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DOCUMENT OF THE INTER-AMERICAN DEVELOPMENT BANK

PERU

IDBCOUNTRY STRATEGY WITH PERU 2007-2011

This document was prepared by the project team consisting of Susan K. Kolodin (SCL/SPH),

David Rogers (CAN/CAN), Kim B. Staking (ICF/CMF), Daniela Lpez (CAN/CAN), RosarioGaggero (INE/RND), Edna Armendariz (CAN/CAN), Gabriela Sylvia Andrade (CCB/CCB),Francesca Castellani (CAN/CAN), and Fidel Jaramillo (CAN/CAN), who was the ProjectTeam Leader, with contributions from CAN/CPE, INE/ENE, INE/TSP, INE/WSA, INE/RND,SCL/EDU, SCL/SPH, SCL/SCT, SCL/GDI, ICF/ICS, ICF/FMM, ICF/CMF, MIF, SCF andIIC.

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CONTENTS

EXECUTIVE SUMMARY

I. DEVELOPMENT CHALLENGES IN PERU............................................................................1

A. Introduction...........................................................................................................1B. Political, economic, and social outlook ................................................................2

1. The new political landscape in Peru .............................................................22. The economic situation.................................................................................23. The social setting...........................................................................................6

C. The governments development agenda ...............................................................8

II. RECENT RELATIONS BETWEEN THE BANK AND PERU ....................................................9

A. The 2002-2006 strategy ........................................................................................9B. Evaluation and lessons learned ...........................................................................11

III. THE BANK STRATEGY WITH PERU FOR 2007-2011.......................................................12

A. Foothold in the global economy and competitiveness .......................................121. Current situation and principal challenges..................................................132. Principal areas of Bank support ..................................................................13

B. Social development and inclusion ......................................................................221. Current situation and principal challenges..................................................222. Principal areas of Bank support ..................................................................23

C. Reform of the State and public management......................................................271. Current situation and principal challenges..................................................272. Main areas of Bank support ........................................................................27

IV. IMPLEMENTATION OF THE STRATEGY ...........................................................................30

A. Lending program.................................................................................................301. Public sector ................................................................................................312. Private sector...............................................................................................36

B. The new business model .....................................................................................37C. The fiduciary situation ........................................................................................37

D. Risks and mitigating factors................................................................................381. Macroeconomic factors...............................................................................392. Social, political, and institutional considerations .......................................393. Environmental aspects and natural disasters ..............................................40

E. Agenda for dialogue............................................................................................40

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ABBREVIATIONS

BCRP Central Reserve Bank of Peru

CAF Andean Development CorporationCCLIP Conditional credit line for investment projectsCGR Contralora General de la Repblica [Comptroller Generals Office]CONSUCODE Consejo Superior de Contratacin y Adquisiciones del Estado [National

Procurement Council]EAP Economically active populationFIDECOM Fondo de Investigacin y Desarrollo para la Competitividad

[Competitiveness Research and Development Fund]FTA Free Trade AgreementIIRSA Initiative for the Integration of South American Regional InfrastructureILO International Labour Organisation

INEI National Statistics InstituteMAPPE Memorandum of Assistance for Project Preparation and ExecutionMEF Ministry of Economy and FinanceMMF Multiyear Macroeconomic FrameworkMSME Micro, small and medium-sized enterprisesNFPS Nonfinancial public sectorSCF Structured and Corporate Financing DepartmentSNIP National Public Investment SystemTC Technical-cooperation operationTFFP Trade finance facilitation programWEF World Economic Forum

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ANNEXES

Annex A Strategy Matrix

Annex B Financing ScenariosAnnex C Millennium Development Goal IndicatorsAnnex D Public Debt RisksAnnex E Preliminary Lending ProgramAnnex F Energy Sector Operations MatrixAnnex G Program of StudiesAnnex H Nonfinancial ProductsAnnex I Country Financing ParametersAnnex J Coordination with Other Multilateral AgenciesAnnex K Active PortfolioAnnex L Balanced Scorecard for COF/CPE, 2006

Annex M Recommendations from the Peru 2002-2006 Country Program Evaluationand Management ProposalsAnnex N Bibliography

BOXES

Box 1 IIRSA Northern Amazon Hub

Box 2 Water resources, drinking water, and sanitationBox 3 Financing and development of the private sectorBox 4 Energy sector operations matrixBox 5 Strengthening the Country Office

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EXECUTIVE SUMMARY

Peru is experiencing its most significant period of economic expansion since the middle ofthe last century: average growth rates have exceeded 5% in the last five years and are

forecasted to reach around 7% in the coming years. This performance is the result of prudentmacroeconomic management that has contributed to growth stability and sustainability. To alarge extent, however, it has been driven by external factors, not based on structural changeor economic diversification.

The booming formal economy coexists with high levels of poverty, employment insecurity,and economic, social, and political exclusion. Although there has been progress on severalsocial indicators, growth has not trickled down enough to the majority of the population, andnearly 50% of Peruvians still live in poverty, particularly in rural areas. The persistence ofunderemployment and poverty could significantly weaken the medium and long-termoutlook for economic development and impair the countrys governance and economicstability.

Given these circumstances, Perus objective is to consolidate the recent pace of growth as away to improve peoples lives. The challenge is to diversify the economy so as to escape theadverse impacts of external volatility and thereby achieve economic growth that translatesinto increased formal employment and enhanced well-being for the majority of Peruvians.

In response to these challenges, President Alan Garcas administration has based its policieson macroeconomic consolidation, modernization of the productive structure, support forlow-income sectors, and reform of the State and decentralization.

In line with these objectives, the Inter-American Development Banks country strategy withPeru for the period 2007-2011 seeks to help the country to: (i) strengthen its foothold in theglobal economy and enhance its competitiveness, (ii) promote social development andinclusion, and (iii) deepen reform of the State and improve public management.

To foster competitiveness and productive diversification the Bank will provide supportthrough: (i) greater investment in infrastructure (highways, ports, logistics), especially inwater resources, drinking water, and sanitation; (ii) access to capital, in particular directfinancing to the private sector; and (iii) support for productive sectors, with the emphasis onsustainable development of hydrocarbons and other extractive industries.

Measures to promote social development and inclusion will be designed to: (i) guaranteegreater access to basic services; (ii) promote opportunities for formal employment; and(iii) strengthen the social welfare system.

In the area of public management, the Banks proposed program will emphasize:(i) decentralization of service delivery; (ii) higher quality in public expenditure; and(iii) strengthening the judicial system.

The Banks financial program for the public sector is consistent with the country financingrequirements and the public debt management strategy set forth in the 2008 2010 MultiyearMacroeconomic Framework (MMF). It contemplates a base-case scenario of US$1.7 billion,and a high scenario of US$2.5 billion, which would consolidate the Banks position as theprincipal source of multilateral financing.

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The following conditions would have to be met for the more ambitious scenario tomaterialize: (i) a commitment to further policy reforms that would justify an increase in theamount of programmatic financing, and (ii) the capacity on the part of the Bank to improvethe financial conditions and the availability of financing in nuevos soles. This latter

condition depends on the authorities commitment to the reform process and their desire toincrease demand for unrestricted funds in local currency, given their interest in reducing thecountrys exposure to foreign-currency debt. This possibility, in turn, depends on thecapacity of markets to absorb hedging in nuevos soles.

Bank support for the private sector and non-sovereign public sector would be primarily forinfrastructure (transportation, energy, water and sanitation, with subnational entities orconcessionaires), and financial markets (capital market, mortgage securitization, financialinstitutions, and trade finance facilitation program). The Bank also plans to continue itssupport to the oil and gas sector, in which it has been a significant player through itsfinancing for the Camisea project and its subsequent phase, Peru LNG.

The proposed program takes a comprehensive approach to each strategic area, with a mix ofprogrammatic, investment, and technical cooperation resources, to contribute to thecountrys development agenda in terms of knowledge, design and implementation of publicpolicies, and the financing of capital projects in the public and private sectors.

The Banks strategy with Peru is being pursued in a context in which country focus is theprincipal thrust of the Banks new organizational structure. The new model stresses theimportance of deepening the Bank-country relationship, and this entails modernizing andstrengthening the Banks Country Office. This will be key for reinforcing dialogue andfocusing on client needs.

