Scenario 2 5 14.6 543.6 570.9 575.0 2,204.0 (*) According to the new regulations, all government participation in crude oil with a rating lower than 23" on the API scale is considered. (**) The total funded by the FEIREP is equal to the government participation in companies that produce crude oil rated lower than 23" API, plus 45 percent of the FEP Source: Author's estimates 10.15 Considering that 45 percent of the FEP goes to fund the FEIREP and that 70 percent of the FEIREP is earmarked to reduce external debt, the government, through this new calculation method, will succeed in collecting US$350 million for external debt in the year 2004. If this figure is compared to Ecuador's level of external debt, which, at market value, is approximately US$4.5 billion, 8 percent of the debt would be paid off in 2004, and for the entire period, up to the year 2007,45 percent of the debt would be paid off. 10.16 Without question, if high oil prices remain in effect in the international market, FEIREP funds will have a major impact on macro-economic results, for which reason we suggest that duly itemized statistical reports be prepared every two months. 111. Fuel Prices and Subsidies 10.17 Ecuador's fuel pricing policy continues to be set without a technical basis. Price setting fails to take certain criteria into account, such as availability, ease of use, opportunity cost, and the possibilities of substitution among the various energy sources. Price setting has responded to immediate fiscal needs, which has translated into continual price increases in the majority of cases or in setting prices in response to political factors in order to prevent social unrest. Such has been the case with liquefied gas, which has caused considerable economic losses as well as a distortion in use. 10.18 Responsibility for setting prices on fuels has been transferred to the President of the Republic, and prices can be set discretionally, pursuant to Article 72 of the Hydrocarbons Act: "Prices for sales of hydrocarbon derivatives to consumers shall be governed in accordance with 227 the Regulations to be dictated for said purposes by the President of the Republic.’’ Based on this provision, several regulations and reforms have been developed, which do not respond to technical criteria and do not guarantee stability for a healthy development of the market. 10.19 The economic authorities have shown an interest in eliminating subsidies, especially subsidies on Liquefied Natural Gas (LNG), which would contribute to establishing a sound energy policy. Yet it has not been possible to convince other political and social sectors of the good such a measure has to offer, by directly targeting the subsidy while raising the price of LNG to its market level. Rather, attempts are made to skirt the issue by trying to place a surcharge on electricity rates, thereby solving nothing and simply creating another problem in another field. This issue is being debated, and it seems unlikely that the current administration will resolve the problem. 10.20 Considering international prices in effect in the U.S. Gulf region as of July 2003, which had already reached a level of more than US$30 per barrel, the following table shows the difference between the prices of economic opportunity and those in effect in the wholesale market5 in Ecuador: (See Table 10.3) Table 10.3. Difference in Prices at Terminal US cents per gallon PRICE EFFICIENC Taxes IN EFFECT PRICE (Subsidies) Super Gasoline 150.00 102.98 47.02 46 Premium Gasoline 116.89 98.11 18.78 19 Diesel 80.42 85.57 (5.15) -6 LNG 6.71 81.34 (74.63) -92 Fuel Oil 62.00 67.15 (5.15) -8 Source: Author’s estimate, MEF 10.21 Based on this analysis, gasoline prices include an implicit tax, the price of diesel and of fuel oil include a small subsidy, and the price of LNG is highly subsidized. Taking into account the estimated consumption of these fuels for the year, the annual value of the implicit taxes and subsidies has been determined for each of these fuels, which together amount to a net subsidy of more than US$190 million. (See Table 10.4). 5 That is to say, at prices at the level of the distribution terminals, excluding transportation and retail marketing costs. 228 10.22 Such a difference in prices makes it very difficult to foresee a prompt liberalization of prices. In particular, the Table 10.4. Current Taxes or Subsidies government’s proposed tax reform Implicit Estimated contains an interim provision that Tax Consumptio Taxes promises not to raise the price of (Subsidy) 2003 (Subsidies) fuels during the current year. The US cents Gallons US$ tax reform includes a Special Super Gasoline 47.02 100,800,O 47,394,480 Consumption Tax (Zmpuesto a Zos Premium 18.78 453,600,O 85,197,960 Consumos EspeciaZes - ICE), Diesel (5.15) 735,000,O (37,876,650) which varies as a function of the LNG (74.63) 352,800,O (263,304,215 opportunity cost on Oriente crude (5.15) 483,000,O (24,892,900) oil, since the government will not Impact (193,481,325 accept an increase in the price of Source: Author’s estimate, MEF fuels. This, in all events, is a small step in the direction of liberalizing the market, since an importer could pay the Special Consumption Tax and start competing, even if the price is fixed. 