FILE COPYCONFIDENTIAL:Report No. 11524 - MOZ Report No.:11524-MlOZ Type: (SEC)Title: SECOND PUBLIC EXPENIDITURE REVIIAuthor: PEREIRA DA SILVA. LExt.:342461 Room:J11031 Dept.:AFbCOGREEN COVERMozambique -Second Public ExpenditureReviewDecember 31, 1992Country Operations DivisionSouthem Africa DepartnentFOR OFFICIAL USE ONLYDocument of the World BankThis document has a restricted distribution and may be used by recipientsonly in the performance of their official duties. Its contents may not otherwisebe disclosed without World Bank authorization.

CURRENCY EQUIVALENT TO THE USD(Local Currency Unit is the Mozarnbique Metical -plural Meticais-- MZM)Value of 1 USD in MZM in year.1975 27.241980 32.401981 35.351982 37.771983 40.181984 42.441985 43.181986 40.431987 289.441988 528.601989 819.711990 1038.151991 official rate 1845.401991 secondary market 2033.001991 parallel market 2247.00MOZAMBIQUE - INFLATION (CPI) RATES AND NOMINAL DEVALUATIONS609 PERCENT NOMI AL^190 DEVALUATION IN ADJVSMENT PERIOD140 n inlao(CPI)LUNE OF 10 PERCENT OF INFLATION40- 19S0 1991 1982 1983 1984 1985 19 1987 1988 1989 1990 1991ABBREVIATIONSBDM Banco de MocambiqueBOP Balance of PaymentsBPD Banco Popular de DesenvolvimentoCAD Current Account DeficitCCCE Caisse Centrale de Cooperation EconomiqueCF Counterpart FundsCG Consultative GroupCGE Central Government ExpendituresCIDA Canadian International Development AgencyCNE National Executive Comission for Emergencies

CNP National Planning CommissionCPE Centrally Planned EconomyDEO Department of Budgetary ExecutionDNIA Direc,o Nacional de Impostos e AuditoriaDPCCN Department for the Prevention and Combat of Natural DisastersEC European CommunityEDM Electricity of MozambiqueEPI Primary Level EducationERP Economic Rehabilitation ProgramESAF Enhanced Structural Adjustment FacilityESRP Economic and Social Rehabilitation ProgramFFP Fundo de Fomento PesqueiroFRELIMO Partido da Frente de Libertac,o de MoNambiqueGDP Gross Domestic ProductGOM Government of MozambiqueIDA International Development AgencyIMF International Monetary FundISP Instituto Superior Pedag6gicoLAM Linhas Aereas de Mo,ambiqueM2 Money and Quasi-moneyMB-10 Common Account for counterpart funds depositsMINED Ministry of EducaionMOC Ministry of ComnmerceMOF Ministry of FinanceMOH Ministry of HealthMZMv Metical or MeticaisNGO Non-Government OrganizationOGE Or,amento Geral do Estado or General State BudgetOGL Open Generalized LicensePDP Priority District ProgramPER Public Expenditure ReviewPFP Policy Framework PaperPFT Trienal Financial Plan or Plano Financeiro TrienalPHC Public Health CarePTIP Trienal Public Investment Program or Plano Trienal de Investimento PublicoRENAMO National Resistance of Mozambique or Resistancia Nacional de Mo,ambiqueSIDA Swedish International Development AuthoritySNAAD System for Non-Administrative Allocation of Foreign ExchangeSNE National Education SystemSPA Special Program of AssistanceSSA Sub-Saharan AfricaTA Technical AssiatnceUEM University Eduardo MondlaneUNDP United Nations Development ProgramUSD US DollarUSAID US Agency for International DevelopmentFISCAL YEARGovernment = January 1 to December 31

TABLE OF CONTENTSExecutive Summara pg. i.1. The 2nd PER and the context of the transition from a war to a peace economy pg. i.2. Backgound: the post-Independence crisis (1980-1984) and the adjustmentprocess in Mozambique (1986-90) pg. iv.3. Public Expenditures and the adjustment process pg. viii.4. The improvements in sectoral policies pg. xvi.5. Quantitative projections of public expenditures for the future pg. xxvi.6. Summary of Conclusions and Recommendations pg. xxix.ChIR2ter I : THE ADJUSTMENT PROCESS AND PUBLIC EXPENDITURESIN MOZAMBIQUE pg. 1.Section L.L. Introduction: the specificity of a Public Expenditure Review(PER) in a war economy pg. 1.Section 1.2. An assessment of the adjustment process 1986-1990 pg. 2.Section 1.3. Pattems of Government's expendituresduring the adjustment process pg. 11.Section 1.4. Summary and Conclusions: the role of Public Expendituresin Mozambique's "heterodox" adjustment process pg. 13.Section 1.5. : Structure of the Report pg. 14.This report is based on the findings of a core mission that visited Mozambique in October/November1991. The main mission consisted of Luiz A. Pereira da Silva (AF6CO), Carla Grasso (consultant),Rocio Castro and Maria Teresa Benito (AF6CO). Sectoral contributions were received from RicardoSilveira and Ruthanne Deutsch (for Education and Health), Roberto Echeverria and Arne Disch (forAgriculture and Fisheries), John Roome (for Infrastructure) and David Phillips (for Industry andEnergy).This Document has a restricted distribution and may be used by recipients only in the performance of their officialduties. Its contents may not otherwise be disclosed without World Bank authorization.Mozambique - 2nd PER - Table of Contents

Chapter 1 PUBLIC EXPENDITURES IN MOZAMBIQUE IN 1991pg. 19.Section 11.1. : The importance of PER for macroeconomicregulation in Mozambique pg. 19.Section 11.2. Govemment Expenditures in 1991first year of the 5th PFP pg. 19.Section 11.3. Summary, conclusions and recommendations:the new challenges for public expenditure programsin the transition to peace pg. 31.Annex 11.1. Mozambique - Conditions ofaccessibility in February 1990 pg. 40.Annex 11.2, : Mozambique - Demobilization ofthe military pg. 41.Annex 11.3. : Mozambique - Summary ofGovernment Finance 1980-1991 pg. 46.Annex 11.4. : Mozambique - Govemment'srecurrent and investment budgets for 1991 pg. 49.Chapter 1I : CROSS-SECTORAL AND INSTITUTIONAL ISSUESFOR PUBLIC EXPENDITURES IN MOZAMBIQUE pg. 51.Section 111.1. : Progress made since the first PER pg. 51.Section 111.2. : The collection of counterpart funds pg. 51.Section 111.3. : Institutional issuesin public finance management pg. 65.Section 11.4. Summary, conclusions and recommendations: pg. 71.Annex 111.1. Accounting of Counterpart funds pg. 80.Annex 1112. : Monetary Accounts pg. 81.Mozambique - 2nd PER - Table of Contents

Chapter IV SOCIAL SECTOR'S (EDUCATION AND HEALTH)PUBLIC EXPENDITURE REVIEW pg. 83.INTRODUCTION pg. 83.THE EDUCATION SECTOR pg. 84.Section IV.]. : Overview of the Education sector pg. 84.Section IV.2. : The Education Sector Expenditures pg. 86.Section IV.3. : The Education Sector Public Investment Program pg. 89.Section IV.4. The Education Sector Financing pg. 92.Section IV.5. : Forecasting resource requirements for the Education Sector pg. 96.THE HEALTH SECTOR pg.l00.Section IV.6.: Health Sector status pg.l00.Section IV.7. : The Health Sector Expenditures pg. 103.Section IV.8. : The Health Sector Public Investment Program pg. 106.Section IV.9. Efficiency of resource allocation pg.109.Section IV.10. The Health Sector Financing pg.l 10.Section IV.11. Forecasting resource requirements for the Health Sector pg. 14.Chapter V AGRICULTURE & FISHERIES SECTORPUBLIC EXPENDITURE REVIEW pg. 1 17.AGRICULTURESection V.]. An Overview of the Agricultural sector pg. 1 17.Section V.2. The Institutional Organization, Strategy and Piiorities pg. 120.Section V.3. Total Sector's Expenditures pg. 126.Section V.4 Structure of the Agricultural sector overall financing pg.133.Mozambique - 2nd PER - Table of Contents

Section V.5 Public expenditure requirements for the transitionin the Agricultural sector pg.136.Section V.6 Summary and recommendations of the 2nd PERfor the Agricultural sector pg. 136.FISHERIESSection V.7 An Overview of the Fisheries sector pg. 139.Section V.8. Fisheries Sector's consolidatedpublic expenditures pg.148.Section V.9 Fisheries sector issues pg.148.Section V.10 Summary and recommendations of the 2nd PERfor the Fisheries sector pg. 158.Annex V.]. Organigram for the Fisheries Sector pg. 159.Annex V.2. Major Firms in the Fisheries Sector pg. 160.Annex V.3. Registered Catches pg. 162.Annex V.4. Sofala Bank Fisheries pg.163.Annex V5. Value of Exports of the Fisheries Sector pg.164.Annex V.6. Relative importance of Income and Expenditurein the Fisheries Sector pg. 165.Annex V.7. Investments in the Fisheries Sector pg. 166.Chapter VI INFRASTRUCTURE SECTOR'SPUBLIC EXPENDITURE REVIEW pg. 167.TRANSPORT SECTOR (RAILWAYS, ROADS, COASTAL SHIPPINGAND CIVIL AVIATION) pg.167Section VI.] Intrduction, summary of findingsand recommendations pg. 167.Section V7.2. : Sectoral Institutional Organization and Strategy pg.168.Section V13. : Sectoral Public Expenditures pg. 181.Mozambique - 2nd PER - Table of Contents

