Report No. 12066-NI

NicaraguaCountry Economic MemorandumFebruary 2, 1994

Country Operation Division IICountry Department IILatin America and The Carribean Region

FOR OFFiCIAL USE ONLY

M4ICROGRAPHICS

Report No: 12066 NIType ECO

Document of the World Bank

This document has a restricted distribution and may be used by recipients onlyin the performance of their official duties. Its contents may not otherwise bedisclosed without World Bank authorization

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COUTRY DATA - NICAAA"

............ ......................... __....._._..... _............... _........_.__................

GeneralAren (Thousands w ) 130.0Population (Cillion) 4.1

Growth Race (latest deade) 3.3Denity (per Ka?) 31.6

Sociat IrdicatorsPopulation Characteristics

Crude Blrth Rate (per 1,000) 38.6Cnud &eth Rate (per 1.000) 6.4

NealthInfant Mortaity (per 1,000 live births) 66.0Population per Physician 1.564.5Population per Nospital led 517.2

Incrm DOstributifn CS of ational Incom)Highest Quintile 65.0Lowest Quintilo 3.0

Access to Slfe WaterX of Urban Population 21.0X of Rural Population 76.0

Access to ElecttricityX of lotat Population 40.9

NutritionPer Capita Calorie Intak (per day) 2,265.0Per Capita Protein Intaes (glday) S4.6

EducationAcklt Literacy tate VS) P0Prifmry Sdhool Enrollmnt 76.0(% of reltvant ag grow)

.. ._______._..............._._^.......__.__._._._.............................. _ _ _. _................

I This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwise be disclosed without Word Bank authoriation.

CONTItY DATA -!'q?AGIA

oroe NatiOaml Proac1t(1992)....... _",_....... _............................._....................

Amut Growth Rate 1X p.a.. conwtant Prices).. .... _... . .. . . .. . ._,_. . .. .

USSR X of GNP 1980-85 1985-90 1991 1992,,....,,.....,,__...............,,..,............. ,0..... .. _,........ ..... ..................

G1P at narkst Price 1.197 100.0 1.0 -4.1 -16.5 -2.1Gross Domistic Investmmnt 330 7.6 70.1 -10.3 10.7 -6.8Gross National Sev Ms (763) -43.8Current Accouat Balance (646) -54.0Export of Goods and IFS 310 25.9 -9.9 3.0 -16.4 18.5import of Goods nd IFS 956 79.9 11.0 -3.1 14.0 6.2

Output, Eaplo).ueni, nd Productivity(1992)..... ........ ___._......... __.........................._..................

Vatue Added Lab Force V.A. per Vorker.................... ................................. .................... ...................... ..........

USsR X of Total Thw. S of Total USS X of Averae............................... .....................................

Agriculture S08 30.3 605 U.6 s4o 5.0Indstry 347 20.7 205 15.8 1,691 130.9Services 824 49.1 489 37.6 1.685 130.4

Total / Average 1,69 100.0 1,299 100.0 1.292 100.0

Govnment Finance................................ ...................................................................... ... _.

General Sovrenuet tontral Governrent............ ...........................____ ............. ................... ...................................... _

COm X of CDP CO X of GOP....... ............. __..... ....... ............. ....... ............... ............

1992 1987 1992 1992 1987.................... ............................................. ____.__.......... _....._....._..

Cwent Receipts 2,35T 28.1 29.4 1.80 22.4 27.7Current Exenditu 2,358 28.1 40.9 2,041 24.3 39.7

Current Surptu (1) 0.0 11.4 (161) -1.9 .12.1Capital E editure 611 7.3 4.8 567 6.8 4.7,......................................._.. ........................

COWT DATA - UICAAU

Money, Credit and Prices... ......................... e. .. .....f . .....................

1987 19l8 1989 1990 1991 1992............... ................................. .... ....... .......... ............. .. ....

(Ni Iion of U owtetading, en of parfod),,,,,,,, ,,. ,,... ..... _.. ....................... ................................................. _,__....... ............

11ny wply 1,454 171 3,600 229,192 721 839Bank Credit to Pubic Sector 347 62 2.13s 770,100 1.117 S07

ank Credit to Privat* Setor 1032 200 7.174 1.1U,261 2,816 2.993_. _...... _.....____._. .................. ............. .................

(Pertentag or 1Idex )n )............ .......................... - .---

Moy as I of CDP 53.9 54.0 23.9 19.2 10.4 10.0CG eral Price Indei M199zlOON) 0 2 100 7.585 215,j90 259,401Arlmu percentage chwope insGenerat Price Index 912 14.490 A,70 7,485 2,742 20Sank Credit to Pubtic Sector 29 17,753 3,345 35,977 608 (55)BSar Credit to Private Sector 562 19,2t4 3,483 16,46 1,056 6

aluane t- payments.. _.............................. _.___ ......................................

1987 IN 1989 1990 1991 1992.................. ........................................ _........................._....... __.. ._

(NfItUians of uSt),_____.______......................................_......................

Eport of Goods nd NFS 302 261 333 390 336 310Jlport of Goods and IFS 895 847 667 679 820 956

(of which petrolesm) 125 121 94 123 11S 121Rsoure Gap (dulicit-) (3) (566) (3) (28) (2) (6W6)

interest Paywnts (net) 208 237 205 217 430 42Other fctor Paym (nct) 0 0 0 0 0 0Not Private Tranfer 0 0 0 0 10 10

Satance n Current Aam teoul. Net OfficiltTrnUre (601) C823) (539) (S06) C902) (1,116)

Net Official Transfe 135 - 189 16 202 483 27Balance an Curent AcowiJt

incd. net OfficialTransfers (666) (634) C370) (304) (19) (841)

Dirct Privte Foreign inwestent 0 0 0 0 0 0Net JLT Uorrowfnr 90 2 (100) (169) (65) (473)Dish"bua nts 490 286 266 228 229 343Amortization 400 254 37 397 914 816

subtotal 90 2 (100) (169) (615) (473)

other Capi tal ed Capitat n.*.I. 353 647 403 275 2.346 1,322Ireae In met serves (C 23) 16 (66) C19S) 1,242 Gross Reeves (and of year) 54 61 120 81 201 225

.............................................. .*

CaUITRY DATA - NIC AA6

Nerchandlie Exports (Average 1987-92)....... .............. ,....,_ _..___._._._._.__.............................. _......................

Value~.................(Cilaloa of USS) 6f Totol

.. . . . . . . . . . . . . . . . . . . . . . . . . . .... ... ... ... ... ... ... .......... .. . .. .

coffee 73.1 26.7Cotton 3P.6 14.1Swar 22.3 8.2Seof 34.4 12.6SaWm"os 16.6 6.83hrfp aid Lobster 11.2 4.1Other Tradtionat Goods 17.5 6.4Roh TrAditional Goods 57.5 21.0

Totat 273.2 100.0

Rtate of Excdhnge

AMiwa AVnageo

1987 1988 1989 10 91 19m.................................. 0.......................................

USI.0O a COS 70.0 190.9 1S,654.6 689,618.6 4.3 5.0CO.OS a US1 0.0143 0.0052 0.0001 0.0000 0.2309 0.2000

Extenal Debt. Ogouer 31, 1992....................... ..................................................... 0- -.. -.--............. - - -...

................. . .. ........ .............................................

Puble Debt. Inc. Gurante 8S.92.6Non-Guaranteed Private Debt 0.0

Total Outstanding & Disbused 8,9u.6

met Debt Srvice Ratio for 1992................................................................................ ........................

1992........................................................... __......................

PdMic Debt, Inc. Guwantee 293.2Non-Guarateed Private Debt 0.0

otal utastnirig & ODebraed

COUMY DATA - VICMWAM

IMD/10DA Lafng (201/92)CUN).................................. ,,,",......, ,,........................ _ ... :.........

.. .. __,................. _.-....... -.-........--.... ,, ............ -.-...--.... .................................

OutstWfnd & OidSburs 103.5 186.4Undisburfd

Total Outstawdng lnci. Undisbumsd

_.__ .__ ........................................ _............_.__._._._.___..............._._._____.......____....... _..............___..___.__

NlClARAUACOUNTRY ECONOMIC MEAMOUU

TABLE OF CONTENTx

EXECUTIVE SM0....Y ......................................... i-vi

CHAPTER 1- INTRODUCTION

CHAPTER 2- RECENT MACROECONOMIC PERFIORMANCE

A. STABLIZATION PROGRAM ................................. SB. FISCAL AND MONETARY POLICY ........ .................... 8C. EXCHANGE RATE POLICY AND CONMETTVENESS .............. 10D. THE REAL SECTOR OF THE ECONOMY ...... ................. 12

Inveament adSavings .......... ...................... 12Output Gwth ...................... 13

E. SUSTAINABIITY OF STABIIZATION ........................ 14Recommendations ...................... 19

ANNEX MEDIUM TERMPERSPECTIVS ............... ....... 20

CHAPTER 3- THE ENABLING ENVIRONMENT FOR PRIVATE SECTOR-LED GROWTH

A. INTRODUCION ............... 23B. THE CURRENTPOLTCALENVIRONMENT .................... 24C. LACK OF DEFINED PROPERTY RIGHTS AND UNCERTANTY. 24D. RULES VERSUS DISCRETION AND THE BUSINESS ENVIRONMENT . 26E. LEGAL FRAMEWORK .28F. INFRASTRUCTURE .29

CHAPTER 4 - PRIVATIZATION

A. RECENT DEVELOPESNTS .31Divestment of state-owned companies held by CORNAP .31

Problems to be Addressed .33

CHAPTER 5- TRADE REFORM

A. RECENT DEVELOPMENTS ........... .............. 36B. THE NEED FOR FURTHER TRADE UBERALIZATION .38C. POLICIESFOR EXPORTPROMOTION ..... . ... 39

ExportPromotion .. 40Free Tl7rade Zone .... . . ... 40

Reommmendations ................................... 40

CHAPTER 6- TAX REFORM

A. RECENT DEVELOPMENTS . ............................... 41B. THE NEED FOR FURTHER REFORM IN THE TAX SYSTEM .... ...... 42

TheTax Burden ............. 43Tax Administration ............. 43Roimmendatios ........... .. 45

CHAPTER 7- FINANCLAL SECTOR REFORMA. RECENT DEVELOPMENTS ............ ............. 46

InterestRatePolicy ......... ................ 47ForeignExchangeControls ............................. 47Superintendency ofBanks .............................. 47State-ownedBanks .................................. 48PrivateBanks ...................................... 49Informal Fiancial Sector .............................. 50

B. FURTHERFINANCLALSECk7ORREFORMS ..................... 51The Central Bank and Credit Policy ........................ 51StateBanks . ..................................... 52Recommendations ................................... 53

CHAPTER 8- AGRICULTURE: THE KEY TO GROWTH

A. THESUPPLYRESPONSE OF THE AGRICULTURAL SECTOR ......... 54B. AGRICULTURAL CREDT ....... 5.......................... 5

CHAPTER 9 - THE LABOR UARMER

A. EMPLOYMENT, UNEMPLOYMENT AND UNDEREMPLOYMENT TRENDS 59B. REAL WAGES AND PRODUCTIVITY .......................... 60C. THE INFORMAL SECTOR ............... .................. 63D. UNIONS, COLLECTIVE BARGAINING AND THE LABOR CODE ... 65E. THELABOR CODE .................. .................... 68F. WAGE INDEXATION AND THE "CANASTA BASICA" ...... ........ 68

Payroll Taxes .... .................................. 70G. RECOMMENDATIONS .................................... 70

TABLES - BOXES:

CHAPTER 1- INTRODUCTION

TABLEl.l PastPerformance ......................................... 2

BOX '.1 QualityofData .......................................... 4

CHAPTER 2 -RECENT MACROECONOMIC PERFORMANCE

TABLE2.1 CHARACTERISTICS OZIHE PROGRAM ....... .................. 6TABLE 2.2 NICARAGUA -C,nsolidated Operations

of the Nonfinncal Public Seor, 1985-92 ....... .................. 9TABLE 2.3 Terms of Trade, Pris and Exchange Rate ........................ 11TABLE 2.4 Savings, Investment and Production ........................ * .... 13TABLE 2.5 Outstanding External Debt .............. .................... 16TABLE 2.6 NICARAGUA - Balance of Pfyments, 1988-92 ...... ............... 18ANNEX MEDIUM TERM PERSPEC7LWES ............................. 22

BOX 2.1 Dependence on aid ....................................... 17

CHAPTER 4 - PRIVATIZATION

TABLE 4.1 Participation of CORNAP'S Enterprises in Sectoral GDP . .............. 32

BOX 4.1 Composition of CORNAP when created .......................... 34

CHAPTERS - TRADE REFORM

TABLE 5.1 AVERAGE NOMPlIAL PROTECTION .......................... 37

CHAPTER 7 - FINANCIAL SECTOR REFORMTABLE 7.1 Nicaragua Banking Sector-Market Shares ......................... 49TABLE 7.2 NicaraguaBnking Secor Indicators ............................ 50

CHAPTER 8 - AGRICULTURE: THE KEY TO GROWTH

TABLE 8.1 Nicaragua: Evolution of the Main Crop Yields ...................... 55TABLE 8.2 Nicagua: Evolution of the Harvested Area

of Exportable and Basic Products .............................. 56

BOX 8.1 How BND's Credik Operates ......... ........................ 58

CHAPTER 9- TBE LAOR UMRKET

TABLE 9.1 Labor Force and Unemployment in Nicaragua ....................... 60TABLE 9.2 Labor Force and Unemployment in Managua ....................... 60TABLE 9.3 Evolution of the Urban Informal Sector .......................... 63TABLE 9.4 Average Labor Income in the Formal and Informal Sector .... ........... 64TABLE 9.5 New Unions and Workers Registered by Central Union 1990-1991 ......... 66

TABLE 9.6 Structure of Expenditure of Families ............................ 69

Figrel AverageReal d DollarWage .......................... 1..... 61BOX 9.1 Collective Agreements' Additional Benefits ....... ................. 67

Data Annex

EXECl=E SMaalx

1. The purpose of this report is to identify the main issues inhibiting private-sector-led, sustainedgrowth in Nicaragua and to suggest ways in which they might be addressed. Recent economicdevelopments are reviewed in the light of the Governmenet's efforts towards stabiliziion and strucralreform. The report analyzes in detail the factors that deter private sector development arising fromeconomic policies, implemeaion, institutional weaknesses and political difficulties. Finally,recommendations are made for additional measures and policy reforms, required for a sustained economicrecovery. Given the main purpose of the study (i.e. to discuss the future policy agenda), it focases onthe chalenges ahead rather than on past developments.

I. TIE ECONOMIC SEITING

2. When the Chamorro Government took office in April 1990, the economy was in disarray: totalexports and GDP per capita had declined to about 40 percent of the levels attained in the early 1970s,and major fiscal and external imbalances had resulted in hyperinflation. The extal debt had grownto more than six times the level of GDP and most extrnal creditors had suspended their operations inNicaragua because of arrears. A decade of centized decision-making had rendered market institutionsextremely weak or non-existent. International trade was almost entirely controlled by state-tradingcompanies. Ihe financial system was naionalized and bankrupt. A massive transferal of urban and rurapropeties caruied out under the previous regime under non-transparen procedures had eroded the privatesector's confidence in the legal and judicial system. Reflecting the economic decline, social conditionshad deteriorated to levels that rank among the worst in Ladn America.

3. In 1991-1992, the Govement had remarkable success in implementing a comprehensivestabilization program, supported by an IM Stand-by arrangement. Inflation was reduced to single digitannual Mates by the second half of 1991. The key factors responsible for this positive development wasthe reduction by two-thirds of the fiscal deficit and the maintenanice of monetary discipline. The impactof this adjustment was strongly cushioned by the Influx of foreign resources that allowed a majorexpansion of private consumption and public investment. Although the fiscal deficit (before grants)declined to 10 percent of GDP, the external resource balance deficit actually rose to 36 percent of GDP.'he Government also succeeded in clearing its arrears with the World Bank and the Inter-AmericanDevelopment Bank (IDB) In September 1991 and reached a Paris Club Agreement on favorable terms inDecember 1991, a first step toward normalizing its relations with external creditors.

Ts repot was prepad by Clwdio Sapelli (LA2C2) bld on th finding of a mission to Nwamuas in October, 1992Contibto to the XXpoEt ws: MU. Caria Pesino, Labor Markt (Consta); Mr. Rafad Y zaval, AgrioutrSeto (Corsutant); Mr. HRmm von Gesdorff, Prvate Sector Devdepmet (LT); Lua Suare7, MaczocoononoFPmwor and Statistics (LA2C2). The Report was evised after discusdo with tho Government of the GOen Cover4tas in Deooaber 1993.

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4. Together with the stabilization program, the Govrment also began to imnplement an ambitiousstructural adjustment program aimed at transforming Nicaragua into a competitive market economycapable of achieving sustained growth. Under this program key policies hindering fbreign trade wereeliminated, state trading monopolies were abolished and import protection was adjusted to a range of 10-40 percent. In the financial sector, a new Bank Supeintendency Law was passed allowing the openingof private banks (7 private banks are in operation), and the Government initiated a program forrestructuring the state-owned banks including substantial reductions in personnel and the number ofbranch offices. Defense expenditure was cut by more than two-thirds, the public sector work force wasreduced, and significant progress was made in the divestiture of state enterprises. These reform measureswere supported by an IDA Economic Recovery Credit, approved in September 1991, and cofinanced byseveral bilateral donors.

II. TBE MAIN CIHALLEGES FACING NICARAGUA

5. Despite the achievements to date, the Government continues to ae great challenges in itsefforts to achieve sustainable growth and preserve stabilization. Deficits in the fiscal and balance ofpayment areas are no longer sustainable as new aid commitments are already declining. The mainchallenge ahead is to maintain the recent stabilization achievements in the face of less aid, whilstsimultazieously improving the conditions for resuming sustained equitable growth. This will be especiallydifficult since the country is stIll in the midst of a structural transition from a centrally controlled systemto a market-ased economy.

6. The current macroeconomic situation is particularly sensitive and requires urgent measures. The1993 financing gap at mid-year stood at $US100 million. This gap was finally financed largely througha loss of reserves. However, this can not be repeated in 1994. Moreover, financing gaps exceedingUS$500 million annually (30% of GDP) are projected through the year 2000. Since the financing gaphas widened rather than narrowed in 1993, and externa aid is expected to contine falling in the comingyears, the Nicaraguan economy requires strong measures to reduce the fiscal and balance of trade deficitsto manageable levels. Unless this is accomplished, the situation will rapidly deteriorate: inflation willincrease necessitating a large devaluation, the Government will have difficulty sereicing its debt, and thehard-won stabilization will quickly disintegrate. This in turn will make international assistance moredifficult to obtain, further aggavating the situation. Addressing this major chalenge should be the firststep in any credible growth strategy, since private investment will not be forthcoming in the presentenvironment of unceainy.

7. The economy's response to adjustnent has so far been limited. Private investment and exportshave declined over the last two years. Since Nicaragua's population growth (over 3 percent per annum)ranks among the highest in the Western Hemisphere, in the absence of faster growth the county's dismalpoverty conditions and fragile social structure will rapidly deteriorate further. A fast reactivation ofgrowth, however, does not appear likely under such tight macroeconomic constraints. Even if additionalcredit can be provided for the private sector through further tightening of the fiscal situation, the best thatcan be hoped for are modest but gradual improvements over last year's growth rate until the structuraltransformation of the economy is well advanced and the private sector has acquired enough confidence(in the political system and in the permanency of past reforms) to step up its investments in the country.Such pattern has been observed in most countries undergoing strucu adjustment programs. In viewof the need to reduce the county's external deficit, growth has to be based on the development of

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efficient export and import-substituting activities especially n agriculture, and through a more efficientuse of the country's limited resources. At the same time, a substantial reduction in total consumption willbe needed in the short run, to start reversing the highly negative gross domestic savings rate and releasemore resources for investment. This poses another major challenge - to prevent this decline fromadversely affecting the standard of living of the poorest and most vulnerable members of the population.

8. To meet these challenges, the structural adjustment process initiated by the Government in early1991 has to be deepened and extended: the remaining distortions and rigidities that inhibit private sectoractivity and impede flexible supply responses need to be removed, both to encourage a more efficient useof existing resources and, eventually, to attract new ones. Also, public savings should be increased andpublic resources need to be reallocated more efficiently to priority areas; in particular, for a betterprovision of basic social services, improved infrastructural support for private production activities andthe expansion of efficient safety net mechanisms aimed at the poor.

9. To support these objectives the report proposes measures to improve the business environmentfor the private sector; to promote export development, and to consolidate economic adjustment (inparticular public sector adjustment).

1Il. MAIN SIRUCTURAL ADJUSTMENT ISSUES

A. Maintenance of an Appropriate Macroeconomlc Fhmework

10. Macroeconomic stability, which is essential for a sustained structural adjustment program, isextremely fagile. The Government's preliminary 1993 macroeconomic program requires substantialadditional ffnancing to achieve its growth and inflation targets. The need to tighten the macroeconomicprogram raises two sets of issues: (i) the types of measures that will be required to close the externalfinancing gap; and (ii) the impact on economic growth, especially in the agriculural sector.

11. During the last two years the flow of international aid has been essential in sustaining theNicarag an economy. It has allowed stabilization to take place at the same level as substantial increasesin wages and consumption, and consequently, in living standards. As intenational assistance decreases,Nicaragua will be forced to adopt the painful measures that such aid has, until now, made it possible toavoid. As shown in the Projections Annex to Chapter 2, adjustments to decreased aid may induce adecline in consumption levels for several years. The main challenge will be to protect the poorest sectorsof society from being seriously affected. If the adjustment is not undertaken in an orderly fashion, it willnonetheless occur, but in the context of a macroeconomic situation that is out of control. To ensure anorderly adjustment, the Government needs to adjust fiscal and monetary policy to the size of the existingaid flows. The larger the fall in aid, the stronger the adjustment will have to be.

12. There are three areas where additional measures will be required; (i) fuiher fiscal compression;(ii) tighter domestic credit; and (ii) policies to encourage exports. Despite significant progress in thefiscd area, there is considerable scope for firther reducing and rationalizing public expenditures, andfor expanding the revenue base. As identified in the Public Expenditure Review (Report No. 10785-NI),savings can be obtained in: a) testructuring public sector compensation; b) reducing expenditure in goodsand sevices (particularly in medicine, water and vehicles); c) reducing defense expenditure in equipment;

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d) reducing administrative staff and e) rationalizing general servces. On the credit side, there is greaterscope for reducing credit expansion by the public sector bak. On the external side, tighter fiscal andcredit policies should help to reduce import demand but greater eforts will be needed to encourageexports. This will require an appropriate exchange rate policy and a strong pro-export bias in theincentive regime.

