65707 Brazil - Municipality of Rio de Janeiro for Fiscal Consolidation for Efficiency and Growth Development Policy Loan - Loan No 7942-BR Release of the Second Tranche – Full Compliance 1. This two-tranche Development Policy Loan (DPL) of US$1,045 million to the Municipality of Rio de Janeiro (MoRJ) in Brazil was signed on August 20, 2010, and became effective on August 27, 2010. The first tranche of US$ 545 million was disbursed on August 31, 2010. The second tranche of US$500 million is to be disbursed upon completion of specific tranche release conditions related to the Government’s reform program. The loan supports the Government in its efforts to achieve faster, more equitable and sustainable growth by increasing investment to improve the quality and coverage of social services, particularly in vulnerable areas of the city and to strengthen public sector management. I. Background 2. The Rio de Janeiro Municipality Fiscal Consolidation for Efficiency and Growth Development DPL supports the Government’s program to create fiscal space for investments to improve the quality and efficiency of public service delivery and to strengthen the institutional framework for efficient public service delivery. The main objective of the DPL is to support the Government in its efforts to foster sustainable growth and improve the quality and coverage of social services, particularly in poor and vulnerable areas. To achieve these objectives, the operation supports: (i) policies to create fiscal space to expand public investment and lay the foundations for municipal growth; (ii) innovations in service delivery to simplify businesses’ registration processes and improve the quality and coverage of public services in health and education especially in vulnerable areas; and (iii) measures to strengthen public sector management through the implementation of a medium term expenditures framework, results-based management with the public sector, and PPPs with the private sector. 3. After years of economic decline which have deepened social and economic inequalities, Rio is now poised for a turnaround. Growth has picked up since 2004, fueled by a positive domestic and international demand. Despite the improvement, Rio’s economic growth is below other state capital cities in Brazil. The city is now laying the foundations for faster, more equitable and sustainable growth by increasing investment in physical and human capital and strengthening government institutions. Stepping-up growth will allow the city to foster fiscal advances and respond to its unique social challenges. The reform program supported by the DPL mirrors the government’s well-defined medium term development strategy to recuperate the city’s investment capacity which is essential for growth, improve the quality and coverage of social services, particularly in low-income areas; and reform the institutional framework for public service delivery by improving internal administrative processes to reduce costs and enhance performance. 4. As a municipal DPL, the operation represents an innovation in Bank operations for three reasons. First, as the first DPL granted to a city, the proposed operation deepens Bank engagement with cities. As the main providers of essential public services including primary health care, primary education and basic infrastructure, cities are critical for the country’s success in promoting growth, reducing poverty, and ensuring that all citizens receive services of equal quality. Second, the operation supports a new generation of policy reforms geared at enhancing fiscal consolidation at the municipal level in Brazil. Third, the DPL supports efforts to better align policies at different levels of government—federal, state, and municipality. 5. This DPL is fully consistent with and closely linked to the objectives of the proposed new Brazil Country Partnership Strategy (CPS) 2012-2015. The new CPS discussed by the Board on November 1, 2011 is grounded in the LCR and IFC regional strategies, which focus on creating opportunities for growth and employment, targeting the poor and vulnerable, strengthening governance and promoting global collective action, as well as stimulating private sector innovation and competitiveness. II. Recent Economic Developments Brazil 6. Growth is decelerating as a consequence of the government earlier monetary and fiscal tightening and amid concerns of a deterioration of the Euro Zone situation. High growth in 2010 was driven by domestic demand, expansionary fiscal policies and a surge in investment on the back of rapid credit growth and low interest rates. Household consumption contributed 4.4 percentage points of the 7.5 percent growth and investments grew by a robust 21.9 percent in 2010. Fiscal policy remained expansionist in 2010, driven by strong rigidities in current expenditures, the election year, and difficulty in reversing the 2009 countercyclical measures- including treasury funding of BNDES. Average real income grew by 4.4 percent, while the number of employed people rose by 2.9 percent in 2010. As of October 2011, concerns regarding a deterioration of the economic situation in Europe and potential spillover effects as well as delayed effects of the monetary and fiscal policy tightening implemented during the year are translating into economic activity deceleration in Brazil. Industrial production, GDP growth projections and labor market numbers are cooling. 