10.23 In an effort to make the subsidies transparent, it is recommended that they be published at least once every two months and/or whenever significant variations are seen in the differences between international prices at the terminal level and prices actually paid. Those differences should be used to estimate the economic subsidy. As a second step, an effort should be made to remove this subsidy from Petroecuador’s accounts and transfer it to the accounts of the Treasury. 10.24 The Situation at the Petroecuador Refineries. No significant investments have been made, nor has a way been found to attract private investment to this sector. A project for an isomerization plant that would supply the national market with unleaded gasoline is still under evaluation. Discussions are also underway on legal reforms (as minimal as possible) to allow for free trade in fuels and the free participation of other agents in the refining and marketing of petroleum derivatives. 10.25 The following table shows that during the first nine months of 2003 the refineries’ crude oil consumption, and consequently, the production of refined products, has been 8.1 percent less than for the comparable period of the year 2002. 10.26 Given that national demand has barely changed, the decrease in refinery production resulted in a 14 percent decrease in exports and a 22 percent increase in imports of refined products. Since what is exported is low-priced mazout and what is imported is increasingly high- priced diesel, the impact on Ecuador’s balance of trade is even more significant. 10.27 It is of vital importance that statistical information continues to be made available. In this sense, efforts to date to create Petroecuador’s website, which provides these figures, should continue, and figures should be updated on a bimonthly basis. 10.28 Audit ofPetroecuador. As part of the agreement with the International Monetary Fund, it was decided that with help from international experts, a technical, economic, and environmental audit of Petroecuador would be conducted. According to information from the Public Investment Office of the Ministry of Economy and Finance, the preliminary study by consultants Gaffney and Clyne will be available during the first week of February. Its review is expected to take place 229 during the third week of February at a workshop with the principal members of the Sectoral Commission. (See Table 10.5). Table 10.5. Crude Oil Consumption January September Change REFINERIES September - 2003 I 2002 percent ESMERALDAS 2,415,508 23,306,494 26,152,894 -10.9 LIBERTAD 1,058,338 10,2 19,07 1 10,597,616 -3.6 AMAZONAS 405,319 4,238,816 4,399,665 -3.7 TOTAL I 3,879,165 I 37,7764,381 I 41,150,175 I -8.2 PRODUCTION OF DERIVATIVES (a) January - September Change PRODUCTS September 2003 2002 percent GASOLINE (b) 911,520 9,510,130 9,666,435 DIESEL 2 & PREMIUM 782,971 8,152,353 9,459,2 10 -13.8 FUEL OIL #4 736,210 7,874,165 7,967,266 MAZOUT(c) 642,676 6,613,157 8,176,149 -19.1 LPG 197,711 1,584,264 1,528,312 JET FUEL 157,121 1,405,217 1,318,466 OTHERS 173,415 I 1,495,799 1 1,743,500 I -14.2 TOTAL 3,601,624 I 36,635,085 1 39,859,338 I -8.1 January - September Change PRODUCTS September 2003 2002 percent TOTAL 4,487,083 I 38,848,732 I 39,338,049 -1.2 January - September Change PRODUCTS September 2003 2002 percent LPG 530,389 4,349,353 4,130,893 5.3 HIGH-OCTANENAPHTHA 180,999 3,102,967 2,719,004 14.1 DIESEL OIL 409,929 3,386,700 2,188,252 54.8 AVGAS 19,457 29,048 -33.0 GAS OIL 202,719 I TOTAL 1,121,317 I 11,061,196 I 9,067,lW I 22.0 January - September Change PRODUCTS September 2003 2002 percent MAZOUT 927,885 5,935,052 7,353,172 -19.3 FUEL OIL #4 180,144 136,425 32.0 TOTAL 1,274,386 I 7,657,337 I 8,926,321 I -14.2 Suurce: Petro-Ecuador 230 IV. A Proposal for a Simplified Tax System 10.29 The central issue of the oil sector is the need for a modern Hydrocarbon Law that allows to attract private investment and take advantage of installed OCP transportation capacity. In addition, a bill has been prepared that includes the establishment of a Special Consumption Tax Zmpuesto a Zos Consumos EspeciaZes (ICE) on fuels. This could be considered a first step towards achieving transparency in the accounts of Petroecuador, since taxes would be collected and payments would be made for raw materials, separating the two in the company’s accounts. As a second step, the problem of refining costs must be addressed. This second stage would only involve the development of regulations and would not have to go through the legislature. 