13. Trne most promising source of gowth In the short and medium-term is the agricultural sector.A real exchange rate correction In response to lower foreig aid inflows would improve incentives foragricultdr production and exports. A tightening of credit, on the other hand, could have a negativeimpact on sectoral growth. The lack of rura credit has been highlighted by the Government as one ofthe biggest constraints in agriculture. This credit constaint, however, appears to be exaggerated. In1992, while credit fell, planted acreage grew (excluding cotton). Moreover, most small farmers have notbeen receivuig credit in the first place, while the larger producers have been able to tap extemal privateresources.

14. Credit does not appear a key issue in the resumption of growth for the next several years. Themost pressing issues in the agriculual sector include the consolidation of propety rights, and theimprovement of technological packages to increase productivity. Increases in planted acreage and inproductivity will be the key growth factors in the medium term. Increased use of existing capacity andincreased productivity (in particular per worker and per acre) are the key sources of growth for theNicaraguan economy over the next five years. Improved working prcices and reallocation of existingresources will be among the most effective policies for assuring a rapid resumption of growth.

B. Improving the Env ment for Private Seetor Develpment

15. Although recent reductions in inflation, price distortions and state interventionism have improvedthe climate for private sector activity, they have not been enough to induce a major economic recovery.The greatest barrier now to private sector development in Nicaragua is the high risk of doing business,reflecting the fragile political eironment, uncertain property rights, a weak judicial system, excessivediscretion in the management of economic policies, and the fear of policy reversal in the event of adeteriorating macroeconomic situation. A weak financial system and inflexibility in the labor market,in tum, restrict a more efficient re-allocation of private sector resources.

The Poii l

16. The current political situation Is fragile and it is not currentiy clear how effective theGovernment can be in mobilizing the necessary consensus to implement the difficult stabilization andadjustment measures that will be required. The Assembly has been basically inoperative since September1992. The lack of a Comptroller General is also disconcerting. The great unceraity prevailing will notbe overcome until there is a solution to both the Assembly and the Comptroller General issues.

PoeMM Rights

17. Secure property rights is the key to the private (especially agricultural) sector's ability torespond to the changing economic envmnen About 1.7 miion hectares of a total 5.7 million hectaresof cultivated land and a substanti number of houses and urban lots were being fought over by different

owners. The lack of clear ownership encourages land invasions and violent confrontations that have beenmet with a weak response from law enforcement agencies. The uncertainty created by these unresolvedproperty conflicts and resulting climate of violence arguably constitates the single most important obstacleto increased private investment in agriculture, and in turn negatively affects the rest of the economy.

18. The Government has recently taken steps to resolve the issue of disputed land rights and hasstepped up its law enforcement efforts to prevent illegal property take-overs. A tentative timetable isestablished to complete the reviews and extend an offer of compensation, or return the properties whenpossible, to the claimants of confiscated lands. Though the framework to solve the problem appears tobe adequate, the issue needs to be addressed quicldy for the agricultural sector to rebound from its presentlow level of cultivated acreage and productivity.

Excessive Discretion in Policy Implementation.

19. Excessive discretion in the mangement of tax, trade, export promotion, and foreign investmentpolicies has resulted in unstable rules for the private sector. 'he Nicaragum Constitution gives theExecutive Branch substantial powers to change domestic taxes, tariffs and non-tariff measures. Althoughthese powers may have been helpful in quicldy addressing fiscal shortfalls at the beginning of theadministation, they have outlived their usefulness. Currently, these powers are exercised at theministerial level with an excessive use of discretion. This hinders the development of private businessactivities as the rules of the game are uncertain, it encourages rent-seeking behavior and, mostimportantly, undermines past policy reforms. Moreover, the ease with which tax rates can be changedhas induced the Government to solve revenue short-falls by raising them, while postponing taxadministration reforms and the removal of tax exemptions, which are mainly responsible for Nicaragua'sextremely narrow tax base.

20. One way of reducing the current use of discretion would be to elevate to the President's levelthe authority to make trade and tax policy changes. To reduce the use of discretion in the administrationof the foreign investment and the export promotion laws, automatic rules should be established thatgovern foreign investors' entry and access to export benefits. To reduce discretion in the taxation offiscal industries, their taxes should be integrated into the general tax system. To render Governmentdecisions more clear, any legally binding change in economic policy should be published in the Gaceta(the Official newspaper) and a wide circulation daily newspaper. Finally, it is important to reduce taxrate dispersion and limit exemptions leaving no room for arbitrary discrimination and rendering rulesmore uniform for all economic agents.

21. The privatization process has been complex and hence has taken a long time to complete. First,the valuation of the 351 companies slated for privatization was complicated by hyperinflation and thesignificant price changes following the liberalization of the economy. Second, there were claims fromformer owners for most of these enterprises and worker participation in ownership was required.However, once the privatization institution (CORNAP) had been established and the legal frameworkclarified, the Government advanced with speed. CORNAP privatized 233 enterprises in the last twoyears. Nearly all enterprises under CORNAP will be divested by the second quarter of 1994. Moreover,the quasi-fiscal deficit generated from bad loans to these enterprises has been reduced. Nevertheless,enterprises not incorporated under CORNAP also need to be privatized. The most important of these are

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established under the Ministries of Transport and Defense, and Petronic (the state institute thatadministers oil imports). The Misty of Defense reains the authority to create new enterprises,contrary to the general direction of divestiture policy.

Public Sector Adjustment

22. Although Central Government current expenditures have been reduced from more than 40percent of GDP in the late 1980s to less than 30 percent in 1992, the public sector is still over-sized andinefficient, crowding out the private sector and generating waste. Central Government expenditurescommand the highest share of GDP (31 percent) in Central America and the Government is still immersedin activities normally performed by the private sector in other countries. It owns commercial enterprisesrepresenting about 10 percent of GDP, has a dominant position in the financial sector and monopolizesthe supply of public utility services. The Government has spread its limited managerial capabilities toothinly and its specialized human capital skills in too many activities. The main challenge ahead is toreduce the public sector in an efficient manner and secure its withdrawal from activities better carried outby the private sector.

Tax Stm

23. Although progress has occurred In the area of tax administation, excessive tax exemptions andpoor tax administration continue to prevent sufficient fiscal revenue collections, and distort and obscureeconomic incentives. The tax system has been simplified, the corporate income tax rate has been loweredto internationally competitive levels, the General Value Tax (IGV) has been transformed into aconsumption based value-added tax, and overall revenues, at 31 percent of GDP, are adequate. However,two basic problems remain: tax collections are highly concentrated and the tax rates applied are high.This reflects a weak tax adminisration and the pervasive use of tax exemptions. Tax administration isfocused on the large tax-payers in Managua, while smuggling and tax evasion in the rest of the countryare rampant. Finally, the lack of coordination between the Central Government and the municipalitiesresults in double taxation. The main task ahead is to expand the tax base by improving tax administrationand eliminating exemptions to allow for lower tax rates without the loss of revenues.

Trade Liberalization

24. Although significant progress has been made in liberalizing trade, more effort is needed toimprove efficiency and reduce remaining anti-export biases. The current level of nominal protection isstill high and dispersed. The Government planned to reduce nominal protection to a 10-20 percent rangeby the end of 1994, but is currently reconsidering this decision and may keep the current levels of 10-40percent untl the end of the decade. The Governm should proceed to reduce the level and dispersionof nominal protection to reduce the implicit level of taxation on exports. It also should: a) avoid the useof discretion in the application of trade policy, apply general rules and policies and have few and well-defined exceptions; b) simplify further import and export procedures; c) abolish remaining exchangecontrols and export licenses; and d) improve administration of the ports and customs.

FinancialS

25. Unfair competition from the state-owned banks and weak prudential regulations hinder thedevelopment of a competitive private sector-based financial system. Also, rigid credit allocation rules

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are obstrucfting the resource reallocation process. Since July 1991 the Government has taken thefollowing actions: (i) the liquidation of one state bank and the down-sizing of personnel and branchoffices by 50 percent of the remaining four; (ii) the opening of the financial sector to private sectorparticipation; (iii) the freeing of interest rates; and (iv) the implementation of a clear mechanism forallocating rediscount credits. In July 1992, the Government recapitalized the commercial state banks,contrary to the spirit of the first ERC, which was to downsize them. Consequently, these banks continueto dominate the market and have extremely high administrative costs which are passed on to the marketvia large spreads. In addition, the Bank Superintendency needs to acquire autonomy from the ExecutiveBranch, issue key policies that are the norm for everyone, and strengthen its administrative capacity toenforce them.

26. To encourage the development of a competitive private sector-based financial system, theGovernment should adopt measures to: (i) gradually down-size the state rural development bank bytransferring its operations to the private sector; (ii) divest, liquidate or reform three state banks; (iii)subject all state banks to universal prudential regulations; (iv) subject the state banks to tighter rediscountlimits linked to loan recovery performance; and (v) restrict the state investment bank's operations to on-lending external resources. The Superintendency Law should be modified to increase the Superintendant'sautonomy and to strengthen prudential norms.

Labor Market Regulations

27. Inflexible labor market regulations reduce labor productivity and impair Nicaragua'sinternational competitiveness. These regulations are contained in the collective bargaining agreementsof the sta-owned enterprises and large private or recendy privatized enterprises, which contain manyprovisions that increase labor costs, depress labor productivity and reduce labor mobility. Theseregulations, together with high tax rates, have resulted in a significant expansion of the informal sector.The most important productivity-decreasing regulations are: Qi) lax strike regulations; (ii) extendedvacation periods and reduced hours of work; (iii) across the board wage indexation; and (iv) an extremelylarge share of fringe benefits, that flaten the wage structure and separate wages from productivity. Themost important policies that reduce labor mobility are: (X) obligation to "promote from within the ranks";(ii) high severance payments; (iii) joint union/management committees to take firing decisions. Currently,a draft Labor Code that tries to extend most of these policies (reduced at present to the sectors wherecollective bargaining exists) to the entire labor market is being discussed in the National Assembly. Ifthis code is passed it will have serious adverse consequences for the international competitiveness of theNicaraguan economy.

28. To increase labor productivity and mobility there is a need to: a) develop a coherent legalframework for the labor market, which is consistent with the country's development needs, and enforceit; b) change the incentive structure in the pay schedule, towards a system that rewards higherproductivity; and c) eliminate wage indexation (principally in the formal private sector).

CHAPrER 1

INTRODUCTION

1.1 By 1992, after fifteen years of decining output, per capita Income in Nicaragua fell to the samelevel as the 1920s. A period of very rapid growth (1950-77), was followed by a period of sveredeterioration, during the Sandinista revolution and administion (1978 to 1990) (see Table 1.1) Theeconomy has not yet recovered since the change of Govemment in 1990. The main purpose of this reportis to evaluate economic developmens since 1990, and to identify the barriers to economic growth withparticular emphasis on those that inhibit private sector development The main ndings and conclusionsare intended to assist the Goverment in the design of policies needed to improve the private sector'ssupply-response capability.1

1.2 As can be seen, the fastest GDP growth corresponds to a period of fast export growth and termsof trade that are over 50% higher than what they have been of late. Nicaragua had been using the incomederived from the higher prices, and higher volumes exported, to subsidize Import substition industriesin the context of the Central American Common Market (CACM). Moreover, it used the increased taxrevenues to reinforce the effects of the trade regime on the industrial and agricultural structures. Whenthe opportunities to substitute imports within the CACM ended, and terms of trade began to decline, thecontinuance of this policy was endangered. However, the Nicaraguan GKvenmen continued with thispolicy, financing the subsidies with increased external debt. By the end of the 1970s, this strategy puta severe strain on Nicaragua's creditworthiness.

1.3 Nicaragua's growth strateg from the 1950s to the 1970s required a rapidly growing volume ofworld trade, high terms of trade, ample fiscal resources, and substantial access to credit. None of theseconditions exist today. World trade is growing slowly, terms of trade are very low, fiscal resources arescarce, and Nicaragua's access to eternal resources is dwindling. Consequenty, this stratey is notreplicable today.

1.4 Moreover, even if external and inten conditions resembled the more prosperous of the 1950sand 1960s, it would not be reasonable to follow the same strate today. Ihis strategy made Nicaragua'sgrowth extremely dependant on the prices of coffee, cotton and beef, and discouraged the developmentof new export industries (internal incentives had a strong anti-export bias). This is why when importsubstitution growth was exhausted (due to the small size of the CACM market), and the terms of tradestarted to fall, Nicaragua had to resort to international borrowing to continue its economic growth in the1970s. The strategy was not able to generate resources internally to make it sustnable without resortto foreign savings.

1. Several growth constits, especially thosc angm n the publi sector, have already been or au beig addressed by theWorld Bank in other recent economic and sector work. The Public Sector Expendue Review, completed in Sepember 1992,addresses the key problems in public sector resource allocation, together with the institutional dvelopment gaps of the CentralGovernment in the areas of aid coordination, public policy formulation and public investment progamming. A study on PublicSector Enterprises and Natural Resource Management currntly undenwy wiU address the instbtional weaknesses in most ofthe rest of the public sector as well as infrastructure boStlenecks in energy, water and sewge, and telecommunications.Transport bottlenecks are being addressed in the pots and access roads project currently under prepartion. Finally, a reeaSocial Sector Review (February 1993) addresses the key issues and instittional problems in nutrition, health, education andfamily planning.

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1.5 For decades Nicaragua has had difficulty generating adequate levels of domestic savings. Thecountry has been highly dependant on foreign savings since the 1960s. It is during this period that thecurrent account deficit peaked at over 8% of GDP (in 1966). During the 1970s, the Government tappedinternational reserves and accumulated foreign debt at an unsusainable rate, in order to support high ratesof imports growth. Previous World Bank reports have identified a very low propensity-to-save, byregional standards, on the part of Nicaraguan entrepreneurs, which has aggravated this problem. Theeasy availability of credit from public banks, at negative real interest rates, was identified as an importantfactor in explaining the lack of private savings.

1.6 GDP coninued to grow during the 1970s, up to 1977, at a high annual average rate of 5.5percent. Subsequently the revolutionary war produced a recession so severe that it lowered the 1979 levelof GDP to the 1970 level. This equates with a 30 percent decrease in GDP per capita during theseventies. During the eighties the economy was stagnant and as a result of rapid population growth, GDPper capita decreased a further 30 percent. After reaching the second highest GDP per capita in CentralAmerica in the late 1960s, Nicaragua becme the poorest country in the region, with income levelsreduced to those experienced 60 years earlier.

1.7 The reasons for economic stagnation during the 1980's include: inappropriate economic policies,adverse terms of trade, unfavorable weather conditions, the U.S. trade embargo, and a protracted civilwar. By the end of the decade, real GDP per capita had fallen drastically, total exports in current dollarsamounted to less than half the levels achieved in the mid-1970s, and inflation had spiralled out of control,with the public sector deficit averaging 20 percent of GDP during the period 1985-1990. Current accountdeficit of the balance of payments averaged 33 percent of GDP over this period. This was mainlyfinanced through the accumulation of arrears with foreign creditors and grants, on which the country hasgrown extremely dependent. The country's external debt ballooned from US$1.7 billion in 1978 to overUS$10 billion in 1990, or more than 6 times the estimated GDP.

1.8 The country's social condition also reflect the extentof the economy's deterioration. Social indicators compareunfavorably with those of ihe other countries in the region. T&U 1.1In particular, Nicar3gua's infant mortality rate (72/1000 ____ PA__ M_O__c_

births), matea mortality rate (159 per 100,000 live births)and low birth weight rates (22 percent) are the highest. P caper capi oftTrX&Finally, in comparison with other countries in the Western 1 Il 21

Hemisphere, Nicaragua stands out by having the thid lowest 19S0.70 35 . 117.2per capita income in 1991 (US$340 according the World 1-7 2.1 2.9 1183Bank's Atlas Methodology) and the highestpopuladon growth 197U9 -7.9 .9.6 78Arate (3.4 percent)2 . Unless economic growth resumes, the 199091 -2.8 -7.5 74.2

country's already dismal poverty indicators will rapidlyworsen. 1/AnsAVesaggwwuast.

21 Aveft hx 1970-100.

1.9 The economic system inherited by the ChamorroAdministration upon assuming office in April 1990 featured a larpe, centralized public sector, and asmall, over-regulated private sector. Total non-financial public sector expenditures were equivalent toabout 50 percent of GDP, while state-owned financial enterprises accounted for 29 percewt of GDP. The

2. Since the last census was perforned in 1971, the accuraq of this figure is uncertin.

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banking system was completely nationalized and bankrupt after a decade of m ament during whichcredit was allocated largely according to political criteria. Foreign trade was heavily regulated, with statetrading companies accounting for almost all exports and over 50 percent of Imports. The remainingimport trasactions were subject to a multiple exchange rate system and a high and dispersed tariffstructure. In domestic commerce, over 50 products were subject to price control. Finaly, one of themost damaging legacies of the previous regime has been the breakdown of the legal framework thatdefines and enforces land-tenure and property rights which constitute the backbone of a private-sector-based economy.

1.10 Despite a continuing fall in GDP per capita, private consumption per capita has grownsubstantially, at a rate of 15 percent per annum in 1991-92, financed by a huge inflow of aid that startedearly on in 1991. The total inflow of grants and concessional loans to Nicaragua during 1991 and 1992has averaged over US$600 million, which is equivalent to about one-third of GDP and translates into anannual transfer of over US$150 per person. This places Nicaragua among the three countries in theworld most generously benefiting from foreign aid. Total consumption has been significantly higher thantotal income in these years, implying large negative savings (see Table 1.4). The economy has consumedfar beyond its means and is totally dependent on foreign savings to sustain its capital base. Meanwhile,exports have declined by almost 30 percent in nominal terms since 1990 (n part because of a loweringof export prices). The country's prodution base has progressively become more inward-oriented, asshown by the declining export-o-GDP shares. At the same time, real wages grew at a rate of 23 percentper annum during 1991-92. In the context of a stagnant economy, this sharp increase in wages, partlyexplains the current high open unemployment rate at 16 percent.

1.11 In sum, while the stabilization program has been highly successful, signs of an impendingeconomic recovery are still very weak two years after the program was introduced. Also, the effortsmade to restructure the economy into an export-oriented, privatesector-led system have yielded mixedresults. The two most important concerms are: (i) the still dominant presence of the state in theeconomy, combined with a decrease in investment from the private sector, and (ii) the poor performanceof exports, together with a continued dependence on foreign aid. The first observation indicates thatmuch remains to be done to create the conditions needed to achieve rapid growth led by the privatesector, while the second one runs counter to the development of an outward-oriented economy. Ileseissues will be addressed in the following chapters.

1.12 The principal challenge now facing the Government is to maintain the recent stabilizationachievements while reactivating growth in an equitable and sustained manner. A first step has been takenwith the successful introduction of stabilization measures and the implementation of structural adjustmentpolicies. As the experiences in other countries have shown, sustained growth is impossible in an unstablemacroeconomic environment. Therefore, Nicaragua's success in achieving price stabilization has beenextremely important. However, while necessary, the achievement of macroeconomic stability is notenough in itself to guarantee sustained growth. Ihe transition from stabilization to sustained growth canonly take place if the structural reforms that were started in 1991 are deepened.

1.13 Tbis chapter reviews recent economic policies and performance. The first section will describethe stabilization and structral adjustment program. The remaining sections will analyze the policiesfollowed under these programs and the results as well as the challenges ahead.3

1.14 The rest of the report is divided into eight chapters, each focussing on one specific topic. Thesecond chapter examines the macroeconomic framework, including Nicaragua's stabilization progrm,its achievements, as well as the challenges that lie ahead. The third chapter discusses the businessenvitonment, analyzing the political landscape, policy uncertainty, and the enforcement of the legalframework. The next four chapters (Chapters 4-7) describe policies in specific areas, and possible waysto Improve Implementaion of: privatization, trade reform, tax reform, and reform of the financial sector.The fia two cbapters analyze the problems of and suggest possible solutions for a key productive sector,(the agricultural sector), and a key factor market (the labor market).

I..-. - ..-

.~~~~~~~~ult .f ,.a.:

1. Current estimates of GDP per capita in Nicaragua ragp fhom USS 450 to USS6S0, depending on the source. However, both the GDiP nd the popuktion dal ta underlie: this c~aXto aepoor. . 4Natioua A6countsar&e d*fiploiWtad Mio censau has bc : a dwsik g . .

. kth WIst .ty.Yazs. iu lat popuation census Wa i z nned *i 1971, and prujo*i:for dte:. foliswing years do not inolude eitimats: of deatbi dt or staes: fbt

. oitMwrd migratio. .

2l Sc 8 5 inboral .sector.s excluded bt mNatWlM Ac'oun's,th le bvel andgrwth at:. of GDP mYa Dased on infbr.na.mon acquiredthrough ahou*eotd *mrvey.pvrfontWd b.bjry Pwidgdi IiWoaenal para el Desailo Roon4micmGlobal (FIDEG), it is likely that I6omle pe qpita is. sibsantily bigher than. curientestimtes (perhaps over US$ 1,000 per capita). FDEqO dita suggest tat while the formalsector has renained stagnan, the informal sector has growa oonsideably.

3. : The doubts coneng the quaL;ty of economic and popuaion data ieprsent amajtor problem tf econoeic management, and require inunediate attention. -Tne presentrepolt uses official data, for lack of an ateatdve.

3. It should be noted that national accounts for Nicaragua are of dubious quality. For one thing, national accounts arc basedon 1980 prices, that are clearly unrepresentative of the present price strctre. Surveys and census on which to update the basicdata have not been performed for over a decade, and a large and growing informal sector is not included in the accounts. Thereame song indications that GDP is higher than what official accounts show (see Box 1.1).

CHAPTER 2

RECENT MACROECONOMIC PERFORMANCE

2.1. This Chapter will analyze the recent macroeconomic performance, centering in the achievementsof the stabilization plan, its sustainability, and the challenges ahead. Particular attention will be givento the behavior of the real sector during stabilization.

A. THE STABILIZATION PROGRAM

2.2. The current administration inherited an extremely difficult fiscal situation when it came to powerin April 1990. By the end of the 1980s, the size of the domestic imbalance was enormous. To makematters worse, the Sandinistas substantially increased public wages and government employment afterlosing the February 1990 elections and before turning the power over to the new administration. Thisconstituted a complete reversal of the fiscal adjustment made in 1989.

2.3. The first stabilization program attempted by the incoming administration in 1990 did notsufficiently focus on the reduction of domestic imbalances. The approach was to bring the economygradually to a "full dollarization" with a new currency called "Cordoba Oro," with a fixed exchange rateof one-to-one with respect to the US dollar. This plan failed because it did not pay enough attention tothe fundamental problems of fiscal and monetary policy, and inflation accelerated to about 40 percentper month.

2.4. In March 1991 a new stabilization program was launched. The Government eliminated the oldCordoba and set the exchange rate at 5 new Cordobas per US dollar. The Government also initiated apublic sectr employment reduction program that was mainly financed with foreign grants and managedto reduce public employment by 12 percent. This measure was complemented with a policy targeted tocut tack expenditures on goods and services.' The Central Bank adopted the key measure ofsignificantly curtailing credit. In the March-December period, credit financing for the private sector wasless than half than what was granted in the first quarter of 1991. After two months the plan's effect oninflation was evident, and price changes fluctuated around a monthly rate of zero.

