DOCUMENT OF THE INTER-AMERICAN DEVELOPMENT BANK

BRAZIL COUNTRY PAPER

JULY 2000

EXPLANATORY NOTE In addition to minor editorial changes, the following information has been added to this final version of the country paper for Brazil: additional information on the issues of gender, poverty reduction, the environment, civil society, tax reform, and Bank action for regional integration a summary of the budgetary priorities for the Government of Brazil the link between the fiscal adjustment program and the Bank program the role of the private sector in the energy sector additional indicators to monitor achievement of the social sector and fiscal reform objectives

CONTENTS

EXECUTIVE SUMMARY I. CHALLENGES AND PROSPECTS .......................................................................................... 1 1. Main development challenges................................................................................... 1 The challenge of achieving faster, more equitable, sustainable growth.................. 3 The challenge of public sector reform ..................................................................... 4 The challenge to make Brazil more competitive..................................................... 5 The challenge of inequities and poverty.................................................................. 6 The challenge of integration .................................................................................... 8 The "Avana Brasil" Plan and the macroeconomic outlook .................................... 8 The government's Multiyear (2000-2003) "Avana Brasil" Plan ........................... 8 Macroeconomic outlook ........................................................................................ 10

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OBJECTIVES AND STRATEGY ........................................................................................... 11 1. Recent Bank activities ............................................................................................. 12 a. The strategy pursued since 1996 ................................................................... 12 b. The Bank's impact ......................................................................................... 12 c. Recent loan approvals and current portfolio ................................................. 13 Action areas in the Bank's strategy ......................................................................... 15 a. Modernization of the State ............................................................................ 16 b. Improving competitiveness and market access by lowering the 'Brazil cost' and modernizing the economy................................................... 17 c. Reducing social inequities and poverty......................................................... 23 d. Environment and natural resources ............................................................... 27 Bank support for integration ................................................................................... 28 Civil society............................................................................................................. 28 Lending scenarios.................................................................................................... 29 Coordination with Private Sector Group instruments............................................. 30 Complementarity with other funding sources......................................................... 31 Strategy implementation risks................................................................................. 32 Monitoring the strategy's implementation .............................................................. 32

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3. 4. 5. 6. 7. 8. 9.

III. TOPICS FOR DIALOGUE WITH THE AUTHORITIES ............................................................. 33 ANNEX: PIPELINE

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EXECUTIVE SUMMARY

Background

Official medium-range planning is a requirement in the Brazilian Constitution, to be built around four-year periods that start one year after a new administration takes office. Brazil's current government began its term in January 1999. This paper covers the same time span as Brazil's multiyear plan for 2000-2003, which takes in the last three years of the present administration and the first year of its successor. Brazil is facing five main challenges for socioeconomic advancement, around which an analysis and determination of strategy guidelines have been structured: reviving economic growth with social equity and respect for the environment, preserving the stability achieved; public sector reform, since key structural reforms must be completed quickly if the fiscal deficit is to be pared; improving competitiveness by substantially lowering the so-called `Brazil cost', modernizing the nation's production apparatus, and supporting microenterprise and small business; addressing social problems, particularly poverty, uneven income distribution, unequal access to basic social services, and inefficiencies in social spending; revitalizing and deepening regional integration.

Development challenges

Multiyear "Avana Brasil" Plan (2000-2003)

The government has unveiled a four-year capital investment and spending plan called "Avana Brasil" to serve as a conceptual and financial framework for what it proposes to accomplish over the next few years. The new development approach embodied in the plan calls for integrated advancement of all regions of the country by heightening competitiveness, raising standards of living, and decentralizing decision-making, with careful attention to the environment. The strategy framed for the Bank is concordant with the "Avana Brasil" plan and with the Bank's Eighth Replenishment mandates. Its core objective is to cooperate with the government in efforts to achieve growth with stability and to reduce inequities and poverty.

Strategy objective

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Executive Summary

Strategy components

In light of the new macroeconomic environment in Brazil since mid1999 and the content of the 2000-2003 Multiyear Plan, the following will be the central focuses of the Bank's strategy: Foster and deepen reform and modernization of the State at the federal, state, and municipal level. Support efforts to make Brazilian products more competitive and improve their market access, helping in initiatives to lower the `Brazil cost' and modernize the economy by strengthening the financial system, supporting microenterprise and the small and mid-sized business sector, rehabilitating basic infrastructure, promoting integration, and developing tourism. Support efforts to reduce social inequities and poverty with priority to the education and health sectors, including actions to make social spending more efficient and decentralize social services, building partnerships with the community and civil society. Address environmental management and natural resources problems, with an emphasis on protecting fragile ecosystems.

Lending scenarios

In keeping with recent approval levels and with spending constraints in Brazil associated with its adjustment process, a base lending scenario of US$6 billion is envisaged for 2000-2003, i.e., an average of US$1.5 billion a year. This is below the figure for the previous period. Also presented is a lower, US$4 billion scenario that would come into play if constraints on federal budget spending and subnational governments' financial capacity are not eased as expected. The Bank's priority concerns: poverty, reform of the State, competitiveness, integration. Operation of the adjustment program and its effect on the Bank's operations portfolio and pipeline Status of legislative approval of strategic reforms: social security, fiscal responsibility, tax reform Subnational government finances Progress on the Multiyear "Avana Brasil" Plan.

Topics for dialogue

I.

CHALLENGES AND PROSPECTS

1. Main development challenges 1.1 Three major shifts in Brazilian development policy have shaped the socioeconomic backdrop for Bank operations in that country in recent years. The first was the 1990 decision, as a national goal, to open up the economy, to help build modern productive sectors that could compete successfully in global markets. To that end, Brazil lowered customs tariffs and did away with other forms of protectionism that had underpinned industrial development for decades. In 1990 it signed the Treaty of Asuncion creating MERCOSUR. A further aim of the modernization strategy was to scale back hitherto heavy State involvement, mainly by way of a privatization program and constitutional reforms to spur foreign investment. The second change was the adoption of measures to curb inflation, which had skyrocketed between 1990 and 1993 at an average annual rate of 2,470%. This move was essential to tackle the widening fiscal deficit that had been aggravated by automatic wage, contract, exchange-rate and other price-indexing arrangements. Apart from rekindling inflationary expectations, these indexing mechanisms made for suboptimal resource allocation and worsened poverty levels. To address this set of problems, the government launched the Plano Real (Real Plan) in June 1994. This innovative stabilization program brought in emergency fiscal measures, abolished most indexing mechanisms and, as its centerpiece, pegged the new currency unit, the real, to the U.S. dollar. The keynote of Brazil's exchange-rate policy in the first months of this Plan was virtual parity in value of the real and the dollar. However, prompted by concerns about the competitiveness of the country's exports, the authorities moved to a crawling-peg approach in their new economic policy, adjusting the exchange rate in small increments. Thanks to its Real Plan and trade liberalization moves, Brazil was able to stabilize prices: inflation plummeted from a June 1994 monthly rate of 50% to less than 1%, on average, in 1995-1999. This climate of price stability, unprecedented in the modern era in Brazil, significantly bettered the lives of low-income groups as their purchasing power soared. The aforementioned gains notwithstanding, the Real Plan's macroeconomic policy underpinnings were showing signs of strain even before the Asian crisis erupted in the last quarter of 1997. One of the main problems was the effective real appreciation of the real, a result of how the new exchange-rate policy had been put into practice. This, coupled with mounting import volumes as the economy opened up, took a severe toll on the trade balance, which plunged from a US$13 billion surplus in July 1994 (12-month figures) to a deficit of US$9.7 billion at its August 1997 low. To remedy this situation and attract external capital to fund the growing current-account deficit, the authorities pushed up interest rates; this in turn dampened economic activity and strained the public finances.

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The picture worsened from 1998 onward as the Asian crisis deepened and Russia declared a moratorium on debt payments. The most serious development for Brazil was a loss of investor confidence that triggered heavy outflows of capital and a hemorrhage of foreign reserves. An IMF standby arrangement signed in November 1998 was not enough to halt the deterioration: in January 1999, the authorities decided to let the exchange rate float. The third fundamental change in Brazil's economic policy was the adjustment of the exchange-rate system. The immediate result of the changeover was a steep devaluation. The authorities thus worked out a revised arrangement with the IMF in March 1999, with heftier targets for the primary surplus: 3.1% of GDP for 1999 and 3.5% for 2001. BRAZIL: Trade balance (bars) and effective real exchange rate index (line)
20 15 10 5 0 -5 -10 200 150 100 50 0
99 19 8 9 19 7 9 19 6 9 19 5 9 19 4 9 19 3 9 19 2 9 19 1 9 19 0 9 19

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Brazil's economic performance in 1999 was stronger than had been forecast at the start of the year. It managed to stave off severe recession, posting 0.8% growth in GDP rather than the projected 4% decline. The devaluation also had a lighter-thanexpected impact on prices: the 20% rise in wholesale prices was well below the 30% some analysts had anticipated, and far less than the 60% hike predicted by others. Consumer prices rose by just 8.9%. The dark spot in this otherwise promising picture was a 6.1% falloff in exports, owing largely to turbulence on global markets and the recession in Latin America, notably in Argentina, Brazil's largest MERCOSUR trading partner. Brazil's success in adjusting to the new exchange-rate regime can be attributed to a combination of factors: a healthy financial system, record agricultural harvests, and a substantial improvement in the public-sector primary balance, which attested to the government's resolve to improve the fiscal accounts. This higher primary surplus, which overshot the target worked out with the IMF, was also decisive in winning back investor confidence. US$30 billion in foreign investment flowed into the country in 1999, up US$4 billion from the previous year. The heavier stream of foreign investment also helped rebuild Brazil's international reserves, which rose by over US$6 billion to stand at US$42.2 billion at the end of 1999 (equivalent to nine months of imports). The cumulative benefits of structural reforms to date, such as a more open economy, regional integration, greater fiscal responsibility, and privatization, are

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Effective real exchange rate index 1990 = 100

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transforming Brazil into a truly modern nation, more resistant to chronic inflation. The country's privatization program - one of the most sweeping of its kind anywhere in the world - has been pivotal in this context, more than 120 public enterprises having been sold off since 1991 in virtually every sector of the economy. It has helped modernize Brazilian industry and utility companies and make them more competitive, and has provided much of the money needed to fund current-account and budget deficits. 1.11 To sum up: these decisive shifts in development policy in recent years have had enormous repercussions in the country and pose distinct challenges for the years ahead. These are outlined in the following paragraphs. The challenge of achieving faster, more equitable, sustainable growth. Even with the considerable gains achieved in price stability and structural reforms, the Brazilian economy has languished since the mid1990s. Real GDP growth rates slipped from an annual average of 5% in 1993-1995 to 3.1% in 1996-1997 to close to zero in 1998-1999. BRAZIL: GDP growth (%)
5 4 3 2 1 0 -1 4.2 2.7 0.8 -0.12 1995 1996 1997 1998 1999 3.6