7. Despite high inflation, the central bank has recently cut its policy rate in response to a worsening of the global economic outlook. Consumer price inflation closed 2010 at 5.91 percent, and reached 6.97 percent in the year to October 2011, thus surpassing the upper limit of the inflation target (6.5 percent). To control inflation, the Central Bank had increased the policy rate by 375 basis points, starting in April 2010, to reach 12.5 percent in June 2011. As a result, inflation is decelerating even though core inflation remains sticky. However, in response to a perceived deterioration in the outlook for global growth and the assessment that this will have a disinflationary bias going forward, the Central Bank reduced its policy rate by 50 basis points in August 2011 and by another 50 basis points to 11 percent in October 2011. 8. Tight fiscal policy has generated strong results so far in 2011. Judging by the strong public sector results for the first nine months of 2011, the Government is expected to meet its primary surplus target in 2011. Between January and September 2011 the cumulative primary surplus stood at 89 percent of the original 2011 target. Despite the budget cuts of R$50 billion announced in February 2011, fiscal performance has relied more on revenue growth than on lasting restraint in noninvestment spending. The Government has recently announced its intent of implementing further cuts if needed in current expenditures, which should contribute to a better balance in the control of domestic demand between fiscal and monetary policy instruments. 9. The strength of domestic demand has contributed to a widening of the current account deficit, which reached 2.3 percent of GDP in 2010 from 1.5 percent in 2009. In the first nine months of 2011, the current account deficit remained relatively stable versus the same period of 2010 -respectively $35.4 billion and $36 billion in 2010 and 2011. From January to September 2011, FDI totaled $50.5 billion versus an inflow of $22.6 billion in the same period of 2010. Foreign direct investments are expected to remain strong and well above the current account deficit. The sharp increase in FDI in recent months was attributable mainly to foreign investors’ favorable reading of Brazil’s economic outlook for the next few years. In recent weeks, the upward pressures on the real appear to have eased on the back of uncertainties in the economic situation of Europe. The trade surplus has grown sharply, from $12.7 billion in January-September 2010, to $23.0 billion in January-September 2011, driven by increasing commodity export prices. 10. Widening current account deficits, swings in the exchange rate and growing private sector indebtedness create difficult economic policy trade-offs. The currency, which had appreciated 11.9 percent in 2010 to reach a high of R$1.59/USD, depreciated 16.8 percent in September 2011 on the back of increasing concerns in Europe. In October 2011, the Real had regained 9 percent on the dollar to reach R$1.69/USD at the end of the month. The Central Bank continues to accumulate international reserves, reaching record level at US$352.5 billion in November 2011. However, this has been accompanied by an increase in broadly defined gross external debt. Private sector’s gross external debt increased 63 percent between December 2009 and July 2011 reaching US$340.9 billion. The Central Bank has stepped up its monitoring of prudential and macro-prudential risks associated with potential currency mismatches by financial and non-financial companies. The Central Bank has also taken macro-prudential measures to contain rapid credit growth, which is driven by public banks. The banking system appears well prepared to absorb a worsening of the credit portfolio. An acceleration in credit expansion marked the first nine months of 2011 with to reach 48 percent of GDP in September 2011 versus 45.4 percent in September 2010. In this context, in order to limit the deceleration of domestic demand and growth, on November 11 the Central Bank issued measures that amount to an easing in macro-prudential regulations. 11. The government’s overall macroeconomic framework is deemed sustainable in the medium term and adequate for the purposes of a DPL. Brazil’s fiscal framework provided the government with the flexibility to successfully respond to the global financial crisis with an array of fiscal, monetary, and external measures to stimulate domestic demand. Gross public sector debt is expected to decline in the future, from 63.3 percent of GDP projected for 2011 to around 58.9 percent of GDP in 2013. Moreover, flexible exchange rates, relatively large foreign reserves as well as the government’s stance to take necessary policy actions should protect Brazil from any potential external crisis should an abrupt change in market perception turn around the trend in capital flows. Municipality of Rio de Janeiro 12. Economic activity in Rio de Janeiro strongly rebounded in 2010 in line with national trends. The pace of the recovery which was fast in the first semester of 2010 due to the government’s countercyclical policies slowed down in the second part of the year. Retail grew 7.7 percent in the first semester of 2010 on the back of increasing average income as well as the expansion of consumer credit. Wages grew 9.3 percent in the first semester of 2010, faster than the national average at 5.3 percent. Unemployment remained very low at 5.3 percent in mid 2010. 