2.5. To support stabilization, the Government reduced expenditures significantly and exercised a tightcontrol over monetary aggregates. Up to September 1992, the Government met all targets. But duringthe second half of the year, the expected disbursement of about US$ 104 million in economic aid fromthe United States was put on hold. This put the Government program off-track, and, amongst otherthings, revealed the fragility of the stabilization effort and the high dependence on foreign aid. It shouldbe noted that US$ 104 million constitutes about 7 percent of GDP, and it would have been extremelydifficult for the Government to adjust to such a shock in a short period of time. In its effects onmacroeconomic variables, it is as if the price of coffee, sugar and beef were reduced by 80 percent.However, in mid-December US$ 54 million were disbursed, solving the short-term liquidity problem thathad been created by the unexpected reduction in aid.2

1. Fiscal and monetary policy ane described in more detail in the next section.

2. The rest of the US aid was eventuaUy released in April 1993.

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2.6. Despite these uncertainties, the stabilization program remained on track. The twelve-monthinflation for 1992 was 4 percent, well below the 20 percent envisioned at the beginning of the IF Stand-by program. The overall deficit of the Central Government remained at about 10 percent of GDP. Thisdid not require financing by the Central Bank since, given the flows of external financing, the domesticcredit to the public sector was negative at 8 percent of GDP (the Central Government repaid debt to theCentral Bank). On the other hand the domestic credit financing to the private sector reached only 7percent of GDP, as compared to the inflationary 20 percent in the first quarter of 1991. TheGovernment's remarkable success in stabilizing the economy was followed by important steps towardsnormalizing relations with external creditors by clearing arrears with the multilateral organizations andreaching a Paris Club Agreement on favorable terms.

2.7. The stabilization program was accompanied by a structural reform program aimed at reactivatinggrowth after years of decline. In September 1991, the Government signed an Economic Recovery Creditwith the World Bank and soon after a Stand-by arrangement with the IMF. Under these agreements theGovernment laid out its economic policy. The program was designed to restructure the economy intoa market-based, export-oriented and private-sector-led system, as a more solid foundation for reactivatinggrowth in a sustained and equitable manner.

FIGURE 2.1: CHARACTERISTICS OF THE PROGRAM

OBJECIVES INSTRUMENT ACHEVEMENTS

Stabilize the economy Downsize thc Public Sector, Central GovernmtIncreasm Revenue, Limit Credit Expenditures were reducedExpansion from 46% to 40% of

GDP. Revenue wasincreased from 18% to31% percent.

I Dr productivit Libealize Foreign Tmdo Taiffs werc reduced tolS20% and n-tariffbarriers removed.

Remove Retrictions on Domestic Price controls were mostlyTrade eliminated and state

trading activities wereprivatiwed.

Restucture the Financial Sector Interest ra controls wer.eliminated, asuperinenency of bankswas created, private bankswere opened, but publicbanks have not been

l___________________ adequatcly reatnotured,

AllUviate Poverty Target expenditu.es to tie poor The Social InvestmentFund (FISE) was cratedto support socialprograms, nutitionalassistance programs were

____________________________ ta.geted to the poor.

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2.8. The Government's program intended to:

(i) downsize the public sector through reductions in current expenditures, demobilization of thearmed forces, an occupational conversion program and divestiture of state-owned enteprises;

(ii) liberalize foreign trade through the consolidation of exchange rates, reduction in tariff ceilings andthe elimination of non-tariff export and import barriers;

(ii) liberalize domestic trade through the elimination of price controls and privatization of state-managed trading activities;

(iv) liberalize the financial sector through the elimination of interest controls, the creation of anautonomous superintendency of banks, the restructuring of the public banks and the opening upof the financial system to private banks; and

(v) create focused social safety nets: the Social Investment Fund (FISE), the National Reconciliationand Rehabilitation Program (PRRN) and nutritional assistance programs targeted at the poor,coupled with an expanded public investment program designed to promote employment and torehabilitate the country's deteriorated social and economic infrastructure.

2.9. By end-1992, the Governent had made significant progress in implemeing its adjustmentprogram. So far, the economy's response to the adjustment measures, however, had not measured upto the initial expectations. This was due to adverse developments in non-economic factors and inadequateprogram execution, which is analyzed in the following sections.

2.10. On January 10, 1993, the Government announced the second phase of its economic program,consisting of a package of measures designed to accelerate the pace of growth and reduce the. economy'sdependence on foreigi aid. In announcing these measures, the Government emphasized its commitmentto redouble poverty alleviation efforts and to attend to the social needs of the population. The mainmeasures were:

(i) a devaluation of the Cordoba by 20 percent, together with the adoption of a crawling pegexchange rate policy designed to devalue the currency by another 5 percent by the end of 1993;

(ii) a reduction in current fiscal expenditures by an estimated 2 percent of GDP and the creationof a budget oversight agency to control the costs of the autonomous public insdtutions, includingthe universities, municipalities and state-owned banks;

(iii) an increase in taxes on luxury import items (especially automobiles), the elimination of taxand tariff exemptions received by state enterprises and institutions, and the imposition of fines onoverdue fiscal payments, all of which are expected to yield a revenue increase of 3 percent ofGDP. The revenue enhancing and cost reduction measures are designed to generate enough publicsavings to permit an expansion of short-term and, especially, long-term credit to the privatesector; and

(iv) the creation of a Ministry of Social Action and Development whose role, would be to: improvethe coordination of existing social emergency programs; define and implemert the Government's

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social policy; and execute an emergency employment program focused on the poorest regions withhigh unemployment rates.

2.11. Overall, the Government's new package of economic reforms points in the right direction.However, these measures are not sufficient in themselves to revive export growth and economic activity.This will partly depend on subsequent wage adjustments (in particular public sector wages). But mostimportantly the effectiveness of these measures will largely depend on the progress made in alleviatingthe impact of non-economic factors, that have so far impeded a more dynamic expansion of private sectoractivities and which will be discussed further on.

2.12. The following sections will elaborate on the policies for sustaining the stabilization and reformefforts, and the challenges ahead. The key policy challenge is to establish credibility on themacroeconomic front and on the sustainability of the structural reforms. The sustainability of themacroeconomic framework, amongst other things, is crucially dependent on the level of foreign aid.Moreover, even with flows of US$ 570 m for 1993 (equivalent to nearly one third of GDP) as it is nowprojected to be, there remains a large unfinanced gap. For the medium term, this gap is expected toremain at US$ 500 m., unless further substantial adjustment is achieved. Consequently, the credibilityof stabilization relies on a strategy that lowers dependence on aid. Most of the challenges faced byNicaragua in the medium-term refer to the dependence on aid (reflected in the low domestic savings ratioand the large current account deficit) and how to overcome it. Policy-makers tend to focus on securingthe continuation of large flows of aid rather than recognizing the urgency of resolving the debt problem,furthering fiscal adjustment and upholding a prudent credit policy. As shown by Nicaragua's own history(see Box 2.1, page 17), the belief that aid will continue to flow may be the program's undoing.

B. FISCAL AND MONETARY POLICY

2.13. In support of the 1991 stabilization program, fiscal and monetary policy were aimed at addressingthe large Central Government budget deficit and at controlling the state banks' credit to the private andpublic sectors. During implementation, expenditures were substantially reduced and revenues increased,while credit and monetary expansion were curtailed.

2.14. The beginning of the fiscal problem can be dated to the early 1980s, when the CentralGovernment current expenditures more than tripled, and total expenditure reached 45 percent of GDP,resulting in an increase in the overall deficit to over one-fourth of GDP in 1983-84. The surge in publicexpenditure was financed, at first, by reducing foreign exchange reserves, accumulating debt and laterarrears, and rescheduling short-term liabilities. The Government only resorted to money-making whenthese sources had been depleted. Thus hyperinflation was prevented untfl the second half of the eighfiesat the cost of accumulating a large extemal debt. In 1989 there was a serious attempt to stabilize theeconomy, when current expenditure was reduced to 27 percent of GDP and the total deficit to 7 percent.This effort was unsuccessful in stabilizing prices since monetary policy continued to be expansive,financing the large publicly owned productive sector.

2.15. The 1991 stabilization program avoided the mistakes of the 1989 program. Its success relied onachieving a significant reduction of the public sector deficit, from 30 percent of GDP in 1990 to nearly8 percent in 1991-92. This was achieved both through major reductions in current expenditures (of about16 percent of GDP) and substantial revenue increases (of about 12 percent of GDP).

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TABLE 22: NICARAGUA - CONSOLIDATED OPERATIONSOF THE NONFINANCIAL PUBLC SECTOR, 1M-92

(As pea t of Current GDP)

198S 1986 1987 1988 1989 1990 1991 1992

Total Revenue 35.9 35.3 28.9 21.7 27.7 18.4 26.5 30.7

Curent Revenue 35.7 35.0 28.8 21.6 27.S 18.4 26.3 30.5(o/w) Tax Revenue of Oral Govt 32.7 31.9 27.6 20.4 24.8 15.8 23.3 26.1

Diect 6.3 7.1 6.3 3.9 5.5 3.6 3.7 3.7Indiect: Donestic 18.7 17.9 16.9 12.8 13.9 7.0 11.3 13.1Foreign 2.6 2.6 1.8 2.6 2.S 2.9 3.9 4.3Other 5.2 4.2 2.6 1.2 2.8 23 4.3 4.9

Operative Surplus of FE 0.8 0.5 -0.7 0.1 0.3 1.3 1.3 2.4

Totd al rpenditure S8.2 50.4 46.9 47.3 33.7 46.2 34.3 40.4(otw) Ceral Gaoernment S4.8 49.6 44.5 47.1 31.3 43.8 28.8 31.1

Ctmnt Expenditure 46.3 43.4 40.8 40.6 29.8 44.7 28.6 28.4Wages & Saaries 9.6 8.6 6.5 3.8 4.0 8.8 9.5 9.1Goods& Serviceas / 31,0 30.5 31.0 28.7 23.1 32.7 15.0 13.4Intrest Payments 2.8 1.3 0.4 0.1 0.0 0.1 1.2 3.3Current Transfen 2.9 3.0 2.9 8.0 2.8 3.1 2.9 3.0

Capita Expenditue 11.9 7.0 6.1 6.7 3.9 1.5 5.7 11.6Fixed Capital Fornmaion 10.1 4.8 5.1 4,2 2.7 1.3 4.7 9.6Capital Trnsfns 1.2 2.2 0.9 2.5 1.2 0.2 0.0 1.6Net Lending 0.5 0.1 0.1 0.0 0.0 0.0 1.0 0.4

Public Saving -10.6 -8.4 -11.9 -18.9 -2.2 -26.3 -2.3 1.7Foreign GrAnts 0.6 1.7 0.5 0.5 3A 14.3 12.8 6.9

Overall Defict befoe Gramt -22.2 -152 -18.0 -25.6 -6.0 -27.7 -7.8 -9.7Overall Deficit after Grant -21.6 -13.5 -17.5 -25.1 -2.6 -13.4 5.0 -2.8

Source: Miniaty of FiPne and Central Bank of Niarua.j/ Wages an salaries of the Mnistries of Defenst and Police were included in Goods aul Seri up to 1990since ther was no beakdown of these niastie burt;. From 1991 on the wages nd saaries of these twominidtiea are repotd corrctly. HceA, the drp in Goods and Saices in 1991 in a larg psa is r cflectionof the reduction in the size of the amy.

2.16. Also, unlike 1988-89, the Government was able to remain in line with it's stabilization targets bymaintaining a tight rein on domestic credit and on money supply. lbe sharp decline in credit to thepublic sector, from 65 percent of GDP in 1990 to -8.4 percent in 1992, was possible both because of:a) the deep cuts made in the fiscal deficit; and b) the availability of large amounts of foreign aid. Creditto the private sector was also lowered from the excessive levels it reached during the late 1980s.

2.17. Since 1990 tax revenue increased substantially through the changes in the tax system aSli theimprovement in tax administration (see Table 1.2 and Chapter 5). Expenditures by the CentraGovernment declined by 16 percent of GDP from 1990 to 1992, but as public enterprises expendituresgrew substantially, nonfinancial public sector expenditures were reduced by only 8 percent. Public

- 10-

savings improved markedly by 30 percent of GDP (from a deficit of 28.2 percent in 1990 to a surplusof 1.8 percent in 1992). However, the large expansion of the investment program implied that the overalldeficit was reduced by only 21 percent of GDP.

2.18. The public investment program, at 11.5 percent of GDP in 1992 is very large. It is driven byforeign aid, and does not necessarily reflect the Government's priorities. Moreover, the overall deficitbefore grants is almost 10 percent of GDP, and one of the Government's immediate goals should be toreduce it to a more manageable level in the next 3 years.

C. EXCHANGE RATE POLICY AND COIPEITrIVENESS

2.19. Following the 400 percent nominal devaluation of March 1991, the stability of the nominalexchange rate up to January 1993 served as an anchor for domestic prices. The fixed exchange rate,however, tied one policy instrument to the achievement of stabilization and meant one less instrument tobuffer the impact on the balance of payments from the adverse shocks experienced by the export sector.The main buffer was provided by foreign aid inflows and a draw-down of reserves, together with atightened monetary policy. These measures succeeded in preventing a major run on the Cordoba, butdid not prevent a deterioration of incentives for exporters.

2.20. The trade balance deficit reached one third of GDP in 1992, almost doubling in two years andreflecting the serious imbalances in the economy. The trade balance deteriorated both because of a fallin exports and a rise in imports. The stagnation of exports is an issue of great concern and deservesmuch attention. Except for a brief surge during 1989-90, total exports have followed a declining trendsince the late 1970s. Six commodities (coffee, cotton, sugar, beef, bananas and shrimp/lobster) accountfor approximately 70 percent of total merchandise exports. All but shrimp and lobster sufferedinternational price declines between 1990 and 1992, with those of coffee and cotton being especiallysevere. These adverse price movements account for about 40 percent of the US$107 million decline intotal exports observed over the last two yen, while the rest was due to reduced production and yields,reflecting a loss of competitivenesse. The country's rigid export structure reflects inadequate exportincentives (in particular the appreciated exchange rate)' and a lack of dynamism in exploiting new exportopportunities.

2.21. However, the main cause of the deterioration of the trade balance has been the rapid expansionof imports during 1991-1992. This reflects a surge in consumption of 16 percent of GDP, fueled by theincrease in the flow of aid and the high wage increases of 1991-92. Although imports in all categoriesincreased by 34 percent between 1990 and 1992, consumer goods imports have grown 84 percent.

3. The sharp fal in ootton eports is pardtularly notable. Loss of competiiveess in this oase is due mostly to strucmralprob:ems (see para. 2.31).

4. An appreciation of the exchange rate is a stylizd fact of exchange rate based stabilization progmms.

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TABLE 2.3: TERMS OF TRADE, MRICES AND ECHIANGE RATE(Index 1980i100)

1980484 198549 1990 1991 1992

1. DOLLAR MRCE IDEXExpont of Goods 92.4 93.0 91.2 8.1 78.4

uornationad (MUV-05) 98.1 119.0 139.0 141.9 148.0

2. TERtMS OF TRADENationd Account Deflaaos 83.6 72.0 68.8 67.3 47.4Expont-Import Goods Pices 94.2 79.0 65.6 62.1 52.9

3. TERMS OF TRADE EFFECTBasedonN.A.(a %of GDP) -0.1 -2.2 -13.1 -11.7 -10.8

4. REAL EXCH RATE FOR EXPORTSGDP Deflator Adjuted 83.3 138.6 156.7 1.64.6 161.3

S. DIFLAIION OF GDP DEFLAIDR 23.1 3795.4 7865.5 2748.5 20.5

Source: Data Annx.

2.22. Although exchange rate adjustment has an important role to play in correcting these imbalancesit cannot be relied on alone to bring about the needed adjustment by itself. Important microcconomicreforms are also needed to increase productivity and remove existing constraints to the supply response.Moreover, a devaluation would result in an increase in the real exchange rate if accompanied byappropriate fiscal and monetary policies. If executed with constant levels of aid, a devaluation needs tobe accompanied by: (i) a sufficient fiscal adjustment to offset any impact on the money supply anddomestic credit; (ii) monetary sterilization through open market operations; and under all circumstances,by (iii) no indexation of wages and prices.

2.23. Current price indexation and supply constrains would severely blunt the effects of a devaluation.The indexation clauses widely used in financial transactions Cm particlar deposits) subject the stabilityof the banking system to great exchange risk and encourage overly consatve lering practices. Thewidespread practice of implicitly indexing wages to a consumpion basket imles the realignment oflabor costs as needed to render domestic production more competitive. During the March 1991devaluation, a nominal devaluation of 400 percen only succeeded in bringing about a real devaluationof 27 percent by end 1991, largely because wages adjusted commensurately. The success of adevaluation also depends on the ability of the private sector to respond to relative price signals.Therefore it is critical to remove the eaisting constraints on private sector development.

2.24. There is also an issue regarding the most appropriate exchange rate system for Nicargua. In1991, the Government chose a fixed exchange rate, and the use of the exchange rate as a nominal anchorwas key to the stabilization effort. In early 1993, the Government shifted to a preannounced crawlingpeg. A crawling peg system is potentially more flexible and can adapt better to the shocks the economymay face, but only if the Government does not precommit itself to a certain rate of devaluadon. With

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no precommitment, the rate of the crawl can be adjusted whenever reserves are lost, so as to resemblea dirty float, with the advantage of not requiring a sophisticated money desk at the Banco Cental deNicaragua (BCN). Such a system would expose the Government to two dangers: on the one hand thereis the temptation to keep the rate of the crawl at a minimum so as to prevent more inflation, resulting ina further loss of competitiveness. On the other hand, if competitiveness is high in the Government'sagenda, and so the crawl (the rate of devaluation) is in some way indexed to the domestic inflation level,there is the danger of losing all nominal anchors and have the system drift into higher inflation levels (thisis especially possible if credit policy is loose) '. In the first case, the exchange rate is being managedpractically as fixed; in the second, as floating. Though given the external shocks the economy couldreceive it may be appealing to float the exchange rate, this requires a capacity to manage monetarypolicy, and a commitment to a prudent credit policy that appears to be lacking today 6. The mostreasnnable arrangement at the moment is to have no precommitment as to the rate of the crawl, and tomanage the crawl by keeping reserves above a certain threshold.

D. THE REAL SECTOR OF THE ECONOMY

2.25. In spite of the significant advances made in the implementation of the stabilization and adjustmentprogram, the economy's response has so far been limited. The notable achievements in the stabilizationfront have not been followed by similar achievements in the area of private investment, exports,employment and output. Despite the substantial inflow of foreign grants and concessional loans whichhave permitted a major expansion of private consumption and public investment, formal sector output isstagnant and unemployment is rising. However, there has been at the same time a remarkable growthin the informal sector (see Chapter 8).

a) Investment and Savings

2.26. Since the early 1970s, investment has been relatively high, averaging 21 percent of GDP.Reflecting these high investment ratios, imported capital goods were from 10 percent in the 1970's to 12and 14 percent in the first and second halves of the 1980's respectively.

2.27. Investment's efficiency was, however, very low, as reflected by the negative ICORs in Table 1.4.The most obvious explanation for the loss in capital efficiency and productivity is the poor investmentsmade under the system of central decision making. There is substantial empirical and historical evidencethat such a system lacks an incenive structure to operate effciently. Moreover, the prevailing warconditions during most of the 1980's pardy explain the low productivity because of the under-utilizationof the capital stock.

5. In Ith case competvecessIs Wh h m th agenda, tough awehang rat poliycan help, ihe key would be to reducedomestc demand and remove tie constaimts to resoure reallocaon.

6. However, credit policy vas restive during 1993. This was the only way to offet a relatively lax fiscal policy and avery low evel of reserves.

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TABLE 2.4: SAVINGS, INVESTMENT AND PRODUCTION(As per-cnt of GDP)

1985-89 1990 1991 1992

1. NATIONAL ACCOUN13GDP p.c. (1990 USS) 553 448 433 422

Gross Domestic Savings 3.9 0.8 -10.2 -16.7Gross Domestic Investment 22.3 19.3 21.0 9.7

Private Sector 16.9 18.0 16.2 10.2Public Sector 5.4 1.3 4.7 9.5

Resouce Balance -18.3 -18.5 -31.1 -36.4Export of GNFS 18.2 25.0 22.4 19.2Import of GNFS 36.5 43.6 53.5 55.6

2. IMPORTS CIF (BOP)Capital Goods 14.5 11.4 10.8 12.1Internediate Inputs 25.4 16.3 19.2 19.5

3. REAL GROWTH RATESGDP -4.0 -0.6 -0.2 0.4Export of Goods (BOP) -3.6 10.6 -16.1 -6.0Import of Goods (BOP) -10.8 -1.9 15.4 12.5

4. ICOR (5 year average) -4.8 -5.2 -4.8 -4.5

Source: Cental Bank of Nicaragua; Bank Staff calcuations.

2.28. The stagnation of the overall level of investment between 1990 and 1992, and the sharp increasein public investment (from 1.5 percent of GDP in 1990 to 11.7 percent in 1992) has been accompaniedby a sharp drop in private investment from 13 percent of GDP in 1990 to 7 percent of GDP in 1992.This trend is, as in the stagnation of exports, alarming since it affects the medium term prospects foreconomic growth, and points to the need for policy changes.

2.29. Overall domestic savings have declined sharply in the last two years from positive 0.8 percentof GDP in 1990 to negative 16.7 percent of GDP in 1992. The effect of high levels of external assistamceon domestic savings is discussed below.

b) Output Growth

2.30. While the stabilization and adjustment program helped to level off the declining output trendobserved since 1983, the 0.4 percent real GDP growth achieved in 1992 fell far short of the 3.5 percent -4.5 percent target rates projected at the beginning of the year, as well as of population growth, estimatedat 3.4 percent per annum. The main sources of growth were expected to be the agricultural, fishing andconstruction sectors. While fishing and construction activities managed to expand by over 10 percent in1992 (still below projected rates), the agricultural sector only grew an esdmated 1.7 percen.Manufactring industry declined by 5 percent, while commerce and services, which account for roughly

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50 percent of GDP, grew by 1.8 percent. It is important to note that these figures mostly exclude thevery large informal sector, that appears to have grown strongly in 1992.

2.31. The agricultural sector, which accounts for approximately 30 percent of GDP and one-third ofthe country's total employment, registered the most disappointing performance as total acreage undercultivation has remained approximately constant since 1990. One notable development has been thevirtual disappearance of cotton production, which was Nicaragua's second largest export commodityduring the 1980s. Declining international cotton prices together with an outmoded technology that relieson excessive use of fertilizers and pesticides have rendered this crop unprofitable. The fall in cottonproduction was mainly compensated by increased basic grains production (rice, maize, beans andsorghum), sold primarily for domestic consumption, thus constituting a rnther inward-reorientation ofproduction. Nicaragua's most important export crop, coffee, rebounded in 1991 from the 1990 drought-induced production decline, but faced a new setback in 1992 when the already depressed internationalcoffee prices fell a further 25 percent. Production of the other major export crops (sugar, beef, bananas)also declined in 1992, in part because of depressed international prices.