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The 1993-1995 slowdown can be traced in large measure to Real Plan policies. The same high interest rates that had helped the country secure the external funding it needed also dampened economic activity, pushed up unemployment and swelled the informal economy, and increased the sovereign risk for government borrowings. The downturn was exacerbated by the turmoil in Asian markets in late 1997 and by fiscal shortfalls that worsened as public debt service and the social security system deficit both increased. The toll that these years had taken became evident in 1999 as frustration with the weak economy mounted, and with it the pressure for stronger growth rates. This will be no easy task for Brazil, which wants to build certain features - stability, equity, and respect for the environment - into the growth blueprint it elects. As the experience of many countries in the 1990s has shown, macroeconomic equilibrium is a necessary backdrop for a strategy pursuing swift, equitable, sustainable growth. This is a paramount consideration for Brazil, to make certain that moves to propel growth do not jeopardize hard-won price stability, since a return to the high inflation and across-the-board indexing of the past would be disastrous for the economy and for the Brazilian people. Accordingly, one of the government's weightiest challenges in the short term is how to rekindle economic growth of the kind described above. To that end, Brazil will

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have to reinforce its efforts to achieve the right kind of fiscal adjustment, since the public finances are still the leading contributor to macroeconomic imbalances. 1.16 The challenge of public sector reform. Revamping the public sector was one of Brazil's central targets for the 1990s. Some moves in this area have already yielded significant gains, two highlights being a late-1998 constitutional amendment that ushered in an overhaul of the federal social security system, and new programs launched to strengthen and modernize federal and state government administration and taxation areas. Thanks to these initiatives and stable prices, the public sector borrowing requirement (nominal deficit) narrowed considerably, notably in 19951996. However, the public finances worsened again in 1997, in part because of heavier subnational government spending and the spillover from the Asian crisis. The performance of the public finance accounts in 1999 was mixed. On the plus side, the public-sector primary surplus stood at 3.13% of GDP, overshooting the IMF target by R$913 million. On the minus side, increases in accrued interest were heftier, to 13.14% of GDP, largely because of the devaluation of the real. This pushed up the nominal deficit (primary surplus plus accrued interest) from 8.06% of GDP in December 1998 to 10.01% in December 1999. This trend can be expected to reverse quickly in 2000, when the initial impact of the devaluation has been absorbed. Though the outlook is generally positive, the public finances are still Brazil's most vulnerable area. The challenge will be to maintain and entrench the fiscal adjustments accomplished thus far, to restructure the public sector and improve its efficiency. The more immediate problem is the need for further social security reforms, both in the general plan covering private-sector workers and the civilservice plan. The overall system deficit of US$21.6 billion in 1999 (equal to 5% of GDP) was considerably higher than the previous year. The public-service plan accounts for the lion's share of the problem: it serves only 2.3 million of a total of 21 million people with coverage, yet it posted a deficit of US$16.4 billion (3% of GDP). Social security reform efforts have run up against strong political resistance and legal obstacles, but the authorities have made major strides. Their key strategies for curbing the two system's rising deficits and placing them both back on solid financial and actuarial footings were as follows: raise the

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BRAZIL: Social security system deficit in Brazilian reals (bars) and as a % of GDP (line)
As a % of GDP 60 $R billion 40 20 0 1997 1998 1999 6 4 2 0

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minimum retirement age; change the core eligibility criterion from years of service to age (the average retirement age in Brazil is only 53); create incentives for workers to defer their retirement; and tie pension amounts to contribution records. Other focuses in regard to the civil-service plan were the abolishment of special retirement schemes and other elements that were jeopardizing the system's actuarial viability. 1.20 As one step in resolving these problems, the authorities are seeking approval, in early 2000, of a constitutional amendment that would boost worker and retiree contributions. However, many of these reforms will apply only to new workforce entrants, so it will take time, and other measures, to see any significant improvement in the social security deficit. The system's straits also are affecting state and municipal governments, as benefit payments to retired public servants rise more quickly than the intake from active contributors. The government is working concurrently on other urgent reforms. Among them is an overhaul of the tax system, one aim being to redistribute the tax burden and give the nation a more equitable, efficiently managed, economically neutral taxation system, to effectively bring down the `Brazil cost'. As of mid-2000, the economic authorities and the legislature were developing the reform, enactment of which would nevertheless still have to overcome major obstacles. Among other problems the current Brazilian fiscal system for transfers from the federal government to subnational governments is very complex. Since the tax burden is already quite heavy (approximately 30% of GDP), the new tax system is not likely to increase it. Progress on this front is essential if Brazil is to raise public saving rates, whereupon it can boost public investment (which has averaged less than 2% of GDP in recent years) and lower financial market interest rates. The problem of subnational government finances is also being addressed by the authorities, one noteworthy measure being the Fiscal Responsibility Act slated for passage in mid-2000. This law caps state and municipal government indebtedness at a percentage of expendable revenues, permits borrowing only for capital expenditures, limits wage bills, and requires that any spending increase that has implications for more than three years be offset by reductions in other expenditures and/or revenue increases. The law also mandates the publication of budget estimates and periodic `report cards' on government financial performance, making for greater fiscal transparency. There is work to be done in the judicial branch as well, to shorten legal proceedings, streamline the many levels of jurisdiction, and ensure that the population, and particularly the poor, have access to the justice system. The challenge of reducing the `Brazil cost' and modernizing productive sectors to make Brazil more competitive. Brazil has made substantial, albeit uneven, progress in this direction. When import barriers began to come down in 1990 the country's producers found themselves exposed to international competition for the first time. After the adoption of the Real Plan in 1994 it was more important than

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ever for the nation to become competitive, particularly in the production of tradable goods. These developments alone were enough to trigger a dynamic restructuring process. 1.25 Industrial productivity is up sharply in recent years, showing that producers have successfully adapted to the new environment despite lower tariffs and high borrowing costs. However, these gains are overshadowed by the fact that industry growth rates have lagged far behind other sectors. When productivity is on the rise but growth in goods and services is sluggish, the economy cannot create the jobs and incomes that Brazilians are demanding. The roots of this disparity, which are lumped into the term `Brazil cost', are well known: high interest rates, onerous taxes, and inadequate infrastructure. The country has had some success in lowering the `Brazil cost' since the early 1990s thanks to the rehabilitation of transportation and energy infrastructure. However, meaningful reductions will only be achieved through sweeping publicsector reforms, to make government work more efficiently and substantially boost public saving. For Brazil to become more competitive, simultaneous advances will be needed on other fronts, particularly in governance. The chief impediments to business operation and growth, according to IDB-World Bank business climate surveys, are complicated regulatory frameworks, official interference in business decisions, and security problems. Work to restructure the productive sectors continues today. Modernization moves thus far have focused less on heavy investment outlays than on resource rationalization and productivity enhancements, which carry a cost in the form of lower formal employment. One result has been an upsurge in informal-sector activity and the birth of huge numbers of small businesses. A major challenge now for Brazil will be to help microenterprises share in the nation's development process. Another of the country's goals is to improve environmental quality at every stage of productive activity, from curbing pollution to improving occupational health and safety (which is particularly complicated in small businesses and microenterprises) to integrated watershed management. The challenge of inequities and poverty. This is perhaps the knottiest challenge facing Brazil. Though it has made considerable inroads into these problems, some of the gains have been short-lived or confined to specific areas. To look first at the question of income: in the wake of the government's 1990 decision to open up the country's markets, and particularly after it adopted a new exchange-rate policy in 1994, inflation rates tumbled and prices stabilized. This directly benefited the country's poorest, who with their enhanced purchasing power could buy more basic food and durable goods. The ranks of Brazilians living in extreme poverty fell sharply, from 43.3 million (30.4% of the population) in 1993 to a fairly stable average of 31.3 million (20.9% of total population) in 1995-1997.

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By late 1997, the improvements in purchasing power that price stability had brought to Brazil's poor came to a halt, first because the economy slowed in the wake of the Asian crisis, and later because of the January 1999 devaluation. In this most recent period, job creation in the formal labor market declined and the country's income distribution remained very uneven (in 1998, the poorest 40% of the economically active population received barely 9.4% of total income; the wealthiest 10% took in 46.5% of the total). The challenges the government faces to fight poverty and promote citizenship and social inclusion are particularly important, especially in the northeastern region of the country, marginal areas of major cities, and depressed rural areas. The government is taking short-, medium-, and long-term measures to address the core issues of hunger (distribution of food to rural families in drought-stricken areas), child labor (inspection, supplementary income), and protection of the most vulnerable segments of the population (sports, youth centers, young entrepreneurs, care and health of the elderly). As for social services, even in an era of fiscal restraint Brazil has made impressive gains in education and health care. Thanks to a massive campaign to make primary schooling available to more children, educational attainment levels have climbed quickly, from under four years, on average, in 1980 to five years in 1990 and 6.5 years in 1998, approximating the Latin American average. Health conditions also improved considerably: between 1970 and 1997, life expectancy rose from 61 to 67 years, and the infant mortality rate dropped from 95 to 34 per 1,000 live births. Though these improvements have not been felt equally in all regions of the country, the progress made in education and health status is a clear testament to the ambitious social agenda Brazil has been systematically implementing in recent years. The government also demonstrated its commitment to that agenda in an IDBsupported emergency initiative to protect several top-priority social programs during the fiscal adjustment, designed to cushion the impact of the steep publicspending cuts required in 1999 on low-income groups. Nevertheless, there are still serious gaps in coverage and quality of basic social services. Broader access to these facilities is crucial if the country is to break the cycle of poverty in the medium and long term, reduce inequities, and boost Brazilian workers' productivity and incomes. The situation is particularly acute in marginal urban areas and in the poorest regions like the northeast, where many basic needs of the most disadvantaged segments of the population are still not being met. The enormity of the problem of basic service shortfalls in urban areas is tied to the rapid growth of Brazilian cities, which in 1999 were home to some 132 million people - roughly 80% of the country's population. As a result, huge sections of these cities have insufficient housing, residents living hand to mouth, and high administration and service costs. All of this takes a disproportionate toll on those of

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fewest means. Some much-needed water and sewer system extensions have been held up because of utility companies' institutional and financial problems. 1.37 Although in the past 10 years, women have made major strides in gaining access to education (primary, secondary, and higher) and entering the work force, the government continues to place special emphasis on this issue, through measures to provide both economic opportunities (training, microenterprise development) and specific social services, mainly in the areas of child and adolescent health and protection. The challenge of integration. Reinvigorating and deepening regional integration is another challenge for Brazil. Between 1990, when it first moved to open up the economy, and 1997, its MERCOSUR trade (exports plus imports) soared from US$3.8 billion (11.3% of the total) to US$18.7 billion (16.3% of the total). Difficulties triggered by the 1997 Asian crisis and the turmoil in global financial markets were aggravated by the January 1999 devaluation of the real. Brazil and Argentina, in particular, adopted restrictive measures (customs valuation, antidumping action, import licensing, inspection systems). As a result of those moves and differences in exchange-rate policy between Brazil and its neighbors, interregional trade flows shrank abruptly, particularly in 1999 when trade was down almost 30%. The crux of the integration challenge for Brazil will be to return quickly to the interregional trade growth rates achieved during the early years of MERCOSUR. As part of an initiative to "relaunch" MERCOSUR, the member states have begun adopting measures to strengthen coordination and help rekindle intraregional trade and investment. Two working groups were set up in 1999, one to examine the members' economic policies and come up with macroeconomic harmonization proposals, the other for trade coordination, with a mandate to assess the impact of currency devaluation on trade flows within and outside the group. Though a successful revitalization effort will require stability and growth in all the MERCOSUR states, an upturn in Brazil's economy - the region's largest - will be pivotal. Brazil's planned drive to deepen regional integration could mean new projects to integrate physical infrastructure, promote regulatory systems and protocols to facilitate trade, and other integration initiatives between the MERCOSUR partners, some in nontraditional areas such as health and education. Gradual macroeconomic convergence is expected to be a longer-range target, perhaps including forms of monetary cooperation among the group. 2. The "Avana Brasil" Plan and the macroeconomic outlook 1.41 The government's Multiyear (2000-2003) "Avana Brasil" Plan. According to the Brazilian Constitution, the Executive Branch must produce a four-year capital investment and spending plan for congressional approval, to serve as a conceptual and financial framework for planned government actions. To afford continuity,