13. The economic recovery was mirrored in the fiscal aggregates through a strong revenues performance. Tax collected and current transfers accounted for 68.4 percent of total revenues in 2010. The increase in tax collected owed much to a strong performance of collection of the tax on services (ISS). Tax collected grew 8.2 percent in 2010 compared to 2009. 1 The acceleration in the growth rate of tax collected was due to the resumption of aggregate demand post crisis as well as fiscal measures to increase the efficiency of collection including through the implementation of the Electronic Fiscal Receipt -Nota Fiscal Electronica supported by the DPL as a first tranche condition. Tax revenues also benefitted in part from higher inflation in 2010. 14. The intergovernmental fiscal arrangements between the Federal Government, the State of Rio de Janeiro and the municipality of Rio de Janeiro are adequate. Current transfers, including from the federal government, the state as well as co -financing agreements, represented 30.7 percent of total revenues in 2010. After remaining flat in 2009, current transfers increased 9.8 percent in real terms in 2010. Growth in current transfers from the Federal Government was driven by transfers earmarked to education (growth of 17.7 percent in real terms) as well as by transfers from the Federal Government’s collection of the industrial production tax for exports (growth of 13.9 percent in real terms). Revenues also benefitted from higher transfers from the State, including oil royalties (growth of 13.4 percent in real terms) and transfers earmarked to the health sector (growth of 10.5 percent in real terms). Notwithstanding those increases, the municipality received lower transfers from the State tax on vehicles (reduction of 5.5 percent in real terms). 15. The expenditures framework of the municipality is adequate; the municipality was able to generate fiscal space for investment in physical capital but also to expand social programs in 2010. The recovery of the city’s capacity to invest is a positive development that the DPL has enabled through its support to the Government’s reform program. Overall 1 They include mainly the tax on services (ISS); the property tax which affects urban property and land (IPTU); the tax on transfer of immovable property (ITBI); and other withholding tax and fees. ISS represented 20.8 percent of total revenues and grew 9 percent in real terms to reach R$3.171 billion in 2010. IPTU, the property tax, which represented 9.4 percent of total revenue, grew 7.1 percent in real terms to reach R$1.430 billion in 2010. investment reached R$1.159 billion in 2010, a 289.3 percent increase over 2009 on the back of the city’s large infrastructure needs made more pressing by the upcoming sporting events as well as funding of social programs to increase coverage and quality of public service delivery in the city. The increase in investment stems from increased revenues as well as lower interest expenditures. The government used the proceeds from the first tranche release of the DPL to pay back expensive government debt. The savings from the debt restructuring amounted to over R$536 millions in the 12 months after the operation. The municipality used those savings to increase physical investments in infrastructure, expand social programs in health and education as well as modernize public sector management. As such one third of the 14.3 percent growth in current expenditures stems from greater capacity to process and pay requests from goods and services providers in 2010 compared to 2009. Expenditures related to personnel and social charges increased 7.3 percent in nominal terms in 2010. 16. The ratio of debt service to net current revenues (NCR) decreased sharply over the past two years on the back of a restructuring of government debt and increasing revenues. As indicated, the government used the proceeds from the first tranche release of the DPL to pay back expensive government debt and as such decreased interest expenditures. The debt service to NCR ratio dropped to 6 percent in 2011 from 8 percent in 2010. The debt stock stood at R$8.5 billion in 2011 from R$8.1 billion in 2010. Moody’s has rated the municipality’s debt investment grade (Baa3 with a positive outlook). 17. Primary and overall budget balances reflect increased budget execution and higher investment in 2010. The primary balance decreased 34 percent to R$895.9 million in 2010. This reflects a recovery of the government’s capacity to execute its budget in 2010 compared to 2009 which was the first year of the government and the year of the global financial crisis. It also reflects a recovery of the government’s capacity to invest in social programs and in physical infrastructure. Budget revenues grew 24.5 percent annually in real terms to reach R$15.243 billion in 2010 (compared 1.5 percent growth in real terms in 2009). 