ReportNo. 10404-VE Venezuela Structuraland Macroeconomic Reforms- The New Regime Public Disclosure Authorized March18, 1993 Country Operations Division CountryDepartment I Latin America and the Caribbean Region iI- .;i: . I1 1 . I ; :a,, ,.; 1 1.t .' ' ' : .1 . ; ~~~~ti,.~~~~~~~~~~~ FOR OFFICIAL USE ONLY ji ,i Public Disclosure Authorized Public Disclosure Authorized

of the WorldBank

Public Disclosure Authorized Document

This documenthas a restricteddistribution and may be usedby recipients only in the performanceof their official duties.Its contentsmay not otherwise bedisclosed without World Bankauthorization. FISCAL YEAR

January 1 to December 31

CURRENCY EQUIVALENTS

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

US$1 = Bs. 79.7 Bs. 1 = US$0.012 Bs. 1,000 = US$12.55 FOR OFFICIAL USE ONLY

GLOSSARY OF ACRONYMS

AEROPOSTAL LUneaAeropostal Venezolana Venezuelan Postal Airliie ALCASA Aluminio del Caroni, S.A. Caroni Aluminum, S.A. BANAP Banco Nacional de Ahorro y National Savings and Loan Bank Prestlmo BANDAGRO Banco de Desarrollo Agrfcola Agricultural Development Bank BAUXIVEN Bauxita Venezolana, C.A. Venezuelan Bauxite, S.A. BCV Banco Central de Venezuela Central Bank of Venezuela BIV Banco Industrial de Venezuela Venezuelan Industrial Ea ,k CADAFE Compania Anonima de Desarrollo y Development and Cooperation for Fomento Electrico Electrical Power Company CAMETRO Compailia An6nima Metro de Caracas Subway Company Caracas CANTV CompafiliaAndnima Nacional de National Telephone, S.A. Telefono CARBOSUROESTE Carbones del Suroeste Southwest Coal Company CASA Agricolas, S.A. Agrarian Industries, S.A. CAVEINEL Camara Venezolana de la Industria Venezuelan Chamber of Electrical Electrica Industries CAVN Compaffia An6nima Venezolana de Venezuelan Navigation, S.A. Navegaci6n CORDIPLAN Ministerio de Planificacion y Ministry of Coordination and Coordinacion Planning CORPOINDUSTRIA Corporaci6n de Dsarollo de la Corporation for the Development of Pequefla y Mediana Industria Small and Medium Industry CTV ConfederacdonTrabajadores de Venezuelan Workers Confederation Venezuela CVF Corporaci6n de Venezolana de Venezuelan Development Fomento Corporation CVG Corporaci6n Venezolana de Guayana Development Corporation Guayana DFI Instituciones Financieras de Development Financial Institutions Desanrollo EDELCA Electrificacid6ndel Caroni Caroni Electrification Company ELECAR Electricidad de Caracas Caracas Electricity Company

This document has a restricted distribution and mavbe used by recipients only in the performance of their officialduties. Its contents may not otherwise be disclosed without World Bankauthorization. ENELBAR Energia Electrica de Barquisimeto Barquisimeto Elelectricity ENELVEN Energia Electrica de Venezuela- Venezuela-MaracaiboElectricity Maracaibo ENSAL Empresa Nacional de Salinas National Saltworks Company FCA Fondode Credito Agrfcola Agricultural Credit Fund FERROMINERA Ferrominera del Orinoco Orinoco Ironore Company FINEXPO Fondo de Financiamiento de las Export Financing Fund Exportaciones FIV Fondo de Inversiones de Venezuela Investment Fund of Venezuela FOGADE Fondo de Garantfa de Dep6sitos Dtposit Insurance Fund FONCREI Fondo de Credito Industrial Industrial Credit Fund GATT General Agreement on Tariffs and Trade HCD Hogares de Cuidado Diario Community-Based Day Care Centers ICAP Instituto de Credito Agropecuario Fanning and Livestock Credit InsCitute INH Instituto Nacional de Hipodromos National Race Tracks Institute INP Instituto Nacional de Puertos National Ports Institute INTERALUMINA Internacional de Aluminio, C.A. Aluninum International, S.A. MEM Ministerio de Energia y Minas Ministry of Energy and Mines MH Ministerio de Hacienda Ministry of Finance MINFAM Ministerio -le la Familia Ministry of the Family NGOs Non Governmental Organizations OCEPRE Oficina Central de Presupuesto Budget Office PDVSA Petrdleos de Venezuela, S.A. Venezuelan Petroleun Company PEP Plan de Enfrentamiento de la Povert Alleviation Plan Pobreza RECADI Officina dAelRgtinen de Cambios Office of the Differential Exchange Diferenciales Rate S&L Savings and Loans SBIF Superiotendencia de Bancos e Superintendency of Banks and Instituci snesFinancieras Financial Institutions SIDOR Siderqrgica del Orinoco, C.A. Orinoco Steel Industries VENALUM Industrias Venezolanasde AlMninio Venezuelan Aluminum Industries VIASA Venezolana Internadonal de International Venezuelan Aviation Aviaci6n VV3UgEL1 STRUB-RAL AND NACR-O0C IC 33 ME-!33EV RESINS

TABLE OF CONTETS

ABSTRACT ...... iv

BXECUTIVE SUMMARY ...... vi

1. STRUCTURAL REFORMS ...... 1

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

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

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

Foreign-Trade Reforms ...... 6 Prior CondLtionsdit.n...... 6 (a) Foreign Exchange Controls and Import Bazriers 6 (b)Tariffs ...... * ...... 9 (c) Export Incentives ...... 11 ReformMeasures ...... 12 Evaluationand Further Reforms ...... 15

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

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

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

Infrastructure.. .. 24 Prior Conditions ...... 24 Policy Reforms...... 27 Evaluationand Further Reforms . . . o ...... 30

FinancialSector ...... 34 PrLor Conditions...... 34 Pol$cyReform ...... s . ... 36 Evaluationand Further Reforms . 37 Social Sectors ...... 39 Prior Conditions ...... 39 Policy Reforms . ... . :...... 40 Evaluation and Further Reforms. . . . . 42

II. MACROECONOMIC REFORMS ...... 46

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

Prior Conditions ...... 46

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

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

The Policy Change ...... 55

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

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

Fiscal Issues ...... 60 Government Revenues ...... 60 Government Expenditures ...... 61 The Budgetary Process ...... 63

Fluctuations in Oil Revenues ...... 64

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

The Real Exchange Rate ...... 70 - iii -

LIST 0P TABLES

Table 1: IMPORT RESTRICTIONS AND AVERAGE TARIFFS BY SECTOR AND STAGE OF PROCESSING, 1989-91 ...... 10

Table 2: IMPORT RESTRICTIONS AND AVERAGE TARIFFS BY MANUFACTURING SURSECTOR, 1989-91 ...... 14

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

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

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

Table 6: MONEY SUPPLY, 1988-91 .51

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

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

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

PREFACE

The Administration of Fresident P6rez, which assumed power in early 1989, has introduced several fundamental measures of ezonomic reform and macroeconomic stabilization. The present study, three years after the introduction of these policies, is intended to serve as a stock-taking. It describes and analyzes the circumstances under which the policies were adopted and the nature of the policies as they were announced and implemented. It also evaluates the achievement of the policies, and indicates the directions in wwhich policies could be further pursued, improved, or changed. Structural reforms are discussed in the first part of the study and macroeconomic policies are analyzed in the second part.

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

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

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

This report provides an evaluation of the policy changes implemented by the new administration of President Perez in Venezuela three years after their introduction. The pattern mostly followed in the discussion of each policy &rea is as follows: a description of conditions and circumstances in the opening position, prior to the introduction of new policies; a presentation of the nature of these policy changes; a discussion of the effectiveness of the new policies; and a suggestion of further policy revisions. The report is presented in two parts: structural reforms in the first part, and macro-economic policies in the second.

Structural reforms are discussed under two headings. One is functional: in this way, two major areas of reform, i.e., privatization and the reform of the foreign-trade regime, are examined. The other framework is sectoral. Under the latter heading the major sectors in which reforms have been undertaken are snrveyed: agriculture; power and energy; infrastructure; the financial sector; and the social sectors.

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

The analysis of the episode of macro-economic stabilization indicates that the policies undertaken to achieve stabilization were indeed effective, and a large measure of balance was achieved. These policies were, however, of a transitory nature, so that in time they were at least partly reversed. Stabilization is, thus, not entirely assured. The developments of this episode illustrate several fundamental factors and inherent long-term macro-economic problems such as the effect of fluctuations of oil revenues, the low level of non-oil taxation, and some salient implications of the system for the country's real exchange rate and its economic structure. These fundamental issues, beyond the analysis of stabilization, form part of the topic of the report's macro-economic discussion. - vi -

EXEuTIVE SUNW&RY

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

ii. After oil prices collapsed in the early 1980s, many Venezuelans realized that this model of economic life and development was grossly deficient. Perceptions of the magnitude of waste, inefficiency, and distortion created by the government's pervasive intervention undoubtedly were heightened by the accumulating experience of countries, particularly in Latin America, that had discarded intervention in favor of free markets, with beneficial results.

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

Structural Reforms

iv. Privatization. During the 1970s and 1980s, successive governments in Venezuela followed a development strategy relying heavily on state control of productive sectors. In addition to traditional public services (e.g., water, telephone, electricity), state-owned enterprises (SOEs) dominated many sectors, including petroleum (PDVSA), mining, aluminum, power, and steel. Expansion into these sectors was part of an ambitious design to direct resources generated by petroleum to develop untapped natural resources, and promote import substitution and self-sufficiency. It was initiated in the mid-1970s with the nationalization of the oil and iron ore industries, followed by heavy public investment in power, steel, and aluminum. Funds channelled through the Fondo de Inversiones de Venezuela (FIV), set up to invest petroleum revenues, were initially provided as loans which, in most cases, have been converted to equity as a result of the inability of the SOEs to repay them. v. In comparison with the other measures in early 1989, the privatization program was slower to develop and initially very modest in scope. In mid-1989, the Economic Cabinet approved a broad SOE rationalization strategy, prepared by CORDIPLAN, that categorized SOEs according to the type - vli -

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

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

vii. The FIV has a well-developed procedure for privatization: an initial diagnostic analysis of the company and the sector; design of a sales strategy; valuation; reparation of a sales memorandum or ptospectus (for a public share issue); nLe-qualificationof potential bidders; and the public tender or share offering.

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

Poreicn-Trade Reforms

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

x. A pervasive system of noi-tariff barriers reinforcing a high level of tariffs had served as the e tctive constraint on imports. For most items, a potential importer had first co obtain an import permit from the Development or the Agriculture Ministry that would be granted only if domestic producers did not object. Importers had then to apply on a case-by-case basis to the Office of the Differential Exchange Rate Regime. xi. Before the trade reforms of 1989, there were 41 tariff rates, the maximum being 135 percent. Tariffs had been established over the years on a case-by-case basis without guidelines. The spread was great: about a sixth - viii -

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

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

xiii. The policy reforms in February 1989 amounted to a radical transformation of the trade regime. In intensity--measured by the extent of the changes and the speed with which they were introduced--they rank at the top, whether in Latin America or in the world as a whole, in recent years. The cornerstone of the reform policy was the unification and floating of the exchange rate. Along with this change came the abolition of foreign-exchange controls and, thus, of a major device for import rationing and rent seeking. Import prohibitions and licensing have been sharply reduced, today protecting only about 2 percent of domestic produc ion, well within the government's goal of no more than 5 percent in the medium term. The greatest incidence of QRs remains in agro-industry. Tcriffs, too, have been lowered substantially. The tariff code for the manufacturing sector has been restructured to afford each line of production roughly the same protection. The level and range of tariffs have been cut substantially. The average rate has been reduced from 37 percent to 16 percent, with consumer goods--at 33 percent--continuing to be subject to the highest rates. The maximum tariff has been lowered from i35 percent to 80 percent and then to 50 percent, and the government's announced target is to reduce it to 10 to 20 percent by 1993. Discretionary tariff exonerations have been eliminated. However, exemptions established by law remain for some entities such as state-owned enterprises, universities, and the central government.

xiv. The reforms have been wide and deep and must lead to major economic benefits. The government, to date, has maintained an admirable degree of uniformity in the treatment of economic sectors, and has replaced the system of QRs, ad hoc protection, and costly export subsidies with a system that--when fully implemented by 1993--will use effective exchange rate management in place of import substitution or export promotion. Moderate tariffs--between 10 and 20 percent--will provide additional protection for import-competing domestic producers, leaving a residual anti-export bias after export subsidies have been eliminated.

Maior Sectoral Reforms

xv. Agriculture. Between 1984 and 1988, the government attempted to maintain high producer prices and profits while maaintaining low and stable - ix -

consumer prices. Imports and exports were restricted. The critical element of the policy was that government resources would subsidize producer prices until inefficiencies in the sector were rectified and the productive capacity expanded.

xvi. The policy was unsustainable and could not have logically achieved the coal of removing inefficiencies in the sector. It resulted in highly distorted relative prices and extensive government intervention. It also entailed huge subsidies. By 1987, these were estimated at almost US$1 billion a year, equivalent to about one-third of agricultural value added and 2 percent of GDP. In addition, the policy failed to keep retail and wholesale food prices low and stable. The attempt to increase resources for private sector investment in agriculture through subsidized credit have had negative effects on the financial sector. Agricultural portfolio requirements and direct credit subsidies have contributed to the underdevelopment and inefficiency of financial institutions, while poor loan repayments have bankrupted one public sector institution (BANDAGRO) and left two others (FCA and ICAP) in a critical sitiation. Further, leakages of subsidized credit to non-agricultural activities have partially defeated the purpose of the program.

xvii. Unifying and floating the exchange rate has been crucial for agriculture. So were other changes in the foreign-trade regime. Since July 1990, prior licensing for most agricultural commodities, with the important exception of feed grains and poultry, have been removed. A transparent price band mechanism for wheat, rice, white corn, oilseeds, yellow corn, and sorghum has also been implemented to stabilize domestic prices and provide additional tariff protection for these key commodities. Export controls on rice, legumes, and cornmeal have also been ended.