The risks facing implementation of the strategy relate to: (i) macroeconomic factors,(ii) social, political, and institutional considerations, and (iii) environmental and natural

disaster-related aspects. These risks could compromise the countrys economic, social, andinstitutional stability and thereby jeopardize its development objectives and implementationof the strategy. Nevertheless, the country and the Bank have incorporated a series ofmechanisms to identify, prevent, and mitigate these risks.

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I. DEVELOPMENT CHALLENGES IN PERUA. Introduction1.1 Perus economic performance has been encouraging and certainly provides grounds

for optimism. In the last year, gross domestic product (GDP) rose by 8%, capping23 consecutive quarters of economic expansion, and one of the longest periods ofsustained growth since the middle of the last century. This dynamic performancehas been achieved in a context of rapidly rising exports coupled withmacroeconomic stability. Peru is likely to join Chile as one of the two most stablecountries, with the lowest sovereign risk in South America.

1.2 Nevertheless, despite these favorable developments, Peru is facing challenges thatargue against complacency. While growth has been substantial, it has been due inlarge part to external factors that could at some point be reversed, and it is justrecovering the pace of growth that prevailed in the late 1970s. Perus productivestructure is today nearly as concentrated as it was three decades ago, and remains

heavily dependent on primary activities.1.3 Moreover, recent growth has been insufficient to create high-quality jobs that

would offset the problems of unemployment and employment in the informaleconomy. Fourteen million Peruvians are still living in poverty, and poverty isespecially severe in rural areas and among indigenous populations. It is clear thatthe countrys sound performance in terms of growth and macroeconomic stabilityin recent years has not trickled down to the majority of the population.

1.4 Under these circumstances, Peru faces the challenge of deepening economic growthin a sustainable way, creating more jobs and opportunities that will enhance thewell-being of the majority of Peruvians. Success on this front will require:

a. Consolidating macroeconomic gains as the basis for developing economicactivities and protection mechanisms for confronting adverse shocks relatingto the terms of trade, financial conditions, and natural disasters.

b. Enhancing competitiveness and diversifying the productive structure,strengthening Perus foothold in the global economy, and guaranteeing aninvestment climate that will foster development of the private sector,productivity, innovation, and job creation.

c. Raising the quantity and quality of investment in human and social capital,and guaranteeing effective delivery of basic public goods and services.

d. Improving government management at the national and subnational levels inthe delivery of public goods and services, and strengthening the accountabilitymechanisms needed for a dynamic, competitive and equitable economicsystem.

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

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for the government, and one of the main suppliers of medium and long-termfunding for the private sector.

B. Political, economic, and social outlook1. The new political landscape in Peru

1.6 The national and regional elections of 2006 bolstered the process of democraticparticipation in Peru. President Alan Garca took office with a mandate to lock ingrowth and stability and to achieve greater equity, transparency anddecentralization.

1.7 President Garcas party, APRA (Partido Aprista Peruano), holds 37 of the120 seats in the National Congress. While the administration does not have anexplicit majority, it has forged working alliances with the Unidad Nacional and theAlianza por el Futuro.

1.8

Despite progress in making the countrys governance more democratic, theelectoral process also revealed a significant degree of political and socialfragmentation. Traditional political parties like APRA received most of theirsupport from higher-income urban voters. In contrast, rural and low-income peopleopted for the party of presidential candidate Ollanta Humala, which took a stancecritical of the countrys prevailing economic and political system. That party led thepolls in 8 of the 10 poorest departamentos of Peru, and opinion surveys show thatPeruvians are increasingly discontent with the results of democracy and the marketeconomy.1

1.9 Perus fragmented political landscape poses a potential source of political andsocial instability, and the risk that the countrys economic direction could be

reversed. Consequently, one of the main challenges facing the currentadministration is to overcome this negative perception, broaden opportunities forthe disadvantaged, and promote access to public goods and services for themajority.

2. The economic situation1.10 Perus economic outlook is positive. On the international front, favorable terms of

trade and ample capital inflows have boosted the countrys economic growth andstability. The last five years have produced annual average GDP growth exceeding5%. Growth in 2006 reached 8%, and the 2008-2011 Multiyear MacroeconomicFramework (MMF) forecasts growth of around 7% for 2007.2 Since 2002, Peru has

achieved positive rates of per capita growth, something not seen since the beginningof the last century. This dynamic performance is expected to continue for the rest ofthe decade.

1 According to Latinobarmetro, 77% of Peruvians are unhappy with the results of democracy, and 88% aredissatisfied with the market economy. SeeInforme Latinobarmetro 2005 and 2006.

2 See the 2008-2010 Multiyear Macroeconomic Framework.

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1.11 This growth has been accompanied by substantial macroeconomic stability.Inflation has been below international levels, real interest rates have remained low,and the currency has tended to appreciate. The Central Reserve Bank has

successfully applied an independent monetary policy using a model based oninflation targets. As a result, inflation was 1.6% in 2006, at the lower limit of theestablished band (1.5%-3.5%).3 Table 1 shows trends for the main economicindicators.

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

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Table 1Main Economic Indicators

2004 2005 2006 2007p

Real Sector and PricesReal GDP (growth, %) 6.5% 6.4% 8.0% 7.2%Unemployment (average, %) 9.4% 9.6% 9.0% 7.4%Inflation (CPI Dec-Dec, %) 3.2% 1.5% 1.1% 1.9%Financial Markets

Exchange rate (average) 3.38 3.36 3.29 3.18

Interest rate-Dep < 30 days (annual average) 2.68 3.21 4.90 5.77

Balance of Payments (US$ billions)

Exports 12.81 17.34 22.73 26.13Imports 9.81 12.08 15.22 17.79Trade balance 3.00 5.26 7.48 8.33Current account (% GDP) 0.0% 1.4% 2.6% 1.5%

Direct investment (net) 1.80 2.50 2.50 2.89International reserves (end of period) 12.65 14.12 17.20 20.8

Fiscal Accounts (% GDP)Revenues (CG) 15.0% 15.9% 17.3% 17.4%Capital spending (CG)* 1.8% 2.0% 2.0% 2.7%Current expenditures (CG)* 12.8% 13.1% 12.2% 13.2%Overall balance (NFPS)** -1.18% -0.51% 2.0% 0.3%Primary balance (NFPS)** 1.03% 1.77% 3.9% 2.4%Public Debt (% GDP)

Total public debt 41.9% 38.5% 32.8% 29.2%External public debt 34.8% 28.9% 23.6% 19.2%Domestic public debt 9.0% 9.6% 9.2% 9.9%

Sovereign Risk RatingsS&P BB BB BB+stable BB+positive

EMBI+ (***) 220 170 131 118

Competitiveness Indicators

Competitiveness Index GEF (****) n/a 77/117 74/125 n/a

Ease of Doing Business IBRD (*****) n/a 71/155 78/175 65/175

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

***** Doing Business Report, World Bank 2006.

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1.12 At the same time, stronger banking supervision within a stable economic setting haskept the financial system sound, and there has been steady improvement in thequality of its assets, capitalization levels and earnings since 2002.4 Financial

dollarization has declined in recent years, although it remains high.1.13 The public finances have shown continuous strengthening. The deficit of the

nonfinancial public sector (NFPS), which exceeded 3% of GDP in the late 1990s,has gradually been eliminated, and a surplus of 2% was posted in 2006. Fiscaldiscipline and the high growth rates of recent years have helped reduce the balanceof the public debt from 45% of GDP in 2000 to 32.8% of GDP in 2006, and itscurrency, cost and term structure has been improved.

1.14 Access to international capital markets has improved, with historically low spreadsthat were only slightly over 100 basis points at the time this paper was prepared. Infact, with this favorable economic and financial performance, Peru could earn a

sovereign risk classification that would make it the second country in SouthAmerica (after Chile) to achieve an investment-grade rating.5

1.15 The external sectors performance has been very strong. Exports have more thantripled in value over the last seven years, from US$7 billion in 2000 toUS$23 billion in 2006. The external current account shifted from a deficit of morethan 1.5% of GDP to a surplus of 2.6% of GDP over the same period. Togetherwith significant capital inflows, this performance boosted the countrysinternational reserves to US$17.2 billion in 2006, double the level recorded in 2000.

1.16 Peru is in the final stages of approving a free-trade agreement with theUnited States, its principal trading partner. The impact of that agreement (and of

others now in place or in the process of completion) will help to maintain thedynamism of foreign trade and economic growth.

