Document of The World Bank FOR OFFICIAL USE ONLY Report No. 62793-BR INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PROGRAM DOCUMENT FOR A PROPOSED LOAN IN THE AMOUNT OF US$300 MILLION TO THE STATE OF RIO DE JANEIRO WITH A GUARANTEE OF THE FEDERATIVE REPUBLIC OF BRAZIL FOR A FISCAL EFFICIENCY FOR QUALITY OF PUBLIC SERVICE DELIVERY DEVELOPMENT POLICY LOAN July 25, 2012 Economic Policy Group and Public Sector Unit Poverty Reduction and Economic Management Brazil Country Management Unit Latin America and the Caribbean Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. BRAZIL - GOVERNMENT FISCAL YEAR January 1 - December 31 CURRENCY EQUIVALENTS (Exchange Rate Effective July 18, 2012) Currency Unit = Brazil Real R$ 1.00 = US$ 0.49 US$ 1.00 = R$ 2.02 ABBREVIATION AND ACRONYMS AGE Internal Audit Department Auditoria Geral do Estado BCB Central Bank of Brazil Banco Central do Brasd BNDES National Bank of Economic and Social Development Banco Nacional de Desenvolvinento Econ6mico e Social CPS Country Partnership Strategy Estrat gia de Parceria cor o Pa/s DPL Development Policy Loan Ern stino para Politicas de Desenvolvinento FDI Foreign Direct Investment Investimento Estrangeiro Direto FGC Deposit Insurance Fund Fundo Garantidor de C4ditos FUNDEB Fund for Maintenance and Development of Basic 0 Fundo de Manuten(do e Desenvolvinento da Educa(do Education &sica FY Fiscal year Ano Fiscal GDP Gross Domestic Product Produto Interno Bruto GIDE Integrated School Management Gestdo Integrada da Escola GoB Government of Brazil Governo do Brasil GORJ Government of Rio de Janeiro Governo do Estado do Rio de Janeiro IDB Inter-American Development Bank Banco Interamericano de Desenvolvinento IBGE Brazilian Institute of Geography and Statistics Instituto Brasileiro de Geografia e Estatistica IBRD International Bank for Reconstruction and Banco Internacionalpara Reconstru(do e Development Desenvolvinento ICMS Tax on Goods and Services Imposto sobre Circula(do de Mercadorias e Presta(do de Servi(os IDEB Index of Development of Basic Education indice de Desenvolvinento da Educa(do Bsica IDERJ Index of the development of primary education on the indice de Desenvolvinento da Educa(do Bsica do Estado State of Rio de Janeiro do Rio de Janeiro IGP-DI General Prices Index indice Geral de Pre(os - Disponibilidade Interna IMF International Monetary Fund Fundo Monet6rio Internacional IOF Financial Transactions Tax Imposto sobre Opera(5es Financeiras IPCA Consumer Price Index indice Nacional de Pre(os ao Consumidor Amplo IPSAS International Public Sector Accounting Standards Normas Internacionais de Contabilidade Aplicada ao Setor Ptiblico IPVA Tax on Motorized Vehicles Imposto sobrepropriedade de Veiculos Automotores JUCERJA Board of Commerce for the State of Rio de Janeiro Junta Comercial do Estado de Rio de Janeiro LDO Budget Guidelines Law Lei de Diretrizes Or(amenuirias LOA Annual Budget Law Lei de Or(amento Anual LRF Fiscal Responsibility Law Lei de Responsabilidade Fiscal NCR Net Current Revenue Receita Corrente Liquida NPL Non-Performing Loan Erstino vencido PAC Growth Acceleration Program Programa de Acelera(do do Crescinento PAHI Program to Support Hospitals Programa de Apoio aos Hospitais do Interior PAF Program of Fiscal Adjustment Programa de Ajuste Fiscal PEA Economically Active Population Popula(do Economicamente Ativa PEFA Public Expenditure and Financial Accountability M&odo de despesa ptblica e responsabilidadefinanceira PFM Public Financial Management GestDo de FinanEas Peoblicas ii PPA Multi-year Plan Piano Plurianual PPP Public-Private Partnerships Parcerias PiTlico-Privadas PSF Program for Primary Health Care Programa Saide Faiia REGIN Integrated Recording System for taxes Sistema de Registro Integrado SAERJ Education evaluation system of the State of Rio de Sistema de Avalia(do da Educa(do no Estado do Rio de Janeiro Janeiro SEEDUC State Secretariat of Education Secretaria de Estado de Educa(do SEFAZ State Secretariat of Finance Secretaria de Estado da Fazenda SEPLAG State Secretariat of Planning Secretaria de Estado de Planejamento SES State Secretariat of Health Secretaria de Estado de Sa,de SESDEC State Secretariat of Health and Civil Defense Secretaria de Estado de Sa,de e Defesa Civil SIL Specific Investment Loan Empr stimopara Investimento Especifico STN National Treasury Secretariat Secretaria do Tesouro Nacional SUS Public Health System Sistema Unico de Saide SWAP Sector Wide Approach Abordagem Setorial Ampla TAL Technical Assistance Loan Empr stimo Para Assist ncia Thcnica TCE Court of Accounts of the State Tribunal de Contas do Estado UPA 24 hour emergency care unit Unidade de Pronto Atendimento UPP Pacification Police Units Unidades de Policia Pacificadora VAT Value Added Tax Imposto sobre o Valor Adicionado WB World Bank Banco Mundial Vice President: Hasan A. Tuluy Country Director: Deborah L. Wetzel Sector Director: Rodrigo A. Chaves Sector Manager: Arturo Herrera Sector Leader: Pablo Fajnzylber Co-Task Team Leader: Yaye Seynabou Sakho Co-Task Team Leader: Roland Clarke 111  BRAZIL FISCAL EFFICIENCY FOR QUALITY OF PUBLIC SERVICE DELIVERY DEVELOPMENT POLICY LOAN TABLE OF CONTENTS I. INTRODUCTION .................................................................1 II. COUNTRY CONTEXT. ............................................................2 A. RECENT ECONOMIC DEVELOPMENTS IN BRAZIL ........................ ...........2 B. CURRENT MACROECONOMIC OUTLOOK ............................... ..........7 C. RECENT SOCIO-ECONOMIC DEVELOPMENTS IN THE STATE OF RIO DE JANEIRO ................9 III. THE GOVERNMENT'S PROGRAM AND PARTICIPATORY PROCESSES .....................19 IV. BANK SUPPORT TO THE GOVERNMENT'S PROGRAM ......................................27 A. LINK TO CPS....... .........................................................27 B. COLLABORATION WITH THE IMF AND OTHER DONORS .................. ..........27 C. CHOICE OF INSTRUMENT AND RELATIONSHIP TO OTHER BANK OPERATIONS..................29 D. LESSONS LEARNED..........................................................31 E. ANALYTICAL UNDERPINNINGS................................................33 V. THE PROPOSED DEVELOPMENT POLICY LOAN..................... .................35 A. OPERATION DESCRIPTION....................................................35 B. POLICY AREAS.............................................................37 VI. OPERATION IMPLEMENTATION....................................................48 A. POVERTY AND SOCIAL IMPACT.................................................48 B. ENVIRONMENTAL ASPECTS....................................................50 C. IMPLEMENTATION, MONITORING AND EVALUATION...............................51 D. FIDUCIARY ASPECTS..........................................................51 E. DISBURSEMENT AND AUDITING ...................................... .........53 F. RISKS AND RISK MITIGATION .................................................54 ANNEX 1. LETTER OF DEVELOPMENT POLICY ................................. .........56 ANNEX 2. OPERATION POLICY MATRIX - RESULTS INDICATORS ................ ...........66 ANNEX 3. FISCAL AND DEBT SUSTAINABILITY ANALYSIS IN THE STATE OF RIO DE JANEIRO .....70 ANNEX 4. BRAZIL AT A GLANCE......................................................84 ANNEX 5. STATE OF RIO DE JANEIRO AT A GLANCE ......................................87 The Rio de Janeiro Fiscal Efficiency for Quality of Public Service Delivery DPL was prepared by an IBRD team consisting of Seynabou Sakho, Roland Clarke, Tarsila Velloso, Pablo Fajnzylber, Patricia Miranda, Rafael Barroso, Edith Kikoni, Cindy Audiguier, Ana Mie Horigoshi Reis, Miguel Navarro, Miguel-Santiago Oliviera, Barbara Bruns, Leandro Costa, Fanny Weiner, Augusto Mendonqa, Alberto Costa, Joseph Kizito, Rogerio Santarosa, Flavia Nahmias, Angela Nieves Porto, Rocio Manrique, Fabio Bittar, Andre Medici, Magnus Lindelow, Joseph Kavanagh, Paulo dos Santos, Mariana Montiel, Ezau Pontes, Florencia Liporaci. 1v  LOAN AND PROGRAM SUMMARY THE STATE OF RIO DE JANEIRO, BRAZIL FISCAL EFFICIENCY FOR QUALITY OF PUBLIC SERVICE DELIVERY DEVELOPMENT POLICY LOAN Borrower The State of Rio de Janeiro, Brazil Implementing State Secretariat of Finance of Rio de Janeiro Agency Financing Data US$300 million with a sovereign guarantee from the Federative Republic of Brazil. Commitment linked, IBRD Flexible Loan with variable spread, with customized repayments, 5 year Grace Period and twenty three years and six months Final Maturity. Operation Type Single tranche Development Policy Loan to be disbursed upon loan effectiveness. Main Policy The proposed operation will support policy actions in the following areas: Areas * Strengthening Tax Administration. * Improving the Efficiency of Public Financial Management. * Increasing the Quality and Efficiency of Public Education and Health Services. Key Outcome Stren!thenin! Tax Administration Indicators (by * The establishment of a Unified General Taxpayer Ledger allowing access of individual taxpayers 2013) to their accounts * Progressive implementation of performance indicators for tax administration (10 indicators in 2012 and 20 in 2013) Improving the Efficiency of Public Financial Management * Investment projects complying with required criteria have been subject to screening process, using the techniques adopted by the State. * Annual commitments of investment projects published starting with five large selected investment projects. * State publishes results of costing at least four major policy programs, with their key results defined. * Intemal control systems improved on the basis of the annual report from AGE. Increasini the Quality and Efficiency of Public Education and Health Services * New school and regional directors selected using new merit-based process. * The State Government has signed contracts with social organizations (OS) to manage 15 health units and strategic services (lab services, imagery services, etc...). * Number of hospitals under the PAHI 1 program with ombudsman services increased by 43%. * Number of hospitals with hospital infection evaluation committees increased by 43%. * Supply of complex treatment to patients from other municipalities increased from 17% to 24%. Program The objective of the proposed operation is to assist the Government of Rio de Janeiro in strengthening Development its tax administration, improving the efficiency of public financial management, increasing the quality Objective(s) and of public service provision in education and health and ensuring that policies adopted are both Contribution to consistent with priorities of the State Govemment and with resources likely to be available in the CPS medium term. The proposed operation is fully consistent with and closely linked to the objectives of the 2012-2015 CPS, which emphasizes sound macroeconomic management, fiscal consolidation, efficient public sector management, and quality of education and health expenditures, especially at the sub-national level, as key pillars for achieving sustainable economic development and inclusive economic growth in Brazil. Risks and Risk The operation is subject to three main risks: Mitigation Economic and fiscal risks: On the economic front, ICMS tax revenues and oil receipts are highly susceptible to macroeconomic fluctuations and oil price volatility respectively. Additional fiscal pressures exist due to structural increases in expenditures related to, among others, World Cup and Olympic Games investment expenditures, as well as personnel expenditures in health, education and security. In addition, high costs of successful govemment programs (pacification of the favelas, establishment of emergency health care clinics) also imply increasing fiscal pressures. These risks are V mitigated by (i) the efficiency enhancing reforms supported by this operation; (ii) the commitment and capacity of the State government to continued fiscal discipline so that the fiscal repercussions of the global slowdown and of the sporting events will be managed prudently; (iii) the Fiscal Responsibility Framework which restricts the State's new borrowing and sets fiscal targets accordingly, and (iv) recent approval by the Senate of a new sharing rule that would be applied to all royalties coming from all Pre-Salt fields, including those already licensed, reduces Rio's share compared to previous legislation but prevents losses for producer states and municipalities. External risks: Brazil could be affected by a global economic slowdown through its growth, its external sector, its fiscal and debt accounts and its financial sector. A slower pace of global growth associated with a slow recovery of the U.S. economy, a deceleration of the Chinese economy and growing concerns with the fiscal situation of some countries in the Euro zone may translate into lower external demand for Brazil's exports. In particular, a Chinese hard landing would hit Brazil's terms of trade, and demand for exports, given the significant demand from China. Secondly, the banking sector is vulnerable to continued global slowdown given the exposure of some small and medium sized banks to liquidity risk. Further worsening of the global economic environment also poses risk to the fulfillment of fiscal targets. These risks are mitigated by the fact that the country has a strong external position, a reasonable fiscal position and a strong financial sector position. System-wide assessment of banks indicates that Brazil's banking system currently has solid liquidity levels and capital cushions. Brazil rebounded quickly from the 2008 crisis to achieve the highest GDP growth rate (7.5 percent) in the last 20 years in 2010. Brazil is poised to respond to a possible crisis, actively using a wide array of policy tools. Early interventions in recent months with the easing of monetary policy and the reduction of capital controls indicate that it is ready to promptly deal with any external threats to domestic growth. Political and institutional risk: The political situation in the State of Rio de Janeiro remains complex and reforms can be opposed by groups with entrenched political interests, such as public employee unions. The World Cup and Olympic Games generate additional institutional and financial risks due to the proliferation of legislation reducing controls and oversight of investments associated with these events. These risks are mitigated by the pace of reforms, such as the implementation of improved PFM practices that would enable taking decisions on the allocation of resources in the full knowledge of possible trade-offs and the future cost implications of policy decisions. Operation ID P126465 Vi INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PROGRAM DOCUMENT FOR A PROPOSED FISCAL EFFICIENCY FOR QUALITY OF PUBLIC SERVICE DELIVERY DEVELOPMENT POLICY LOAN TO THE STATE OF RIO DE JANEIRO I. INTRODUCTION 1. This program document presents a proposed Development Policy Loan (DPL) in the amount of US$300 million for the State of Rio de Janeiro, Brazil. This DPL is designed to assist the Government of Rio de Janeiro (GORJ) in continuing its efforts to improve fiscal management, social service delivery in health and education, and public financial management. Although requested as a stand-alone DPL, the operation forms part of a long term quasi- programmatic engagement with the State. It is the third DPL operation with the State of Rio de Janeiro following the Fiscal Sustainability, Human Development and Competitiveness DPL that was approved by the Board in February 2010 (DPL1), and the Rio de Janeiro Metropolitan Urban and Housing DPL approved by the Board in March 2011 (DPL2). The proposed operation is fully consistent with and closely linked to the objectives of the Brazil CPS (2012-2015).1 This DPL directly addresses two of the four pillars of CPS (Increasing the efficiency of public investment and improving the quality of public services for low income households) while the other two pillars (promoting regional economic development and improving the sustainable management of natural resources and enhancing resilience to climatic shocks) were the main focus of the DPL2. 2. The policies supported by this third DPL are part of the GORJ's medium-term reform program and would deepen and extend the areas covered by the first DPL. Specifically, the operation will support measures to: (i) improve the efficiency of tax administration; (ii) improve budgetary management, including screening and evaluation of new public investment projects, better estimating costs of new policy initiatives, and strengthening internal controls; and (iii) increase quality and efficiency of the education system, by introducing merit-based selection processes for school managers, annual school-level performance targets, and performance-linked pay, and in the health system by increasing the efficiency of health spending, both in regional hospitals and smaller municipalities. 3. The proposed operation is closely linked to the on-going Rio de Janeiro State Strengthening Public Sector Management and Integrated Territorial Development Technical Assistance Loan (TAL)- P106768, and its additional financing which is now under preparation and enables the provision of technical support to the State in the policy areas included in the DPL. The proposed operation also both builds upon the reforms under the DPL1 and complements those of the DPL2 which focused on urban planning issues, disaster risk management as well as service delivery to the poor. The proposed operation is consistent with the credit ceilings specified in Rio de Janeiro's Program of Fiscal Adjustment (Programa de Ajuste Fiscal - PAF) and has been approved by the National Treasury Secretariat (Secretaria do Tesouro Nacional - STN). 1 World Bank Group's Country Partnership Strategy (CPS) 2012-2015 (Report No.6373-BR), was discussed by the Executive Directors on November 1, 2011. 1 4. The operation represents a continuation of an on-going engagement with the State of Rio de Janeiro. The first DPL was very effective in supporting fiscal consolidation with the effect of increasing the State's capacity for investment in infrastructure and improving the living conditions of the poorest communities. By also supporting health and education particularly in the most marginalized communities (which were also the focus of DPL2), the previous operation (DPL1) contributed to one of the central axes of State policy, that of reintegrating a state with major inequalities in wealth, income and access to public services and security. Thus although Rio de Janeiro is one of the richer states in Brazil it is also characterized by acute inequalities, and its reform experience can serve as a model for the development and diffusion of institutional reforms and approaches to reducing inequality, particularly in access to public services. II. COUNTRY CONTEXT A. RECENT ECONOMIC DEVELOPMENTS IN BRAZIL 5. Brazil's relative resilience to the global financial crisis reflected good macroeconomic management and a solid financial system. Following the global crisis in September 2008, Brazil suffered a sudden reduction in external and domestic credit, and significant currency depreciation. Rapidly falling external demand and a sharp decline in investment led to a 4.2 percent contraction in Gross Domestic Product (GDP) in the fourth quarter of 2008 followed by a 2 percent decline in the first quarter of 2009. The recession, however, lasted only those two quarters. Prompt response by the authorities avoided a credit crunch, and mitigated the impact of the global financial crisis on the Brazilian economy, which recovered rapidly. Fiscal policy was appropriately countercyclical in 2009 and remained expansionary in 2010, driven by strong rigidities in current expenditures, the political cycle, and difficulties in quickly reversing the countercyclical measures enacted in the previous year. After contracting by 0.3 percent in 2009, the economy grew at a 7.5 percent annual rate in 2010. 6. At least until mid 2011, large portfolio inflows exerted a strong upward pressure on the real and were accompanied by growing private sector external indebtedness. The currency, which had already appreciated by 11.9 percent in 2010, traded at a high of R$1.59 per US dollar at the end of August 2011, a 44 percent appreciation since the start of 2009. The Central Bank rapidly accumulated international reserves, reaching US$372.4 billion in May 2012 (up from US$239.1 billion in December 2009). This was accompanied, however, by an increase of about 50 percent in Brazil's total external debt, from US$198 billion in December 2009 to US$298.2 billion in end-May 2012, of which 89 percent had a maturity of more than 360 days. Broadly defined gross external debt, however, including intercompany loans and nonresident holdings of domestic fixed income instruments, has also increased significantly, from US$373.4 billion to US$543.7 billion between December 2009 and May 2012. Private sector gross external indebtedness, in particular, rose 66 percent over this period, reaching US$347.3 billion. The biggest increase occurred among banks, whose gross external debt reached US$135.6 billion in May 2012, a 113 percent increase with respect to December 2009. 7. At the same time, Brazil's public external debt-to-GDP ratio has shown a marked decline in recent years, largely reflecting the country's prudent fiscal policy stance. Gross public sector external debt as a share of GDP plummeted from 9.3 percent in 2005 to 2.7 percent 2 in 2011, and is projected to stabilize around that level for the next few years. Other external sector vulnerability indicators have behaved similarly. For example, total external debt service in terms of exports fell by 38 percent between 2007 and May 2012. Even more remarkably, total external debt as a share of international reserves plunged from 557.1 percent in 2002 to a projected 82 percent in 2012. In addition, nonresident holding of general government debt remains relatively low, estimated at end 2011 as 3.8 percent, in comparison to the emerging market average of 20.4 percent. Table 1: Brazil Macroeconomic Indicators 2005-2015 Projection Indicator 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 National Accounts (annual real percent change) Real GDP Growth 3.2 4.0 6.1 5.2 -0.3 7.5 2.7 2.5 4.3 4.3 4.2 (in percent of GDP) Gross domestic investment 15.9 16.4 17.4 19.1 18.1 19.5 19.3 19.9 20.6 21.2 21.2 External Sector (in USS billions, unless noted) Current account 14.0 13.6 1.6 -28.2 -24.3 -47.3 -52.5 -65.8 -69.4 -89.0 -101.9 Trade balance 44.7 46.5 40.0 24.8 25.3 20.1 29.8 18.2 14.8 4.4 1.0 Exports (fob) 118.3 137.8 160.6 197.9 153.0 201.9 256.0 263.4 277.9 295.3 325.5 Imports (fob) 73.6 91.4 120.6 173.1 127.7 181.8 226.2 245.2 263.1 290.9 324.5 Nonfactor services, net -8.3 -9.6 -13.2 -16.7 -19.2 -30.8 -38.0 -39.8 -45.2 -54.9 -59.3 Income and current transfers, net -22.4 -23.2 -25.3 -36.3 -30.3 -36.6 -44.3 -44.2 -39.0 -38.5 -43.5 Direct investment, net 12.5 -9.4 27.5 24.6 36.0 36.9 67.7 55.1 59.0 62.0 65.1 Portfolio investment, net 4.9 9.1 48.4 1.1 50.3 63.0 35.3 25.9 26.4 28.8 31.2 Gross international reserves 53.8 85.8 180.3 193.8 238.5 288.6 352.0 381.3 392.1 404.0 439.7 Current account (% of GDP) 1.6 1.3 0.1 -1.7 -1.5 -2.2 -2.1 -3.0 -2.9 -3.2 -3.4 General Government (in percent of GDP) Total Revenues and Grants 35.8 35.9 35.7 36.3 35.0 36.6 36.2 36.2 36.5 36.5 36.7 Total Expenditure 39.3 39.5 38.3 37.7 38.1 39.4 38.6 38.8 38.9 39.0 39.1 Current Expenditure 37.2 37.4 36.4 35.3 35.6 35.1 35.8 35.9 35.9 35.9 36.0 ofwhich: Interestpayments 7.3 6.8 6.1 5.4 5.2 5.2 5.5 5.8 5.6 5.5 5.4 Capital Expenditure 2.1 2.1 2.0 2.4 2.4 4.3 2.8 2.9 3.0 3.1 3.1 Primary Balance 3.8 3.2 3.4 4.0 2.1 2.4 3.1 3.1 3.1 3.0 3.0 Overall Balance -3.5 -3.5 -2.7 -1.4 -3.1 -2.8 -2.4 -2.6 -2.4 -2.5 -2.4 Gross Public SectorDebt 69.2 66.7 65.2 63.5 66.9 66.8 63.0 61.0 58.1 55.4 53.2 Domestic Debt 59.9 60.0 60.6 58.4 63.2 63.7 60.1 57.9 55.0 52.6 50.4 ExternalDebt 9.3 6.7 4.6 5.1 3.7 3.1 2.9 3.1 3.0 2.9 2.8 Prices (annual percent change) GDP Deflator 7.2 6.2 5.9 8.3 7.2 8.2 7.0 5.5 5.0 5.0 5.0 ConsumerPrice Index(eop) 5.7 3.1 4.5 5.9 4.3 5.9 6.5 5.0 5.6 5.1 4.8 Producer Prices (eop) -1.0 4.3 9.3 9.8 -4.1 13.8 4.1 6.0 4.9 4.8 4.7 Memorandum items: Nominal GDP (in R$ billions) 2,147 2,369 2,661 3,032 3,239 3,770 4,143 4,366 4,781 5,236 5,729 Source: IMF, BCB, IBGE, EIU, WB Calculation 8. To address risks of overheating, in 2010 the Central Bank adopted a contractionary monetary policy stance, complemented with a tighter fiscal policy in 2011. Consumer price inflation (Indice Nacional de Preos ao Consumidor Amplo - IPCA), as measured by the Brazilian Institute of Geography and Statistics (Instituto Brasileiro de Geografia e Estatistica - IBGE), closed 2010 at 5.9 percent. To control inflation, the Central Bank increased the policy rate by 375 basis points, starting in April 2010, to 12.5 percent in June 2011. Furthermore, in February, 2011, the Federal Government announced cuts in budgeted expenditures of R$50 billion, which, coupled with strong revenue performance enabled it to generate a projected 3 primary surplus of 3.1 percent of GDP in 2011, compared to 2.4 percent in 2010 (see Table 1 for Key Macroeconomic Indicators). 