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

xix. Several measures have liberalized interest rates and credit allocations to agriculture. But major steps are still required to achieve full liberalization of finance in the sector. Another sphere in which even less has been done is irrigation. The planned phasing out of water subsidies has been very slow, and at the present rate is unlikely to achieve full cost recovery in the foreseeable future.

xx. Power and Energv. Power prices in the past decade have not reflected the cost of service and have resulted in an unsatisfactory general rate level and distorted tariff structure. This policy has had two adverse consequenc-s: (i) it has compounded the financial difficulties of the utilities and increased their dependence on government contributions; and (ii) it has sent distorted signals to the consumer, promoting waste and inefficient use. A pricing policy that rationalizes the tariff structure and increases prices to the level of costs is needed. xxi. The reforms have been directed att (i) reducing the dominance of the public sector through restructuring and privatization; (ii) increasing operational efficiency; (iii) providing a strong central institution to review and coordinate expansion plans, investment programs, and other activities related to the sector; and (iv) establishing a rational pricing system based on long-run marginal cost criteria aimed at improving the economy's efficiency and reducing government transfers. xxii. At the start of the reform program, the price of gasoline was increased significantly. Yet, even today, it is less than US$.30 per gallon-- still among the lowest in the world. By comparison, the international wholesale price in the Caribbean market is about $.6C-.70 per gallon; and domestic prices in European countries are about $2 per gallon. It appears that the government is no longer adhering to an original adjustment schedule, which was supposed to raise prices to their full opportunity costs. xxiii. InfrastrMeture. Reforms have been undertaken in the sector's major subsectors: telecommunications, ports, shipping, water supply and sanitation, interurban transport, and urban transport. xxiv. The reform of telecommunications has four components, of which the principal component has been the privatization of CANTV through the sale in November 1991 of a control block of 40 percent of its shares to an international consortium led by GTE for US$1.9 billion. Ali additional 11 percent has been sold to the employees. Other reform measures are: the injection of limited private competition in cellular telephones; the introduction of a new tariff structure, with telephone rates progressively adjusted to cost levels; and the submission to Congress of a Telecom Law that establishes a new regulatory regime and introduces greater private investment and competition. xxv. In early 1990, the government decided to undertake the following reforms in ports: the dissolution of INP and the dismissal of all INP workers; the establishment of regional port authorities to oversee the ports (with the commensurate transfer of responsibility for ports administration to state governments); and the operation of all ports by the private sector under concession agreements. Consulting firms and auditors were hired to design the new ports regime and prepare the dissolution of INP. By the end of 1991, much of the reform program had been completed. xxvi. Over the past 12 months, the government has implemented a number of measures to liberalize shipping and increase competition. Numerous restrictions faced by importers and exporters have been eliminated, including those pertaining to transshipment, opening new routes (and route extensions), and use of CAVN for shipments financed through letters of credit. A number of regional and bilateral agreements have eliminated cargo reserve requirements, allowing shippers freedom of choice in selecting a carrier. - xi -

xxvii. In water supply and sanitation,the government launched a far- reaching restructuringstrategy in mid-lS90 aimed at liquidatingthe national agency, establishingautonomous and financiallyself-sufficient regional water companies, and, where feasible,privatizing operations through concession agreements with private operators. Progress, however, has been slow.

xxviii. In inter urban tranLnortation,the main objectives are to decentralizethe management of rural roads and to establish a national road fund. The fund will be financed by new taxes on petroleum products earmarked for the rehabilitationand maintenance of the national highway and rural feeder road networks.

xxix. In July 1990, a steering group was formed under the InterministerialCommission on Urban Transport to determine objectives and priorities,to make recommendationson the sector's institutionaland regulatory frameworks,to evaluate policies, and to formulate a strategy for the short aiidmedium terms. A review of tariffs and subsidies has been completed, and studies have been launched on financingmechanisms, institutionalarrangements (particularlythe roles of the various governmental levels), and options for expanding urban transport to the poorer areas on the outskirts of Caracas.

xxx. The Financial Sector. Until the reiorm, interest rates were subject to ceilings. As a result, real interest rates were mostly low and, particularlywith the accelerationof inflation in the second half of the 1980s, often negative. New liquid assets were formed to circumvent the regulationsthat made real interest rates on deposits negative (these assets are not subject to reserve requirements).

xxxi. Beyond the segmentationcreated by the existence of numerous public credit institutionswith power to determine rates and conditions of loans, there were portfolio requirementsfor private banks. Commercial banks were subject to a 22.5 percent lending portfolio requirement for agriculture and agro-industry. Interest rates for these loans were required to be below market rates. A particularlyserious problem is the weak financial position of some institutions,which makes insolvency likely. Mortgage banks and S&Ls are experiencingmajor financialproblems because of the mismatch between the maturity and rate structure of their assets and liabilities. Multiple government-sponsoredprograms that finance housing have made most of these institutionshighly dependent on subsidiesto survive. xxxii. The objectives of the financial sector reform are: (i) to liberalize the financial policy environment (interestrates, allocation of credit, foreign ownership, universal banking, etc.); (ii) to reduce the role of government in financial intermediation(by privatizationand liquidationof public banks, consolidationof DFIs, rationalizationof housing finance policy, etc.); (iii) to limit the role of the BCV to providing liquidity and to monetary management; (iv) to improve the supervisionand handling of bank crises; and (v) to increase competitivenessin banking. - xii -

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

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

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

xxxvi. Previous anti-poverty programs attempting to redistribute income through general food subsidies and free social services failed despite high expenditures. The main beneficiaries of food subsidies tended to be the middle and higher income groups, who could afford to buy greater quantities of subsidized goods. While social services were presumed to be universal and free of charge, poor management and inefficient investment left many b--neficiaries out of reach of service delivery.

xxxvii. In 1989, the government replaced general food subsidies with programs specifically for lower-income groups and expanded existing programs that target the most vulnerable members of society. These actions were designed to shield the poorer segments of the population from the adverse effects of structural adjustment and to overcome past deficiencies in targeting, coverage, and administration of selected social services. The government has undertaken a huge effort in this area: the resources budgeted for these programs in 1992 surpassed US$700 million.

xxxviii. The new strategy emphasizes a shift from general subsidies to programs benefiting lower-income groups. Its principal objectives are to: (i) relieve the severe hardship resulting from economic decline; (ii) mitigate the impact of adjustments in the economy necessary to achieve sustainable, long-term growth; and (iii) set the basis for human capital development, an essential factor of growth with equity. Other elements of this strategy are to improve the planning and monitoring capacity of participating ministries and to increase the efficiency of service delivery. xxxix. To increase the cost effectiveness of social expenditures, the government has emphasized three principles in the selection of projects: (i) increased targeting of the poor; (ii) decentralization of design and - xiii -

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

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

Evaluation and Recommendations for Further Reforms

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

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

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

xliv. Probably the most far-reaching transformation has been achieved in the trade reaime. Here, avoiding any reversal is probably more important than the achievement of any specific target of further reforms. Among the latter, three measures would be particularly significant: the abolition of remaining non-tariff barriers to imports in the agricultural sector; the elimination of remaining tariff exemptions; and the encouragement of private credit markets for exports, to replace the subsidized government finance. xlv. The agriculture sector has adjusted well to the reform process, with the output mix responding to the changes in relative prices and to the large measure of removal of protection. But reforms in this sector, while significant, have not gone far enough. The most important further steps which should be undertaken are: complete elimination of import licensing and - xiv -

minimum-price programs--a step the Government plans to take over the next two years; phasing out of price-stabilization schemes; elimination, as the Government indeed plans, of the fertilizer subsidy; elimination of government marketing and divestiture of its storage facilities; deregulation of agricultural credit; increase (in fact, introduction) of water charges in irrigation schemes to cover full costs; and land reform, to establish clearer entitlements and property rights.

xlvi. In the sector of Dower and_enerav, while some prices have been liberalited in the 1989 reform, inadequate prices remain a key issue for petroleum, electricity, and gas. Likewise, the progress towards privatization has been minor. Thus, the two areas of required reforms are, first, the establishment of prices at the levels of long-run marginal costs--a policy to which the Government is committed in principle, and which it expects to introduce gradually; and Pt least a beginning of a gradual, long-tern. process of privatization of activities in the production and distribution of petroleum, gas and electricity.

xlvii. In the infrastructure sectors, the greatest progress has been achieved in telecommunications, with the privatization of CANTV. In oorts, the dissolution of the INP and the transfer of all cargo handling and stevedoring to private forms have already had a dramatic impact on efficiency. Further important reforms would be the granting of concessions to private firms for operation of entire ports or individual terminals, allowing competition both between ports and within large ports. In water supplv and isanitation,important decisions have been made, but implementation has been delayed. The actions required now are, primarily, the enactment of a new water sector law; the development and implementation of a new structure of water tariffs; the liquidation of INOS, transferring its assets to the new regional water companies; and the transfer of the Caracas water system to a private operation. In the inter-urban transoort sector, the required reforms consist, first, of establishing appropriate prices--of petroleum, or of road uses. A concession program should be established for private sector construction and operation of expressways. Finally, in urban transport, the recommended agenda for further reforms should include: the deregulation of the bus system--particularly of fares; the replacement of generalized subsidies by targeted subsidies; the strengthening of agencies involved in urban transport; and a redefinition of the roles of the public and private sectors in the provision of passenger services within Caracas.

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

xlix. In the social sectors, finally, a lot has been accomplished, over a wide front. The government has shifted from highly inefficient generalized subsidies, available to the entire population, to directly-targeted programs benefiting those most in need. This strategy represents a serious effort to address the issue of poverty both efficiently and equitably. Many problems remain, though, including: highly centralized management, despite serious decentralization efforts; expenditures skewed towards higher-cost, inefficient uses of allocated resources; lack of targeting mechanism or sufficient data to identify target groups; insufficient attention to design and to delivery mechanisms; and inappropriate or inadequate technical skills in the operation of social-sector programs. All these issues should be addressed, within a revised version of the Government's poverty-alleviation strategy. In addition, in all social- sector activities encouragement should be offered to the use of both for-profit and non-profit private-sector mechanisms for delivery of social services.

Macroeconomic Reforms

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

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

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

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

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

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

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

lvi. Impact of the Stabilization Policy. The higher exchange rate translated into higher prices of tradable goods; combined with the increase of public-sector prices, the elimination of subsidies, and the removal of price controls, this led to a massive increase in the price level. This one-time jump in prices should not be confused with an acceleration of inflation. The process of inflation clearly had been checked. While the monthly increase in consumer prices averaged around 5 percent during the last quarter of 1988, it was only about 2 percent in the last quarter of 1989. In terms of annual inflation rates, this is a reduction from about 80 percent to 27 percent. A sharp decline of real activity accompanied this process. GDP fell by 8.6 percent from 1988 to 1989 (by 9.4 percent if the petroleum sector is excluded).

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

norninalmoney supply (MI) also changed. In the last quarter of 1989, money increased by about 26 percent (an annual rate of 152 percent). During 1990 as a whole, nominal money supply increased by 43 percent, in contrast with a fall of 8 percent during the first three quarters of 1989. The real interest rate peaked in the last quarter of 1989 and the first quarter of 1990--the only extended period in whicl. it was generally positive (within a range of 5-10 percent per year). From then on, nominal interest rates have declined while inflation has not, so that real interest rates generally have been negative and declining.

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

Inherent Macroeconomic Issues

lix. Government Revenues. Aside from oil revenues, derived from the tax on the PDVSA surplus, government revenues are amongst the lowest in the world, just 5-6 percent of GDP. Essentially, oil revenues have replaced domestic taxation as a means of financing both current and capital expenditures.

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

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

investment,through the placement of the government'sresources in the capital market.

lxii. It is evident that the existing tax structure could yield substantialadditional revenue through improved tax administration,the closing of loopholes, and the reductionof exemptions. Beyond this, there are three main candidates for raising the level of net taxation: (i) domestic oil prices, which even after they were raised in early 1989, are still among the world's lowest and contain a large implicied subsidy; (ii) other public-sector prices, which still imply large subsidies in various government-providedgoods and services, especially electricityand water; (iii) a value-addedtax (VAT), a major government objective during the last two years. Altogether, tCese three changes could yield a revenue of over 5 percent of GDP.

lxiii. Fluctuationsin Oil Revenues. Oil revenues are highly volatile, primarily because of changes in oil prices. Ideally, the government should adjust its spending to changes in permanent income, rather than to transitory changes. Failure to behave according to this pattern would lead to two complementaryscenarios. One is that the government adjusts its spending continuouslyto the fluctuationsin revenues, opening the way to cycles of inflation and recession. The other is the well-known "ratchet"effect, where t'e government matches expendituresto increasedoil revenues and maintains this higher level of spending even when oil revenues fall, thereby creating a fiscal deficit or reinforcing an existing one.

lxiv. An oil stabilizationfund should be of prime importance for economic policy and a vital condition for the long-termmaintenance of macroeconomicstability. This fund should perform the following functions: (i) it should establish a formulationfor identifyingthe permanent level of oil revenues for any given year; (ii) each year it should transfer to the government an amount equal to this permanent level; and (iii) it should invest any excess after the transfer in foreign exchange, and draw on its foreign assets if there is a deficit.

lxv. Taraets and Instrumentsof Monetary Policy. The Central Bank has a potentially inconsistentset of targets: the level of foreign-exchange reserves; the rate of expansion of the money supply; and, often, the nominal and the real rates of exchange. Both the nominal and real rates of interest ari also considered targets. Until recently, the Central Bank attempted to control not money supply but the monetary base. In the absence of a portfolio of government bonds, it does not conduct open-market transactionsin government paper. The monetary base is thus determined as follows: A net acquisitionof foreign exchange is offset to the desired degree by an open- market sale of the Central Bank's own short-term paper (the zero-couponbond). This practice has serious implications. To the extent that the rate of interest on the paper (deflatedby the rate of devaluation)is higher than the rate of interest on the foreign-exchangeholdings, a fiscal liability is created. Even more important is that the paper acquired by the public through these sales is liquid enough to be a very good substitute for money. - xix -

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

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

lxviii. Exchanae-Rate Policy. Whether or not the real exchange rate should be managed is probably the central issue of macroeconomic policy in Venezuela. There is a strong argument to allow the rate to be determined strictly by market forces, which would ensure maximum levels of efficiency and production and the highest rate of growth. The only factor that might justify intervention is the predominant role of oil exports. It is conceivable that because of it the allocation of resources to maximize production is not necessarily compatible with the achievement of long-term growth, and that the special nature of the oil industry denies the country the benefits of the externalities generated by tradable activities.

lxix. This case is not easy to establish. The government will have to make a policy decision based more on speculation than on information and quantitative analysis. But the important point is that, if the principle of diversifying exports is adopted, the real exchange rate would be the best instrument of policy implementation. An exchange-rate policy would uniformly encourage exports as well as import-competing activities, thus ensuring maximum efficiency.

lxx. Raising the real exchange rate would require creating, or expanding, an excess of saving over domestic investment by increasing the budgetary surplus. This surplus would finance an accumulation of foreign- exchange reserves, which in turn would reflect a current-account surplus created by the increased real exchange rate. Without an accompanying budgetary surplus, any attempt to increase the exchange rate through intervention in the foreign-exchange market would lead to a rise in the nominal exchange rate, followed shortly by a nearly equivalent rise in domestic prices, with only a very limited impact on the real rate of exchange.

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

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

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

A. Introduction

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

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

1.3 Growing numbers of Venezuelans also began to realize the magnitude of waste, inefficiency, and distortion arising from pervasive government intervention in the country's economic life. They were undoubtedly influenced by the accumulating experience of countries, particularly in Latin America, that had discarded intervention in favor of free markets, with beneficial results. This experience also reinforced the perception that large- scale economic restructuring was necessary to sustain these benefits.

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

1.5 This policy was adopted in February 1989, immediately after President Perez took over the administration. Since then, structural transformation has been an ongoing process rather than a one-shot operation; - 2 -

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

1.6 The policy changes will be analyzed by their nature and by economic sector, leading in consequenceto some repetition in the discussion that follows. The next section treats of their nature, under Drivatization and dereculationand foreign-tradereforms. The section following that discusses their impact on the agriculture,power and energy, infrastructure, financial, and social sectors.

B. Malor Areas of Reform

Privatization

Prior Conditions

1.7 During the 1970s and 19808, successive governments in Venezuela followed a development strategy that relied heavily on state control of productive sectors. In addition to traditional public services (e.g., water, telephone, electricity),state-owned enterprises (SOEs) dominated many sectors, includingpetroleum (PDVSA),mining, aluminum, and steel (CVG). Expansion into these sectors was part of an ambitious design t direct resources generated by petroleum to maintain artificiallylow prices for key goods and services, develop untapped natural resources, and promote import substitutionand self-sufficiency. It was initiated in the mid-1970s with the nationalizationof the oil and iron ore industries,followed by heavy public investment in power, steel, and aluminum. Funus channelled through the Fondo de Inversionesde Venezuela (FIV), set up to invest petroleum revenues, were initiallyprovided as loans, which, in most cases, have been converted to equity as a result of the inability of the SOEs to repay them. By the end of 1989, the FIV had equity totalling roughly US$2 billion (book value at historic costs) in more than 30 SOEs in mining, electricity,basic industries (steel, aluminum), manufacturing (cement,pulp and paper), shipping, and finance.