1.17 Despite this favorable picture, the country must address a number of vulnerabilitiesin order to consolidate achievements to date. These weaknesses have to do with thehigh level of financial dollarization in the Peruvian economy, low tax revenues, anddependence on primary products.6 The favorable economic scenario could also beaffected by Perus vulnerability to natural disasters, in particular the El Niophenomenon. From a medium-term perspective, it must be recognized that, despitethe solid performance of the last five years, Peru is just now recovering from a

4 The return on financial system assets rose from 0.8% in 2002 to 2.2% in 2006, and the return on equity jumped from 8.3% to 23.5%. Over the same period, nonperforming loans as a percentage of the totalportfolio declined from 7.6% to 1.9%.

5 In the past, Colombia and Uruguay enjoyed investment-grade ratings. See Peru and Investment Grade,Andrew Powell, IDB 2007.

6 Chapter IV examines macroeconomic risks and their mitigating factors in greater detail.

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severe collapse, and has barely reached the levels of per capita income thatprevailed in the 1970s (see Figure 1).7

Figure 1GDP and exports per capita (constant dollars of 2000)

1500

1600

1700

1800

1900

2000

2100

2200

2300

2400

2500

1975

1976

1977

1978

19

79

1980

1981

1982

1983

19

84

1985

1986

1987

19

88

1989

1990

1991

19

92

1993

1994

1995

19

96

1997

1998

1999

2000

2001

2002

2003

20

04

2005

150

200

250

300

350

400

450

500

550

Per capita GDP (left axis) Per capita exports (right axis)

Source: World Development Indicators, World Bank 2006.

1.18 The collapse of the Peruvian economy was closely linked to contraction in theexport sector, in a context of severe macroeconomic imbalances. The currentrecovery can be explained to a large extent by the export boom, driven by highinternational prices. Yet this improvement has not resulted in any major changes inthe productive structure: Peru still relies on unsophisticated primary goods with

little labor content.3. The social setting

1.19 In contrast to the countrys economic performance, progress in its social indicatorshas not been very encouraging, particularly when it comes to employment. In 2005,nearly 58% of the economically active population (EAP) was unemployed orunderemployed. Between 2001 and 2005, most of the new jobs created were in theinformal sector, particularly in agriculture and in services. Meanwhile, employmentin the formal sector grew by only 6%, less than half the rate of increase in theworkforce. As a result, unemployment and underemployment indicators haveshown no improvement since 2000.8 The degree of informality in Peru is in fact

among the highest in Latin America and the Caribbean.

9

7 See Growth Diagnostics, Ricardo Hausmann et al., 2007.8 See Crecimiento, generacin de nuevas actividades productivas y empleo formal, Carmen Pags, IDB

(2007).9 According to ILO indicators, informal employment in 2002 represented nearly 60% of total employment,

the third-highest level in Latin America, after Bolivia and Colombia. See opo et al. 2006.

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1.20 During this time, output per worker grew very little and real wages fell, particularlyin the informal sector. Generally speaking, labor market conditions havedeteriorated: the number of people working more than 48 hours a week has risen, as

has the number of those working without a labor contract and the proportion ofemployees who have no social security coverage.

Table 2. Employment levels: 2005 (as a percentage of EAP)Geographic spread

Urban Rural Total

Unemployed 7.5 0.7 5.0Underemployed 46.5 63.5 52.6

By hours 10.3 8.4 9.6By earnings 36.2 55.1 43.0

Adequately employed 46.1 35.9 42.4Percentage 100.0 100.0 100.0

Total EAP 8,800,197 5,007,696 13,807,894

Source: National Statistics Institute (INEI) National Household Survey on Living Conditions and Poverty,ongoing 2005.Prepared by: Ministry of Labor and Job Promotion Labor Statistics and Research Program (PEEL).

1.21 Given the labor situation, it is not surprising that poverty levels remain high. In2005, 50% of the Peruvian population was living in poverty, and 18% in extremepoverty. In rural areas the poverty rate is nearly double that in the cities, indicatingthat there is a high incidence of poverty and exclusion among indigenouspopulations. Inequality, as measured by the Gini coefficient, was estimated at 0.43.

1.22 Despite progress in social indicators and in meeting the Millennium Development

Goals,10

the country still faces challenges in the coverage and quality of basic publicservices. In some areas coverage remains very low, particularly in the countryside,where one child in two lives in extreme poverty, and more than 40% suffer chronicmalnutrition. It is estimated that 25% of the total population has no access to water,and more than half lack adequate sanitation. The quality of education is among thelowest in the hemisphere.11

1.23 Slow progress on the labor and social front underscores the difficulty in ensuringthat economic growth translates into greater formal employment and well-being forthe majority of Peruvians. What is needed is not only to accelerate growth andbroaden its basis, but to adopt a social development policy that includes greaterinvestment in human capital, effective social welfare provisions, and creation of

opportunities for people who have been excluded from the benefits of growth.

10 Maternal-infant mortality, for example, has declined from 75 per 1,000 in 1990 to 28 per 1,000 in 2003.Education coverage has already achieved the goal of universal primary schooling. See Annex B for a statusreport on achievement of the Millennium Development Goals.

11 IDB, 2006. Nota Tcnica Sector Educacin, Nota Tcnica Sector Agua y Saneamiento; NotasTcnicas Sector Salud.

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C. The governments development agenda1.24 The Peruvian government has said that its principal challenge is to address the fact

that economic growth has not produced significant benefits for the majority of the

population.12 To this end, it is pursuing an ambitious development program thatseeks to consolidate achievements to date, to accelerate economic growth, and tomove forward in terms of opportunities and social welfare. It has proposed a seriesof initiatives to reduce macroeconomic vulnerabilities and enhance the efficiency ofthe public sector; to strengthen the countrys foothold in the international economyand foster private initiative; and to promote job creation and efficiency in thedelivery of public goods and services.

1.25 The MMF calls for reinforcing the institutional framework for fiscal policy in waysthat will promote public investment and will punish noncompliance with tax rules.Tax reform is also planned, to improve collection and to make the economy morecompetitive, and budgeting-by-results will be introduced to improve the quality ofexpenditure.

1.26 On the international front, Peru is pursuing an active strategy to enhance the qualityand diversity of its participation in the global economy. This involves expandingaccess to the major external markets through the negotiation of free-trade andintegration agreements with several other countries, in particular the United States.At the same time, this strategy is promoting a domestic agenda to create capacitiesfor production and trade, including policies and initiatives to foster competitivenessand to promote private investment.

1.27 The governments social program relies on two pillars: encouraging job creation inthe formal sector and guaranteeing greater access to basic services, in particular

drinking water, housing, and health. To coordinate its social interventions moreeffectively, the government has approved the Social Program Reform Plan, whichtakes a comprehensive long-term approach and includes the reorganization andreorientation of social programs.13 Management by results in budget allocations andgeographic targeting are key components of the planned reform. Labor reforms areplanned to reduce informality and to foster formal employment. A central point ofthis strategy is its emphasis on the quality of education.

1.28 The Bank shares this vision and the objectives of the development program and inthis document it sets forth a strategy for the period 2007-2011 to assist the countryin implementing this program and achieving its objectives.

12 Based on documents and presentations from the ministries of labor, economy and trade during the PolicyDialogue meeting in February 2007.

13 Decree 029-2007-PCM, March 2007.

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II. RECENT RELATIONS BETWEEN THE BANK AND PERUA. The 2002-2006 strategy2.1 The IDB has had a close and very active relationship with Peru. In the first quarter

of 2007, the Peruvian portfolio was the Banks fifth-largest,14 accounting for 4% ofthe total, and Peru had the second-highest number of operations.15

2.2 The Banks country strategy with Peru approved for 2002-2006 identified threepriority areas for support: (i) raising the economys productivity andcompetitiveness; (ii) improving the efficiency of social policy; and (iii) creating amodern, decentralized, and efficient State.

2.3 During this period the Bank approved loan operations with the public and privatesectors totaling US$2.284 billion, or 7.3% of total Bank loan approvals, at anannual average of US$457 million, which represented a significant increase over

the average of US$346 million from 1990-2000. Technical-cooperation operationsamounted to US$27 million, or 3.6% of the Banks total. With respect to the publicsector, the IDB accounted for 16.7% of Perus total external debt in 2006, versus14.6% in 2002, becoming the countrys primary source of multilateral financing,with 47% of its total multilateral debt.