9. Although inflation accelerated during most of 2011, starting in August 2011, the Central Bank eased its policy stance in response to the worsening global and domestic economic outlook. During most of 2011, labor market conditions tightened, with record levels of job creation and historically low unemployment (4.7 percent in December). Inflation reached 6.5 percent in 2011, in line with the upper limit of the inflation target. However, since August 31, 2011, in response to a perceived deterioration in the outlook for global growth and the expectation that it will have a disinflationary impact in Brazil, the Central Bank of Brazil (Banco Central do Brasil - BCB) has reduced its policy rate by 450 basis points to 8 percent by July 2012. Moreover, in November, 2011, the BCB significantly reduced capital requirements for consumer loans, by 50 percent in the case of loans with terms above 60 months. Similarly, in January 2012 the BCB allowed large banks to use up to 36 percent of their reserve requirements on time deposits to provide liquidity to small and midsize banks, and in May 2012, the Government announced new rules reducing the minimum guaranteed return on tax-free savings deposits, to facilitate further policy rate cuts. On the fiscal policy front, however, the Federal Government intends to maintain its current neutral policy stance. In particular, it has committed to primary surplus targets of 3.1 percent of GDP in both 2012 and 2013. This commitment, backed by the announcement in February 2012 of cuts in 2012 budgeted expenditures of R$55 billion, has to date resulted in a primary surplus of R$62.8 billion in the first five months of 2012, representing about 45 percent of the target for the year. 10. Economic activity decelerated significantly during 2011 reflecting both domestic and external factors. On the one hand, the deceleration was driven by the tighter monetary and fiscal policy stances adopted by the Federal Government during the first half of the year. On the other hand, a slow recovery of the U.S. economy, a deceleration of the Chinese economy and growing concerns with the fiscal situation of some countries in the euro zone have already led to a worsening of the global economic outlook that has been reflected in a reduction in business and consumer confidence. In this context, GDP growth decelerated to 2.7 percent in 2011. After stagnating during the third quarter of 2011, GDP posted a modest recovery and increased 0.2 percent in the last quarter of the year, below the observed average for the previous four quarters (0.5 percent). In the first quarter of 2012 GDP increased another 0.2 percent. On the supply side, the weak sequential figure owes chiefly to the 7.3 percent quarter on quarter contraction of the agriculture sector. Industry and services increased by 1.7 and 0.6 percent from the previous quarter, respectively. On the demand side, growth was driven by government (1.5 percent) and private consumption (1 percent), while gross fixed capital formation contracted 1.8 percent. 11. More recent data suggest that the industrial sector continues to dampen the pace of economic activity, despite robust consumption growth. Strictly defined retail sales expanded 9.2 percent year to date through May, while broadly defined retail sales (including vehicles and construction material) grew 5.8 percent year to date. The more moderate performance of expanded retail sales has been driven mainly by the deceleration of vehicle sales. Going forward, the outlook for retail sales and private consumption remains positive, driven by falling interest rates, a tight labor market, moderating inflation, and fiscal incentives targeted to consumption. However, recovery in the industrial sector remains slow as illustrated by the 0.9 percent 4 contraction of industrial production in May 2012. In this context, the Central Bank's economic activity index (IBC-Br), a proxy for monthly GDP, was practically unchanged in May, posting a 0.02 percent contraction. Considering the quarter ended in May 2012, IBC-Br increased by 0.07 percent, well below the 0.31 and 0.54 percent expansions observed in April and March, respectively. The weak pace of economic activity in the first half of 2012 has been influenced mainly by the negative performance of the industrial sector and the concomitant deceleration of gross fixed capital formation associated with increased external uncertainty. During the second semester of 2012, however, growth should regain momentum and possibly surpass potential by the end of the year, in response to the various stimulus measures implemented so far by the authorities. 12. To counter the recent growth slowdown, particularly regarding domestic industrial output, the Government has taken action to curb exchange rate appreciation and has also moved towards more direct industrial policy interventions. Specifically, the Government has enhanced restrictions on capital inflows through the extension of financial transaction taxes on international flows (Imposto sobre Operaq5es Financeiras - IOF), to cover all loans maturing within the next five years, and more recently the Central Bank stepped up its interventions in the spot foreign exchange market. The result of these actions, in combination with the easing of monetary policy and an unstable global economy, has been a rapid depreciation of the real against the dollar by over 19 percent between February and mid July 2012 (from an average of R$1.71/US$ in February to R$2.03/US$). Furthermore, a new package of industrial policy measures aimed at bolstering the manufacturing sector was launched in April. The measures include the reduction of payroll taxes for industries hardest hit by unfavorable global and domestic conditions and additional funding to the National Bank of Economic and Social Development (Banco Nacional de Desenvolvimento Econ6mico e Social - BNDES), amounting to R$45 billion. To compensate for some of the possible revenue shortfalls, including losses from industrial payroll taxes that are currently estimated at R$7 billion, the Government has announced an increase in the rates of two corporate social security taxes. Furthermore, in June 2012 a US$4 billion stimulus package focused on gross fixed capital formation was launched and the BNDES lending rate was lowered by 50 basis points, in a new effort to boost Brazil's investment rate, thus complementing previous measures to stimulate consumption. 13. The financial system remains stable, coping well with heightened turbulence in global markets. The stock of credit to the private sector reached R$2.1 trillion in May 2012, equivalent to 50.1 percent of Brazil's GDP, a jump of 4.4 percentage points in a year. The slow but steady loan quality deterioration is expected to stabilize in the months ahead. Early stage delinquency indicators (loans that are between 15 and 90 days overdue) have broadly stabilized after a prolonged cycle of deterioration. As of May 2012, consumer's non-performing loans (NPL) retreated to 6.7 percent from 7 percent in the previous month. Meanwhile, corporate entities' NPL remains stable at 2.3 percent since the beginning of 2012. Falling interest rates should help ease pressure on borrowers and keep delinquencies at stable levels. In addition, banks appear well prepared to withstand negative developments in loan quality. The system-wide solvency ratio stands at around 16 percent (as of April 2012), as supervisors have been phasing in tightened capital requirements in anticipation of Basel III while banks have obtained robust profits which they have been able to capitalize. Moreover, loan loss provision coverage remains broadly healthy at 150 percent of NPLs in April 2012. Housing loans have grown very strongly: 40 percent in the year to May 2012, accounting for 18.3 percent of the 18.3 percent expansion in 5 total credit to the private sector over that period. However, there is a low risk of an "asset bubble" developing in Brazil's real estate markets. Indeed, those loans still represent only 10 percent of total private sector credit and their delinquency rates have fallen significantly thanks to improvements in mortgage foreclosure processes.2 The system also has important non-fiscal buffers in the event of a liquidity crunch: not only are international reserves at record high levels, but also the deposit insurance fund (Fundo Garantidor de Creditos - FGC) has R$19 billion in liquid assets and reserve requirements stand at R$396 billion. 14. The current account remained roughly stable during 2011 while Foreign Direct Investment (FDI) exhibited solid growth even as the global economic outlook has deteriorated. The current account deficit totaled US$52.6 billion in 2011 (2.1 percent of GDP, compared to 2.2 percent in 2010). Net direct investment, however, reached US$67.7 billion in 2011 compared to US$36.9 billion in 2010. Going forward, the current account deficit is expected to increase in 2012, driven by lower growth in export prices and a reduction in the trade surplus. At US$23.3 billion through May 2012, FDI flows are expected to remain strong over the medium term despite uncertainties centered on the unfavorable external scenario and the possibility that some of the high FDI flows in 2011 were reversible interest-sensitive flows circumventing the IOF tax on fixed income capital flows. Owing to the high liquidity in international markets and the prospect of higher growth in the economy over the next few years compared to most developed economies, FDI flows should remain sufficient to finance the majority of the current account deficit. 15. The prospect for growth in foreign portfolio investments is less positive. Driven mainly by high real domestic interest rates at a time of exceptionally low interest rates internationally, these inflows put strong upward pressure on the Real and prompted the authorities to the IOF of foreign fixed income investments from 2 to 6 percent in October 2010. This measure, together with recent increases in global risk aversion associated with the fiscal crisis in Europe, has already caused a slowdown in portfolio flows. Going forward, these inflows could be negatively affected by the increased international turmoil. Moreover, while real interest differentials are likely to remain large, the recent BCB decisions to reduce the policy rate will diminish the incentive for carry-trade operations. On the positive side, portfolio inflows should benefit from the suspension of IOF taxation on foreign variable income investments announced in December 2011, as well as on external debt issuance and foreign loans with maturities between 2 and 5 years; the 6 percent IOF taxation will now be restricted to external bonds and loans maturing within 2 years. Portfolio investments amounted to US$7 billion in the first five months of 2012. 16. Going forward, persistently higher domestic interest rates should lead to a further build-up of reserves, but are also expected to prompt the private sector to continue increasing its external indebtedness. In this context, the BCB has stepped up its monitoring of prudential and macro-prudential risks associated with potential currency mismatches by financial and non-financial companies, by increasing reporting requirements on foreign borrowing by non- financial corporations. It has also taken measures to mitigate those risks by tightening regulations 2 For example, loans overdue for more than 90 days have fallen by more than 75 percent since 2006. In addition, housing credit demand is being driven mainly by first time home owners, rather than by purchases with speculative purposes. 6 on banks' net open positions and, at least until very recently, by also tightening capital requirements to curtail credit growth. B. CURRENT MACROECONOMIC OUTLOOK 17. The medium-term macroeconomic outlook points to an annual GDP growth rate of between 4 and 4.5 percent. In the short term, the forecast is for lower growth compared to previous periods, as the Brazilian economy suffers the consequences of the deteriorating global economic outlook. In the medium term, growth is likely to be driven by strong domestic aggregate demand. Investment growth, in particular, will be spurred by the development of new offshore oil fields and preparations for upcoming mega events. 18. Despite the moderate growth forecast, inflation should remain slightly above the target of 4.5 percent. Recent stimulus measures have renewed concerns over the BCB's commitment to achieving the central inflation target. Average inflation in 2012 is expected to be around 4.9 percent. The forecast takes into account the expected relatively small pass-through of the more depreciated exchange rate to tradable prices, in the context of falling commodity prices and weak economic activity. 19. In the short term, the external sector is one of the main sources of Brazil's vulnerability to a global slowdown through possible impacts on trade volumes, terms of trade and exchange rate movements. A worsening of the global economy caused by a possible U.S. and/or Chinese slowdown, coupled to a worsening of the fiscal situation of some countries in the euro zone, may translate into lower external demand for Brazil's exports, given the composition of its export markets. In 2011, exports to the US, Europe, and China represented almost 50 percent of total exports, with China accounting for 18 percent, the EU-25 for 21 percent and the US 10 percent. External vulnerabilities also arise from the growing share of commodity exports, estimated by the Government of Brazil (GoB) to have reached 59 percent in 2011, driven largely by price increases of the main export commodities. As prospects for China's economic growth that supported high commodity prices in the past abate, Brazil's terms of trade are expected to continue declining, leading to further weakening of the real. Nonetheless, Brazil's vulnerability to external events remains moderate due to its high reserves and favorable external debt composition. 20. Notwithstanding its stable position, the banking sector is vulnerable to a continued global and domestic slowdown. Small and medium sized banks, currently holding 8 percent and 12 percent respectively of the Banking system's assets, are exposed to liquidity risk given their reliance on volatile sources of domestic funding, while the larger banks, with greater access to external financing could face difficulties in rolling over external debt. Indeed, rising private sector external debt levels, largely reflecting increased issuance of bonds by corporate and banks, have raised concerns about the capacity of some companies to carry their debt. However, most traditional capital structure metrics suggest that the level and composition3 of private sector external debt pose no particular risks to stability of the financial sector at this stage. Overall, system-wide assessment of banks indicates that risks are well managed. Brazil's banking system Short term private sector external debt levels remain relatively low, despite some increase since 2007. 7 currently has solid liquidity levels, adequate capital cushions and the system's direct exposure in foreign currency is limited: 7.2 percent of liabilities and 4 percent of assets. 21. Further worsening of the global economic environment also poses risk to the fulfillment of fiscal targets. The achievement of primary surplus targets may be affected by the deceleration of economic activity, as federal revenues could decline and social protection expenditures are likely to increase. Moreover, despite the Government's current commitment to using mainly monetary policy levers to counter the ongoing economic deceleration, recent policy measures to boost the industrial sector suggest that it remains open to adopting complementary fiscal and quasi-fiscal stimuli if economic activity were to decelerate more sharply. Additional fiscal risks to be monitored stem from multiple sources, such as the January 2012 minimum wage increase, the upcoming municipal elections, tax relief for selected industries, and quasi- fiscal activities by BNDES. 22. In the medium term, Brazil faces structural challenges that limit its long-term growth potential. A short list of challenges includes developing a private market for long-term financing and improving the business environment (in particular, reducing the costs associated with complying with tax obligations and obtaining business permits and licenses). Other important issues are the need to increase public and private investment, so as to address growing infrastructure bottlenecks and achieve faster productivity growth, and that of improving the effectiveness and cost-effectiveness of public expenditures. 23. Despite the above external risks and domestic policy challenges, the Government's overall macroeconomic framework is deemed adequate and sustainable in the medium term. Brazil's fiscal framework (see Box 1 for more details on Brazilian Fiscal Federalism) has provided the Government with the flexibility to successfully respond to the 2008/09 global financial crisis as well as to the ongoing worsening of the external environment driven by the European fiscal 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 63.0 percent of GDP in 2011 to 58.1 percent of GDP in 2013, despite difficulties in maintaining fiscal balance in the face of large investment needs and pressures from current expenditure growth. Moreover, flexible exchange rates and relatively large foreign reserves should help Brazil address the consequences of a potential external crisis, including a possible abrupt shift in market perceptions and an associated turn-around in capital flows. 8 Box 1: Brazilian Fiscal Federalism and the Control of Sub-National Fiscal Performance The fiscal stance of Brazilian states has always been an important element in macroeconomic management in Brazil. Until the late 1990s, the expansionary fiscal policies by the states and the lack of effective controls over their indebtedness resulted in frequent sub-national debt crises. On three different occasions (1989, 1993 and 1997) the Federal Government had to take on and reschedule the debts of the states. The largest operation occurred in 1997, under Law 9496, when the Federal Government restructured R$200 billion (12 percent of national GDP) of the debts owed by the states. In the 1997 refinancing operation, the debts were refinanced for 30 years. This refinanced debt, so called intra- limite debt, carries a real interest rate of 6 percent with the nominal value of the debt rising by inflation. The debt service was capped at 13 percent of states' net current revenues. Any debt service above the 13 percent cap is recapitalized and added to the intra-limite debt stock. At the end of the contracts (in 2028), if there are residual debt balances, the state must pay off the remainder within 10 years. The 1997 bailout was conditioned upon the state's compliance with medium-term fiscal adjustment and structural reform programs. In exchange for the rescue package, the debt renegotiation contracts mandate the implementation of three-year rolling PAFs to be agreed upon by the STN and the 25 states that had their debt rescued by the National Treasury Secretariat during the period of the contract. The PAFs set annual targets on indebtedness, primary balances, personnel spending, tax revenue and public investment, in order to guarantee a gradual decline in indebtedness. In addition, the PAFs include structural reforms such as privatization or other public sector modernization initiatives. The controls on sub-national fiscal performance were further strengthened by the approval of the Fiscal Responsibility Law (Lei de Responsabilidade Fiscal-LRF) in 2000. The LRF institutionalized fiscal discipline at all levels of government, incorporating hard budget constraints into a single unifying framework. It explicitly prohibits debt refinancing operations between different levels of government, thereby addressing the moral hazard problem in intergovernmental fiscal relations caused by sequential bailouts. Complementary Senate resolutions also prohibit borrowing if: (i) the net consolidated debt exceeds twice net current revenue (Receita Corrente Liquida - RCL)) (ii) new credit operations exceed 16 percent of RCL; and (iii) debt service exceeds 11.5 percent of RLC. Borrowing is also prohibited if it violates the debt reduction schedules set by the debt renegotiation contracts under the Law 9496. Finally, issuance of sub-national governments bonds is generally prohibited through 2016; however, states whose net debt is less than net current revenue can issue bonds after 2011, although even here the Federal Government retains the option to review the decision to issue bonds. This system of controls has resulted in repeated state and municipal surpluses-an adjustment that has continued through four federal administrations. In addition, this system has also favored the adoption of appropriate expenditure programs by sub-national governments. Besides the controls on indebtedness, LRF requirements improved transparency and strengthened budgetary practices. Transparency: budget outtums and compliance with the LRF -including a statement of corrective measures if the relevant provisions are breached-are reported on a regular basis. Municipalities and states are also required to report the fiscal outturns of the previous year to the Ministry of Finance. The legislative branch of each level of government, aided by its respective Court of Accounts, monitors observance of the fiscal targets and ceilings. Budget Institutions: the LRF introduces more stringent requirements on fiscal targets in the preparation of the Budget Guidelines Law (Lei de Diretrizes Orqamentarias-LDO), strengthening its role in budget preparation and fiscal management in general. The LRF also calls for a detailed assessment of the Government's contingent liabilities and strengthens the link between the Annual Budget Law (Lei de Orgamento Annual-LOA) and the LDO. A complementary Fiscal Crime Law is applied to all levels of the public administration, with the possibility of detention for those public officials not complying with the LRF. C. RECENT SOCIO-ECONOMIC DEVELOPMENTS IN THE STATE OF RIO DE JANEIRO 24. After years of stagnation, the State economy experienced moderate growth from 2003 to 2008 and since 2009 has been growing well above national average. After a long period of economic decline, due to the migration of the capital to Brasilia and of businesses to Sdo Paulo, Rio's economy experienced its first turning point in 2003. Since then, 9 rapid industrial growth (in particular petroleum and steel) has spurred renewed economic activity in the State. The oil and gas industry accounts for 30 percent of industrial production and 6.4 percent of industrial employment. The discovery of oil fields in Bacia de Campos in the 1980s has been a boon for Rio. This has revitalized industries that rely heavily on petroleum and has had a positive impact throughout the economy. Besides that it created an important source of fiscal revenue from the sharing of royalties on oil production. The revenue from oil royalties accounts for 11 percent of the State's total revenues. In real terms the economy grew on average 2.8 percent in the period 2002-2009, although in the last four years this rate increased to 3.4 percent annually. In 2009, State GDP grew 2.0 percent above Southeast and national averages. While participation of the industrial sector in total GDP increased in the past 10 years with significant advances in the mining industry (oil and gas), services continue to dominate the economy, accounting for 73 percent of state GDP. 25. The State economy rebounded strongly from the global financial crisis, with indicators of economic activity rising above their pre-crisis levels in 2010. The industrial sector which was the hardest hit, especially in the first half of 2009 recovered from the crisis, with industrial production increasing by 37 percent between its lowest point in February 2009 and October 2010. Indices of employment and hours worked also peaked at the end of 2010. In 2011, however, industrial production stagnated at about end 2010 levels. The service sector was largely unaffected by the crisis due to its structure as seen in the performance of retail sales. The service sector benefits from the expansion of formal jobs, real increases in the minimum wage and expansion of conditional cash transfer programs as well as the expansion of credit (see Figure 2). 