THE WATER SECTORSection VI.4 Overview of the Water sector in Mozambique pg. 1 87.Section V.S. :. Sectoral Public Expenditures pg.187.Section VI.6. Financing of Public Expendituresand potential for increased financial resources pg.188.Section Vl.7. Conclusions and recommendations: pg. 190.Chapter VII : INDUSTRY AND ENERGYSECTORS PUBLIC EXPENDITURE REVIEW pg.191.THE MINING AND INDUSTRIAL PROCESSING SECTORSection VII.l. : Overview of the Minig and Industrial Processing sector pg.191.Section V11.2. : Insttutional structure, Organization and Strategyfor the Industry sector pg.192.Section V11.3. : Total Public Expenditures in the Mining andIndustry sub-sector pg.193.Section V11.4. : Financing Public Expenditures - Mining andIndustry sub-sector pg.196.Section VII.5. : Public Expenditures and Industrial strategyduring the transition to a peace economy pg. 196.THE ENERGY AND TELECOMMUNICATIONS SECTORSection V11.6. : Overview of the Energy and Telecommunications sector pg.201.Section V11.7 : Institutional and Organization structure pg.202.Section V11.8 : Total Public Expenditures program pg.202.Section V11.9. : Strategy for the transition to peace andits implications for Public Expenditures pg.204.Section VII.1 0: Implications of Peace: medium-term investment scenario pg.206.Section VII.)): Summary and Recommendations:the implications of Peace for the sector pg.206.Mozambique - 2nd PER - Table of Contents

Chapter VIII SIMULATION OF ALTERNATIVE MACROECONOMICSCENARIOS FOR PUBLIC EXPENDITURE POLICIES pg.209.Section VIII.) Introduction pg.209.Section V111.2 The essential features of the PER Model pg.210.Section VIII.3 Results of the simulations pg. 214.Section V111.4 Linkage between monetaryand public expenditure policies pg. 223.Section Vll.S Sectoral enveloppes and macroeconomic scenarios pg. 232.Annex VIII.). The PER Model pg. 240.Annex V111.2. Graphs of major macro variablessimulated by the PER Model pg. 263.Mozambique - 2nd PER - Table of Contents

EXECUTIVE SUMMARY1. The 2nd PER and the context of the transition from a war to a peace economy,from emergency aid to reconstruction and economic and financial Independence1. Improvements in public expenditure programs in countries that have on-going civil wars or ahigh degree of social strife and political instability might seem a thankless task. The civil war, actingas an unproductive tax and/or a fixed additional cost on all economic activities, was and still is at thecenter stage of all economic analysis in Mozambique. In spite of that, a Second Public ExpenditureReview (2nd PER) for Mozambique started much before (March 1991) the present fundamentalchanges in the country's political scene could be foreseen (i.e., the recent peace agreementl betweenthe Government and the main opposition movement, RENAMO). At that time, the building and/or theimprovement of the methodological and analytical framework for Public Expenditures inMozambique seemed necessary regardless of the political and economic scenarios that could beenvisaged. Today, the signing of the Peace Agreement adds a new dimension to the 2nd PER. Peacecould open the first period of time since the mid-1960s (beginning of the armed struggle forIndependence) when the country could focus its attention entirely and exclusively on developmentalissues. Peace will also require that, during a transition period, public expenditures will have tocontribute substantially to the rehabilitation and reconstruction of the country2 since it is likely thatprivate investment-led growth will only occur after a long period of time. That raises both short-(tactical) and long- (strategic) term issues for the use of public resources during the transition fromwar to peace. The longer term issue for Mozambique is to be able to generate a growth pattem that issustainable without the present high levels of foreign assistance. Even when an optimistic scenario iscontemplated for the regional economy of Southem Africa, the challenge, is immense. The shorterterm issue for Mozambique --with its present institutional framework and administrative capabilities--is to be able to move from what was --and still is to a great extent-- an emergency-aid economytoward an economy that will progressively formulate its own independent development goals andreconstruction objectives.2. The overall foreseeable cost of rehabilitating and reconstructing the physical infrastructuredamaged by the war is likely to amount to several percentage points of Mozambique's GDP. Veryrough and preliminary estimates for the transition period's annual gross "rehabilitation bill"amount to about 15 percentage points of the present GDP or about USD 200 million (broken downinto about USD 60 million in infrastructure rehabilitation -4.5 percent of GDP; about USD 13million for improving and rehabilitating rural and urban water supply -1 percent of GDP; about 2or 3 percent of GDP for rehabilitation of schools and possibly another 2 or 3 percent for healthcenters; and last but not the least, about S to 6 percent of GDP for initiating the demobilization ofmilitary personnel in 1992). These numbers are estimates and should be taken only as indicators oforders of magnitude. It is also almost inevitable that a time lag will occur between theimplementation of expansionary public expenditure policies (associated with the country'sOn August 7, 1992. a Solemn Declaration was signed by both the President of the Republic of Mozarnbique and theleader of the major opposition movement, Resistencia Nacional de Mocambique or Mozambique's NationalResistance (RENAMO). The document reaffirmed their commitment to a peace agreement and set the stage fornegotiations aiming at a cease fire by October 1 and general elections under the auspices of the United Nations.Sixteen years of war were finally ended on October 4 with the signing of the Peace Agreement between RENAMOand the Government of Mozambique's FRELIMO Party (Partido da Frente de Ubertag4o de Mocambique).2 In that sense an increase in the ratio of Central Government Expenditures (CGE) over GDP is likely to happenbecause of the time lag between investing in rehabilitation and reconstruction and the expected correspondingsupply responseMozambique - 2nd PER - Execunve Summary

iirehabilitation and reconstruction priorities) and the collection of the "peace dividends" (e.g., newgrowth pattem, additional tax revenues, etc.) by the Govemment. Therefore, maintaining the presentstabilization process is likely to require additional extemal assistance. It is also very likely that theeffectiveness of this additional extemal assistance effort will depend on its degree of flexibility:untied aid will certainly be necessary to face the changing circumstances that Mozambique is goingto have during this transition period. However, this additional extemal assistance requires a numberof conditions to be met before new commitments are made. Inter alia, both the Government and thedonors will have to ensure that the existing extemal financing is being disbursed on a timely basisand that resources are being allocated efficiently and according to the future development objectivesof the country. That, in tum, requires progress in the areas of public finance and public sectormanagement, monetary and financial policies and sectoral public expenditure policies. The 2nd PERis precisely covering these three broad topics.3. Progress in the areas of public finance and public sector management is of the utmostimportance given the role of the public sector in the coming phases of rehabilitation andreconstruction. The monitoring of public expenditures will be a critical task in order to maintain thestabilization objectives of the country's reform program during this phase of fiscal expansion. Thestrengthening of the phases of budget preparation and execution and the integration and/or mergingof both the recurrent and the capital budgets are important tasks lying ahead. The coordinationbetween the fiscal authorities and the donors (already a very important necessity in the past) will beessential to assess the degree of implementation of projects and to maintain donors' allocation in linewith agreed development priorities. In addition to that, only a strengthened public administrationwould be able simultaneously to: (i) take into account the additional transitional costs of safety netsrelated to the drought, the demobilization of military personnel and their re-integration into a civilianlife, and the reintegration of civilian refugees; (ii) prepare the Rehabilitation and NationalReconstruction Plan; and (iii), maintain and improve the existing macro management instruments (theBudget, the Public Triennial Investment Program (PTIP) and the Triennial Financial Plan (PFrT)).4. For all these reasons, the central task of public finance management will be to target areasonable profile for the fiscal deficit after official grants over the coming years and monitor publicexpenditures accordingly (i.e., making the level of expenditures in line with the inflows of revenueboth domestic and foreign or in other words, keeping the stabilization pattem of the reform programdespite the uncertainties brought by the new political situation). The importance of macro-economicconsistency during this transition explains why this 2nd PER uses extensively macroeconomicscenarios deriving from a macro-modeling exercise to discuss the consistency between publicexpenditure programs and the economic reform program (see Chapter VIII). Given Mozambique'sheavy dependence on external sources of financing and its vulnerability to domestic political shocks,this approach ensures adequately what could be the upper limit of expansionary public expenditurepolicies given an explicit set of exogenous variables (e.g., available extemal financing for aReconstruction Plan).5. Simulating the macro-consistency of public expenditure policies is particularly importantnow that the Peace Agreement has been signed, thus altering radically both the perception ofpotential foreign investors regarding the country's prospects and domestic factor productivity.The transition to peace will be a difficult process where stabilization obiectives will have to be keptin the Government's agenda while, at the same time. sectoral expansionary policies(reconstruction and rehabilitation) will have to be implemented to attain hopefullv much higherlevels of growth than in the nast. The only way to test the consistency of these two (onlyapparently) contradictory elements of the future political and economic agenda is to ensurethrough a macro-model the consistency between the overall stabilization targets with the desired(and badly needed) levels of sectoral expansionary spending.6. Progress in financial management and appropriate monetary policy will be also a criticalelement during the transition to a peace economy. The general objective that Mozambique will haveto achieve is to continue shifting from a system of administrative allocation of financial resources(with direct controls through either credit ceilings or administrative allocations of credit and foreignexchange) to a system relying much more on price mechanisms (indirect control through interest ratepolicy and no pre-determined administrative or sectoral allocations).Mozambique - 2nd PER - Executve Summary