1.8 By the end of the 1980s, there were about 125 commercially oriented SOEs in Venezuela in the followinggroups:

* The petroleum sector, including PDVSA (the state-ownedoil company) and seven subsidiariesin associated and downstream activities (e.g., natural gas, petroleum distribution,fertilizers, petrochemicals) 1';

* Twenty financial SOEs, including banks, specializedcredit agencies, and insurance companies;

PDVSA also has equity in several downstream joint ventures. -3-

* Fourteen basic industry and infrastructure enterprises under the Corporaci6n Venezolana de Guyana (CVG), including steel (SIDOR), aluminum (VENALUM, ALCASA, INTERALUMINA), iron, bauxite and coal mining (FERROMINERA, BAUXIVEN, and CARBOSUROESTE), hydro-electric generation (EDELCA), and other capital-intensive industry and mining operations;

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

* About 70 smaller SOEs operating in a variety of sectors (e.g., tourism, agro-industry, manufacturing), many of them created under the now-defunct Corporaci6n Venezolana de Fomento (CVF), an industrial development agency established in the 1970s.

1.9 There was little private investment during this period. In 1984- 88, SOEs accounted for 22 percent of GDP, 34 percent of investment, and 5 percent of employment. Excluding PDVSA, SOEs accounted for 6 percent of GDP, 23 percent of investment and 3 percent of employment during this period.

1.10 The adjustment measures undertaken by the P6rez government had an immediate detrimental impact on many SOEs, particularly those functioning in a highly protected and distorted environment (e.g., SIDOR). The overall SOE deficit increased from 0.9 percent of GDP in 1988 to 2.0 percent in 1989. Government transfers to SOEs exceeded US$1 billion (2.5 percent) in 1989. It was in this context that the new government initiated a broad public enterprise reform program aimed at: reducing the scope of the public sector in the economy; reducing the fiscal burden of SOEs; improving the efficiency of key public services; and adjusting prices of SOE goods and services to economic levels.

Obiectives, Policies and Targets

1.11 In comparison with the other measures in early 1989, the privatization program was slower to develop and initially modest in scope. In mid-1989, the Economic Cabinet approved a broad SOE rationalization strategy, prepared by CORDIPLAN, that categorized SOEs according to the type of market (competitive vs. monopolistic) in which they operated and the feasibility of privatizing them. Privatization in the short term was to be limited to small- and medium-sized companies in tourism, manufacturing, agro-industry, and banking. Most of these (eg., cement, sugar) were CVF holdings and many were bankrupt or operating at very low capacity. They were targeted for several reasons. There was no justification for maintaining state ownership; there was no need for major restructuring prior to privatization (in terms of layoffs, debt repayments, and legal or regulatory changes); and privatization was not likely to engender much labor or political opposition. The larger SOEs, which were thought to be more difficult to sell, were expected to be privatized in a second phase. -4-

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

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

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

1.15 During 1992, the government expected to privatize the following enterprises: (a) fifteen hotels, in three separate bidding packages; (b) five out of the six remaining state-owned sugar refineries; (c) the domestic airline (AEROPOSTAL); (d) the Caracas water and sewerage system (through a concession contract with a private operator); (e) the racetracks (INH); (f) the Caracas cable car and associated Humboldt Hotel; (g) the salt refineries (ENSAL); (h) a Caracas entertainment park (Poliedro); (i) some small CVG and CVF holdings in the cement, metallurgical, textile and dairy industries; and (j) three regional electricity companies (ENELVEN, ENELBAR and ENELCO). The successful privatization of these companies is dependent upon the establishment of an appropriate regulatory framework for the sector.

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

3/ Forty percent of the common shares, but with control of the Board of Directors. In addition, 11 percent was sold to CANTV employees. The government has retained 49 pes cent, but expects to sell this later via public share issues. 1.16 An interministerial commission was established by decree in July 1989 to oversee privatization. It is chaired by the FIV President (ministerial ranking) and includes the Ministers of Planning, Finance, and Development (Fomento), as well as representatives of the Confederation of Labor (CTV) and the Chamber of Commerce (FEDECAMARAS). The FIV acts as secretariat to the commission and manages the program. A new law passed by Congress in Devember 1991 formally transforms the FIV into the government's privatUation and restructuring agency and calls for the phased elimination of governt'enttransfers to the FIV.W In addition to the FIV Law, Congress recently passed a Privatization Law formalizing the policies and implementation procedures for the program.

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

Lessons and Issues

1.18 Several lessons can be drawn from the privatization experience to date: * privatization has been most rapid in those enterprises where new management was brought in to implement the changes (e.g., CANTV, VIASA and INP);

* consensus with the political parties and labor unions is important. In this context, FIV management indicated that having labor and business representatives on the privatization commission ensures that all issues are discussed at an early stage; and

* in more complex cases, privatization needs to be accompanied by broader reform of the sector to ensure competition and economic efficiency (see infrastructure chapter ir paras. 1.111, 1.112 and 1.114 for a discussion

4/ Under the original legislation that created it, the FIV receives 5 percent of the government's petroleum revenue. Under the new law, this will be phased out as follows: 3 percent in 1992, 2 percent in 1993, 1 percent in 1994, and zero thereafter. -6-

of competition issues in the telecommunications and ports sectors).

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

(i) ScoRe. The successful privatization of CANTV has generated public support and foreign investor interest in the program, making this an opportune time for the government to consider privatizing CVG's industrial and mining SOEs (e.g., SIDOR, ALCASA). This would confirm the government's intent to reduce public sector participation in production activities (where direct ownership no longer serves any public policy objectives), provide the needed capital for sector expansion, and eliminate government support, either directly (through loans, equity, or transfers) or indirectly (through loan guarantees), for these companies' ambitious investment programs. It would also improve efficiency and performance through the introduction of private management and shareholders.

The phased privatization of PDVSA and its subsidiaries coulz' also be considered, though this would clearly be more contentious and would also face constitutional restrictions. The example of Petro-Canada may be instructive. The Canadian Government initiated a phased program to privatize Petro-Canada via a series of public share issues, giving Canadian citizens the feeling that the Canadian public owns Petro-Canada. A similar strategy may be possible for PVDSA.

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

Forei$n-Trade Reforms

Prior Conditions

(a) Foreion Exchange Controls and Import Barriers 1.20 A pervasive system of non-tariff barriers reinforcing a high level of tariffs had served as the effective constraint on imports prior to the reform.

1.21 From 1973 to February 1983, Venezuela maintained a fixed exchange rate of 4.3 bolivars to the U.S. dollar that increasingly overvalued the bolivar. Early in 1983, a series of currency crises was resolved by introducing the multiple exchange rate system that prevailed through early 1989. Initially, an exchar.gerate of 4.3 Be. per U.S. dollar was set for the petroleum sector, essential imports, and foreign debt service; an official rate of 6.0 Bs. applied to most commercial transactions; and a free market rate applied to nontraditional exports, tourism, and capital transfers. The official rate was raised to 7.5 Bs. in March .;984and to 14.5 Bs. in December 1986, and there were numerous shifts of items among categories. At one point the system included four rates: 4.3 Bs. for foreign debt; a 6.0 preferential rate; the 7.5 official rate; and the free market rate. From 1984-88, the free market rate ranged from 60 percent to 200 percent above the official rate, averaging 110 percent. In February 1989, the multiple rates were unified and the exchange rate was floated.

1.22 For most items, a potential importer had first to obtain an import permit from the Development or the Agricultural Ministry that would be granted only if domestic producers did not object. Since tariffs were prohibitive, the importer had to apply for the tariff to be reduced to a reasonable level.

1.23 Importers had then to apply on a case-by-case basis to the Office of the Differential Exchange Rate Regime (Oficina del R6gimen de Cambios Diferenciales, RECADI) or its successor organization (commonly called ex- RECADI). The procedures changed frequently, there were no clear criteria for decisions and the priorities were general: (1) food and medicines; (2) raw materials; (3) intermediate goods and CKD kits; (4) capital goods; and (5) all others.

1.24 From 1983-88, the most heavily subsidized commodities through the exchange rate were food and raw materials, and the most heavily taxed were consumer goods--particularly luxuries--and alcoholic beverages. Capital goods and transportation equipment were taxed about equally. This pattern of taxing consumer goods and subsidizing inputs was intended to protect domestic production. Industry was given greater protection than agriculture, but both agricultural inputs and food imports entered at favorable rates, so that effective protection was generally minimal and, in cases, could even have been negative. For example, in 1984 and 1985, agricultural inputs entered at an average exchange rate of 5.0 Bs. and 6.2 Bs. and basic foods at 4.6 Bs. and 5.2 Bs., respectively.

1.25 It is difficult to estimate the benefits rendered by RECADI from existing data, but it is clear that they were large. For all imports, the benefits averaged nearly 15 percent of GDP; and for the imports where RECADI exerted the greatest discretion, benefits averaged 6 percent of GDP. While the government's goal was to reduce consumer prices, the benefits may actually - 8 -

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

1.26 In 1982, the import of 1 percent of the items in the tariff code was prohibited, and 6 percent required a license. The remaining 93 percent were either freely importable or required a health permit. This changed abruptly in 1983, when imports of 8 percent of the items were prohibited and 34 percent were reserved for import by the government and required a license (a delegation of the government's right to import.) By the time of the 1989 trade reform, 11 percent of tariff items were on the prohibited list, and 29 percent required licenses or delegations (see Table 2).

1.27 Depending on the item, import permits were granted by the Development Ministry, the Finance Ministry, or the Agriculture Ministry. Importers often had to give the Development Ministry a "letter of no objection" from the producers, association stating that the domestic industry was unable to produce the items in the quantity to be imported. The import licenses the Development Ministry issued generally exceeded the foreign exchange budget the Finance Ministry administered, so that, effectively, both ministries administered industrial policy. The system of import permits was also used to establish de facto import monopolies for state enterprises in steel, aluminum, and petrochemicals. For example, only SIDOR could import steel, regardless of whether or not it produced competing items.

1.28 To approximate the domestic production covered by NTBs, an index was developed by weighing 1987 production levels (at the four-digit ISIC level) with the percentage of tariff items, under each classification, produced in each sector. These numbers, aggregated to the two-digit ISIC level, are shown in Table 1 and indicate that before the 1989 reforms, 17 percent of domestic manufacturing was protected by import prohibitions and 33 percent by licenses, 6 percent required a health permit,W and 43 percent were free of NTBs. Combining this index with the unweighed incidence of import restrictions shows that the 10 percent of prohibited items represented 17 percent of domestic production, the 29 percent requiring licenses represented 36 percent of domestic production, and the 3 percent requiring health permits represented 6 percent of production. The 57 percent of tariff items that were free of NTBs corresponded to 43 percent of domestic production. The subsector in which this gap was most dramatic was wood and cork products, where 10 percent of the imports were prohibited but represented 56 percent of production.

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

6/ These are instances where health permits are used with the same restrictive effects as licenses or prohibitions; however, it is not known how widely this may have occurred in Venezuela. -9-

(b) Tariffe

1.29 Before the trade reforms of 1989, there were 41 tariff rates, the maximum being 135 percent. Tariffu had been establishedover the years on a case-by-casebasis without guidelines. The spread was great: about a sixth of the items attracted tariffs below 1 percent and a fifth above 80 percent. In addition to ad valorem tariffs, 854 items also attracted specific duties so that effective rates were as high as 940 percent. Average tariff rates by sector and stage of pracessinghad the cascading pattern (high for final goods, low for inputs and capital goods) typical of import substitution (Table 2). Tariff rates for items restricted by NTBs were higher than for those freely importable. There were also large differences in average tariffs among the manufacturing subsectors.

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

1.31 Actual tariff collectionsaveraged about 10 percent of import values (and about 1.2 percent of GDP) in 1984-85. Exonerationswere about two-and-a-halftimes as great as tariff receipts. In 1984 and 1985, exonerationswere 12.2 billion Be. and 14.5 billion Bsa, respectively,or 2.9 porcent and 3.2 percent of GDP. Since tariffs represent about 4 to 5 percent of government receipts, the effect of the exonerationswas to reduce government revenues, but the exonerationswere not coordinatedwith overall fiscal policy. Table 1 shows the level of tariffs and the extent of quantitative restrictionsfor the economy as a whole and for the major sectors. - 10 -

Table 1: IMPORT RESTRICTIONSAND AVERAGETARIFFS BY SECTORAND STAGEOF PROCESSING,1989-91

LICENSE REQUIREMENTS AVERAGE TARIFFS All 1989 Import Proh. Lic. Hith. Free Items Proh. Lic. Hlth. Free Items 9 % % %_

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

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

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

1990

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

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

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

I991

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

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

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

Note: Averagetariffs in 1989 reflected only ad valorem tariffs; 651 items also attracted specifictariffs. Sources: Gaceta Oficial de la Republicade Venezuela,#4176, March 30, 1990; #4271, May 7, 1991. - 11 -

(c) Export Incentives

1.32 To offset the strong anti-export bias inherent in the import regime and the overvalued exchange rate, the government offered three export incentives: the bono de exportacifn, a subsidy to non-traditional exporters paid as a percentage of their export receipts; a currency retention scheme; and subsidized credit for exporters through FINEXPO. The bulk of export subsidies went to state-owned enterprises, which generate most of the nontraditional exports (65 percent of exports qualifying for the bonos de exportaci6n).

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

The subsidy initially was designed to compensate exporters for the difference between the free market rate and the official rate at which they were required to exchange their foreign currency at the Central Bank. However, the free market rate continued to rise and, while the rate of the subsidy and the method of its computation were changed frequently (and on short notice), it seldom offered sufficient compensation. The subsidy was offered at rates between 15 and 48 percent (depending on the domestic content) on the eve of the 1989 reform.

(ii) Currency Retention. After the multiple exchange rate system was adopted in early 1983, nontraditional exporters were offered a currency retention scheme, whereby gross foreign currency proceeds from exports--minus 50 percent (later 80 percent) of the value of inputs imported at the official rate--could be exchanged at the free market rate. From 1984 through 1986 the free market rate was at least twice the official rate, and this scheme provided a considerable incentive. It was discontinued in December 1986 when, combined with the export subsidy, it appeared to overcompensate exporters--particularly where the good had a high import content. This subsidy was thought by many to encourage inefficient exports, sometimes to the extent that the foreign exchange cost of the export was greater than the foreign exchange receipts (i.e., the foreign-exchange value added was negative). - 12 -

Currency retention was more important than the export subsidy. In 1986, when the difference between the official and free market rates made the retention scheme most costly, nontraditional exports eligible for the subsidy were 9.9 billion Bas. and received subsidies of 1.8 billion Be. If the average domestic content of the exports was 65 percent, then about 8.2 billion Be. could have been exchanged at the free market rate. The differential between the free and official rates in 1986 averaged 160 percent (19.7 Bs./USS compared with 7.5 Bs./US$), so the value of the currency retention would have been 13.1 billion Be. Thus, in 1986, currency retention for this group of exports was about 2.8 percent of GDP, when total nonpetroleum exports were 4.4 percent cf GOP and the exports recelving the bonus just 2.0 percent of GDP. To the extent that the scheme was merely compensating exporters for the overvalued exchange rate, it encouraged a more efficient allocation of resources. Where it overcompensated exporters (e.g., low value-added exports), it encouraged an inefficient allocation.

(iii) FINEXPO Credit. The Export Financing Fund (Fondo de Financiamiento de las Exportaci6nes, FINEXPO) of the Central Bank offers extensive facilities for export financing. Financing is available at preferential rates-- up to 7 percent below market--and commercial terms of up to 12 years for feasibility studles, market research, promotional expenses, fixed capital investment, working capital, inventory financing, and direct medium- or long- term financing for foreign buyers. About three-fourths of the credit authorized is post-shipment financing, and one- fourth is pre-shipment. In 1988, FINEXPO approved 3.4 billion Bs. in credit, or about 13 percent of the 26.9 billion as. of nontraditional exports. If the average concession in the interest rate was 5 percent, then the amount of subsidy would have been less than .01 percent of GDP. Reform of these credit subsidies will be included in the government's overall financial sector program.