26. Economic activity in Rio de Janeiro slowed down in 2011 compared to 2010. The industrial sector grew by 0.4 percent in 2011, the same as the national performance, as a result of tightening measures as well as the global crisis effects. The modest growth of industrial production in Rio de Janeiro was on the back of a sharp drop of extractive industries (-8.7 percent) which was balanced by growth in transformation industries (2.6 percent compared to 0.25 percent at the national level). Economic activity in Rio de Janeiro also benefitted from strong growth of retail sales, up 6.8 percent in 2011 compared to 2010. The index of economically active population (Populagdo Economicamente Ativa - PEA) for Rio de Janeiro increased 3.2 percent in September 2011 compared to the same month in 2010. The level of formal employment also increased 7.1 percent during this period. Figure 1: Rio de Janeiro Real GDP growth (1996-2009) 5.0% 4.0% 3.0% - 2.0% 1.0% 0.0% -1.0%6 -* V -2.0% Source: IBGE 10 Figure 2: Growth in Industrial Production and Retail Sales - Rio de Janeiro Industrial Activity Retail Sales 15% - 12.0% 10% - - 10.0% 5% - 8.0% 5 0% -'6.0% _5% 4.0% 2.0% -10% 0.0% -1%0 0 0 0 0 0 0 0 0 -~ -~ -~ - - -~ - N~~~ M NM0 0 0 0 0 0 99 9 9 0ao0aa ------- - -C>. C>ac>ac>ac - RiodeJaneiro --- Brazil - RiodeJaneiro --- Brazil Source: IBGE 27. Strong growth has been accompanied by robust job creation in the formal sector. Indeed from 2004 to 2010 the State created almost one million net formal jobs. The crisis temporarily reversed this trend. In 2010, the effects of the crisis were overcome and the economy generated more than 217,000 formal jobs (Figure 3), with strong performance in the industrial and especially the service and retail sectors, which accounted for 78 percent of the new jobs. More than 200,000 formal jobs were generated in 2011. However, the average wage of workers although growing, did not grow as fast as in other States. One possible explanation for that is that the jobs being created are mostly in the service sector and are mostly minimum wage jobs. The unemployment rate in the Rio metropolitan region is below the Brazilian average and decreasing, albeit at a slower pace than at the national level (Figure 4). Figure 3: Net Job Creation, 2002-12 Figure 4: Unemployment rate (%) 12 months average 250,000 14.0 12.0 200,000 10.0 - - 150,000 6.0 - - - - - - - --- - - - -- -- --- 50,000 0.0 2002 2003 2004 2005 2006 2007 2008 2009 2010 20112012* ----Rio - Brazil *Formal jobs generated from June/20 11 to May/2012 Source: IBGE Source: MTE/Caged 28. The perspectives for the economy in the near future are good. The oil and gas industry should continue its strong growth with the exploration and starting of production of the giants fields of Pre-Salt. Associated with oil industries the ship industry is being revitalized and is also growing fast. The State is also becoming an important logistic hub with a huge project in the north (Porto do Agu). The State has a growing petrochemical complex (Comperj) and a consolidated auto industry. Finally, the upcoming mega sports events (World Cup 2014 and Olympics 2016) have been an opportunity to accelerate investments in physical and social infrastructure which should lay the foundations for higher State growth. 11 Recent Evolution ofFiscal and Debt Indicators for the State ofRio de Janeiro4 29. In 2010 and 2011, revenues rebounded quickly from the crisis to grow by 7 and 7.6 percent in real terms. Tax revenues accounted for 50 percent of this increase. Capital revenues increased 50 percent as well on the back of royalties (including so-called participaq5es especiais royalties, generated by high-performing wells). Transfer revenues from the Federal Government increased driven by transfers from the Fund for Maintenance and Development of Basic Education (Fundo de Manutenqdo e Desenvolvimento da Educagdo Bdsica - FUNDEB) for education and financing agreements (convinios) for public investment projects, including the National Program for Growth Acceleration (Programa de Aceleraqdo do Crescimento - PAC). As such, overall balances increased considerably compared to 2009. 30. Current expenditures have kept pace with current revenues. The 7.3 percent increase in current spending compared to 2010 was mainly driven by higher personnel and other current expenditures which increased by 6.8 percent and 8.9 percent respectively. During 2011, the larger wage bill was due to additional increase in the minimum wage5 and was also driven by new recruitment through public selection processes (Concursos Publicos) as well as salary increases in education and security among others. These developments may have long term implications and increase the rigidity of the wage bill in the future. 31. Overall, state investment expenditures have increased and debt indicators have improved. Since 2008, investment expenditures responded to the increased revenues, but also to growth in resources from credit operations and new co-financing agreements. However, in 2011, investment decreased 11.3 percent in real terms compared to 2010 as a result of a slower pace of construction partly due to 2011 being the first year of the government when it is common for investment to fall. Over the same period, a positive primary balance has been maintained albeit declining, owing largely to the higher investment levels. Similarly, indebtedness indicators have continued to decline. Due to growing fiscal revenues and consistent fiscal adjustments, the net consolidated debt-to-revenue ratio fell steeply from over 200 percent in 2004 to 146 percent by 2011, well within the LRF limit of 200 percent (see Table A3.4 and Figure 6). Debt stock increased by 12 percent in 2010 largely due to an increase in the retail inflation index (Indice Geral de Preqos- Distribuiqdo Interna - IGP-DI) to which debt with the Federal Government is indexed. Debt service has been growing modestly, driven by higher amortization rather than interest payments. 4 The fiscal annex 3 at the end of the document present the detailed fiscal analysis including the evolution of the fiscal balances in the past five years as well as the assumptions for the baseline scenarios. 5 The minimum wage was revised in January 2010, 2011 and 2012 by 9.7, 5.9 and 14.1 percent respectively. 12 Figure 5: Current Revenue and Expenditure 60 Revenues and Expenses (GFS Methodology) 150% Annual Growth in Revenue and Exenditure 500 7 50 % 10.0% 6 5 a 5.0% - 4N 20~~ 00% - 5.0% - 2005 2006 2007 2008 2009 I 2010 1 -5.0%I 2004 2005 2006 2007 2000 2009 2010_gg- -Re nu Crntx ndtt = LREVENUE II.EXPENSE -II. GROSS OPERATING BALANCE (I -II) Source: SEFAZ, WB Calculations 32. Fiscal arrangements between the State, Federal and municipal governments are deemed appropriate, as net transfers are expected to remain stable in the medium term. Transfers are the result of a stable rule based system which implies that net transfers will move broadly in line with overall revenues. Transfers accounted for an average 15 percent of total revenues during 2006-11, with growing transfers from FUNDEB and convinios. Rio's net transfers are negative, as transfers to the municipality and FUNDEB exceed current and capital transfers from the Federal Government and from FUNDEB (see Box 1 on Fiscal Arrangements). Figure 6: Evolution of Debt and Debt Service during 2004-10 250% NetConsolidated Debt 70 12.0% Debt Service 3.0 200% 10.0% 2.5 j 50% 150% 40 2.0 6.0% 1.5 100% 30 4.0% 1.0 20 50% 10 2.0% 0.5 0% 0 0.0% 00 2004 2005 2006 2007 2008 2009 2010 2011 2004 2005 2006 2007 2008 2009 2010 Net Consolidated Debt -NCD (I - II) H Net Current Revenues -NCR m Inerest Pay en Amortization - Debt Service / NCR -NCD/NCR Source: SEFAZ, WB Calculations 13 Table 2: Rio State Fiscal Balances According to GFS Classification, 2004-10 Millions R$ 2010 Constant Prices 2004 2005 2006 2007 2008 2009 2010 I. REVENUE 36,535 37,419 40,887 42,376 47,224 43,747 49,322 Taxes 21,899 21,457 22,929 23,614 25,322 26,355 29,087 Social Contributions 1,204 1,086 1,062 2,483 2,281 2,429 2,639 Transfers 3,089 3,421 3,890 3,988 5,097 5,727 6,265 Other Current Revenues 10,342 11,454 13,006 12,290 14,524 9,235 11,332 II. EXPENSE 31,998 33,457 36,005 36,975 39,757 41,233 44,484 Compensation ofEmployees 8,557 8,562 9,023 10,732 11,165 11,849 12,970 Pensions 5,845 6,398 7,066 6,746 6,959 7,310 7,882 Interest Payments 2,042 2,277 2,376 2,507 2,503 2,429 2,334 Transfers 8,769 8,780 9,352 9,507 10,143 10,263 10,908 Goods and Services 6,784 7,440 8,188 7,484 8,987 9,382 10,390 III. GROSS OPERATING BALANCE (I - II) 4,536 3,962 4,882 5,400 7,467 2,514 4,838 (as % oJ NCR) 16.2% 13.6% 15.3% 17.2% 21.2% 8.2% 14.0% IV. TRANSACTIONS IN NON-FINANCIAL ASSETS 1,349 1,467 2,652 1,591 1,941 3,036 5,291 Net acquisition ofnon-financialassets 1,331 1,429 1,854 1,513 1,798 2,898 5,166 Other investments in assets 19 38 798 78 143 138 125 V. NET LENDING / BORROWING (III - IV) 3,187 2,495 2,230 3,809 5,526 (523) (453) (as % oJ NCR) 11.4% 8.6% 7.0% 12.1% 15.7% -1.7% -1.3% VI. PRIMARY BALANCE (V + Net Interest Payments) 5,229 4,773 4,606 6,316 8,028 1,906 1,882 (as % oJ NCR) 18.7% 16.4% 14.4% 20.1% 22.8% 6.2% 5.4% VII. TRANSACTIONS IN FIN. ASSETS & LIABILITIES (689) 127 83 (540) (556) (284) 363 New Loans 348 354 431 191 194 291 1,295 Amortizations, net (1,049) (674) (627) (733) (752) (1,050) (978) Amortizations received - - 127 116 103 149 149 Amortizations paid 1,049 674 755 849 855 1,199 1,127 Asset sales 12 447 280 1 2 475 46 TOTAL BALANCE (incl. Intra-Orcamentaria) (V + VII) 2,498 2,622 2,314 3,269 4,970 (807) (90) Source: SEFAZ, WB Calculations Fiscal and Debt Projections for 2011-2020 33. The projected fiscal and debt paths for the State of Rio de Janeiro are deemed sustainable in the medium-term. Baseline scenario projections indicate a sustainable path, despite a deterioration of fiscal balances due to increased investment in the next five years. Net Consolidated Debt is projected to stabilize at about 156 to 158 percent of NCR as rising investment is largely financed from increasing income. Nevertheless, Rio's fiscal balances (the primary fiscal balance and the gross operating balance) are expected to decline over the projected period from 7.1 and 13.5 percent of Net Current Revenue (NCR) in 2011 to -1.1 and 8.3 percent respectively in 2020, due to the higher levels of public investment (see Annex 3). 34. In particular, average expenditure growth exceeds revenue growth, leading to a declining primary surplus. On the expenditure side, current expenditures are rising as a result of real increases in employee compensation, and goods and services (custeio) in line with higher levels of investment. On the revenue side, the principal growth drivers are taxes (primarily from ICMS, which is heavily dependent on economic growth), royalties, and current transfers from the Federal Government (from FPE, Conv6nios and FUNDEB). Tax revenues, social contributions and capital transfers increase gradually while other current revenues fall in real terms. Oil and gas revenues, which accounted for 18 percent of current revenues in 2011, account for a slightly declining share of current revenues during the projected period (7 percent in 2020). 14 35. In the baseline scenario, the debt dynamics are sustainable and comply with the Fiscal Responsibility Law (LRF). Net consolidated debt is projected to increase gradually until 2020. As a share of net current revenue, net debt is expected to increase to reach 158 percent in 2012 from its initial 146 percent in 2011, and to stabilize afterwards reaching 156 percent in 2020. In the projection period, debt service payments are expected to remain constant as a percentage of NCR, while interest payments fall. Nevertheless, both net consolidated debt and debt service remain within the limits set in the LRF as well as in the fiscal adjustment program between the State and the Federal Government. Risk Analysis 36. The risk analysis assesses the impact of uncertainty surrounding fundamental variables for Rio's fiscal outlook. The main risks that could lead to deterioration in the State's fiscal balances are related to (i) fluctuations in macroeconomic variables, including growth and exchange rates (ii) uncertainty surrounding oil and gas revenues (related to prices, volumes, exchanges rate, sharing rules), and (iii) expenditures related to large capital investment such as the 2014 World Cup and the 2016 Olympic Games. 37. The fiscal and debt situation of the State of Rio de Janeiro is deemed sustainable in the medium term. However, the analysis points to possible vulnerabilities of fiscal balances and debt stemming from higher investment, lower royalties revenues and lower GDP growth. Additional debt due to higher capital investment for the preparation of the World Cup and the Games should not violate the LRF as it is not accounted in the computation of the Net Consolidated Debt Indicator for the LRF. In contrast, a combined adverse shock on macroeconomic variables could cause a deterioration in fiscal balances and debt levels, which could possibly surpass the prudential limits of the LRF. Specifically, lower GDP growth rates would have a large negative impact on current revenues, which would grow at a slower pace than current expenditures. While this alternative scenario indicates a breach of the debt limit, there is scope for adjustment, given the relatively high investment levels. See Annex 3 for more details. Social Development 38. Following the nationwide trend, poverty and extreme poverty in Rio de Janeiro have significantly decreased since 2003. Rio de Janeiro halved its extreme poverty which fell from 7.6 percent in 2003 to 3.7 percent in 2009 (15.2 percent to 7.3 percent in the nation). Meanwhile, poverty was reduced from 24.9 percent to 13.5 percent (35.8 percent to 21.4 percent in Brazil). 39. Despite its decreasing trend, inequality remains in high levels and its reduction pace is lower than the Brazilian average. The Gini index, which measures the degree of inequality in per capita household income decreased from 0.572 to 0.542 in the 2001-2009 period. However, Rio de Janeiro's performance was much less robust and stable than that of Brazil as a whole (Figure 7). While in the mid 1990s Rio de Janeiro's levels of inequality were lower than Brazil's, by the end of the 2000s, Rio's Gini was practically equal to the still high Brazilian average. Rio de Janeiro's Gini is also the highest among Southeastern states. 15 Figure 7: Gini coefficient, Rio de Janeiro and Brazil - 1995-2009 0.610 0.600 0.590 0.580 0.570 K % A 0.560 0.550 S 0.540 N ' 0.530 -4- Rio de Janeiro Brazil Source: Ipeadata 40. Due to a weaker contribution of inequality reduction, Rio de Janeiro faces larger challenges to reduce poverty. The 3.7 percent extreme poverty headcount is higher than those of states with similar average per capita household income, like Sdo Paulo (3.0 percent), Santa Catarina (1.7 percent), Rio Grande do Sul (3.5 percent) and ParanA (3.6 percent). While Rio de Janeiro has the third largest average per capita household income between Brazilian states, it is ranked 10th in the list of states with smallest extreme poverty. 41. Extreme poverty in Rio de Janeiro has fallen less in its metropolitan regions. During the past decade the share of the population living with less than R$70 per capita per month dropped in both metropolitan and non-metropolitan areas (Figure 8). However, while in 2001 extreme poverty was 5 percent lower in Rio's metropolitan areas, by 2009 it was 21 percent higher than in non-metropolitan regions. On the one hand, the large extreme poverty reduction observed in Rio de Janeiro during the period - 54 percent in non-metro areas and 41 percent in metro areas -reveals how successful Brazil and Rio de Janeiro have been in addressing poverty. On the other hand, this experience highlights the challenges associated with bringing public services, including social protection programs, to the most vulnerable populations in the State's metropolitan areas. This issue is of special importance in the case of Rio's favelas, which have traditionally had lower access to government services. During recent years, however, the State Government has implemented specific programs aimed at increasing state presence and furthering social development in those areas Figure 8: Share of population living in households with less than R$70 per capita 4.1% 39 JUJI 2 3% 2001 20 UNon metropolitan areaofiRiodelaneiro E Metropolitan area olRiodeJaneiro 16 Source: Own calculation using PNAD 2001, 2009 42. Rio state provides efficient access to several household utilities, but there is space for further improvements. Garbage collection and electricity are nearly universal. In addition, Rio reports the highest adequate sanitation and safe water coverage rates among Brazilian states. Despite that, only 72.7 percent of households in the State have access to the sewage network and 88.1 percent of dwellings have access to the water network. Access to these services is significantly lower in non metropolitan areas. 43. Broader performance of the Rio State education system has been poor. With 1,447 schools, slightly over 1 million students, and 75,000 teachers, the Rio state education system is the third largest in Brazil. Despite its historically strong base, poor administration over the past two decades has allowed school infrastructure to degrade, teacher quality to decline and a politicized process for the selection of school district supervisors and school principals to result in a low accountability, low performing system. The system may have reached a nadir in 2009, when the performance of Rio State secondary schools on the national standardized Prova Brasil test was the second lowest in Brazil (above only Piaui, which spends much less per student). Tellingly, while the national average on Brazil's Index of Development of Basic Education (Indice de Desenvolvimento da Educaqjo Bcisica - IDEB) improved steadily from 2005-2009, from 2.9 to 3.2, Rio State's score of 2.8 remained flat. 44. A large part of the problem is high repetition and low graduation rates. In 2010, Rio state had the fourth highest repetition rate in Brazil for upper primary education, with 48 percent of all students at least two years behind the appropriate grade for their age. For secondary education, the state had the eighth worst record, with 52 percent of all students at least two years overage. In these and most other education indicators, Rio is below the national average and much lower than the rest of the Southeast (for example Sdo Paulo had only 12.8 percent of students at least two years behind in primary education and Minas Gerais 30.1 percent compared with Rio's 48 percent). Rio State schools are plagued by teacher vacancies, especially in math and sciences, high absenteeism and tardiness, ineffective teaching practices and few programs to target support to students falling behind. At the secondary level, 41 percent of Rio's students are enrolled at night, which means teachers must try to cover the broad curriculum in only 4 hours per night, when both students and their teachers are often exhausted from their daytime jobs. Dropout rates are also high compared to other states, especially for students in the secondary school (Figure 9). 17 Figure 9: Dropout rates by states in Brazil, 2010 (Rio de Janeiro highlighted) Dropout rates (1st to 4th grades) 6.0% 2.0% 0.0% Dropout rates (5th to 8th grades) 20% 15% 0% S ur MC/INEP/DTDIEV the SDropout rates (9th to 12th grades) 20% 15% i-- 10% ..III i WO ccV 2 L < ZC Source: MEC/INEW/DTDIE 45. In the health sector Rio de Janeiro's performance is also disappointing relative to the State's level of economic development. Infant mortality rate dropped from 17.9 to 14.0 per 1000 live births between 2002 and 2010. Indicators such as child immunization and coverage of prenatal care reached 95 percent since the beginning of the 2000's and mortality by violence and crime has been reduced. However, given the advanced stage of the demographic transition in the State, chronic conditions (such as diabetes and hypertension) were responsible for more than 60 percent of total mortality in 2008. The family health program (Programa Saude Familia - PSF), which could be essential to increase promotion and prevention, especially for chronic diseases, covers only 24 percent of the State population in 2011 compared with a national average of 49 percent. Compared with other States in the South-East Region, Rio de Janeiro presents the lowest PSF coverage. In the Rio de Janeiro Municipality there have been some improvements in PSF coverage brought by the implementation of the Clinicas de Familia program. However, in the large and poor municipalities that make up most of the periphery of the Metropolitan Region of Rio de Janeiro, PSF coverage is much lower and infant mortality is above the State average. 18 Table 3: Percent of Population Covered by Health Family Program in Brazil and South-East Region States, 2007-2011 2007 2008 2009 2010 2011 Brazil (BR) 47,0 48,9 49,9 52,3 48,8 Rio de Janeiro (RJ) 23,8 24,7 24,7 25,8 23,9 Espirito Santo (ES) 47,0 51,0 49,9 58,3 51,7 Sao Paulo (SP) 26,0 27,7 28,1 28,9 29,3 Minas Gerais (MG) 59,0 56,7 57,6 63,8 61,5 Source: Pacto pela Sadde Indicators (DATASUS/MS) III. THE GOVERNMENT'S PROGRAM AND PARTICIPATORY PROCESSES The Government Program 46. At the end of 2010 the Government of Rio de Janeiro was reelected, following a first term (2007-2010) in which it pursued a comprehensive reform program to improve effectiveness and efficiency in the provision of public services, After a previous decade or more of decline, neglect, poor management and corruption. Building on these reforms the current administration adopted the Plano Plurianual 2012-2015 (PPA)6 to articulate its key priorities and strategies. Within the PPA the Government has identified the following priorities: (i) Economy and management, where the principal objectives are to increase tax compliance and promote responsible fiscal management as well as modernizing the public administration of the State; (ii) Infrastructure, where the objective is to extend infrastructure as a means of social and economic inclusion; and (iii) Citizenship, where the principal objectives are the integration of social policies, eradication of extreme poverty and the promotion and defense of human rights as well as the pacification of favelas, the reduction of crime and the increase in citizen security; (iv) Quality of life where the objectives are to improve the health of the population, to promote sustainable environmental development and to reduce the risk of natural disasters; (v) Human capital where the objective is to ensure that Rio is among the top five States in educational outcomes. The proposed operation will directly support three of the five priority areas of the PPA. For completeness the main points of the overall Government program, are outlined below, and summarized in Boxes 2 and 3. 