2.32. Aside from these short-term adverse price movements, agricultural export production also sufferedfrom an appreciated real exchange rate, tighter credit market conditions, uncertain property rights, anda surge in rural banditry, land invasion, and road blocking that disrupted harvesting and marketingactivities. A similar wave of strikes and disturbances occurred in urban areas, triggered by theprivatization of state-owned enterprises and public sector budget cuts, disrupting production and marketactivities in the manufacturing sector. Though the country was afflicted by two natural catastrophes (theeruption of a volcano in April 1992 and a tidal wave that struck the Pacific coast in September 1992),neither appears to have had a significant impact on aggregate economic activity.

E. SUSTAINABILlTY OF STABIL1ZATION

2.33. It is extremely important for potential investors to believe in the sustainability of stabilization.Sustainability depends on: a) the control of credit expansion; b) substantial fiscal adjustment; c) thereduction of the level of debt; and d) the adjustment to a lower level of aid.

2.34. Credit policy was the weak link in the implementation of the stabilization strategy during 1991and 1992. The rise in private consumption was fueled by transfers channeled through the state banks (inthe form of uncollected loans). However, the Government believes that credit is needed for private sectorgrowth to occur, and would want to expand it fiuther. The connection between credit and growth is notstraightforward as is shown by the large credit flows to the private sector in the late 1980s (in the orderof 40 percent of GDP) that occurred at a time of falling output, and the resurgence of growth of the last2 years, obtained with very low levels of credit. By contrast, the connection between excess credit andmacroeconomic imbalances is very clear. Consequentdy, the Government should be prudent in theconduct of credit policy. The Government's inclination to increase credit presents a further risk to thesustainability of the stabilization program.

2.35. The diagnosis of public sector expenditures contained in the PSER brought out six pressing issues:(a) there are serious institutional, procedural and processing problems of budgeting, investment planningand aid coordination; (b) the accounting function is very weak, leading to poor ex-post control and non-existing auditing; (c) recurrent expenditures continue to be too high; (d) expenditure patterns (in particular

- 15-

in the social sectors) do not reflect government priorities; (e) insdtutional and administrative capacity isweak, both in the line ministries and the public enterprises; and (f) the PIP is too large for theGovernment's implementation capacity.

2.36. All of these problems need to be urgently addressed if public expenditures in Nicaragua are tomake a significant contribution to the economic and social development of the country. The PSERproposed a phased approach to taclde these issues. The first phase should address the issue of the highlevel of recurrent expenditures. Moreover, several steps would be taken concurrendy to address theinstitutional weaknesses in the areas of budgeting, expenditure control, aid coordination, accounting andauditing. Not much progress has been achieved in addressing these most urgent problems.

2.37. To reduce and restructure the Central Government current expenditures, the PSER proposed thefollowing immediate measures:

(i) reduce the size of the wage bill while increasing wages for professionals;

(ii) reduce expenditures in Goods and Services, while increasing allocations for O&M; and

Ciii) reduce expenditures for defense.

2.38. At six times GDP, the total db remains unmanageable and unserviceable. Foreign debt has beena major financing source of domestic imbalances for the last twenty years. The financing gap reachedUS$ 768 million in 1992 and is expected to reach US$ 644 m. in 1993 (including debt service), despitelarge flows of official grants. The closing of the financing gap is covered by accumulaig arrears ofinterest and by restructuring principal.

2.39. Nicaragua stopped servicing commercial bank debt in 1986 and mulilater debt in 1988. By theend of 1990 total arrears were about US$ 4 billion of which up to US$ 2.3 billion could be defined asprincipal arrears (including capitalized interest).

2.40. After the March 1991 stabilization program, the Govermnent began the process of reestablishingfinancial relations with international creditors. First all arrears with the World Bank and IDB werecleared. Then, agreements with Mexico and Venezuela were reached on beneficial terms that amountedto a combined total forgiveness of US$ 1.3 billion. In addition US AID granted a 100 percent debtforgiveness amounting to US$ 260 million, all of which was in arrears.

2.41. In December 1991, Nicaragua signed its first rescheduling agreement with the Paris Club. Thisagreement covered public or publicly guaranteed loans with a commitment date on or before November1, 1988. It also covered short-term debt failing due between January 1, 1991 and March 31, 1993 aswell as all arrears due as of December 31, 1991. The participating countries chose a 50 percent debtreduction for all concessional debt, extending concessional loans for the difference. As regards non-concessional debt they had two options; a) wridng off 50 perent of outsunding debt with the differencefinanced with loans at market interest rate, or b) extending a new loan for the outstanding balance at aconcessional interest rate.

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TABLE 2.5: OUTSTANDING EXTERNAL DEBTillbon of US Wollar)

1971 1979 1984 1990 1991 1992

DEKr OUI3TANDING AND DISBURSEDPublic & Publicly Gust. LT Debt 179 1,084 4,060 1,067 8,703 8,875

OfficialCreditor 122 660 2,762 6,63S 6,511 6,682Multilateal S9 344 669 976 9S7 997of which IDA 3 23 59 60 113 186of which IBRD 31 8S 134 239 124 103

Bilateral 64 316 2,093 5,659 5,554 5,685

Private Creditors 57 424 1,298 1,432 2,192 2,192Bonds 8 0 0 790 790Commorcial Banks SO 393 1,2S9 1,298 1,298 1,298OtherPrivate 7 23 39 134 105 105

Private Non-Guantweed LT 0 0 0 0 0 0Total LT DOD 179 1,084 4,060 8,067 8,703 8,875Use of IMF Credit 12 57 9 0 24 24Short-Term Debt 0 389 680 2,S56 1,718 1,927Total Exernal Debt 191 1,531 4,748 10,623 10,446 10,826

2.42. Total outstanding debt amounted to US$ 10.8 billionby the end of 1992, broken down as follows:more than 50 percent is owed to bilateral sources (34 percent to the former socialist countries and 21percent to Latin America). This does not include the former Democratic Republic of Geemany (DRG)debt (5 percent of the total) that reunited Germany want to include in the Paris Club (9 percent of thetotal without DRG) 7. Multilateral agencies hold 1 percent of the total debt and commercial banks 11percent.

2.43. Virtually total forgiveness will have to be obtained from bilateral creditors and commercial banksif the level of debt is to reach manageable levels. Settlement of the debt question is key to a healthiereconomic environment for Nicaragua. Having a debt level that is impossible to service provides an addedsource of uncertainty for the private sector. The Government urgently needs a well-thought strategy toachieve the substantial forgiveness it requires. IDA is assisting the Government to develop such astrategy.

2.44. Another issue that lowers the credibility of the macroeconomic framework and the sustazabibityof the reforms, is the continued level of dependency on fbreien aid. There are already strong indicationsof a decline in the readiness of donors to continue supporting Nicaragua with the levels of resources ofthe past three years and the Government urgently requires a strategy which adapts to lower levels of aid.This requires a major improvement in the savings to GDP ratio from the -13.1 percent realized in 1991to a significantly positive flgure by the end of the decade. It also requires a reversal of the decliningtrend of exports. Both imply that there would have to be a substantial reduction in consumption per

7. The inclusion of the East German debt in the Pars Cub is opposed by thc Govem t of Nicaragua.

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capita. In the scenario presented in Table 11, it is demonstrated that consumption per capita has to bereduced by 10.5 percent from 1992 to 1997 to adapt to lower, projected levels of aid.

2.45. A significant increase in foreign donations and concessional loans, which together amounted toabout 33 percent of GDP in 1991 and 1992 has financed the current account and the capital account ofthe balance of payments. Net disbursements of offlcial loans on concessional terms and foreign donationsaveraged US$632 m. in 1991-92, compared to US$436 m. in 1989-90. When analyzed on an accrulbasis, the main reason for the overall deterioration in the balance of payments from 1990 to 1992 is thevast increase in external debt servicing obligations, both interest and principal, as of 1991 (see table 1.6Amortization and Interest Due Lines). Even on a cash basis, however, the current account deficitincreased substantially, due primarily to the deterioration of the trade balance.

Ng~ ~ ~~~. . *.' . \ E . ____

2.46. If one compares thie 1990 and 1992 balance of payments, several diffierences stand out, aside fromthe already noted increase in the trade deficit -and in total aid and concessional debt. Firstly, amordzationof principal and interest increased from US$17 in 1990 to US$151 in 1992. Secondly, te flow of private

- 18 -

capital' changes dramatically from a capital outflow of US$255 m. in 1990 and US$186 in 1991 to acapital inflow of US$167 m. in 1992. This is important becase private capital flows are not at allcontrolled by the Government and can fluctuate much more widely than official flows. This US$350 m.swing is a key element in financing the deterioration of the current account in 1992, and could reveal ashift in attitude by private investors towards Nicaragua9.

2.47. The economy also needs to generate the foreign exchange required to import and repay externadebt. For this, exports need to grow at relatively high rates in the next decade. Forunately, the termsof trade are not expected to be as unfavorable as they have been during the last two decades. Howeverit is unclear how it will be possible for Nicaragua to keep a competitive exchange rate at the same timethat it is receiving huge flows of aid. The flows of aid increase aggregate demand in both the tradableand non-tradable sectors;10 they reduce the supply of goods for export and increase the demand forimports, increasing the trade balance deficit; and they increzse non-tradeable prices, especially wagesthereby decreasing the competitiveness of exports.

TABLE 2.6: NICARAGUA - BALANCE OF PAYMENTS, 198892(Millions of US Dollars)

1988 1989 1990 1991 1992

CURRENT ACCOUNT BALANCE -633.8 -369.8 -303.9 419.4 440.9TRADE BALANCE 43.9 -236.6 -236.8 -395.3 -S60.2

Exoiu (FOB) 232.7 310.7 330.6 268.1 224.0inpoIs (FOB) 716.6 S47.3 S67.4 663.4 784.2

NPS BALANCE -102.5 -97.3 -51.7 -86.2 46.0Expods of lIFS 27.9 21.9 59.8 702 86.2ImportsofNPS 130.4 119.2 11.S 156.4 172.2

RESOURCE BALANCE -586.4 -333.9 -218.5 -481.5 -6462NET FACTOR INCOME -236.S -204.8 -217.0 430.4 482.1

Ine Paymets 238.6 211.6 228.8 440.1 489.8Paid 9.6 7.5 12.0 21.1 87.7

NEr CURRENT TRANISFERS 189.1 168.9 201.6 492.5 287.4CAPITAL ACCOUNT 118.3 -137.S -170.2 -640.5 -473.1

Official MLT 2.4 -100.4 -169.0 -684.6 -473.1Disbursemnts 285.9 2863 227.5 229.0 342.8Amniortzation 283.S 386.7 396.5 913.6 81S.9

Pad 5.1 8.0 S.1 29.0 3.3Othes 115.9 -37.1 -1.2 44.1 0.0

ERRORS AND OMISSIONS 63.8 -122.7 -25S.3 -186.2 167.2OVERALL BALANCE 451.7 -630.0 -729.4 -1,246.1 -1,146.8Memo:Stock Net Off. Reserves -851.6 -919.3 -1,116.3 126.0 133.8

Source: Cenm Bank of Nicragu.

8. The flow of private capital is usually approximated by the item "c= and omission? of the Balance of Pgyments.

9. However, it is likely that most capital flows went into financial deposits.

10. This refers mostly to untied aid, and the component of local eedbitur in projesb.

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2.48. The increase in wages is a matter of concern, since it has been financed by the inflow of aid.It will be hard to reduce wages once aid decreases and so output may be severely affected. Moreover,since the savings ratio has substantially deteriorated in the last two years, and imports of consumptiongoods have increased significantly, it appears that the population may be mistakingly assuming that theincrease is permanent. Only if a very substantial part of these imports are durable goods, can thesefigures be reconciled with the population's understanding that the present standard of living is beingsustained by a temporary flow of aid, and that consequently it will have to be adjusted downwards in thefuture.

2.49. In conclubion, exporters are not only uncertain as to the ability of the Government to adjust toa lower level of aid, while maintaining the achievements of the stabilization program, but also have toface a high level of domestic costs due to the influx of aid.

Recommendations

2.50. The Government should reassure investors that it does have a strategy to address the expecteddecrease in aid and large financing gaps. One way to alleviate the undesirable effect of external aid inthe economy is to use it for investmnent purposes. The government has already done this to a great extentby financing a relatively large public investment program (PIP)." The altenative is to save the aidby reducing public dissavings. There are three areas where additional measures will be required:

a) further fiscal compression: the reduction and rationalizing of public expenditures, and theexpansion of the revenue base;

b) tighter domestic credit: there is still room left for reducing credit expansion by the publicsector banks. State banks should be subject to tighter rediscount limits linked to loanrecovry performance; and

c) external policies to encourage exports and reduce Import demand: tighter fiscal and creditpolicies should help to reduce import demand, and an appropriate exchange rate policyis needed to encourage exports.

11. However, sin¢c the overaU level of investme has remained stagnant, sad enpos hae. fillen, aid ha principallyfileld a rise in pivate cosumption.

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ANNEX

MEDIUM TERM PERSPECTIVES

1. Nicaragua's medium-term outlook is largely dependent on the Government's ability to implementthe adjustment measures described in Chapter 1. To assess the country's perspectives, a scenario wasdeveloped for the rest of the decade. The results for the medium term projection for the period 1993-2000 is presented in the following Table (see page 23). Several assumptions were made in preparingthis projection. On one side, the macroeconomic scenario was prepared assuming that the resourcebalance deficit will have been sbrply reduced, as gross inflows of foreign capital go down from 33.7percent of GDP in 1992 to 15 percent of GDP in 2000. It is fiunier assumed that the Government willadminister fiscal and monetary policy in such a way that they achieve an 'orderly' adjustment to a lowerinflux of aid. On the other hand, the microeconomic scenario assumes that substantial progress will beachieved with the help of the strucural reforms identified above. With particular, reference to propertyrights, the financial sector, labor productivity, reduced policy and improved infrastructure.

2. An 'orderly" adjusunent would be attained if the overall deficit is reduced from approximately10% of GDP in 1992 to approximately 0% by the year 2000 (see Table on page 23). Since the majorityof the reduction in international aid is expected to occur in the next two years, the overall deficit shouldbe reduced to 2.7 percent by 1995. This could be achieved through an increase in revenues and adecrease in expenditures of similar levels. Since revenues are expected to increase substantially in 1993,the main objective of fiscal policy will have to be to reduce expenditures. A 12 percent reduction isprojected in 1993. This adjustment is the only way that a reduction in overall demand can be compatiblewith a growth of GDP and a sharp increase in exports.' Moreover, an adequate management of themacroeconomic framework is the only scenario in which international aid will be maintained, even at thereduced rates that are expected. If the adjustment is not orderly, aid would decrease much more rapidly.

3. Even after the adjustment mentioned above, this scenario continues to depend on a large inflmuxof aid to finmce a resource gap that would have to diminish to US$389 million in 2000 (from US$646million in 1992). The average resource gap in 1993-2000 would be US$422 million.

4. The required US$257 million of adjustment will be achieved in an orderly manner if totalexpenditure of the NFPS falls from 28.8 percent of GDP in 1992 to 21.7 percent of GDP in 2000. Theadjustment should fall exclusively on current expenditures for the infrastructure to be rebuilt in a waywhich encourages sustained growth. Monetary policy should adjust accordingly. Net domestic creditwill have to fall from a stock level of 41.7 percent of GDP in 1992 to 21.4 percent of GDP. If theadjustment in public sector expenditure is achieved, then the adjustment in net domestic credit can bedone without constraining the private sector's credit. In this scenario, net domestic credit to the privatesector would grow from 35.7 percent of GDP in 1992 to 52.7 percent in 2000. Prudent management offiscal and monetary policy could allow inflation to remain at one digit levels, reserves to decrease by onlyUS$30 million up to 1995 and then go up, and the balance of trade deficit to diminish from US$841million in 1992 to US$364 million by the year 2000.

5. Through the consolidation of the structural reforms, exports are assumed to grow by 6 percentper annum in the period 1993-2000. Gross domestic invetment is supposed to grow from 20 percenin 1992 to 26 percent in 2000, mostly driven by private investment. Gross domestic savings will go up

1. Although growth i1 per capita prvat conwption wil only be atainble if GDP gowwis very high.

-21-

from minus 16.7 percent of GDP in 1992 to a positive 4.1 percent in 2000, helped by the decrease ofthe fiscal deficit before grants from 9.7 percent of GDP In 1992 to 0.4 percent in 2000.

6. For the macroeconomic adjustment to evolve without a recession, adjustments will need to bemade to the exchange rate and the real wage rate. The projections assume that the labor market showsgreat flexibility, allowing a reduction in international costs per unit of production and facilitating thereallocation of resources. If this is not so, then adjustment will be more painful.

-22-

SlCARAGUA -KEY END TOORS

1991 1992 19i3 1994 19m 19 I997 199 999 29

Red1 Gvod RtAamn Dmwdo ouwx -..2 04 0 4 2.1 3.4 3.7 3* 4.1 4.2 4AMDP po.aqb -3.4 -2 -2A4 .1.2 01 0.4 0 08 0.9 I .1Tdd _ ocisowom. 4.0 .3* 0.6 is 1.5 2 2.6 2.8 3.31i Cmw &.pca 29.0 -2.9 01 1 -13 -1.9 4B 4 0.7 .4.5 0.2fda Cm _fA PM "ph -36.t -7.1 -2B9 4.9 -3.0 4.7 40.7 4.1. 4.1 -t3Pqfmla lGrowt Rob 3.2 33 3.3 33 33 33 33 33 33 3.3

NodIW Aa.O (As S .tGMICam,dr 2t1O 116.7 1G9.9 1i07 103.4 103.5 M4 99 97.7 959Glass_D_NWo_bmaus" 210 19.7 21A 21J4) 212 22* 233 24.5 250 154await d&0bANFS 22. 19.2 24* 253. 274 31.1 37 35.5 343 40*hP at da eaNFS 53$3 55. 6 561 54 4.2 57.4 574 59.9 61.1 619Goo n _W Sb -102 -16.7 -9.9 -tJ7 54A *3X ^1 0.2 2.3 4.1

TOWl Ca 26.3 3AS 3.6 343 343 34A 34A 34.4 342 33STOW C zuiwlim 24 23* 25* 269 23.9 23A 22A 29 22.4 21.1ToW. C*k1 Fq _NS 5.7 1 . 6 1264 14.1 133 1U.4 132 13.2 13.1 12P dA hici& -66 4 .2.9 0.2 1.1 2.2 2.5 2.9 32 33o0 _a l7m 4.7 .0.1 -t.1 -4.6 -2.? -2.0 -12 -1.5 -1.1 404

0fl 3gum ._ 5.0 -2. 1.2 3. 0 4.1 445 4.5 4.2 4.4 4.9

Pad Raw ms wbDEsta Gd NFS -2164 18.5 -10 9S 64 5 4.4 4B 5D0 S0frpmsaGob*NtFS 14. 62 .19D 3.7 2.1 OA 0. 1S 0.7 2.1

_eau. 3.1mm -31.1 -36A4 313 -28.7 -26 -26.4 -24 -24.3 .3.S -21.Comm Acom48- PI- -13 .3.9 LI -tA -7- -7.2 A4 4t -53 .4(As s4o d dmtaGoods)

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CHAPTER 3

THE ENABLING ENVIRONMENT FOR PRIVATE SECTOR-LED GROWTH

A. INTRODVCTION

3.1. In 1990, the principal challenge facing the new Government was to prevent the reemergenceof civil strife in a still highly divided society and to strengthen the legal and political foundations of ademocratic system. In 1991, it was to regain macroeconomic stability after three years of hyperinflation.The Government was successful in achieving both. However, it has yet not been successful in meetingthe third challenge: to reactivate economic growth in an equitable and sustained manner, withoutjeopardizing the hard-earned gains made on the stabilization front. To meet this challenge, theGovernment has a long way to go yet in facilitating the transformation of the economy into a market-based and private-sector-led system.

3.2. Resumption of growth through the expansion of private sector activity faces some severelimitations in the short-term: in view of Nicaragua's recent history of macroeconomic instability and stateinterventionism, the private sector is understandably cautious in tying up its capital in major newventures, despite the important economic reform measures already implemented by the Government.More importantly, private investors are not likely to invest significant amounts until the risk of policyreversals and political instability have diminished sufficiently.'

3.3. In the short-term, growth will have to come mavily from improvemens in productivity. Forhigher productivity to be achieved, the public sector needs to focus on reallocating resources to priorityareas, away from administrative and unproductive expenditures but rather towards the delivery of moreand better public services and improved infrastructural support for private economic activities.2Similarly, greater efforts need to be made to improve the coordination of foreign aid to ensure thatexisting aid allocations conform with the Government's priorities. Finally, existing distortions andrigidities that inhibit private activity and impede flexible supply responses need to be removed quickly,both to attract new private resources and encourage a more efficient use of existing ones.

3.4. In the medium-term, the achievement of an adequate level of investment and of sustainable growthwill depend on both political and economic factors. This report will not dwell on the key politicaluncertainties. However, the fragility of the UNO coalition, the confrontation between the NationalAssembly and the Executive, the potential Sandinista role in the government, and the behavior of thearmy and police are all issues that have increased political uncertainty. Some of these issues have beenbrought up by donors when deciding whether to disburse aid or not, consequendy adding to the economicuncertainty. Also, the habitual recourse by unions and other organizations to violence in support ofeconomic demands increases the risk involved in doing business in Nicaragua.

1. Moreover, Solimano (Understanding the Investment Cycle in Adjustment Prgrams, WPS 912) has found that successfulstructural adjustment process show a lag of 3-5 years bdween reforms and a pick-up in private investment. Although nostudies exist yet, this period may be more extended for economies in the transition to a market economy. The experienoe inthe Eastern European countries has been that this transition has bcen accompanied by sharp falls in output that wereprevented in the case of Nicaragua.

2. See Nicaragua Public Expenditurc Review (Report No. 10785-NI, September 11, 1992).

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3.5. Beyond the political problems, sustained economic growth in Nicaragua requires a clear medium-term economic framework that will allow the development of a dynamic and diversified export sector.In the present conditions, the adoption of such a framework is hampered by the uncertainties generatedby the economy's dependence on a substantial flow of foreign aid and the unresolved huge debt overhang.The key accomplishment of the present economic policy i.e., the stabilization of prices, is heavilydependent on successfully adapting to lower aid flows and on the favorable settlement of the debtproblem.

3.6. While the uncertainty about the sustainability of the stabilization policies is the most pressingissue, several other barriers to economic growth exist. For private, export-oriented investment torecover, the Government will have to address: a) the unresolved property conflicts and the weakenforcement of property rights; b) excessive use of discretion in the management of tax, trade, and exportand investment promotion policies; c) ineffective allocation of credit by stateowned banks and unfaircompetition from them preventing the development of the private sector banks; d) inflexible labor marketregulations; e) the lack of regulatory framework in several key sectors (natural resources, public utilities);and f) high tax burdens due to excessive exemptions and poor tax administration.