ReforM Measures

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

1.34 The cornerstone of the reform policy was the unification and floating of the exchange rate, which will be discussed extensively in the analysis of macroeconomic reforms. Along with this change came the abolition of foreign-exchange controls and, thus, of a major device for import rationing and rent seeking. - 13 -

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

1.36 Tariffs, too, have been lowered substantially. The tariff code for the manufacturing sector has been restructured to afford each line of production roughly the same protection. The level and range of tariffs have been cut substantially. The average rate has been reduced from 37 percent to 16 percent, with consumer goods--at 33 percent--continuing to be subject to the highest rate. The maximum tariff has been lowered from 135 percent to 80 percent and then to 50 percent, and the government's announced target is to reduce it to 10 to 20 percent by 1993. Discretionary tariff exonerations have been eliminated. However, exemptions established by law remain for some entities such as state-owned enterprises, universities, and the central government. The Development Ministry does not have a complete list of exemptions but estimates that they affected less than 3 percent of imports in 1988.

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

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

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

1.40 Following further changes in 1992, the present (fall 1992) maximum tariff rate is 25 per cent (with two exceptions in the automobile branch). Export subsidies have been totally eliminated in all activities except agriculture, in which they have been retained for about 200 commodities. A free-trade agreement has been signed with Columbia; whereas Venezuela has granted a free-trade status to the Caribbean countries without reciprocity. -14-

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

1989 LICENSE REQUIREMENTS AVERAGE TARIFFS All Subsector Import Proh. Lic. Hlth. Free Items Proh. Lic. Hlth. Free Items % % %% % . 9t % % All Manufacturing 5749 10 29 3 57 37 60 46 43 28

31 Food, Beverages, Tobacco 550 30 49 12 9 58 65 58 65 58 32 Textiles, Leather 584 30 36 5 30 53 60 53 44 46 33 Wood, Cork Products 88 10 34 14 41 75 82 98 51 62 34 Paper, Printing 172 6 20 - 74 45 49 62 - 40 35 Chemicals, Petroleum, Coal 1814 2 17 4 77 22 57 31 35 19 36 Nonmetallic Minerals 183 15 30 - 55 53 53 60 - 50 37 Basic Metal Industry 331 0 36 - 64 22 45 17 - 24 38 Metal Products, Machinery 1796 07 33 - 60 37 56 47 - 29 39 Other Manufacturing 199 34 26 - 41 54 53 51 - 56

1990

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

31 Food, Beverages, Tobacco 608 25 25 25 26 35 40 32 32 35 32 Textiles, Leather 973 10 0 2 88 36 48 10 10 35 33 Wood, Cork Products 98 21 - 16 63 37 44 - 28 38 34 Paper, Printing 188 - - - 100 18 - - - 18 35 Chemicals, Petroleum, Coal 1734 0 7 14 79 09 50 04 10 09 36 Nonmetallic Minerals 168 2 - - 98 24 45 - - 24 37 Basic Metal Industry 390 - - 4 96 07 - - 04 07 38 Metal Products, Machinery 2073 1 - 1 98 15 29 - 20 15 39 Other Manufacturing 223 17 - 3 80 27 47 - 35 24

1991

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

31 Food, Beverages, Tobacco 614 - 19 77 05 23 - 24 24 15 32 Textiles, Leather 966 - - 2 98 27 - - 10 28 33 Wood, Cork Products 99 - - 14 86 30 - - 29 31 34 Paper, Printing 187 - - - * 100 16 - - - 168 35 Chemicals, Petroleum, Coal 173 30 1 13 86 10 30 5 11 10 36 Nonmetallic Minerals 172 - - - 100 20 0 0 0 20 37 Basic Metal Industry 414 - - 5 95 09 - - 07 09 38 Metal Products, Machinery 211 60 - 2 98 13 30 - 17 13 39 Other Manufacturing 219 0 - 3 96 22 40 - 20 22

Sources: LEGIS, Arancel de Aduanas de Venezuela No. 95 (1989); Gaceta Oficial de Ia Republica de Venezuela, #4176, March 30, 1990, #4271, May 7, 1991. - 15 -

Evaluation and Further Reforms

1.41 It is too early to evaluate the impact of the reforms on the economy. They cannot be expected to affect imports in any significant way in such a shorc time, particularly in view of the recession that accompanied macroeconomic stabilization and lasted for over a year. A fortiori, the influence of fundamental changes in the structure of the economy, in efficiency, patterns of investment, and the like, will be evident only after several years.

1.42 But the reforms have been wide and deep and must lead to major economic benefits. They have replaced the system of QRs, ad hoc protection, and costly export subsidies with a system that--when fully implemented by 1993--will use effective exchange rate management in place of import substitution and export promotion. Moderate tariffs--between 10 and 20 percent--will provide additional protection for import-competing domestic producers, leaving a residual anti-export bias after export subsidies have been eliminated.

1.43 The most important single element of the trade reform program has been the unifying and floating of the exchange rate. It will be necessary to manage the rate to avoid the mistakes of the 1980s if there are unexpected changes in petroleum prices. This is discussed more thoroughly in the next part in the context of macroeconomic policies.

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

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

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

1.47 Legislation should be introduced to eliminate the remaining tariff exemptions, which give domestic enterprises an unfair commercial advantage and some foreign producers preferential treatment. Protecting the domestic manufacturer denies the foreign manufacturer a price advantage, but implicitly requires consumers of the product to bear the added cost. To - 16 -

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

1.48 The government should encourage private markets to provide suitable instruments for export credit and credit insurance. FINEXPO offers a limited number of exporters subsidized credit rates for which there is no justification because they encourage many diste-rtions in industrial incentives. Exporters should pay market rates for credit.

C. Sectoral Surveys

Agriculture

Prior Conditions

1.49 Until 1983, inconsistent policies and negative protection hampered agricultural development. The controlled exchange rate and low prices for domestic agricultural products reduced profitability (despite some input and credit subsidies) and the acreage cultivated.

1.50 From 384-88, however, there were attempts to improve agricultural growth. The policy was based on the belief thats (a) farmers would respond to price incentives and improved services by increasing output; and (b) the increased output would lower consumer prices. It was an attempt to maintain high producer prices and profits while maintaining low and stable consumer prices. Imports and exports were zestricted and the budgetary allocations for infrastructure and support services were increased. The critical element of the policy was that government resources would subsidize producer prices until inefficiencies in the sector were rectified and the productive capacity expanded.

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

1.52 Overall, the agricultural sector achieved a high average annual growth rate of 6.3 percent from 1984 to 1988. But the policy clearly was unsustainable and, from the outset, was unsuccessful in removing inefficiencies in the sector. It resulted in highly distorted relative prices and extensive government intervention. It also entailed huge subsidies. By - 17 -

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

1.53 The attempt to increase resources for private sector investment in agriculture through subsidized credit have had a negative effect on the financial sector. Agricultural portfolio requirements and direct credit subsidies have contributed to the underdevelopment and inefficiency of financial institutions, while poor loan repayments have bankrupted one public sector institution (BANDAGRO) and left two others (FCA and ICAP) in critical condition. Further, leakages of subsidized credit to non-agricultural activities have partially defeated the purpose of the program.

Policy Reforms

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

1.55 Trade. In July 1990, all 117 agricultural commodities were removed from the prohibited list of imports and 70 - with the important exceptions of feed grains, soybeans, and poultry - from the list of imports requiring prior licensing. Four tariff levels were introduced, and restrictions on agricultural exports were eliminated, except for sardines. A transparent price band mechanism for wheat, rice, and white corn has also been implemented to stabilize domestic prices and provide additional tariff protection for these key commodities, and is in the process of being applied to yellow corn, oilseeds, and sorghum. Export controls on rice, legumes, and cornmeal have also been ended.

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

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

1.58 Retail Pricas. The twelve food items initially subject to price control were first redu_ed to five (precooked cornmeal, mixed vegetable oil, white cheese, sugar, and sardines) and more recently to one (sardines). - 18 -

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

Evaluation and Further Reforms

1.60 The policy reforms of 1989 and 1990 have begun to correct the distortions evident in uncompetitive agricultural production and high food prices. Resources are being reallocated to those tradeable commodities where Venezuela has a comparative advantage. While value added in the agricultural sector declined by about 5 percent from 1988 to 1989 (compared with about 8 percent for the overall economy) and stabilized in 1990, growth in 1991 is estimated at about 6 percent. The sector is adjusting well to the new relative prices and the mix of outputs is changing. Before the reform program, extensive regulation and protection raised domestic prices much higher than import parity levels. The crucial question is whether the reforms have gone far enough or whether residual regulations and interventions are continuing to cause distorted patterns of investment and production. The answer appears to be that the reforms, although significant, need to go further if the sector is to be market driven. The most important measures for the near and medium term are described below.

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

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

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

1.64 Its future is now being considered. In principle, the policy is to divest the government of ownership of all storage facilities and to ensure that CASA does not become another reason for subsidies. Currently, CASA's role is limited to: (a) purchases of commodities from producers to support - 19 -

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

1.65 Domestic marketing controls on coffee and cocoa, and the export monopoly of FONCAFE and FONCACAO have ended. These two institutions are also being restructured to eliminate their credit activities and strengthen their technical assistance role.

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

1.67 Irrigation. Ir_.igationwater invoicing is to be increased so that eventually all operation and maintenance costs, as well as investments in modernization or rehabilitation, will be recovered. Water charges for new schemes also will be set to recover capital costs. This is probably the area least touched by the reform policy, one in which much waste has occurred, and in which planned policy changes are obviously inadequate. The phasing out of water subsidies is very slow, and it is doubtful whether full cost recovery will be achieved in the foreseeable future.

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

Power and Energy

Prior Conditions

1.69 The power sector consists of four state-owned (EDELCA, CADAFE, ENELVEN, and ENELBAR) and seven private companies. EDELCA, a generation and transmission company, owns and operates the hydro-plants on the Caroni River, and is the bulk supplier to the industrial complex in Guayana and other utilities; CADAFE, a generation, transmission and distribution company, serves most of the country (almost 60 percent of all residential consumers) except for the largest urban centers and the industrial area of Guayana; ENELVEN, a generation, transmission and distribution company, serves Maracaibo and Western Zulia; and ENELBAR serves Barquisimeto and its outskirts. The main - 20 -

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

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

1.71 The current legal and institutional arrangements of the Venezuelan power seccor do not favor economy and efficiency. As there is no electricity law, the country lacks fundamental regulations for the industry. Several unsuccessful efforts have been made in the past to enact an Electricity Law which would provide an integrated, comprehensive and rational basis for regulating electric utilities. In addition, there have been proposals to reorganize the activities of, and the government's control over, the national (government-owned) electric utilities, involving the creation of a holding company. Resolution of issues raised by these proposals may take considerable time. Substantial progress is expected in solving sector problems based on actions that could be taken in two respects: (i) establishment of a coordination unit to handle the sector issues of all, public and private utilities, including investment planning with a national perspective; and (ii) the establishment of a new regulatory framework through the issuance of an Electricity Law for the sector and the establishment of a sector regulatory agency.

1.72 The power sector has been a major recipient of government investment, and its substantial growth during the last 15 years reflects an ambitious development strategy that has emphasized increased investments in generation and the maintenance of artificially low prices for electricity.

1.73 As a rule, prices in the past decade did not reflect the cost of service and have resulted in an unsatisfactory general rate level and distorted tariff structure. This pricing policy has had two adverse consequences: (i) it has compounded the financial difficulties of the utilities and increased their dependence on government contributions; and (ii) it has sent distorted signals to the consumer, promoting waste and inefficient use of electricity. A pricing policy that rationalizes the tariff structure and increases prices to the level of costs was needed. - 21 -

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

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

1.76 PDVSA generally is considered an efficient and sophisticated national oil company. Its coordinating committees, with representatives from the operating subsidiaries, integrate various activities. PDVSA is run by the General Assembly (stockholders). The Ministry of Energy and Mines (MEM) is the sole shareholder, with the Minister serving as chairman, and thus is the government entity responsible for the oil industry, approving the general direction of policies, new investments, domestic prices, and conservation. General policy directions are approved by the President, and MEM and Congress can become involved in budget issues. The budget is approved annually at the stockholders' meeting. PDVSA reports on its activities through an annual report, financial statements, and a Fivs-Year Plan, all approved by the stockholders. MEM exercises supervision through its Hydrocarbons Division but leaves the management to PDVSA's well-trained technocrats. Thus, PDVSA has escaped the political interference and labor union problems often characteristic of national oil companies.

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

Policy Reforms 1.78 In the power sector, the reforms have been directed at: (i) reducing the dominance of the public sector through restructuring and privatization; (ii) increasing operational efficiency; (iii) providing a strong central institution to review and coordinate expansion plans, investment programs, and other activities related to the sector; and (iv) reviewing the sector regulatory framework through the establishment of a regulatory agency and issuance of an Electricity Law.

1.79 Public enterprises with financial problems or posing bottlenecks to efficient production of electricity will be restructured. Among eight major public enterprises, CADAFE (one of the largest public power utilities) has been selected for restructuring and possible privatization. The restructuring of CADAFE (para. 1.78) will consist of the company's complete - 22

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

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

1.81 The Government has been considering the establishment of a supervising entity for state-owned power companies, which would hold the state's shares in these companies, and organize them as follows: (i) three generating companies, namely EDELCA, Planta Centro, and Uribante Caparo (at present, these last two are under CADAFE's control); (ii) four distribution companies; and (iii) a national transmission company to operate the interconnected grid. ENELVEN and ENELBAR will maintain their present structure (under FIV's control) and are part of the government plans for privatization in the short-term. Mainly because of struggle between EDELCA and CADAFE over control of the transmission network, the restructuring commission failed to report by the required deadline in December 1991.

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

1.83 So far the Committee has not been fully effective, largely because of a lack of authority, an adequate structure and budget, and qualified staff. Despite this, it has been able to coordinate the utilities efforts to establish and enforce a uniform system of accounts for tariff adjustment requests from the power utilities and for tariff setting within the general government policy. It has also been able to complete technical studies on tariff structure and levels for each utility, a long-run marginal cost study for electricity tariffs, and a study to define the criteria to be used by the utilities in the revaluation of assets. It has played an important coordinating role among regional and public or private sector entities.

1.84 By Decree 1790 of 08.21.91, the government created two commissions to carry out the .nain tasks for this purpose, within four months. One of the commissions was to propose a new regulatory framework for the sector through the issuance of an Electricity Law and the establishment of a - 23-

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

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

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

Evaluation and Further Reforms

1.87 Inadequate prices remain a key issue for petroleum and for electricity, gas, and water. The new policy essentially increased power rates in a manner that increased differentials and distortions. The largest tariff increases applied to commercial and industrial users, whose tariffs had already been close to marginal costs; whereas the smallest changes applied to residential users, whose tariffs have all along been below cost. On the petroleum side, there have been problems. A February 1990 decree established gradual price increases of petroleum products and fertilizers, which by early 1993 should reach the levels of their export opportunity costs. Presently, gas tariffs are different for different categories of consumers and can vary by load factor; but the average tariff is very low. Fertilizer prices in 1990 were estimated to be 65-75 percent of opportunity (border price) costs. The Agriculture Ministry subsidizes fertilizers and is supposed to compensate PDVSA for the differential, but there is some doubt about whether this payment is actually made.

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

1.89 If natural gas production is to be economically viable and gas substitution encouraged to free oil products for export, it is imperative that the domestic prices of gas and its alternative fuels, i.e., residual fuel, - 24 - diesel, propane, and butane, be raised to their full economic cost. Furthermore, the price paid at the wellhead by the joint venture in the San Cristobal Colon LNG project needs to be determined.