18. The overall macro fiscal framework of the municipality of Rio de Janeiro is adequate. The Government has been able to recover its capacity to invest by growing its revenues and significantly reducing interest expenditures to generate fiscal space. The municipality has used the fiscal space generated to expand the quality and coverage of social services, increase investment in physical infrastructure, and to strengthen the institutional environment for public service delivery, setting up the foundations for faster, more equitable and sustainable growth. The municipality is expected to continue to comply with all the indicators of the Fiscal Responsibility Framework in the medium term. By virtue of the limits on external borrowing set by the federal government on Rio de Janeiro, almost all of the city’s investment will be funded with the Municipality’s own revenues. III. Progress in Implementing the Reform Agenda 19. Overall progress in the government program has been highly satisfactory. The objective of the reform agenda is to guarantee equal opportunities for Rio’s citizens and young people by improving public service delivery. The strategy is to increase fiscal consolidation to generate investment which will allow to innovate in public service delivery and to strengthen the institutional framework for public service delivery within the public sector and with the private sector (PPPs). The multiyear plan, which focuses on actions and programs in fiscal consolidation, public services delivery and private sector management, lays the foundations for faster, more equitable and sustainable growth. 20. The Government has successfully created fiscal space to increase investment. As mentioned in the section on recent economic developments, investment almost tripled on the back of successful reforms to increase revenues and rationalize expenditures. On the expenditures side the biggest impact came from the Government’s debt restructuring of expensive debt from the Federal Government which opened significant fiscal space with interest expenditure savings and improvements in the debt-service profile. 21. The city has made significant progress on the rationalization of pension expenditures, at least in terms of actions that are within the control of the municipality’s Executive Power. The municipality moved forward with the submission of a draft pension law on pension fund capitalization plans (a second tranche disbursement condition). While the Legislative Assembly already passed this law, it has yet to approve the draft pension law to reform the administrative rules for calculating pension benefits, submitted by the Executive as a first tranche disbursement condition. The municipality also completed the audit of the wage bill for active and inactive public servants as well as the organizational restructuring of the pension fund administrative body to improve its corporate governance and institutional capacity to manage the pension funds’ assets. 22. The municipality has made significant progress in simplifying business registration procedures and in establishing a new system of performance based bonuses for schools. The Municipality has implemented a one stop shop for business registration (REGIN). This allows for the centralization of the registration process to minimize the number of steps and time it takes for businesses to register and be licensed with the various levels of government that regulate business activity in Brazil. The municipality has implemented the new system of bonus pay for schools that attain annual targets for improvements in student learning and student flows. Out of 964 eligible schools, 513 received an award and out of the 150 Escolas do Amanhã 2 in the most violent neighborhoods 91 received an award. 23. The municipality has made significant progress in building the institutional framework for public service delivery within the public sector with results agreements and with the private sector with PPPs. The municipality’s system to monitor and evaluate results agreements is in operation. The new IT system updates information on progress towards achievement of targets for elaboration of monthly status reports. The municipality regularly holds quarterly meetings on the progress towards achieving results agreements targets and has prepared an annual report on lessons learned in the first year of implementation of results agreements and their monitoring system. The municipality’s PPP unit is operational and has 2 The Escolas do Amanhã are schools located in the 150 most disadvantaged areas, which receive from the municipality a comprehensive package of targeted support to create both state-of-the-art educational institutions and community centers. supervised the preparation of a PPP project resulting in a call of interest for a public sanitation project. 