B. THE CURRENT POLITICAL ENVIRONMENT

3.7. A survey conducted by INCAE shows that Nicaraguan entrepreneurs are frustrated by thefrequent changes in their external enviroment, and that their major source of uncertainty is related topolitical issues. Dui Mg late 1992, a conflict between the Legislative and Executive Powers rendered thelegislative inoperative. In late December 1992 the Assembly's Board was dissolved by the Executive.Since then UNO has refused to participate in ftis year's Assembly meetings, therefore continuing a periodof questioned legality of the Assembly's operation. The Assembly proceeded to fire the ComptrollerGeneral. His firing has also been a point of contention between political parties. As a result of thissituation, and the perceived influence of the Sandinistas over the Government, the private sector's outlookfor the future has become more pessimistic.

C. LACK OF DEFINED PROPERTY RIGHTS AND UNCERTAINTY

3.8. The property rights issue is having a significant impact on the business and investment climate.The problem is not only the undefined ownership of a significant percentage of the agricultural and evenindustrial properties, but also the violation of the property rights of those that have a clear title to theirproperty. The Govermnent's inability to take action to prevent and avoid property right violations, toreverse acts of expropriation, and to enforce the law is producing a climate of violence and uncertaintywhere few people are willing to invest, given the threat that the land might be claimed by a formerowner, invaded by squatters, or subjected to crop theft. What makes matters worse, some of thosewilling to invest may lack access to credit, since the absence of a title makes it impossible for banks toaccept land as collateral.

3.9. In an attempt to improve the security of land property rights, the Government: a) has establisheda commission to elaborate a draft law to consolidate and guarantee property rights; b) has completed theclassification of all unduly expropriated or assigned rural properties and proceeded with a financialcompensation plan; c) has issued an executive decree establishing land ownership criteria and technicallysound land titling procedures; d) has instituted the legality of permanent and provisional land titles, as

- 25 -

well as "constancias de asignacion" and "cartas posesorias", awarded to beneficiaries of the agrarianreform by the present or past administrations; and e) is strengthening the property title and land registryoffices so they can perform their duties, through the World Bank's proposed Agricultral Sector Loan.However, most of these actions have been relatively recent and/or have yet to be completed, so they havenot yet had an effect on the prevailing uncertainty.

3.10. To date, progress in resolving claims on property has been very slow. About 200,000 petitionsregarding the violation of property rights have been presented to the Attorney General. The main causeof the current tenure uncertainty lies in the mumber of mechanisms used by the previous Government toseize properties from former owners, together with all the mechanisms used to transfer (or not transfer)them legally to agrarian reform beneficiaries. There were at least nine ways in which the State acquiredland, agricultural, industrial, and commercial enterprises. They range from the Agrarian Reform Laws(Decrees 329 and 782) that supposedly were drafted with some degree of objectivity, to other propertyappropriations, that are linked to specific and clear political circumstances. Among the latter, Decree 760refers to the confiscation of properties that were abandoned or whose owners were out of the country withno intention of returning. Many former owners are now demanding the restitution of their propertiesclaiming that they always had the intention of returning. Also, decrees 3 and 38 through which the goodspertaining to the Somoza family and to Somoza officials or people linked to Somoza government wereconfiscated, are of an elastic interpretation. These decrees used a legal concept of confiscation that hasthe character of punishment. However, this kind of punishment does not exist in criminal law and nocourt orders were issued in this regard. Most demands are based on the fact that decrees 85 and 86 usedthe legal procedure of expropriation to transfer properties, when expropriations require a previouscompensation that in most cases was never granted.

3.11. Claims by ex-landowners amount to 75 percent of the reformed area.' Most of these propertiescontinue to be registered under the name of their former owners. According to the Ministry of Finance,out of 8 million cultivable manzanas in the country, 2.2 million are being claimed, of which 1.2 millionhave been resolved by the "Comision Nacional Revisora de Confiscaciones'. Those that have beenresolved were the simpler cases and the criteria to resolve the others has yet to be defined. In addition,even after the authorities make a decision, the present legal owner of the property has to go through ajudicial process to try to vacate the property as the committee only decides on the issue of property, butdoes not resolve the issue of possession.

3.12. The Government has devised a compensation scheme for those whose property was unjustlyexpropriated or confiscated but who cannot recover their property. The compensation will be in bondswith a 20 year maturity at an annual interest rate of 3 percent (indexed to the US$ exchange rate) thatcan either be kept to maturity or used to buy public assets. The main problems with the scheme are thelow interest rate and the low cadastre property values. At a discount rate of 10 percent the present valueof the compensation is of about 40 percent of the nominal compensation; using the current deposit ratethe present value is of only about 27 percent. In addition, the cadastre value is less, and sometimessubstantialy less, than the market value of properties. Thus, the present value of the compensation couldbe very low relative to the market value of the property. The 'Asociacion de Confiscados" rejects this

3. The refomed sector (those favored by the agrerian reform) achieved ownership of 36 percent of the total 8 millionsowbe manbanas in fte country by 1991.

- 26 -

form of payment and demands the restitution of properties4 . According to the public prosecutor, thosewho do not accept the bonds, can go to Court and use the judicial mechanisms available, includinginternational arbitrage.

3.13. There is doubt as to whether the property issues are in fact being legally resolved as theGovernment has been addressing the problem of property by using decrees which have less strength thana law to speed up and expedite the process. Thus, all those affected by confiscations and expropriationsthat do not accept the compensation offered by the Government could continue claiming their properties.This adds to the prevailing uncertainty.

3.14. There is, moreover, litde point In establishing property rights if they cannot be enforced. Thenumber of land invasions, continue to be very high. It can take the Government up to 90 days to carryout evictions, by which time the intruders can have caused severe damage to the property, andlor profitedconsiderably from their actions. It is unclear what sanctions intuders receive once they are forcefullyevicted. Mechanisms have to be found so that the intuders can be evicted more quicldy and properlypunished thus lowering the incentive to invade the properties. Ihis is part of a more general problem:frequent recourse to violence as a method to settle disputes; strikes dta threaten to affect the provisionof public goods and services; and the weak enforcement of laws and Government decisions by the police.

3.15. Broader policies should be devised that can deal with a large number of cases at once as thereare so many unresolved property claims. Once decisions have been made based on these rules,enforcement needs to be swift, both in terms of issuing clear title and in the physical return of theproperty. The compensation package for those who do not recover their properties needs to be mademore attractive, this could be done by adding public enterprise shares to the package, which would alsopromote privatization.

3.16. There is a 6% tax on all property transfers. This is high for a country that urgently needs tobring order to property ownership claims. In addition the tax on the formal registation of asset transfersmight further cloud the picture as to who is the real owner of assets in Nicaragua. It may be advisablethat propert transfers up to a certain date should be exempt from this tax in order to encourage a fastregistration and transferal of properties thus clarifing Nicaragua's ownership situation.

D. RULES VERSUS DISCRErION AND THE BUINESS ENVIRONMEN

3.17. One of the principal problems to be addressed is the use of discretion with which existing normsare applied. As the focus of the Goverment's policy shifts from stabilization to restturing theeconomy and promoting long-term growth, gaps are fbund in the basic legal and regulatory frameworkneeded to attract private investment. These gaps are being addressed in an ad-b manner throughadministrative fiat and interpretation, that does not provide a sufficient enough guarantee forsustainability.

4. Arges Sequeira, presiderA of the 'Asociaci6n de Confisoados and at the same time president of the 'Union ofAgricultural Producers of Nicaragua" (UPANIC), which groups medium and large famers of the country, was assassinatedin Managua on Nov. 23, 1992. Pormer Sandinista army officials have been accused of hIs death.

-27 -

3.18. This case-by-case approach not only increases the transaction costs of doing business, but drawson one of the scarcest human resources in Nicaragua: managerial ability in the public sector. In the day-to-day operations of enterprises, control mechanisms continue to pervade and many permits arerequired.' The Economic Cabinet should rule out the use of discretion and ensure that problems aresolved within the existing legal framework. The constant change of legislated rules through Executivedecrees, though apparently supported by the Constitution, appears to be excessive.

3.19. The case-by-case approach also leads at times to a divergence between the country's statedeconomic strategy and its implementation. Often Government employees prefer to maintain control overthe private sector instead of encouraging and facilitating it's development. This gives rise to accusationsof arbitrariness and corruption on the part of the civil servants. A special deregulation unit in theMinistry of the Economy (MEDE) was created to solve this but it has been slow in starting to operate.The reduction in the size of the public sector, in consonance with the changing role of the State shouldalso help to solve the problem. In a policy environment where the private sector is assigned the leadingrole in economic growth, a smaller but more efficient public sector is essential.

3.20. Price controls is another area where there is a disparity between declared policies and theirimplementation. Although price controls have been formally abolished, MEDE monitors the prices ofbasic goods and tries to manage them. This occurred, for example, in the period following the January1993 devaluation. MEDE negotiates directly with main producers on what prices they should charge.Its main bargaining instruments are "ordenes ministeriales' that the Ministry of Finance signs whichmodify the level of import quotas and taxes for goods and inputs and require no advertising; and themanagement of goods donated by the international community. The credibility of the Government'seconomic policy is undermined when it artificially reduces the price of basic goods for short-term politicalgain and encourages the creation of monopoly rents that could lead to even higher prices in the future.6

3.21. In sum, norms should be clear, so to prevent ample use of discretion by public employees thatimplement them, and the capacity to modify norms without any prior notice through 'ordenesministeriales' should be abolished. The practice of ruling by decree should be curtafled, in partic~ularwith respect to the ease and frequency with which taxes are changed (see Chapter 5). Even though theConstitution gives the Executive the authority to do so, the frequency and the way in which these powersare uset appears to be excessive. The present Constitltion created a double legislative system. On oneside it confers to the Assembly the faculty to legislate without restrictions. On the other, it confers onthe President the faculty of issuing executive decrees with force of law in fiscal and administrativematters, without defining the exact scope of these areas. Even if it were clear exacdy what was meantby fiscal and administrative matters, and the uncertainty were removed, there would remain an area in

S. For exanplc, tire imports arm nominaly free but it is not possble to import them wvhout the authorization of theMinistry of Transport and Construction. Also, somc of the bureaucratic constrains that wee eiminated by the Govemmaetwere taken over by the municipalities.

6. A recent exampk of MEDE's exercise of price polioy is the gentllnen's agreemCeta with the chicken producers(ANAPA) on the price of chicken. ANAPA would reduce the retail price of chicken from US$1.17 per pound to US$1.04in exchange for the Goverment's assurance that imports would supply only 10% of the Nicaraguan chicken market whichaverages about 4 miion pounds per month. Chicken producdon is a hgy concentratd industry in Nicaragua with oneprodu¢er accounting for 809% of production. It is principaly this enterprise that is now being protected from its maincompettor, namely imports, creating the potenial for monopoly rnts in the future. This contradicts the Government'sstated trade policy.

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which both powers would have responsibility, and were there could be conflicts and insecurity if bothpowers were to tackle the same topic with different perspectives.

3.22. This situation is made more complicated by the fact that the Assembly's procedure to legislateis excluded from the Constitution, and Is included in the General Statute of the Assembly that could bereformed without the Executive's consent.

E. LEGAL FRAMEWORK

3.23. The best way to encourage the private sector to expand into areas where Nicaragua has acomparative advantage is by providing an incentive structure that does not discriminate between differentactivities and that is stable over time. The Covernment should not be sidetracked into trying to identifycomparative advantages and offer special incentives for certain activities. Based on experiences in othercountries, the private sector generally has proven more adept than governments in identifying the mostprofitable investment opportunities. Furthermore, in view of the fragile state of public finances, thereis little room on the part of the Government for offering significant incentives. Instead, the Governmentshould concentrate its efforts on improving the overall business environment through the consistentapplication of existing tariffs and duties, the elimination of unnecessary licensing requirements and acurtailment in the discretionary powers of different ministries. Ihis includes the substitution of reviewboards by fixed norms in setting the conditions under which foreign investors and exporters operate. Theexplicit abolition of certain existing legal requirements is also required in some instances, including theCentral Bank's legal powers to authorize foreign exchange transactions.

3.24. An important example of the problems in the current legal framework is the Foreign InvestmentLaw. The country should offer foreign investors the same conditions as those fbr local investors withoutany special incentives or privileges. No examination or approval, apart from registration, ought to berequired. Exceptions should be few, specific and applicable without prior negotiations. Unrestrictedtransfers should be permitted for dividends, royalties and fees, as well as for interests and repaymentsof loans. Repatriation of capital should also be freely permitted. No restrictions should be placed on theavailability of foreign exchange.

3.25. Viewed in this light, Nicaragua's Foreign Investment Law needs to be revised. The law leavestoo much to discretion leaving room for different decisions, incentives, and benefits for investors insimilar situations. Also, the implementation of the law is not working smoothly. Investors thatregistered their foreign exchange in the BCN have only obtained foreign exchange to pay principal butnot for interest since June 1992. In other cases investors have been unable to repatriate dividends.

3.26. The Foreign Investment Law defines foreign investnent on the basis of the origin of the capital,not the nationality or residence of the investor. Thus, expatriate Nicaraguans investing in the countryare considered foreign investors. Domestic investors entering into a joint venture agreement are accordedthe same rights and are subjected to the same supervision and restrictions as foreign investors, except thatthe domestic investors do not enjoy repatriation and remittance rights.

3.27. The Foreign Investment Law's main restrictive clauses are those which:

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(i) impose an authorization process that leads to an "Investment Contract" with theGovernment and establishes a TForeign Investment Committee" for this purpose. lhereis no appeal to decisions made by the Committee except to the Committee itself;

(ii) tax or duty exemptions are awarded at the discretion of the Committee. Hence, investorsdon't know beforehand what investment incentives the country offers or whether acompetitor may be awarded higher incentives. Even if this discretion were not used todiscriminate, its mere existance generates uncertainty;

(Wii) the Committee has to approve the enterprise's management organization;

(iv) the Committee can limit foreign investors' access to domestic financing to short-termcredit and only for worling capital; and

(v) permission is required to buy foreign exchange from the Central Bank and it can limitcapital repatriation to funds received from the sale of shares of the company.

3.28. All these clauses should be modified so that the foreign investment law:

(i) avoids screening procedures;

(ii) provides clear rules that are not subject to bureaucratic interpretations or flat; and

(iii) protects investments from arbitrary treatment. Efforts should then be directedtowards establishing proper accounting standards and requiring that firms adhereto basic, internationally recognized accounting standards.

F. INFRASTRUCTURE

3.29. Given the wide array of constraints to private sector developmet, entrepreneurs do not considerinfrastucture problems a priority. However, in order to provide the necessary complementary physicaland social infrastructure the solving of the istituional problems has to be linked with plans forinfrastructre mvestment. Nicaraguan seaports have lost trade volume to ports in neighboring countrics,due to high tariffs, poor service', and deteriorated and obsolete facilities. The country's twenty year oldinternational airport is congested, and will not be able to handle efficiently anticipated future traffic flows.The lack of roads and the bad condition of existing ones in the mountain zone, is a problem, in particularfor both coffee and cattle. Electric power supply is irregular (sudden cuts} and low quality (sharpvariations in voltage), which affects irrigated crops, cooling facilities for exportables, machinery, etc..Given the Government's stra of growth through the development of exports one of the key issues thatwill constitute a bottleneck for export development is transport.

7. Members of the Foreign Investnent Commiitte are: the Minister of Economy and Development (Chair); the Minister ofExternal Coopetion; the Minister of Fuance; the Presient of the Cental Bank of Nicaragua; and a representative of apoL;tical party or parties who obtained the second place in the last elections.

8. Some entrepreneurs state that they even have to use their own workers and are paying just for access to te port.

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3.30. The rest of the report is structured as follows. Chapters 4 to 7 examine recent developments inmajor policy areas. Ihese areas are privaization, trade reform, tax reform, and the fincal sectorreform. The relevant chapters contain a summary of recent changes in policies, the impact of thesechanges on the economy, and identify additional steps required to deepen the refbrm process. A commonthread of these chapters is the discussion of how the changes have affected the business climate inNicaragua and what fiurher needs to be done to improve this climate. Chapter 8, on the agriculturalsector, focuses on one sector of the economy where rapid improvements are essential for the revival ofoutput and export growth. Finally, Chapter 9 is devoted to key issues in the labor market which havea strong bearing on the transition to a market-oriented, competitive economy where the private sector isexpected to play the leading role.

CHAPTER 4

PRIVATIZATION

A. RECENT DEVELOPMENTS

4.1. Despite recent action taken towards divestiture, Nicaragua still has an extensive state enterprisesector that is a burden on the economy, and which was esdmated to have had a final cost of someUS$200 million since 1990. Nicaragua's state enterprises are comprised of: Ci) the public utilitiesincluding the electricity monopoly (INE), telecommunications (MELCOR), water and sewerage (INAA),and the port and airport authorities; (ii) the state banks that according to the consitution can't beprivatized; (iii) some enterprises that are not utilities and are still directly controlled by Ministries; and(iv) the commercial state enterprises still under the control of Corporacdones Nacionales del SectorPdbllco (CORNAP).

4.2. The Sandinista government nationalized the core economic activities and put them under the Areade Propiedad del Pueblo (APP). State control of production led to heavy political intervention, reductionof production, technol gical backwardness, and excessive employment in both manufacturing industriesand agriculture. Mc, a than 30 percent of GDP was produced in 1990 by state enterprises, excludingthose in the financiz sector. The state controlled 45 percent of value added in manufactring, 70 percentin mining, and 26 percent in agriculture.

4.3. The privatization of the state-owned commercial and industrial enterprises is a major componentin the Government's strategy for structural adjustment. Privatization has Liduced the sale of companieslegally owned by the Government, the return of confiscated companies to their legal owners, andliquidation. By divesting these entities, the Government aimed to reduce the public sector share in theeconomy, lower it's administrative functions and management responsibilities and earn additional revenuefor the budget. One of the earliest steps taken by the new Govenment was to set up the Junta Generalde Corporaciones Nacionales del Area Publica (CORNAP) and make it responsible for carrying out theprivatization process.

4.4. The process of preparing these companies for privatization has proven to be difficult and timeconsuming, due to legal, technical, political, and financial considerations. A major obstacle in privatizingthe non-agricultural companies has been the procedure for determining whether the Governmentlegitimately owns a company. In addition, the Government's respect for the demands of the workersemployed by these companies has added to the slowing down of the process.

Divestment of state-owned companies held by CORNAP

4.5. CORNAP has made substantial progress in the divestiture process having divested approximatelytwo thirds of the 351 enterprises it inherited. However, the international business community has shownlittle interest in bidding for CORNAP's assets and there has been little capital repatriation connected withthe privatization. The situation after the recent divestiture efforts can be summarized as follows:

(i) international trading is mostly back in private hands;

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(ii) the liberalization of internal trade was carried out In early 1991 when almost all enterprisesof the Corporacion Comercial del Pueblo (CORCOP) were privatized;

(iii) agricultural production is now largely back in private hands, including cooperatives, with theexception of rice and sugar;

(iv) in the industrial sector, where 40 percent of output was in public hands during 1988-1989,only 5 percent of total industrial output has been divested to the private sector, and in somesectors divestiture has yet to take place;

(v) the fisheries sector was liberalized before the privatization of the flsh processing plants. Thisis one of the few sectors to where foreign investment has taken place; and

(vi) in the mining sector, which was entirely in public hands, a number of small mines have beensold to workers and the larger mines are being offered to private buyers.

TABLE 4.1: PARTICIPATION OF CORNAI"S ENTERPRISES IN SECTORAL GDP(pe e)

Sector 1989 199Q

Total in GDP 29.2 17.9Totl in CORNAP Sectors 39.1 24.0Agriculture 25.7 8.0

Cotton 28.7 0.0Couon Sced 26,1 0.0Banna 100 0.0Coffee 12.6 0.0Corn 8.2 0.0Sorghum 28.2 0.0Tobacco (Burley) 34.8 0.0Sugar Cane 41.8 41.8Tobwco (Ha ) 100 100Rice 38.0 38.0Cattle 19.3 0.0Forestry 59.1 59.1Fi*ing 100 24.5Mining 100 74.0Industry 43.9 35.5Construction 35.9 17.8Transport and Comm. 29.9 12.0Commerce 50.0 25.0

Source: CORNAP

4.6. The employment cut-backs in CORNAP companies have been greater then the reductionin the number of enterprises. The number of enterprises was reduced by 45.6 percent, out of 351enterprises. From June 1990 to March 1992 the number of workers was reduced by 57.6 percent -from

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77,824 to 32,959. One third of the remaining employ.e work in the 64 enterprises let In theCorporacion Industrias del Pueblo (COIP), and another third in the 9 enterprises of the sugar corporation.

4.7. The income generated by CORNAP's privtzation has been low because in many casesenterprises were returned to former owners. In others, privatzatlon was preceded by *buying out' thecollective agreement i.e., all workers were fired and compensated as stated In the collective agreement.As of May 1992, completed privatization generated C 157 million of which only C 9 million arose fromcash sale operations, and the rest from different kinds of credit sales or rent operations.

4.8. The share of CORNAP's enterprises in GDP has been significant, in particular theinfluence of tfie public sector on certain sectors (see Table 4.1). In 1989, CORNAP's enterprisesparticipated in sectors equivalent to 75 percent of GDP '. Public sector participation in these sectors wasmore important than in the economy as a whole, at 39 percent. As of May 1992, this participation hadbeen reduced to 24 percent of GDP.

4.9. Several Ministdes are engaged in entrepreneurial activities that were not transferred toCORNAP or that were transferred to them by CORNAP. The firms operating under these Ministriesshould be privatized or closed. The number of firms operating under Ministries, their employment, assetsand the amount of subsidies they are receiving need to be determined and an action plan to divest themshould be prepared. In particular, Decreto ley 2-91 needs to be modified to withdraw the army from theproduction of goods and provision of services which compete with the private sector (and to subject thearmy to public sector rules for procurement).

4.10. The privatization process could also be furthered through: (i) the private sector's provisionof services to state-owned frms, including transportation, services like billing, catering and cleaning, themaintenance of port facilities, and operation of sea twansporation services; (i) increased privateinvolvement in education and health management; and Oii) contracting out by private firms to selectedgovernment services, e.g., building and maite ce of roads, garbage collection, garden and parkmaintenance, among others.

Problems to be address_d

4.11. Privatization through CORNAP is taking anywhere between 1 month and 2 years to giveclear title to the new owner. This is due to the delay involved in checking: (a) that CORNAP Is actuallyentitled to privatize the enterprise by establishing the legitimacy of Government ownership and (b) thatthe liabilities with workers and other creditors have been covered. The length of the titling process canvary from case to case depending on the seriousness of the legal and labor issues. Whoever purchasesan enterprise is therefore faced with the uncertainty as to when he wfll receive a clear title. To resolvethis issue, privatization through a kind of leasing agreement ('rent with option to buy') is being used totransfer the properties before formalizing the sale.