6 Approved on 28 December 2011 (Lei No 6.126) 19 Box 2: Recent and Ongoing Reforms in public administration and financial management Theme/Sector Reform Measures Undertaken Year Strengthen Enhancingfinancial and cash planning: Introduction of a financial program that publically 2007 public financial sets out the monthly and quarterly receipts and spending limits for each public agency (see management decrees 40.567/07 and 41.162/08). New rules for payment processing: Introduction of a monthly disbursement schedule 2008 (Decree 41.162/08) and measures to ensure the timely flow of resources (Art. 11). Improving commitment controls: New quarterly commitment limits introduced and a program (including new control and payment procedures) to clear the State balance sheet 2007/8/9 of carry-over debts to providers of goods and services, or Restos a Pagar initiated. (see various Decrees, e.g. 40974/07 or more recently 41625/09). Strengtheningfinancial management: Restructure of the Treasury to enhance its investment management capability (including risk management) Greater transparency and accountability: Since April 2008, information on the payment process was made available to public agencies, the public and with secure access to 2008/9 confidential-client information for certified suppliers on the SEFAZ website. Strengthening Procurement: Introduction of an integrated procurement management system (Sistema Integrade de Gestdo de AdquisigOes - SIGA) and introduction of Price 2008 Registry and Pregdo Electr6nico in 2008 as preferred procurement methods. Improving the Cadastro Fdcil (Facilitation of Firm Registration) initiated to provide a more efficient 2008 Business business registration process. Environment Establishment of Rio Poupa Tempo, Integrated Service Centers that provide services such 2008 as company registration, licensing and permits, among other services, in one location. Establishment of Escritura(do Fiscal Digital, a Digital Tax Archive requiring companies to generate documents related to payment of taxes and sales and purchases, in digital format. Adoption of the Nota Fiscal Eletr6nica (Electronic Invoices) for the collection of the State VAT, to increase tax compliance and oversight Redesign and implementation of processes related to key interactions between SEFAZ and businesses. Transfer to Electronic Form and Digital Certification of Processes and Documents at the Commerce Board (Junta Comercial). Expansion of Commerce Board Regional offices, to reach regions of the State until now unattended by the services provided by the Board. Implementation of REGIN or Registro Mercantil Integrado, a centralized business registration system. Strengthening Install biometric registry for all public employees and pensioners (Identidade Funcional) public sector Increase the number qualified staff through hiring new staff with selective public exams 2010 administration (concursos) and creation of specialist careers in public policy and management, planning and budgeting, public financial analysis and health management. Restructuring and elimination of overlapping agencies and implementation of new administrative units such as INEA (2007), CEPERJ (2009), SEDEC (2011) and SEDRAP (2011), in Environment, Planning, Civil Defense and Development respectively. 20 Box 3: Recent and Ongoing Reforms in Public Service Delivery Theme/Sector Reform Measures Undertaken Year Improved Projeto Autonomia introduced to offer over-age students a chance to graduate on time by 2009 Quality and following a special compressed curriculum with intensive teacher support. Efficiency of Introduced the education MIS Program (Conexdo Educaqdo) which promotes access to Basic Education digital teaching and learning resources and allows for real-time monitoring of student and teacher attendance. Introduced annual, school-level targets (metas) for improving student learning outcomes 2012 and student flows, based on SAERJ (annual state learning assessment) results and introduced performance pay linked to results Adopt legislation to establish new, meritocratic processes for appointing school directors 2011 Establish a new in-service teacher training academy (Escola SEEDUC) designed to upgrade teachers' skills. 2012 Establishment of a new research and evaluation unit in SEEDUC to evaluate the impact and cost-effectiveness of its education strategies and programs. Improved Develop new strategy for providing urgent and emergency care through UPAs (Unidades 2009 Coverage and de Pronto Atendimento) Efficiency of Establishment of a new State agency (Central de Regulaqdo) to address the referral and Health Services counter-referral system of all urgent and emergency care within the State. Established the Program to Support Municipal Hospitals (PAHI), a performance-based 2009 financial transfer system between the State and municipalities Implement medical protocols starting with the more costly and prevalent diseases. 2009 Establish State Health Foundations to introduce flexibility and strengthen performance orientation and accountability in the system Perfbrmance-based scheme expanded to regional hospitals: Introduce PAHI2 to increase the incentives for responding to medium and high complexity needs through regional hospitals placed outside the Rio de Janeiro Metropolitan Area. Ensuring Fiscal Institutional refbrms to adapt State pension system to the requirements of the Federal 2007/8 Sustainability Constitution: Law to unify the entities responsible for managing the State Employees' pensions passed (law No 5109/2007) and the different pension regimes existing in the State were unified (law No 5260/2008). Reducing long term fiscal risk by transferring oil revenues to the pension fund: Adoption 2009 of Decree 42.011/2009 which establishes royalties as assets of Rio Previdencia, and therefore cannot be used for other purposes and are protected from executive discretion. More importantly, the law allows recapitalizing Rio Previdncia by providing future flows of oil revenues as assets. Introduction of the Fiscal Transparency Bulletin (Boletim de Transparencia Fiscal), a 2008 bimonthly publication that analyzes fiscal risks to the achievement of the Fiscal Responsibility Law targets and publication of all fiscal data used in the analysis. Infrastructure Implementation of the Inter-municipal "One Ticket" system (bilhete uinico) through State 2009 and Urban Law 5628 (approved in December 2009). Development Creation of the State Institute of Environment (INEA) in 2007, under Law 5101 of 2007 October 2007, with a mission to protect, conserve, and restore the environment and promote sustainable development. Complementary Law 131-2009 enacted, which allows the government to donate state land 2009 in order to provide titles to low-income families. The donation of these State lands makes it possible for private developers to enter to build low income housing and receive federal government subsidy Citizenship Introduction of the Unidades de Policia Pacificadora (UPP), or Pacification Police Units. 2008 Introduction of programs designed to provide income and employment in the integrated communities. 21 Economy and Management 47. Before 2007, the annual budget was almost irrelevant and funds were allocated on a day-to-day basis. The State's revenue base had been eroded and there was virtually no new investment, while existing infrastructure was deteriorating for lack of maintenance. Between 2007 and 2010 the GORJ embarked on a program to increase the revenue base of the State and strengthen basic financial management processes. Tax Administration 48. The State of Rio has increased tax collection significantly since 2006, due to economic growth but also to key efficiency reforms. Going forward, the State Government will need to implement more fiscal reforms so as to be able to keep up with structural increases in expenditures related to, among others, education, health, contingent liability expenditures and possibly a decreasing share in oil revenues. 49. Measures being adopted in the area of tax administration include: (i) Introducing performance management to the tax administration of the Secretariat of Finance; (ii) Integration and synchronization of municipal, state, and federal taxpayer registration systems, to facilitate registration and increase compliance; (iii) Introduction of digital certificates for taxpayers; (iv) Development of taxpayer ledger so that eventually the taxpayer ledger will be integrated in a single unified account to which taxpayers will have access, thus increasing compliance; and (v) Returning control of the tax on motor vehicles (Imposto sobre Propriedade de Veiculos Automotores - IPVA) to the Secretariat of Finance from the private bank with which it currently resides, to increase compliance as costs will be reduced and payment can be made in any bank in the State. Public Financial Management Processes 50. The importance of sound budgetary and administrative management in the next few years has increased as a result of a number of high profile international events to be held including the World Cup in 2014 and the Olympic Games in 2016. These events together with the effort which the GORJ is making to ensure the full integration of the State, require both major investments and a policy environment which fosters partnerships with other levels of government and the private sector. For these reasons the State Government is planning to introduce public investment management processes to ensure that the investments carried out ensure the most effective uses of scarce resources and are consistent with long-run fiscal sustainability, and also processes to cost proposed major new programs. 51. The GORJ wishes to ensure that policies adopted are both consistent with its objectives and priorities and with resources likely to be available in the medium term. In light of the recent expansion in service provision and in the investment portfolio of the State, this key concern has translated into increased attention to two topics: public investment management and medium term fiscal sustainability. The Government has focused on revising its multi-annual plan and new procedures were adopted in this process to ensure that sector programs are in line with the Government Strategy. Nonetheless, challenges remain in adequately assessing the medium term cost of such programs and in selecting investment projects. Going forward, the 22 GORJ intends to focus on strengthening public investment management and medium term cost estimates to ensure that policy commitments are consistent with long term fiscal sustainability. 52. Strengthening internal controls. The Government has enacted a new decree, which creates a new management and career structure for the accounting and audit personnel both at the State Secretariat of Finance (Secretaria de Estado da Fazenda - SEFAZ) and based on the various entities around the State Government. The new decree also establishes a duty for the Internal Audit Department (Auditoria Geral do Estado - AGE) to provide an annual audit plan and an annual report on internal controls and to increase the capacity of personnel. Public Administration Reform 53. Reform of public administration has been at the center of the State's program since 2007. The central objective has been the modernization of personnel, budget and technical management, so as to lower the cost of service delivery and increase efficiency. This was achieved through restructuring and elimination of overlapping agencies as well as the introduction of widespread transparency. In addition, the State has also been introducing results based management and reforming human resource management practices through the recruitment and training of new managers and the creation of specialist careers in public policy and management, planning and budgeting, public financial analysis and health management. Infrastructure 54. The State is supporting a program for the development of infrastructure to transform Rio de Janeiro. These investments in infrastructure will be part of the renovation of Rio de Janeiro prior to the World Cup and Olympic Games, and serve as a base for an economically vibrant and socially integrated State. The objective is to provide high quality and efficient economic and social infrastructure to support growth and equity over the next decade. Among the most important projects are those that focus on providing urban infrastructure in marginalized and low income communities, including particularly water and drainage, and the provision of transport infrastructure, and particularly the metropolitan ring road to connect the Baixada Fluminense with the rest of the metropolitan area. The completion of the Metropolitan Ring Road will be fundamental to renovate the road infrastructure and to reduce transportation costs of goods produced in different parts of the territory of Rio de Janeiro, as well as for providing access and employment for the residents of the Baixada Fluminense. 55. The State will also be improving transport infrastructure through the extension and integration of the Metro, bus and water routes to provide an integrated transport system which gives access and mobility to residents in peripheral areas (particularly through the expansion of the single ticket- Bilhete Unico system). In addition to extending the passenger transport network, the State will be improving the operational efficiency of the ports and airports in its territory to facilitate the transport of goods, and reduce the costs of economic activity. Finally the State will be investing in housing through the project of Integrated Residential Units (Nticleos Habitacionais Integrados), and through other programs to improve the quality and infrastructure of housing as well as strengthen land regularization. 23 Citizenship (Integration of communities) 56. One of the central goals of the State Government is to integrate the previously marginalized communities. These communities were excluded for decades from many aspects of the life of the State including access to basic services and security from violence. Starting in 2008 the State of Rio de Janeiro embarked on a new program, the Unidades de Policia Pacificadora (UPP), or Pacification Police Units. The aim of the UPP is to provide the protection of the State to communities that have been under the control of drug gangs. The pacification gains are creating enabling conditions for new economic, social, and political opportunities for community residents, thus facilitating the integration of the communities with the rest of the city, and breaking Rio's historical image of a divided city. In addition to the UPPs, the GORJ has launched the UPP Social Program, a systematic and deliberate attempt to bring public services to the "pacified" communities. 57. Social policies include specific measures aimed at pacified communities. These include building partnerships with the Federal Government and the municipalities with a view to strengthening sectoral policies and the fight against extreme poverty, with programs designed to provide income and employment in the integrated communities. Already the impact of the initial pacification has resulted in the flourishing of small businesses in the communities as well as increases in land values. Quality of Life (Health) 58. The primary focus of health policy in the State is to support improvements in the management of health units, by implementing new contract models that allow better governance and payments for performance. The Government is also introducing measures to improve the coordination between the primary health services and the hospitals in the small municipalities, setting-up better referral and counter-referral processes between primary care and municipal hospitals and increasing the capacity of regional hospitals to respond to medium complexity health care needs for patients outside of the Metropolitan area. In addition it is expanding access to urgent and emergency care in the State by extending the 24-hour emergency care unit (Unidade de Pronto Atendimento - UPA) model to the municipalities outside of the Metropolitan Region of the Rio de Janeiro. 59. Efficiency and effectiveness of government health spending and health service provision in the State of Rio de Janeiro is being increased by (i) creating the legal foundations for and implementing new models for contracting health services from non-profit providers (organizaq5es sociais); (ii) providing support and incentives for governments and hospitals in small municipalities in the interior (less than 115,000 inhabitants) to improve primary health care and the quality of hospital care (PAHII); and (iii) increasing the incentives for regional hospitals to respond to medium and high complexity care needs, including for patients from outside the municipality where the hospital is located (PAHI2)7. 7 PAHI1 (Programa de Apoio aos Hospitais do Interior 1); PAHI2 (Programa de Apoio aos Hospitais do Interior 2) is dedicated to support improvements on management and infrastructure for regional state hospitals or those 24 Human Capital (Education) 60. The creation of human capital is a key element in the GORJ's agenda to promote social inclusion, labor productivity and growth. Rio state has set the ambitious target of becoming one of Brazil's five highest-performing states on the Federal Government's IDEB education quality index by 2013 (in contrast to 26th position in 2009). To achieve this, the State Secretariat of Education has made impressive progress in the last two years in building a strong technical team and developing and implementing a comprehensive reform agenda that exemplifies the state administration's commitment to public sector efficiency and service delivery quality. The reform program is in line with global best practice and research evidence on how to improve school systems' results focus and accountability. It includes two key reforms which are described below. 61. Raising the quality and accountability of school managers. In January 2011, the State adopted far-reaching legislation which established new processes for the appointment of school district managers (regional directors) and for filling leadership vacancies at the school level. For the first time, these appointments are made directly by the Secretary of Education, through a transparent process of competitive selection among qualified candidates. The entire top management level of the state system was replaced in 2011 (100 percent of 28 positions at the regional level) and all 74 of the school director vacancies that have arisen since January 2011 have been filled through the new, meritocratic process. The same legislation also introduced the first-ever process of annual performance evaluation for regional and school directors, including a review of results and 360 degree feedback from teachers, students and parents about directors' interpersonal and leadership behaviors. This set of reforms has already produced a significant upgrade in the technical quality of the state's top education managers and their accountability to the Education Secretary. The new annual performance evaluations offer the Secretary an additional tool for addressing management issues in the system's worst-performing schools. 62. Strengthening incentives for schools to focus on results. In a second key management reform, to tackle the state's low test scores and graduation rates, the Secretariat in January 2011 introduced annual school-level improvement targets and bonus pay linked to these results. The Secretariat agrees with each school director at the beginning of the school year on a transparent set of targets with two components: (i) grade promotion and graduation rates; and (ii) test scores on Rio state's annual learning assessment (Sistema de Avaliaqdo da Educaqdo no Estado do Rio de Janeiro - SAERJ). Schools that achieve 90 percent of their targets or higher (up to a cap of 120 percent) receive a proportional salary bonus (90-120 percent of one extra monthly salary) for all personnel in the school. The targets for 2011 were established by working backward from the State's goal of raising its national ranking by 2013 and projecting a linear improvement path for each school, from its 2010 starting position to the desired level in 2013. 63. These two major reforms are part of a more comprehensive program implemented by Rio State. First, the Secretariat's Integrated School Management (Gestdo Integrada da Escola - GIDE) program in 2011 recruited a new cadre of 200 young professionals with strong hospitals with medium complexity covering more than one municipality according to the health regionalization plan of the Rio de Janeiro State. 25 public sector management skills who are each assigned to support 5 to 7 schools with strategic (school development) planning, financial management, infrastructure planning and management, and human resources management (planning for impending vacancies, for example for retirements or maternity leave) and training priorities. This is an innovative approach that appears to be having positive results. Second, the Secretariat of Education (Secretaria de Estado de Educaqjo - SEEDUC) established a new research and evaluation unit, which has already had a clear impact on the quality and timeliness of education statistics and management information and which also has the capacity for rigorous evaluation of the impact and cost-effectiveness of SEEDUC programs. Third, the state is implementing a thorough reform of the curriculum, especially at the secondary level. Fourth, in February 2012 the secretariat inaugurated a new in- service training academy (Escola SEEDUC) for teachers, managers and other education personnel. Fifth, the State is actively partnering with the private sector in technically-oriented secondary schools, such as the Oi Futuro school (electronics) and the NAVE (food services) school. Finally, the ambitious long-term plan of the Secretariat is to expand and upgrade all school infrastructures at the secondary level so that by 2021 all students have access to full-day (6 hours or more) instruction. Public Consultations 64. Rio de Janeiro's development priorities are embodied in the PPA and reflect not only technical analyses, but also a participatory decision-making process established in the State's constitution. The PPA, LOA, and related government initiatives are regularly and extensively discussed at the State Assembly, which has the authority to revise and approve the Government's proposals. The PPA is the subject of an annual review by the State Assembly, at which time the government reports on the previous year's performance in meeting the objectives of the Plan. 65. Policies of the education sector supported by the Bank operation are an integral part of the Multi-Annual Plan of State Education. To define this Plan, the Secretariat has systematically held municipal consultations and regional meetings, and hundreds of teachers, principals and representatives of parent-teacher associations were heard. 66. By law all State health policies are discussed and approved at the monthly meeting of the State Health Council. The Council is composed of 28 members (50 percent are users, 25 percent are health workers and 25 percent are health services providers). 67. Policies related to the public financial management reforms are also part of the PPA and have benefitted from institutional and participatory processes. The State has established a system to strengthen the links between planning and budgetary processes, and ensure that policies adopted are both consistent with priorities of the GORJ and with available resources. Moreover, over the past three years the State Government has directed considerable effort to strengthening the annual budget process and increase transparency by making budgetary data publicly available. 26 IV. BANK SUPPORT TO THE GOVERNMENT'S PROGRAM A. LINK TO CPS 68. Brazil and the World Bank Group have a long-standing partnership. The Country Partnership Strategy 2012-2015 (CPS) for Brazil8 recognizes significant achievements in tackling development challenges using innovative approaches, and contributing to shaping the global policy agenda. The CPS also responds to the demand for more flexible and efficient products that are better suited to the country's evolving needs, while maintaining a focus on key long-range development issues. 69. The aim of this operation is to build upon the partnership with the State of Rio de Janeiro by consolidating reforms which address complex and challenging development issues that have significant long-term implications. The reforms and the challenges in Rio de Janeiro are a microcosm of those facing Brazil as a whole (both in terms of development of institutions and with regard to poverty and marginalization). By working with a State such as Rio de Janeiro with relatively high capacity, the policies and innovations being supported can serve as models for other states in Brazil. The operation will help the GORJ reinforce fiscal and financial discipline, in the face of increasing pressures on expenditure while improving public service delivery and reintegrating the social pattern of the State. 