7. Maintaining stabilization objectives will require a strong supervision of monetary and creditdevelopments if the Government wants to avoid an inflationary outburst deriving from therehabilitation / reconstruction effort and the associated inflow of extemal financing. In particular, thelack of a comprehensive and consistent picture of 'the consolidated public sector borrowingrequirements needs to be corrected. Special financing through sector-specific development fundsneeds to be avoided and a better interaction with the emerging commercial banking system isrecommended. Similarly, the resort to credit creation outside the banking system (e.g., through theissuance and acceptance of promissory notes) needs to be discontinued.8. By the same token that financial needs of the public sector need to be clearly defined andmonitored, it is also clear that part of the financial requirements during the transition will not beeligible to strict commercial lending. When needed (e.g., for social and political reasons, or becausethe market prospects for a specific activity are uncertain / unclear/ not assessed, etc.) a policy oftransparent subsidization of the budget is preferable to a policy of administrative allocation offinancial resources (e.g., through ear-marked lines of credit or sector-specific or enterprise-specificinterest rate policies).9. Finally, progress in financial management will be crucial to improve the rate of collection ofcounterpart funds. Transparency of accounts and a clarification of cross-enterprise / Treasury debtswill help in determining the best routes to facilitate the collection of these revenues.10. Progress in sectoral policies will finally consolidate the above mentioned steps. It is animportant element of the Government's development strategy. Specifically the enhancement ofhuman resources and the rehabilitation of social and physical infrastructure, particularly in ruralareas, will have to be maintained as valid development objectives. The rehabilitation andreconstruction of both physical and human infrastructure are the highest priorities in order to restorea high growth pattem for the economy and catch-up with the pre-Independence levels of output,which --in some cases-- can be considered as the development targets for a given sector. The sectoralstrategies need to take into account both available domestic resources and the amount of externalassistance to (i) optimize the use of their overall resource envelope; (ii) avoid the dependencysyndrome where the planning, disbursement and implementation of projects rely exclusively ormainly on donor-driven procedures; and (iii), limit the recourse to special sectoral financing throughdevelopment funds,"Fundos de Fomento," outside the renewed banking system and/or Government'sbudget support.11. However and more specifically, progress in sectoral strategy will also imply revisiting some ofthe implicit sectoral strategies elaborated during the civil war and insecurity period. Peace indeedchanges a number of assumptions that were used by both the donors and the Government to build thepast public investment program. For example, restored accessibility in the rural areas gives moreweight to an Education and Health strategy focusing on the pre-war network of primary schools andhealth centers rather than strengthening the university in the capital city; improved securityconditions in the countryside could alter a cost-benefit analysis comparing inland road transportationwith air or coastal maritime transportation; and, the need to succeed in the demobilization of themilitary and the reintegration of civilian refugees into productive economic and social activities couldmodify temporarily the balance between large-scale agricultural projects, public works programs andfamily-sector and small-scale projects in the forthcoming public investment programs of thetransition.12. For the moment, managing an economy that is still affected by the war has importantimplications for the allocation of public expenditures. Despite today's low level of domestic revenuesand production, the Government has, to the extent possible, to meet existing social and economicobligations nation-wide. Furthermore, military expenditures inevitably crowd out development-oriented expenditures. Finally, the insecurity in the countryside makes an economic return to.investment low and uncertain. Therefore, these difficulties associated with the armed conflict bring aquasi-inherent inefriciency in public spending which will remain for a while. The altemative ofreducing or cutting expenditures in insecure Provinces is neither politically feasible nor economicallydesirable in the longer term.Mozambique - 2nd PER - Execuave Summary

iv13. In what follows, a brief picture of the post-Independence crisis (1980-84) and the adjustmentprocess (1986-90) in Mozambique is given; then, the role and the characteristics of PublicExpenditures during the adjustment process (1986-91) are analyzed; improvements in sectoralpolicies related to the reform process are reviewed; and, finally, quantitative projections of publicexpenditures for different scenarios for the future are examined.2. Background: the post-Independence crisis (1980-84) and the adjustment process (1986-90) inMozambique14. The political and economic factors that have been constraining Mozambique's developmentprocess are weU known: during the five centuries of colonial rule little was done to develop social andphysical infrastructure. Independence in 1975 came after a long armed-struggle against the formercolonial power. The take over of the colonial administration by the liberation movement, the Frentepara a Libertacao de Mocambique (FRELIMO), happened in a context where, on the one hand, littletechnical expertise on how to manage a colonial economy was in the hands of the liberationmovement, and, on the other hand, fears of retaliation against whites had triggered a massive exodusof former Portuguese settlers to Portugal and South Africa. Given the occupational structure of theeconomy, where whites had preempted about 90% of skilled and semi-skilled jobs, this massiveexodus of human capital tumed out to be, in fact, a time-bomb in the hands of the new authorities.The shortage of skiUed manpower was acute even by Sub-Saharan African standards. Partly by thelack of technical expertise and partly by ideological choice, the authorities relied on inappropriateeconomic policies to address the urgent development needs of the country. Thus, Mozambique'spath to macroeconomic instability is not extremely different from what could be drawn from LatinAmerican experiences with populist macroeconomics . It extends the framework to its most extremeconsequences and is, of course, compounded by destruction caused by the civil war.a) In an initial stage, a new Government takes over the colonial administration with littleadministrative capabilities and the belief that income distribution should improve visibly andradically in the short term. This view is understandably supported by the majority of thepopulation deeply dissatisfied with economic policies during the colonial era. The packageimplemented includes a wage hike benefiting mainly workers in the formal sector and thepublic administration and the extension of social welfare benefits to a much larger share ofthe population (Education and Public Health). The real wage is usually set at a higher levelthan that of the colonial era (and sometimes combined with an allowance of basic goodsgiven in kind to public sector employees). Wage differentials are also usually substantiallyreduced in almost all categories irrespective of acute shortages of skilled workers at almost alllevels of productive and administrative activities. Simultaneously, the new Government alsofreezes domestic prices and the exchange rate to guarantee its redistributive policy. Inparallel or soon after these initial steps, the new Government is confronted with an armedopposition movement usually sponsored by political enemies. Military expenditures have torise. Some of the cost of the emerging civil war is financed by external assistance but someneed to be financed domestically.b) The consequences of both the measures implemented and the civil war are quitestraightforward: there is a dramatic increase in the fiscal deficit, on the one hand, and acollapse of domestic output and of exports, on the other hand. The fiscal deficit increases asa result of both the wage hike and the provision of social welfare benefits to a much largershare of the population than before. Rising military expenditures also contribute to boostpublic spending. The collapse of domestic output and exports, in turn, is caused by both thegrowing insecurity in the countryside and the consequent inflow of refugees into the urbanareas, and the adverse price incentives resulting from the freezing of producer prices and theexchange rate. In Mozambique for example, by 1986, real GDP had fallen to about twothirds of the 1980 level, exports were reduced to less than one third of their 1980 value andMozambique - 2nd PER - Execuave Summary