1.90 The government's plan to organize the power-sector activities into separate generation, transmission, and regional distribution companies would support the government's long-term objsctives. However, the proposed holding company could be too powerful in the sector to be held publicly accountable. To avoid this outcome, a better option should be to leave the ownership divided between CVG and FIV. If the Government does set up this holding company, it should ensure that it appoints a properly constituted Board of Directors that is given the autonomy to set policies for the companies and hold its management accountable for performance.

1.91 The progress towards privatization in the sector has been minor. Privatization of most of the power system--except EDELCA's hydro generation and the main EDELCA and CADAFE transmission network--is being considered. The government recognized that the establishment of a regulatory agency (by law) and the unfreezing and adjustment of power tariffs are preconditions for this. PDVSA has announced that it is opening 46 fields, which are considered marginal, to foreign companies under operating agreements. Approximately 130 companies are now interested in bidding for the right to reactivate these fields. PDVSA is inviting them to work as contractors to a PDVSA affiliate, which is acceptable politically because this type of arrangement is allowed by the Nationalization Law and the number of fields is small. The companies would put up the funds to reactivate the fields and would collect a fee per barrel produced; bu- the oil would be owned, delivered, and sold by the PDVSA affiliate. The production fee would be independent of the price at which PDVSA sells the oil. Royalties and taxes are to be paid by PDVSA.

Infrastructure

1.92 This section reviews the reform process in telecommunications, ports, shipping, water supply and sanitation, interurban transport (including highways), and urban transport., For each subsector, the report describes: (i) the prior conditions; (ii) policy reforms enacted by the P6rez Administration; and (iii) evaluation and further reforms.

Prior Conditions

1.93 Telecommunications. Telecommunications service in Venezuela is perhaps the single greatest obstacle to economic growth and development, particularly business expansion. There are approximately 1.4 million subscribers, but unmet demand exceeds 1.5 million and some customers must wait over one and a half years for a telephone. Service quality is poor, with call completion rates of only 24 percent for international calls and 49 percent for local calls. Faced with these problems and the inability of the state-owned monopoly (CANTV) to improve or expand service, the government decided in late 1990 to privatize CANTV and open the sector to iLcreased competition and private investment. - 25 -

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

1.95 The reform focused on the INP ports, which handle roughly 10 million tons of cargo annually, representing 90 percent of the general cargo and virtually all the container traffic. INP was responsible for providing labor, equipment, and all services but suffered from low productivity and inadequate equipment, particularly efficient container handling. As a result, shippers frequently hired private firms to handle loading and unloading, while still paying INP tariffs and being subject to its restrictive labor agreements. The shipping conferences applied various cargo surcharges for congestion and port cost differential at an expense for the nation estimated at US$30-50 million annually. To add to this, INP was a burden on the government's budget, with annual transfers averaging US$25 million in 1989 and 1990.

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

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

1.98 Water SuDolV and Sanitation. The water supply and sewerage networks provide 85 percent and 61 percent coverage, respectively, to urban residents and 80 percent and 15 percent, respectively, to rural residents. Although this ranks high in comparison with other Latin American countries, service has steadily deteriorated through the 1980s, primarily as a result of two factors. First is the absence of significant tariff increases since 1981; - 26 -

this has resulted in current tariffs covering only about 10, percent of costs 'flrgely operating costs only, as capital investments have not been made due lack of funds). The second factor is the inefficiency of INOS, the ational agency responsible for water supply and sewerage services. The agency is heavily overstaffed, with 15,260 employees--a ratio of 10 per 1,000 connections, compared with an average of 3.6 in five other Latin American countries. Losses are extensive; in 1988 INOS reportedly billed for only 37 percent of the water it produced, and in 1990 its operating los exceeded the equivalent of US$125 million. Maintenance is inadequate throughout the system. Government budgetary transfers, ior both operations and investments, totalled the equivalent of US$110 million last year and are forecast at US$170 million this year.

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

1.100 The cosd network consists of expressways (1,500 km), highways (25,500 km), ana .gricultural feeder roads (44,000 km). Over 90 percent of the country's non-urban traffic is carried on the expressways and highways. The highways, which were built in the 1960s and 1970s, have been used more heavily than expected and generally have been inadequately maintained. About 22 percent of the highway network requires extensive and costly rehabilitation, and about 50 percent will soon reach that point without timely preventive maintenance and strengthening. The higher cost of road transport on deteriorated highways is affecting economic growth, especially in the agricultural and industrial sectors, and Venezuela's export potential.

1.101 Three main factors have contributed to the decline of the road system. First, road users have been given subsidies in the form of low fuel prices. Secondly, the management of the system, highly centralized in the MTC, has neglected rural roads and overlooked the needs of local communities and agricultural development objectives. Thirdly, road programs have been funded mainly through unpredictable and inadequate budget allocations from the national treasury, which has hampered the appropriate programming of expenditures and the effective management and maintenance of the networks.

1.102 Urban Transport. In Caracas, public transport services are provided by both the public and private sectors. These services include: CAMETRO, which operates the subway and metrobus system; regular bus services provided by private companies; and "por puesto," privately owned minibuses operated on specified routes. Metro ridership has been increasing by 30 percent annually and is now estimated at 1 million passengers daily, or roughly 20 percent of total trips. In comparison, ridership on regular buses has been declining and is estimated at less than 10 percent of the trips, and "por puesto" with about 56,000 minibuses in the metropolitan area accounts for - 27 -

35 percent of the trips. Despite the growth of metro ridership, private cars and taxis still account for up to 40 percent of transport in Caracas in terms of riders/day, a reflection of low prevailing gasoline prices. Other large cities are served mainly by "por puestos," many of them facing rapidly growing congestion problems.

1.103 All three levels of government (national, state, and municipal) have responsibilities for urban transport, but there is little coordination, particularly in the major metropolitan areas. The MTC regulates taxi and "por puesto" tariffs, as well as intermunicipal bus rates, including those for the metropolitan area of Caracas. Fares generally have not kept pace with fuel price. CAMETRO fares range from about US$.14 (for a trip of up to four stations) to US$.21, which are very low in comparison with subway fares in other countries. CAMETRO receives a small operating subsidy (US$10 million budgeted for 1992). However, it is unclear whether fare revenues plus this subsidy are enough to cover depreciation and debt servicing. Many private bus operators are in financial difficulties from a combination of rising costs and controlled fares. The number of buses in service declined from about 1,500 in 1975 to about 500 in 1989, partly because of these difficulties and partly because of the introduction of the metro. The "por puestos" tend to be better off financially because fares are higher and graduated with distance.

Policy Reforms

1.104 Telecommunications. The reform program has four elements:

* the sale in November 1991 of 40 percent of the shares of CANTV, with majority voting control, to an international consortium led by GTE for US$1.9 billion. An additional 11 percent has been sold to the employees. GTE has already signed the sales agreement and taken over management of CANTV.

* the introduction of limited private competition through the granting of a license to Telcel (a Bell South consortium) to operate the second cellular band, 7/ and permission for private networks to provide value-added services.

* tariff increases under a phased program to progressively adjust telephone rates

7/ The privatized CANTV operates the other cellular band. - 28 -

to economic levelsP' and ensure adequate financing for CANTV's investments. Rates will be automatically adjusted under a price cap system (inflation less a productivity factor).

* a new Telecom Law that, inter alia, establishes a new regulatory agency (CONATEL) and opens up the sector to greater competition and private investment. The law is still before Congress. In the interim, CONATEL has been established by decree.

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

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

- the layoff of all 11,000 INP workers2 ' and the transfer of all cargo handling and stevedoring activities to private firms;

* the introduction of new wharfage and dockage fees in line with competing ports in neighboring countries;

* the establishment of new regional port authorities in the seven regions with INP ports (the eighth INP port is in the

a/ This will require increasing local rates and decreasing international rates.

9/ Severance pay was financed from a Restructuring Fund in the FIV. - 29 -

Federal District and will continue to be managed by the Federal Government);

* the signing of agreements formally transferring responsibility to the seven regional governments; and

* submission to Congress of a law formally dissolving the INP.

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

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

1.109 A small tariff increase was recently implemented for industrial and commercial users. The process of privatizing the Caracas water system is now underway. Sector officials appear committed to the objective of establishing a sector regulatory agency.

1.110 Hiahwavs and Interurban Transport. The main objectives are: to decentralize the management of rural roads; and to establish a fund financed - 30 -

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

1.111 An ambitious plan developed under the previous administration for the construction of an integrated railway system is receiving strong support from various interest groups. The government does not yet have a clear policy for interurban transport and has made no decision regarding the implementation of the proposed railway projects. The Minister of Transport and Communications has agreed to the preparation of a comprehensive freight transport plan that would review the performance of the existing transport industries and the related institutional and regulatory frameworks before proposing appropriate reforms for the short and medium terms. Some economic analyses of proposed railway and water transport investments have been undertaken, and a consortium of consultants is being contracted for the freight transport plan now scheduled to be completed by the end of 1992.

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

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

Evaluation and Further Reforms

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

1.115 The major issue in the medium term is whether the CANTV privatization and concession contract includes sufficient incentives to ensure an appropriate balance between competition/efficiency and network expansion. The new operator was granted a nine-year monopoly for basic services (local and long distance) in exchange for commitments to implement a large expansion - 31 -

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

1.116 A related issue concerns the adequacy of the incentives for the new operator to fulfill the expansion program. The concession contract sets out several sanctions for non-compliance to be enforced by CONATEL. But the optimal method of ensuring compliance is a combination of competitive pressures and an appropriate tariff structure, rather than regulatory enforcement. It should be in the new operator's best interests to expand the network and ensure reliable service if the tariff rates reward this and the competition forces it. It is unclear at this stage whether the CANTV transaction has sufficient incentives built in, or whether it relies (perhaps unduly) on regulatory enforcement.

1.117 Ports. The dissolution of the INP and transfer of all cargo handling and stevedoring to private firms has already had a dramatic impact on efficiency. Preliminary data show a substantial improvement in several key productivity indicators (e.g., tons/man-hour have nearly doubled from 21.16 to 40.03).

1.118 Nevertheless, further reforms at the regional level are desirable to maximize economic efficiency and private participation. Specifically, this would involve the granting of concessions to private firms, through competitive bidding, for the operation of individual terrmiinalsin larger ports or the administration of an entire port where more than one concession would be impractical. Such arrangements would ensure maximum competition both within the larger ports (by allowing terminal concessionaires to compete for business) and between ports (by allowing ports to compete against each other in terms of rates and service).

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

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

11/ Each regional government has prepared its own legislation for the operation of its port authority. - 32 -

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

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

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

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

development and implementation of a new tariff structure, implementation of substantial increases in water and sewerage rates to enable the new local and regional water companies to become financially viable, and adequate rate regulation to ensure sustained viability;

* liquidation of INOS; termination of its employees; transfer of all assets to the new regional water companies; and institutional, commercial and managerial strengthening of these companies;

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

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

1.123 As was evident in several other SOEs (notably INP, CANTV, and VIASA), resolution of these issues will require new leadership committed to the dissolution of INOS, privatization and commercialization of water system operations, and development of financially viable regional and local water companies.

1.124 Highways and Interurban Transport. The decisions to decentralize rural road planning and expenditures and to establish a road fund are important first steps in reform. Over the next 12 months, the government should concentrate on: - 33 -

* continuing adjustmentsof domestic petroleum prices to promote efficient resource allocation and transport use;

* redefining the extent of the highway network that is of national interest and transferringthe rest to the newly created decentralizedadministration;

* formulatinga road cost-recoverypolicy, establishingcost- recovery and funding mechanisms for road maintenance,and determining appropriateuser charges and toll levels; and

* formulatinga concession program for building and operating expressways (with an appropriateregulatory framework) and initiating and granting concessions.

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

1.126 Urban Trans2ort. The recommendedagenda for further reforms should focus on:

* liberalizationof the bus system regulations (notably deregulationof fares);

* phased replacementof generalized subsidies with targeted subsidies linked to affordability;

X progressiveadjustment to realistic fuel prices;

X strengtheningthe agencies involved in urban transport at the national and local levels, specificallyby establishing urban transport policies at the central government level; ensuring that local governmentsare equipped to undertake their responsibilities;and improving the capacity of local government agencies to plan, design, operate, and maintain the urban transport systems.

* defining the roles of the public and private sectors in the provision of public transport services within Caracas. Many private bus operators, caught in the squeeze between rising operating costs and low regulated fares, are on the verge of bankruptcy,while CAMETRO is expanding its subsidizedbus and rail network..!Y

12/ There is also an equity problem. CAMETRO buses tend to serve predominantlymiddle-income areas; while transportusers from low-income areas, using privately operated jeeps and buses, pay higher fares and pay several times for trips involving interchange. - 34 -

Financial Sector

Prior Conditions

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

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

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

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

1.131 Beyond the segmentation created by the existence of numerous public credit institutions with power to determine rates and conditions of loans, there are portfolio requirements for private banks. Commercial banks have been subject to a 22.5 percent lending portfolio requirement for agriculture and agro-industry. Interest rates for these loans are required to be below market rates. - 35 -

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

1.133 Mortgage banks and S&Ls are experiencing major financial problems because of the mismatch between the maturity and rate structure of their assets and liabilities. Multiple government-sponsored programs that finance housing have made most of these institutions highly dependent on subsidies to survive.

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

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

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

1.137 The regulations are not effective in ensuring the solvency and financial stability of credit institutions. Standards on loan classification, - 36 -

provisioning, capital requirements, lending concentration, lending to related parties, control mechanisms, and fines and sanctions are weak. Accounting rules are not sufficiently clear, external audits are inadequate, and information disclosure by banks and by the SBIF is deficient. Examinations are not frequent and tend to focus on enforcing specific monetary, fiscal, and other regulations rather than on credit risk analysis and assessment of overall solvency.

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

Policy Reforms

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

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

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

1.142 The government has reduced the mandatory agricultural loans of commercial banks from 22.5 percent to 12 percent of their portfolio and intends to eventually eliminate this constraint on credit allocation. - 37 -

1.143 Intervention in the financial system has been reduced. The government has already privatized three banks previously owned by the Central Bank, has decided to liquidate Bandagro, and has adopted a plan to restructure the BIV and its four regional banks.

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

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

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

Evaluation and Further Reforms

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

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

1.149 A very important aspect of the reforms is recognition of the need to properly administer the fiat money system to attain price stability and the consequent change of the legal environment. The recently published Law gives to the BCV the power and the tools to carry out a sound monetary policy. Of particular importance is the elimination of the old arrangement that forced public debt into the banking system. - 38 -

1.150 The new rules are designed to strengthen fiscal discipline and improve the financial condition of the BCV, as well as to allow the use of Treasury bills as instruments of open-market operations. The introduction of BCV bills in November 1989 already permitted open-market operations, but it is expected that the BCV will be able to trade in Treasury bills to avoid the quasi-fiscal implications of trading in its own.

1.151 By giving the Central Bank much greater independence from the Treasury, the reforms should create a sound market for public debt, eliminating the difficulties of maintaining monetary targets in the face of major fiscal shocks. The problem of coordinating monetary and fiscal policy will continue as lonag as public debt is not properly used to isolate public expenditures from fluctuations in fiscal revenues.

1.152 Closely related to the proper role of the Central Bank is its authority to regulate interest rates. For legal reasons this authority was retained in the BCV Law, although in effect the policy of the monetary authorities has been not to make the regulation of interest rates a binding constraint. It would be desirable for this last remnant of the old regulatory system to be eliminated as soon as possible.

1.153 The reforms aim at fostering competitiveness by replacing segmentation with universal banking and opening all kinds of financial institutions to foreign investment. Although the proposed new Banking Law sets a transitory period during which foreign ownership of commercial banks will be limited to 20 percent of capital, this restriction too is expected to be removed eventually.