10.30 The creation of the Special Consumption Tax on fuels would represents a taxation of consumption on each gallon of fuel, with a specific tax, equivalent to the existing difference between the price in effect and the price of economic efficiency. Obviously, this tax applies to cases where the difference is positive. 10.31 Beyond the immediate objective of clarifying a tax already in existence, application of the Special Consumption Tax furthers other objectives, such as: 0 It guarantees that the national budget will receive at least the same level of revenues from fuels as it does now. 0 It keeps the price of fuels unchanged for consumers. 0 It enables entry of new suppliers onto the fuels market, without undermining the government’s involvement in that market, as the pricing is now transparent. 0 It enables Petroecuador to earn more if it manages to improve efficiency instead of seeing all such gains disappear into the government’s account. 10.32 The sales price at the terminal level should correspond to the cost of raw materials, whose opportunity cost is the price of oil earmarked for export, plus refining and marketing costs, plus taxes. The variable in this equation is the price of the raw materials; that is to say, oil, since the other costs are relatively stable over time. 10.33 Since the sales price at the terminal is a constant, and since a tax exists on fuels, it is said tax that should vary as a function of the price of oil. Taxes should be low when oil prices are high and vice versa. 10.34 The implicit tax is the difference between the price at the terminal without VAT and the cost of raw materials, refining, and marketing. 10.35 Environmental Management. One of the principal deficiencies in Ecuador’s oil industry is its weak environmental management, which is detrimental to sustainable development. It is recognized that any effort at increasing hydrocarbon exploration and production must incorporate state-of-the-art technologies developed by private companies; consultation processes with local communities; participatory follow-up and monitoring; and the best environmental practices available. All this is in order to prevent adverse impacts on the environment. 23 1 10.36 The Environmental Management Act passed in July 1999 regulates the execution of industrial projects. Specifically, the Environmental Regulations for Hydrocarbons Operations, amended in February 2001, regulate oil industry activities with respect to environmental and social management. The principal change introduced by the new regulations was to raise the environmental parameters to international levels, with special emphasis on formation-water injection, the monitoring of emissions, environmental restoration, and procedures for environmental auditing and control. Also included were supplementary rules for qualifying environmental hydrocarbon consultants, the setting of fees for services rendered by the Ministry so that the Ministry could self-finance its budget, and the qualification and registration of environmental hydrocarbon laboratories. These improvements in the regulatory framework, in turn, create new needs for institutional strengthening of the control entity, in order to attend to and control the new requirements. 10.37 It is expected that the Ministry of Energy and Mines, on its website, will post approvals of environmental impact studies and environmental management plans prepared by Petroecuador andor contractors, required for new oil investments pursuant to the current regulations. Nonetheless, neither the Ministry of Energy and Mines nor Petroecuador have yet updated their websites. Furthermore, neither of them have yet established procedures for periodically posting -we would say bimonthly- environmental studies on their websites. It would be recommendable for the Ministry to also post the number of complaints and inspections, as indicators of compliance with the regulatory framework. 10.38 In 2003 the control entity evaluated and approved 188 environmental impact studies, 28 percent and 8 percent more than in 2002 and 2001, respectively, despite the fact that as of 2001 more stringent regulatory measures have been adopted. 10.39 An audit of Petroecuador should be conducted, which would include a chapter on the status of environmental management. This audit should also include recommendations to improve the current legislation, if applicable, in order to confront and solve the national oil industry’s serious environmental problems. 10.40 Consultations with and Participation of Local Populations. In 1998, Article 84 of the Constitution of the Republic acknowledged the need for collective or specific consultations with the Indigenous and Afro-Ecuadorian Peoples. Article 88 of the Constitution acknowledged the need to consult with local communities regarding issues that could impact the environment. This right is also recognized in the International Labor Organization Convention 169, which refers to the rights of indigenous and tribal peoples, ratified by Ecuador in 1998, and in the Environmental Management Act passed in 1999. 