vaccounted for only about 15 percent of imports and the financing of the extemal imbalancesled to the accumulation of extemal debt arrears.c) These first round consequences trigger; in tum, a second round of problems. First, inorder to finance a growing fiscal deficit and in view of the lack of a modem financial sector,the new Govemment either monetizes the growing fiscal deficit through printing money orborrows abroad. The collapse of domestic production and the lack of price incentives toprivate producers cause both the emergence of parallel market activities and the need toincrease the imports of previously domestically produced goods (a sort of inverted import-substitution strategy). Of course, the monetization of growing deficits also triggers anaccelerated depreciation of the currency which given its fixed parity translates into askyrocketing premium in black markets for foreign exchange. -The strengthening of parallelmarkets finally reduces even more the rate of tax collection and compounds even further thecrisis of public finance. Once the country reaches a creditworthiness limit for commercialextemal borrowing the classic balance of payment crisis appears. The need for a reformprogram, possibly under the auspices of the IMF and/or the Bank becomes inevitable.15. In effect, in early 1987, the Government initiated an Economic Rehabilitation Program (ERP)to tackle the economy's structural problems and distortions and was supported by both the IMF andthe Bank. The stated intention was to shift toward a more market-based economy with lessadministrative controls and with more reliance on intemational and domestic market mechanisms toprovide signals to economic agents. The ERP correctly revolved around the idea that stabilizationhad to be addressed up front in the reform process. The program has involved, inter alia, reforms inthe following areas: price liberalization (including the unification of the exchange rate markets);fiscal adjustment; tight monetary policy; and improving the efficiency of public administration.16. The major characteristics of the reform program are as follows:a) Stabilization of the economy through restrictive fiscal and monetary policies cameup front in the reform program to ensure the deactivation of the money machine (themonetization of fiscal deficits and/or the granting of "bad" credit to an inefficient publicsector). After reaching more than 18 percent of GDP in 1984, the Government's fiscal deficit(after official grants) was reduced to about 1 percent in 1991 while money/quasi-money (M2)was set to grow at less than the inflation rate and credit ceilings were established. However,progress in reducing the public sector consolidated fiscal deficit is difficult to assess becauseof the lack of consolidated public sector fiscal accounts inclading the quasi-fiscal deficit ofthe Central Bank, "Banco de Mocambique" (BDM). The establishment of such accounts istaking quite some time because of the existence of informal ad hoc agreements between theTreasury, some parastatals and both the banking system and the Central Bank. In addition, aworkable strategy to separate the central and commercial banks within the present CentralBank has not been achieved yet. As a result, there are still high amounts of unclassified oroff-balance sheet assets (representing more than twice the current GDP) that may bedisguising significant losses (present or past) of the public sector.b) A gradual liberalization of prices succeeded in eliminating most of the moneyoverhang in the economy. (After addressing the flow problem of the fiscal deficit, thereduction of the money stock became a matter of ascertaining the trade-offs between apotential supply response and the adverse social consequences of changing the level ofdomestic prices.) In line with a massive devaluation of more than 600 percent at the start ofthe reform program in 1987, domestic administered prices were realigned by about 160percent and only then progressively liberalized. Real money balances have been consistentlydeclining (a decrease of 43 percent in 1987 and an average decrease of 5 percent from thereon): the ratio of M2 to GDP fell from about 80 percent in 1983 to about 35 percent in 1991.c) Changes in the incentive structure (the exchange rate regime, private ownership,etc.) proved critical for obtaining a supply response from both exporters and producers forthe domestic market. However, the civil strife situation does continue to be the majorimpediment to the resumption of economic activities in the countryside. Besides a move ofMozambique - 2nd PER - Executve Summary

vithe real exchange rate from about 100 in 1985 to about 850 in 1991, private sector activitieshave been encouraged but concentrated essentially in the tertiary sector in urban areas.Export growth, in real terms, has accelerated from about 4 percent per annum in 1988 toabout 11 percent per annum in 1990, and 28 percent per annum in 1991.d) Inflows of foreign savings (through aid or direct private investment) played anessential role in increasing competition, creating positive extemalities, setting new standardsfor both labor and capital and supporting balance of payments (BOP) stability. In thatrespect the Mozambican case is exceptional: total official grants rose from about 3 percent ofGDP in 1986 to more than 21 percent of GDP in 1991. That allowed the Govemment to startrepaying the banking system while stopping its non-concessional extemal borrowing.e) The establishment of a minimum social safety net was an important mechanism topreserve a much needed political consensus in a transition to a market economy. Food andincome subsidies represented an important component of the fiscal packages (about 3.5percent of GDP in the initial year of the program) agreed on by both the Fund and the Bank.That, in tum, reinforced the political stability of the FRELIMO Govemment allowing thecommitments for the proper set of reforms. Despite the civil strife situation, or maybebecause of that, the FRELIMO leadership was able to debate the pace of reform pathintemally while showing extemal commitment to the program's objectives.17. To summarize, donor financing has been playing an essential role in supporting theprocess of reforming the Mozambican economy. Government spending (particularly donor drivenpublic investment) played and still plays a major role today in Mozambique's growth process. Theadjustment process followed by Mozambique is heterodox: all actors participating in the processacknowledged that it was unrealistic and counterproductive in Mozambique to reduce the externalimbalance through an up front reduction in public expenditures (e.g., to "adjust" expenditures --public and private-- to the level of available domestic resources given the dramatic collapse ofdomestic output). In fact, an expansion of extemally financed public expenditures was the basis uponwhich to build, rehabilitate and maintain the country's social and physical infrastructure which, intum, would eventually become an incentive for private sector investment. There was up front animplicit assumption that while it was important to develop a market-oriented institutional frameworkand a corresponding system of incentives, private sector confidence would only emerge after the endof the civil war and with strong evidence that political stability in the country would last. In themeanwhile, it was important to mobilize and to use external financing in the reform process.18. In that context, the major achievement of the ERP is to have reversed the economic decline ofthe early 1980s and to have put in place the necessary incentive mechanisms consistent with amarked-based economy. Despite the civil war, there were a number of areas of success including theresumption of strong growth in the export sector and the attainment of more realistic levels for thefiscal deficit, together with its financing by non-inflationary external sources. Given thesecharacteristics, the success achieved in stabilizing the economy remains somewhat fragile anddependent on the continuing inflows of high levels of foreign savings.Mozambique - 2nd PER - Executve Summary

..... .....................*...... ...... Ins pereent changep. Ap ag i 0~~~~~~~0GDP real growth - - 0.5 -3.4 -12.9 0.9 -8.8 0.9 4.4 5.4 5.4 1.3 0.3 ' ' ,4Import real growth -- i.e 11.5 -20.3 -13.4 -13.1 28.0 7.6 -2.0 28 0.0 1.9' 4.. 2._Export real growth -- -10.9 7.8 -37.1 -37.2 -2.0 -8.3 8.3 4.4 8.4 10.6 27.5 .14.6 11.8 Inflation (CPI) - - 18.6 12.0 14.8 46.1 8.2 163.5 69.2 44.2 32.0 34 5 20.0 68.7 NNomindal Exchange Rate -- 9.1 6.8 6.4 5.6 1.7 46.4 609.3 84.5 40.8 24.8 54 3 3.9 162.8 OIncrease In Read Money Supply (M2) -- 26.1 9.5 7.0 -0.8 -22.7 2.3 -39.3 5.5 7.1 0.2 -29.0 3.6 *11.1In percentage of GDPTotalConsumptlon 99.5 97.4 101.0 108.3 104.5 101.4 99.9 106.2 117.3 119.1 111.8 1102 101.7 112.9 OPrivate 81A 76.8 77.4 79.9 78.5 78.9 74.5 85.1 94.7 93.6 86.2 86 2 782 89.1 0Government 18.1 20.7 23.6 28.4 26.0 22.4 25.4 21.2 22.6 25.5 25.6 24.0 23.5. 23.8 la0*Government Revenues 22.3 25.7 26.0 26.7 26.1 25.5 25.8 32.7 37.4 40.0 40.3 44.2"" s ' -*or which OMdal Grants 2.7 2.3 2.5 3.2 2.7 2.0 2.3 9.2 14.0 16.5 16.9 20.8 2.5 .155 ..Government Current Expenditures 18.1 20.7 23.6 28.4 26.0 22.4 25.4 21.2 22.6 25.5 25.6 24.0 23.5 23.8 -.Government Overall Fiscal DefidtcBefore Omdal Grants -9.6 -12.0 -16.9 -21.4 -18.1 -3.6 -7.5 -13.6 -20.5 -24.2 -26.3 -25.1 .t2. 1.90After OMdal Grants -7.0 -9.7 -14.4 -18.2 -15.4 -1.5 -5.2 -4.4 -6.5 -7.7 -9.4 -4.3 - -6.5 , oGross Investment (Indud.VarStocks) 18.9 20.3 19.3 9.9 10.6 6.9 9.7 23.8 32.6 33.0 38.1 41.8 13.7 33.j9 Private 7.8 5.6 2.5 -6.5 -4.9 2.3 4.2 7.9 11.3 10.8 13.9 17.3 1.6 12.3Government 11.2 14.7 16.8 16.4 15.5 4.5 5.6 15.9 21.3 22.2 24.2 24 5 12.1 21.6Gross Nat. Savings Ind. Off. Transf. 3.2 4.8 1.5 -5.0 -1.8 0.7 2.5 3.0 -3.3 -2.5 5.1 106 0.8 2.6Private -1.0 -0.2 -0.8 -3.3 -1.9 -2.4 2.1 -8.5 -18.1 -17.0 -9.6 -9 6 .1.1 .12.6Pub0c 4.2 5.0 2.4 -1.7 0.1 3.0 0.4 11.5 14.8 14.5 14.8 20.2 1.9 15.2IQCurrent Account Delidtexduding oMdal transfers -18.4 -17.8 -20.3 -18.2 -15.1 -8.3 -9.6 -30.0 -49.9 -52.1 -49.9 -52.0, ..> 4i .4'.8Induding oMdal transfers -15.7 -15.5 -17.8 -14.9 -12.4 -6.2 -.7.2 -20.8 -35.9 -35.5 -33.0 -31.2'12.8. 41.3lxi ~ ~ ~Ttl oerm'00Total Government Expenditures 29.3 35.4 40.3 44.8 41.6 27.0 30.9 37.1 45.7 48.9 51.5 50.4:::. ::35,6. 46.7(including interest and enterprise debt ass.)p.mGross Domestic Productinacurot MZMBillion 78 81 93 92 108 147 167 428 657 966 1,340 1,909in curent USD Billion 2.41 2.28 2.45 2.29 2.54 3.40 . 4.13 1.49 1.24 1.30 1.44 1.33OMdal Transfers to Gov. Budgetin cuffent MZM Billion 2.1 1.8 2.3 3.0 2.9 3.0 3.9 39.6 91.8 159.8 226.3 397.0in current USD Billion 0.06 0.05 0.06 0.07 0.07 0.07 0.10 0.14 0.17 0.21 0.24 0.28