1.154 The most important next step is the approval of the laws now before Congress, which is not expected to pose any serious obstacle to the reform process. Congress may e'en adopt a more liberal position on foreign investment in commercial banks. If, however, it upholds the restrictions now proposed, the opening of commercial banking to full foreign investment would be left to the discretion of tae authorities.

1.155 An element that badly needs reform is the housing finance system. Among the laws proposed to Congress is the National Savings System Law that identifies the main problems and suggests remedies.

1.156 As explained earlier, the critical financial situation of both BANAP and the S&Ls is the result of high market interest rates that could not be reflected in mortgage loans under the existing regulations. This distortion requires drastic and urgent correction, and is addressed in another proposed law before Congress.

1.157 The need for a well-functioning national savings system to finance housing can hardly be exaggerated. A law passed in 1989 decrees that a monthly mortgage payment greater than 25-30 percent of a borrower's monthly income must be subsidized. Up to a price limit, all primary homes are covered by this protection. The amount of the subsidy in 1990 is estimated to have been about 0.7 percent of GDP. The reforms aim at making subsidies to low- income families compatible with the financial stability of the national - 39 -

savings system. The proposed new law redefines the functions of BANAP and its recapitalization; phases out funding by government, BCV, and any external source, and outlines policies for the financial support of S&L,;. The S&Ls will be required to recapitalize and also will be allowed to provide new services, including credit cards. They will be encouraged to transform into corporations and will be authorized to issue bonds backed by individual mortgages guaranteed by BANAP. This new function for BANAP aims at developing the secondary mortgage market. Depositors will not be insured by BANAP but by FOGADE. BANAP will still be a first-tier institution providing finance for special housing programs.

1.158 The proposed reform reinforces the control of financial intermediation by eliminating the specialized S&Ls Superintendency and turning over its functions to the Banking Superintendency.

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

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

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

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

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

Social Sectors

Prior Conditions

1.164 Venezuela's per-capita income is amongst the highest in Latin America. But its highly skewed distribution of income leaves large segments - 40 -

of the population in poverty. Infant mortality rates have fallen substantiallysince 1965 (from 65 per 1,000 to 36 per 1,000 in 1988), but still remain double those of Jamaica and Costa Rica, which have half the per capita income. Similarly,although school enrollmentshave increased rapidly over the same period, gross secondary school enrollment is only two-thirds that of Uruguay, Argentina and Chile. The illiteracyrate for adults has decreased 65 percent since 1965 but still remains at a relativelyhigh 13 percent. The total fertility rate (3.8) is higher than in many other Latin American and Caribbean countrieswith much lower GDP per capita. Recent estimates show two main trends in selected health indicatorsduring the 1980s: a significantslowdown in improvementsin neonatal, postnatal, and maternal mortality; and an increase in undernutrition,child mortality due to malnutrition, and morbidity due to endemic diseases. Similar trends have been noted in the education sector, where enrollmentshave leveled off and repetitionand dropout rates have increased.

1.165 Three major factors have contributedto the persistence of poverty and its manifestations: (i) public services have been poorly managed, highly inefficient,and not directed to those most in need; (ii) rapid urbanizationand especiallythe growth of metropolitanCaracas have severely strained the government'scapacity to provide health and education services. Urban dwellers now represent nearly 85 percent of the population, and many of them live in large slum communitieson the urban periphery,with only limited basic services and markedly inferior standards of education,health, nutrition, and hygiene; and (iii) although population growth has declined, the rate remains high at 2.8 percent.

1.166 Previous anti-povertyprograms attemptingto redistributeincome through general food subsidies and free social services failed despite high expenditure. The main beneficiariesof food subsidies have tended to be the middle- and higher-incomegroups, who could afford to buy greater quantities of subsidized goods. While social services were presumed to be universal and free of charge, poor managementand inefficientinvestment left many beneficiariesout of reach of service delivery and obliged others to pay for medicines, bandages, textbooks,and other school materials that were not made available.

Policy Reforms

1.167 In 1989, the government replaced general food subsidies with programs specificallyfor lower-incomegroups and expanded existing programs that target the most vulnerablemembers of society. These actions were designed to shield the poorer segments of the population from the adverse effects of structural adjustmentand to overcome past deficienciesin targeting, coverage, and administrationof selected social services.

1.168 The new strategy emphasizes a shift from highly inefficient general subsidies available to the entire populationto programs targeting lower-incomegroups. Its principal objectivesare to: (i) relieve the severe hardship resulting from economic decline; (ii) mitigate the impact of adjustments in the economy necessary to achieve sustainable,long-term growth; - 41 -

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

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

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

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

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

1.173 Maternal-Child Health Care. The purpose of this program is to expand delivery not only of preventive medical care but also of health, education, and nutritional support. Food supplements, especially powdered milk, are distributed to the targeted population according to socioeconomic and biological risk criteria. The maternal health program aims to improve the quality and service delivery of prenatal and postnatal care, to reduce maternal and child mortality, to stimulate breast-feeding, and to reduce mortality and morbidity due to uterine and breast cancers. The basic objective of the program is to provide a nutritional supplement free of charge to the target population in order to attract the most vulnerable groups to health posts for medical care and eventually to improve their nutritional status. In 1988, about 25 percent of pregnant women were receiving prenatal care and only 5 percent were receiving postnatal care. No more than 16 percent of infants under two years old and 10 percent of preschool children - 42 -

from two to six years old received health care that year. By 1994, this program is expected to expand coverage to 50 percent of pregnant and postnatal women (600,000), 50 percent of infants under two years of age, and 10 percent of preschool children (more than two million). Expansion of coverage will be exclusively for low-incomegroups.

1.174 Community Day-Care Centers. In 1991, this program expected to reach about 150,000 children, from about 24,000 children in 1989. This home- based program provides nutrition, health, and childhood developmentassistance for poor children and promotes community education and development. Until recently, there has been only one type of HCD: about eight children cared for by one community mother in her home for a twelve-hour period. The government gives the mother a loan to equip her home and pays her a monthly stipend supplementedby fees paid by the parents of the children under her care. Three more types are being introduced: (i) part-time HCDs (four-hour shifts); (ii) multi-HCDs, in which three community mothers care for 30 children in a specially adapted community center; and (iii) natural HCDs focusing on the poorest of families in which mothers do not (or cannot) work.

1.175 Preschool ExRansion Prouram. Expanded coverage under this program is expected to reach 96,000 children from three to six years of age in formal preschools, and 16,000 in nonformal preschools throughout the country. The existing program covers only about a third (mostly from middle- and higher-incomefamilies) of about 1.7 million preschool children. To improve equity and access, the new policy is to allocate all public funds for new preschool constructionexclusively to poor urban and rural areas. The formal preschools will be assisted by state education budgets, teachers, and supervision. The nonformal preachools will be served by local-levelNGOs and community organizations,and will be given greater future emphasis if they are successful.

1.176 There are several minor programs, the most importantof which are informal-sectorsupport and other nutritionalprograms also aimed at strengtheningthe institutionalsocial network. Other measures increase unemploymentbenefits and modify the social-securitysystem.

Evaluation and Purther Reforms

1.177 The reform program introduced in 1989 was designed to counter the pervasive inefficiency,economic decline, and increased poverty that public sector economic and social policies had spawned. The strategy for poverty alleviation is to promote sustainablegrowth and expand social programs, moving from highly inefficientgeneral subsidies available to the entire population to assistance that targets those most in need.

1.178 In this context, the government'spoverty alleviation strategy is an innovative approach to moving poverty problems to the forefront, but it has not yet entirely reversed the misdirectionof resources. In 1989, funds for poverty alleviation representedapproximately 11 percent of social sector spending; in 1990, they had increased to 16 percent. Maternal-childhealth expendituresgrew from 68 percent in 1989 to '.5 percent in 1990. But about - 43 -

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

1.179 In an effort to improve the planning and management of social programs, the government recently announced the Social Megaproject. It is an umbrella project hich covers about 15 ongoing programs and new proposals covering a broad range of social services, from day-care and nutrition, to health and education, and the rehabilitation of social infrastructure. These projects are in various stages of preparation, and some are still in need of financing. The Social Megaproject would be coordinated by CORDIPLAN, which will provide overall guidelines, and executed by the Ministries of Health, Education, Family, Urban Development and Transportation, as well as state and local governments.

1.180 The social sector still faces these major problems:

* highly centralized management;

* expenditures skewed to higher-cost, inefficient projects;

* insufficient data to identify target groups;

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

* inadequate technical skills to plan and manage sustainable programs.

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

1.182 The misallocation of resources persists. Higher education, which accommodates very few low-income students, receives about 40 percent of the education budget. Health resources are oriented towards curative medicine and hospitals, not to preventive care. Programs to improve nutrition do not cover some of the most vulnerable groups. Nonsalaried workers are excluded from social security benefits.

1.183 There is likely to be considerable pressure for a return to general subsidies, and it is extremely important that the government stand - 44 - firm. Evidence to date suggests that the reforms will be continued, judging from the seriousness with which the government has embarked on a difficult course of social policy reform and the importance it has given to the sectors. The following are specific recommendations:

(a) The government should revise the poverty alleviation strategy, as to its priorities, costs, and short- and medium-term objectives so that it focuses not merely on the new poverty alleviation programs, but on reforming established social sector oroarams. The strategy should include: (i) ongoing social programs with poverty alleviation objectives (e.g., school feeding, health promotion, and nonformal preschool education) that could benefit from improved efficiency and targeting mechanisms, and political support; and (ii) a second phasri of the poverty alleviation strategy emphasizing fundamental reform of the health, education, and nutrition sectors. The Ministry of Family (MINFAM), as the secretariat for the Presidential Commission for Poverty Alleviation (COPEP), should promote the revised strategy among all participating agencies and the general public to mobilize greater efforts by service providers and greater awareness and participation among the beneficiaries.

(b) Targeting mechanisms and sectoral resource allocation should be directed to achieve greater efficiency and equity. Poverty maps should be updated to include municipal, barrio-level, and health and nutrition indicators to identify those most in need. MINFAM should ensure that the revised indicators are incorporated into all poverty alleviation programs. School feeding and maternal-child health programs should be consolidated. Allocations should be revised to correct: (i) disproportionately high expenditures at the cost of operations and maintenance expenditures in both health and education; (ii) bias towards higher education at the cost of basic education; (iii) bias towards tertiary/curative health care at the cost of primary/preventive health care; and (iv) remaining untargeted food subsidies for school children. In general, primary school education and primary health care offer higher social rates of return and thus represent a more efficient use of public resources. The government should begin exploring mechanisms for selective cost recovery to include: public-university fees, combined with a student loan program and scholarships for low-income students; and health care fees based on ability to pay, or in conjunction with subsidized health insurance for the poor.

(c) Both for-profit and non-profit private sector agencies should be used for greater efficiency in delivery services. In health, some options to consider are: contracting for - 45 -

hospital management or the provision of select services; encouraging competition in the distribution of pharmaceuticals; and establishing a compensatory scheme under which patients treated in private clinics are covered by some form of public (or private) health insurance. In education, increased private sector university and preschool services for those who can afford to pay would free up public resources for higher priority areas, such as basic and secondary education, textbooks, and other materials for those who cannot afford them. In nutrition, local companies, which often buy and distribute goods more cheaply than the public sector, could improve efficiency. NGOs often are more effective in delivering services to the poor because of their location, commitment, and community orientation. They also promote local participation and resource mobilization at a relatively low cost. A survey of NGOs should be completed to determine their strengths, weaknesses, and needs for coordination with the public sector.

(d) The overall management of programs to alleviate poverty should be strengthened by better coordination of policy development, project formulation, monitoring, and evaluation. The transformation of the MINFAM into the Ministry of Social Development should be completed, placing particular emphasis on establishing working links with all agencies involved in poverty alleviation. Each agency should provide MINFAM with accurate cost estimates of social programs and in turn receive technical assistance in project design, targeting, monitoring, and evaluation. Reforms are badly needed to correct problems of weak management, unqualified personnel, low salaries, poor project formulation, unintegrated planning and budgeting, and low quality of service.

(e) The new Decentralization Law has many implications for the social sector. Since the state governments are expected to request the decentralization of education and health first, these ministries should prepare an implementation strategy that determines: which services could be more effectively delivered at the local level or by the private sector; the costs and personnel involved; the best way to maintain or improve quality of service; and the capacity of the states to assume their new responsibilities. Central funds could be used as matching grants for priority programs and as a means of redressing social or regional inequalities. Local authorities have little, if any, experience in planning and delivering social services, a deiiciency that must be corrected by urgent technical assistance in all phases of the work. - 46 -

II. MACROECONOMIC REFORMS

2.1 This section of the report discusses Venezuela's macroeconomic issues under two headings: the 1989 stabilization policy, and the country's inherent macroeconomic problems. The first concerns a specific event of prime importance to Venezuela's recent economic life; the second embraces features of a more permanent nature--some of which are clearly demonstrated by the stabilization experience. The analysis does not intend to provide an up-to- date assessment of Venezuela's macroeconomic performance.

A. The Stabilization Policy

Prior Conditions

2.2 Venezuela has had continuous inflation since the first major oil-price increase of 1974. Until the late 1980s, however, inflation was moderate and rather stable, with an average annual rate of 11 percent from 1974-86 and not much variation except for a jump following the second oil-price increase of 1979 (Table 3).

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

PertentageIncrease of Nominal Rate of CoinsumerPrice Index Exchange,End Year Year (AnnualAverages) (Bs per USS) (1) (2)

1970 2.5 4.5 71 3.2 4.5 72 2.9 4.4 73 4.1 4.3 74 8.3 4.3 75 10.2 4.3 76 7.7 4.3 77 7.8 4.3 78 7.2 4.3 79 12.3 4.3 1980 21.6 4.3 81 16.2 4.3 82 9.6 4.3 83 6.3 4.3 84 12.8 7.5 85 11.4 7.5 86 11.6 14.5 87 28.1 14.5 88 29.5 14.5 89 84.5 43.1 1990 36.5 50.4 91 '0.7 61.6

Source: Banco Central de Venezuela(BCV); and I.M.F. InternationalFinancial Statistics (I.F.S.), various issues. - 47 -

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

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

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

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

Maior Elements of the Stabilization Plan

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

The Foreign-Exchange Rate

2.8 The change in the foreign-exchange system was clearly the key to the stabilization plan. Under the existing multiple exchange rate system, the principal (official) rate, applying to most transactions and especially to oil exports by PDVSA, had been maintained at a constant nominal value of 14.5 Bs per US$ since December 1986. Two lower rates applied to the official debt and to minor transactions, and a higher, "free-market" rate served for non- traditional exports (predominantly of goods such as steel and aluminum by public-sector enterprises). The stabilization plan unified the exchange rate and left it free to float. It increased immediately to 39.3 Bs per USS by the end of February 1989. - 48 -

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

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

Nominal Exchange Real Exchange Rate v Rate End Quarter Quarter Average (Bs per USS) (I 1988 = 100) Quarter (1) (2)

1988: I 14.5 100.0 II 14.5 99.9 III 14.5 90.3 IV 14.5 83.8 1989: I 36.9 85.8 II 37.1 124.5 III 38.3 115.2 IV 43.1 120.6 1990: I 43.6 119.9 II 46.8 122.0 III 48.5 124.7 IV 50.4 119.2 1991: I 54.0 117.2 II 55.3 113.5 III 59.2 113.4 IV 61.6 111.6

For 1988, this is the official rate.

Source: Based on I.F.S., various issues. - 49 -

Fiscal Policy

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

(i) An increase in the PDVSA surplus was the predominant element of fiscal change and of the stabilization package as a whole, closely related to the change in the foreign- exchange regime. Most of PDVSA's income is surplus (that is, an excess over the cost of production), and most of this surplus constitutes a source of government budgetary revenues through taxes. An increase in the real exchange rate thus raises real public-sector revenues. In the evert, this increase was dramatic: PDVSA's surplus increased from 11.4 percent of GDP in 1988 to 20.5 percent in 1989. Contributing to this large increase was a 24 percent increase in the dollar value of Venezuela's oil exports.