2.4 Operations with the private sector totaled US$333 million, thereby substantiallyincreasing the nonsovereign portfolio in the country, using innovative financialinstruments and involving key sectors for the Peruvian economy.

2.5 In terms of instruments, policy-based loans represented roughly 57% of approvals,investment operations 28%, and private sector operations 15%. Unrestricted funds

covered, on average, 40% of the needs for such financing, in support of the strategyfor optimizing the public debt structure and terms.

2.6 The lending program focused primarily on competitiveness (41% of approvedoperations), followed by modernization of the State (36%) and the social sector(25%). The emphasis on competitiveness was reinforced by technical-cooperationoperations (TCs), financed for the most part by the MIF, with the long-termobjective of increasing the potential for economic growth and sustainable socialdevelopment.

2.7 With the solid economic trend and the performance of the external sector achievedduring implementation of the strategy, the country has moved forward toward itsdevelopment objectives. Despite problems of attribution, it can be said that theBank provided timely support for the development of policies to promote trade andcompetitiveness.

14 After Brazil, Argentina, Mexico and Colombia.15 After Brazil.

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2.8 With the stepped-up pace of trade negotiations, Bank support was critical for gainsin areas that are key to competitiveness, including lowering transportation costs,greater agricultural productivity, the supply of natural gas, the facilitation of

business creation, and execution of bank guarantees.2.9 Also of great importance was the Banks support for development and investment

in the private sector, achieved through the direct financing of projects as well asthrough innovative instruments that facilitate private participation. Given theprivate sectors limited access to long-term financing, the Banks catalytic role hasbeen crucial in attracting commercial financing and new investment to the country.

2.10 The Camisea project, for example, marks a milestone in the Banks support for thecountrys energy strategy and private sector development in the energy sector.16

2.11 The transportation sector is a central focus of the current portfolio. The IIRSANorthern Amazon Hub project, in particular, represents a double milestone, as the

first guarantee project approved by the Bank and the first project financed under apublic-private partnership in Peru (Box 1).

Box 1. IIRSA Northern Amazon Hub

Innovative Financing in Support of Regional Integration, Private Sector Development, andCompetitiveness

In February 2006, the IDB approved a partial credit guarantee of US$60 million to support the Government of Peru inconcessioning infrastructure projects through a financing arrangement that would attract private sector participation. Theinnovative financing structure is based on annual payments for construction issued against certificates of completion,whereby the government undertakes to pay for the works in a series of annual payments defined upon completion of eachphase of construction. The Banks involvement generated confidence, increasing the number of firms interested inparticipating, fostering competition, and reducing financing costs.

The concession contract distributes the principal risks among the parties, including the construction and maintenance risks,traffic shortfall risks, and environmental risks (including natural disasters and El Nio). Moreover, the financingarrangement allows the government to account for the costs in the budget, rather than as debt, thereby improving its riskratings and lowering the countrys borrowing costs in capital markets.

The concessioned works relate to the improvement and rehabilitation of 960 kilometers of roads, making this one of thelargest concessions in the region, linking areas of great geographic complexity. The new infrastructure will encourage tradeand the establishment of new inter- and intraregional production centers, thereby significantly reducing transport costs. Itwill facilitate ecotourism and the production and marketing of tropical fruits and other products from the area. It is alsocreating jobs in construction and maintenance of the works, and is providing greater access to social services for localpeople, particularly those in remote areas.

The project was recognized by Project Finance International as Latin American project bond deal of the year in 2006. Ithas opened up new opportunities for using guarantees to help governments in the region expand their financing options,encouraging new private investments, and promoting greater development.

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

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

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inequality and poverty. This suggests the need to bolster Bank support and to adoptan approach that combines strengthening the social welfare system for the mostvulnerable and excluded groups with support for creating opportunities for the

majority of the population, emphasizing investment in early childhood, technicaland vocational training, and the quality of basic education.

2.13 When it comes to public management and reform of the State, the most significantoutcomes were recorded in the support granted by the Bank for managing fiscalpolicy, the quality of public expenditure, and managing the public debt. Thecountry now has a modern administration system and the public accounts are moretransparent. The quality and the transparency of the public information system areparticularly noteworthy.17 Bank support has been fundamental in moves tostrengthen medium-term economic planning and to achieve orderly and progressivedecentralization consistent with fiscal discipline. Yet the State reform process hasbeen spotty, and a greater effort is needed in various areas of government at the

national and subnational levels.2.14 As a result of this strategy, the current portfolio consists of 27 loan operations

totaling US$1.43 billion (see Annex K).

B. Evaluation and lessons learned2.15 In general, the evaluation of the previous strategy was favorable. In financial terms,

the IDBs share in the multilateral financing market rose significantly. At the sametime, direct support to the private sector expanded in key sectors of the Peruvianeconomy. As to the impact on development objectives, the Bank strategy supportedthe countrys agenda, particularly in the areas of competitiveness and growth.

2.16

The Office of Evaluation and Oversight (OVE) conducted an independentevaluation of the strategy and concluded that the Bank was a relevant partner forPeru in addressing the countrys development problems. Annex M describes therecommendations presented by the OVE and the actions taken or planned byManagement to address them.

2.17 The analysis of the Banks work with the country and the OVE evaluation point tothe following key recommendations for the design and implementation of thecurrent strategy.18

2.18 Optimizing the generation and use of nonfinancial products. Analytic work isan essential element for sharpening the country focus and strengthening: (i) policydialogue with the country, (ii) priority setting for areas of intervention,(iii) development of the strategy, and (iv) the design of operations.

2.19 A programmatic approach. The relationship between the countrys achievementsand the Banks initiatives indicates that support is most effective when it focuses on

17 Montenegro (2006) highlights Perus achievements in this area and ranks it among the leading countries ofthe region in terms of the availability and transparency of public information.

18 See Melo (2006), Country Program Evaluation (CPE): Peru: 2002-2006.

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a limited number of areas and takes an integral approach which, by strategicallycombining available instruments (policy-based loans, investments and credit to theprivate sector) can strengthen results-based orientation.

2.20 Emphasizing the production-based approach to social development andinclusion. The slow progress that has been made in combating poverty and creating jobs demonstrates the need to encourage greater articulation between policies foreconomic inclusion (i.e. microfinance, production chains) and combating poverty(the social agenda) in order to achieve sustainable structural change.

2.21 Improving coordination within the Bank. Coordination of public and privatesector operations is essential for strengthening the Banks strategic vision ofsupport.

2.22 Supporting the consultation process. A smooth-flowing dialogue and aconsultation policy that includes all stakeholders are key to maximizing the impact

of Bank support.2.23 Strengthening project preparation and execution. Strengthened analytic work

and institutional analysis and effective risk management are important elements forthe design and effectiveness of programs. Particularly important in this context isthe Banks role in providing project management training, consulting and technicalassistance services for executing units.

III. THE BANK STRATEGY WITH PERU FOR 2007-20113.1 The new 2007-2011 strategy continues the thrust of the Banks work with the

country in areas relating to competitiveness, social development, and modernization

of the State, taking account of lessons learned and the OVE recommendations setout in the previous chapter.

3.2 The strategy reflects wide-ranging discussions of policies with the government andwith Peruvian society to identify the constraints the country faces in achieving itsdevelopment objectives, and is designed to support Perus development agenda bydeepening the countrys sustainable economic growth and generating greateropportunities for the majority of Peruvians. Bank support is grouped into threestrategic pillars: (i) strengthening Perus foothold in the global economy andenhancing competitiveness; (ii) promoting social development and inclusion; and(iii) deepening the reform of the State and improving public management. Whileeach area constitutes an objective in its own right, the programmatic approachadopted ensures that the pillars and their objectives are closely linked.

A. Foothold in the global economy and competitiveness3.3 The central objective of this strategic area is to strengthen Perus foothold in the

global economy and increase competitiveness as the primary engines of sustainedgrowth and job creation in the Peruvian economy. This will require expandingaccess to international markets, diversifying the economic structure, and promotinginvestment and productivity in the private sector.