4.12. In the bargaining process with trade unions, the concept of worker participation wasdeveloped but it does not have a clear legal framework, nor is the goal of government policy in this areaclear. It is unclear as to whether the Government will provide specW protection or subsidies to theseworker-owned enterprises and this creates uncertainty. The Government should avoid taking any action

1. Using GDP's 1987 structutr.

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Box 4.1

omnAon ofCORNlAP when

CORNAP wuS cetod in May, 1990 to mag tho prhVaiza of th 351 earpri ht the Govenmentinherited. 'new we gmouped in 22 corporations. The wow:

1) AGROEXCO (6 eptprises: production of oolton, aoli)2) BANANIC (2 entepri: production and m of banan)3) CAFENIC (14 a4trrises: production an com liin of cofee)4) CAN (4 etepie: poultry product)5) CATCO (21 eaterprises: ion d epair of car and tueb)6) CNC (11 ntepris lau ou)7) COENCO (6 entepris: Construction)8) COFARMA (9 aeteprses: commerclition of Phannrmaecls)9) COIP (86 enterrie: industial fmu -texte, sho, et.)IO)CONAZUCAR (9 aanis: production of sugar)I I)CONECB (7 enterprises: foreign trade)12)CONILAC (3 caterprise: milk products)13)CORCOP (45 nterprises: commacial fims -suprmarkets,e)14)CORWOP (13 entupses: proesing of wood, fiure )1S)COTRAP (18 enterprises: tansport)16)COTUR (29 enterprise: tourism rlated hotels, retaurants, etc.)17)HATONIC (18 enterprise: livestck)18)1MSA (9 eprises: aricuural sevices)19)INMINB (10 enterprises: minig)20)INPESCA (7 etaprse: fishin)21)NICARROZ (8 enterprises: rice)22)TABANIC (S aeteprises: tobacco)23)Others (11 entepia : vegablae, oil fuit ju, de.)

Wen CORNAP was frmed k Ws mprsd of 77,824 worer. By Marb 1992, this had been reduced to32,959. In tms of employment by far the most importa were COP and CONAZUCAR (each with onetird of the employumet of CORNAP).

that may indicate that this is a possibility, to avoid discouraging potential enns int these sectors.There is also the concern that unfir competition may arise with those enteprises that continue operatingwithin Ministries Cm particular, within the Ministry of Defense). A second issue with regard to worker-owned enterprises is whether the unions wilt have the power to disrupt the flow of supplies to enterprisesthat compete with them. Striles that are perceived as targeting specific firms in order to acquire anunfair competitive advantage should be stongly discouraged.

4.13. In addition, unions are planning to restrict the sale of shares only to other workers in theenterprise or to the enteprise itslf, thus, impedng a future sale of the enterprise and potentiallyestablishing the union as the only possible manager. If the unions succeed, then the worker will only bean owner as long as he works for the firm, and the value of the share will be monopolistically set by the

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union. Tbis arrangement gives workers the henive to decaitalize the enterprisW. Tho only way toprovide the correct incentive in the case of minority owners, is to havo a stock exchang where sharescan be freely traded. Moreover, the ownership of shares in the same enterprise in which they workunduly concentrates the financial risk faced by workes, since the return of their capital and their workdepends on the fate of one enterprise. If worker ownership of the companies is an important objective,rather than distributing shares direcly to the employees, they could be administered by a fnd In whichthe workers have an interest. This mutual fund would diversify the workeres risk and the adminisaioncould be evaluated according to the fnaocial performance of the fimd.

2. The key issue is that, sinc leaving die finm could imply a capital lo under the aragemnt describd, workme prevetthis potential loss by voting for morc dividend distribution and lus capital imcsent. See PNiovi and Punubotn (ads.) ThcEconomics of Property Rights, g Ballinger, 1974, in partiular chapter XVI on the Yugoswvin cpienoc.

CHAPrER 5

TRADE REFORM

A. RECENT DEVELOPMENTS

5.1. The current Government inherited a trade regime under which foreign trade waspractically closed to the private sector. Incentives were largely biased towards import substitution. lheold incentives system, coupled with exchange controls and arbitrary variations in the real exchange ratewere responsible for the reduction of exports to 50 percent of their 1978 level. During the 1980s, mostinternational trade was performed by the state trading companies. These companies monopolized theexport of trad1itional products (coffee, cotton, sugar, bananas, cattle, precious metals, seafood and forestryproducts), and in some years accounted for up to 98 percent of exports.

5.2. State-owned trading companies managed the trade with the Eastern block and imports ofinternational donations. In 1989 these companies accounted for 56 percent of total imports, includinga monopoly on the import of oil and fertilizers. Import quotas and prohibitions only existed for basicgrains and related products, while some export quotas and prohibitions applied to forestry, fisheries andcattle. Private importers had to register officially at the Ministry of External Trade and had to getspecific import permits from the Central Bank. Nominal import protection was not clearly defined andwidely differentiated. It ranged from 4 percent to 253 percent, averaging 48 percent.

5.3. The Government moved quickly to liberalize and deregulate trade. After the drasticdevaluation of the exchange rate, in March 1991, the allocation process for foreign exchange wasliberalized. In principle, importers now need neither ministerial nor Central Bank permits to have accessto foreign exchange. The state trading monopolies were eliminated by a decree in January 1991, openingtrade to the private sector. Practically all imports except oil are now handled by private companies. Thesame process is taking place, more slowly, with exports. For example, in the 1991/92 season, privatecompanies accounted for all meat and banana exports, 50 percent of coffee exports but only 10 percentof cotton sales and none for sugar. In the last case, private entry is being delayed because of anagreement that allows the privatization of three of the mills under the condition that the state tradingcompany be permitted to operate for another year. There is some uncertainty about the timetable forwithdrawal of the state from export trading. This requires a decision from the Government so as tofacilitate private investment in this area.

5.4. Between August 1990 and January 1992 there has been a substantial reduction in nominalprotection. The highest tariff was reduced from 100 percent to 20 percent but additional import chargesremain. Average nominal protection including tariffs, stamp duties, and selective consumption taxes fellfrom 43 percent to 15 percent (see Table 5.1). The reduction in nominal protection has continued in1992 and is planned to be reduced to an average of 13 percent by December 1993.

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Table 5.1: AVERAGE NOMINAL PROTECTION

SECTOR 1990 1992

Final Consumption Goods 68.7% 19.8%Intermediate Goods 26.2% 11.7%Capital Goods 30.2% 14.3%Total 43.2% 15.3%

5.5. Quantitative restrictions aimed at stabilizing the prices of basic foodstuf.s have beenreplaced by a price band mechanism (i.e. rice, corn, and sorghum, whose tariffs can reach a top 45percent). There remain a few import prohibitions including eggs from El Salvador and Costa Rica, andfabrics and yarn made out of jute and other vegetable fibers. The main import restrictions are for chickenin pieces, sugar, and vegetable products. Restrictions to exports have also been reduced and the mainones remaining are for cattle and meat, wood products, scrap metal, capital goods, and bananas. TheGovernment, however, still intervenes in nominally free areas, for example in the processing of cattlefor export from the three large slaughterhouses,' and detergent may be imported only in containers largerthan 250 grams. Other goods sometimes also require permits to be imported, mainly i; they are part ofthe canasta bdsica.

5.6. The Governmenthas signed several bilateral (with Mexico and Colombia) and multilateraltrade agreements or frameworks. Nicaragua has been an active participant in the reactivation of theCentral American Common Market (CACM) and the creation of a new lower Common External Tariff(CET) for Central America. To support the reconstruction of its economy Nicaragua was allowed to keepa decreasing import protection through selecive consumption taxes (ISC) on goods originating in CentralAmerica while enjoying all the benefits of the CACM. Though the schedule foresaw a reduction in themaximum ISC from 20 to 0 percent by December 1993, Nicaragua has obtained permission to continuewith a 20 percent level for the indefinite future.

5.7. The new Common External Tariff (CET) will have four tariff levels of 5 percent, 10percent, 15 percent, and 20 percent.2 Capital goods, inputs and finished goods not produced in theregion will have import duties of 5 percent and if produced in the region of 10 percent, an import dutyof 15 percent for processed inputs produced in the region and finished goods not requiring protection,and a 20 percent rate for all other goods. The exceptions are: (i) each country can have a number ofbasic goods at a tariff of 1 percent; (ii) a list of goods with important revenue implications will be defined

1. The Ministry of Agriculture (MAG) refused in 1992 to grant a permit to process catle for export to a slaughterhouse becauseits rates were too low compared to the other slaughterhouses.

2. The tariff was effective in Guatemala, El Salvador and Nicaragua on Febnuary 27, 1993. Costa Rica expects to join beforeJune 30, 1993 after approval by the Assembly. Honduras would join in April 1993.

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and those goods can have tariffs over 20 percent; and (iii) several goods will reach the range of 5-20percent only by December 1994.

5.8. Only since September 30, 1992, have agricultural products been included in the CACM.This expansion of the CACM should favor Nicaragua because of its agricultural potential even with thecontinued exclusion of sugar and some minor products. The exclusion of sugar from free trade in theCACM is negative because it will force Nicaraguan consumers to continue to subsidize sugar producersby paying about US$0.27 per pound, a higher price than external consumers.

5.9. Import procedures in the local financial system operate well. However, one of theadministrative import procedures in the financial sector requires authorization from the Central Bank tosell fbreign exchange, which amounts to an authorization to import, given that the foreign exchangemarket is free. This applies also in cases where the importer uses its own foreign exchange. Thejustification for such authorization in the present context is unclear. The Central Bank should eliminatein all cases the need for an authorization to buy foreign exchange, thus improving the business climateand reducing the feeling that the Government's behavior is discretionary.

B. THE NEED FOR FURTHER TRADE LIBERALIZATION

5.10. Continued trade reform and liberalization is most important in order to assure thedevelopment of a sound export-oriented private sector. The main problems in external trade include: (i)individually negotiated cases of import and export agreements between government and entrepreneurs;(ii) high port costs; (iii) widespread smuggling; and (iv, external trade procedures that still need to beimproved.

5.11. Di jretion. In the area of tariffs and quotas there are clear examples of the tendencyto solve particular problems by departing from general rules. For example, ministerial orders are issuedgranting exemptions from customs duties and they are not published. Although the number ofadministrative interventions has been declining and the number of authorities allowed to perform themhas been reduced, it is necessary to eliminate them to improve the business environment and thecredibility of the rules.

5.12. olr costs are very high in Nicaragua. For many goods it is cheaper to send themoverland to Puerto Limon .s Costa Rica or Puerto Cortez in Honduras with the additional advantage thatthey have faster access to the US East coast. The port's main problem is not the physical infrastructurebut rather the need to deregulate its operation and tackle the problem of the labor union. For example,only union trucks are allowed to enter into the port to pick up merchandise that is then delivered to othertrucks waiting outside, thereby unnecessarily raisisg transport costs.

5.13. The amount of smuggling is high. According to MEDE, registers in 1991 show thatabout 1,000 containers that entered Nicaragua in transit never left the country and are most likelysmuggled goods. The Government is trying to reduce smuggling by an increased control of invoices.However, in the long run, only 'ower tariffs, better customs operations and improved tax administrationwill provide a permanent solution.

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5.14. Import and export procedures have been streamlined considerably but there is still roomfor improvement. In customs the time required to clear imports is reasonable but merchandise lossesare high. All exports require at least 10 steps, one of which is the permit from the "one-stop-shop", andauthorization is still required to purchase foreign currency, which is now obtained through the commercialbanks. Import and export procedures have not completely shed their 1980s objective of ensuring that theGovernment absorbed and used most of the foreign exchange generated by external trade. This wasachieved by controlling external trade, rather than by facilitating it, as is now necessary.

5.15. Exporters complain that they are hindered by the export earnings surrender requirementsof the Central Bank (BCN) that are closely monitored and by the number of certificates and binders ofdocumentation required for each shipment. Exporters can open a foreign currency account but its useis closely monitored by the BCN. This account should Fe at the free disposal of the account holder.Exporters are required to have for each container or truck (and not for each shipment) its own plant oranimal health certificate and an export binder that has to be prepared by a customs agent costing US$100,though it could be easily completed by the exporter himself. It would be a great improvement ifshipments required only one health certificate and one export binder. Export licenses are charged to allexporters. The export license for traditional products costs between US$1,000 to US$4,000. The highfee is particularly a burden for small producers of sesame seeds (US$1,000), seafood (US$1,500), andbananas (US$3,700) and should be reduced.

5.16. On the other hand, it is necessary to have authorization to export other traditionalproducts, be it by the relevant National Commission, or by MEDE (Bananas). Such authorizations areneeded to collect the percentage corresponding to Fondo de Desarrollo Tecnologico (EDT) and othercharges by each Commission, for statistical purposes and/or for compliance with international agreements(e.g. coffee). In any case, by delaying permits or authorizations, any Commission today is capable ofhandling its sector's exports at will. When the Commissions are transferred to the private sector, theopportunity should be taken to reform the whole system eliminating all elements which restrict trade.

5.17. The administration of donated food products must be carried out in a way not to harmdomestic production, as agreed by the Government with USAID, and other institutions. In the case ofdonated machinery and equipment for agriculture, where there are large donations of tractors and relatedequipment, destined to the basic grains sector that are programmed to be sold at one third the marketprice and at a subsidized interest rate of 10 percent a year. This can lead the domestic suppliers tobankruptcy. To prevent this, donations must be sold at market prices and the Government should auctiondonated goods among suppliers and producers. The same treatment must be given to other agriculturalinputs that may eventually be received as donations.

C. POLICIES FOR WXPORT PROMOTION.

5.18. To improve the investment climate the Govermnent enacted the Foreign Investment Law,Export Promotion Law and a Free Trade Zone Law during the second half of 1991. The implementingregulations for these laws were issued in 1992.

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Export Promotion

5.19. The Export Promotion Law which was legislated in 1991, differentiates betweentraditional exports, including coffee, cotton, sesame seed, meat, sugar and bananas, and non-traditionalexports. The benefits granted to all exports are: (i) import tax and duty exemption for equipment, spareparts, raw materials, components, intermediate goods, and packaging materials. Exemptions worked outin proportion to the value of exports; (ii) sales tax exemption on the purchase of local inputs; and (iii)access to foreign exchange generated by their exports through dollar accounts monitored by BCN. Non-traditional exports are eligible for the following additional benefits: (i) six-year income tax exemptiondeclining from 80 percent in the first year to 60 percent in the last year; and (ii) a six year tax benefit(Certificado de Beneficio Tributario) equivalent to a percentage of the FOB value of exports. The taxbenefit diminishes from 15 percent of the value of exports during the first year to 5 percent during thelast year. The benefit is granted in negotiable bearer documents that are not indexed and can only beused for tax payments.

5.20. To obtain the benefits under the Export Law, exporters must enter into an export contractwith the Government after the approval of the Comisidn Nacional de Promocidn de Exportaciones. Non -traditional exporters must prove that at least 25 percent of their annual sales are exports outside CentralAmerica and that those sales have 35 percent of domestic value added. The determination of such valueratios is difficult because it is hard to assess the foreign component of locally purchased inputs. This ruleintroduces a wide margin of subjectivity to the concession of benefits, creating the potential for subjectivejudgement.

5.21. The Government is planning to make revisions in the application of the law. However,not all problems arise from the application. For example, certain benefits should be extended to allexporters, and not only to those with an "export contract" (e.g., the reimbursement for the indirect taxesexporters pay in Nicaragua). Hence, the system should evolve (when the administrative capacity isstrengthened) from the current CBTs to a simplified system of drawbacks.

Free Trade Zone

5.22. The Free Trade Zone Law offers similar benefits to those offered in most other free tradezones in the region. Amongst the benefits are a 100 percent income tax exemption for the first 10 years,60 percent exemption thereafter, and exemption from all import duties and levies, sales taxes on importedmaterial and equipments. However, no exemption from exchange controls is granted, a benefit grantedby most other laws in the region. There is one Industrial Free Trade Zone in Nicaragua. Currently 8enterprises are operating or about to start operations, employing about 1,000 workers. The BCEE hasapproved a loan to expand the Zone.

Recommendations

5.23. The use of discretion should be avoided, and import and export procedures furthersimplified. In particular, the remaining exchange controls and export licenses should be abolished. Theadministration of Corinto should be deregulated, and the customs administation improved. Discretionalincentives are difficult to implement and are less effective in stimulating investment than are overallimprovements to the business environment. Consequently, the authorities should not be sidetracked intoplacing too much emphasis on adding benefits to the Export Promotion and Free Trade Zone.

CHAPTER 6

TAX REFORM

A. RECENT DEVELOPMENTS

6.1 The new government inherited a highly discretionary, complex, and severely distortedtax system that added to the problems in the trade regime. The Corporate Income Tax had highlydifferentiated and high marginal rates, ad hoc exemptions and incentives. The Personal Income Taxsystem compounded the above distortions through multiple bases, excessive brackets, and extremely highmarginal rates. The General Sales Tax also included multiple exemptions, and multiple rates, thatcoupled with the weak administration, created arbitrary distortions throughout the economic system. Aselective sales tax was applied to 700 products with high import rates and extremely high rates for thefiscal industries (soft drinks, beer, rum, cigarettes, and oil derivatives).

6.2 During 1990 the new Government enacted a tax reform to address most of the abovedistortions. It improved the income tax system by eliminuing some tax exemptions and most fiscalincentives. To widen the income tax base, the Government implemented new presumptive income taxcollection methods. Ihe sales tax was extended and the rate raised. The Government eliminated severaltaxes including the capital gains tax, wealth transfer tax, surcharge on income and wealth tax, bequesttax, and taxes affecting the formation and modification of corporations. The selective sales tax waseliminated for all but the fiscal industries. These measures improved the tax system's efficiency but hadlittle impact on tax collection. Details of the changes in the tax system are as follows.

6.3 The main modifications undertaken in mid-1990, in trying to improve the horizonta andvertical equity of income taxes as well as tax collection and administration were:

(i) the tax base was extended to cover all sources of income;

(ii) the corporate income tax was unified at 38.5 percent (changed to 35.5 percent forfiscal year 1991(92 and later to 30 percent);1

(iii) the number of brackets for the personal income tax was reduced to five, with themaximum marginal rate at the same level as the corporate rate;

(iv) the tax rate on dividend repatriation was reduced to 5 percent from 20 percent;

(v) a mininmm income tax was established, equal to 4 percent of net wealth or 2 percentof gross income, whichever is larger;

(vi) the tax on dividends to nationals, the exemptions for the reinvestment of profits andthe interest income received by corporations were elimnated;

1. The fequent changes in tax rates is a chracteristic of all hxes, as will be scen below.

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(vii) advance paymens we¢o established for corporate and personal Income taxes; and

(viii) tie 6 perce tax on salaries was elimiated and Intgrated into the pesonal incometax.

6.4 Conditions wene improved for the cration of a series exchange by eliminting thetaxes on capital transfers and on the formaton and modification of corporations. Tho only tax thatfinancial institutions have to pay on their capital now is on e estate they own. Ihe real estate tax of1 percent of die cadastre value Is collected by the municipalides2 .

6.5 The General Sales Tax (IGV) rate was increased from 10 to 15 percent in 1990 3. Inaddition, the coverage was extended to almost all sales of goods and services. The system's efficiencyimproved by the broadening of the tax base. The Govenme granted exemption from IGV for allimports of machinery, equipmenit, and spare parts for industry ad agculture initally until July 31, 1991and then extended this benefit untl December 31, 1992 and the Mimistry of Finance was granted theauthority to further extend this period. With the increasing number of entefprises that are allowed todeduct the IGV they paid when buying inputs, from the IGV remittances to the Government, thisexemption has become unnecessary and should be eliminated.

6.6 In 1990 in order to improve tax collection and administration, tax liabilities were indexedto the US dollar, and administratively granted exemptions were discontinued. In 1991, remaing incometax exemptions were elimated (thougl there has been some backtracking since), a program to phase outindirect tax exemptions was inidated, a special unit for large taxpayers was established, stronger sanctionsfor tax evasion and non-ompliance were introduced, custms posts were relocated, in-bond houses forthe clearing of customs began operations and programs to computerize tax information, control systemsand to train the revenue and customs personnel.

6.7 As a reult of these reforms, Central Government tax revemnes increased from 13.8percent of GDP in 1990 to 21.2 percent in 1992. Nearly all thncrease was concenated in taxes ongoods and services, whose revee grew from 7 percent of GDP in 1990 to 13.1 percent in 1992. Inparticular excise and selective consumption taxes grew, as a percentage of total revenues, from one thirdto almost one half.

B. THE NEED FOR FRITHE REFORM IN THE TAX SYSTIEM

6.8 After the improvements made in the tax system in recent years, two basic problemsremain: tax collections are highly concentrated on a few tax payers and tax rates are generally high.Also, -although much improved- tax administation remains weak and there are excessive tax exemptions.The main task ahead is to expand the tax base so that tax rates are lowered without the loss of revenue.

2. The real ot tax in th ca of thc aiutual sector, disoura addtional investmes that improve land producdviy(i.e. plntalons, infastructu for product procsing, et.). As dis_ussd in Chapter 2 (ar. 2.19) a 6% ax rat on real estatetransons inbis ad mad;et deveopment, ad should be at las temporaily reduced or susedod.

3. Tb. IGV rate was sbsequently lowered to 10% for a brief pedod and then increased to l5%.

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ITe Ta Burden

6.9 The tax burden in Nicaagua is high for a country at it's stage of development. Forexample, the tax burden on a manufacturing company is about 22 percent of gross sales and if importcharges are included the burden is about 25 percent. The largest tax is the IGV of 15 percn followedby the income tax which, depending on profits, normally is equivalent to 3 to 4 percent of sales. Theburden imposed by the municipalities is also high and includes a municipal sales tax of 2 percent of salesand registration fees equivalent to about 0.3 percent of sales. The corporate income tax of 30 percent(since July 1, 1992), is in line with taxes in other countries. Dividends to nationals do not pay incometaxes but dividends to non-residents pay a 5 percent tax. ITis discrimination againstnon-residents shouldbe abolished.

6.10 An important advance in the tax system for private enterprises was the elimination inFebruary 1992 of the progressive tax on net capital of over $80,000 at 2.5 percent. Depending on therate of return to capital the tax on net capital was equivalent to a rather high additional tax on income.'The tax on capital increased the demand for borrowing becase borrowing reduced net capital andtherefore, the taxes to be paid.

Tax Administration

6.11 The way tax collection is inisteed reflects the long period of hyperinfation. Theobjective was then to collect taxes as soon as possible to avoid losses due to inflation. Inflation is nowunder control and this tax collection system is draining enterprises out of working capital to provideliquidity for the Government (and is yet another feature of the tax system that increases the demand forcredit from the prvate sector). The income tax is paid in advance by monthly payments of 3 percent ofsales5 (4 percent undl early 1992) and of 1 percent for agriculture (was 2 percent) except for cotton andcoffee that do not pay the tax in advance. The monthly tax payments increase the yearly working capitalrequirements of the enterprises by about 19 percent of their monly sales, adding to the percVption ofscarcity of capital, and together with the prevailing high real interest rates, increase costs.