Table5: PUBLICSECTOR FISCAL ACCOUNTS, 1988-91 (ANNUAL) (in percentageof GDP)

1988 1989 1990 1991±'

(1) Ordinary Revenues,total 24.4 30-4 34.0 34.0 Principalconmponents: PDVSAsuiplus 11.4 20.5 25.9 24.5 OtherSOEs surplus 2.5 3.0 1.9 2.3 Taxes 8.6 5.5 4.9 6.8 () Ordinaryexpenditures, total 20.1 203 206 20.2 Principalcomponents: Wage payments S.1 4.6 4.4 4.7 Purchaseof goods andservices 1.3 1.1 1.3 1.3 Intereston externa debt 2.6 4.7 4.0 3.7 Transfers 6.2 6.7 7.4 7.0 Exchangelosses 2.5 2.1 2.3 1.0 (3) Capitalexpenditures, total 13.9 11.4 12.5 13.7 Principalcomponents: Centralgovernment 3.2 1 .7 1.5 PDVSA 2.7 3.4 3.9 4.3 OtherSOEs 4.7 4.9 4.1 4.6 (4) Surplus(+) or Deficit (-) - (1)-X(2)+(3)j -9.6 -1.4 1.0 3L (5) Changein deficitfrom -1.1 -3.0 -1.6 previous year excludine PDVSAsurplus (minus sign indicatesan increase in deficit)

11 Preliminary. F ITis figure reflects some adjustmentsand is thus not fullyconsistent with the rest of the table. -sotirceD BCV, Inforne Economico,1989 and 1990;1991 data providedby ECV. - 50 -

(ii) Reduction of canital expenditures. This component was of some substance. Public-sector investment declined from 13.9 percent of GDP in 1988 to 11.4 percent in 1989. The brunt of the reduction was carried by the central government, whose investment virtually disappeared falling from 3.2 percent of GDP in 1988 to .1 percent in 1989. PDVSA and other public-sector enterprises, on the other hand, increased their capital expenditures in 1989.

(iii) Changes in current expenditures. Total government expenditures on current account increased slightly from 1988 to 1989 due to a significant increase in the domestic value of external debt payments--from 2.6 to 4.7 percent of GDP--resulting from the real devaluation. Domestic current government expenditures remained practically constant: 12.6 percent of GDP in 1988 and 12.4 percent in 1989. For purposes of analyzing the impact of the budgetary changes on domestic demand and money creation-- and thus on inflation--it is domestic expenditures that are relevant. We may thus infer that reduction of current government expenditures was not used to support the stabilization effort. Even the reduction of the government's real wage bill by .5 percent of GDP, or 10 percent of its 1988 level, was due more to a fall of real wages in the *ublic sector than to a decline of real activity.

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

Monetary Policy

2.11 Table 6 presents monetary aggregates for 1988 and 1989. Monetary developments largely reflect the change in the fiscal stance and its impact on the monetary base. They also reflect a policy of contracting private-sector credit. Having earlier exhibited a very rapid increase, the nominal supply of money (M1) declined by 3.5 percent in the first quarter of 1989, and fell further by 1.4 percent and 2.9 percent, respectively, in the following two quarters. Thus, by the end of the third quarter of 1989, nominal money supply was about 8 percent below its level at the end of 1988. The decline would be even sharper if comparison were made not with December 1988 but with February 1989, the eve of the stabilization pPlicy. - 51 -

Table 6: MONEY SUPPLY, 1988-91

Real Nominal Real Nominal Quarterly Money Money Quarterly Money

Money Percentage (M1 ) (M2 ) Percentage (M2 ) Quarter (b.Bs) Change (I 1988=100) (b.Bs) Change (I 1988=100) (End) (1) (2) (3) (4) (5) (6)

1988: I 109 - 100.0 290 - 100.0

II 118 8.2 104.5 304 4.8 96.4

III 124 5.0 98.5 307 1.0 89.0

IV 145 16.9 103.0 335 9.1 83.7

1989: I 140 -3.5 84.8 348 3.9 68.9

II 138 -1.4 60.6 353 1.4 56.1

III 134 -2.9 54.5 397 11.3 58.2

IV 169 26.1 63.6 464 11.7 64.1

1990: I 175 3.5 62.1 513 11.1 66.7

II 181 3.4 59.1 540 5.3 65.0

III 191 5.5 57.6 625 11.6 69.1

IV 241 26.1 66.7 747 12.0 75.5

1991: I 247 2.5 63.6 786 5.2 75.1

II 294 19.0 70.7 899 14.4 80.1

III 329 11.9 73.6 983 9.3 81.4

IV 322 -2.1 67.1 995 1.2 76.8

Source: BCV, Boletin de Indicadores Semanales, various issues. - 52 -

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

2.13 Interest rates, freed by the plan, increased sharply. The controlled lending nominal interest rate of 13 percent per year turned into a free rate hovering at around 32 to 40 percent throughout 1989. During most of the year, this implied a slightly negative real interest rate; but it represented, nevertheless, a very sharp increase of the real rate from minus 20 to minus 40 nercent prior to the reform.

Impact of the Stabilization Policy

2.14 The higher exchange rate translated into higher prices of tradable goods; combined with the increase in public-sector prices, the eliminat on of subsidies, and the removal of price controls, this led to a massive increase in the price level. This one-time jump in prices should not be confused with an acceleration of inflation. The process of inflation clearly had been checked. Overlooking the substantial price increase of March-April 1989, the rate of inflation from May-June 1989 onward was much lower than prior to the plan and kept decelerating throughout 1989 (Table 7). While the monthly increase in consumer prices averaged around 5 percent during the last quarter of 1988, it was only about 2 percent in the last quarter of 1989. In terms of annual inflation rates, this is a reduction from about 80 percent to 27 percent.

1/ M2 includes M1 (cash and sight deposits) and term deposits, saving deposits and a form of CDs. - 53 -

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

Monthly Average Monthly

1988: I -.53 1989: 1 1.11

II 2.80 2 3.15

III 3.05 3 21.26

IV 5.05 4 13.50

1989: I 8.51 5 6.35

II 7.68 6 3.20

III 2.64 7 2.47

IV 2.03 8 2.17

1990: I 2.02 9 3.28

II 2.63 10 3.01

III 2.86 11 1.33

IV 2.99 12 1.74

1991: I 1.90

II 2.37

III 2.43

IV 2.33

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

2.15 This major moderation of inflation was due to the large reduction in the private sector's real disposable income, the sharp decline in real money balances and the need to rebuild them, and the higher (though still mostly negative) real interest rates, all of which led to a substantial decline in the demand for goods and services. Not surprisingly, these also led to a sharp decline in real activity (Table 8). Table 8: GDP AND ITS MAIN COMPONENTS, 1988-91

Billions of Bolivars. 1984 Prices % Change

1988 1989 1990 1991 1989/88 1990/89 1991/90 1991/88 Total GDP 491.4 449.3 473.0 516.5 -8.6 5.3 9.2 5.1 Petroleum 93.9 93.6 106.3 116.8 -1.4 13.6 9.9 24.4 Crude & Nat. 70.2 70.7 82.6 94.2 0 17.6 14.0 34.2 Gas

Refining 23.7 23.3 23.7 23.7 -1.6 1.6 0 0 Non-Petroleum 386.8 350.3 363.2 394.4 -9.4 3.7 8.6 2.0 Agriculture 27.3 25.9 25.8 27.3 -5.1 0.3 6.0 0 Mining 3.9 3.8 3.9 3.7 -4.3 3.9 -4.1 -5.1 Manufacturing 87.0 74.3 77.9 82.1 -14.6 4.9 5.4 -5.6 Electricity 6.8 6.9 7.1 8.0 1.3 2.5 12.3 17.6 Water 0.8 0.8 0.8 0.9 3.0 2.6 12.5 12.5 Construction 30.0 21.9 23.3 31.2 -27.1 6.7 33.9 4.0 Commerce G 70.6 57.9 59.0 65.4 -17.9 1.8 10.8 -7.4 Transport

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

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

General Gov't 39.1 40.7 43.9 48.1 4.1 7.8 9.6 23.0 Other 89.1 87.1 90.3 94.4 -2.3 3.7 4.3 5.6

Source: BCV, Informe Economico, 1989 and 1990; 1991 data provided by BCV. - 55 -

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

The Policy Chanes

2.17 Towards the end of 1989, and clearly by early 1990--roughly a year after the introduction of the stabilization package--the restrictive macroeconomic policy came to its end.

2.18 A reversal appears in the fiscal stance, although the raw data do not reveal it: cn intrinsic budgetary deficit is hidden by the swelling of government revenues from oil taxation, resulting from the substantial increase of world oil prices following the Persian Gulf crisis. Thus, an apparent continuing improvement of fiscal performance is shown: a change of the public sector balance from a deficit of 1.4 percent of GDP in 1989 to a surplus of 1.0 percent in 1990. But when the change in oil-tax revenues (resulting from its increased world price) is abstracted from, a reverse impression emerges: rather than an improvement, a deterioration of the fiscal stance from 1989 to 1990, of the order of 3 percent of GDP, is seen to have taken place. In 1991, the dollar value of oil exports changed only little from 1990, so that this impact on the budgetary performance was not of much significance.?l

2/ A distinction should be made between increased oil-tax revenue resulting from a higher exchange rate (that is, an increase of the domestic value of oil exports at given world prices), and an increase resulting from a changed dollar value of the exports (whether due to change in oil prices or in the volume of exports - with fluctuations of prices being usually the major source). In the former case, when oil revenues increase as a result of an increase in the foreign exchange rate, this change is identical in its impact to increased revenues from non-oil taxes, and should hence be regarded as part of a genuine change in the government's fiscal stance: since the government is the major supplier of foreign exchange, real exchange rate depreciation works very much like the imposition of a uniform tariff on imports of goods and services. This was primarily the source of changes in government oil revenues in 1989, although the impact of the devaluation was reinforced that year by a 24 per cent increase of the dollar value of oil exports. The case in which government oil revenues increase as a result of change in the dollar value of oil exports - as happened in 1990 - is quite different. In its short term macroeconomic impact, financina government expenditures out of such an increase is equivalent to financing them by borrowing from the central bank or by an external capital inflow: the impact on money creation, or on the private sector's disposable income, would be the same. - 56 -

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

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

In BitlionsBs., In percentage Cunrnt Price of GDP

(1) (2)

1989: 1 -7.0 -1.8 II 25.7 6.4 III 1.7 .4 IV 40.7 8.9 1990: 1 -4.1 -.8 il -1.8 -.3 If -22.0 -3.4 IV 51.9 8.6 1991: 1 19.2 2.9 II -42.8 -6.2 III 2.7 .4 IV 27.1 2.6

Source: Providedby BCV. - 57 -

2.20 The trend in the nominal money supply (M1), also changed. In the last quarter of 1989, money increased by about 26 percent (an annual rate of 152 percent), partly in response to a seasonal increase in demand. (In the last quarter of 19A) the increase in the money supply was exactly the same as a year earlier, and much above "normal".) But even allowing for the seasonal variation, a change in trend is apparent. During 1990 as a whole, MI increased by 43 percent, in contrast with a fall of some 8 percent during the first three quarters of 1989. In 1991, the rate of expansion declined somewhat to about 34 percent. For M2, the rates of increase were: 18 percent in the first three quarters of 1989 (an annual rate of about 25 percent); 61 percent in 1990; and 33 percent in 1991.

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

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

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

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

3/ This is a somewhat uncommon pattern. In most recent stabilization experiences, exchange-rate appreciation followed almost immediately the introduction of the stabilization package. In these episodes, tight monetary policy (and often less than complete fiscal adjustment) led to high interest rates and, in turn, to capital inflow and currency appreciation. Jn Venezuela the interest rate was much above its pre-stabilization level but still negative, in real terms, or barely positive - at a level, that is, not high enough to attract capital from abroad. Indeed, no large-scale capital inflow accompanied Venezuela's stabilization. Currency appreciation started, in Venezuela's experience, only with the massive increase of proceeds from oil exports following ths Gulf crisis. - 58 -

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

2.25 Real activity, too, responded fast to the policy change. GDP, particularly its private-sector component, started increasing in the second quarter of 1990, rising in 1990 by 5.3 percent (3.7 percent without the oil sector) from 1989 (see Table 8). Construction and manufacturing, two of the 3ectors hit hardest in the recession of 1989, expanded most in 1990 but still not to their 1988 levels. In 1991, the national product increased even more-- by 9.2 percent, or 8.6 percent in the non-oil economy. Once more, the construction sector registered the highest growth. Throughout, the general- government sector kept increasing, so that by 1991 its product exceeded that of 1988 by almost one quarter. The only major activity that had not rebounded by the fall of 1991 was private-sector investment, which between 1988 and 1989 fell from about 20 billion to 8 billion Es and in 1990 was negative in net terms. In part, this reflacted a large inventory accumulation prior to the widely expected 1989 devaluation and a decumulation following it. Unemployment, which increased from 6.9 percent of the labor force in the second half of 1989 to 10.9 percent in the first half of 1990, declined to 9 percent by the end of 1991.

Evaluation of the Stabilization Policy

2.26 The stabilization program enjoyed immediate success, lowering the annual inflaticn rate of some 60 percent prevailing in the second half of 1988 to about 34 percent in the first year following the program. (The period March-May 1989, when a one-time increase in the price level occurred as an instrument of stabilization, should be ignored.) The balance-of-payments situation changed dramatically, even before the oil-market bonus of 1990: a 50 percent drop in net foreign-exchange reserves, from US$4 to US$2 billion, in the last 10 months preceding the program turned into an increase of US$4 billion during the period March 1989-July 1990 (after which the increase accelerated due to the oil-price increase).

2.27 Long-term stabilization, however, has not been achieved. During 1990 and 1991 and up to the present (Fall 1992), the rate of inflation has continued in the range of 30 percent per year. This is much higher than Venezuela's traditional inflation: it is higher than in any year prior to the program save the last two (1987 and 1988), when it was at about this level. The level _f inflation is also substantially higher than in countries such as Chile, Mexico, or Israel duzing the first few years following the introduction of similar programs. In most countries, an inflation level of 30 percent per year would be judged as unstable, likely to lead within a shcrt time to increased inflationary expectations and to accelerated inflation. Venezuela may be benefiting now from its long experience of relatively stable prices, a tradition in which accelerated inflation is not perceived as an imminent threat. It is also possible that the conclusion, in December 1990, of a debt and debt-service ("Brady Plan") agreement with foreign commercial banks has given the government's stabilization plan a measure of credibility. But even so, it is unlikely that such a level of inflation cculd be sustained for years: if it does not go down, it is likely to go up, given the present condition of the fundamental determinants of the macroeconomic situation. - 59 -

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

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

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

B. Inherent Macroeconemic Problems

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

4/ A substantial nominal devaluation in September-October 1992, of some 12-13 per cent, was followed by nominal stability, so that by the end of 1992 the real rate was still roughly at its level before this devaluation. - 60 -

Fiscal Issues

Government Revenues

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

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

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

2.35 A case may also be made to the effect that oil revenues, which constitute rent income for Venezuela, should have been used to increase the economy's capital stock, that is, to boost investment; whereas public consumption services should be financed, as almost anywhere else and in Venezuela prior to the appearance of oil, through taxation. To the extent that this argument is acknowledged, it would call for increased taxation along with increased capital outldys. This should not be confused, though, with an increase in the government's investment in state enterprises: as will be argued shortly, the capital outlays (whether increased or not) should ke undertaken by the private sector.