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1. Current situation and principal challenges3.4 The recent performance of Perus external sector has been extraordinary. Growth in

the value of goods exports, led by mining exports, has been the highest recorded in

the last six decades of Perus history.19 Nontraditional exports, in particularagricultural and textile products, have also shown significant growth.20

3.5 Despite this performance, the Peruvian economy remains relatively closed. Thedegree of openness, measured as the sum of exports and imports as a percentage ofGDP, has not changed substantially in the last 40 years,21 and per capita exportsremain among the lowest in the hemisphere. Primary products and raw material-intensive manufacturing account for more than 80% of the countrys external sales.The share of manufactures in exports is among the lowest in the region. Empiricalevidence suggests that the scant diversification of Perus exports and the countrysdependence on unsophisticated exports of a limited number of natural resourcescould hold back the countrys long-term growth potential. Moreover, thisconcentration in capital-intensive goods helps to explain why recent growth has nottranslated into greater employment gains in the formal sector of the economy.

3.6 The key problem is that Peru has not gone through a process of discovery of newsectors, of innovation and the emergence of new businesses that would bringgreater productive diversification, new exports, and more jobs.22 The competitiveclimate in Peru has not favored diversification and private sector development.According to the World Economic Forum, Peru ranks 74th among the 125 countriessurveyed. Its relative international standing has not changed significantly in recentyears, despite its improved performance in terms of growth and exports.

3.7 Consequently, a strategy for deepening Perus participation in the global economy

must go hand-in-hand with efforts to reinforce the countrys competitiveness andproductive diversification. The following sections describe the main areas of Banksupport for achieving the objectives of this first strategic pillar.

2. Principal areas of Bank supporta. Market access

3.8 The government has adopted an active strategy for expanding access to externalmarkets through integration and free-trade agreements with various countries,including the United States, which is the worlds largest market and the maindestination of Peruvian exports. Other agreements are being negotiated with theEuropean Union, Chile, Mexico, Thailand and Singapore as part of a strategy to

19 External sales rose from US$5.8 billion in 1998 to US$23.8 billion in 2006. The figure for 2007 isestimated at US$26.4 billion, representing a nearly fivefold increase over the last nine years.

20 Nominal annual growth is estimated at 20% over the period 2003-2007.21 In 1960 this indicator was 42%, and in 2006 it was 43%.22 See Growth Diagnostics, Ricardo Hausmann et al., 2007.

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boost competition, seek out new markets, and achieve sectoral and geographicdiversification.

3.9 The U.S. and Peruvian governments reached an agreement on the terms of a free-

trade agreement, which is now being implemented.3.10 The conclusion of the free-trade agreement (FTA) with the U.S. and other trade

agreements is only the first step in a long process, one that will demand great effortin terms of legal reforms, new regulations, standards, administrative procedures andinstitutional changes. According to IDB studies, once the FTA with the U.S. isimplemented, the industries that should experience the greatest growth will betextiles and clothing, metal products, and food products.23

3.11 Yet, in the absence of parallel policies to open the economy, trade integration withUnited States will tend to accentuate the concentration of exports, and would nothelp position the country in high value-added market niches. That outlook

highlights the need to accompany trade liberalization with competitiveness policiesthat will strengthen the dynamic impact of integration.

b. Domestic agenda3.12 While the different scenarios are all favorable, trade agreements by themselves are

not a panacea for achieving greater growth and export diversification. To ensurethat increased international economic dealings can be an instrument for achievingdevelopment objectives, the Peruvian government is at the same time pursuing adomestic competitiveness agenda complementary to its trade initiatives, designed toincrease opportunities and minimize risks.

3.13 The domestic agenda includes promotion of investment and development of the

private sector in ways that will reinforce the links between trade and growth andthat will also create jobs and promote well-being. Such linkages are essential if allsectors of the population are to participate in the opportunities that greater linkageswith the international economy will bring.

3.14 The Bank has been playing an effective role in articulating public-private dialoguefor identifying priority initiatives and policy reforms to address the barriers tocompetitiveness.24 It is important to deepen the Banks catalytic role by supporting

23 Inter-American Development Bank, INT/ITD, Documento de Discusin sobre Comercio e Integracin,2006.

24 According to an IDB study, the main barriers have to do with: (i) a weak institutional framework and weakinstitutions in both public and private sectors, resulting in unstable rules of the game, high levels ofcorruption, and little cooperation; (ii) the lack of modern business legislation and a judicial system that isslow, uncertain and nontransparent; (iii) a structurally deficient tax system with high levels of evasion;(iv) limited access to credit and financial services, with weak protection of property rights; (v) laborrigidities and an inadequate flow of information in labor markets; (vi) shortcomings in basic publicinfrastructure, especially ports, transportation and logistics; (vii) the poor quality of public education (basic,technical and university) and weak linkages between technical and vocational training programs and thedemands of the productive sector; (viii) poor management of natural resources and the environment; and(ix) a low level of innovation. IDB 2006, Nota Tcnica Desarrollo del Sector Privado.

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institutions such as the National Competitiveness Council and private sectororganizations, and by directly fostering the development of productive clusters.Tourism, in particular, is a sector with great potential.

3.15 While all of these factors are relevant, Bank support will need to focus on the mostconstraining obstacles that have discouraged private investment and ventures intonew sectors and enterprises, where the Bank at the same time has a particularstrength or advantage. Three principal areas of concentration have been identified:

(i) Infrastructure (roads, ports, logistics), relating especially to waterresources, drinking water and sanitation.

(ii) Access to capital, in particular direct financing for the private sector.

(iii) Support for productive sectors, with the emphasis on the sustainabledevelopment of hydrocarbons and other extractive industries.

3.16

At the same time, it is proposed that the Bank support the country in otherinterrelated areas that are key to improving the countrys competitiveness:

(i) The business climate.

(ii) Labor markets.

(iii) Innovation and the adoption of technology.

(iv) Environmental sustainability.

(i) Infrastructure3.17 Public investment in physical infrastructure in Peru has amounted to about 1% of

GDP in recent years. Private investment has also been very limited. Consequently,

the investment shortfall in physical infrastructure, especially transportation, ports,logistics and water resources management, stands at US$22 billion. To cover thisgap, public investment at the national and subnational levels must be increased, andthe private sector must be encouraged to participate through concessions and othertypes of public-private partnership.

3.18 This investment shortfall has left Peru with serious deficiencies in infrastructureand logistics services, especially in port infrastructure, the efficiency of which,according to WEF indicators, is among the lowest in the region and indeed in theworld (105/125).25 The lack of investment in the countrys main port, Callao, meansthat container handling costs are high: the average charge for a 20 ft. container is

80% higher than in Valparaso and dock times are 50% longer than the internationalaverage.26 This is a critical issue for Perus competitiveness, since more than90% of its exports are shipped by sea. Transport costs constrain the volume and

25 WEF, 2006.26 UNCTAD, 2005; CAF, 2003.

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diversification of exports. Transport operating costs are relatively high in Peru, atUS$0.62 per kilometer, compared to US$0.55 in Colombia and US$0.34 in Spain.27

3.19 There are significant shortages of water infrastructure. Access to this resource has

become a strategic issue from various standpoints, in particular as a critical factor ofcompetitiveness. Mining, agriculture and energy production account for 80% ofwater consumption. If Peru aspires to continue growing at the current pace, it willhave to ensure access to and sustainable management of this resource. The Bank,together with the Peruvian authorities, has therefore identified the sector as apriority for a long-term programmatic approach. In fact, this is one of the clearestexamples of the strategic focus of the Banks activities in the country, as indicatedin Box 2.

Box 2. Water resources, drinking water, and sanitation

A shared vision and a strategic approach

The IDBs activities in the water sector in Peru demonstrate the strategic support that the Bank can offer the country forachieving its development objectives. A number of aspects are worth noting. On one hand, its approach is based onextensive analytic work and ongoing policy dialogue with the country to identify priorities. On the other hand, it has aflexible programmatic approach that uses various windows and financial and nonfinancial instruments of the Bank, with amedium-term vision that combines public policy reforms in the sector, investment projects, and private sector participation.

The Bank will continue to focus its attention and resources on this sector in order to help achieve the objectives of thevarious programs and ensure that they contribute to Perus development. The first year of this strategy calls for a total ofUS$450 million in investment loans, programmatic operations in the sector of water resources, drinking water andsanitation, and technical assistance. For the remainder of the strategy, additional operations have been preliminarilyidentified amounting to between US$600 million and US$800 million, making this the Banks biggest sector ofconcentration in Peru.