10.41 In 2000 and 2001 a consultation process was developed, along with a citizens’ social and environmental monitoring and oversight program, in eleven municipalities, for the construction of the Heavy Crude Oil Pipeline. Furthermore, in 2001, with the enactment of the Superceding Environmental Regulations for Hydrocarbon Operations, public presentations of environmental impact studies became mandatory. 10.42 In December 2002, the Regulations on Consultation and Participation for Carrying Out Hydrocarbon Activities6 were issued, addressing Indigenous and Afro-Ecuadorian Peoples and all individuals or legal entities, as the result of a tripartite effort from the indigenous, 6 Executive Decree No. 3410, published in Official Registry No. 728 of December 19,2002. 232 governmental, and industry sectors, brought together in a Technical Committee. These regulations define procedures and instruments for applying collective consultation and participation rights, such as: the times of consultation -one consultation must take place prior to the bidding competition and another, called a pre-execution consultation, must take place prior to approving environmental impact studies for specific hydrocarbon a~tivities;~the objective of the consultation; participation mechanisms, meeting calls, dissemination of the information and collection of opinions; consultation instruments; timeframes for conducting the consultations and collecting opinions; analysis and evaluation procedures for collecting the opinions and complying with the regulations; and participation in the monitoring process. 10.43 The Ministry of Energy and Mines (MEM), through the Undersecretariat of Environmental Protection (Subsecretaria de Proteccibn Ambientul - SPA), is the agency responsible for ensuring the principles and procedures established in the regulations are implemented. The regulations propose the use of the Ministry of Energy and Mines’ website to disseminate information on the consultation process, with the understanding that said Ministry is responsible for monitoring the application of these regulations and for disseminating the results. Nonetheless, that website has yet to incorporate this information. 10.44 In 2003, when the Consultation Regulations went into effect, the control agency supervised 82 consultation processes, representing a 134 percent and 35 percent increase as compared to 2002 and 2001 respectively, when the only requirement was a public presentation of the environmental studies. The opening of avenues for consultation appears to influence the number of complaints, which increased by 712 percent from 2001 to 2003. (See Table 10.6) Table 10.6. Social and Environmental Management Indicators of the Undersecretariat on Environmental Protection SOCIAL PARTICIPATION AND COMMUNITY RELATIONS 2001 2002 2003 Public Dresentationsor other dissemination activities * 26 35 82 Percentage change 35 134 Complaints 8 70 65 EVALUATION OF ENVIRONMENTAL STUDIES Environmental studies** 135 147 188 Percentage change 8 28 * Does not include marketing activities **Includes activities of exploration, exploitation, refining or processing, storage, transportation, and marketing. Source: Athor’s estimates 10.45 Based on a workshop held in March 2003 with the indigenous sector, as well as other opinions collected in the industry, the Underscretariat of Environmental Protection (SPA), of the Ministry of Energy and Mines (MEM), is working on an amendment to the regulations. The industry has requested that the amendment clarify whether the pre-implementation consultation is by project or by phase. At the request of the industry, it has also been proposed that timeframes for conducting the consultations be shortened -in the case of the pre-bidding consultation, from sixty to thirty days, and in the case of the pre-implementation consultation, from thirty to fifteen days. At the request of the indigenous sector, the SPA is proposing to 7 Hydrocarbon activities are understood to include exploration, exploitation, refining or processing of hydrocarbons, storage and transportation of hydrocarbons, and marketing of petroleum derivatives. 