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such plans cover the second, third, and fourth years of one presidential administration and the first year of its successor. 1.42 The government that took office in January 1999 modified the multiyear planning approach to include a preparatory study to identify development issues, opportunities and constraints, a definition of geographical "integration enclaves", and a nationwide participatory process of consultations with civil society and local authorities. Unlike previous multiyear plans, the 2000-2003 blueprint called "Avana Brasil" will have objective implications for the programming and execution of Bank activities. Using the new format, the authorities will be able to identify external funding requirements, and the expected contribution of externally funded projects to the Plan's priority programs will be made explicit in terms of development objectives. The Plan identifies three key challenges for Brazil: sustained growth in a stable economy; economic and social progress with respect for the environment, social justice, and democracy; and massive investments in economic infrastructure and in the social sphere that are to create jobs and raise incomes. The Plan states clearly that maintaining economic stability is essential for growth with equity, pointing to the success of efforts to tame inflation and underscoring the need for balanced public finances for a stable economy. According to the Plan, the new development approach seeking integrated growth of all regions in the country will rest on four pillars: heightening competitiveness, raising living standards, decentralizing decision-making, and careful attention to the environment. In the integration area (development and opportunities for all regions) the Plan outlines specific agendas for social progress ("A More Just Brazil"), economic infrastructure ("A Stronger Brazil"), information and knowledge ("A More Competitive Brazil"), and the environment ("A Brazil that Conserves"). The Plan's goals are a government that works efficiently, transparently, and in close touch with the citizenry; a new project management model; integration of budget planning and preparation functions, and particularly the building of strategic partnerships between the federal government, states, municipalities, international agencies, nongovernmental organizations, and the business community, to make the planned programs workable. There is a noteworthy similarity between the priorities mapped out in the Multiyear Plan and the strategy focuses that have guided the Bank's efforts in Brazil since the 1996 country paper, namely: reform of the State, reduction of the 'Brazil cost', and addressing social needs and poverty reduction. The Plan calls for a total of R$985 billion in spending on what it terms "endsdriven" programs (those whose ultimate aim is to benefit Brazilian society), 59% of it for social advancement (64% for social security, 13% for health, 6% for education, 4% for housing and urban development, 1% for sanitation) and 22% for economic infrastructure (78% for energy and 17% for transportation). It names 365

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priority programs and proposes integrated investment actions (federal, local, public and private) worth R$317 billion for nine geographic areas or "development hubs". 1.48 For the year 2000, under the fiscal adjustment program, budgetary allocations for the executive (not including social security, transfers to subnational governments, or payroll) total R$37.7 billion (3.51% of GDP, compared with 4.27% in 1998 and 3.52% in 1999). Of that amount, 67% is earmarked for social development (42% for health, 22% for labor and employment, 7% for education, 7% for social welfare, 3% for sanitation and housing, and 3% for agricultural organization); 7% for the productive sector; and 6% for infrastructure (80% for transportation, 13% for energy, and 7% for communications). Macroeconomic outlook. The forecasts presented in Table 1 rest on a number of core assumptions. The first is that the fiscal adjustment effort will continue. This would help reduce the nominal deficit quickly, from 10.3% of GDP in 1999 to 5.2% in 2000 to 3.8%, on average, in 2001-2004. With this lower deficit, inflation (measured as the percentage change in the implicit GDP deflator) could be brought down to 3.6% in 2000 and hold fairly steady at 4.7%, on average, between 2001 and 2004. The main premise for the marked improvement in the balance of payments posited in the table is that the country would close the period with a US$14.1 billion trade surplus, after reporting a US$1 billion deficit in 1999. Driving the improvement would be export growth (as a result of the new exchange-rate system), further productivity gains, and a recovery of external demand. This latter factor, it should be noted, will depend not just on stronger economic activity in Brazil's trading partners but also on better access for Brazilian products in those markets. These trends would gradually lift the flat growth rates of 1998-1999, with real GDP growth averaging 4.4% in 2001-2004.

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Table 1
BRAZIL. Macroeconomic projections Actual 1998 Change in real GDP Inflation (change in implicit GDP Balance of payments (US$ billion) Current account deficit Trade balance Exports Imports Services + Transfers External debt (net) Fiscal indicators Nominal deficit as % of GDP Memorandum items Current account deficit (% of GDP) Interest rates Exchange rate (R$ to one U.S. dollar) Source: IPEA. November 1999 and RE1/OD1. -4.7% 28.5% 1.2 -4.4% 25.0% 1.8 -3.1% 16.7% 1.9 -2.5% 11.9% 2.0 -2.3% 13.3% 2.1 -2.3% 14.2% 2.2 -2.3% 14.2% 2.3 -8.1% -10.0% -5.2% -3.1% -3.6% -4.1% -4.4% -33.6 -6.6 51.1 57.7 -29.5 206.6 -24.4 -1.2 48.0 49.2 -25.2 189.5 -17.5 6.5 56.3 49.8 -24.0 185.8 -14.5 10.2 62.3 52.1 -24.7 181.9 -14.0 11.9 68.9 56.8 -25.9 179.2 -14.5 12.9 75.0 62.1 -27.4 176.7 -15.0 14.1 81.9 67.8 -29.1 173.8 -0.1% 10.5% Prelim. 1999 0.8% 6.0% 2000 3.3% 3.6% 2001 5.1% 4.3% Projections 2002 4.3% 4.7% 2003 4.0% 4.7% 2004 4.2% 4.7%

II. OBJECTIVES AND STRATEGY 2.1 The core objective of the strategy framed for the Bank matches the thrust of the "Avana Brasil" Plan and is consistent with the Bank's Eighth Replenishment mandates: cooperate in the government's efforts to achieve growth with stability and reduce inequities and poverty. With due regard to the new macroeconomic environment in Brazil since mid-1999 and the content of the 2000-2003 Multiyear Plan, the following will be the central focuses of the Bank's strategy: Foster and deepen reform and modernization of the State at the federal, state, and municipal level. Support efforts to make Brazilian products more competitive and improve their market access, helping in moves to lower the `Brazil cost' and modernize the economy by strengthening the financial system, supporting microenterprises and small and medium-sized businesses, rehabilitating basic infrastructure, developing tourism, and advancing regional integration. Support efforts to reduce social inequities and poverty, with priority to the education and health sectors, including action to make social spending more efficient and decentralize social services, building close partnerships with the community and civil society.

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Address environmental management and natural resources problems, with an emphasis on protecting fragile ecosystems.

1. Recent Bank activities a. The strategy pursued since 1996 2.2 A qualitative assessment of the Bank's strategy for operations in Brazil as set out in the approved 1996 country paper points up the following: The 1996 strategy was very much on the mark: its focuses proved to be central issues in Brazilian development - reform of the State, reduction of the 'Brazil cost', and poverty. By virtue of the dialogue sustained between the Bank and the Brazilian authorities, the latter gained a strong sense of ownership of the strategy. The Bank was extremely consistent in implementing its strategy: the established focuses and priorities were heeded in all operations approved over this interval. Another point worthy of note is that the strategy was applied from the start, with similar numbers and volumes of approvals each year. The Bank's actions were appropriately scaled in terms of its own output capacity and the country's absorption capacity (though, owing to spending constraints, aggregate loan approvals were lower than in the original scenario).

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As for the strategy's implementation, the Bank efficiently translated the strategy guidelines into active projects, the time required for contract ratification and signature and fulfillment of conditions precedent having been shortened considerably. Its action also has been effective: in only one operation (and only temporarily) was there any question as to whether the ultimate development objectives would be attained. b. The Bank's impact

2.4

In a country as vast as Brazil, the relevance of the Bank's activities lies not in the relative size of its financial support but in how it targets its efforts and what it has accomplished as catalyst and innovator. It has a very high profile as a contributor to priority elements in the "Brazil in Action" and "Avana Brasil" plans, which are compendiums of the government's key strategic investments. The Bank's focus in the course of its collaboration with Brazil has evolved from productive infrastructure to sanitation infrastructure, urban problems and poverty, the social sectors, work with subnational governments, and reform of the State. A list of Bank efforts that have been successful by reference to their impact in key areas of concern for Brazil's development would include the following:

2.5

- 13 -

In the areas of improving competitiveness and national and regional integration: Expansion of road infrastructure at the federal and state levels, in cities, and linking Brazil with its neighbors. This has had a marked effect on highwaysector administration, furthering decentralization and increasing privatesector participation. The supply of medium-term finance to small and mid-sized businesses by way of multisector credit programs channeled through commercial banks. Huge electric power and gas infrastructure projects to integrate different Brazilian regions and link the country to its neighbors, with a growing measure of private-sector involvement.

In areas of the social agenda and urban problems: Programs and projects to resolve problems associated with unregulated and substandard housing, by introducing integrated barrio improvement, housing and services models to tackle this critical concern in Brazilian cities today. Pioneering initiatives to address the problems of children and youth in marginal urban areas, including training, working closely with civil society. Support for health and education reforms and, during the crisis and fiscal adjustment, new social protection initiatives. Credit and technical support for microenterprise, notably activities to create and strengthen the capacity of Brazilian institutions to assist that segment of the economy, and support for small-business development.

In the area of modernization of the State: Modernization and reform of federal, state, and municipal taxation systems and administrative apparatus, with an impressive impact on revenue intake and use.

In the environmental area: Environmental sanitation and amelioration plans for bays and watersheds, blending cleanup measures with actions that produce a strong social impact. Environmental management projects for critical ecosystems, with an ecotourism dimension. c. Recent loan approvals and current portfolio 2.6 In the 1996-1999 period the Bank approved a total of US$9,728.9 million in funding for Brazil: 31 investment loans totaling US$5,939.8 million, eight private-

- 14 -

sector operations (A loans) for a total of US$389.1 million, and two Emergency Program operations totaling US$3.4 billion. The following table shows the number and amount of these loans by the strategy focus pursued (of the three set out in the most recent country paper):
Number Reform and moderniz. of the State 4 Administrative reform 2 Fiscal management 2 Modern. of prod. and Brazil cost 17 Transportation 11 Energy 4 Credit 1 Other (liberaliz.) 1 Social inequities and poverty 18 Education 3 Health 2 Urban poverty 4 Social reform and protection 1 Sanitation 3 Tourism and environment 3 Other social (credit) 2 TOTAL Investment loans * % AmountUS$Mill % 10.2 882.0 13.9 82.0 1.4 800.0 12.6 43.6 2,697.1 42.6 1,200.1 19.0 722.0 11.4 750.0 11.9 25.0 0.4 46.2 2,749.8 43.4 600.0 9.5 535.0 8.5 829.0 13.1 42.0 0.7 296.3 4.7 97.5 1.5 350.0 5.5 6,328.9 100.0 TOTAL* AmountUS$Mill 882.0 82.0 800.0 3,897.1 1,200.1 722.0 1,950.0 25.0 4,949.8 600.0 535.0 829.0 2,242.0 296.3 97.5 350.0 9,728.9 % 9.1 0.8 8.2 40.1 12.3 7.4 20.0 0.3 50.9 6.2 5.5 8.5 23.0 3.0 1.0 3.6 100.0

39 100.0

* Note: Investment loan figures include eight PRI operations; TOTAL includes two Emergency Program loans.