6.12 The corporate income tax also has an annual minium payment equivalent to 4 percentof net capital or 3 percent of gross incomewhichever is higher Cm early 992 the minmum tax was 6percent of net capital, this was reduced to 3 percent and was then increased again to 4 percent in June1992). The minimum tax payments result in a heavy burden for enterprises witout profits and inparticular for new enterprises that have yet to break even. The exisn of minimum tax paymentslinked to sales or capital is therefbre a barrier to entry. Also, in the same way as the abolished tax onnet capital, it articially increases the demand for credit In order to reduce the amount of the minimumtax payment by reducing net capital. The Governmen's jusdfication for this minimum tax is its susicionof widespread tax evasion and its desire to reduce "idle assets. Though it may be justified as atemporary measure whilst the tax administration is being improved, it is important to reform the tax lawsas soon as possible in order to facilitate entry into private enteprise and to encourage self-fnancing. Amore intensive use of idle assets through the tax contradicts the idea of using the tax to address the

4. A return on capital of 20% rmushed in an addtonal inoome tax of 12.5%.

5. Thcadvancepaymnaton dhe incometaxof3% is basedon theasnptionthatenrprisesmaea 10% profiton theirsales.

problem of widespread evasion. A heavy burden ^n firms with a low return on capital will only drivethem out of business or into the informal sector.

6.13 Some legal norms exist which allow enterprises to request a reduction in their advanceincome tax payments but the criteria for granting this reduction are not defined. This has led to thecreation of an "informalt system for such reductions ("fiscal credits"), in which a high degree ofdiscretion is used by the tax authorities. When an enterprise has problems making tax payments or needsthe resources for another purpose, it negotiates with the tax authorities on the amount and timing of theirpayments. The system of "fiscal credits" has also been extended to include IGV remittances. Althoughthe system works both ways and is used by the Government to negotiate an increase in tax payments(fiscal 'advances") when it needs liquidity, 'ilscal credits" should be abolished. The system of "fiscalcredits" encourages the use of discretion and undermines the existing rules and makes it impossible todetermine if enterprises are competing under the same conditions, thereby encouraging rent seekingbehavior. To compensate enterprises for the elimination of "fiscal credits," advance tax payments couldbe reduced.

6.14 Ihe Internal Revenue Service (DGl), is increasing the number of enterprises that collectthe IGV. Enterprises that are collectors of the IGV can deduct from the remittances to the Governmentthe IGV payments they made when they bought goods and services, they are in effect paying taxes onlyon their value added. This is automatically transforming the saes tax into a value added tax. Becauseof the administrative cost of implementing a true value added system the DGI has only about 35,000collectors. However, they represent most of the sales taxes collected. The system has als included theproviders of professional services such as doctors and consultants. Those that are not collectors of theIGV make a monthly payment evaluated on their business volume. Small enterprises hat pay the IGVdo not pay on their actua sales but pay an estimate calclated by a tax inspector.

6.15 Out of total tax collection, 49 percent comes from 11 enterprises also called "fiscalindustries' in the liquor, tobacco, beer, soft drinks, and oil sectors. The fiscal industries have a speciallegal framework that is constanly being renegotiated. For emple, the Government manages theprotection levels of the "fiscal industries' so as to combine raising the revenue and protecting the localindustry. However, the "fiscal industries" have a separate tax regime where the Government receivesa higher share of gross sales than the IGV. In many respects the Government is enforcing amonopolistic framework on industry with the intention of sharing the monopoly surplus. In effect, theGovernment sets prices for these goods together with the owners of the enterprises to ensure a sufficientflow of revenue. The "fiscal industries" are even becoming a problem for Nicaragua's free tradenegotiations because the Government is trying to keep them out of the agreements. Because of theseparate tax regime, the Govemment directly controls on a case-by-case basis the imports of theseenterprises, grandng special import licenses at sate not only import quantides, but also taxes to be paid,and prices for retailers. Tle special treatment should be discontiued; price controls and the special taxand trade regimes should be removed and replaced with predetermined excise taxes.

6. The fiscal indutdis taxes ate remnant of fhe mor than 7,250 linds of tes lvied on a broad range of goods iat existedat the beginuing of the current GoernmeaL

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6.16 The municipalities also play an important role in the tax system. As regards the 2 percentsales tax that productive enterprises7 have to pay to the municipalities there is confusion in the enterprisesas to whether tax should be paid to the municipality where the good is produced or where the good Issold. Municipalities do not agree on the subject, and so enterprises are sometimes faced with demandsto pay the tax to both municipalities. In some cases it has even been reported that municipalities claima 2 percent tax for goods that travel through their territory. This problem has the potential for generatinggreat uncertainty. Moreover, in goods where the rate of return is 20 percent, the tax is equivalent to a10 percent income tax. Consequently if the tax were implemented either as a cascading sales tax, or asan internal tariff, the consequences for the productive sector would be enormous. It would be moreefficient if the same criterion followed by the DGI for the national sales tax were used by all. The mostcost effective solution would be that the DGI collect all taxes (therefore saving the municipalities thecollection costs) and then distribute the revenue. If no agreement is reached on how to distribute the tax,the DGI could proceed to collect it, and then decide together with the municipalities how the revenue isto be divided thereby eliminating this source of uncertainty for the private sector.

Recommendations

6.17 While high tax rates impede business activity and make Nicaragua a less appealingproduction base, they were originally needed to reduce the fiscal deficit and stop inflation, whichconstituted an even greater disincentive to investment. Efforts must now focus on reducing the taxburden, broadening the tax base and maintaining a more stable tax regime. Over the last two years, forexample, the sales tax was changed twice, as was the rate applied to the minimum income tax liability.Although these changes were prompted by the need to respond quickly to exogenous developments thatimpinged on the fiscal deficit, such variability in taxes deters investors as the future profitability of anenterprise remains uncertain. A broadening of the tax base, coupled with the reduction of rates facingindividual enterprises, would contribute to raising the profitability of these enterprises and generatinggreater stability in tax revenues. It would also reduce the incentives for tax evasion which is nowprevalent as demonstrated by the rapid expansion of the informal sector. Finally, a major effort needsto be made to reduce the still bloated level of fiscal expenditures, which would permit reductions in theoverall tax burden without destabilizing the economy.

6.18 The Government has also to consolidate municipal taxes, define exemptions from theminimum income tax for new enterprises, and eliminate "Fiscal Loans" obtained thfrough the delay inscheduled payments of income taxes and of IGV. The tax incidence on investment should be reviewedto eliminate constraints and distortions. Taxes on "fiscal industries" should be replaced by a welldesigned, predictable excise tax. With the increasing number of enterprises that are allowed to deductIGV they paid from the IGV remittances to the Government, IGV exemptions have become unnecessaryand should be eliminated.

7. Commercial establishments have a differnt regime, they pay a 1% sales tax for the first US$20,000 in sales, 4% for therest of the sala and 9 % for the sale of liquor.

CHAPTER 7

FINANCIAL SECTOR REFORM

A. RECENT DEVELOPMENTS

7.1 By 1979, Nicaragua had one of the most advanced financial systems in Central America. Acombination of state, private national and foreign subsidiary banks offered finanil services. Aftertaking power in July 1979, the Sandinista government eliminated private sector financial institutions;transferred control of state bank operations to a holding company (which evolved into the CorporacionFinanciera de Nicaragua, CORFIN), and progressively reduced the mnmber of financial institutions tofive: Banco Nacional de Desarrollo (BND), Banco Nicaraguense de Industria y Comercio (BANIC),Banco Popular (BP), Banco Inmobiliario (BIN) and the investment lending institution, FondoNicaraguense de Inversion (FNI).

7.2 The state-owned banks were functioning in specific sectors. Managers rolled over poor or non-performing loans to maintain the flow of financial resources to targeted sectors. Moreover, periodicGovernment forgiveness or rescheduling of overdue loans and continued negative real interest rates onloans did not provide any incentive for management to seek high return projects for their investments.

7.3 While some important steps have been taken to liberalize the financial sector to better meet theneeds of a market-oriented economy, state-owned banks remain dominant and most credit is directed bythe Central Bank and by donor agencies. The Constitution states that the Central Bank, the nationalfinancial system, insurance, reinsurance and foreign trade, as instruments of the economic policy, belongsolely to the State. Through the "Acuerdos de Concertacidn, ' the Constitution was interpreted as beingonly applicable to financial institutions existig when it was enacted. This interpretation, enabled theSuperintendency of Banks of Nicaragua (SBN), to authorize the establishment of new private banks inApril 1991, through enactment of a new law. The legal boundaries between the Constitution, the existingBanking Law and the regulations that have been set forth by the Superintendency are unclear and dependon the interpretation of the existing authorities. A change in authority could easily result in a differentinterpretation. Consequently, there is a need to reform the Constitution and clarify the status of bankinglegislation. Other key issues that affect the operations and development of the private sector are: a) theneed to reduce the size of state banks, or to "privatize" them by divesting branches;' b) the need tosubject the state and private banks to the same regulatory framework, and allow no privileges; and c) theneed to improve loan recovery by state banks. The long term goal of the reform process should be tohave the Central Bank withdraw completely from the credit market; reduce state presence in the sectorto second-tier banks and assistance to the development of community banks; and develop an adequate setof prudential norms and an independent and effeetive superintendency of banks to regulate the privatesector.

7.4 A cornerstone of the new administration's program in reforming the financial system was torestructure the state-owned banks and reduce their size, and cease all Central Bank (Banco Central deNicaragua, BCN) subsidies and discounts (due to interest rate or foreign exchange controls). A new

1. These reoommeadations ame consftained by the curet Constiton that prevents ther outright prtion.

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Superintendency of Banks was created, in order to develop a healthy private finatcial sector. Withrespect to interest rate policy, the government planned to remove the system of interest rate controls.

Interest rate policy

7.5 Interest rates were liberalized in November 1991, except for a minimum set by BCN for 30 daydeposits (currently set at 10 percent). However, operations with BCN rediscount funding is subject toa minimum annual interest rate for short term operations. Long term rediscount operations have onlya benchmark rate.

Foreign exchange contro1s

7.6 Until September 1991, BCN executed all foreign trade transactions while some state banks wereauthorized to act as external agents for BCN. Since 1992, BCN's role in foreign trade operations hasbeen drastically reduced. BCN handles only the foreign operations of the public sector, particularly oilimports and gold exports.

7.7 A foreign exchange control system managed by BCN is in place2, but in practice, many of thesecontrols are ignored and every buyer can easily obtain foreign exchange in the parallel market at apremium of about 10 percent. However the legal requirements could be reapplied at any time, or worse,applied selectively. Foreign exchange controls should be removed dejure and not only defacto in orderto further liberalize foreign trade and to reduce the unceranty surrounding the availability of foreignexchange.

Supeintendency of Banks

7.8 The Bank Superintendency (Superintendencia de Bancos de Nicaragua (SBN)) started functioningduring the second half of 1991. The new Superintendency Law establishes that the SBN is anautonomous body, and that it regulates private and public fincial institutions in bankdng, insurance orreinsurance activities. Also its supervises savings and loans associations, the stock exchange andsecurities agents. The Superintendency is directed by an Executive Council mostly composed of politicalappointees, headed by the Minister of Economy. This structure limits SBN's independence. To maintainits independence, the Law should require that the SBN eliminates the council and has an independentSuperintendent, designated by the President and ratified by the National Assembly.

7.9 Independent supervision of banks is new for Nicaragua and therefore, the creation of theSuperintendency and its norms represents progress. However, because it was recently created it is notpossible to evaluate how well norms are being applied and enforced.

2. The foreign cxhange control system legally in plac. requires that: (i) eaporters mut surrender 100% of their export-eanngsto the BCN with 45 days folowing shipment of their goods (there are numerous excepion); (0) proceeds from foreiginvestments and loans must be sold to BCN; (iii) foreign bs must be rgiered with the BCN and rgistation is granted onlyif maturities are longer than three yeas, and intest rates do not exceed six-month LrBOR pbls a spead ddened by theBCN, For fixed rate loans, BCN determines the maximum rate allowed; (iv) dividend temances, capital repatiation, royaltypayments, interest and principal repaymet and flunds for impos must be authorized by the BCN; and (v) contrcs exoewtdwithin Nicaragua must be paid in local currency at the offlcial exchange rate.

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State-owned banks

7.10 In order to allow the state banks to operate under the same rules as private banks, theGovernment decided to restructure them and bring their capital level in line with SBN norms. In June1992, the Government bought the non-performing loans with long term bonds from the state banks. Thestate banks used the bonds to repay BCN's debt. Finally, those Goernment bonds are to be redeemedby the Government who is taking responsibility for BCN's external debt. M1FIN has contracted privatebanks to manage the portfolio of loans acquired from the state banks.

7.11 The total cost of increasing the capital of the state banks amounted to C$1,200 millions (aboutUS$240 million). Bad loanS fom FNI tat will eventually also have to be restructured raise this figureto US$400 million. Of this, approximately US$140 million are loans granted during this administration,in 1991. The task of solving the problem of bad loans and the State Banks lack of adequateadministration in the advancement of loans has not yet been fully addressed. Also, there needs to be clearguidelines for the borrowers on what happens if loans are not repaid. State banks should be willing topursue every possible means to recover loans. As mentioned below, there has been some progress inpursuing these goals.

7.12 Despite the 'restructuring and cost reduction' program state banks still have high overall costs,and further losses are expected. Even though the cost reduction program closed an inpressive numberof branches and encouraged the retirement of a large number of personnel this seems to be insufficient.For example BANIC has not been able to cover its costs since the portfolio cleanup because of the highemployment level it has to maintain and a lack of adequate technology. Another reason for the high costsis the high volatility of deposits that force banks to keep reserves of about 20-25 percent of depositsinstead of the legal requirement of 10 percent. In addition the BCN is using the state banks to protectforeign exchange reserves by forcing them to keep reserves of 50 percent on their foreign exchangedeposit levels as of August 31, 1991. For foreign exchange deposits above this level the reserverequirement is only 25 percent.

7.13 New loans from the state banks are based on stricter credit criteria but collecdons still lag becasethe borrowers assume from past experience that state banks wil be lenient. Only borrowers that are up-to-date in their obligations can obtain new credit. Ihis may change attitudes towards repayment. Forthe first time in May and June 1992, BND sued borrowers whilst trying to collect loans in arrears. Inthese 216 cases the borrowers had sold the goods that were guaranteeing the repayment of the loan. Thiswas th . Government's way of warning the borrowers that loans have to be repaid in order to correct themessage given in April 1992, when the Government arranged once again, for a favorable reschedulingof the cotton growers debts3 in response to low prices.

7.14 State banks are constrained by lack of resolution of outstanding property rights, since they arenow required to ask for collateral. For example a privatized slaughterhouse is not being financed byBND because it is still waiting for the property title.

7.15 Fixed assets in the state banks are valued at 1/10 of their market vWalue (as esfimated by the BCNofficers coordinating the state banks). If these assets were valued at market prices the lending capacity

3. The debts were restructured into a 10 year debt at 12% inteest and famners get a bonus of yearly US$100 per 0.7 ha. theplant for four years.

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of the state banks would increase by US$800 million, more than twice their preset leading capacity.This would be an unfortunate development as it would further concentrate the financal market.Consequently, an extra capitalization of the state banks by means of asset revaluation should be avoidedin order to keep the system competitive.

Table 7.1: NICARAGUAN BANNG SECTOR-MAURKI SHARES

TOWa Iaau Tota Dqmdbh

-m s - -/92 a 1 - tPAtceBn=b 4% 6% 9% 14% 13% 21% 26.% 2%

Staklab 96% 9t. 91% 1s 1% 74% 72%

ID AbwbhS Ftm KM8 =Mln)___________., __ _~..'u Z .

Fnvaft Bmzk 13 _23 34 3S 28 5 S a I 74

Stte II"" 312 340 344 233 187 j92 1S 190

se Swin a2a &BUc, 1m.

7.16 The opportunity of seriously reducing the state's role in the financial sector during therestructuring was missed. One of the reasons often given for maintaining the large size of the state bankswith respect to the total market, is that only they are expected to lend to small rural borrowers.However, as has been shown elsewhere (e.g., most recently in Guatemala) small rural producers andmicroenterprises are served by informal credit markets, while credit from state banks teach only afraction of the intended beneficiaries. Therefore, the Government shWd carry out the policy of reducingthe size of the state banks. Also, to further develop financial markets, stps should be taken todemonopolize the insurance industry which according to the Constiution is now a state monopoly.

Private Banks

7.17 In August 1991, the first private bank was set up, followed by six other private banks. Presently,two more applications for private banks are awaiting the enactment of the new banking law. Due to theirshort period in operation, private banks have only a small (but growing) market share (see Table 7.1).They are more active in deposit taking and services. In total lending, especially agricultural lending, theirvery small market share reflects their conservative approach to a risky business. Nevertheless, privatebanks have also been increasing their market share in this area and have recently sWed giving loans forcattle feeding projects.

7.18 The total net worth of all the private banks is small, US$36 million. By comparison, the networth of the Nicaraguan financial system in 1978 was US$160 million, in curret dollars. However,private banks do not need any additional equity to grow. Their total lending potential is larger th thestate banks and they can almost triple in asset size. However, each individual bank's small equity

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highlights the disadntage they have for lending large loans compared with the newly capitalized statebanks (see Table 7.2).

7.19 There is a strong concentration of short term operations in the system, both in assets andliabilities. The Nicaraguan banking system is highly liquid. The reason for this high liquidity, is theshort term composition of the deposits and the instability of the deposit base. Private long term lendingis practically non existent. All long term lending is funded by BCN through its rediscount window.

Table 7.2: NICARAGUA BANKING SECTOR INDICATORS(As of June 30, 1992)

BND1 BANIC| BAMER' BAN| RO BAC' rAN'_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _C EN TR O

Average Interest 18% 14% 17% 22% 20% 18%on Loans I

Lending/Liabilities 76% 43% 52% 53% 33% 20%

Adm. Exp./Revenus 55% 67% 78% 73% 50% 69%

Individual Credit 2,250 1,050 284 334 491 313Lmit (in US$000) . .

Source: uc de Bancos, 1992.1 Public Z Privne Banks.

7.20 Financial information on the private banks, as a whole, shows the cautious approach beingfollowed in expansion (see Table 7.1). Total deposits in private banks as of lJue 30, 1992 were US$74million. The total loan portfolio by June 30, 1992 was US$38 million or 14 percent of total lending.However, at the margin their participation is larger. For the period January-September 1992, out of totalcredit for US$247 million, private banks had a participation of 28 percent. The 7 private banks manageabout 40 percent of total deposits of which 72 percent are savings accounts. Private bank maintain theirexcess liquidity in external accounts to protect themselves from a devaluation.

7.21 To conclude, the key to private bank expansion is to require state banks to opera on equal termswith the private bans. One of the options 'or increasing the private bank' loanable fbuds could be torestrict the bids for funs from BCN's rediscount facility to state banks that are showing losses. Thiswould improve compeftitve conditions. The implied deposit guarantee for state banks needs to beresolved, by formalizing the exact extent of the guarantee and charging banks for it.

Jnformal Financial Sector

7.22 The infornal credit system which was practically destroyed in the 1980s is reemerging as credithas tightened and the commercial distnrbution network has returned to private hands. In the lowest

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bracket, there is informal financing for small tradesmen with a daily interest rate of 10 percent.Managers of large hardware stores and other commercial companies do not grant credit because they donot trust the Cordoba or the economy. A 7 day credit facility, for certan customers, is the longest termthey grant. However, credits for supplies given by eterprises reach In some cases averages of 52 daysand are not indexed. Cooperatives are also granting credits to small farmers and charging high interestrates.

7.23 The non-banking credit system has not developed in Nicaragua like in Peri and Venezuela, wheresimilar spreads between deposit and lending interest rates exist. There are two main reasons: the lackof a repayment culture and the lack of confidence in the judiciary system to legally enforce creditoperations.

B. FURTHER FINANCUAL SECTOR REFORMS

IMTe Centl Bank and Credit Poliey

7.24 The degree of intervention of the Central Bank in credit markets has been declining. Only tworediscount windows remain, one for agriculture and cattle raising and another for industry. However,BCN continues to monitor sectoral use of financial resources very closely. For example, in 1992 BCNstopped rediscounts for cattle raising in order to protect the amount of credit available for otheragricultural activities. The Central Bank has also eliminated direct lending, with the exception of someimport operations of the e?ectricity utility and the financing of privatizaton/liquidation costs of CORNAPenterprises, that are made with a repayment guarantee by MIFIN.

7.25 Credit targeting has been eased in the short-term rediscount programs, but not in BCN's long-term rediscount facility disbursed through the Fondo Nacional de Inversiones (FNI), a seconA tier bank.Here, the BCN continues to allocate credit to each economic sector. In the case of agriculture BCN setsthe amount of credit available for each crop. Although it is doubtfil that loans directed to one economicactivity are really used only for that purpose, this results in the channeling of loans to state-favoredsectors and away from those that are not. However, since applications are evaluated and approved ona loan-by-loan basis, there is already a structure in place which could permit credit allocation accordingto the merits of the project instead of BCN's choice of sectors. In an economy that is undergoing majorstructural transformation, it is difficult for the state to be adequately informed on the effects of all changeson sector profitability, consequently the inefficiency of credit targeting is even greater than in othereconomies. The complete phasing out of credit targeting is therefore essentil and should be done withoutdelay.

7.26 The Government has not yet officially defined the future role of the Central Bank in creditallocation but it is anticipated that the Central Bank will become a lender of the last resort and willexclude direct or indirect credit operations to non-financial intermediaries from its responsibilities. Aphased agenda for changing the role of the Central Bank in credit allocation should be announced.

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7.27 The control of credit policy has been key to the success of the stabilization plan.' However, thepresent reduced availability of credit when compared to the very loose policies that preceded thestabilization plan have prompted complaints about the lack of availability of credit to the private sector.This is understandable in view of the change in present policies compared with the traditional lowrepayment discipline (that predates the Sandinista regime). In addition, though between January-September of 1991 and 1992 net credit shows only a slight real reduction, most was rolover of existigdebt due to the low repayment capacity, in particular of the coffee and cotton sectors. There wastherefore a nominal reduction in gross credit of about 37 percent, severely reducing the access to creditfor new borrowers. These developments are a constaint to private sector development because they tieavailability of credit to the previous structure of production. For example, low repayments and less grosscredit will tend to keep up the public sector's share in outstaning credit (currenly at 55 percent) andreduce the availability of credit for the private sector.

7.28 In sum, in the present macroeconomic environment, with a large fiscal and current accountdeficit, it is hard to envisage how credit policy can be relaxed without raising inflation or draininginternational reserves. Only if a large fiscal adjustment Is achieved prior to loosening credit policy, couldits negati re macroeconomic consequences be kept under control.