24. The municipality has also implemented the initial steps to implement a Public Investment Framework. The framework will allow the municipality to evaluate and select capital investment projects. The municipality has issued a Joint Resolution which represents initial efforts towards the development and introduction of basic processes and controls for the municipality to evaluate and select capital investment projects. IV. Progress against Tranche Release Criteria 25. The municipality of Rio de Janeiro has made significant progress in the implementation of the second tranche release conditions. The implementation of the reforms supported in the first tranche has been satisfactory and all actions for the second tranche withdrawal for the operation have been met. 26. Action 1. The MoRJ has submitted to its Legislative Assembly a draft law, and/or has adopted the adequate regulatory framework, to allow adequate transfers to recapitalize FUNPREVI (including through future royalties revenues of the MoRJ, returns from the portfolio of real estate loans and real estate assets of FUNPREVI and of the MoRJ or other equivalent measures). 27. This action has been taken. The municipality was able to gather the political support needed to pass the law. The Legislative Assembly has approved the Law 5.300/2011 dated September 13, 2011, which provides for the capitalization of FUNPREVI (the pension fund) Plan and other measures. The law allows the funding of the R$22 billion actuarial deficit (in present value): R$1.7 billion through transfers from PREVIRIO (the management body of the pension fund), R$2.5 billion by transfers of royalties over 45 years and the rest through additional contributions, spread over 35 years. The reform is an important milestone for the municipality as the actuarial deficit of the pension fund is a burden to the Municipality’s treasury which transfers the difference between the contribution and the paid benefits. 28. Action 2. MoRJ has implemented the electronic fiscal invoice system (Nota Fiscal Eletrônica) for the collection of the municipal tax on services, and has created a database system (Inteligência Fiscal) to facilitate the identification of the fiscal evasion related to said municipal tax on services. 29. This action has been taken. MoRJ issued an Official Memo on March 23, 2011, reporting on the implementation status of the “Nota Fiscal Eletrônica� and the “Sistema de Inteligencia Fiscal�. This followed the issuance of a decree governing the implementation of the Nota Carioca (the electronic fiscal receipt for Rio City), Decree No. 33442, dated February 28, 2011, and the carrying out of homologation testing for the system “Sistema de Inteligencia Fiscal� in May 2010, which MoRJ reported as concluded in August 2011. As a result of the reform, the collection of the city’s main tax ISS in the first 9 months of 2011 totaled R$2.7 billion, representing a real growth of 10.8 percent (nominal 18.2 percent) over the same period in 2010 (January to September). 30. Action 3. The MoRJ has submitted to its Legislative Assembly a draft law, in form and substance satisfactory to the Bank, for approval thereof, to expedite judicial enforcement and recovery of tax arrears. 31. This action has been taken. The Municipality submitted a draft law (Projeto de Lei No. 536/2010, and the substitute project sent on May 31, 2011) proposing changes to the time period to have debt classified as active debt. As a result the period to initiate judicial enforcement should be reduced to eight months. 32. Action 4. The MoRJ has expanded the implementation of the legal and administrative framework of the new management model through the execution of five new separate management contracts between the Municipality’s Health Secretariat and qualified social organizations to deliver services in ten additional family health care clinics and four additional emergency care clinics. 33. This action has been taken. As of October 2011, there are thirty (30) operating clinics and urgent care centers and health care teams registered with the Secretariat of Health and providing twenty seven (27) signed contractual services in the health sector through qualified Social Organizations (“Organizacoes Sociais�). As a result, the coverage of family health services to the public in the city of Rio de Janeiro reached 26.4 percent in October 2011 from a baseline of six (6) percent in January 2009. 34. Action 5. The MoRJ has operationalized the new model of integrated early child care and pre-school services EDIs (Espaços de Desenvolvimento Infantil) with a first set of ten centers in targeted low-income areas duly operational. 35. This action has been taken. The ten centers are duly operational and they are indeed located in low income areas. The localization of the EDIs indicates that they are in the poorest and neediest areas of the city. Indeed the 10 EDIs, are concentrated in 9 districts; 8 of which have the worse Human Development Index of the city (their IDH rank among the lowest 30 out of 126 districts in Rio), the ninth EDI is localized in a very violent slum (Bonsucesso- Complexo do Alemão). As a result of the reform, enrollment in ECD centers and pre-schools targeted to low-income communities has increased from 107,766 nurseries and preschools in January 2009 to 113,479 nurseries and pre-schools in September 2011. The availability of new openings in preschools has increased despite a small decrease in the number of students in pre-schools as the legal age to start elementary school was lowered. 