2.7

The volume of 1996-1999 approvals added greatly to the size and complexity of the Bank's portfolio of active loans in Brazil, which is its largest. As significant as the portfolio's rapid growth and aggregate amount are the large number of operations, program size (averaging US$190 million, not counting the emergency operations), the operational difficulties associated with a wide array of borrowers and executing agencies - federal government, state and municipal governments, public enterprises and banks, private sector - and the geographical dispersion of operations from one end of this vast country to another. In February 2000 the Bank's active loan portfolio in Brazil was made up of 19961999 approvals plus 19 previously approved operations (totaling US$3,828.3 million) that are nearing completion, 74.4% of their proceeds having been disbursed. This makes for 59 operations in all, totaling US$13,624.7 million, with a disbursement rate of 47.5%; this group includes seven PRI operations for US$456.6 million. There also are 62 nonreimbursable technical-cooperation operations under way in the country for a total of US$74.9 million, 22 small projects for US$10.9 million, and 14 MIF operations for US$27.3 million. In early 1999 the Bank approved two fast-track operations totaling US$3.4 billion under its new emergency-lending mandate that came out of the Asian crisis, and as part of a concerted effort with the World Bank and IMF. This support took the form of a US$2.2 billion social reform and protection program cofinanced with the World Bank and a US$1.2 billion credit program with Banco Nacional de Desenvolvimento Econmico e Social (BNDES) targeting small and mid-sized

2.8

2.9

- 15 -

enterprises (SMEs). The social protection operation was approved by the Brazilian Senate after lengthy committee reviews that sparked wide-ranging public debate on the situation of the most vulnerable segments of society during the financial crisis and how they would be affected by adjustment measures and tightened spending. The first disbursement under that program (US$1.122 billion) was released in December 1999; as of February 2000 over US$500 million had been disbursed for the SME operation. 2.10 Complex though the portfolio of Bank operations in Brazil may be, its implementation record has traditionally been very good thanks to a coordinated monitoring system and periodic meetings between the Ministry of Planning's International Affairs Secretariat and the Bank. According to the December 1998 portfolio performance review, it was "probable" or "very probable" that all the programs would achieve their development objectives; only four loans were rated "unsatisfactory" as to execution, a showing consistent with previous years. Nevertheless, the tightening of government spending since 1999 is having an effect on the portfolio, reflected in a new kind of "operation with implementation problems" where the difficulties are not stemming from internal situations and the solution lies outside the control of the executing agencies and the Bank. In the December 1999 review exercise, the implementation of 15 programs (of 48 evaluated) was rated unsatisfactory. The problem in eight of the operations was the availability of funds; in six, the unsatisfactory rating can be attributed entirely to spending authorization constraints. As for "development objectives", it was reported that all but one of the projects would "probably" or "very probably" meet those goals. The single exception was given a temporary rating of "doubtful"; the situation has since been rectified. The rapid growth in the Bank's portfolio was matched by increases in annual disbursement volumes, from US$812 million in 1996 to US$1.647 billion in 1998. In 1999, even in the climate of fiscal restraint, that upward trend held for programs that did not rely on the federal budget and for the emergency loans. A total of US$1.362 billion was disbursed in 1999 under regular operations and US$1.646 billion for emergency loans. Consequently, Brazil posted positive net annual cash flows, topping US$950 million in 1998 and, by virtue of the emergency loans, exceeding US$2 billion in 1999. 2. Action areas in the Bank's strategy 2.13 In order to address the challenges Brazil has identified and in line with Bank priorities and the government's agenda, the Bank will focus in 2000-2003 on four strategic areas, bringing to bear a combination of its funding facilities and other forms of support - investment loans, nonfinancial products and services, technical cooperation, and private-sector support. These areas are structured around four themes: modernization of the State, competitiveness, poverty, and the environment.

2.11

2.12

- 16 -

2.14

The proposed Bank action implies concurrent, integrated work in the four strategic areas identified to achieve the central objective of growth with stability and reducing inequality and poverty. It reflects the understanding that in order to achieve the social objective of reducing poverty and inequality and the economic objective of growth with stability in the long term, there is an urgent need for modernization of the State, improved competitiveness, and economic modernization through a complex set of integrated activities at the federal, state, and local levels involving both the public and private sectors. Because of the magnitude of the challenges facing Brazil and its vast geographic expanse, the Bank will endeavor in each priority target area to select spheres in which the impact of its contribution can be maximized. It also will seek ways in which it can efficiently serve smaller, dispersed borrowers (small and mid-sized businesses and microenterprises, municipal governments). To that end, it will help forge strategic partnerships with Brazilian institutions that can bring experience and expertise while mobilizing resources of their own for such efforts. A first step in this direction was the initiative launched with BNDES in 1998. a. Modernization of the State

2.15

2.16

Modernization of the State is the most critical challenge for Brazil for two interrelated reasons. First, if it can advance in this area the country can reverse the downturn in public saving, which measured by the national accounts plunged from 5.9% of GDP, on average, in the 1970s to -0.7% of GDP in 1996-1997. Second, Brazil's success in tackling its other challenges will unquestionably depend on its success in boosting public saving. This is particularly true in the case of modernization of productive sectors, lowering of the 'Brazil cost', reducing social inequities and, above all, for keeping prices stable and moving the economy back onto a sustainable growth path. Because of its intertwined effects and given the current synergies, modernization of the State will be the unifying concept of the Bank's strategy for 2000-2003. In 2000 the government will continue to seek passage of legislation to improve fiscal management, with a second phase of reforms to modernize the Brazilian State: the Fiscal Responsibility Act, further social security reform measures, and tax reform. However, the complete fiscal adjustment process is taking a long time because the administrative process to secure the requisite constitutional amendments is cumbersome and politically intricate, and few subnational governments have the capacity for efficient administration and fiscal management. The Bank thus will continue to give high priority to modernization of the State, with improvements in efficiency and transparency of the workings of government as its strategy guideline. Its actions will follow two broad lines. First, given the serious state of the country's social security system and its contribution to the fiscal deficit, the Bank will support efforts at every level of government to overhaul the system. Independent of political-process requirements (approval of new reforms, amendments, and laws), the Bank can do much to help strengthen elements of the

2.17

2.18

- 17 -

management of the private and public social security schemes (contributions, awarding of benefits), the design of social security models at the subnational level, and pension fund development and management. Second, the Bank will step up its support for the area of administrative and fiscal modernization at the federal, state and municipal levels. These efforts would directly complement the strategic objectives in the government's Multiyear Plan: balance the public finances and make government work more efficiently.
Active operations
FISCAL MANAGEMENT, STATES NETWORK IPEA, IBGE, FGV & OTHERS TC EXTERNAL RELATIONS TC TAX ADMINISTRATION ADMIN. REFORM-MIN.STATE ADMIN. LEGISL. INTEGRATION FISCAL MANAGEMENT, MUNICIPALITIES REGUL. FRAMEWORK PENSIONS (MIF) LABOR MEDIATION (MIF) CONSUMER PROTECTION (MIF) MEDIATION AND ARBITRATION (MIF)

US$MILL
500.0 25.0 10.0 78.0 57.0 25.0 300.0 1.2 1.5 0.8 1.0

New operations identified

MODERNIZ.SOC.SEC.REVENUE AREA FISCAL MGT. MUNICIPALITIES 2 COMPETITION POLICY (MIF)

US$MILL
85.0 400.0 0.5

b. Improving competitiveness and market access by lowering the 'Brazil cost' and modernizing the economy 2.19 The Bank will give continuing priority to lowering the 'Brazil cost' and modernizing productive sectors, by supporting the country's efforts to invigorate infrastructure investment, strengthen the financial sector, serve the needs of SMEs and microenterprise, promote occupational health programs, improve the environmental quality of productive activities, develop tourism, and bring in sound regulatory frameworks. Support for these areas will be provided as well by the MIF and the private-sector window, which will continue with electricity and transportation project finance. The Bank's planned actions in this strategy area would support government priorities set out in the "Avana Brasil" Plan ("A Stronger Brazil", "A More Competitive Brazil"). Road transportation. With Bank support, the government has successfully implemented highway modernization projects on major corridors, including road rehabilitation work, doubling the number of lanes on highways, and private concession arrangements. This has eased congestion and reduced accidents. Through PRI, the Bank initiated financing for concession operators for heavily traveled thoroughfares. Brazil relies on its road network for virtually all intercity passenger transit and for 60% of freight traffic, yet only 10% of the total system is paved. Moreover, a substantial portion of the network has reached the end of its service life or has been damaged by overweight vehicles, and needs restoration. Most roads pose safety hazards or need work to remedy and prevent slope erosion and other environmental problems. There is an urgent need to double lanes in the larger cities to remove bottlenecks that are holding back development. The Bank will offer support for highway transportation at the federal and state level, specifically for integration routes to facilitate regional trade; decentralization

2.20

2.21

2.22

- 18 -

and rehabilitation of the federal highway system, including road transfers to the states; rehabilitation, expansion and concessioning out of major arterials, with special support from PRI; state roads programs, including strengthening of road management and maintenance agencies; and direct finance for private concessionaires. 2.23 Urban transit. The increase in the number of vehicles moving around Brazil's largest cities is worsening pollution, lengthening travel times, and generally driving up transportation costs, taking a particular toll on low-income residents who rely on public transit. The Bank will continue to support the development of economically efficient, environmentally sustainable urban transit approaches, building on successful ventures in the country like the Curitiba bus system and So Paulo's commuter train network. Priorities in all such programs will be traffic safety and private-sector involvement. Transportation sector reforms will open up new opportunities for project finance and technical assistance in the port, airport, and rail transport spheres. For ports, Bank efforts can help lower foreign-trade costs through modernization projects and institution-strengthening. For airports it can support the building and expansion of facilities, particularly in promising areas for tourism development, and initiatives involving air transport safety. Its role in railroad projects could be to help Brazil integrate its rail systems with those of neighboring countries and mesh the operations of different national concessionaires.
Active operations
STA CATARINA ROADS FERNAO DIAS HIGHWAY SO PAULO COMMUTER TRAINS CURITIBA URBAN TRANSIT FERNAO DIAS II HIGHWAY RIO GRANDE DO SUL ROADS CEARA II ROADS DECENTRALIZ. FEDERAL HIGHWAYS BAHIA II ROADS YELLOW LINE (PRI) DOS LAGOS TOLL ROADS (PRI) CASTELO RAPOSO TAVARES TOLL (PRI) ANHANHUERA-BANDEIRANTES TOLL (PRI) YELLOW LINE II (PRI) ECOVIA INMIGRANTES TOLL (PRI) RG TRANSPORT CONCESSIONS (MIF)