233 increase the meeting notice publication time from two to four days, and to add assemblies and informational workshops. The SPA will consult the indigenous sector and the industry regarding these proposed changes, and hopes to issue amended regulations in June 2004. Subsequently, when the amended regulations go into effect, a broad process of dissemination and socialization will be carried out. 10.46 In order to respond to the recurring complaint that Indigenous Peoples have minimal if any access to oil revenues, even though the Indigenous Peoples are located in the hydrocarbon activities’ areas of direct influence, the SPA is developing a specific proposal to amend Law 010 on Amazon Regional Eco-Development Ecodesarrollo Regional Amazbnico (ECORAE). At present, Law 010 indicates that oil companies must contribute US$O.4O/barrel for eco- development of the Amazon region. This contribution shall increase annually by US$O.OS/barrel until reaching US$O.SO/barrel in 2006. The funds so generated are distributed in the following proportions: 60 percent to the municipalities, 30 percent to the provincial councils, and 10 percent to ECORAE. The amendment seeks to redistribute these percentages in order to allocate 10 percent to the Indigenous Peoples. This initiative demands agreement between diverse political interests, and the development of sound allocation mechanisms. 10.47 In order to correct faulty relations between government, industry, and the population, where arbitrariness and a populist culture have prevailed, the SPA is interested in developing a strategic community relations plan in connection with hydrocarbon activities. 234 Author Biographies ALEJANDRO IZQUIERDO, Senior Economist, Research Department, Inter-American Development Bank, holds a Ph.D. in Economics from the University of Maryland, an M.S. from the Instituto Torcuato Di Tella, Argentina, and a B.A. in Economics from the Universidad de Buenos Aires, Argentina. Previously he worked at the World Bank in PREMs Division of Economic Policy, and taught courses on macroeconomics and international finance at several Latin American universities. His current research interests include issues in international finance such as the identification and determinants of sudden stops in capital flows, fiscal sustainability under sudden stops, and amplification effects of collateral constraints on the real exchange rate and output. He has also worked on the impact of macroeconomic external shocks and public expenditure allocation on poverty reduction for developing countries using computerized general equilibrium models. ALBERT0 MELO, a native of Colombia, is a Country Economist at the Inter-American Development Bank (IDB). He is a Physicist from the Universidad Nacional de Colombia, and pursued graduate studies in Economics at the Universidad de los Andes in Bogot6. He holds an M.A. and a Ph.D. in Economics from Indiana University. Before joining the IDB, he was a researcher at Fedesarrollo and at the Colombian National Federation of Coffee Growers. He also taught at Universidad Javeriana and Universidad de los Andes and was a Visiting Professor at Indiana University. He has published articles and studies addressing issues in the areas of macroeconomics, applied econometrics, industrial policies in Latin America, national innovation systems, and the competitiveness of Andean countries. Along with JosC R. L6pez-C6lix, he was the Co-Task Manager for Peru's 2003 Public Expenditure Review, a joint effort by the World Bank and the IDB. CARLOS GOMEZ, is a Junior Professional Associate who joined Global ICT in July 2002. As a World Bank intern in 2001, he worked for the Latin America PREM network where he assisted in the preparation of various research papers related to health, labor and poverty in Peru, Brazil and Mexico. He was also an intern for the UN in 1999. Carlos has a B.A. in economics (2000) from the Monterrey Institute of Technology and Advanced Studies (ITESM) in Mexico and a master's in public policy (2002) from the University of Chicago. He speaks Spanish and some French. He is currently responsible for providing analytical support in the telecommunications sector and participates in various telecommunications reform projects in Latin America and South Asia. ELEODORO MAYORGA ALBA, is a Petroleum Economist with more than 25 years experience in the oil and gas industry. In particular, he has hands on experience in reservoir simulation, negotiation of contracts, economic assessment, design of corporate policies and management of large project. Before joining the Bank, Mr. Mayorga Alba held positions as CEO-General Manager of Petroperu; Energy Economist at UN-ECE; university teacher in oil refining; and consultant to United Nations Conference On Trade And Development, International Labor Organization, United Nations Development Program and World Bank. 235 ELOY VIDAL, Regional Telecommunications Coordinator, Latin America and the Caribbean Global Information and Communication Technologies Department, Policy Division The World Bank, Washington, D.C. , assisted the Governments of several Latin American countries with privatization of the telecommunications enterprises, restructuring of the telecom sector and supporting regulatory institutions. He is now supporting Governments to develop rural telecommunications and use ICTs for