70. The proposed operation is fully consistent with and closely linked to the objectives of the CPS, 2012-2015. This operation is one of a number of sub-national DPLs and SWAPs designed to reinforce fiscal discipline, public financial management and service delivery as an integral part of the Bank's Country Partnership Strategy in Brazil. By focusing on a State with such a large economy and high inequality as Rio de Janeiro, the operation will address both the Investment and Service delivery pillars of the CPS. In particular, the policy measures supported by the operation are aligned with the CPS objectives of (i) increasing the efficiency of public and private investments; and (ii) improving the quality of public services for low income households, and expanding their provision through public and private channels. By supporting policies with objectives such as increasing State revenue performance, improving efficiency in tax collection, implementing a merit-based selection process for school directors, and new management models for health units as well as improvements on the efficiency of the budget transfers to small municipalities in health, the operation will contribute to improve such CPS outcome indicators for the whole country. The contribution will both be direct and indirect through the contribution that the reforms make to knowledge transfer within Brazil. B. COLLABORATION WITH THE IMF AND OTHER DONORS Collaboration with IMF 71. Since the International Monetary Fund (IMF) does not work directly with state governments there has been no direct collaboration with the IMF on this specific operation. However, the Bank and Fund teams work very closely on the overall Brazil program. This is consistent with the Joint Management Action Plan (JMAP), which, in order to improve coordination at the country level, called for Bank and Fund staff to consult at least annually in 8 Country Partnership Strategy 2012-2015 (Report No. 63731-BR) discussed by the Executive Directors on November 1, 2011. 27 the preparation of their work programs. Brazil country teams from the Bank and the Fund have also been meeting regularly. Collaboration with Other National and International Partners 72. The Inter-American Development Bank (IDB) is providing support to Rio de Janeiro through the Programa de Apoio d Gestdo e IntegraVdo dos Fiscos no Brasil (PROFISCO) which consists of technical assistance in order to: (i) enhance the planning, budget, and financial instruments that support decision-making; (ii) increase the state's internally generated revenue; (iii) enhance transparency mechanisms and the efficiency, effectiveness, and control of public expenditure; and (iv) improve the quality of services provided to taxpayers by the State of Rio de Janeiro Secretariat of Finance. 73. The reforms and actions supported under this operation are clearly linked to the Federal Government's strategy to improve the overall quality of education in Brazil, given the role of the State of Rio de Janeiro in delivering education services. Rio has eight education programs supported by the Federal Government (see Table 3). Table 4: Federal Education Programs in Rio de Janeiro State Program Main Purpose National School Feeding Program Transfer financing resources to the city to support (Programa Nacional de Alimentaqdo merenda escolar. Escolar, PNAE) Programa Dinheiro Direto na Escola Transfer financing resources directly to each school to (PDDE) improve pedagogical and physical infrastructure. Open School Program (Programa Escola Transfer financing resources to promote sports, Aberta) cultural, and arts activities on weekends. Programma de Desenvolvimento Enfantil Transfer financing resources to support schools with (PDE) - Escola low Indice de Desenvolvimento da Educaqdo Basica (IDEB) levels. The schools will be in charge of developing action plans to help low-outcome students. More Education (Mais Educaqdo) Transfer resources to extend school time and arts, cultural, sports, and learning activities. National Program of Educational Distribute to schools computers, digital resources, and Technology educational content to promote the use of information (Programa Nacional de Tecnologia technology in public education. Educacional, PROINFO) National Textbooks Program (Programa Distribute textbooks to students and teachers in the Nacional de Livro Didctico, PNLD) following subjects: Portuguese, mathematics, science, history, geography, and literacy. National School Library Program Distribute books to build libraries for students in (Programa Nacional de Biblioteca da Ensino Fundamental. Escola, PNBE) 28 C. CHOICE OF INSTRUMENT AND RELATIONSHIP TO OTHER BANK OPERATIONS Choice of Instruments 74. DPL vs. Investment Lending. The DPL supports a multi-sectoral approach directly linked to the strategic objectives outlined by the GORJ in its strategic plan. A DPL is therefore the appropriate vehicle. The state's reform program is robust and embodies crosscutting themes, such as the development of human capital, strengthening of social, physical and institutional infrastructure and improving governance and public sector management. The Government's program and priorities provide a solid ground for confidence that the operation will contribute to poverty reduction. 75. One-tranche DPL vs. two-tranche DPL. A single-tranche DPL was preferred for two reasons. First the previously mentioned long partnership of the Bank with the State of Rio de Janeiro, which signifies that support to the GORJ is quasi programmatic, second, the relatively higher capacity of the Government, compared to other states in Brazil and its strong commitment to increasing the capacity and efficiency of public administration further confirm the single- tranche choice. 76. A programmatic DPL series versus a series of single tranche operations. The reason for choosing a series of stand-alone operations is that the current fiscal responsibility law would make approval of a programmatic series bureaucratically very complex, and potentially impossible as the law requires an evaluation of borrowing capacity at the current moment in time. Even if approved each new loan in the programmatic series would also have to be approved separately. By using the series of single tranche loans in a programmatic fashion, the Bank is able to maintain a mature dialogue with the State based upon a relationship of trust. Relationship to other Bank Operations 77. The proposed operation follows the successful implementation of two previous DPLs with the State and one with the Municipality of Rio de Janeiro: the first State DPL (Fiscal Sustainability, Human Development, and Competitiveness DPL- P 117244), which was approved by the Board in February 2010, was designed to assist the GORJ in sustaining its efforts to improve fiscal management, competitiveness, and social service delivery in the context of a temporary fall in revenues associated with the global recession. That operation supported measures that: (i) strengthen fiscal consolidation by reducing long-term fiscal risk, improving the efficiency of tax administration, and strengthening budget procedures and financial management; (ii) improve the quality and efficiency of the business registration process; (iii) took initial steps to improve the quality and efficiency of the education system; and (iv) increase access to health services and improve their efficiency, especially for urgent and emergency health care in disadvantaged areas and for low-income populations. 78. The Second State DPL (Rio de Janeiro Metropolitan Urban and Housing Development Policy Loan - P122391) was approved in March 2011. That operation was designed to support the GORJ to strengthen its policies for planning and managing territorial growth in the Rio de Janeiro Metropolitan Region, promoting the provision of affordable 29 housing, and creating integrated social development programs targeted at the urban poor. These two operations will be followed by this proposed third State DPL to consolidate reforms related to fiscal consolidation, human development and public financial management. 79. The Rio Municipality DPL (Fiscal Consolidation for Efficiency and Growth - P111665) was approved in July 2010 and focused on (i) creating fiscal space to expand public investment and lay the foundations for municipal growth; (ii) reforming public service delivery with increased access to quality family health care and emergency care services through a new model for subcontracting social organizations to manage health facilities; and high quality Early Child Development (ECD) and primary school services targeted to children in high-conflict favelas, as well as system-wide actions to raise student learning outcomes; and (iii) developing a framework to improve the efficiency of services delivery in the public sector through introduction of result-based management (RBM) tools and the implementation of the first steps of a Medium Term Expenditure Framework (MTEF) and in the private sector through public private partnerships (PPP) in priority areas. 80. The first State DPL was in response to the crisis where the Government was concerned that the fall in revenues could destabilize the overall reform agenda, and particularly jeopardize the financing of health and education programs, at a time when the fiscal reforms had not been consolidated. The second DPL was also a response to the natural disasters from heavy rain which highlighted the issue of urban housing. The current DPL, while building on the two previous ones, also allows support for strategic long term issues, particularly in public financial management, which can now be addressed because many of the basic reforms have been carried out. 81. All the three previous DPLs covered the same broad areas in fiscal reform, health and education, with the same team working in the operations to ensure the coordination of policies across different levels. In the education sector, the DPLs tackled the problem of poor outcomes in Rio at different points in the system. Complementing these policies, the State's program also focuses on improving student learning through accountability reforms. In the health sector, policies with the two subnational governments have a mutually reinforcing impact on health-care integration. The DPLs with the GORJ supported policies to deliver better coverage and quality of health services through expansion of the PAHII and increased coverage of primary care in high density populated municipalities in the Rio de Janeiro Metropolitan Area. In the proposed operation this process is being taken further as, for example, it is supporting the regional decentralization of health services away from Metropolitan area health facilities. 82. The proposed operation is accompanied by a technical assistance project (Strengthening Public Management and Integrated Territorial Development TAL) and facilitates the continuity of support for the sector reform agenda. This TAL and its Additional Financing (to be presented to the Board in Q2 FY13) supports the reform areas of the proposed operation. This design also supports the achievement of medium- and long-term goals and reforms, and helps improve the ability to measure outcomes. 30 Table 5: World Bank support o Rio de Janeiro Approval Amount Main policy areas Active Projects Date (US$m) Strengthening Public 26 Aug 10 18.67 * Core government systems and Management and Integrated management tools; Territorial Development TAL Additional * Education management capacity; Financing * Health management and information (Q2 FY13) systems; * Metropolitan management through integration and coordination in urban development, housing and transport; * Disaster risk management capacity; * Living conditions in the most vulnerable social settings; * Core finance and taxation functions; and * Support for project management. Sustainable Rural Development 10 Sept 09 39.5 * Supporting Rural Production and Project SIL Competitiveness; * Strengthening Institutional Frameworks Mass Transit Project II SIL 09 July 09 211.7 * Public Transportation: (i) Infrastructure and Development and (ii) Institutional and Policy Development Closed Projects Metropolitan Urban and 15 Mar 11 485.0 * Planning and management of urban growth Housing Development DPL in the metropolitan region; * Affordable housing with access to infrastructure and service; * Social development program for the urban poor. Fiscal Sustainability, Human 2 Feb 10 485.0 * Fiscal consolidation; Development and * Business registration process; Competitiveness DPL * Basic education system; * Health services, especially in disadvantaged areas and for poor people. Municipality Fiscal 1 July 10 1,045 * Revenue collection and pension Consolidation for Efficiency and expenditures; Growth DPL * Public service delivery in the areas of registering businesses; family health; and primary schools; and * Strengthening the institutional framework for efficient service delivery D. LESSONS LEARNED 83. The Bank is in a strong position to support the State of Rio de Janeiro in its efforts to achieve efficiency, equity and integration. The proposed operation builds on both the Bank's long collaboration with the Government of Rio de Janeiro and also the experience of numerous other Bank operations with Brazilian State Governments. In particular, the policy content and priorities reflect relevant findings of the Bank's extensive body of analytical work in Brazil and in the State of Rio de Janeiro. The design of the operation incorporates specific lessons learned from the implementation of previous Bank-supported lending and non-lending operations in Brazil and elsewhere in Latin America and the Caribbean. The most important 31 among these are the Fiscal Sustainability, Human Development and Competitiveness DPL (Pl17244), the Rio de Janeiro Metropolitan Urban and Housing Development Policy Loan (P122391) and the Rio de Janeiro Municipality DPL (P111665). These three operations, and particularly the first and the last allowed the bank to support the alignment of health and education policies between the State and Municipality, and this will continue with the current operation. 84. Main lessons from the Bank's experience: * The policy content and prior actions of an operation should reflect the Borrower's program and priorities developed through a policy-making process that involves broad public consultation. The strongest evidence of the GORJ's commitment to the policies supported by the DPL is the sustained progress that has been made in implementing reforms of previous DPLs. The Bank has added value to the program through its extensive collaborative lending and non-lending engagement with the government on fiscal consolidation, public financial management and social issues. * The importance of maintaining a close dialogue with the State during the preparation of the proposed operation. The project team has worked in close partnership with the State Government to define the reforms and actions that will be supported by the DPL, and to put in place arrangements to assist in their implementation over the medium term. The Technical Assistance Loan that will accompany the DPL will provide the framework for ongoing collaboration and engagement with the borrower through analytical and advisory services that are necessary to add value to the program. * Importance of using an appropriate instrument. In this case, as noted in the Implementation Completion Report (ICR) for the first DPL with Rio de Janeiro State9 "A rapidly disbursing single-tranche DPL is most likely to be successful with clients that have a robust policy framework, well-defined programs and sound monitoring and evaluation systems in place, as was the case with GORJ. * Prior actions should be limited to a few key policy and institutional reforms. Without such a focus, implementation by the Borrower and supervision by the Bank risk losing sight of the operation's priorities. This operation has eight prior actions divided into three policy priority areas: tax administration, public financial management, health and education. * Analytical work is an extremely important tool for project preparation. Analytical work helps to identify gaps in specific sectors, inform stakeholders, build consensus around important development issues, and prepare the groundwork for future engagement in areas of mutual interest. Experience in Brazil has shown that the government greatly values the range of global expertise the Bank can bring to complex development issues. In particular, the first and second DPLs concluded in 2009 and early 2011 provide strong support to this proposed third DPL. 9World Bank Report No: ICR00001836 32 85. Many of the above lessons also reflect the conclusions and recommendations that emerged from the previous DPL1 and DPL2, as well as good practice principles on conditionality (Box 4). Box 4. Good Practice Principles on Conditionality Principle 1 - Reinforce Ownership: The operation has strong ownership at the highest levels of State and Federal Goverments. All secretariats involved in the DPL have shown commitment to the Govemment's medium-term reform program. The team worked intensively with the Govemment to agree on prior actions that clearly supported the Govemment's program. Principle 2 - Agree up-front with the Government and other partners on a coordinated accountability framework: The Bank's support is summarized in a brief and focused policy matrix with observed and expected results. Principle 3 - Customize the accountability framework and modalities of Bank support to address country circumstances: Brazil's rigorous fiscal control regime has contributed much to enforce fiscal responsibility since the late 1990s and has provided a powerful framework to ensure all borrowing, including from IBRD, is consistent with a sustainable fiscal environment. Principle 4 - Choose only actions critical for achieving results as conditions for disbursement: The Bank's policy matrix uses a limited number of prior actions. They are part of a comprehensive policy reform plan with a solid track record. The matrix also uses select benchmarks to track implementation of the Government program. Principle 5 - Conduct transparent progress reviews conducive to predictable and performance-based financial support. The program has been developed through close and regular engagement of the team with the State. This will continue during supervision to ensure that expected progress is achieved. E. ANALYTICAL UNDERPINNINGS 86. The proposed operation builds on a series of discussions and analysis of policy in Rio de Janeiro. The analysis includes the State of Rio de Janeiro Strategic Plan 2007-2010 and the multi-year plan (PPA) (2012-2015). In particular in the area of fiscal sustainability and public financial management reform the specific policy reforms areas are based on a seminar which took place in May 2011 with the State authorities and Bank experts. 87. The Fiscal and Debt Sustainability Analysis is based on the attached Annex 3, "Fiscal and Debt Sustainability Analysis in the State of Rio de Janeiro" (2012). The analysis therein highlights the impact of different shocks on the fiscal and debt paths of the State on the Fiscal Responsibility Law Indicators for the State. The State Government fiscal reforms are based on the State's PPA and the Fiscal Adjustment Program (PAF) with the Federal Government for 2011 and 2012, which set the objectives and targets of the State's fiscal policy. 88. Tax Administration: During the preparation of the operation, the Secretariat of Finance requested Bank support to assess how to introduce performance management in the sub secretariat of revenues. The Bank produced a report "A proposal to reform performance indicators in revenues collection" as well as a technical workshop for the authorities in the Secretariat of Finance. The recommendations of the report identified which performance indicators were relevant for tax administration and defined a strategy to implement them as well as potential risks to the strategy. The Secretariat of Finance of Rio de Janeiro welcomed the findings of the report and decided to implement them. The reforms supported by this DPL on Tax Administration and performance indicators draw heavily on this analytical work as well as the discussions with the GORJ around the implementation of the report's recommendations. 33 89. Public Financial Management: In 2009, the Bank carried out a Public Expenditure and Financial Accountability (PEFA) assessment and a Public Investment Management assessment at Federal level, as well as PEFA assessments for a number of states (Minas Gerais, Ceard, Federal District and Pernambuco), all of which indicated that the issues on budget and public investment management identified in Rio de Janeiro are common to many of the states in Brazil. In addition, the report titled "Brazil: Improving Fiscal Conditions for Growth" (2008) addresses important policy issues related to budget rigidity and expenditure management. It contributed to the assessment of the fiscal and public financial management challenges the State faces. Furthermore, in 2009 the Bank produced a report titled Topics in Fiscal Federalism, which describes the existing system of controls of sub-national governments and highlights their achievements and limitations. Finally, a comprehensive assessment of the debt management functions of the State of Rio de Janeiro was carried out in April 2011 using the World Bank's Debt Management Performance Assessment methodology. 90. Education: A 2011 World Bank studylo suggests that the principal challenges for Brazilian education over the next decade are to raise teacher quality, improve spending efficiency, and work collaboratively with the private sector to improve the quality and relevance of secondary education. The report also calls for states to take a leadership role vis-d-vis municipal education systems to improve coordination and raise overall quality. There is evidence that Brazil's substantial progress in equalizing access to education and doubling the average schooling attainment of the labor force over the past two decades has been a major driver of poverty reduction and improved income equality. Rio State's education reform program is directly focused on all of the key challenges identified in the Bank's analytical work and is implementing reform approaches that are considered global best-practice. The development of the program was also directly supported by the on-going TAL, as well as ongoing policy dialogue in education. 91. Health: The health strategy has been built upon the Federal Ministry of Health's National Policy for Urgent Care (2007). The Secretariat of Health for Rio carried out a study indicating that hospitals are the principal entry point to the health system for urgent and emergency care, especially after normal working hours. Further, about 70 percent of cases presented at hospitals are at a low level of complexity. These factors form the basis for the new strategy for providing urgent and emergency care through UPAs (Secretaria de Sadde, 2009). Furthermore, recent PSIA research concludes that poverty in Rio de Janeiro city is strongly related to access to public services especially in the sanitation and public health sectors. Thus, the poorest regions of the city present the worst public health and public health services indicators. The objectives and reforms of this third operation, such as improving basic care and hospital health care in the municipalities with less than 115,000 inhabitants and stimulating higher quality health services in regional hospitals outside of the Metropolitan Area will build on other Bank financed operations where public health policy is targeted to bring more benefits to very poor people as it renders more viable their access to needed and appropriate health care. The design of support to the State program to improve the management of public hospitals and health units is also aligned with findings from the 2008 World Bank report, "Hospital Performance in Brazil: The 10 See Bruns, Evans and Luque, 2011. "Achieving World Class Education in Brazil: The Next Agenda", World Bank, Washington, DC. 34 Search for Excellence". The report documents findings of a review on the challenges to Brazil's hospital system and provides policy recommendations to addressing them. V. THE PROPOSED DEVELOPMENT POLICY LOAN A. OPERATION DESCRIPTION 92. Development objective. The objective of the proposed operation is to assist the Government of Rio de Janeiro in strengthening its tax administration, improving the efficiency of public financial management, increasing the quality of public service provision in education and health and ensuring that policies adopted are both consistent with priorities of the State Government and with resources likely to be available in the medium term. 93. The proposed operation is a stand-alone development policy loan. The US$300 million DPL will be disbursed once the operation goes into effect and is contingent upon the Government's completion of prior policy actions. The three policy areas supported by this DPL are described in the next section and in more detail in Table 5. These policy areas are: (i) Strengthening fiscal management related to tax administration; (ii) Improving the efficiency of public financial management in public investment management (PIM), costing and internal control; and (iii) Increasing the quality of public service provision in education and health. 