2.24

US$MILL
102.5 267.0 420.0 120.0 275.0 150.0 115.0 300.0 146.0 14.0 13.5 55.0 50.0 6.6 75.0 1.1

New operations identified

TRAFFIC SAFETY IN CITIES SO PAULO ROADS FORTALEZA CITY STREETS METRO TRANSIT CURITIBA SO PAULO BELTWAY SP SUBWAY LINE 5 CURITIBA APUCARANA (PRI) ITAPOA PORT (PRI) SUPERVIA COMMUTER TRAINS (PRI) MODES OF TRANSP. & ACCIDENT RATES DRIVER TRAINING MUNICIPALIZATION OF TRANSIT TRANSPORTATION FINANCE

US$MILL
TBD 150.0 85.0 135.0 500.0 500.0 72.0 17.3 75.0 (Study) (Study) (Study) (Study)

2.25

Energy. Brazil is moving from a system dominated by direct State involvement through a system of federally and state owned public enterprises to an environment of increasingly more open, competitive markets and heavy private investment. Now that basic guidelines have been devised for the new electric power and oil and gas industry regulatory frameworks, institutions are being restructured and new laws and operating regulations are being put into practice. In the electric power sector, the program to sell off federally owned companies to private operators is moving forward, though the timetable had to be reworked after the financial crisis. Many states have already privatized their energy enterprises and/or are setting up regulatory agencies. In the hydrocarbons sector, the government is implementing an active policy of opening up to the private sector in the areas of drilling, production, refining, transportation, and distribution of oil and gas, in certain cases

- 19 -

in association with Petrobrs, in which the State will retain substantial shareholdings. 2.26 To assist Brazil as it modernizes its productive sectors, the Bank will step up support for both public and private agents in the transition to open markets, and will help in the implementation of lasting reforms. In the electricity sector it will build on previous initiatives in the areas of institution-strengthening, studies, and longrange planning, and support the organization of the natural gas market, which could include transportation and distribution project finance. Such support would be extended to state regulatory and concession oversight bodies, the priority being to maintain and improve the technical caliber hitherto evinced by the public sector in such key areas as long-range planning and the engineering and operation of complex systems. Expansion of the electric transmission system. For the medium term, the new regulatory framework leaves the public sector at the center of the power transmission sector, through State companies to be set up when the current integrated electric utilities are unbundled. By virtue of a recent government decision, expansion projects are to be tendered out as private-sector concessions. As an adjunct, the government has mapped out a major transmission investment plan for the coming years, which will be crucial to avoid service interruptions and expand the grid. Successful restructuring of the transmission system also is crucial for sector reforms to be sustainable, so providers can deliver quality services at affordable prices and private investors can be confident that the power they produce or distribute will reach end users. Expansion of power generation. New projects in this sphere pose a complex set of challenges during the current transition stage towards broad private-sector participation, but they are essential to keep up with soaring demand for electricity, there being few economically viable alternatives in the medium term. Innovative approaches will be a must to complement government initiatives with private-sector participation and share the various kinds of risks fairly. This will be particularly important in the short term, primarily to support the emergency plan to expand power generation capacity being implemented by the government in order to ensure a smooth transition. The Bank also should continue supporting operations to expand coverage in rural areas and bring modern power service to remote communities. Energy efficiency. The Bank should heighten its efforts to foster the adoption of efficient, clean technologies through sustainable market-based mechanisms. Economic, energy-efficient urban transit projects will be particularly important here.
Active operations
NORTH-SOUTH ELEC.GRID ITA HYDROELECTRIC PLANT (PRI) VBC DISTRIBUTION EXPANSION (PRI)

2.27

2.28

2.29

US$MILL
307.0 75.0 100.0

New operations identified

NORTH-SOUTH TRANSMISSION 2 CANA BRAVA HYDRO PROJECT (PRI) MACHADINHO HYDRO PROJECT (PRI) DONA FRANSCISCA HYDRO PROJECT (PRI) ENERGIA NORTE THERMAL PLANT (PRI) PECEM THERMAL PLANT (PRI)

US$MILL
500.0 75.0 75.0 10.0 23.9 35.0

- 20 -

2.30

Integration infrastructure. The Bank will keep up support for integration infrastructure projects, notably to expedite binational power projects that are very complicated to arrange and finance because different countries' institutional features have to be made compatible. Transportation will be another focus, to tackle fundamental regulatory and institutional issues that are key to lowering costs and improving the quality of service between countries in the region. Coordinating initiatives to facilitate multimodal transport and smooth customs entry would be important activities to that end.
Active operations
BOLIVIA-BRAZIL INTEG.GAS PIPEL. MERCOSUR HIGHWAY

US$MILL
240.0 450.0

New operations identified

MERCOSUR HIGHWAY 2 MERCOSUR HIGHWAY 3

US$MILL
322.0 TBD

2.31

Financial sector. As in the past, the Bank will focus on activities to give microenterprises and SMEs broader and deeper access to the financial markets, supporting the government's ambitious plan to develop microfinance programs. This will mean promoting innovative technologies that can lower intermediation costs, and developing services to better mobilize domestic saving. A second continuing focus of support will be the strengthening of second-tier operations of government-owned banks and other public financial agencies, to boost the volume of long-term funds those institutions inject into the economy while making certain the money is channeled on true market terms, and encourage private commercial banks to do more production credit business. Other prospective targets for Bank support are regulation and oversight, reform of state banks, development of nonbank sources of long-term finance, and capital markets. Support for SMEs and microenterprises. Since SMEs create so many jobs, adapt nimbly to shifting market conditions, build economic fabric, and are adept at innovating and making productive use of scarce resources, it is important that they have access to a larger menu of finance options. The SME strategy developed with Banco do Nordeste was built around the following elements: promotion of new financing instruments, support for human resources training, strengthening of systems of technical support for management and cooperation between businesses, and support for technology development and innovation systems. This choice of priority targets was a way of assisting in the modernization of productive sectors while bolstering government moves in related areas, such as lowering the 'Brazil cost' and creating employment. A next step for the Bank to consider would be to take the experience gained thus far to other parts of Brazil. Fully 90% of Brazilian businesses are microenterprises, and they account for 35% of all jobs in commerce and industry. But the majority of microentrepreneurs today never finished high school, have little training in how to manage a business, and have virtually no chance of borrowing from formal financial intermediaries. Loan security requirements, transaction costs, and the dearth of financial products tailored to their needs are a source of frustration for microenterprise operators.

2.32

2.33

- 21 -

2.34

The Bank has approved 37 small projects totaling US$17 million in this area plus associated technical cooperation operations, most of them designed to strengthen NGO-operated microfinance programs. The Bank also has technical cooperation operations under way through BNDES and the National Federation of Support to Small Business, to strengthen microfinance institutions. The 1998 credit program with BNDES earmarked US$150 million for microenterprises. The Bank will continue to support the development of sustainable microenterprises and, in particular, will foster the development of institutions prepared to gear their products to the needs of these businesses and serve low-income and minority (indigenous and women) microentrepreneurs. Support for technology development. Brazil needs to continue modernizing its economy in order to position it securely in the competitive global marketplace. To keep pace with progress elsewhere, its productive sectors have no choice but to constantly innovate and adopt new technologies. University research teams and government institutes will have to build more meaningful links to the producing sectors without compromising the caliber of their work, and support for basic science will need to be stepped up, with careful attention to quality to meet internationally accepted standards. To assist in Brazil's efforts to make its exports more competitive, the Bank will support: (i) participation in cooperative ventures; (ii) technology enclaves and parks, including business incubators; (iii) development of basic industrial technology infrastructure and technology management and planning programs; (iv) strengthening of technology training tailored to specific business needs; (v) expansion of technology and engineering extension services; and (vi) bolstering of research and development capacity with an eye to the market and to seizing technology opportunities identified by businesses.
Active operations
BNDES MULTISECTOR CREDIT SMEs BNDES MICROENTERPRISES BNDES SMEs (EMERGENCY) FINEP SCIENCE AND TECHNOLOGY TECHNOLOGY-BASED COMPANIES (MIF) SC BUSINESS INCUBATORS (MIF)

2.35

2.36

US$MILL
750.0 150.0 1,200.0 160.0 8.3 3.5

New operations identified

BN MICROENTERPRISES NORTHEAST SMEs NORTHEAST BNDES SME EXPORTS FINEP 2 SCIENCE AND TECHNOLOGY MICROFINANCE NORTHEAST (MIF)

US$MILL
50.0 150.0 500.0 TBD 2.1

2.37

Tourism. Though Brazil has acquired an image throughout the world as an attractive tourist destination, its international tourism business is quite light. Compared to the income and jobs the tourism industry is creating elsewhere, it is still in its infancy in Brazil. The high cost of international and domestic air transportation, lack of modern infrastructure, pollution and public safety concerns at major destinations, a shortage of trained workers, and the absence of incentives to private-sector investment in the sector all play a part here. The government's goal is sustainable tourism development, which it will pursue by way of tourism hubs associated with the National Development Hubs described in the Multiyear Plan. It will prioritize training, encouraging partnerships with civil society to increase the supply of direct and indirect jobs, and take special care to safeguard the environment and the country's cultural heritage. A federal working

2.38

- 22 -

group is currently examining a plan to remove constraints to tourism growth (air transport, training, infrastructure, public safety). 2.39 Priority in Bank financing will go to projects that bring private money into the sector and form enough of a critical mass to be able to promote at home and in foreign markets. Since developing a tourist attraction is a multisectoral endeavor involving zoning, water and sewer systems, city sanitation, transportation, and environmental protection, a parallel focus of the Bank's strategy will be to strengthen institutional capacity in the public sector. Studies also would be done to help the government craft national and regional tourism strategies and to look at the relationship between developing tourism and preserving the country's natural and historical heritage.
Active operations
PRODETUR HISTORICAL HERITAGE ECOTUR

US$MILL
400.0 62.5 11.0

New operations identified

PRODETUR 2 NORTHEAST PRODETUR SOUTH ECOTUR 2 ECOTOURISM STRATEGY

US$MILL
300.0 200.0 TBD (Study)