education, health, e-government and e-commerce applications. He joined the World Bank in 1986. Previously, he was Technical Director of COMTELCA, the Central American Regional Telecommunications Commission, from 1982 to 1986, and Manager of Telecommunications Operations in Instituto Costanricense de Electricidad (the national telephone company), in San JosC, Costa Rica, from 1968 to 1982. He has a Master of Science in Electrical Engineering from Stanford University and an Electrical Engineer Degree from University of Costa Rica. Since joining the Bank as Petroleum Economist in 1991, his work has been focused on evaluation of oil and gas projects, development of international gas trade, implementation of sector reforms and mitigation of environmental and social impacts. FERNANDO LECAROS, Energy consultant to the World Bank, IDB, power utilities, regulatory commissions, oil companies, and government agencies. Projects have encompassed the restructuring of energy sectors, regulation, pricing analyses, and project studies. Over twenty years experience in 20 + countries in Latin America, the Caribbean, Africa and Asia. HALSEY ROGERS, is a Senior Economist in the Development Research Group (Public Services Team). His current research focuses on incentives for teachers and other service providers, and he is coordinating a multi-country project on provider absenteeism in education and health launched as background research for the World Development Report 2004. His research and policy work have spanned several areas, including determinants of human capital investment, aid effectiveness and development approaches, economic history of financial markets, sources of entrepreneurship, and trade policy. He is co-author of the forthcoming Growth and Empowerment: Making Development Happen (MIT Press), with Nicholas Stem and Jean-Jacques Dethier. Since joining the Bank in 1996, he has also worked in the Office of the Chief Economist as an advisor to Nicholas Stem and Joseph Stiglitz, as well as in the World Bank Institute. Before 1996, he was staff economist at the US Council of Economic Advisors in Washington and at the Indonesian Ministry of Finance in Jakarta, and he also held positions at UC Berkeley and at the Korea Development Institute in Seoul. He holds an AB from Princeton University, an MPP from Harvard’s Kennedy School of Government, and a PhD in Economics from the University of California, Berkeley. JOSE CUESTA, is a Spanish national. He holds a PhD in Economics at University of Oxford. He has visited the economic departments of University of Warwick, Universidad de Chile, ECLAC (Chile), Universidad Nacional Aut6noma de Honduras and FLACSO (Ecuador). He worked as an Economist for the United Nations Development Program Country Office in Tegucigalpa, Honduras. He has been a consultant for the World Bank, SIDA, UK’s DFlD, the Ministry of Social Affairs in Ecuador, and the Ministry of Planning in Venezuela. He has researched on poverty and inequality, social transfers and labor markets in Latin America, trade liberalization and growth, as well as social risk management and economic impact of HIV/AIDS 236 and malaria. Currently, he is a lecturer in Development Economics at the Institute of Social Studies, The Hague. JOSE ROBERTO L6PEZ-CALIXYa native of El Salvador, is Senior Economist in the Economic Policy Group for the World Bank’s Latin America and the Caribbean Region. He obtained his PhD, MSc and bachelor’s degrees from the Catholic University in Louvain, Belgium, and an MSc degree with a major in International Finance from the University of Pittsburgh. He began his professional career by working in a number of international organizations, including the United Status Agency for International Development, the Canadian International Development Agency, the United States Congress, and the Inter-American Development Bank, specializing in macroeconomic policy, econometric analysis, public finance, international migration and foreign debt management. From 1989 to 1991, Dr. Upez-CBlix served as General Director for the Ministry of Planning’s Economic and Social Advisory Group with responsibility for El Salvador’s special budget, and in this capacity was a member of the team that designed and implemented structural adjustment policies to govern the transition between the pre- and post-war periods. In 1994, he joined the World Bank in Washington, D.C., where he worked in the Department of Central American Operations. Two years later, he was named Country Manager of the Bank’s Office in Guatemala. In 1999, together with Guatemala’s Integrated Financial Management Project Team, he was awarded the prestigious “President James D. Wolfensohn Award”. In 2000, he returned to Washington, D.C., and since that time has worked primarily with the Department for Ecuador, Bolivia, Peru and Venezuela. Mr. L6pez- Calix has been a Visiting Professor at Florida