94. Yet this operation is not a self standing operation; it is part of a broad engagement with the State of Rio de Janeiro. As noted in the introduction, this operation forms part of a long term quasi-programmatic engagement with the State. It is the third DPL with the State and follows a DPL with the municipality that is fully aligned with the state DPLs. The proposed operation is also closely linked to the on-going Rio State Strengthening Public Sector Management and Integrated Territorial Development (TAL). 95. Following good practice principles on conditionality, the operation's policy matrix will use a limited number of prior actions that have been chosen according to their importance in achieving results. These actions are part of a comprehensive reform plan with a solid track record of implementation. Table 6: Summary of the Proposed Operation Objectives, Policy Areas and Prior Actions Objectives Prior Actions for Loan Disbursement Policy Area 1. Strengthening Tax Policy and Tax Administration Tax Administration Prior Action 1. The State of Rio de Janeiro through SEFAZ has strengthened Increase State revenue implementation of the synchronized taxpayer registration system (REGIN) by performance establishing the Comiti Gestor de Integraqdo do Registro Empresarial, as evidenced by Decree No. 42.890, dated March 21, 2011, and appointing the principals and deputy members to the Comiti Gestor de Integraqdo do Registro Empresarial, as evidenced by JUCERJA's Portaria No. 1018/2011, dated April 26, 2011. Prior Action 2. The State of Rio de Janeiro, through SEFAZ, has adopted standards to improve collection of state taxes, including ICMS, as evidenced by Resolution SEFAZ No. 468, dated December 27, 2011 Prior Action 3. State of Rio de Janeiro has, through SEFAZ, established a process to implement a results-based management system for tax administration, as evidenced by Resolution SEFAZ No. 498, dated June 12, 2012. 35 Objectives Prior Actions for Loan Disbursement Policy Area 2. Improving the Efficiency of Public Financial Management Public Investment Prior Action 4. The State of Rio de Janeiro has adopted a methodology and Management procedures for evaluating, selecting and approving proposals for public investment projects estimated to cost over R$50,000,000, as evidenced by Decree No. 43.631, Improve the quality of dated June 6, 2012 and Resolution SEPLAG No. 714, dated June 13, 2012. investment spending and the investment selection process Ensure that investment decisions are consistent with fiscal sustainability Costing Prior Action 5. The State of Rio de Janeiro has piloted a methodology for costing Ensure that policy the its public policy programs on social and economic development, as evidenced by commitments are consistent the report issued jointly by SEEDUC, SEPLAG and SEFAZ, in accordance with the with long term fiscal joint Resolution SEEDUC/ SEPLAG/ SEFAZ No. 691, dated January 5, 2012; and sustainability the report issued jointly by SES, SEPLAG and SEFAZ, in accordance with the joint Resolution SES/ SEPLAG/ SEFAZ No. 31, dated January 6, 2012; and selected four public policy programs for the purpose of costing in accordance with the piloted methodology mentioned above, as evidenced by Resolution SEFAZ No. 502, dated June 19, 2012. Internal Control Prior Action 6. The State of Rio de Janeiro through its Governor has restructured its Increase efficiency of public internal audit institutional arrangements, as evidenced by the its Decree No. 43.463, expenditures dated February 14 2012; and through SEFAZ, approved AGE's Action Plan for calendar year 2012, as evidenced by Despacho do Secretdrio, dated May 3, 2012, and a copy of AGE's Action Plan. Policy Area 3. Increasing the Quality and Efficiency of Public Education and Health Services Education Prior Action 7. The State of Rio de Janeiro has: (i) adopted and implemented a merit-based selection process for regional and school Increase the quality of directors, as evidenced by: Decree No. 43.451, dated February 3, 2012; and Atos Education through stronger de Designaqdo listing the regional and school directors appointed between performance incentives and February 2011 and February 2012 in accordance with the adopted selection accountability mechanisms process; and (ii) adopted annual school-level targets for improving student leaming and graduation rates and a bonus pay system for schools that achieved their respective annual school-level targets, as evidenced by Decree No. 43.451, dated February 3, 2012; and Resolution SEEDUC No. 4.768, dated February 7, 2012; and Resolution SEEDUC No. 4.771, dated March 1, 2012. Health Prior Action 8. Improved efficiency in the The State of Rio de Janeiro has: delivery of public health (i) adopted a legal and administrative framework to assess and contract social services organizations to manage public hospitals and health units, as evidenced by: Law No. 6.043, dated September 19, 2011; and Decree No 43.261, dated October 27, 2011,. (ii) through its secretariat of health (SES), has (i) adopted regulations defining the evaluation mechanisms to transfer bonuses and monetary incentives to municipalities and municipal hospitals, under PAHI1, as evidenced by Resolution SESDEC No. 1.550, dated March, 16, 2011 Resolution SESDEC No. 1.551, dated March, 16, 2011; and (ii) adopted regulations defining the evaluation mechanisms to transfer bonuses and monetary incentives to regional state hospitals, under PAHI2, as evidenced by Resolution SESDEC No. 1.552, dated March, 16, 2011. 36 B. POLICY AREAS Policy Area 1: Strengthening Tax Administration 96. Government policy objectives. In its second term, the main objective of the GORJ is to consolidate and institutionalize advances achieved in the first term. In the first term, the GORJ was able to maintain positive fiscal balances, while simultaneously expanding the fiscal space to carry out investment and maintenance which had been severely neglected prior to 2007. Since 2007, SEFAZ has been developing the structural and institutional organization, as well as fiscal management procedures needed to fulfill this mission effectively. To achieve this objective the strategy of the Government has been to improve the efficiency of tax administration to increase revenue collection as well as rationalizing expenditures to maintain fiscal sustainability. 97. Challenges. When the administration took office at the beginning of 2007, the fiscal situation was characterized by several problems, including highly volatile oil revenues and very limited tax administration capacity. The State has markedly increased tax collection from 2007 to 2011 (30 percent real growth over the period or an average of 7 percent per year). The State's main source of revenues is the Value Added Tax on goods and services (ICMS).11 The growth in revenues owes much to the strong State GDP growth during the period but also to key efficiency reforms. Those reforms are related to the implementation of the barreira fiscal which increased tax collection across state borders; the introduction of the Nota Fiscal Eletr6nica and, an increase in the number of fiscal agents contracted (more than 300 over the period), an increase in on the job training to existing and newly recruited fiscal agents, as well as performance based contracts to increase productivity. Yet going forward, the state faces two main challenges: first the need to institutionalize the advances and strategic vision of efficiency and performance implemented since 2007. Second, after many years where revenues have increased steadily, and expenditures are rigid, the State is under pressure to ensure increased revenues growth. Given that the state cannot control the external environment, the state is moving forward on reforms within its control to sustain effectiveness and efficiency of revenues administration so that in the future the state is well placed to face external challenges or those linked with increasing and rigid expenditures. Measures supported by the operation 98. Going forward, the State Government recognizes the need to improve the efficiency of tax administration to increase resources and maintain fiscal sustainability, and is implementing a reform program to strengthen tax administration. 99. The operation supports the implementation of the synchronized taxpayer registration system to simplify the registration procedures and to increase compliance. In particular, SEFAZ is establishing a management committee -Comit Gestor de Integraqjo de Registro Empresarial, and is appointing the principals and deputy members of said committee. This will strengthen the implementation of the new taxpayer registry based on REGIN (Integration and synchronization of municipal, state, and federal taxpayer registers). The 1 The State also collects tax from personal property, motor vehicles (IPVA) and on donations and inheritances (ITCMD). See Annex 4 for the composition and evolution of tax revenues. 37 implementation requires integration of SEFAZ's systems to adapt them to the new design of the new electronic based taxpayer registry (Sistema de Registro Integrado - REGIN). The registry will be housed in the Company Registration Office (Junta Comercial), which will enter all the necessary data in the system and send it to the relevant agencies for processing. The integration and synchronization of taxpayers registries across the three levels of government (federal, state and municipal) with the Junta Comercial is expected to reduce compliance costs, make the registration process faster and more comprehensive, set the foundations for a unique taxpayer identification number in the future. In the long term the reform is expected to have an impact on reducing the size of the informal sector and on the State's competitiveness to attract new investments. 100. The DPL also supports procedures to allow for the introduction of a unified Taxpayer Ledger. The prior action supports SEFAZ adopting standards required for a taxpayer ledger which would provide a view of all taxpayers' debits and credits. The system is being implemented in two phases. Phase I will include all taxes but would not provide access by taxpayers. The strategy is to keep individual taxpayer current accounts for various taxes levied by the State (including ICMS and ITD returns) as well as for audit assessments. The first phase is a prerequisite for the second phase which will result in the establishment of the general taxpayer ledger. 101. The second phase of implementation will focus on integrating the taxpayer ledger in a single unified account. It will include updates for changes in the judicial enforcement system and for changes during the appeals system. It will allow taxpayers to have access to their accounts and provide for the automatic authorization of payment by installment. The reform is expected to better control debts (from ICMS and ITD returns) and credits (payments made through the banking system). More generally by essentially automating filing through extensive e-filing, and tax payments through the issuance of payment slips for all taxes, it will vastly reduce the major current source of errors and losses in tax administration. The new system will replace antiquated procedures, which in the past have led to the accumulation of tax arrears (divida ativa). Thus one of the major results of the reform supported under this action will be the establishment of the unified tax payer ledger in 2013. 102. The DPL also supports the implementation of a performance-based management system for the Secretariat of Finance (SEFAZ) in Tax Administration. More precisely, SEFAZ has already developed a set of performance indicators to support the design of tax collection strategies, measure the efficiency of the tax collection unit (cost) and measure the efficacy of the unit (quality). However SEFAZ has expressed the need to define additional indicators to improve the efficiency and effectiveness of the tax revenues sub secretariat. In addition, the new indicators as well as the old need will need to be institutionalized through mandated usage. Examples of such performance indicators are the tax gap -the ration between the value of tax that was not collected to the potential of collection; and the cost of collection - the ratio of the tax administration cost to total collection. These measures are expected to result in increased tax compliance and a reduction in the administrative costs of SEFAZ. The latter reform should increase the performance orientation of the tax administration of the GORJ but also broaden the coverage of performance indicator to include the Fiscal Council and the State Attorney General. 38 103. The prior actions supported by the operation are as follows: Prior Action 1: The State of Rio de Janeiro through SEFAZ has strengthened implementation of the synchronized taxpayer registration system (REGIN) by establishing the Comit Gestor de Integraqdo do Registro Empresarial, as evidenced by Decree No. 42.890, dated March 21, 2011, and appointing the principals and deputy members to the Comit Gestor de Integraqdo do Registro Empresarial, as evidenced by JUCERJA's Portaria No. 1018/2011, dated April 26, 2011. Prior Action 2: The State of Rio de Janeiro, through SEFAZ, has adopted standards to improve collection of state taxes, including ICMS, as evidenced by Resolution SEFAZ No. 468, dated December 27, 2011 Prior Action 3: State of Rio de Janeiro has, through SEFAZ, established a process to implement a results-based management system for tax administration, as evidenced by Resolution SEFAZ No. 498, dated June 12, 2012. 104. Expected Results. The actions supported in tax administration will result in (i) ICMS and ITD revenues increase by 15.6 and 12.4 percent respectively from 2011 to 2013; (ii) The establishment of a general taxpayer ledger allowing access of individual taxpayers to their unified accounts and (iii) the State is progressively implementing performance indicators for tax administration from a baseline of zero indicators in 2011, to 10 indicators by end 2012 and 20 indicators by end 2013. Policy Area 2: Improving the Efficiency of Public Financial Management (PFM) 105. Government policy objectives. The overall objective of the Government of Rio de Janeiro has been to put in place the structural and institutional organization, as well as financial management systems and procedures needed to maintain fiscal discipline, strategic allocation of resources, according to Government priorities, and efficient service delivery. To reach this objective the GORJ recognizes the need to establish processes to manage fiscal risks and ensure predictable budget execution; establish links between planning and budget preparation (particularly for public investment) to ensure that resources are allocated to priorities; and finally put in place internal controls to provide management assurance that resources are used in an orderly, ethical, economical, and efficient manner and contribute to efficient service delivery. Improving the efficiency and transparency of Public Financial Management (PFM) also involves introducing procedures for costing and evaluating projects and policies, and upgrading and integrating PFM information systems to improve the transparency of State operations. 106. Challenges. When the administration took office at the beginning of 2007, financial management and budget processes were deficient and in many cases non-existent, leading to arrears of unknown magnitudes, slow and uncertain payments, weak budget constraints, and non- credible budgets. During the first term of the administration, several basic financial management processes were put in place, with the result that budget execution became an orderly and rule based process, arrears were eliminated and suppliers and budget institutions can now be confident that financial obligations of the State will be complied with in pre-defined periods. The principal challenges now relate to ensuring that budgets are allocated according to Government priorities, that the State does not take on unsustainable liabilities in future spending and that 39 internal controls are applied in a flexible but efficient manner and allow appropriate managerial discretion. Each of these three challenges is explained below. 107. Investment within the Budget Process. Formal budget planning is guided by the Multi- Annual Plan (PPA) which is legally required at the beginning of each government term and is valid for a period of four years. In practice, however, the PPA is updated on an annual basis to incorporate the decisions of the annual budget. Moreover, actual budget allocations are guided at a macro level by the resources available shown in the budget guideline law (Lei de Diretrizes Orqamentcirias - LDO), which are assigned in a relatively ad hoc incremental manner based upon historical allocations. Moreover in the area of investment projects, until recently the low investment levels meant that few feasibility studies had been prepared and there are few formal mechanisms for filtering and prioritizing investment proposals. Despite recent improvements in the planning process, it is recognized that the final investment selection is still not very well linked to the planning exercise. The information available on the proposed investments at the time of the preparation of the PPA is not sufficient to inform decision-making on the investment portfolio. The recent efforts had focused mainly on aligning sector programs and projects with the overall GORJ strategic priorities, but no formal screening and evaluation process was in place for investment projects. Parallel efforts were also under way to improve the management of investment projects related to the World Cup and to the Olympic Games. However, these efforts focused on monitoring implementation progress and not on the selection and costing of investments. Due to a growing demand for investments by line secretariats, the adoption of measures to strengthen management of state investments is crucial as part of the reform supported by the Bank. 108. Elements and Procedures for Medium Term Fiscal Sustainability. In recent years the State of Rio de Janeiro has undergone great advances in terms of service delivery and increased investments. Services were expanded and new forms of service delivery introduced. New infrastructure investments will be accompanied by operation and maintenance expenditures; the new health units will need to be staffed and operated, etc. However, the operation and maintenance costs of new investments may be either underestimated or not included at all in budgetary planning exercises. The same happens for new programs, especially in health and education. While cost estimates are prepared during the planning phase, the lack of clear methodologies and a formalized process prevent these estimates from being verified for consistency and realism; furthermore it impedes a rigorous analysis by the Finance Secretariat for the consistency of the overall expenditure program with the medium term fiscal framework. Essential to introducing a medium term focus to the budget is the development of cost estimates of major investment projects and policy initiatives, and integrating these into the budgetary decision process. Currently, the State follows standard and sound procedures to record expenditures thoroughly. However, this data will provide cash outflows rather than the cost of each program including expenditures associated to support and back office activities, centrally procured goods and services. 109. Strengthening of internal control and audits and the transparency in State operations, while allowing flexibility for managers is essential to increasing the efficiency of public expenditure. Auditoria Geral do Estado (AGE), the agency responsible for internal control in the State, faces two legal requirements which almost entirely dominate its workload: 40 the need to examine and sign-off the many accounting returns (prestaq5es de conta) and other accounting documents which SEFAZ receives from the various entities and satellite organizations within the ambit of the State. In 2010, AGE examined over 3,400 such "processos", and this work accounted for around 90 per cent of their workload. As a result of this mandatory workload, there has been little time or resources to carry out other activities. Indeed, AGE acknowledge that their work on these 3,400 processes is not as deep or rigorous as they would like. While they have been taking some tentative steps to improve risk-based auditing, and to explore performance or value for money auditing, these have not progressed very far. The main challenge is to develop additional resources so as to be able to begin to carry out risk based auditing with a focus on performance rather than compliance. AGE staffing fell to 53 at end 2010, from a previous figure of around 150. The new decree, and associated initiatives, should allow AGE to rebuild its career workforce to around 120 by end June 2013, and enable it to undertake a more effective program work. Specific measures supported under the DPL 110. Investment Management. The action supported by the DPL is the adoption of formal procedures for evaluation, selection and approval of public investment projects which have a total estimated cost of over R$50 million. In addition the State will be carrying out a detailed analysis of all ongoing major investment projects to document costs and future operating and maintenance costs, beginning with the following five investment projects during 2012: Arco Metropolitano (R$230 million); Ampliaqdo da Rede de Ensino (R$222 million); Ampliaqdo da Via Light (R$161 million); Conservaqdo de Rodovias (R$133 million); Projeto Iguaqu (R$89 million); Projeto Saneamento (R$80 million). The limit of R$50 million will enable the state to cover the majority of investments and concentrate on the major projects. In the budget for 2012 there were 26 investment projects of R$50 million or over, accounting for 68 percent of the R$6.8 billion investment budget of the State. 111. The GORJ has clearly defined the functions and responsibilities of the public entities involved in the various stages of the approval process, as well as adopting the technical criteria to be used to appraise investments projects. The data from the detailed studies of major projects will be made publicly available to increase transparency on the GORJ commitments with big investment projects and their future operational and maintenance costs. 112. The prior action for these measures is as follows: Prior Action 4: The State of Rio de Janeiro has adopted a methodology and procedures for evaluating, selecting and approving proposals for public investment projects estimated to cost over R$50,000,000, as evidenced by Decree No. 43.63 1, dated June 6, 2012 and Resolution SEPLAG No. 714, dated June 13, 2012. 