The Banks program in the water sector is helping to achieve various objectives of the Banks strategy with Peru: it is

providing inputs and basic infrastructure for improving the countrys competitiveness, it is enhancing the delivery of anessential good for the poorest population, and it is modernizing the institutional framework for decentralized resourcemanagement. In addition, it is addressing the needs of conservation and sustainable management of natural resources and isconsistent with two priority Bank initiatives: the Water and Sanitation Initiative and Opportunities for the Majority.

Despite progress in recent years, water resource management in Peru still suffers from problems of scarcity, inefficiency andpoor quality. Water demand to satisfy human consumption needs, productive activities and environmental requirements hasbeen growing significantly, and programs in this sector are thus priorities for achieving the countrys developmentobjectives.

(ii) Access to capital3.20 The development of financial markets in Peru has helped to improve

intermediation, microfinance, and financial services to the private sector. Averageinterest rates have remained stable, and spreads have dropped to historic lows,thereby facilitating access to external financing for the financial and businesssector. According to the Doing Business report, there was a significantimprovement in the private sectors perceptions of access to financing from 2002 to2006.

27 Instituto Peruano de Economa, 2003.

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3.21 Nevertheless, access remains limited for low-income sectors (natural and artificialpersons). The problem is particularly acute for micro, small and medium-sizedenterprises. Only 9% of such firms borrowed from the formal financial system (in

contrast to 100% of large companies), and the average interest rate on loans tomicroenterprises is 38.7% (compared to the banks prime corporate lending rate of5.2% for their lowest-risk clients).

3.22 The IDBs different windows for the private sector have the comparative advantageof facilitating access to financing. Box 3 summarizes the strategy for supportinggrowth of the private sector, and emphasizes the IDBs role both as a direct lenderand as a catalyst for financing private productive activities.

Box 3. Financing and development of the private sector

The strategic pillar supporting a foothold in the global economy and competitiveness is closely related to the development of

the private sector.

Beyond promoting reforms to improve the business climate and facilitate access to key factors such as infrastructure, theBank can contribute directly to private sector development through financing and other financial products offered by theprivate sector window, the Structured and Corporate Financing Department (SCF), the Inter-American InvestmentCorporation (IIC) and the Multilateral Investment Fund (MIF).

The Banks new vision consolidates the different private sector windows and provides a wide variety of financialinstruments including direct loans, A/B operations, guarantees, and direct or catalyzing interventions in capital markets (forexample, mortgage securitization).

Through SCF and the IIC, the Bank has an extensive network of clients in the traditional sectors (financial and corporate).Nevertheless, it could position itself as well in new sectors where it could add value.

For its part, the MIF is supporting small-scale interventions to carry out experimental pilot projects that could spark newpractices and encourage larger scale reforms. The MIF can provide nonreimbursable technical assistance to the private sector

to improve the business climate, build the capacity of the workforce, and expand the economic base for participation bysmall businesses.

(iii) Energy and extractive industries3.23 The central message of the Banks strategy with Peru is the need to foster

diversification in the Peruvian economy. Given the wealth and enormous potentialof the countrys extractive industries, especially hydrocarbons, however, the Bankshould not turn its back on these sectors, and should indeed support the sustainableuse of natural resources, innovation and the generation of new activities of greatervalue added, based on these resources.28 Short-term economic growth prospects will

continue to depend on the performance of these sectors. Recent investment inextractive industries has been impressive, with a cumulative total ofUS$14.3 billion between 1994 and 2005. The share of this sector in GDP innominal terms rose from 4.4% in 1998 to 11% in 2005. This reflects growth in realoutput and improved terms of trade for minerals and hydrocarbons, particularlysince 2003. Exports in 2005 reached 14% of GDP, representing 66% of the

28 Espinasa, R., 2007.

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countrys total exports. Higher levels of production and activity in mining andhydrocarbons has significantly increased their fiscal contribution, in both absoluteand relative terms, although that contribution is still one of the lowest among

countries that export these goods.

29

3.24 According to a survey by the Fraser Institute, reported in its Annual Survey of

Mining Companies 2005-2006, Peru ranks first among 64 mining countries andregions around the world in terms of its mining potential. Yet when looked at solelyin terms of the policy environment, without taking into account the geological oreconomic evaluations, Perus ranking drops to 44 out of 64, while Chile stands infourth place. This indicates that mining exploration and operations are hindered bythe uncertainty surrounding government policies and the business climate.

3.25 Peru has important reserves of natural gas, the exploitation of which, through theCamisea and Peru LNG projects, would allow the country to satisfy its domesticdemand and, in future, to become a net exporter. The Bank is supportingdevelopment in this sector, and in particular gas production through the Camiseaproject, as well as its second phase, Peru LNG. Both projects are part of acomprehensive approach in the energy sector, reflected in an operations matrix (seeBox 4 and Annex F).

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

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Box 4. Energy sector operations matrix

Peru has abundant natural resources for producing energy. In recent years, it has established a legal and regulatoryframework to promote various sources of energy, and this has sparked greater private investment as well as incentives for

research and technological development. In particular, the countrys energy policy supports efforts to develop the natural gasmarket in order to derive maximum benefit from an energy alternative that is cleaner and more economical than oil, andmore stable than hydropower. However, development of the energy sector faces major environmental and social challenges.

The Bank has supported Perus efforts to diversify its energy matrix. It financed a portion of the downstream component ofthe Camisea project (the Camisea deposits are located in the Department of Cuzco). A US$75 million loan from the privatesector window is financing construction of dry and liquid gas pipelines (see www.camisea.com.pe for project details). Inaddition, the Bank supported a further project to reinforce the governments capacity to supervise and control theenvironmental and social impacts of the Camisea project.

The private sector window is now performing due diligence work on the Peru LNG Project, for purchasing and liquifyinggas from Camisea for export to markets in the Pacific Basin. The project involves an extension of the Camisea gas pipelineto a liquifaction plant and a sea terminal. The cost of the project is US$3.8 billion, representing the largest private investmentin Perus history. The Bank would provide an A loan of US$400 million and a B loan of the same amount. The projectis expected to generate revenues of US$800 million annually; it will create around 35,000 jobs, directly and indirectly,during the construction phase, and 2,750 jobs for the life of the operation. The Government of Peru will earn average annualroyalties of US$200 million, plus US$150 million in tax revenues during the first 20 years of operation.

Peru LNG poses institutional challenges as well as environmental ones, particularly in the Bay of Paracas, and it is importantto continue strengthening the governments capacity to monitor and regulate socioeconomic conditions in this area. Basedon experience with the Camisea Project, Peru LNG has adopted a policy of consultation and participation with the mainstakeholders (the public and private sectors and civil society). An environmental and social impact assessment has beenprepared for each component of the Peru LNG Project (see www.perulng.com for details on the environmental and socialimpact report).

The Government of Peru is also seeking Bank support for preparing a medium-term strategy that would establish a policyframework for sustainable development of the hydrocarbons sector. The Bank has begun work on the design of aprogrammatic loan to identify a new sustainable energy matrix, by creating a new investment framework for the energysector that will maximize economic benefits from hydrocarbon resources and apply comprehensive environmental andsocial safeguards. Through technical-cooperation operations, the Bank is assisting in various areas, including a strategy forhydrocarbons development and management, support for the social and economic development of indigenous communities

in the Lower Urubamba, and strengthening the governments capacity to regulate and supervise energy efficiency.The sustainable development of the energy sector in Peru is a very complex process that will require a high degree ofcoordination between sectors, supported by integrated policies. This offers new opportunities for the Bank over the short andmedium term, through integrated and coordinated support in four interrelated areas: (i) energy sustainability policies;(ii) financing of private investment; (iii) environmental and social sustainability; and (iv) energy efficiency and thedevelopment of renewable sources.

3.26 As noted above, other themes have been identified that are complementary to theareas indicated as priorities, and are fundamental to strengthening the countryscompetitiveness. In particular, interventions are being considered to address thebusiness climate, labor markets, innovation, and environmental sustainability.

(iv) The business climate3.27 The business climate for private investment in Peru has been affected by

expropriation risks and uncertainties over legal stability and property rights. In fact,some of the events that contributed to the collapse of exports in the past weresparked by nationalization in the mining and agroindustrial sectors. While suchrisks have now diminished, transaction costs remain high, and these affect business

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productivity and profitability and explain in part why there is such a large informalsector.