2.40

Agriculture. The agriculture sector figures prominently in Brazil's move toward a stable, open, globally integrated economy. However, if the sector is to continue to hone its competitive advantages, it will have to contend with a number of serious challenges, for instance: (i) shift government action to areas of the public welfare that cannot be left to the marketplace and encourage private enterprise to invest in the sector; (ii) regulate the pushing back of the agricultural frontier, protecting fragile natural resources; (iii) spur changes in the land tenure system to ensure more equitable distribution of that resource and more technically and economically efficient land use; and (iv) generate and disseminate improved technologies to attend to user and market demands and overcome constraints to development at every stage of the principal agrifood chains - production, processing, marketing and sale, and business management. But the agriculture sector cannot grow as quickly as it needs to unless problems of rural poverty and social inequities are duly addressed. The government is focusing its support on making the agriculture sector more competitive so Brazilian agrifood products can make inroads into the global market and rural poverty can be alleviated, and on opening avenues for private-sector participation in decision-making and investment finance. Paramount among the government's concerns is the agrarian reform process, which it is striving to make more efficient and sustainable so settlers do not end up as new minifundistas. Its poverty alleviation measures include a new generation of rural development projects in several states, principally in the northeast. The Bank's strategy will target four priority areas: (i) support for a new irrigation model built on efficient, sustainable foundations, that will encourage private-sector participation in irrigation system financing and operation, user-managed approaches, and sustainable use of natural resources; (ii) strengthening of the national agrifood technology system to supply the technology needs of producers and of the entire agrifood chain, with bolstered and more competitive innovation

2.41

2.42

- 23 -

systems, closer coordination between the agencies involved, and promotion of schemes that are financially self-sustaining; (iii) improvement of animal health and plant protection and food safety systems, to meet international standards and reduce productivity losses caused by pests and disease; and (iv) alleviation of rural poverty, through programs and productive and social investments to improve living conditions in rural areas, help consolidate communities of settlers, and curb migration by training rural workers for new kinds of jobs in the community.
Active operations
MODERNIZ.AGRICULTURE NEW IRRIGATION MODEL (MIF)

US$MILL
67.5 1.4

New operations identified

RURAL SETTLEMENTS METEOROLOGY AGRICULTURAL RESEARCH NEW IRRIGATION MODEL RURAL SECTOR OPER.STRATEGY

US$MILL
50.0 50.0 60.0 90.0 (Study)

c. Reducing social inequities and poverty 2.43 Actions identified by the Bank for this strategy focus in the coming years fit perfectly within the government's "A More Just Brazil" program, one of the priorities in its Multiyear "Avana Brasil" Plan. As Brazil strives to complete a socially equitable fiscal adjustment program, questions of targeting and efficiency of social spending need to come further to the fore in the Bank's strategy. Hence, priorities for its support will be: (i) an analysis of the distributional impact of social spending and development of systems to better target public monies to the most vulnerable groups, with consistent consideration of gender factors and care for children and the elderly; (ii) implementation, strengthening, and evaluation of the social safety net, backing actions that can do the most to alleviate poverty, along the lines of school-attendance grants and minimum income guarantees targeted to the poorest; and (iii) reforms, including the deepening of ongoing reform processes, in the education, health, social services, and urban and municipal development sectors, to make for more equitable delivery of efficient, high quality services to Brazilians. Education. Education is very high on the government's agenda. Raising education levels is seen as a key to the productivity and competitiveness needed for sustained economic growth, and to improved income distribution and poverty reduction in the medium and long term. Government priorities are to develop and expand primary education (grades 1 through 8), improve and expand secondary education (grades 9 to 11), revamp the vocational education system (education for employment), and gear higher education to the labor market. Among the pieces of special legislation the government has sponsored in recent years are a law governing the Fund for Primary Education Maintenance and Development and Teacher Compensation (1997) that deals with primary education funding and teacher compensation, mandating a minimum per-pupil expenditure and encouraging municipal control of primary education; the 1997 National Education Policy Act regarding decentralized organization of the education sector; and a bill on university autonomy that has not yet been passed into law.

2.44

2.45

- 24 -

2.46

Though there is near-universal access (95%) to primary schooling in Brazil, high repetition and dropout rates and the number of over-age students are still a problem: only 65% of children who start grade 1 are likely to finish primary studies. The high-school enrollment ratio is a low 31% because so many children never complete the full primary cycle and because of secondary-school repeater and dropout rates and over-age enrollees. Only 35% of any given grade 1 cohort will finish high school. As for equity of completion rates, only 13% of children from poor families manage to finish primary school and only 4% make it through secondary school. The country's most serious challenge thus is secondary education, to improve enrollment figures, efficiency, quality, and equity. State education systems are not equipped to meet the demand: their curricula are outdated, they need better trained teachers, and they lack the requisite infrastructure and materials. A massive effort is needed urgently on this front. In light of these conditions, the Bank will support activities to: (i) improve the quality of education, particularly at the secondary level during which students receive their preparation for the working world; (ii) expand the education system, again concentrating on secondary education and on measures to make schooling accessible to disadvantaged groups; and (iii) modernize state education systems and enhance spending efficiency. The Bank has been a prominent supporter of education projects and programs in Brazil in recent years, notably for secondary and nonuniversity postsecondary education, including special sectoral studies and projects. Its role will be heightened in the planned new stage of the secondary education program and associated actions (already identified) in the states, beginning with So Paulo. A pressing task in the short term will be to help raise the educational attainment of young people and adults who never finished school, who currently make up the bulk of the workforce.
Active operations
IMPROV. SECOND. EDUCATION PARANA VOCAT. EDUCATION REFORM EXPANSION SECOND.EDUCATION PRIV.INVESTM.EDUCATION-BNDES TOURISM ACCREDITATION (MIF) SKILLS CERTIFICATION (MIF)

2.47

2.48

2.49

US$MILL
100.0 250.0 250.0 100.0 2.5 0.9

New operations identified

SECONDARY EDUCATION SO PAULO TRAINING UNION LEADERS (MIF) TRAINING MICROENT.& SMEs (MIF) SECONDARY EDUCATION IN BRAZIL

US$MILL
150.0 1.4 1.0 (Study)

2.50

Health. The majority of Brazilians look to the Single Health System (SUS) for care and treatment. Largely federally funded (70%) with contributions also from state and municipal governments, it operates through an extensive network of public and private establishments. Another forty million Brazilians (a quarter of the population) are covered by group medicine plans, health insurance or maintenance organizations, company-managed health plans, and medical cooperatives. With this organizational makeup, the sector's most serious problems have to do with overcentralization of SUS resources and management at the federal level and deteriorating plant and equipment at every level in the system, the fruit of chronic funding shortages. Another concern is the preeminence of curative care models that

2.51

- 25 -

look at individual patients rather than the community and tend to concentrate on treatment that is not cost-effective from the standpoint of its impact on the health status of the population. Persistent inequities in resource distribution account for the marked differences in health conditions from one state and municipality to another. Critical needs in this regard, according to the country's health authorities, are human resources training and development with a strong health promotion and disease prevention thrust, to improve primary health care outcomes and encourage community involvement. 2.52 The Bank will support efforts to: (i) target resources to illnesses that are accounting for the heaviest share of the country's burden of disease, and to groups that are the most vulnerable economically and geographically, encouraging initiatives like the Family Health Program that involves the community in solving its health problems, with an emphasis on promotion and prevention; (ii) decentralize SUS management to the states and municipalities, spurring innovative local management approaches that segregate funding and service delivery functions; (iii) promote human resources training and professional development; and (iv) strengthen the regulatory framework for private health-insurance organizations and accreditation of private providers, better meshing that system with government health-care delivery strategies.
Active operations
HEALTH REFORM AND INVEST. PRIVATE INVESTM.HEALTH BNDES PROFESS.DEVT.HEALTH WORKERS

US$MILL
350.0 100.0 185.0

New operations identified

PRIVATE HEALTHCARE ORGS. NATIONAL HEALTH CARD REGUL. HEALTH PLANS (MIF) HEALTH EXPENDITURE 10 YEARS OF THE SINGLE SYSTEM

US$MILL
35.0 50.0 1.3 (Study) (Study)

2.53

Social assistance. The creation of the National Welfare Secretariat ushered in a new policy of social services decentralization, with heightened involvement of the three levels of government and of civil society. Much remains to be done to solidify this system, which is still in its infancy. During periods of fiscal adjustment it offers a lifeline to the "structurally poor", i.e. those unable to work - children and youth, the elderly and the incapacitated - who need government services and transfer payments to survive. The Bank-supported Social Reform and Protection Program (emergency social program) protected spending on major social assistance programs for a time and laid a foundation for efficiency, equity, and service quality improvements. In terms of its institutional apparatus, however, this area is weaker than the other social sectors. Though no specific projects have been identified, the Bank would promote the consolidation and deepening of concrete social assistance initiatives. Urban problems. In addressing general problems of poverty and living conditions in cities the Bank has broadened its focus to take in urban and municipal development, low-cost housing, and problems of marginality, in addition to its traditional support for operations to improve the urban environment, most frequently by way of water, sewer, and waste treatment systems.

2.54

2.55

- 26 -

2.56

Urban and municipal development. In a country as highly urbanized as Brazil where responsibility for many services has already been decentralized, the urban sector is a key piece in the development strategy. Municipal governments are shouldering more and more social-sector responsibilities, including basic education, health care, welfare services, and poverty alleviation programs. Since spending on urban infrastructure has lagged far behind urban growth, actions to build up infrastructure and provide low-cost housing can significantly improve the lives of city residents. The Bank will support capacity-building activities to equip municipalities to manage urban and social activities and fund them with locally generated revenues, so as to make the decentralized government model workable (strengthening of municipal management, fostering intermunicipal collaboration for delivery of common services, pursuit of efficient models to contend with problems of unregulated urbanization). Low-cost housing. The growth in Brazil's economy and in its population are widening the gap between the demand for accommodation and the stock of basic housing that low-income groups can afford. The result has been a surge in substandard dwellings (shantytowns, illegal subdivisions, shared accommodation). The government is pushing for housing finance reform, but specific action is needed if the poorest Brazilians are to benefit from the improvements - targeted subsidies and mechanisms to encourage families' own efforts and private-sector participation, for instance. To continue its support to this sector the Bank will foster activities that can have a demonstration effect in barrio and housing improvements, like the successful efforts under way in Rio de Janeiro and So Paulo. The Bank also will explore avenues for cooperation in preventing and dealing with violence (an initiative begun as part of the Rio de Janeiro program), which is a very serious concern in marginal districts of large cities. Basic sanitation. Some 88% of the population of Brazil's cities have piped water and only 40% have sewer service. This low coverage ratio is causing health and quality-of-life problems for city residents. Since less than 20% of sewage is being treated, rivers and bays are becoming heavily polluted. Over US$2 billion a year in investment outlays would be needed to make up the current shortfall in services and keep pace with population increases to the year 2010. Given the financial state and operating conditions of most water and sanitation utilities, alternative management, investment, and cofinancing approaches will be needed to close this huge coverage gap. Private enterprise could provide part of the answer in many instances, provided that regulation in the sector and the role of states and municipalities are clarified. In its support for reform and modernization of this sector the Bank will keep to its pragmatic, flexible strategy, focusing particularly on actions to establish regulatory frameworks that aim for self-sustainability in the long run, provide vast segments of

2.57

2.58

2.59

2.60

2.61

- 27 -

the population with water and sewerage services, attract private enterprise to the sector, make service delivery more efficient, and protect the environment.
Active operations
SOCIAL ACTION-SANITATION SANITATION AND ROADS-BELEM GUANABARA BAY CLEANUP ENVIRON.AMELIORATION-GUAIBA FAVELA B. RIO JANEIRO URBAN DEVELOPMENT-PARANA FAVELA IMPROVEMENT-SO PAULO ENVIRON.-TODOS LOS SANTOS BAIXADA VIVA-RIO DE JANEIRO STATE MUNICIPAL DEVT. PORTO ALEGRE FAVELA IMPROVEMENT (HABITAR) FLOOD CONTROL CAMPINAS SANITATION TIETE 2 SOCIAL REFORM CEARA SOCIAL PROTECTION (EMERGENCY) REG.FRAMEWORK WATER GOIAS (MIF)