113. Expected Results. The expected result of the action in investment management is that the methodology and decision process for approval of new investment projects is approved and projects complying with required criteria have been subject to screening process by end 2013. In addition, consolidated information will be published on the portfolio mapping of the five investment projects mentioned above, showing annual commitments of these investments. Over 41 time the coverage of the portfolio for which these commitments will be published will be extended. In the medium term, the measure is expected to reduce medium-term fiscal pressures due to cost overruns on low priority investment projects. In addition the measure would enable the authorities of the GORJ to take decisions on the allocation of resources with the full knowledge of possible trade-offs and the future cost implications of policy decisions. 114. Costing. The Government has decided to improve its medium term expenditure estimates by beginning to introduce new costing requirements for the proposal of new programs and developing costing methodologies for existing programs in the health and education sectors. The costing methodologies for selected health and education programs was produced by two working groups established by the joint resolutions No. 31 of January 6, 2012 and No. 691 of January, 5 2012. The exercise carried out by the two working groups provide sample methodologies, builds capacity and generates buy-in for the changes introduced. These methodologies include standard cost parameters, basic scenario analysis and expected costs on an annual basis for at least the next three years. Under Resolution No. 502, dated June 19, 2012 the methodology is being applied now to four major programs: Bilhete Unico, Renda Melhor, Distribuiqjo de Remedios, Aluguel Social, during 2012. This policy action provides the GORJ with a baseline for evaluating cost-effectiveness of expanding services and will increase the predictability of budget as well as increase fiscal sustainability. 115. The prior action for these measures is as follows: Prior Action 5: The State of Rio de Janeiro has piloted a methodology for costing its public policy programs on social and economic development, as evidenced by the report issued jointly by SEEDUC, SEPLAG and SEFAZ, in accordance with the joint Resolution SEEDUC/ SEPLAG/ SEFAZ No. 691, dated January 5, 2012; and the report issued jointly by SES, SEPLAG and SEFAZ, in accordance with the joint Resolution SES/ SEPLAG/ SEFAZ No. 31, dated January 6, 2012; and selected four public policy programs for the purpose of costing in accordance with the piloted methodology mentioned above, as evidenced by Resolution SEFAZ No. 502, dated June 19, 2012. 116. Expected Results. The costing action would result in developed methodologies for costing and defining key results from programs and at least four policy programs being costed, and have key results defined by December 2013. In the medium term, the reform supported would provide the Government with a baseline for evaluating cost-effectiveness of expanding services setting the basis for more stable and predictable budgets. 117. Internal Control: The DPL will support the issuing of a new Decree to restructure the Auditoria Geral do Estado (AGE) which will involve increasing the focus of work on assurance of the quality of internal control systems, improving the structure and career path within the AGE, and a requirement for an annual report on AGE activity and its work on accounts. The decree will also create a new management and career structure for the accounting and audit personnel both at the center of SEFAZ and based in the various entities around the GORJ. Additional resources, and new methods, should allow AGE to produce an annual report on the quality of internal control systems, including recommendations for improvement. 42 118. The prior action for these measures is as follows: Prior Action 6: The State of Rio de Janeiro through its Governor has restructured its internal audit institutional arrangements, as evidenced by its Decree No. 43.463, dated February 14, 2012; and through SEFAZ, approved AGE's Action Plan for calendar year 2012, as evidenced by Despacho do Secretario, dated May 3, 2012, and a copy of AGE's Action Plan. 119. Expected Result. The main result is improved internal control and stewardship of State resources as well as adequate staffing of AGE. In particular an action plan to improve internal control systems will be developed in 2013 on the basis of the annual report from AGE to the State Government on the performance of internal control systems. In the medium term, the GORJ's internal control systems should be updated to reflect the findings of the annual report on internal controls. Policy Area 3: Increasing the Quality and Efficiency of Public Education and Health Services Increasing Accountability for Results in Education 120. Government policy objectives. The GORJ recognizes the need for strong actions to improve education quality and efficiency if it is to reach the ambitious target of becoming one of the five top-performing states in Brazil on the national IDEB index by 2013. The core of the State's strategy is to improve student learning and graduation rates by improving system management, making schools more accountable for results and rewarding schools for improved performance. The Education Secretariat has introduced a comprehensive and ambitious overall reform program. Two key elements - which are supported by the DPL- focus on management reforms to make district-level and school-level managers more accountable for performance, and to strengthen the incentives for schools to focus on student learning results. 121. Challenges. A major source of Rio's education decline has been a decades-long lack of accountability. Regional supervisors and school principals appointed through highly politicized processes resulted in supervisors and directors whose tenure was virtually guaranteed, irrespective of the quality of their management or their schools' results. Successive Secretaries of Education had little latitude to address chronic issues of low school performance in many parts of the state. There was a lack of results focus at the school level, as well. A school bonus program adopted a decade ago lost credibility because neither the scale nor the basis for rewards was transparent. Rio's students took annual learning assessments, but the weak central system failed to feed results back to the schools. 122. New Strategy. Since late 2010, SEEDUC has moved on several fronts to address these management challenges. First, it established new processes for filling leadership vacancies at the school district and school level that involves competitive selection from among qualified candidates by the Secretariat of Education. This is a radical change that brings the accountability relationships between school district supervisors, school directors, and the Secretariat of Education into alignment for the first time. Second, it has carefully developed a new system of 43 annual school targets and bonus pay. Accompanying these and other actions is a clear commitment to public transparency and consultation. The State's reform program has been developed with extensive state-wide consultations; the Secretariat has invested in abundant information dissemination since its launch. An example of the new approach is the February 2012 publication "SEEDUC em Ntimeros: Transpar6ncia na educaqjo" which includes the most detailed education performance information the state has ever published, with all information disaggregated by district, to permit clear comparisons of inputs and performance. 123. Specific measures supported under the DPL. The DPL is supporting two prior actions in education to improve the efficiency and quality of public service delivery, which are expected to have significant impact on the education system. These actions are: 1. Adoption and implementation of a transparent, merit-based selection process for regional directors and school directors and 2. Adoption and implementation of annual school-level targets for improving school results and bonus pay for school that achieve their targets 124. The prior action for these measures is as follows: Prior Action 7: The State of Rio de Janeiro has: a) adopted and implemented a merit-based selection process for regional and school directors, as evidenced by: Decree No. 43.45 1, dated February 3, 2012; and Atos de Designaqdo listing the regional and school directors appointed between February 2011 and February 2012 in accordance with the adopted selection process; and b) adopted annual school-level targets for improving student learning and graduation rates and a bonus pay system for schools that achieved their respective annual school- level targets, as evidenced by Decree No. 43.451, dated February 3, 2012; and Resolution SEEDUC No. 4.768, dated February 7, 2012; and Resolution SEEDUC No. 4.771, dated March 1, 2012. 125. Merit-based selection of system managers. Legislation establishing the new, transparent and competitive process for the selection of regional directors and school directors was adopted in January 2011. Over the course of the 2011 school year, SEEDUC implemented the new legislation through reorganization and complete restaffing of its regional administration. To reduce administrative overhead, it consolidated 30 previous regional offices into 14. To strengthen technical capacity at the regional level, it named one pedagogical director and one administrative director for each office, with all candidates selected through a transparent and highly competitive process. The process was completed and the new regional directors were publicly announced in February 2012. 126. For school directors, SEEDUC has also established a new, transparent and merit- based recruitment process. The process has 4 steps: (i) review of candidates' CVs, (ii) tests of pedagogical and management knowledge, (iii) psychological evaluation/interview/group dynamics observation, and (iv) a management training program. Candidates who pass all phases are ranked and assigned to posts in order of their ranking. To avoid disruption at the school level, the Secretariat has opted to introduce the new process in a phased manner, applying it for 44 vacancies due to retirement of the previous director and in a few cases where the Secretary determined that school conditions were so problematic that an immediate change of leadership was required. 127. As of February 2012, 82 school directors had been appointed through the new process and the estimate for 2012 is of a similar order of magnitude. While at this pace, it would take 20 years to upgrade the entire leadership of the 1,447-school system through the new process, SEEDUC has also introduced a new annual performance evaluation process for all school directors and regional directors which includes 360 degree feedback. Under the new process, any director with two successive unsatisfactory annual evaluations may be replaced. Given the important role that school directors play in building effective schools, the new SEEDUC research unit is planning a rigorous impact evaluation of the school director reform. 128. School-level targets and bonus pay. To strengthen the incentives for school directors, teachers, and other personnel to focus on improving results, the state in 2011 (Decreto No. 42.793) also adopted a new system of annual targets and performance-linked pay. Targets for student learning improvement and graduation rates are set for each cycle, and schools that achieve between 90 percent and 120 percent of their targets receive a bonus of approximately one-month' salary for all personnel in the school. Schools' progress in achieving the targets is measured at the end of each school year (December), through the application of a state-wide test of student learning in math and Portuguese in selected grades and school census data that track changes in repetition, dropout and graduation rates. Each school's results are fed back to them by April of the following school year, and are the basis for a new round of targets. Results 129. The direct impact of these reforms will be to ensure that all 28 regional directors and all at least 164 school directors will have been selected through competitive processes by 2013. In addition bonuses will be paid to teachers according to the degree to which school targets have been met by June 2013 for performance in 2012. In the medium term, these policy actions are expected to contribute to improving Rio State's Index of Basic Education Quality (IDERJ) scores for secondary education, which is at present the worst-performing segment of the Rio state system. The IDERJ index is a composite indicator of student achievement test results and student flows that is calculated for each Rio State school annually (usually within 3-4 months of the end of the school year). The State's goal is to increase its overall IDERJ result for secondary education from 1.1 in 2009 to 2.3 for 2012.12 This is a very ambitious "stretch" target, designed to stimulate maximum progress and it represents a degree of improvement that is well above past trends. For the purposes of monitoring the effective implementation of the education program and its expected impact on core results, success may be defined as achievement of at least 80 percent of the secretariat's "stretch target", or an IDERJ for secondary education of 1.84 for 2012. 12 IDERJ results are based on student tests taken at the end of the school year (i.e. December 2012) which are typically analyzed and available in March/April of the following year. Thus, the 2012 IDERJ result should be available by April 2013. 45 Increasing the efficiency in the delivery of public services in health 130. Government's policy objectives. The Government's objective is to create a legal framework for contracting health services from non-profit providers (organizaq5es sociais), support the qualification of the basic health care services in municipalities with less than 115,000 inhabitants (PAHII), and to increase the capacity and incentives of regional hospitals placed outside the Rio de Janeiro Metropolitan Area to attend medium and high complexity care needs (PAHI2). Currently, patients from the interior municipalities tend to use emergency room and other hospital facilities in the Metropolitan area, contributing to over-crowding and poor quality of care. 131. Challenges. The health system in the State of Rio de Janeiro faces three major challenges: (i) the lack of coverage and quality of health services to respond to urgent and/or emergency needs of populations living in the poorest neighborhoods; (ii) inadequate access to hospital care in the poor areas of the Rio de Janeiro State, in particular small Municipalities in the interior; and (iii) problems of poor quality, efficiency and inter-municipal coordination of medium- and high-complexity care provided by regional hospitals in the interior of the Rio de Janeiro State. 132. Lack of coverage and quality of urgent and emergency care. In 2007, the incoming State Government faced problems of coverage and quality throughout the State's health system. Weak prevention strategies and lack of access to basic and medium-complexity care affected the poorest populations. Most non-hospital health units only provided services during working hours, making it difficult for poor families that faced urgent health needs at other times of the day. These non-hospital units cannot handle more complex cases for lack of qualified human resources, equipment, diagnostic facilities, transportation and/or supplies. As a consequence, the urgent care and emergency hospital services were overwhelmed with too many patients and weak prioritization of cases by severity levels. The deployment of new delivery system of urgent and emergency health (the UPA model) supported by the Rio State DPL1 Loan has partially addressed the lack of medium complexity care capacity. Since 2007, when the first UPA was installed, this system filled a huge gap in the State's health network, providing better access and coverage of urgent and emergency care to the poorest population, improving referral and counter-referral mechanisms and contributing to the coordination and integration of the state health network. However, with plans to expand the UPA system, the GORJ wants to develop and implement new approaches to contracting services, including from non-profit providers (organizaq5es sociais). 133. Low efficiency characterizes health services in small Municipalities and Regional Hospitals outside the Metropolitan Area. The GORJ identified several critical management- related issues in the health system and in the budget transfers to the municipal health departments including: (i) lack of coordination between primary care and hospitals due to the lack of sound referral mechanisms; (ii) insufficient resources in small municipalities necessary to keep public and private non-profit hospitals operational and efficient; (iii) lack of management tools and processes associated with state budget transfers such as performance agreements and systems for monitoring and evaluation; (iv) inadequate incentives for personnel that result in absenteeism and low productivity; (v) uneven distribution of human resources by skill levels and 46 among different areas and functional structures; (vi) poor managerial skills and lack of trained hospital managers; and (vii) constant breakdowns in supply chains and insufficient access to diagnostic facilities. The first DPL supported SESDEC's efforts to put in place performance- based financial transfers to support municipalities with less than 115,000 inhabitants to improve the coordination between primary care and municipal hospitals, contributing to increase coverage and quality health services for the poorest, and reducing infant and maternal mortality and hospital infection rates. Moreover, regional hospitals, which should play a critical role in providing medium- and high-complexity care to patients from the surrounding area (typically covering several municipalities) have been suffering from problems of low quality and efficiency, and patients from outside the municipality where the hospital is located have often had problems accessing care. 134. Specific measures supported under the DPL. The DPL will support improved quality and efficiency in the delivery of public health services through the subcontracting of social organizations to manage public hospitals and health units. This new management model will provide the state with increased flexibility to expand the supply of health care services and is expected to stimulate innovation and improved efficiency in service delivery. In addition the DPL will support improvement of the system of incentives to municipal governments and hospitals under the Program to Support Hospitals in the Interior (PAHI1 and PAHI2). Specifically, new regulation will establish indicators, administrative systems, and other operational features of the program, with the aim to strengthen primary care and hospital services in small municipalities (less than 115,000 population), and enhance the quality, efficiency and inter-municipal coordination of medium- and high-complexity services provided by regional hospitals. 135. The prior action for these measures is as follows: Prior Action 8: The State of Rio de Janeiro has: a) adopted a legal and administrative framework to assess and contract social organizations to manage public hospitals and health units, as evidenced by: Law No. 6.043, dated September 19, 2011; and Decree No 43.261, dated October 27, 2011. b) through its secretariat of health (SES), has i) adopted regulations defining the evaluation mechanisms to transfer bonuses and monetary incentives to municipalities and municipal hospitals, under PAHII, as evidenced by Resolution SESDEC No. 1.550, dated March, 16, 2011 and Resolution SESDEC No. 1.551, dated March, 16, 2011; and ii) adopted regulations defining the evaluation mechanisms to transfer bonuses and monetary incentives to regional state hospitals, under PAHI2, as evidenced by Resolution SESDEC No. 1.552, dated March, 16, 2011. 136. Expected Results. The results indicators of the DPL include the signing of contracts between the GORJ and OSs are signed to manage 15 health units and strategic services, improved indicators for primary health care (maternal care, child care, and chronic diseases); increase in the number of hospitals under the PAHII program with ombudsman services (from 44 to 63 in 2013); increase the number of hospitals with hospital infection evaluation committees 47 (from 46 to 66 in 2013); and increase the supply of complex treatment to patients from other municipalities as a percentage of the total (from 16.8 percent to 24 percent in 2013). VI. OPERATION IMPLEMENTATION A. POVERTY AND SOCIAL IMPACT 137. During preparation, the Bank undertook a poverty and social impact analysis to explore the disaggregated social impacts on different stakeholder groups. It is based on primary and secondary sources: social and economic analyses utilizing demographic and census data and consultations with key stakeholders. 138. Overall, the specific policy reforms supported by this operation are expected to have significant and positive poverty alleviation and social development impacts in Rio de Janeiro. Each of the policies and reforms supported by this operation has a likely overall positive poverty and social impact. Taken together, the policies have the cumulative potential of bringing economic and social benefits in both the short and long term. Reforms in health and education are expected to generate the most rapid positive gains for poor people and vulnerable populations. 139. Social and economic inequality remains high in the state of Rio de Janeiro. Both metropolitan and non-metropolitan regions present relevant challenges to further reduce poverty and improve health and education services. While the program supports improvements in the quality of public services delivered in health and education used especially by the poor, it is expected that it will result in an increase in equality of opportunities across the State. 140. Education. The State Government's program to improve education quality and efficiency is expected to have highly positive social outcomes with markedly greater gains for poor people and vulnerable groups who usually have no alternative to the public school system. Out of all students from the first and second quintiles, 91 and 80 percent attend public schools (Figure 10). An across-the-board increase in education services will therefore be particularly beneficial for these households. All stakeholders consulted tend to concur with this assessment. For example, it is expected that the first policy supported by the DPL in the education sector- meritocratic selection of school and regional directors - will lead to improve learning outcomes. The highlighted advantages of such a policy are clear accountability criteria for managers' performance, policy uniformity and continuity, and increased partnership between regional and school directors. Other benefits include the possibility to identify leaders among educational professionals, the equal opportunity given to all civil servants and formation of a manager cadre made not only of qualified people, but also of people who were willing to take managerial positions. The second education policy supported by the DPL- the setting of learning targets and bonus pay for schools that achieve their targets should also contribute to the achievement of better education outcomes. 48 Figure 10: Share of students within income distribution quintiles that attends public schools in Rio de Janeiro - 2009 100% 91% 90% 80% 80% 65% 70% 60% 50% 40% 23% 30% 20% 10% 0% 1st 2nd 3rd 4th 5th Source: PNAD 2009, Bank staff calculation 141. Health. Coverage of the public health system is an issue for Rio de Janeiro State, which is lagging behind other Southeast States. In 2009, doctor appointments in the public health system (Sistema Onico de Sade - SUS) to habitants' ratio were 2.31 the lowest in Southeast and below national average of 2.69. The share of the population that attended a doctor appointment in SUS was also lower than other Southeast states. Furthermore, hospitalization figures evidence the declining position of Rio in this area. In 2009, the number of hospitalizations in SUS by 100 habitants was 3.97 (Brazilian average was 5.78) and the share of hospitalized people in SUS was 2.9 in 2008 (Brazilian average was 4.8). The GORJ efforts to address these issues are very important to improve the coverage as well as the quality of public health services. 