36. Action 6. The MoRJ has: (i) initiated the implementation of a medium term expenditures framework (MTEF). 37. This action has been taken. The municipality has elaborated its first medium term expenditures framework document. This effort represents the initial year of the 3-5 years strategy with associated expenditures plan and financing plan used for the preparation of the guideline budget law of 2012-LDO (Law of Budget Guidelines) in April 2011. The report titled “Marco de Gestao de Medio Prazo (MGMP) do Municipio do Rio de Janeiro�, dated April 2011, sets forth a medium term expenditure plan for the MoRJ in accordance with fiscal resources and medium term priorities was sent to the Legislative Assembly along with the draft budget law in April 2011. The document was updated and made public in July 2011. The municipality will send an updated version with the guidelines of the 2013 budget law. The MTEF will be an important tool for the municipality to improve medium term planning of expenditures especially given the uptake on investment for the next 3-5 years. 38. Action 7. The MoRJ has: (ii) enhanced the implementation of result-based management tools through the carrying out of an evaluation of the sixteen results agreements with respect to the 2010 targets. 39. This action has been taken. The “Secretaria da Casa Civil� of the municipality has published a report evaluating the 16 results agreements. MoRJ has also issued Decree 33813, in May 2011, setting targets and performance indicators for the public sector in results agreements and Decree 33887, in June 2011, governing the procedures to establish targets and performance indicators for the public sector in results agreements. As of October 2011 the MoRJ signed or renegotiated agreements with 38 agencies covering approximately 82 percent of servers of the municipality. This compare to results agreements signed with 19 agencies, which covered 73 percent of servers of the City in 2010 and a baseline of 0 in 2009. The award, to the agencies and public servants that met the targets were first paid in June 2011. 40. Action 8. The MoRJ has created a public-private partnership (PPP) unit fully staffed and operational 41. This action has been taken. The municipality issued four decrees in April-June 2011 to: (i) create a coordinating unit for public-private partnerships (Decree 33656, of April 12, 2011); (ii) modify the organizational structure of the “Secretaria da Casa Civil� to create a unit responsible for public-private partnership (Decree 33733, of May 3, 2011); (iii) nominate a head of the PPP unit, and staff adequately the unit (with three staff members) (Decree “P� No. 550, of May 5, 2011); and (iv) adopt a governance structure for the public-partnership unit (Decree 32422, of June 21, 2011). In addition, the municipality has received intensive training session on PPPs public-private partnership offered on June 13-17, 2011. The municipality is also in the process of hiring a resident advisor. The Bank will continue its engagement to build capacity in the municipality to structure manage and procure PPPS through a Fee Based Service (FBS) in the short term and a Technical Assistance Loan (TAL) in the medium term. 42. Action 9. The MoRJ has implemented a stock management system for the health sector and approved a schedule for a system wide roll-out within 15 months (including the e- procurement scheme at municipal level). 43. This action has been taken. The MoRJ has implemented a stock and inventory management and control system, based on barcode reading. The new system is currently largely used in the health secretariat –mainly in hospitals and local health units. The municipality has a clear plan to roll it out to other municipal government units and training has already begun. Improved efficiency in stock management from the reform has reduced losses in the stock of goods in the health sector. The reforms supported in the first tranche related to electronic auction have resulted in a saving of 23 percent in the cost of goods and services purchased during the period from January to June 2011. V. Conclusion 44. In view of the overall performance and progress with the implementation of the program supported by the Loan, and in compliance with the specific conditions of release as described in Section II.D.1 of Schedule 1 to the Loan Agreement, dated August 20, 2010, namely: • The progress achieved by the MoRJ in carrying out the Program is satisfactory; • The Guarantor has maintained a macroeconomic policy framework which does not jeopardize the objectives of the Program; • The MoRJ’s expenditure program, and fiscal arrangements with the Guarantor, are consistent with the objectives of the Program; and • The tranche release conditions described in Part B of Section I of Schedule 1 to the Loan Agreement have been met. 45. Therefore, the second tranche will be released to MORJ.