US$MILL
50.0 145.0 350.0 132.3 180.0 249.0 150.0 264.0 180.0 76.5 250.0 19.8 200.0 42.0 2,220.0 0.7

New operations identified

URBAN IMPROVEMENT RIO 2 SANITATION IGARAPES MANAUS SANITATION FEDERAL DISTRICT SANITATION GOIAS REHAB.MULTIFAM.HOUSING SO PAULO SOCIAL ACTION-SANITATION ENVIR. AMELIOR. GUAIBA 2 GUANABARA BAY CLEANUP 2 SANITATION CEARA 2

US$MILL
200.0 50.0 130.0 70.0 70.0 250.0 100.0 350.0 100.0

d. Environment and natural resources 2.62 Brazil has the greatest biodiversity on earth, along with 40% of the tropical rainforests and 20% of the freshwater in the world. One of Brazil's preeminent concerns is to protect and preserve its natural heritage and make sustainable use of its resource endowment. The Bank's activities in the environmental sphere cut across all its priority action areas. Key focuses are urban sanitation (described above under "Urban problems"), which takes in traditional targets of Bank support: water, sewage conveyance and treatment systems, pollution, and solid waste; the environmental impact of productive activities (mentioned in the section on competitiveness), and natural resources management. Bank efforts in these areas will help considerably in implementing the "A Brazil that Conserves" program, one of the pillars of the government's Multiyear Plan. The government's strategy focuses here are: (i) direct investment in natural resources conservation and quality improvements, including protection for the most fragile ecosystems; (ii) strengthening the regulatory framework, particularly at the state level; and (iii) eliciting greater involvement of civil society organizations and the private sector in conservation activities and enhancing the quality of their participation. Of particular import are national programs to improve urban environmental quality, use of clean production technologies, rational use of water and forest resources (reforestation and the prevention of and fight against deforestation, land-clearing fires, and wildfires) and regional activities such as the Pantanal program that the Bank will support. In addition, a national program for environmental and economic zoning of the country will provide guidance for land use and sustainable development. Pollution and resource depletion take a disproportionate toll on the poor in cities and rural areas alike. The Bank sees environmental amelioration actions as a way to lighten that burden. Thus, it will concentrate on programs designed to conserve and make sustainable use of natural resources and improve environmental quality. Institutional strengthening and modernization of state and municipal environmental

2.63

2.64

- 28 -

licensing agencies, and projects and programs designed from the start to give civil society organizations and the private sector more of a role in conservation activities, are additional Bank strategy focuses.
Active operations
DRAINAGE-SO PAULO DRAINAGE-RIO JANEIRO ENVIRONMENT FUND 2 Others described under Urban/Sanit. par. 2.60

US$MILL
302,0 30,0 24,0

New operations identified

SUSTAIN.WETLANDS DEVT. MATA PERNAMBUCO ZONE MICRODRAINAGE SAO PAULO SUSTAINABLE DEVT. ACRE ENVIRON. DEVT. TOCANTINS INDUSTRIAL POLLUTION CONTROL

US$MILL
100,0 120.0 300,0 50,0 TBD (Study)

3. Bank support for integration 2.65 The various action areas targeted in the Bank's strategy contain elements to help Brazil reinvigorate and deepen regional integration. The Bank thus seeks both to deepen the activities in this area and to identify new ones (nontraditional activities for integration). To supplement the measures taken to date, which have had a significant impact, focusing on the transportation and energy sectors, the Bank will maintain and step up its support for physical integration projects (highways, power transmission systems, gas pipelines, removal of restrictions in border areas), help identify regional financing mechanisms, and provide nonfinancial support for the development of regulatory systems to facilitate regional trade and other integration initiatives, including nontraditional areas such as health and education. Many of the activities identified on a preliminary basis in the operations program for the country, particularly in infrastructure, even though that area concerns local development, may contribute to regional integration. The Bank will also make a special effort to include specific components and activities in other projects (initially but not exclusively in education and health) to help support integration. In particular, the Bank proposes to support instruments that can help strengthen economic and trade ties within MERCOSUR and the coordination of member states' macroeconomic policies in the long term. Some examples would be a system of short-term macroeconomic indicators for MERCOSUR countries (inflation, fiscal equilibrium, movements in exchange rates and other monetary variables); development of a database on intraregional investment; development of a system to track intraregional trade flows; and efforts to put the Brasilia Protocol to more efficient use as a MERCOSUR dispute settlement mechanism. 4. Civil society 2.67 There are over 220,000 nonprofit or philanthropic organizations in Brazil today and more than 50,000 charitable or benevolent institutions. Many of these agencies play a vital role in service delivery to sectors of the population that neither the State nor the market has managed to reach efficiently. The role of civil society having been redefined in recent reforms of the State, these organizations are working more actively and assuming progressively greater responsibility for the welfare of the communities they serve, particularly for social-services delivery and environmental protection.

2.66

- 29 -

2.68

Starting in 1995, as part of its policy to make social spending more effective, the government did away with the main agencies that had had direct responsibility for social assistance, strengthened the sector ministries in charge of the social safety net, and fostered the creation of solid partnerships with civil society, to ensure that the fruits of growth would be equitably shared. The Bank has supported Brazilian government efforts to better coordinate a set of priority social programs through the " Community Solidarity" program, and in poverty alleviation programs it will continue to help forge partnerships between the federal government, municipal governments, and different quarters of civil society. The Bank will also continue to create opportunities and improve systems for all the stakeholders in the initiatives supported by the Bank to be adequately involved and participate in the processes that affect them. It will support dialogue and actions to bolster relations between the government and civil society organizations that are most effective in reaching the population, and to firm up a strategy of shared responsibility for development. Special attention will be paid to shared responsibility for activities to fight poverty and for environmental management. 5. Lending scenarios

2.69

2.70

Given the magnitude of Brazil's needs, two considerations in putting together Bank lending scenarios are the Bank's own institutional capacity and the debt ceilings the country adopts. The country paper approved in 1996 set out a base lending scenario of US$6 billion over three years (an annual average of US$2 billion). Total approvals for the three-year period 1996-1998, which were lower than the base scenario owing to spending restrictions, came to US$4,785.3 million, averaging US$1,595 million a year. In 1999 the Bank approved US$1,154.5 million in regular investment loans plus two emergency operations totaling US$3.4 billion. In line with those recent approval levels and particularly in light of limits on spending associated with the country's adjustment process, the base lending scenario presented for the four-year period 2000-2003, not counting private-sector operations, is lower than the previous-period figure, at US$6 billion (US$1.5 billion a year, on average). A "low scenario" devised - US$4 billion in approvals over that four-year span - would have to come into play if good portfolio performance levels are not regained and/or if federal spending restrictions are not eased and subnational governments' finances do not improve as expected. The adjustment program being carried out by the government is having two major practical effects on the level and pace of Bank activities in the country. First, it is directly affecting the annual execution level of ongoing operations that depend on the federal budget, given the lower levels of authorized budget allocations for counterpart contributions and Bank financing. However, this effect is not consistent in all sectors due to the priorities set by the government for projects for the social sectors and for modernization of administrative and tax management. Second, as long as the current limitations on spending required under the adjustment program

2.71

2.72

- 30 -

are maintained, new debt (in those cases directly involving the federal government) must remain at levels consistent with the alternative low spending scenario. 2.73 The general exposure indicators are eminently reasonable considering the volume of Bank financing relative to the size of the Brazilian economy. The ratio most in need of close monitoring is Brazil's debt to the Bank as a share of aggregate borrowing member country debt to the institution. Between 1990 and 1995 that ratio dropped from 12.8% to 10.6%, but it has been on the rise ever since: 11.4% in 1996, 13.3% in 1997, 15.5% in 1998. Emergency-loan disbursements in 1999 made for a temporary high concentration that pushed the percentage to 19.1%; it will rise again in 2000 to 21.5% or 22.4% depending on the lending scenario. However, the ratio would trend down as Brazil began to repay those loans in 2001 or 2002. 6. Coordination with Private Sector Group instruments 2.74 Private Sector Department (PRI). Since its first operations in 1995 PRI has targeted the transportation and energy sectors, supporting operations that have contributed to the modernization of Brazil's economy generally and to its privatization program in particular. In the process PRI has developed a solid, close relationship with Banco Nacional de Desenvolvimento Econmico e Social (BNDES). Its preeminent focus will continue to be infrastructure projects, seeking to maximize the Bank's presence in leveraging additional funds. To that end, the department is working with Region 1, the Brazilian government, Eletrobrs, Petrobrs, and BNDES to develop and implement its operations program. Apart from its traditional support for transport and energy ventures, PRI will explore opportunities in the basic sanitation sector in various states and larger municipalities. It also has launched a partial risk guarantee program, the first of these facilities having been approved in 1999. Multilateral Investment Fund (MIF). Brazil's private sector is the focus of MIF support in four areas: (i) investment in transportation, energy, infrastructure, and water supply systems; (ii) strengthening of small and mid-sized businesses by giving them access to venture capital; (iii) institution of dispute settlement mechanisms; and (iv) heightening workforce competitiveness. Priorities for MIF support henceforward will be the establishment of sound regulatory frameworks; regional development by way of such ventures as ecotourism programs; improving labor conditions through occupational-health activities; making businesses more competitive by adopting production quality standards; giving microenterprises and small businesses readier access to credit and innovative financial services; and giving small and mid-sized companies access to venture capital, notably in the information technology and high-tech areas. Inter-American Investment Corporation (IIC). The IIC's active portfolio in Brazil comprises 13 projects totaling US$84 million, 47% of them in the financial sector, 36% in manufacturing industries, and 17% in the form of private investment fund holdings. There is expected to be heavy demand for long-term capital in 2000 as the Brazilian economy shakes off the recession. The IIC thus will step up its