142. Increasing access and efficiency of health services in small municipalities and outside of the Metropolitan area are expected to have overall positive social impacts, especially for the poor and more vulnerable groups who must rely on public health services. The PAHI program is already demonstrating its effectiveness, especially for the poor in Rio. To date, the program has allowed the State to increase service provision and upgrade the quality of health services in the inland municipalities, thus reducing pressure in city hospitals. Specifically, PAHI is having a positive impact on poor people's access to public health services for two main reasons. First, the PAHI 1 policy targets municipalities with poor neighborhoods and less than 115,000 inhabitants that are not adequately covered by the public health services network. It is expected to increase household welfare, through among others, savings on private medical fee expenses. Secondly, under PAHI2, regional hospitals have been chosen in accordance with SUS regulations and reflect an existing demand flow. 143. To demonstrate the potential pro-poor effects of improvements in the access and quality of public health services, it is necessary to assess the proportion of poor people who attend and need most these services. Table 6 shows that the poor have a lower self-evaluation about their health status than higher income groups. Moreover, a very small proportion of people in lower income groups have access to health insurance plans or are able to pay for private medical appointments. Indeed, the proportion of poor people who use public health units is much larger than for the highest income brackets. Therefore, improvements in quality and coverage of 49 public health services will primarily benefit low income groups as well as reduce inequality in access to basic health services. In addition, according to stakeholders consulted, 95 percent of the population living inland of the Rio state are dependent on public health services (SUS) Table 7: Share of population by health status, health services attendance and income brackets, 2008 Up to 1 From 1to 2 From 2 to 3 From 3 to 5 From 5 to 10 From 10 to 20 More than 20 minimum wage minimum wages minimum wages minimum wages minimum wages minimum wages minimum wages Self-evaluation of health status as: Good or very good 69% 76% 77% 80% 83% 86% 88% Regular 35% 25% 25% 21% 18% 15% 12% Bad and very bad 26% 25% 17% 15% 16% 9% 12% People covered by health insurance 7% 12% 19% 30% 51% 75% 90% plan People that attend 70% 68% 57% 47% 29% 8% 2% public heath units People that attend private medical 9% 11% 18% 26% 46% 68% 82% appointment Source: PNAD, 2008 144. Fiscal Consolidation. Policy reforms to increase the efficiency of tax administration are geared towards the curtailing of tax evasion which tends to affect higher income groups and thus not have a direct impact on the poorer segments of the population. Policies supported will not result in changes to the taxation system of consumer goods that may affect the poorer and more vulnerable portions of the State population. 145. Overall, distributional impacts of fiscal reforms are expected to be largely pro-poor. Improved fiscal sustainability and expansion of fiscal space for investment would likely have positive social impacts due to Government's ability to improve public services and public investments. When public services improve, low income groups with a history of very low access to these services experience relatively larger gains. More investments are also likely to benefit lower-income groups via increased job opportunities in construction of public infrastructure and related activities. It is worth noting that many new investments that are being drawn to the state are being directed to lagging regions of the state such as the northwest part. Furthermore, the state is taking measures to ensure that the majority of benefits are reaped by the local population. B. ENVIRONMENTAL ASPECTS 146. The specific actions supported under the proposed DPL under all three components are not likely to have significant positive or negative effects on the country's environment, forests, and other natural resources as they have to do with fiscal management and public sector management reform. There are no conditions in those pillars that may trigger environmental concerns or that may affect environmental laws and regulations, their enforcement or associated organizational framework in Rio de Janeiro. In all cases the reforms supported are concerned with organizational and efficiency issues and no specific investments are supported or required as a result of the reforms. 50 C. IMPLEMENTATION, MONITORING AND EVALUATION Implementation 147. The preparation of this operation is being led by the State Secretariat of Finance (SEFAZ), which is also responsible for the fiscal consolidation; the work is in close collaboration with the Secretariat of Planning (SEPLAG) and the Office of the Chief of Staff (Casa Civil). The Secretariat of Health (SES) is in charge of the reforms associated with the quality of urgent and emergency care, and the efficiency of state health services. The Secretariat of Education (SEEDUC) is conducting reforms to improve the quality and efficiency of basic education, mainly through the introduction of modern management techniques to improve education services in State schools. Monitoring and Evaluation 148. SEFAZ, together with SEPLAG and the individual sector monitoring units, will be responsible for the overall implementation of the proposed operation, for reporting on progress, and for coordinating actions. It will collect the necessary data to indicate that the results indicators have been achieved. SEPLAG has a monitoring tool for certain strategic programs, called SigeRio, which allows real-time monitoring of the status of the program implementation through a web-based interface. Other programs are monitored within the purview of the sectors. 149. A Project Implementation Committee made up of officials from the agencies directly involved in the DPL-supported reform agenda will monitor implementation, including all essential technical assistance activities. In addition to monitoring and management systems, this project will support a number of evaluation activities that will generate data to inform State policies and thereby strengthen a culture of evidence-based policy-making. D. FIDUCIARY ASPECTS 150. A number of analytical studies underpin the Bank's knowledge of the fiduciary environment in Rio de Janeiro. A review of the performance of the federal financial management and related information systems, as well as investment management efficiency was completed in 2009 and was based on PEFA methodology. Also, the IDB completed a review of the fiscal management environment in April 2009. Finally, a comprehensive assessment of the Debt Management functions of the State was carried out in April 2011 using the World Bank's Debt Management Performance Assessment methodology. 151. A robust legal framework serves as the basis for Brazil's public financial management environment. The legal framework provides for a strong PFM mandate at the sub- national level. The existence of federal laws and regulations for specific PFM areas helps to promote uniform requirements in PFM practices across sub-national entities. The framework provides for a clear definition of the responsibilities of federal and sub-national entities. In addition, institutional arrangements for the management of public finances are clearly established: SEPLAG is responsible for planning and budget preparation and SEFAZ is responsible for managing the treasury, and accounting and reporting processes. In addition, the Court of Accounts of the State of Rio de Janeiro (Tribunal de Contas do Estado de Rio de 51 Janeiro - TCE) is charged with responsibility for external scrutiny, and the legislature plays an external oversight role. 152. The budget classification system is governed by federal rules that are consistent with international standards. These rules also lay down specific requirements relating to the inclusion of comprehensive information in the budget documents. The budget preparation process is orderly, and is designed in such a way as to promote participation by all key stakeholders and sector agencies. The process is guided by well-defined budget preparation procedures and a calendar that establishes the proper sequencing of activities to allow sufficient time for them to be undertaken. The state has consistently met deadlines for the preparation of key budget documents and for submitting them to the legislature for consideration and approval. These documents include the Plano Plurianual de Aqdo (PPA), the Lei de Diretrizes Orqamentcirias (LDO), and the Lei Orqamentciria Anual (LOA). The GORJ is committed to improving the medium-term outlook in its planning and budgeting process. 153. The financial programming process is currently working well. SEFAZ is responsible for formulating cash flow forecasts, as well as updating them and monitoring their implementation. To increase the predictability of budget execution and improve the relationship between planned activities and the availability of financing, the Government embarked on a series of reforms to strengthen annual financial programming processes. It also introduced measures that required suppliers to be paid in a timely manner. The use of the single treasury account model of cash management and a clear allocation of responsibility for managing it facilitate the performance of bank reconciliations on a regular basis and in a timely manner. 154. The state's PFM system features strong internal rules and controls on commitments. However, a number of weaknesses still limit the effectiveness of the internal audit agency, the Auditoria Geral do Estado (AGE). This agency currently reports to SEFAZ and is responsible for providing management assurance about the functioning of the internal control system. Although still limited, it also plays a role in assessing value for money aspects of budget execution by government agencies. The state intends to reform the institutional structure of the AGE in order to enhance its independence. The Integrated Financial Management System for States (Sistema Integrado de Administraqdo Financeira para Estados e Municipios - SIAFEM) also plays a key role in ensuring the implementation of the internal controls through existing procedures for the budget execution process. However the weaknesses in the system and the consequent use of ancillary systems by some service delivery units may introduce some element of risk and further weaken the internal control environment. 155. Both the State of Rio de Janeiro and the Federal Government of Brazil possess a great degree of budget transparency. The State Government publishes timely, electronically and in print form, its annual budget proposal as well as the approved budget. It also provides the general public with periodic budget execution reports. The same level of transparency is matched by the Federal Government. In fact, the PEFA assessment for the Federal Government rated "A" public access to key fiscal information (PI-10). 156. In addition, Brazil has established a timetable for the adoption of international public sector accounting standards (IPSAS) in all federal entities by 2013. The adoption of IPSAS is 52 intended to improve the quality and relevance of financial information available for decision making by public sector managers. This would enhance transparency and accountability in the management of public resources while supporting the State's objective of enhancing the efficiency of the management of these resources. 157. As a result of the above review, the bank is satisfied that the PFM environment in the State of Rio de Janeiro is adequate to support the proposed operation. In addition, the Government's development strategy and actions undertaken to implement reform actions are a satisfactory reflection of its commitment to improving the PFM environment. Foreign Exchange Control Environment 158. The IMF undertook a Safeguards Assessment of the Central Bank of Brazil and concluded that the Central Bank does not present widespread vulnerabilities that could compromise the safeguarding of Fund resources. The Bank team also reviewed the financial statements of the Central Bank for the years ended December 31, 2006 to 2010 in order to assess the extent to which the foreign exchange control environment continues to be adequate. The Bank's conclusion is that the control environment continues to be adequate. E. DISBURSEMENT AND AUDITING 159. The proposed operation will follow the World Bank's disbursement procedures for development policy loans. The loan proceeds will be disbursed against satisfactory implementation of the development policy program and will not be tied to any specific purchases. Once the loan is approved by the Board and becomes effective, the World Bank will deposit the loan proceeds in an account designated by the State at the Banco Bradesco S.A. Banco Bradesco S.A. is a commercial bank, deemed an acceptable financial institution to the World Bank as it is: (i) financially sound; (ii) authorized to maintain the account in the currency agreed between the World Bank and the State; (iii) is audited regularly, and has received satisfactory audit reports; (iv) able to execute a large number of transactions promptly; (v) is able to perform a wide range of banking services satisfactorily; (vi) is able to provide a detailed statement of the account; (vii) is part of a satisfactory correspondent banking network; and (viii) charges reasonable fees for its services. 160. This account, at Banco Bradesco S.A., is denominated in foreign currency and does not form part of the country's official foreign exchange reserves. However, the Central Bank will be notified of the deposit of this amount. The State will ensure that upon the deposit of the loan proceeds into said account, an equivalent amount will be credited in the State's budget management system. The State will provide a confirmation to the Bank that: (i) the loan proceeds were received into the foreign currency denominated account, and (ii) an equivalent amount was credited to the account that finances budgeted expenditures. Such a confirmation will be sent to the Bank within 30 days after payment. If the proceeds of the loan are used for ineligible purposes as defined in the Loan Agreement, the World Bank would require the State to refund the amount. Due to the conclusions related to the adequacy of the State's public financial management environment, no additional fiduciary arrangements will be put in place for the operation. 53 F. RISKS AND RISK MITIGATION 161. The proposed operation is considered to have moderate risks. 162. Economic and fiscal risks. On the economic front, ICMS tax revenues and oil receipts are highly susceptible to macroeconomic fluctuations in Brazil and partners countries, and oil price volatility respectively. Risks to state finances, and consequently successful implementation of the operation, are also associated with ongoing royalties reform. Additional fiscal pressures exist due to structural increases in expenditures related to, among others, World Cup and Olympic Games investment expenditures, as well as personnel, health and security expenditures and contingent liability expenditures. In addition, high costs of successful government programs (pacification of the favelas, establishment of emergency health care clinics) also imply increasing fiscal pressures. These risks are mitigated by: (i) the set of key efficiency reforms supported by this operation; (ii) the commitment and capacity of the State Government to continued fiscal discipline so that fiscal repercussions of the global slowdown and of the sporting events will be managed prudently so as not to offset the gains made in the last five years; (iii) the Fiscal Responsibility Framework which monitors the state's new borrowing and sets up fiscal targets accordingly, and (iv) recent approval by the Senate of a new sharing rule that would be applied to all royalties coming from all Pre-Salt fields, including those already licensed, reduces Rio's share compared to previous legislation but prevents losses for producer states and municipalities. 163. External risks: Brazil could be affected by a global economic slowdown through its growth, its external sector, its fiscal and debt accounts and its financial sector. A slower pace of global growth associated with a slow recovery of the U.S. economy, a deceleration of the Chinese economy and growing concerns with the fiscal situation of some countries in the Euro zone may translate into lower external demand for Brazil's exports. In particular, a Chinese hard landing would hit Brazil's terms of trade, and demand for exports, given the significant demand from China. Secondly, the banking sector is vulnerable to continued global slowdown given the exposure of some small and medium sized banks to liquidity risk. Further worsening of the global economic environment also poses risk to the fulfillment of fiscal targets. These risks are mitigated by the fact that the country has a strong external position, a reasonable fiscal position and a strong financial sector position. System-wide assessment of banks indicates that Brazil's banking system currently has solid liquidity levels and capital cushions. Brazil rebounded quickly from the 2008 crisis to achieve the highest GDP growth rate (7.5 percent) in the last 20 years in 2010. Brazil is poised to respond to a possible crisis, actively using a wide array of policy tools. Early interventions in recent months with the easing of monetary policy and the reduction of capital controls indicate that it is ready to promptly deal with any external threats to domestic growth. 164. Political and institutional risk. The political situation in the State of Rio de Janeiro remains complex and reforms can be opposed by groups with entrenched political interests, such as public employee unions. The World Cup and the Olympic Games generate additional institutional and financial risks due to the proliferation of legislation reducing controls and oversight of investments associated with these events. These risks are mitigated by the pace of reforms, such as the implementation of improved PFM practices that would enable taking 54 decisions on the allocation of resources in the full knowledge of possible trade-offs and the future cost implications of policy decisions. Risks related to specific sectors 165. Improving the Efficiency and Transparency of Public Financial Management. Implementation of the new procedures to improve the management of public investments will require considerable coordination between various secretariats and leadership from the center. Given that public investment management always has a strong political dimension, there is a risk that procedures may not be fully adopted if there is significant opposition from any of the institutions involved. In addition, there is a risk that that procedures developed are seen as being too complex to be useful and therefore quickly abandoned, or that costing procedures are developed by not integrated into the budgetary process. In both cases, mitigation efforts will focus on providing technical assistance to ensure workable procedures are developed and consensus building and workshops to illustrate the collective benefits of instituting new procedures. 166. Increasing Accountability for Results in Education. The two major implementation risks for the education program are turnover in leadership of the Secretariat and possible lessening of political and budgetary commitment to the school bonus program over time. The education reform program is closely associated with the current secretary, who has won wide respect as a thoughtful and results-oriented manager willing to tackle key issues that were previously considered politically impossible. Both the new managerial selection process and the school bonus program supported under the DPL have faced some stakeholder resistance because they have introduced transparent, merit-based and results-oriented management processes in place of discretionary distribution of political favors and budget. 167. The Secretariat has three core strategies to mitigate these political risks. The first and most central is a policy of transparency, widespread consultation and abundant information provision to stakeholders and the broader public about both the processes being implemented and the results being achieved. The second is to ensure that the overall program balances increased accountability pressures with an equal increase in performance supports and rewards. The latter include not only the school bonus program but extensive new training opportunities for teachers, directors and other system personnel through the new Escola SEEDUC, and a greatly expanded program to upgrade school infrastructure and distribute learning materials; the idea is that schools and teachers wanting to improve performance will receive support. The third core strategy - which has been essential to support the other two - is a significant upgrade of the Secretariat's own analytical and management capacity, equipping it for the first time with a team capable of high quality research on program cost-effectiveness and real-time diffusion of education performance data, so that parents and civil society are aware of the progress being made. 55 ANNEX . LETTER OF DEVELOPMENT POLICY GOVERNO DM ESTAODO IO DE JAMEIRO GABINETE DO GOVERNADOR OFICIO GG W 2572C12 Rio de Jæneiro, 28 de junho de 2012 Mr, ROBERT S. ZELLICK Preidnt The World Baok Washingon. OC Ref LETTER OF DEVELOPMENT POLICY Prezado Senihor, A presente cara raa do Programa de DesenvcMmento Econrmico, Social e de Sustentabilidade Flacal d Eslado d Rio de Janeiro, que fem como objetivo prncipao apcio ås pollits pana fortaecimeto dos progromos estratégicos do Estado do Rio de Jaeiiro, relativs å melhre c aumento da cobertura dos serviços prestados o nide pblica estadual de educaçlo e de swúde 0 å consolidao do auste fisca4. em andamento A crescente demanda por açbes govemamentais. em urna economia de porte do Estado do Rio de Janeiro, no necessarlamente å suprid unicamnente por recursos provenientes das receitas tuibtdias, de arrecadaço prpria ou de transferéncias. A recente revisåo d* Programa de Ajuste Fiscal, mantido com a Secrtearia do Tesouro Naconal - STN, asseguru o Estido neov spaço fical pera contrataçlo de operaç6es de crédito intlemo e extrno, voltdas para os projetos prioritårlos do Governo, dentre eles o presiente Programa. o Estide do Rio de Janeiro sadita que e necessåia a ssistncia fnanceira do Banco Mundial. sob a forna de um Empréstimo de Apoio å Polltica de Desenvolvimento - DPL, para garantir a continuidade destas reformas esfruturas. antecipando resultados å sociedade e å economia. Esado do Rio de Janeiro: voluso rcente, deaullos 0 pcrpectiva Ha mais de uma década, c Brasi teom passado per mudoanas Regais e administrativas de donrm a ganntir que rformas fiscais sejam realizadas em todos os niveis de governo. A realize;o destas reformas foi e contrua send fundamental para que se consolide um ambiente macroeconåm:o fovoråvel ao investimento e a0 rescimento de renda, do emprego e ds provisåo de servçs púbcs. 56 GOVERNO DO ESTADO 00 RIO DE JANEIRO GAINETE DO GOVERNADOR o Estado do Rio de Janmero, de forna inovadora, preparou una agenda frcal própria para que as reformas necessårias fossem executadas de furna selida, som prejudicar o fornecimento de serviços como educaçg, aåde, segurança, dent outros. Em meados da déoada passada, engajou-se em um significtivo esforço de sluste. aperfeiçoando os procednenlas oamentérins, financesios e de controk do gasto públo, slém do aumento da transparencia, o que possiilitou alcançar resultados positives g significaivos na me4horia da adminisraçåo pública. Neste contexto, o Estadc do Rio de Janeiro, por meio de uma nova administraçlo tributira. auou forlemente n arrecadaçåo de impostos. Foram divers aç~es de modernýaç tanto para c Estado,