3.28 The International Finance Corporations Doing Business Report (2007)30 has

raised the ranking of Perus business climate from 78 to 65 among 175 countries.Nonetheless, businesspeople still perceive excessive licensing requirements andregulations as obstacles to investment, and this perception indeed worsenedbetween 2002 and 2006.31 The report ranks Peru very poorly in terms of the cost ofenforcing contracts, which is equal to 35% of the claim, twice the prevailing levelin Argentina or Chile. It also highlights difficulties in opening a business orbuilding a warehouse, which is more costly and takes longer than in comparablecountries. For example, it takes 72 days to incorporate a company, compared to44 days in Colombia or 27 days in Chile. The tax burden and labor regulationsappear to be the most complex in Latin America.

3.29 The Bank has been supporting government efforts to improve the investmentclimate and reduce transaction costs. Following dialogue with the principalgovernment and private-sector stakeholders, a Plan of Action for the Private Sectorhas been prepared to guide IDB initiatives in this area.

(v) Labor market3.30 Private-sector investment in new economic sectors and businesses will be the basis

for broadening growth and creating jobs. To facilitate the latter, however, Peru mustadapt its labor market institutions to encourage demand for labor, especially in theformal sector of the economy. To begin with, nonwage costs are among the highestin Latin America, at 66% of the payroll. Firms attempt to boost their productivityby operating with fewer workers, and hiring them without contract. Even the most

productive sectors rely on informal workers to reduce labor costs.3.31 Given the low productivity of labor, the availability of training is inadequate to

meet demand, recognizing that businesses, especially the smaller ones, do notthemselves invest in training. The quality of training providers and the instrumentsadopted varies greatly, and it is often difficult to ascertain the relevance and qualityof the training provided. Even in the private sector, where incentives to offer qualityservices should be stronger, there is still (with a few exceptions) a glaring mismatchbetween training and private-sector demand.

(vi) Technological adaptation and innovation3.32 Technological innovation is a crucial element for enhancing productivity and

boosting competitive development. Peru has increased its investment in researchand development (R&D) as a proportion of GDP (from 0.08% in 1997 to 0.11% in2001), but it remains far below the average for Latin America and the Caribbean

30 Peru is continuing to improve its business climate according to the 2008 Doing Business Report, with itsranking rising to 58of 178 countries.

31 See Carmen Pags, 2007.

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(0.62% of GDP in 2001). This is one of the lowest levels in the region, similar tothat of Ecuador and far below Brazil (1.05%) and Chile (0.57%). The private sectoraccounts for only a marginal share of R&D spending in Peru. From an institutional

viewpoint, there is a lack of articulation between players in the system(government, universities, research centers, and businesses) and resource allocationbears little relationship to sector priorities.

3.33 The National Competitiveness Plan includes the goal of developing a culture foradopting new technologies and innovations, fostering research, specialization andtechnology transfer as key elements for boosting the countrys competitiveness andits ability to face the challenges of free trade with the United States. Technologicalinnovation has also been identified as one of the key aspects for increasing the shareof industry in GDP and in the countrys exports. In this context, the Ministry ofEconomy and Finance (MEF) recently announced the creation of three funds insupport of science, technology and innovation.32

(vii) Environmental sustainability3.34 Given the projected patterns of future growth, in particular the development of

mining, energy and agriculture and of infrastructure projects, it is essential to ensuresustainable use of natural resources and sound environmental management. Theeconomys dependence on natural resources such as minerals, fuels, and fish, has insome cases led to degradation of the environment, of biodiversity, and of humanhealth.

3.35 These economic activities generate adverse impacts on the state of naturalresources, and those impacts must be internalized. The present institutionalstructure in fact makes it all the more urgent to work closely with the productive

sectors. The absence of a strong and independent environmental regulatory agencyundermines the effectiveness of the many environmental regulations that have beenadopted in Peru.

3.36 The environmental management strategy should address three major challenges:(i) identifying the specific environmental impacts of each sector, and mechanismsto internalize their costs; (ii) strengthening the institutional structure to ensureindependent supervision and regulation; and (iii) reducing the growing cost ofenvironmentally-caused health problems.

3.37 Recognizing the interrelationship between economic development, the expansion ofmining, and the need to remedy mining liabilities, as well as to avoid future

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

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environmental damage, the Bank is working with the government on a potentialloan for a program of comprehensive remediation of mining liabilities.

B. Social development and inclusion3.38 The objective of this pillar is to develop the conditions, capacities and opportunities

needed so that the majority of the population can participate effectively ineconomic growth, so as to improve their well-being and reduce poverty andinequality.33 This will require an increase in the quantity and quality of socialinvestment and the effective delivery of public goods and services, so as to achievegreater inclusion and opportunities for the poorest and most vulnerable population.

3.39 This pillar is complementary to the support for gaining a foothold in the globaleconomy and competitiveness, and entails efforts in three interrelated areas:(i) long-term investment in human capital (education, health, housing, and basicsanitation), (ii) social welfare and inclusion, and (iii) opportunities for the majority.

1. Current situation and principal challenges3.40 Peru has a long history of poverty, discrimination and social exclusion. Nearly half

of Peruvian society lacks human capital and the essential conditions to subsist in themodern economy. The majority of these people work outside the formal sector insmall businesses or microenterprises, or in low-productivity subsistence farming,and they are highly vulnerable to external shocks that affect their capacity to work.Recent economic growth represents an undoubted opportunity to address Perussocial challenges. Yet one of the main problems has been that the basis of economicgrowth has been too narrow, and job creation has been insufficient.

3.41 This trend is of concern, in light of current demographic patterns. The slow growth

of labor demand is at odds with the high growth in the workforce and the increasingparticipation rate of women. According to estimates of the National StatisticsInstitute (INEI), the dependency ratio in Peru will reach historically low levels by2030, when there will be two people working for every child or elderly person.Currently, around 60% of the population is under the age of 29.34 This so-calleddemographic dividend represents a great opportunity for growth, as the presentgeneration will have to integrate itself into a dynamic economy. Yet that samestructure could become a risk if this population remains marginalized. Thus, thefirst pillar of the strategy will support a broader base for Perus economic growth inorder to create job opportunities and capitalize on this demographic dividend.

3.42 Greater growth and new jobs are essential but not sufficient conditions forimproving social welfare in Peru. Concerted government efforts are also needed toensure greater and better social investment and the delivery of public goods and

33 Conditions and capacities refer to minimum elements of human capital development such as housing andbasic sanitation, health, and education. Opportunities are those elements needed for access to the labormarket, productive activities, and public goods and services.

34 ECLAC/CELADE, Cambios en la estructura poblacional: Una pirmide que exige nuevas miradas, 2005.

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services to the poorest population, as proposed in this second strategic pillar.Various studies show that social expenditure in Peru has frequently been inefficientand regressive, despite the rising amounts involved.35

3.43 In addition to traditional social problems, Peru faces a serious situation of socialexclusion for indigenous and Afro-Peruvian populations. Recent studies haveshown that these people are poorer and have less access to education, health andcredit than the nonindigenous population.36 The geographic location, educationallevel, gender and ethnic background of a person will for the most part determinewhether that person is poor or not. A woman with four years of schooling, living inthe Sierra and speaking a native language, has a very high probability of being pooror very poor. The lack of social mobility virtually condemns her daughter to thesame fate.

3.44 Thus, generalized efforts to improve living conditions and enhance opportunitiesfor the majority must include a special focus on the social, political and economicinclusion of these populations.

2. Principal areas of Bank support3.45 The governments social platform is three-pronged: (i) guaranteeing greater access

to basic services, (ii) promoting opportunities for formal employment, and(iii) strengthening the social welfare system.37 Key to the strategy is the emphasison the quality of education, reflecting the consensus achieved in the NationalAccord.

a. Access to basic public services3.46 The governments plan emphasizes access to education, health, drinking water and

sanitation, and housing for the most vulnerable groups, through coordinatedinterventions. The Bank will continue to support the achievement of long-termobjectives in these areas.

(i) Education3.47 The net enrollment rate is 93% for compulsory primary education, and 70% for

secondary education, with lower coverage (53%) in rural areas. While Peruvianshave among the highest mean education levels in Latin America, in terms of yearsof schooling (Barro and Lee, 2000), there are problems with the quality ofeducation, and Peru ranks last in this regard, well below countries at similar levels

35 Carranza et al., 2007.36 opo, Hugo; Saavedra, Jaime, and Mximo Torero (2004)Ethnicity and Earnings in Urban Peru, in Social

Inclusion and Economic Development in Latin America; IDB (2004) Mayra Buvinic and Jacqueline Mazza,eds.