2.75

2.76

- 31 -

corporate lending; it is currently looking at projects in the hotel and tourism, infrastructure, consumer products, and food processing areas. As for financial services, the IIC's strategy is to provide loans and equity finance to new specialized financial intermediaries and to develop special lending facilities whereby banks onlend IIC funds to small and medium-sized businesses. Consideration is being given to including mortgage administrators and securitizers as specialized financial intermediaries. There are no plans in the immediate future to acquire further stakes in private investment funds, since only three of the four funds are fully invested. 7. Complementarity with other funding sources 2.77 The Bank's activities in Brazil dovetail closely with those of other external agencies and funders, particularly the International Monetary Fund, the World Bank, and Japan. Just how efficiently this meshing of efforts can work was pointed up as a support package was put together to help Brazil deal with the financial crisis. This should continue to be a feature of Bank activities in Brazil, to maximize the efficiency and impact of its contribution. International Monetary Fund (IMF). The IMF has played a strategic role in Brazil, helping the country withstand the spillover from the Asian crisis. Its support began in November 1998 with a standby arrangement for SDR 13 billion (US$18.1 billion); increasing the primary surplus was the principal performance target. That facility paved the way for US$41 billion in funding mobilized by the international community, including strong support from the Bank in the form of US$3.4 billion in emergency loans. The arrangement with Brazil was revised in March 1999 to reflect the impact of the devaluation. The country met every one of the performance targets in 1999 (critical fiscal targets among them), surpassing by a wide margin the results of its nine previous IMF arrangements. This showing also attests to the government's determination to make necessary adjustments in the balance of payments and the public finances. World Bank. The World Bank's strategy priorities closely match the ones mapped out in this country paper and the guiding principles of the "Avana Brasil" Plan. Its priority focuses are: (i) reducing poverty and inequities, with education at the top of the list; (ii) fiscal adjustment, with plans for sector loans to support structural reforms (overhaul of the social security system), regular loans to strengthen state government administration and fiscal performance, and actions to improve the efficiency of social spending; (iii) rekindling economic growth and lowering the 'Brazil cost', by way of support for infrastructure (particularly for transportation), the financial sector, and private-sector development with International Finance Corporation funding; (iv) public-sector effectiveness, and (v) the environment. The World Bank is looking at US$3 billion to US$5 billion in approvals for 2000-2002. Japan and other sources. Other external funding sources will continue to be very important for Brazil, to support studies, technical cooperation, and project preparation work and directly cofinance some activities. Japan continues to be a

2.78

2.79

2.80

- 32 -

premier provider of external assistance, notably for initiatives with the federal level, where infrastructure and the environment have been its primary focuses. 8. Strategy implementation risks 2.81 Brazil's strategy, and by extension the Bank's, could be open to different kinds of risks. Chief among them would be a loss of momentum of the fiscal adjustment process. It will be difficult for the government to repeat the substantial primarysurplus gains it achieved in 1999; chances of further improvements will hinge on the country's capacity to continue moving through and securing the passage of pending structural reforms and constitutional amendments and then implementing them. Particularly important are changes to the tax and social security systems and pieces of legislation like the Fiscal Responsibility Act that will be key to strengthening the management of state finances. The round of municipal elections slated for late 2000 also could slow the adoption of outstanding reforms, or reforms could end up being less comprehensive. One external risk for the country's strategy has to do with export performance. In principle, Brazil's external prospects improved considerably with the January 1999 decision to let the exchange rate float. Though the devaluation did not have the anticipated effect on exports in value terms, export volumes do appear to have been on the rise since August 1999. However, the pace of export growth is a concern, especially if Latin America does not bound back from the steep 1999 recession. Above all, Brazil would be affected by the situation of Argentina, its main MERCOSUR trading partner. 9. Monitoring the strategy's implementation 2.82 Monitoring the implementation of the Bank's strategy in Brazil will pose some unique challenges. In financial terms the Bank's role in the country is quite small relative to the vast economy, making it very difficult to come up with meaningful measures of the macro effects of Bank operations. Compounding the problem is an array of reform programs running in tandem whose effects will only be felt in the medium and long term and whose ultimate configuration will depend greatly on internal political and economic processes. The annual programming and portfolio review missions will be focal points for monitoring the strategy, to assess its relevance and how it is being put into practice in loan and technical cooperation operations and other services offered to the country. Specific elements requiring a close look will be the strategy's pertinence, the country's sense of ownership of the strategy, consistency of Bank operations approvals with the strategy, and how efficiently and effectively the strategy is implemented. The attached Bank action matrix includes a set of key indicators that can be used to monitor the strategy's progression. Some would help gauge how the Bank's strategy is being carried through, others how the country's development strategy is being put into action. Proposed as the chief measure of efficiency of the latter process is public saving at the three levels of government. This would be an acceptable yardstick of what has been accomplished in reform and modernization of the State the priority around which the strategy is structured.

2.83

- 33 -

III. TOPICS FOR DIALOGUE WITH THE AUTHORITIES 3.1 The following items should be high on the agenda for dialogue between the Bank and the Brazilian authorities: The Bank's priorities (poverty, reform of the State, competitiveness, and integration) as a general framework for its action in Brazil and as a determinant of specific actions called for in the strategy. Progress in Brazil's ongoing adjustment program. Implementation of the emergency operations the Bank approved as part of the international community's response, and the adjustment program's effects on the Bank's portfolio and pipeline (stemming from spending restrictions). The status of strategic reforms requiring legislative approval (social security, fiscal responsibility, taxation) and how the Bank might be of service on these fronts. The financial condition of subnational governments and its implications for future Bank operations with states and municipalities. Progress on the Multiyear "Avana Brasil" Plan, particularly as regards the strategy's consistency with the Plan and the anticipated demand for external financing (areas, amounts).

Matrix for Bank action in Brazil

Main government actions and policies The Bank's strategy Focuses of Bank action Other agencies Key indicators

The challenge of achieving faster, more equitable and sustainable growth Continue with fiscal adjustment Step up the privatization program Reduce the current-account deficit Institute inflation targeting Support the macroeconomic adjustment, particularly in pursuit of modernization of the State Finish disbursing the 1999 emergency loans IMF and World Bank are supporting the country's macroeconomic adjustment effort Reduction in currentaccount and fiscal deficits as percentages of GDP Lowering of interest rates

The challenge of reform and modernization of the State Reform of the social security system Fiscal Responsibility Act Tax reform Privatization program Regulatory frameworks Strengthening tax administration Accelerating fiscal adjustment with the states Heighten the Bank's catalytic role in areas of municipal government strengthening, in fiscal management and administration areas and for more efficient basic service delivery Modernization of the social security system Management of municipal finances Preparation of basic studies for reforms Regulatory bodies and frameworks (MIF) Social security systems modernization World Bank: social security and social sector reforms; support for fiscal adjustment in the states Public saving (Given the urgent need for macroeconomic adjustment to ease imbalances in the public finances and balance of payments, public saving is seen as the most critical variable in the short and medium term.) Modernization of administrative and fiscal management:* 700 municipalities. Municipal management efficiency:* 35% in municipalities with over 200,000 inhabitants; 10% income for investment.

The challenge of heightening competitiveness Opening up of the economy Concessioning of transportation infrastructure operation and maintenance to the private sector Road system rehabilitation Energy sector organization, reorganization, strengthening and expansion (natural gas, electric sector, including privatization) The Bank will support priority initiatives in: (i) transportation and energy infrastructure rehabilitation and expansion and (ii) other action areas, including education, to lower the `Brazil cost'. Continue to support the financial sector (long-term credit and technical support for SMEs and microenterprises) Integration highways National and state highways Toll roads (PRI) Highway safety Ports (PRI) Power plants (PRI) Multisector credit, support for SMEs and microenterprise Incubators, microfinance and training for SMEs (MIF) Water resources and agrifood research World Bank: road system rehabilitation JBIC-Japan: infrastructure Lowered transportation costs Fuller SME integration into the national economy, including a higher share in exports Increase in private investment Recovery of external competitiveness

The challenge of inequities and poverty Rekindling of growth with equity Continuation of reforms to decentralize basic services and improve their quality, particularly in health and education New natural-resources legislation, including water resources and environmental management Addressing land tenure problems The Bank will focus on persistent problems, particularly unequal access to education and health care, and poverty reduction in critical areas Coordinated approach to environmental problems, including cities The Bank will give high priority to education, especially the secondary cycle and technical-vocational education Fostering of active participation by civil society Improvement of shantytowns and substandard housing Basic sanitation Improvement of secondary education Training (MIF) H World Bank: rural poverty; primary education; agrarian reform H JBIC-Japan: health Basic nutrition:** 32% malnourished Infant mortality:** 31 per thousand Improved housing:* 70,000 families Improved sanitation:* 65,000 families Illiteracy:** 10% Primary school completion:** 50% Secondary school enrollment:** 80% Greater basic service coverage, especially in poor areas

-2-

Improved nutrition and higher enrollment rates for children in difficult circumstances More self-reliant rural settlements Better sewage treatment The integration challenge Reinvigorate and deepen regional integration, including new action areas Step up action in traditional and nontraditional areas Support for highway, power transmission, oil pipeline integration projects Border area initiatives Health and education integration activities Regional financing mechanisms Infrastructure improvements in Brazil and the region Improvements in regional trade indicators Nonconventional integration actions

*= **=

goals for projects BR-0273 (favela improvement) and BR-0286 (municipal fiscal management) goals for the 2000-2003 multiyear Avana Brasil plan

1. Social indicators Population (millions, 1999) Under 15 (%, 1998) Annual growth rate (1989-1998) Vital statistics Infant mortality rate (per 1,000 live births) 1997 Poverty and inequality Monthly income by decile (% of total in 1995) 40% poorest 10% wealthiest Education Gross primary enrollment ratio, 1995 Gross secondary enrollment ratio, 1995 Average years' schooling, 1995 (over-25 population) Illiteracy rate (% in 1997)

164.9 31.9% 1.3%

34

8.9% 45.0% 117.4 47.4 3.9 16.1

Multiyear "Avana Brasil" Plan (PPA) (in billions of current R$) 1. Total expenditure by year 1/ 2000 248.886 2001 274.719 2002 289.452 2003 300.256 Total 1,113.323 2. Sectoral breakdown of PPA public expenditure 2/ * Social development 585.019 * Physical infrastructure 219.017 * Environment 3.353 * Productive sectors 134.838 * Justice and civil society 4.038 * Other 38.661 Total 984.926 1/ Includes private sector. 2/ Includes R$107 billion in private-sector resources. Source: Planning and Administration Ministry. 1996 2.6 1.3 1997 3.6 2.2 1998 -0.1 -1.5 1999 * 0.8 -0.5

2. Economic Indicators Real GDP (% change) Per capita GDP (% change) Nonfinancial public sector (% of GDP) Borrowing requirement Primary balance ( - = surplus) Money and credit (% of GDP) Domestic credit Money supply (M1) Prices and wages (% change) Consumer prices (IPCA) Real wage Exchange rate Market rate (R$/US$) Effective real exchange rate index (1990 = 100) Balance of payments (US$million) Current-account balance Trade balance Exports of goods Imports of goods Balance of services Balance on capital and financial account Change in reserves (- = increase)

1995 4.2 2.8

7.2 -0.4

5.7 -0.1

4.2 -1.0

8 -0.1

10.0 -3.1

32.7 3.2

37.6 4

35.4 4.8

42.1 5.4

32.9 5.2

66 10.4

15.8 7.4

5.2 2.1

1.7 -0.4

8.9 s.d.

0.92 112.4

1.01 106.2

1.08 101.8

1.16 104.2

1.85 157.7

-18.136 -3.157 46.506 49.663 -18.600 29.609 -12.920

-23.248 -5.453 47.851 53.304 -20.272 33.566 -8.326

-30.491 -6.652 53.189 59.841 -25.653 25.367 8.284 191.084 33.9%

-33.829 -6.603 51.136 57.739 -28.662 29.375 6.990 s.d 39.1%

-24.375 -1.198 48.011 49.201 -25.202 16.552 7.822 s.d. s.d.

External debt (US$ million) 158.236 178.037 Interest as % of goods and services exports 12.6% 31.5% * preliminary Sources : IBGE, IDB (Statistics and Quantitative Analysis Unit) y IDB (RE1/OD1)