viii3. Public Expenditures and the adjustment process (1986-91)19. In 1991, Central Government Expenditures (CGE), by far the largest component of PublicExpenditures in Mozambique, accounted for more than 50 percent of GDP. In 1991, theyrepresented about MZM 959 billion (about USD 668 million) out of a GDP of about MZM 1,871billion (about USD 1,304 million). The CGE/GDP ratio is much higher than the average for Sub-Saharan African (SSA) countries of the sum of overall Government consumption (about 33 percentof GDP) added to an average public investment ratio over GDP for SSA countries of about 10-13percent3. The macroeconomic importance of Govemment spending in Mozambique increasedsubstantially from the mid-1980s until now. That corresponded to the dramatic increase of extemalassistance given to Mozambique after 1986 in support of its economic reform program.20. This very high Government's expenditure figure by any standard is explained by the need tokeep providing public goods and services to the population while the country's GDP wasexperiencing a dramatic fall due to the civil war. It is also clear that due to the civil strife situationwhich has severely affected all private sector activities in the past and even now remains the majorobstacle to private-sector led economic recovery; the role of the public sector is and will remainessential during the rehabilitation and reconstruction period. This characteristic of the country wasacknowledged and integrated into its stabilization program. Because of the armed conflict, militaryexpenditures have been naturally crowding out development-oriented expenditures and representedabout 27 percent of overall Government spending in 1991. However, despite the war, theGovernment has maintained a strong commitment toward protecting social sector expenditures whichreceived about 34 percent of total Government expenditures in 1991 (of which about two thirds or 20percent went to Education and Health). Nevertheless, the absolute level of social sector expendituresremains insufficient to cope with the needs of the population. Moreover, because macroeconomicimbalances have been financed essentially by external support, and because extemal support comesusually through tied project-aid, there is an imbalance between recurrent and capital expenditures(e.g., sometimes insufficient levels of resources available for maintenance and other recurrentspending). However, this imbalance is sometimes merely a statistical bias (e.g., a misclassification ofthe true nature of the extemal assistance).21. Mozambique is now facing a new phase in its economic development: the foreseeabletransition to a "peace" economy. This is an important juncture in its process of economic reformunder the Economic. and Social Rehabilitation Program (ESRP) which stresses economic recoveryand expansion of GDP as the key objectives of the adjustment process. On the one hand the impactof the civil war is still adversely affecting the rehabilitation and recovery of the country's economyand hence, keeping it stabilized at a low-level equilibrium. On the other hand, there is already a needto prepare the economy for a post-war situation with concomitant additional -but foreseeable-burdens on public finance. Most of these are linked to the on-going process of militarydemobilization and the return of civilian refugees.22. Mozambique is facing this transition in a new intemational context4. The level of extemalfinancing which traditionally supported the country's development needs will not only have to bemaintained but will likely have to be increased in order to cope with the additional needs arisingfrom both the rehabilitation and reconstruction process (and also the demobilization and the returnof refugees). However, it is as yet undetermined whether the required amounts of additional extemal3 Source: African Development Indicators, 1992, The United Nations Development Program and the World Bank,May 1992.4 Mozambique is also facing this transition in a new domestic context. As a result of both its adjustment processand extemal shocks (e.g. the substantial decrease in foreign assistance from the former centrally plannedecononies (CPEs) of Eastern Europe and the USSR and the repatriation of about 18,000 Mozambican workers fromthe former East-Germany) the various segments of the formal economy (the Government, the parastatals, thecentraVcommercial bank, the emergency-aid economy and the defense-related economy) which enjoyed previouslya certain degree of autonomy, are progressively being forced to merge within a single consolidated economycovering the whole public sector.Mozambique - 2nd PER - Executive Summary

ixfinancing could be mobilized for Mozambique5.23. Therefore, the transition to peace has to be carried out in a difficult context of uncertaintyregarding the overall resource envelope. Both its available domestic resources (output and domesticrevenues) and the amount of additional external financing are, so far, difficult to determineaccurately. However, one assumption that one has to make is that it is likely that the global level ofexternal assistance that the country has been receiving for the last couple of years will at best bemaintained for a couple of more years before starting to decline progressively. The four challengesthat Mozambique faces in this transition to a "peace" economy are: (a) the immediate pressure forincremental public expenditures; (b) the need to improve the efficiency of public expenditures; (c)the need to continue improving public sector management; and (d), the need to continue obtainingadditional untied assistance.3.1. The immediate -ressure for incremental nublic expenditures24. The first challenge for Mozambique is to address the immediate pressures for incrementalpublic expenditures that are coming from two major areas: the unforeseen cost of demobilizing andreintegrating military personnel and refugees into a productive economic and social activity; theadditional costs caused by the drought which is affecting all Southem Africa; and, the rising demandsfor additional recurrent expenditures at a sectoral level. Therefore, Mozambique could be facing anadditional expenditure burden of about 8-10 percent of GDP in the short term before the beneficialimpact of peace could bring additional revenues. Therefore, one of the biggest challenges for theGovernment during the transition to peace is the need to raise additional revenues. Raising additionalrevenues is an essential factor to make the expenditures program more flexible. Those additionalrevenues would have to come from both an increase in extemal assistance and an improvement in theefficiency of the present system. In what regards the variables that are under the direct control of theMozambican Govemment, any increase in revenue collection will have to come from the present taxsystem and the improvement in counterpart funds collection. Under the present circumstances thelatter is the major determinant, but not the only one, of any significant growth in sectoral expenditureprograms. However, improvement in the efficiency of the present system can also bring substantialbenefits.a) The additional burden25. The cost of demobilization and reintegration of military personnel. The Govenmmentinitiated in 1990 the demobilization of its armed forces6. Peace will require immediate additionalexpenditures resulting from the demobilization of part of the military and the reintegration of civilianrefugees into an economic activity. These costs will be substantial but they will also trigger therecovery of economic activity in the Provinces. In that sense, they are likely to be one of the mostprofitable investments for longer-term development. The Government has issued a study on the costof a first phase of demobilizing the military which estimates the cost of this first phase to be aboutMZM 114 billion between November 1991 and December 1992 (6 percent of the 1991 GDP, of5 The donors pledges for 1992 in the December 1991 Consultative Group Meeting showed an increase from a total(including food-aid, debt cancellation and debt rescheduling) of USD 1,071 million in 1991 up to a total of USD1,151 million for 1992. That represented an increase of 75 percent in USD terms. At that time, without a cease-fire, it seemed likely that the total extemal assistance to Mozambique was about to reach or was very close to an"implicit" ceiling or an upper limitL Peace adds a new dimension to this process where donors' pledges couldincrease given the needs during the reconstruction period. A lot will depend on the outcome of the presentpolitical negotiations emerging after the Peace Agreement signed between the President of the Republic and theleader of RENAMO.6 Starting in 1987, the withdrawal of Eastern European and Soviet military assistance --only partly recorded in theOGE-- forced the Government to use domestic resources to fund a substantial amount of previously externally-funded military expenditures. In that respect, the Government is working with the donors on a temporary externalsupport for the demobilization of the military.Mozambique - 2nd PER - Execunve Summary