2.36 Finally, an argument for raising more non-oil tax revenues could be mnade - and very often is - on the grounds that virtual dependence on oil makes the government hostage to a single, volatile revenue source: the diversification of revenue sources would eliminate, or greatly reduce, the fluctuations of aggregate revenues and expenditures. This argument holds true under Present circumstances. But, as will be seen later it would have no validity once an oil-stabilization fund is established.

2.37 There is ample evidence that the existing tax structure could yield substantial additional revenue through improved tax administration, the closing of loopholes, and the reduction of exer,ptions. Beyond this, there are -61 -

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

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

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

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

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

Government Exoenditures

2.39 In Venezuela, more than in most other countries, capital expenditures are a major component of public-sector expenditures, most of them on public-sector enterprises led by PDVSA and CVG (see Table 5). This, again, is a reflection of the role of oil revenues in the economy and in the government's budget. Part of these revenues finances current expenditures, but a large part finances investment, to a much greater degree than a - 62 -

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

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

2.41 The decision of the Government of Venezuela to privatize the state enterprises has not yet been reflected in privatizing CVG corporations (with minor exceptions) or PDVSA. Reaching this stage will, and should, take time - particularly in reference to PDVSA; and the process would inevitably be gradual. But there is no need to continue the model of government investment as it has been pursued hitherto. Thus, we recommend that a gradually increasing portion of the resources presently invested in public-sector enterprises should be placed at the disposal of the Private sector, not invested by the government itself. This could be done through a capital budget providing long-term loans to private enterprises at non-subsidized interest rates (beyo:a the fact that access to such facility would imply an element of subsidy). The rate of interest would be at a level at which no quantitative rationing of this credit would be required. As long as public- sector enterprises are not privatized, they would have the same access to the fuildsas private-sector enterprises, with no preferential conditions or treatment.21

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

5/ Since conventional accounting rules do not regard such lending as government expenditure (on goods and services), the practice suggested here would lead to the appearance of a large budgetary surplus. - 63 -

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

2.43 A specific issue to be faced now is whether PDVSA should adopt a large-scale investident plan for the next few years financed partly by foreign borrowing. PDVSA presumably is able to raise funds abroad at a reasonable price and, from the investment of these funds, to generate enough additional foreign-exchange receipts to service and eventually repay the debt. But such borrowing and expenditure would be inconsistent with the need for Venezuela to actually export capital in order to change some basic features of its economic structure.

The Budgetary Process

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

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

b. Biased proiection of revenues. The Budget Office (OCEPRE) starts designing the annual budget by estimating expected revenues, both oil and non-oil, in ways that can lead to wide margins of error. Projections of oil revenues, which make up some 7C percent of total government revenues, tend to follow past high prices. Projections of non-oil revenues consistently exceed the proceeds realized by an average of 10 percent (or 3 percent of total revenues). The Budget Office believes it has changed this procedure now by choosing to underestimate revenues. Should this indeed by the new practice, an important source of budgetary deficits and inflation will have been eliminated.

c. Incomplete follow-up of budgetarv nerformance. The Budget Office is expected to make adjustments, as the year proceeds, to match actual revenue performance. But it is doubtful whether it receives continuous and timely information to do this accurately. It appears to have an up-to-date record of revenues, but its information on

6/ In the aforementioned study by Sebastian Edwards (Report 0148'- VE), it is estimated that a permanent reduction of government expenditlures by 10 percent (not offset by increased expenditure due to the interest revenue on the accumulated foreign investment) would lead to a permanent increase of the real exchange rate by about 6 percent (mostly reached within two years). - 64 -

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

d. Incomplete control of public enteroriLes. The business plans of public enterprises are determined as part of the general design of the budget. But once determined, the only control exercised is through the transfers from the central government to the enterprises. (This obviously does not apply to PDVSA.) The enterprises can in fact vary the size of their investments by changing the amounts they borrow from non-government sources.

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

Fluctuations in Oil Revenues

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

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

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

2.48 In December 1990, following the jump in oil prices shortly after the Gulf crisis erupted, Venezuela established a mechanism to neutralize fluctuations in oil revenues, in accord with the IMF. The mechanism stipulated a baseline of gross export revenues equal to an annual volume of 1.9 million barrels at an export price of US$19 per barrel. Of oil revenued exceeding this baseline, only 25 percent would be spent and 75 percent would be frozen. In fact, while the central government did deposit 75 percent of - 65 -

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

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

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

(ii) The fund should establish a formula to determine permanent oil revenues in any given year, and modify this formula (as distinct from the derived level of income) only infrequently and in response to major changes in the behavior of the oil market.

(iii) Each year the fund should transfer to the government an amount equal to the "permanent" level of oil revenues, as determined by the formula. This amount should be known well in advance of the annual budgetary preparations and should not change during the year.

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

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

a/ Stabilization, or smoothing out, of government expenditures is not identical with stabilization of the real exchange rate; but the two are Lntimately related. In the study by Sebastian Edwards (Report 0181-VE) a simulation exercise demonstrates that fluctuations of the real exchange rate in the last 15 years would have been drastically lowered had an oil stabilLzation fund been operating. In addition, the lflvel of the exchange rate would have been hlgher--an outcome relevant to the following discussion of the real exchange rate.

2/ See Ricardo Nausmann, Andrew Powell, and Roberto Rigobon, "Facing Oil Income Uncertainty in Venezuela: An optimal Spending Rule with Liquidity Constraints and Adjustment Costs." Mimeo., Instituto de Estudios Superiores de Administraci6n, Caracas, December 1991. - 66 -

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

Taruets and Instruments of Monetary Policy

2.50 There are several basic problems in the way the Central Bank operates.

(i) Inconsistency of Targets. The Central Bank has a number of targets, and the set of targets and instruments is potentially inconsistent. The targets are: the level of foreign-exchange reserves; the rate of expansion of money supply; and (less clearly or emphatically) the real rate of exchange. It also seems that, less systematically, both the nominal and real rates of interest are considered as targets.

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

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

(iv) Cr ation of Near Money. The practice of offsetting the im_ ct of accumulated foreign-exchange reserves by open- - 69 -

(i) If the Central Bank sells bonds to the commercial banks, the use of the two alternative instruments would leave the money supply unchanged. The use of the reserve-ratio lnstrument would result in a higher monetary base but the holding of Central Bank bonds by the commercial banks would be lower.

(ii) Another course, the one most common in Venezuela, is the sale of Central Bank bonds to sectors other than the financial sector. Here the same conclusion holds as before regarding the levels of the monetary base and the stock of Central Bank bonds. The difference would be in the size of money. The money supply, strictly defined (M1 or M2) is smaller when open-market operations are used, but the stock of Central Bank paper held by the public is larger by the same amount. Since the Central Bank's paper is extremely liquid, it qualifies as a component of mc;.ey supply. Using a broader definition of money, the inference is thus that money supply is affected to the same extent by either alternative.

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

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

,m .. mu.. . mN m M - 70 -

The Real Exchange Rate

2.60 Whether or not the government should intervene to manage the real exchange rate is a central, long-term issue of macroeconomic policy in Venezuela, at the heart of much of the economic debate in the country. It concerns basic issues of the country's economic structure, of the government's finance, and of fundamental policy guidelines.

2.61 There is a sound argument for allowing the rate of exchange to be determined strictly by market forces. Through the exchange rate, the market would establish a relative price which would ensure maximum levels of efficiency and production and the highest rate of growth. Tampering with the exchange rate, to fix it at other than its equilibrium level, would only introduce distortions and lower welfare.

2.62 The only factor that might justify intervention is the predominant role played by oil exports. Dependence on oil expo-'s has two distinctly different components. The first concerns the stability of oil revenues, and has, in turn, also two aspects. One is the potential short-term fluctuations of these revenues; that, indeed, would require intervention. in the way discussed earlier when the stabilization fund was suggested. But over the long run, this intervention would not be intended to establish a level of the real exchange rate different from what the market would. The other aspect is the potential disappearance, complete or partial, of the oil revenues some time in the proximate future. This is an unlikely eventuality for Venezuela. But even if it were not, it might be argued that the market would anticipate the change and make the most efficient adjustment over time.

2.63 The other, more serious component of dependence on oil exports is their impact on the economic structure. It is conceivable that because of it the maximization of present efficiency, or the allocation of resources to maximize present production, is not necessarily compatible with the achievement of maximum growth over a longer period. This would be the case-- and such a possibility may well warrant consideration--if the "enclave" nature of the oil industry denies the country the benefits ("externalities") of an industrialized economy in general, and of the externalities presumably generated by tradable activities in particular. This is the so-called "Dutch Disease," which may be caused by permanent large-scale capital inflows (as in colonial Spain) or by "enclave" exports in wh;ch rent is dominant - oil exports are today's prime example - and which are equivalent to foreign capital inflow for the purpose on hand.1 01 The presumed externalities stenm from a strong learning-by-doing element in activities that compete continuously in an outside market. This hypothesis is supported, though by no means proved, by empirical studies of production functions which conclude that the size of exports, as such, is an element that increases production (beyond

10/ An empirical investigation of the channels through which oil revenues in Venezuela have led to a real appreciation of the exchange rate (hence to the contraction of other tradable activities) may be found in the report by Sebastian Edwards (Ibid.). Oil revenues are indeed found there to be the most important determinant of changes in the real exchange rate.

I - 67 -

market sales of Central Bank bonds has serious monetary implications. To the enttent that the rate of interest on the paper (deflated by the rate of devaluation) is higher than the rate of interest earned on the foreign-exchange holdings, a fiscal liability is ct-.ated. Even more important is that the short-term paper acquired by the public through these sales is liquid enough to be a very good substitute for money. Thus, while this practice determines the stock of the monetary base presumably at its targeted level, the effective supply of money increases beyond that. Since this increase is not fully recognized as such by the government, there is some illusion about the size of money supply. The money involved is an interest- bearing asset roughly indexed, through the level of interest rates, to the rate of inflation. Thus it escapes the imposition of an inflation tax, thereby increasing the rate of inflation resulting from any given level of such tax.

(v) The Monetary Implications of the Budcet. The fiscal stance has an obvious and important impact on the money market. Although no direct government borrowing from the Central Bank takes place to finance a deficit, the monetary implications of a deficit do not thus disappear. The Treasury, short of cash when presented with a payment order authorized by the Ministry of Finance's Controller for service to the government, has one of three courses of action:

1. It can refuse to honor the order--and in consequence create a deficit on an accrual basis financed by involuntary supplier credit.

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

3. It can raise the money through the market sale of short-term Treasury notes, which are recognized as part of commercial-bank reserves for maintaining minimum-reserve ratios. In its impact on the monetary base, this operation would be similar to borrowing from the Central Bank.

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

2.52 In the light of this evaluation of the major issues affecting monetary policy, the following recommendations are made: - 68 -

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

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

2.55 Instruments. Two factors affecting money supply are beyond the control of the Central Bank: governmentborrowing, whether directly from the Central Bank or through the sale of Treasury notes to the public; and the acquisition of foreign-exchangereserves as a government investment (see the following discussion of fiscal policy and the real exchange rate). But the Central Bank does have three instrumentsthat can affect the monetary base or the money multiplier: open-marketoperations; changes in minimum-reserve ratios; and the discount window. In principle,the number of such instruments is not limited: others may be added as institutionsdevelop.

2.56 Open-market ogerations. In conductingopen-market operations,the Central Bank could add transaftionsin securitiesother than its own zero- coupon bonds; specifically,. SA bonds might be introduced. A stock of PDVSA bonds will be created gradually as it turns progressively from long-term borrowing abroad to long-term borrowing in the domestLc capital market. (To a large extent, this would actually establish such a market.) The sale of these bonds would lower domestic liquidity if, indeed, there was a reasonable guarantee that they were replacing, not adding to, borrowing fron abroad. In time, the accumulated stock of PDVSA bonds would be used by the Central Bank in its open-market transactLons.

2.57 Chanaes in minimum-reserveratios. These have been used recently for the first time. They do not affect the size of the monetary base but of the money multiplier (that is, the credit-supplycapacity of the banking system, given the level of the monetary base).

2.58 Assume the two instruments,open-market operationsand changes in the reserve ratio, are employed alternativelyto counter an increase in foreign-exchangereserves of the Central Bank (which, in turn, implies a regime in which the government intervenesin the foreign-exchangemarket). In one instance, the Central Bank sells bonds to equal the increase in foreign- exchange reserves, so that in the end the monetary base is unchanged. In the other case, the monetary base is allowed to increase, but reserve ratios are raised to prevent any increase of domestic credit from the banking system. The difference between the two alternativeswould be as follows: - 71 -

its function as a source of finance of imports). An important presumption - as yet uncontested in empirical studies - is that the effect of externalities is uniform over the factors of production that participate in expandable activities. Were the beneficial effect due to the enhanced quality of just one identifiable factor, a less costly policy might have been the subsidization of that factor in the production of exports rather than the uniform promotion of all exports implied by a higher level of the real exchange rate.

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

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

1-/ Thib impact would be "limited" rather than nil due to a real- balinr-e affect: if money supply is not expanded vari oassu with the rate of (continued...) - 72 - which the government would change the real exchange rate is, thus, the creation of a budgetary surplus and its use to finance the acquisition of foreign exchange.

2.66 The unique position of oil revenues in Venezuela's economy leads automatically to the creation of a budgetary surplue by an increase in the real exchange rate. This is the essence of our earlier discussion of the nature of the stabilization policy of 1989. Since the government, through PDVSA, is the major supplier of foreign exchange, an increase in the relative price of foreign exchange yields increased government revenues (through larger transfers from PDVSA) and an increased surplus. 'his automatic impact partly obviates the need for any further action to increase the budgetary surplus.IV It is estimated that, with Venezuela's present attributes, a one percent increase in the real exchange rate would yield additional government revenues (net of increased expenditure on the government's own use of foreign exchange) of US$80-100 million dollars. Thus, for example, a 10 percent increase in the real rate would automatically create a budgetary surplus of some 1.5 percent of GDP, which, in turn, would amount to a ratio of 20-25 percent of non-oil exports.

2.67 It is essential for the government to realize that the increase in revenues should not be a signal for increasing expenditures. The increase must be devoted to the creation of a budgetary surplus, if the real-exchange rate depreciation is to be sustained. Moreover, this surplus should not be a tempora.Ly phenomenon bst a permanent feature of the budget. One possible mechanism conducive to such behavior, suggested earlier, is the proposed oil stabilization fund, which would transfer annually to the government's budget ll/( ... continued) nominal devaluation, real money balances would decline, thus enabling some increase of th. real exchange rate. The trade (current-account) surplus would then be made possible by increased saving, required to re-establish real money balances; and a reduction of domestic investment due to higher real interest rates. la/ Assume that all foreign exchange in the econor.y is supplied by the government (and demanded by private agents). When the Central Bank introduces its own demand, to raise the exchange rate, it accumulates reserves and pays with domestic monrey. If the elasticity of demand for foreign exchange is unity, the amount of money paid is identical ts the size of additional revenues flowing to the government, and thus to the increase in the budgetary surplus. No net injection of money takes place, and no need exists for any further government or Central Bank action. If demand elasticity is below unity, the budgetary surplus would exceed the size of payments for acquired reserves; whereas the relationship would be reversed with an above-unity elasticity. The concrete case of Venezuela is not so extreme, although the deviation from the hypothetical case is not overwhelming (oil exports being 70 to 80 per cent of total exports, and not much below this as a fraction of total foreign-exchange supply). The deviation would become bigger, of course, the more the increase of the foreign-exchange rate raises private-sector exports. - 73 -

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

2.68 At the end of thiu process, the structural changes introducedby it would be a higher real exchange rate leading to a higher share, and diversification,of non-oil tradable activities, and the creation of a current-accountsurplus. This surplus would be reflected in the accumulation of foreign-exchangereserves; that is, in an investment abroad. This, in turn, would be offset by a reduction of domestic consumption and investment, with investment being directed in a pattern quite different from what it would have been without a change in the real-exchangerate.