International University in Miami and has published numerous books and articles on specialized subjects, including parallel exchange markets, international coordination in macroeconomic policy, public finance, public expenditure monitoring surveys, trade policy and free trade agreements, and family remittances. JOSE ROSERO, is Ecuadorian and a trained economist. He obtained his MA in development economics with the Institute of Social Studies, The Hague. He is at present an analyst of the Integrated System of Social Indicators of Ecuador (SIISE), mostly engaged with poverty analyses and microeconometric studies of the labor market, household behavior, health and education. Previously he worked as a survey specialist at the Catholic University (Quito) charged at the time with the implementation of a continuous labor force survey for Quito, Guayaquil and Cuenca. JUAN PONCE, is an Ecuadorian national. He holds Master’s degrees in Political Sciences (FLACSO-Ecuador) and Economics of Development (Institute of Social Studies, The Hague) and has a post-graduate diploma in Statistics (Escuela PolitCcnica Nacional-Ecuador). Currently he is a PhD candidate at the Institute of Social Studies (The Hague-The Netherlands) and a lecturer of economics at FLACSO-Ecuador. Previously, he was director of SIISE in Ecuador. His research interests include economics of development, economics of education, impact evaluation of social programs, and applied microeconometrics. His most recent publications include “The determinants of secondary school enrollment in Ecuador” (MA Thesis, ISS, The Hague, 2002); “Simulating Progressive Social Transfers: gas subsidies and solidarity bonus in Ecuador” (with JosC Cuesta and Mauricio Le6n; ISS Working Paper Series No. 193,2004; and forthcoming in a volume published by the IDB). He is a co-author of Who gains from social expenditures in Ecuador? (edited by Rob Vos; in Spanish; Abya Yala Editores; Quito, 2003). 237 KARTHIK MURALIDHARAN, is a Ph.D. candidate in the Department of Economics at Harvard University. His main research interests are in development, political economy, and public finance. His current research focuses on public service delivery in India and the political economy of public good provision. Karthik graduated summa cum Zaude in economics from Harvard College and obtained an M.Phi1. in economics from Trinity College, Cambridge University where he was the Eben Fiske Scholar and recipient of the Stevenson Prize. He is currently a Fellow of the Justice, Welfare, and Economics program at Harvard and is also a recipient of the Bradley Fellowship in Public Economics. NAZMUL CHAUDHURY, recently joined South Asia HD from the Public Service Delivery unit of DEC where he has been working on issues of teacher and medical provider absence, vulnerability and child schooling, and child mortality. Nazmul is currently working on institutional accountability in service delivery and on impact evaluations of various types of interventions (social protection programs; sanitation; poverty alleviation programs) on poverty and HD outcomes. Nazmul joined the World Bank as an economist in the Poverty Anchor of PREM where he worked on issues of rural poverty and impact evaluations of adverse shocks on gender-differentiated HD and labor market outcomes. Nazmul has field-based work experience in Bangladesh, Ethiopia, India, and Nepal. MARfA ANGELICA SOTOMAYOR, is an economist working in the Urban Development, Water and Sanitation Cluster of the Finance, Private Sector and Infrastructure Department (FPSI), Latin America and Caribbean Region, of the World Bank. She joined the World Bank in 1996 as a consultant in the Water and Sanitation Anchor, in 1999 she moved to the LAC region working mainly in the economic analysis of Water and Sanitation Projects, the development of sector strategies and sector regulation, she also provided support to the Water Resources management Team in ESSD. She is currently the leading the Bank’s sector dialogue in Paraguay, and task team leader of water and sanitation projects in Paraguay and Peru and co-task manager of the Rural Water and Small Towns Project in Ecuador. She is also responsible for the economic analysis of several urban development and water and sanitation projects in Ecuador, Brazil, and Guyana. She holds a Master Degree in Economics. Before joining the World Bank she worked for 4 years in the private sector as a consultant in economic analysis of projects, and for 2 years as a research and teaching assistant in the Program for Economic Analysis of Investment projects sponsored by the IDB and Los Andes University in Bogota, Colombia. MAURICIO LE6N, is an Ecuadorian specialist on macroeconomics and poverty. He has a Master’s Degree in Economic Policy. He is the current director of SIISE, Ecuador. His research interests include the impact of macroeconomic policies on living conditions and income distribution in Ecuador. He has been engaged in a vast number of studies about the Ecuadorian economic crisis of the late 1990s and its social impact, including work for the World Bank (Ecuador Poverty Assessment 2003, and Ecuador Social Sector Report 2000) and collaborative research with the Institute of Social Studies of the Netherlands which have led to publications on trade liberalization and poverty; crisis and social protection; distributive effects of social expenditures; and urban poverty trends and determinants in the 1990s in Ecuador. 