xwhich about 1 percent is domestic and about 5 percent requires external financing)7. The studyshould be the basis to further work on quantifying all costs and benefits of the process beyond thefirst phase: the additional charges of the demobilization; its potential savings; its longer-term impacton the economy; etc.26. The cost of reintegrating the civilian refugees is likely the most difficult item to assess. Itsimpact on public finance, however, is certainly very important. The Government is planning toaddress the issue in its National Reconstruction Plan. About 4 to 5 million Mozambicans can beconsidered either refugees or displaced persons.27. Estimating the additional requirements due to the drought. The emergency alert issued onMarch 12, 1992, includes preliminary estimates of food aid requirements for the 1992/93 year (May1992-April 1993) taking into account the impact of the drought. It is estimated that 1.2 million tonsof food aid (358,000 tons for relief distribution) were appealed for, compared to the 976,800 tonsthat were requested at the 1991 consultative group meeting (CG) (234,000 tons for relief). Thisimplies an additional amount of about 250,000 tons over the 1991 appeal. This assumes a 50%reduction in domestic output and the same level of commercial food imports as in the previous year(both of which account for a small proportion of total requirements). The number of beneficiarieseligible for food relief is estimated to increase by I million to 2.8 million compared to the 1991appeal.28. The rising demands for more recurrent expenditures at a sectoral level. In many sectors(Water Supply, Roads, Health, Education) the levels of recurrent expenditures available through theGeneral State Budget, "Orgamento Geral do Estado," (OGE) and/or the PTIP are insufficient tomaintain the existing stock of capital and/or to achieve reasonable objectives of each sector's strategy.Demands coming from the sectors are clearly incompatible with the overall envelope. However, inthe transitional period where priority will be given to the reintegration of refugees and militarypersonnel, the availability of recurrent expenditures will be a critical variable for the success of thedemobilization/reintegration program.29. Therefore, it will be necessary to start shifting and/or redeploying public expenditures tofinance additional recurrent expenditures at a sectoral level. It could be assumed that thereclassification exercise provides an estimate of the "real" level of recurrent spending at present: aboutMZM 61 billion of the Capital budget (3 percent of GDP in 1991) are in fact recurrent expendituresclassified in the investment budget bringing total recurrent spending to about 28.5 percent of GDP.Now, it could be assumed that most of the refugees population is not benefiting from any assistancecoming out of the Government's budget. If, in addition, one assumes that the reintegration of civilianrefugees and military (about one to two tenths of the total population) means that public expenditureswill have also to cover this new segment of the population (even at its present low level of service),that would obviously mean an increase in expenditures of about the same ratio (10 percent or about 3percent of GDP). Of course, redeployment and/or efficiency gains may occur. However, aconservative estimate is that the pressure for additional recurrent spending in the social sectors couldrepresent for the transitional period about 2-3 percent of GDP (about 10 percent of total recurrentexpenditures in 1991).b) The potential for additional revenues30. The impact of the above mentioned expenditure items is expected to be reflected in 1992 andbeyond. The Govemment will need to assess how much could be mobilized from extemal sources(e.g., inter alia, in the collection of counterpart funds where further steps need to be taken both byGovernment and donors to ensure sustainability of the progress made) and how much could bemobilized from improvements in the collection of domestic revenues (tax and non-tax).31. Additional revenues from improvements in the collection of counterpart funds. Counterpartfunds are defined as the local currency value foreign assistance, excluding Government project7 See Republic of Mozambigue. A Demobilization and Reintegration Program for Mozambican miliuuy personnel(First Phase, 1991-1992), Maputo October 1991.Mozambique - 2nd PER - Executive Summary

xlfinancing and emergency aid. They are, on the Government revenue side, essentially a mirrorreflection of the external assistance received by Mozambique. These funds are a major source ofrevenue to the Treasury, and have a direct impact on the level of public expenditures, and onGovernment repayment to the banking system. The generation of counterpart funds depends on thenon-government sector's capacity to absorb foreign assistance and the efficiency of domestic creditmarkets. Given the substantial amount of extemal aid received by Mozambique, not only in absoluteterms (USD 650 million in 1991) but also relative to the size of the economy (50 percent of GDP),the management of counterpart funds has significant implications for macroeconomic policy.Problems in collecting and recording counterpart funds are the result of inefficient practicesinvolving both the Govemment and the donors. Remedies to that situation will constitute a challengefor both the donors and the Govemment.32. In terms of the accounting of counterpart funds, the following results were obtained: the localcurrency value of the counterpart funds that could have been generated in 1991 was MZM 445billion. Of this total, MZM 335 billion were recorded (75 percent). One interpretation is that part ofthe unpaid counterpart funds were transferred to the non-Government sector in a variety of ways,such as, through the issuing of promissory notes (PNs) by some of the recipient companies or simplyas implicit subsidies provided primarily in the form of unrecorded counterpart funds. In order tomeet the ambitious targets in counterpart fund collection, it is important that the recording system ofcounterpart funds be improved.Table 2 MOZAMBIOUE - Summary table on counterpart funds (1990-91)In MZM Billion and Percentages(Source: Chapter Ell)1990 1991 1990 1991Tot. Official Grants (A) 226.3 397.0Tot. Disbursements (B) 191.8 176.4Tot (A)+(B) 418.1 573.4Potential CPF 350.0 445.0 100.0 % 100.0 %Unrecorded 78.8 110.0 22.5 % 24.7 %Recorded 271.3 335.0 77.5 % 75.3 %Awaiting Collection 90.0 94.0 25.7 % 21.1 %Prom. Notes 83.0 94.0 23.7 % 21.1 %Collected 181.2 241.0 51.8 % 54.2 %33. Since 1990, the Government has taken a number of positive steps aimed at improvingtransparency, accountability and efficiency in the management of counterpart funds (e.g.,discontinuing the acceptance of promissory notes as a means of payment). With the improvement inthe recording system, a reasonable assumption would be that a proportion of counterpart fundssubject to delayed payment agreements could be available to increase public expenditures. Thisproportion would consist of promissory notes maturing in 1991 (the promissory notes issued in 1990and maturing in 1991 represent about MZM 35 billion or about 2 percent of GDP in 1991).However, this could have other implications: first, on the credit ceilings established under the presentreform program (if the banking sector has to refinance the promissory notes issued by theimporters); and/or second, on the financial viability of importers (if repayments can not be donethrough the banking system).34. Additional revenues from improving tax collection. Improvements in the present tax systemcould also bring additional revenue. It is necessary to strengthen inspection and collection of taxesMozambique - 2nd PER - Executive Summary

xiiboth in terms of personnel and procedures. Data from the Ministry of Finance8 indicate for 1990that the collection of income tax amounted to about MZM 9 billion (about 10 percent of the taxableincome and 0.5 percent of the 1991 GDP). Studies should be conducted, aimed at identifyingmeasures that can be adopted to reduce the erosion of tax revenue by inflation. It is possible thatimprovements in the income tax system could increase the coverage of tax collection and extend it toMozambicans working for specific intemational organizations and to some of foreigners who arepermanent residents9. Based on an estimate of the size of wage payments related to externally-provided technical assistance (about MZM 90 to 100 billion in 1991), a progressive scheduleapplying to the relevant taxable individuals (depending on specific conditions applied by donors)could possibly bring another MZM 9-10 billion on top of the present income tax revenues (0.5percent of GDP in 1991). As explained in the Public Sector Pay and Employment Review, this willneed to be discussed between the Government and the donor community.3.2 The need to iMnrove the efficienCv of Public ependitures35. The second challenge that Mozambique is facing in its transition to peace concems thecontinuing improvement in the efficiency of public expenditures (i.e., identifying sound publicexpenditure programs producing the highest sustainable growth pattem at the lowest cost for publicfinance). The efficiency of public expenditures in Mozambique depends on three factors, oneendogenous and two exogenous: (i) continued improvement in public sector management tools (seebelow); (ii) better donor coordination (including the untying of external assistance as explainedbelow); and (iii) the end of the civil war and the consequent "peace dividends".36. One, if not the major, problem in public resource allocation in Mozambique is the limitedamount of recurrent expenditures vis-a-vis the existing stock of capital that has to be maintained orrehabilitated. The segmented nature of the economy, donors' independence vis-a-vis centralinvestment guidelines and the lack of reliable communications between the Provinces and the centralGovernment had compounded the problem: scarce resources for recurrent expenditures have beenspread across sectors. Though keeping a relatively adequate cross-sectoral structure (in percentualterms), the result is that the levels of actual recurrent expenditures are grossly inadequate to maintainthe existing facilities or fulfill the requirements of the sectors' development strategies.37. Mozambique needs to deepen the PTIP exercise in order to prepare public expenditurescenarios with areas of emphasis where efficiency gains can be achieved. In particular, that wouldrequire:a) Selecting more focused public expenditure policies in sectors where scatteredallocation does not allow the implementation of a sustainable and coherent sectoral policy(for example; in Agriculture, continuing the policy of reducing expenditures for large-scaleirrigation schemes; in Education, focusing public expenditures on the priority sub-sectorssuch as Primary Education; in Transportation, modifying the intra-sectoral profile of publicexpenditures by reducing the portion of public investment on rail-port corridors).b) Programming operating/maintenance expenditures more realistically and integratingthem into the budget (OGE). The planning and programming phases of both the PTIP andthe OGE could start with the assessment of the sectoral recurrent needs before identifying thesectoral investment ceilings and new projects (for example, in the water and roads sectors,resources for maintenance were considered extremely low as compared to the investmentportfolio). This would require strengthening the dialogue between the Ministry of Finance,the National Planning Commission (CNP) and the sectoral ministries. In particular,,continuing the work in progress to identify the share of recurrent expenditures financed8 Source: Direcao Nacional de *Ipostos e Auditoria Ministry of Finance, August 1990.9 As explained in Public Sector Pay and Emplovment Review, The World Bank, Report No. 9815-MOZ, December1991, p. 50.Mozambique - 2nd PER - Executve Summary