37 Measures to reduce informality and promote the creation of formal employment also include reforms toreduce nonwage labor costs.

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of development.38 Public spending on education fell from an annual average of3% of GDP in the 1970s to 1.6% in 1990. It has recovered in recent years to 3%,but still falls short of international standards in education, as measured by

cumulative outlays (on a PPP

39

basis) to 15 years of age. This indicator stands atUS$3,479 for Peru, compared with US$41,627 for Spain, US$18,893 forArgentina, US$17,820 for Chile, and US$12,189 for Mexico.

3.48 The Banks proposal is to support the extension of early education with theobjective of: (i) universalizing it for children aged 4 and 5, (ii) expandingopportunities for early childhood stimulation and integral service for children up toage 3, and their mothers, and (iii) considering an integrated package ofinterventions in nutrition, education and health in the program targeted at childrenunder 6.

(ii) Health3.49 The same pattern can be seen in health expenditure (3% of GDP). Despite progressin reducing child mortality and malnutrition, there are disparities in access to

services, reflecting the unequal distribution of available medical infrastructure. As aresult, 60% of Peruvian provinces have no local hospitals, meaning that:(i) approximately 4.3 million people have no access to hospital care, and (ii) thosewho do have such access face high costs in terms of travel and time. Thegovernments priority goal is to increase the use of institutional services to reducematernal-infant mortality.

3.50 The IDB and the World Bank are providing joint support to the country inmodernizing and reforming its health system, with a view to improving healthconditions for low-income mothers and children by expanding access to effective,

efficient, and high-quality health services. Future efforts will maintain their focuson reducing maternal-infant mortality, combining this with the strategy to promoteintegral care and service for children under 3.

(iii) Water and sanitation3.51 There is still a critical lack of drinking water and sanitation services. Water service

coverage averages 74%, and sanitation 56%. Household water connections reachonly 66% of the population, while 8% rely on public standposts; 49% of thepopulation has household sewer connections, and 7% use latrines. In 1999, sewagetreatment coverage was estimated at 16% nationwide. To reduce the service deficit,particularly for the poorest people and those in rural areas, the government has

launched a program, Water for All. The Banks approach in this area is describedin Box 2.

38 Obviously, there is some circularity to this argument. In effect, the problems observed in the educationsystem could be endogenously derived from the lack of effective demand for improvement.

39 Purchasing Power Parity.

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(iv) Housing and neighborhood improvement3.52 With 75% of its people living in cities, Peru is highly urbanized, and this means

growing demand for housing, particularly for low-income families. It is estimated

that 68% of urban dwellers are living in substandard homes without basic services.The lack of funds for building even the simplest dwellings,40 and difficulties inarranging mortgages, has led the government to launch programs called MyHome and My Neighborhood ( Mi Vivienda and Mi Barrio), to encourage thepurchase of basic housing and improve conditions in urban settlements. The Bankhas long experience with the country in this sector, and is working in accordancewith guidelines provided by the authorities on a proposal to strengthen the low-costhousing market, through: (i) creation of a Family Housing Bond for the purchaseand upgrade of basic housing; (ii) mortgage financing; (iii) servicing of lots forlow-income housing in high-quality urban developments; and (iv) integralneighborhood improvement, including road access and the establishment of

neighborhood councils.b. Promotion of opportunities

3.53 To achieve a sustainable impact on social development, the authorities haveadopted a strategy to boost job creation in labor-intensive activities, and to supportthe development of rural businesses through initiatives to provide clear landownership rights. This approach complements and reinforces the objectives of thecompetitiveness pillar.

(i) Fostering rural exports3.54 The program conceived by the government for integral development of the Sierra

proposes initiatives to expand its productive potential by developing competitiveexport activities (in farming, agroindustry, livestock, aquaculture, handicrafts,textiles, jewelry, forestry and tourism), and to enhance their commercial value. Theobjective is to link small producers in the Sierra with regional and internationalmarkets, and thereby to diversify the rural economy and promote the sustainablemanagement of natural resources, improve standards of living, and preserve theenvironment.

3.55 To develop and consolidate local and international markets for specific productsfrom the Sierra, the Bank is supporting design work on this program, by financing astudy to categorize investmentand and technical cooperation opportunities thatcombines: (i) promotion and strengthening of production chains; (ii) formulation

and implementation of rural business plans for selected production chains, usingcompetitive procedures based on social and economic criteria that will have a clearimpact on reducing poverty in rural communities (competition-based funds); and(iii) decentralized planning of regional development, to help generate anappropriate climate for rural businesses to flourish.

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

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(ii) Land titling3.56 Rural development in Peru has been held back by difficulties in defining land

ownership rights, regularizing landholding, and registering properties. Lack of title

precludes access to financing for rehabilitation or reconstruction and discouragesproductive investment. All of this depresses incomes and encourages informalactivities. The government intends to move forward with the certification of landtitles, which so far has covered 53% of individual properties, and to strengthen localand regional land survey and registry services. The Bank has already played a rolein this process, supporting ownership regularization of around a million propertiesalong the coast, and proposes to pursue cooperation with the government torevitalize the land market.

(iii) Microfinance3.57 There are some 3.1 million microenterprises and small businesses in Peru,

constituting 97.7% of all entrepreneurial units, employing 70% of the economicallyactive population, and generating around 42% of GDP. Despite the widespreadpresence of financial institutions serving microenterprises, a significant portion ofthe low-income population has no access to financial services that meet their needs.It is estimated that the commercial banking system covers fewer than 30% ofmicroenterprises and small businesses, and coverage is even lower in rural areasand in smaller cities. Rural credit is generally seen as entailing high risks and lowreturns. Among the obstacles to increased coverage are the limited range of specificproducts offered, and collateral requirements that are inappropriate for the ruralsector.

3.58 With its experience in this sector, the instruments available (i.e. MIF), and the work

already done in the country, the Bank is in a position to help the authorities improveaccess to high-quality financial services for segments that use bank services verylittle. In this context, future activities will be designed to strengthen financialinstitutions in their capacity to manage risks, develop new products, and enhancecorporate governance, with particular attention to the cajas rurales (rural bankingcooperatives) and EDPYMEs (small business and microenterprise developmentagencies), so that they can expand and consolidate their operations and penetratenew markets.

c. Social welfare3.59 Social spending rose from 3.9% of GDP in 1990 to 7.3% in 2005. Yet poverty has

not declined, and this points to problems of efficiency. Social programs producelimited results because of lack of targeting and institutional weaknesses in the socialwelfare system. When it comes to social security, coverage is very limited: in 2000,72% of salaried workers and 83% of all workers were in the social security system.The government is preparing a plan to rationalize and target social welfareprograms so as to enhance their impact, reduce administrative costs, generateeconomies of scale, cut service delivery costs, and foster accountability.

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3.60 The Bank has been supporting the countrys efforts to target and consolidate theallocation of funds to regional social programs. These efforts could be enhancedthrough support for integrating the programs in the context of the Social Program

Reform Plan, with emphasis on rationalizing resource use and developing thecoordination and supervisory capacities essential to operation of an integratedsystem, and the design of policies to expand social security coverage.

C. Reform of the State and public management3.61 This strategic area is essential to strengthening democratic governance in Peru, and

critical for putting the Banks strategy with the country into effect. The centralobjective is to support Perus efforts to enhance government management of publicgoods and services at the national and subnational levels and to strengthenaccountability mechanisms needed to maintain a dynamic, competitive andequitable economic system.

1. Current situation and principal challenges3.62 Public administration in Peru has made progress, particularly in terms of

macroeconomic management, including fiscal policy, and in certain regulatoryareas where the State has performed well. Yet overall efficiency is still low when itcomes to the delivery of goods and services, and especially the provision ofinfrastructure and social services. This is reflected in the indicators of confidence inpublic institutions, and more particularly in perceptions of institutional quality andcorruption, where Peru ranks in the 85th and 75th percentiles respectively,according to the World Economic Forum.41

3.63 The governments capacity to lock in economic growth and strengthen the public

finances, promote development of the private sector, and create opportunitiesdepends on strengthening democratic governance, including: (i) creating anefficient, flexible public administration that will contribute to a favorable businessclimate while achieving soci