238 MICHAEL KREMER, Michael Kremer is the Gates Professor of Developing Societies in the Department of Economics at Harvard University and Senior Fellow at the Brookings Institution. He is a Fellow of the American Academy of Arts and Sciences and a recipient of a MacArthur Fellowship and a Presidential Faculty Fellowship. Kremer’s recent research examines education and health in developing countries, immigration, and globalization. He and Rachel Glennerster have recently published Strong Medicine: Creating Incentives for Pharmaceutical Research on Neglected Diseases. His articles have been published in journals including the American Economic Review, Econometn’ca, and the Quarterly Joumal of Economics. Kremer previously served as a teacher in Kenya. He founded and was the first executive director of WorldTeach, a non-profit organization which places more than two hundred volunteer teachers annually in developing countries (1986-1989). PHILIPPE DURAND, Lead Energy Specialist with the LAC region. Fifteen years of World Bank operational experience in energy sector reform, private participation, regulatory aspects and access issues. Currently based in the World Bank in the Argentina Office to cover energy issues and projects in the sub-region. RUTH LUCIO, is an Ecuadorian national. She is presently an analyst of the Integrated System of Social Indicators of Ecuador (SIISE). An economist by training, she has focused much of her work on health economics and institutional reforms of the Ecuadorian health system, becoming one of the country’s leading experts in the field. Her research interests further include poverty analysis and social accounting. RAFAEL ROFMAN, is a graduate from the University of Buenos Aires in Economics, with a master degree in Social Demography from the University of Lujan in Argentina and a PhD in Demography from UC Berkeley. He has been a consultant for international organizations and national governments in Argentina, Brazil, Peru, Mexico, Uruguay, Venezuela, Hungary, Poland, Croatia, Slovenia, Lithuania, Ukraine, Thailand, Sri Lanka and Mauritius. In Argentina he has been head of research at the Supervision of Pension Funds, at NACION AFJP, advisor to the Minister of Economy and to the Secretary of Social Security and, until mid 2002, Vice-president of the Board of NACION AFJP. He joined the World Bank as a senior economist for Social Protection in the Latin America and the Caribbean region in September 2002, and has worked on social protection and pensions in Argentina, Bolivia, Dominica, Ecuador, Peru, Ukraine, Uruguay, and Venezuela since then. He is author of many studies on adult mortality, social security and pension reform, presented in meetings and published. He has been university professor at the University of Buenos Aires, University Di Tella, New York University and the National University of Honduras. ROB VOS, is a Dutch citizen and a professor of economics at the Institute of Social Studies, The Hague and the Free University Amsterdam. He is also the former deputy rector of the ISS. He has worked as an advisor for many governments throughout the developing world, including many parts of East Asia, Kenya and throughout Latin America. From 1994 to 1997 he was Senior Economist at the Inter-American Development Bank (IDB) in Washington D.C., the largest multilateral regional development bank, where he co-founded the Institute for Social Development (INDES) and designed the regional program for improving household surveys of living conditions 23 9 for Latin America (MECOVI). His research interests cover international trade and finance, fiscal policies, income distribution and human development; poverty analysis and applied general equilibrium modeling. His most recent book publications include Who gains from free trade? Export-led growth, trade reform and poverty in Latin America (Routledge, 2004, forthcoming); Who gains from social expenditures in Ecuador? (in Spanish; Abya Yala Editores; Quito, 2003); Economic Liberalization, Distribution and Poverty: Latin America in the 1990s (with Lance Taylor and Ricardo Barros; Edward Elgar Publishers 2002), Ecuador: Crisis y Protection Social (Abya Yala Publishers, Quito, 2000), External Finance and Adjustment (with Karol Jansen; Macmillan and St. Martin's Press, 1997). 240