xiiithrough the investment budget is essential.c) Reducing expenditures in non-development sectors (like defense-related activities) tothe extent possible. The demobilization process (which will require in the short termadditional resources) is a good example of expenditure cuts that will increase availableresources for development-oriented activities in the medium-long term.d) Reducing inefficient public sector commercial operations, either throughrestructuring, privatization or associations and joint-ventures with private entrepreneurs (forexample, the leasing-arrangements that can be put in place for both the maintenance of theroad network and the Maputo rail-port corridor).3.3 The need to continue imDroving Public Sector Management38. Despite substantial progress in the area of public sector financial management, the mostimportant tool to implement and monitor stabilization policies and/or to undertake expansionaryreconstruction policies, the Government's budget - OGE, still suffers from weaknesses. The majorproblem arises from the still weak integration between the OGE and the donor-driven investmentbudget. The PTlP, in particular, lacks information on implementation rates of donors investmentprojects, thus posing serious problems. As a result, it is difficult to confirm early if a budgetaryexercise has been restrictive or expansionary (the poor quality of monetary statistics also compoundthe problem). Therefore, the third challenge for the transition is to continue improving theperformance of public sector management. This will have to address the following areas: improvingthe quality of data and National Accounts; improving the presentation of consolidated public sectoraccounts; linking financial sector reform with the public expenditure financial problems; and,continuing the improvement of both the planning / programming and monitoring / execution phasesof the Government's budget .39. Monitoring the economy through improving the quality of data and National Accounts. Itis important that Mozambique enters peacetime with the statistical instruments it needs to make betterassessments of the effects of economic reforms program on the real economy. Consequently, thequality of basic statistical data such as the National Accounts should be improved. Since there is agreat deal of uncertainty, it is very difficult to assess the margins of errors in the estimates of somekey aggregates that are crucial for the monitoring of the program (for example, GDP)10.40. Improving the presentation of the consolidated public sector accounts. Improving theconsolidated public sector accounts, means, inter alia. the inclusion of public non-Government creditsand debits into a comprehensive financial picture of the whole public sector. The normalizationand/or liquidation of financial debits between the Treasury, the rest of the public sector (essentiallythe parastatals) and the Central Bank ought to be encouraged as an essential part of the reformprocess. Also, the success of the privatization program depends on restoring the financial viability ofthe banking system; the clearing of non-perforning debt of the parastatals depends on an accurateprogramming of the needed financial cash flows; and the overall budgetary programming relies onan assessment of the stock of domestic public debt.41. The central feature of this clearing and cleaning process revolves around determining the netcreditor/debtor position of the public sector for each individual actor and as a whole (the Treasury,the Central Bank and the parastatals). To make matters more complicated, the crucial issue is toassess the amount of credit/subsidies that have been generated by the release of extemal financial10 The basic data used to calculate output are sectoral production data. However, there is no information on importanttechnical coefficients (for example, the relationship between value added and value of output) and only limitedinformation on the services sector. Therefore the estimate of GDP is constructed from the aggregation ofexpenditures but the assumptions on the size of informal agricultural private consumption, private investment,etc., play a decisive role without any possibility of cross-checking their accuracy. Given the importance of GDPas the denominator of most of the indicators for the present reform program, it is critical to improve its statisticalaccuracy.Ifozambique - 2nd PER - Execunve Summary

xivassistance to Mozambique (the counterpart funds, see Chapter III). Indeed, a balanced extemalaccount can correspond to a variety of intemal situations in terms of the stocks and flows ofcounterpart fundsll. There are important sequencing issues (like the relation between reforming thefinancial sector, separating the two wings of the Banco de Mocarnbique, preparing the privatization ofparastatals, writing off past debts, etc..) that will have to be related to the targets set by a monetarypolicy for the transition period.42. Financial reform and public expenditures. The cleaning of accounts may not be enough tobuild the required instruments for sound macroeconomic policy in Mozambique. Although it isimportant to acknowledge that the reform program has succeeded in reducing direct Central Bankfunding to finance the Government's deficit, it could be argued that the present strategy may not bestrong enough to avoid future losses in the banking system. A sanitized central bank balance sheetwill certainly help to better monitor the reform process, as well as strengthen the country's financialinfrastructure (banking legislation, supervision, training capabilities, etc.). The question is whetherthat infrastructure is enough to control the leakages from the banking system, especially those thatare likely to appear during the transition period to peacei2.43. During the transition period, it is very likely that whatever progress is made in separating thecommercial and central bank wings of the Banco de Mogambique (BDM), and despite improvementsin credit allocation, the banking sector will be facing high risk lending demands and potentialmounting losses. Almost none of the enterprises have sufficient equity or stable business profits to becreditworthy by commercial standards. There is probably no altemative to high risk lending fromthe banks for the transition because the prospects for a recovery of the economy in the medium termcan be judged acceptable. However, this should be acknowledged and dealt with openly, becausethe future responsibility of high risk lending in the banking system will eventually fall on theGovernment and will have an impact on fiscal policies. A number of possible solutions exist rangingfrom open subsidies to privatization of enterprises and new entries of banks into the new bankingsystem that go beyond the scope of this exercise. However, irrespective of the mix of solutions, bankswill have to move toward greater transparency, accountability and when needed, a transparentinvolvement of the Treasury during the transition period.44. Improvements in the efficiency of public expenditure programs needs to be accompanied bymaking the monitoring, planning and budgeting procedures more comprehensive and expeditious.Donors perceived improvements in public sector financial management as a critical condition inorder to increase the amount of untied external assistance to Mozambique. The donor communitywould not be prepared to accept major shifts in the structure of aid unless it can be assured that theinflows of external financing be spent on properly defined development objectives and in atransparent manner. This will require, inter alia:a) Monitoring and controlling the execution of the budget with a more detailedbreakdown of budget items. As it was mentioned, presently only global items like "Salaries"or "Material and Supplies" can be controlled. A more detailed breakdown would allow the11 Besides the accounting problems related to the counterpart funds, the assumption that the non-Government sectorcan absorb external concessional aid on a sound commercial basis may need to be revisited. The existence of aquasi net lending by the Treasury (through the promissory notes and/or through the Special Funds, "Fundos deFomento") to non-Government sectors (e.g., the parastatals) can be considered net credit creation outside of thebanking system (there is apparently no record of such transactions in the consolidated balance sheet of thefmnancial sector). This illustrates that most of the potential recipients of external concessional aid are unable toborrow on commercial terms. More worrisome, the capacity of these borrowers to repay the Treasury is in somecases doubtful. This obviously affects the fiscal accounts (revenues) although, overall, the external account isbalanced.12 Following the recent experiences in reforming centrally planned economies, there is growing skepticism that thestandard strategy of passing a new banking law, training Central Bank staff to perform bank supervision, andinstruct commercial banks to stop losing money can contain losses in highly distorted economies. There are tworeasons why bank supervision is not robust enough: (i) the lag between granting a loan and when the loan fallsinto arrears; and (ii) bank supervision is a highly politicized process: bank supervisors usually do not closebanks. Evidence from developed countries are plentiful.Mozambique - 2nd PER - Execuuve Summary

xvBudget Directorate to analyze actual resource allocation linking sectoral developmentobjectives with expenditure programs.b) Improving the disbursement and controlling procedures at the Central Bank given thecomplexity and the number of different procedures required by donors.c) Integrating into the area of budget execution the information on execution ofinvestment financed by extemal sources (that information is now only partly available and isunder the responsibility of the donor community). This task was partially started in October1991 and efforts should be made to continue the work and make the appropriate resultsavailable to both the CNP and the Ministry of Finance (MOF). It is of the utmost importancethat the donor community shares with the Mozambicans its information on the execution ofits projects so that the Government can have a clear and complete picture of budget executionas a whole 13.d) Improving the management of the public debt which could be put under a singleagency outside the BDM. In addition, computerizing procedures and strengthening of thestaff are important since public debt management needs a dynamic "on-line" process forexamining and controlling the cash position, the volume and the timetable of public debtservice flows at any moment.d) Programming the financial execution of the Budget. Together with a furtherdisaggregation of Government's expenditures, it is recommended that each budgetary unitpresent to the MOF proposals for timetable / schedule of payments of endowments. The MOFshould hence be able to control the programming of the financial execution of the OGE andthus formulate the guidelines and directives for sectoral schedules of payments, limits forperiodical withdrawals from the Treasury's accounts and the required level of general cashflow.3.4 The need to continue obtaining untied external assistance.45. The fourth and last challenge for Mozambique relates to the continuation of donors' effortsto increase the proportion of untied external financial assistancel4. This will accompany theimprovements in public sector management and would represent an important incentive aiming atenhancing the efficiency of expenditures. In practice, this would mean a gradual shift, that would belinked to progress made on the public sector's management capabilities, from a relatively tied project-aid assistance to a more untied program-aid assistance or, in other words, from an assistance directedprimarily to the investment budget to one directed to both the recurrent ad the investment budgets.For example, the analytical work that estimated the size of recurrent expenditures included in theinvestment budget is a first step for identifying the areas where the donor community has beenactually financial recurrent expenditures. This analytical exercise should now evolve toward practical13 The CNP will be working in this direction with the UNDP and the donor coordination groups to prepare a commondata sheet on financial and physical implementation of the projects; this is a fundamental piece of information forevaluating the progress made and the level of real investment in social and productive sectors. The World Bankwill continue urging the information exchange process to become a priority for the donor community.14 In tha respect, the Tokyo Special Program Services (SPA) initiative on Public Expenditure Reviews also supportsand addresses this issue. It could be assumed that efficiency gains in public expenditures in Mozambique is relatedwith the relation between tied to untied external financing. The argument revolves mainly around the fact that afixed or tied allocation of external assistance may adversely affect development-oriented policies because of therapidly changing circumstances driving the demand for foreign exchange and imported goods in a still war-devastated economy. When demand shifts considerably because of exogenous factors, it could becounterproductive to maintain a too tied supply of foreign assistance. Obviously, some degree of tied assistancecan help the Government in better controlling the mobilization and utilization of external financing. However,there could be a trade-off between the growth performance of the economy and the characteristics of externalfinancing.Mozambique - 2nd PER - Executive Summary

xvisolutions allowing a reclassification of expenditures and an untying of a share of extemal assistance.Another example is the possible untying of a share of foreign technical assistance (linked toprojects) and its shift to support the needed pay raises of higher level, skilled, public sectortechnicians (through a special salary fund instead of topping up salaries on a non-transparentmanner).4. The improvements in sectoralpolicies46. By strengthening macroeconomic management tools Mozambique can aim at facilitating theimprovements of sectoral policies. Sectoral policies will aim essentially at the rehabilitation andreconstruction of the human and physical infrastructure of Mozambique. However, peace also meansthat progress in sectoral strategy will also imply revisiting some of the implicit sectoral strategieselaborated during the civil war and insecurity period. Peace indeed changes a number ofassumptions that were used by both the donors and the Government to build the past publicinvestment program.47. Sectors could be divided into two broad categories: first, sectors which are providers ofservices and inputs; and second, productive sectors. The ideal situation (see Figure 1 below) is onewhere the productive sectors are restored into a high growth pattern as quickly as possible with thehelp of external assistance and domestic budgetary resources. High growth, in turn, increasesdomestically produced resources and impacts favorably the Government's budget. That, finally,allows a progressive reduction of the levels of extemal assistance. The critical issues here are,therefore, (i) to find the proper mix of external assistance/domestic resources and (ii) to find theproper sequencing between jump-starting the reconstruction process with heavy investments on theservice sectors and the accompanying public expenditures in the productive sectors. Furthermore,realistically, there will be a time lag between the supply response of the productive sectors and theinjection of resources into the economy either in the service or the productive sectors. Thoseresources will have to be injected into botih the productive d the service-provider sectors because oftechnical linkages (e.g., between increasing agricultural output and the availability of transportationand infrastructure).FIGURE 1:SERVICE PRODUCTPSESECTORS SECT'ORSSOCIL4,SECTORS AGRICULT.i ENERGY *FSHERIE TELECOM.EXTERNAL .GVRNMENTASSISTANCE BUDGET Mozambique - 2nd PER - Execudve Summuary

In 1991 SOCIAL SECTORS AGRICULTURE TRANSPORT & IND. & ENERGY TOTLNon-Reclassified Expenditures INFRASTRUCT.EDUCAT. HEALTI TOTAL AGRIC FISHER. TOTAL TRANSP. WATER TOTAL INDUST. ENERGY TOTAL .: VALUE-ADDED In MZM Blillon 712.5 72.1 784.6 181.6 251.7 433.3 355.5 8.6 364.1 I>.in USD MiUion 496.5 50.3 546.8 126.6 175A 302.0 247.7 6.0 253.7 i ... :Percent of GDP 373 3.8 41.1 9.5 13.2 22.7 18.6 0.5 19.1 X 9 Growth Rate 1990 1.1 0.5 -9.7PUBLIC EXPENDITURESRECURRENT In MZM Billion 63.3 29.8 93.1 8.7 0.8 9.5 29.8 7.3 37.1 1.7 1.4 3.1 142.in USD Million 44.1 20.8 64.9 6.1 0.6 6.6 20.8 5.1 25.8 1.2 0.9 2.2 D .BPercent of GDP 3.3 1.6 4.9 0.5 0.0 0.5 1.6 0.4 1.9 0.1 0.1 0.2 7.5Percent of Total Public Expenditures 64.8 563 61.8 9.7 7.9 9.5 56.3 6.8 23.3 6.9 3.5 4.9 $4;; 3INVESTMENT In MZM Billion 34.4 23.2 57.6 80.7 9.6 90.3 23.2 99.1 122.3 23A 36.9 60.3 3.4 ;in USD Million 24.0 16.1 40.1 56.2 6.7 62.9 16.1 69.1 85.2 16.3 25.7 42.0 230;2 :.Percent of GDP 1.8 1.2 3.0 4.2 0.5 4.7 1.2 5.2 6A 1.2 1.9 3.2 .. 3 xPercent of Total Public Expenditures 0.4 43.7 38.2 90.3 92.1 90.5 43.7 93.2 76.7 93.1 96.5 95.1 69TOTAL In MZM Billion 97.7 53.0 150.7 89A 10.4 99.8 53.0 106.4 159.3 25.1 38.3 634 :73.2 X0in USD Million 68.1 36.9 105.0 623 7.2 69.5 36.9 74.1 111.0 17.5 26.7 44.2 ;2 9.Percent of GDP 5.1 2.8 7.9 4.7 0.5 5.2 2.8 5.6 8.3 1.3 2.0 3.3 -Percent of Total Public Expenditures 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 D0 _;MAJOR SECTORAL PROBLEMS Destruction of schools and Security situation during the The security situation & des Due to the circumstances at S_health centers in the rural war period and emphasis on tructions by the war; lack of Independence. State inter-areas due to the civil war. unsustainable capital-inten- managers; lack of resources vention and heavy invest.Increasing demand due to sive projects. Donor-driven for maintenance. Sabotage of power plants & 0population growth while investment program and lac Uncertainty on future levels lines during the war.resources are stagnant. of coordination. and structure of demand noo Disruption of producL duethat there is Peace. to lack of foreign exchange .SECTORAL STRATEGY Improve formulation of full Shift from large-scale agric. Reduce weight of rail- Reliance on private sector & ;Xsectoral strategy. Promote to increased emphasis to the corridors on sectoral invest. small-scale enterprisesthe expansion of primary family-sector Agric. Provi- Linkage of strategy with Rehabilitation of Cahora f'education and also increase sion of services and price news needs in productive Bassa. Privatization but 2the number of university incentives to producers Lin- sectors and new patterns need to restructure & cleangraduates up to a minimum kage is needed with Infras of demand. accounts before 0_level to run the civil service rehabiliL and Teconstruction 2iMAIN RECOMMENDATIONS Raise addidonal resources Reintegration of refugees Capacity building, training Continue policy reforms to Cfrom sub-national Govemts. and milit personnel should Restructure parastatals improve business environt. .and targeted cost recovery not be forgot. Develop joint Improve full Cost reCovery Transparent subsidies fromExtemal assistance to be ventures for State-farms to Drought relief needed for Budget if needed duringredirected towards recurrent be privatized. Heavy infras water invest. Infras. invest. transition, discontinue allexpenditures invest. may be needed & critical to commercializatio non-banking Credit creationcoordination with transport. in Ag. and refugees reinteg. ._i:____

xviii4.1 Social Sectors (Education and Health)48. Following Independence in 1975, high priority was assigned to social services, particularlyhealth and education. In addressing poverty alleviation, the Government committed itself to theestablishment of an expenditure program with emphasis on the social sectors.15 The newGovernment embarked on a massive program of expansion of social services with an emphasis onprimary education, adult literacy and primary health care. However, the combined effects ofmacroeconomic mismanagement (thereby reducing real resources available to the social sectors),population growth (augmenting service demand) and widespread destruction and disruption broughtabout by the war, have led to a substantial decline in service delivery capability and jeopardized itssustainability. Nevertheless, the Government is making encouraging progress in implementing aneconomic program that provides a promising basis for future development.49. In the past few years, Government has re-asserted its strong commitment to the social sectorsby placing increasing emphasis on poverty alleviation as a central feature of its economic recoveryefforts, symbolized by the re-characterization of the ERP as the Economic and Social RehabilitationProgram (ESRP). Within this context, and in recognition of the appalling living conditions enduredby about two thirds of the population, the Government is now more strongly committed to improvingsocial sector services, including education and health. In addition, realizing that the process ofstabilization and structural adjustment could lead to further hardships for already-vulnerablepopulation groups in the near future, the Government is attempting to systematize a safety net oftransfers and services to the poorest households. The Government has assured that, within acomprehensive public expenditure program, poverty alleviation interventions in the social sectors willbe given full priority status.50. Since the early 1980s and until 1987, Mozambique experienced a sharp decline on healthand education expenditures. As a percentage of total, government expenditures for the two sectorsfell from about 19% in 1980 to 8% in 1987, but rebounded to 15% in 1990. In constant 1980prices, per capita government expenditure on education and health that had reached 410 MZM in1981 dropped to 180 MZM in 1987 before rising to an estimated 276 MZM in 1990. The users didnot bear the entire burden of this decline, though, as real wages in the two sectors fell steeply duringthis period. And the decline would have been even more dramatic if donors' contributions had notincreased to partially offset the fall in intemally-fuhded government expenditures. Contracting realwages and reliance on donors' contribut