State Banks

7.29 In spite of the downsizing efforts of the last two yearse state banks still control the financialsystem'. This hinders the private sector's full participation in the financial sector. In July 1992 theGovernment recapitalized the State banks to expand their overall lending capacity contrary to theGovernment's program which was backed by the ERC. The dominant role is accenuated by the fact thatthey have implicit deposit insurance and prefereatial access to Central Bank rediscount facilities forloanable funds. Credit subsidies have been maintained by loose loan collection policies7. In thisinstitutional setting, state-owned banks cannot be expected to avoid continued losses, in spite of therestructuring programs that were carried out in 1992. This situation wil soon force to the government,and in particular the Superintendency, to enforce uniform rules to state-owned and private banks, evenif this means declaing the state banks insolvent. This is essential in the development of an efficientfinancial system, but will be difficult to implement whilst the Superintendent is subject to politicalpressures.

4. This is true in paruar during 1993. Moreover, though mangemen of redit policy was too tosw during 1991 and1992, it was notably better than credit policy during fth 1989 slabilinaion atempt.

5. The four state banks reduced their sim by: a) reducing the number of employees from 7,800 in July 1991 to 3,300; and b)reducing the number of branches by half, fom 191 in July 1991 to 97.

6. They capture 72 percaet of deposits and give 84 porcent of domestic credi.

7. As of April 1992, of the USSSOO million disbursed loans by the publi entdies (incuding }NI) 12.5% are problem loawwith less dtan 50% probability of repayment. The ttal of problem loans included in the portfilio of the stat banks as of Apri1992 amowuded to US$190 million.

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Recommndations

7.30 The Government should set a firm timetable for the elimination of Central Bank directed credit.The sector's general legal framework needs to be reinforced and stabilized in order to boost confidencein the new system. The authorities need to ensure that state banls operate under the same rules as privatebanks. The restructuring of the state banks presented an opportunity for their privatization, which wasruled out by the Constitution. The Government also needs to speed up the downsizing of BND.

7.31 To promote the development of a competitive private sector-based financial system, theGovernment should: a) divest, liquidate or reform BANIC, BP and BAVINIC; b) gradually downsizeBND; c) subject all banks to prudential regulations; and d) subject the state banks to tighter rediscountlimits subject to loan recovery performance.

CHAPTER 8

AGRICULTURE: THE KEY TO GROWTH

A. THE SUPPLY RESPONSE OF TIE AGRICULTURAL SECTOR

8.1. As seen in Chapter 1, in spite of the significan advances made in the implementation of thestabilization and adjustment program, the agricultural sector's response to these adjustments has beenlimited. The key to short-term resumption of growth is the reactivation of the depressed cultivation andyield levels in the agricultural sector. To realize this, the agricultural sector will have to go through asubstantial restructuring given the low profitability of several crops that occupy a substantial part of thecultivated area.

8.2. A severe limitation to the sector's growth is the fact that 39 percent of total planted acreage isused for non-profitable activities, including cotton; coffee produced with technified and semi-technifiedtechnologies; sugar cane; irrigated rice; beans; sorghum produced with technified and irrigatedtechnologies; and soybeans. Ihe only reason why the area covered by unprofitable crops is so large isthat up to 1991 farmers had been given subsidized credit by state-owned banks that covered their lossesand permitted them to avoid the costs of reconversion. Since then, state-owned banks have been slowin collecting loans, in effect extending the subsidies. This has happened even though collection of loansis now being enforced more stringently than in the past (see para. 7.9).

8.3. Causes of low rates of retm for cotton. coffee, and sugar cane. First and foremost is the dropin international prices. Second, these three crops have experienced in Nicaragua a decline in yields, ascan be seen in Table 7.1. Finally, there has been a rise in costs per manzana, particularly for cotton.Although part of the increase can be attributed to exchange rate variations, the fact is that the physicalamounts used had to be increased due to a growing resistance to plagues and diseases.

8.4. Potential effect of rea devaluation of 30 percent and 60 percent on the rates of return ofagricultural and livestock products.1 Devaluations of 30 and 60 percent will not suffice to render thesecrops profitable. The lack of profitability is not due to the exchange rate, but due to the level ofproductivity. As for products that are profitable today, a devaluation benefits them all. Even though theywould not directly solve problems such as those found in cotton; coffee produced with technifiedtechnology; or beans, they would contribute to solve them indirectly, since they would improve earningsin a variety of products that may replace them or with which they can be produced jointly.

8.5. The challengeoof reconversion in agriculture. Based on the previous paras., the following changesin the sector's product mix can be foreseen. The area allocated to basic grains and to artificial orimproved natural pastures will expand. As for rice, corn, and sorghum, as long as they continue to beimport substitutes,2 their production will be protected by price bands. An increase in the area destinedto agroexportable products such as sesame seeds, bananas and others not covered herein, such as tobacco,peanuts, melons, and onions, can be expected. All these products can be cultivated in the cotton-growingzone, and are expected to be profitable. The declining trend of area devoted to sugar cane should

1. The costs, prices and exocangc rate considered ae those in eff;ct in November 1992.

2. If production exceeds domestic consumption, then the price bands will have to be revised.

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Table 8.1: NICARAGUA: EVOLUIION OF THE MAIN CROP YIELDS

PEIUODS Peeta Variaion

CROPS 19fS179 1980/85 1985190 85190-79f79 851900/85

COFFEE (qq/rez) 9.2 10.0 8.4 (8.7) (16.0)CarlwON (qq/mz) 30.6 33.3 29.1 (4.9) (12.6)SUOAR CANE (qq/lnz) 9.8 8.3 8.6 (12.2) 3.6BANANAS (boxes/=) 1,833.80 1,62S.50 1,S61.20*0 (14.9) (4.0)SUGAR CANE, (S.T./al;) 47.7 48.8 44.6 (6.5) (8-6)SESAME SEED

RICE (qqlmz) 28.7 33.7 28.0 (2.4) (16.9)BEANS (qq/snz) 10.3 9.6 8.7 (IS.) (9.4)CORN (qq/miz) 13.6 16.1 21.3 56.6 32.3SORGHUM (qq/mz) 19.0 27.9 27.3 43.7 (2.2)

' 1975/80** 1981/85** 1986/90Source: MAO, Phaning Division: *Emteg;a Agropecuaria, Rorel y Agminduata de Nieamus 1992-1996. M ,anagua October 1991.

continue. The cotton area is likely to stay at the already significanty reduced present level. The coffeecrop is undergoing a recovery process in the areas that were affected by the wa'3.

8.6. If the land tenure situation is resolved, and those zones where banditry still exists are pacified,then total cultivated area should expand, reaching at least the historical maximums of the seventies (morethan I million manzanas). Additional expansions of the total area under cultivation would mainly dependon the aggressiveness with which international market oppormnities are pursued.

8.7. In sum, the many changes that have occured in the economy have influenced the agriculturalsector, forcing it to adjust to changes in price and profitability at a time of very low historical prices forthe main export crops. It is important to move away from the cultivation of cotton which had been themost important export for many years. However, the agricultural sector is adjusting and there are severalproducts with high profitability and potential. A real devaluation of the Cordoba would ease thistransition by providing the sector with higher profits and less need to finance itself with credit from theformal or informal sectors.

B. AGRICULTURAL CREDIT

8.8. The many changes that have been occurring in the financial system have strongly affected theagricultural sector. The unanimous complaint by producers is the scarcity and high cost of loans toagriculture. As for scarcity, it is paradoxical that while in July 1991 the Banco Nacional de Desarrollo(BND)'s agricultural credit program showed a disbursement rate of 48 percent, by 1992 it was 29

3. Some 35,000 manzanas may have been lost during the War, and about 7,000 are mined as of today.

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percent. Since the goals BND set for Itself for credit to the agriculural sector were being substantiallyundershot, the problem behind the low credit level must be in the demand for credit, rather tban in thesupply. The reduced demand is possibly due to the high cost of credit, and not to its scarcity.

8.9. Lending real interest rates in 1992 were 15/20 percent. Ibis is not unusually high for a high riskcountry with a recent stabilization program. However, the increase V biWrend by agricultr producersis very high, since they now expect to be asked and if necessary forced, to repay the loan. HistoDrical datashow that agricultural and livestock portfolio recovery as a percentage of total loans is extremely low'and even though collection has been pursued more actively and rewvery has improved, recoverycontinues to be low. Given this high cost, the drop in BND loans to the sector could be interpreted asa reduction in demand rather than to a restriction in credit supply. This hypothesis appears to besupported by the fact that planted acreage remained practically constant (it fell by 3 percent: see table 8.2)

Table 8.2: NICARAGUA: EVOLUTION OF THE HARVESTED AREAOF EXPORTABLE AND BASIC PRODUCTS

YEARLY YEARLY RLAn ONSAVERAGE AVERAGE 1992/93 1992193

PRODUCS 1975179 198015 1990/91 199192 199293 197579 19085

A) lCOFFEE 128.0 127.9 100.1 106.5 107.1 0.84 0.84CarTON 222.1 145.1 63.1 50.9 3.0 0.01 0.02SUGAR CANE 57.0 59.1 59.0 60.0 56.0 0.98 0.95BANANA 3.4* 3.7" 3.5 3.4 3.5 1.03 0.95TOBACCO 3.0*" 2.5**" 0.9 1.4 2.1 0.70 0.Q4SESAME SEED 10.9 21.5 50.7 23.8 18.0 1.6S 0.84

SUBI.-TOrAL 424.4 360.4 277.3 246.0 189.7 0.45 0.53

B) BASICRICE 40.1 57.2 57.6 55.0 60.0 1.50 1.05CORN 318.4 259.2 277.8 282.2 300.0 0.94 1.16BEANS 110.9 105.4 161.0 135.7 150.0 1.35 1.42SORGHIUM 75.0 68.8 65.1 68.5 60.0 0.80 0.87

SUB-TOrAL 544.4 490.6 561.S 541.4 570.0 1.05 1.16

TTrAL 968.8 851.0 838.8 787.4 759.7 0.78 0.89

Souice: -MAG: 'Esnategi A4rpcqwuaso y ombn! de Ncuagua, 1992-1996, Man4pe, OcL 1991.-INEC: Niomiaga on cifiru 1991, Mamagua, AgSoi 1992..CABLE CBNrTROAMERICANO, Sept. 28-octubie 3, I992.

4. It was 38% in 1987; 16% in 1988; and 24% in 1989, but low rexcvery has been, for decades, a constant problem for theNicaragua stato fnancl setor.

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in 1992, so producers must have found altrnatve sources to fnance production'.

8.10. According to several producers borrowing carries a high risk as credit cost is high inrelation to crop returns. Farmers have ways to reduce this risk. Table 8.2 shows an increase in theacreage planted with basic grains and soybeans which generally offer .e farmer a faster cost recovery,a lower absolute cost level per unit area and a substantial decrease m agroexportables, mainly cotton,whose rate of retn is negative." Producers are changing their crop mix in order to adapt to changingcircumstances.

8.11. In the agriclWtural sector's current credit system there are two factors which need to beaddressed. First, there is the issue of tidtles and collateral. This affects not only small farmers who gainedland from the agrarian reform but have not yet received their definite ownership titles, but alsoagroindustrial enterprises. In a similar situation, after Allende's agrarian reform, Chile successfully usedthe figure of 'mortgage promise' I as a guarantee, in cases where only administrative formalitiesremained before the requirement of the title, and where It was reasonably clear who the final ownerwould be.

8.12. Second, the current loan system available for farmers to finance crop producton has BNDoperating like a central planner. It has targets for maximum credit per crop, and for each crop it has aninput structure that it finances. Moreover, it does not deliver everything in cash, but rather pays thesuppliers directly. This influences the input structure that producers use (see Box 8.1 for a descriptionof how credits are delivered) and implies that BND decides what crops to plant and how to plant them.

8.13. The credit system is adjusting in the right direction to encourage the medium-term growthof the agricultural sector. The following measures should be taken to speed up the adjustment process:i) utilize the juridical figure of 'mortgage promise" as a collateral for loans to individuals or firms whosefinalized property titles are still pending; and ii) modify the current program of crop financing by BND.Loans should be made entrely in cash and in no more than three disbursements. Ihe bank collateralsystem to finance input purchases should therefore be eliminated.

5. The marked change in composition in favor of non-exportable products may also have been caused in part by theproblans of high cost of crcdm. Exportable products arc more intensive in credit than non-exportablc products.

6. In paricular, the price bands for basic gains huve diminished some of the risk implied Ln dteir production, and so havecontibuted to a more inward looldng production suture in the agrcultural sector.

7. A 'wotgage promise' is a fomdal document that states that the property wil be mortgaged once theitle is available.

Pt!11 it If~~~~~~~i

- ~~~~~~~~~~~~~~~~~~~~Ittj~~t a' sVtrl1 tR.;q~~~~P

I s D R I,~~~~~~~~~~~~~~~S

CHAPER 9

THE LABOR MARKET

A. EMPLOYMNEN, UNEMPLOYNME AND UNDEREMPLOYMEN TRENDS

9.1 The modest output growth achieved in 1992, together with the compensatory program introducedin 1991, have not reversed the rising trend in the official unemployment rate, which increased during1992 from 14 percent to 16 percent, although the estimated underemployment rate has remainedapproximately constant at 44 percent. The unemployment figures, however, may not be fully indicativeof actual trends: the official unemployment statistics cover approximately 20 percent of the labor force,which are registered with the social security institute, INSSBI, and the Labor Ministry. Of these, adisproportionately high percentage (40 percent) is accounted for by government workers, while the restare employees in statewned enterprises and formal private sector firms. These sectors have been themost affected by the Government's fiscal retrenchment and divestiture program, and by the reduction inoverall protection previously granted to many obsolete industries, rendering them uncompetitive.Conversely, the main sectors that did exhibit some growth in 1992, agriculture and commerce,predominately employ informal labor that is not captured in the official statistics.

9.2 There is evidence in surveys showing a rapid growth of the informal sector during the last twoyears. For example, according to a sample survey conducted by FIDEG in Managua, the informal sectoraccounted for 65 percent of total employment in April 1992, compared to 48 percent in 1989. Thesefigures, even if just remotely indicative of actual economic activity patterns, cast serious doubt on theaccuracy of both the official employment data 1, as well as the national income statistics.

9.3 While official unemployment rates have increased, average real wages have also increased byroughly 33 percent since April 1991. The data on informal markets, indicates that, for comparable jobs,real wages are similar to those in the formal sector. Also, in spite of the lack of output growth during1991-92, private consumption per capita increased by about 33 percent in real terms since 1990, largelyfueled by an inordinate inflow of foreign grants. While these indicators suggest adjustment may have nothad a negative impact on society, a more definitive assessment will have be await the completion of aLiving Standards Measurement Survey currendy being carried out by the Government with donor support.

9.4 Both unemployment and underemployment have been steadily growing for the last 5 years (seeTable 9.1). Unemployment has increased steadily since 1985 with sharp increases (more than 2percentage points per year) since 1989, after the first Sandinista stabilization plan was put into effect.The unemployment rate in 1992 is estimated to be twice the rate in 1989. The underemployment rate 2in Nicaragua also shows an increasing trend during the period and a strong increment since 1988 (morethan 3 percentage points each year), except for the preliminary data from 1992, where it actuallydecreased.

1. More , daa on population, labor force, unemployment and underempyment is not collected on a periodic basis. Thelack of a Popultion Census since 1971, and the absence of a periodic household survey (the last national survey was ESDENICin 1985) have forced the Government to estimate these figues or the years in between censuses or surveys.

2. INEC defines underempleqment as the number of people that work involuntarily less than full-time (visible underenployment)and the number of peoplc Utat are working in an actvity with incomc andtor producivity that are "insufficient" (invisibleunderempltment).

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TABLE 9.1: LABOR FORCE AND UNEMPLONENT IN NICARAGUA(Thusand of eoDns)

Year Lab Por UnykeV (fP1e0t) U0dmplrnie=nt RAte (prcet)(1) ) (3s) 3b)

1983 1,077.3 3.2 19.9 20.61986 1,125.6 4.7 21.0 22.01987 1,175.3 5.8 23.1 24.519U8 1Z'4.6 6.0 26.5 28.21989 1,276.9 8.4 31.0 33.91990 1,331.2 11.1 33.2 37.71991 1,386.3 14.0 38.0 44.3

1992* 1,445.4 16.2 37.8 43.7

SOURCE: 1977-1984 INIESEP, Principsles Indiadores Bcondmilo 1977-1986117-1991 and Cental fank ofNicaraua 1985-1992M RAB, on tXe basis of ESDBNC 85 an ts ea their own estumtes an Cental Bakof Niaraa.

(I) Lbor Fore - Employed + Umploycd. It coaideM the popultion often or more yea.

(2) Un.mpkqmmn rt e Fcen4tp of Unmployed on Labor ForcUneployed pecn e aho tha a not workg but arn looking for employme

(3) Undeemployment rate = Pecentge of Employed ha e asona employmen or do not work fi-Utime.(3&) (3) wihk data fiom 1985-1992Ifom MfRAB(3b)- (3) with dAt fom 1985-1992 fom Cenwr Bank of NicaguaPrelminary

9.5 A private (non-profit) institution In Managua, Fundacion Internacional para el Desaffo EconomicoGlobal (FIDEG) has been conducting since 1991 a periodic Household Survey in the city of Managua.lhe survey data is consistent with the official data for the whole country in terms of trends, howeverFIDEG esdmates a much greater decrease in the rate of underemployment. In 1992, unemployment andunderemployment moved for the fit time in opposite directions. The decrease in underemployment maybe related to workers finding employment in the informal sector.

9.6 In sum, there have been dramatic jumps in the level of unemployment and underemployment,that can be related to the sharp increase in wages in the formal sector, the sagnation of output and thegrowth of the informal sector. To revive the creadon of jobs, the wages in the formal sector and laborregulations need to be revised in line with the recommendations at the end of this Chapter.

TABLE 9.2' LABOR FORCE AND UNEMPIOYMENT IN MANAGUA

Jun/Aug 1991 Apil 1992

Labor Foe ('000s) 380.6 381.7Unemployed(peren) 18.2 20.8Underemploment (pecent) 32.0 21.0

Soure: FIDEG

B. REAL WAGES ANM PRODUCTIVITY

9.7 Low competitveness in international marke is due to high unit costs of production and thesecosts depend both on the wage level in dollars (which is io turn related to the level of appreciation of theexchange rate) and the productivity of labor. Hence, the lack of compedtivenme of the MNic.tr,uaneconomy, is due to both low productivity and high wage levels. These are more profound structural

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causes behind Nicaragua's lack of competitiveness than just the exchange rate. Such a problem could besolved by either lowering wages or increasing productivity. It would be preferable if it were solved byincreasing productivity, given the low level of wages (if compared with its historical level). At presentthere appears to be a high dollar wage but with low relative (to other Central American countries or owntime series) purchasing power.

9.8 As seen in Figure 1, real wages increased by more than 300 percent from 1988 until 1992(September). In that period, wages in dollar terms increased twenty times (i.e. by 2000 percent). Thisbig jump in real wages took place during the transition from the Sandinista government to the currentadministration. While part of this jump may be attributed to a "real' increase in wages, a considerableamount corresponds to the transfer of in-kind benefits to money wages. Real wages remain below their1978 level (see Figure 1), but wages in dollars are 40 percent higher in 1992 than in 1978.

AVERAGE REAL AND DOLLAR WAGENatonal Level 1980=100

147

120CI

700

78 -t9 mdi 83 04 85 de 9, I ab sX di 5' 2

| et _ a bY CM -l aWid by ExcRatt|

ure 1

9.9 The purchasing power of wages is significantly lower today than at any time in the last 14 years.On average, it is also lower than in other Central American countries. This is not surprising given thatfrom 1978 until 1991, GNP per capita declined by 58 percent and private consumption by 42 percent.3

However, wages in dollars terms are higher today ta in the past, and compared to other CentralAmerican countries they are lower in sriculture and slightly higher in informal activities.

3. However, the datsmitbeove mangthedeolinenthepurchasingpowesince sing in the 1980sunions havegainedstrength setting Collectve Bargaing Ageemen that _red subsntially the lvel of finge benefits.

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9.10 The key problem is that wages are out of line with respect to productivity. Low laborproductivity was cited in most of the interviews with govemment officials, unions and firms as the majorproblem in the labor market.

9.11 INCAE (July 1992) studied unitary costs of production of coffee, cotton, rice and corn inNicaragua, Costa Rica, El Salvador, Guatemala and Honduras. Ihe study reports that for all products(except rice) input prices are consistently lower in Nicaragua. However, productivity is also significantlylower, causing unitary costs of production to be higher in Nicaragua for some products.' The studymentions that Nicaragua has the lowest productivity measured in terms of yield per manzana in theproduction of coffee and corn and only surpasses El Salvador and Honduras in productivity of cotton andrice.

9.12 There are four main reasons behind low productivity. First, there was a drastic decline in capitalper worker during the 80s as capital accumulation did not keep pace with the population growth.' Theamount of capital per worker can only be increased with more net investment, and can only be solvedin the medium to long run.

9.13 Second, there is the problem of the worker's limited drive and intensity in the workplace,inherited from the Sandinista period. ITis can probably be explained by the substantial change in theincentive framework. Wages were set independent of productivity, mandatory fringe benefits wereincreased, the dismissal of workers was forbidden in most activities and, in agriculture, the workday wasshortened to four hours. This indicates a very flat pay schedule with respect to production. With thispay schedule, given the substantial amount of fringe benefits, there is little room to implementproductivity incentives, and to correlate the pay schedule with production. The level of unionization andthe agreed compensation packages and rules, are analyzed below (Section E). These agreements provideworkers with a basic salary and fringe benefits that sometimes cost more than the basic salary (medicalservices, uniform, shoes, two or three meals, transportaton subsidy, seniority pay up to 40 percent ofbasic salary, etc.) and leave little room to implement productivity incentives such as basing salaries onproduction levels. It should be noted that the business owners and managers have done little torenegotiate these collective agreements, preferring to continue to lobby the Government for protectioninstead, continuing a tradition of rent-seeking behavior that predates -but was intensified during- theSandinista regime.

9.14 Overstaffing was also inherited from the Sandinista period. During the Sandinista period, statefirms increased employment without consideration for the cost involved. Since 1990 powerful laborunions have prevented any significant employment reduction. With reference to the privatization of statefirms by CORNAP, even though some employees were discharged with large amounts of severancepayments, the pressure exercised by the unions restricted their number, and/or pressured the new ownersinto rehiring the previously fired (and compensated) workers. Most of these privatized firms have theCentral Sandinista de Trabajadores (CST) as their union and further reductions in personnel areconsidered impossible. The difficulty in reallocating workers is a key explanation for the low laborproductivity. Tihe authorities are approaching the problem cautiously because of union opposition to laborretrenchment. This in turn is affecting the willingness of firms to hire new workers, since dismissal isextremely costly,' and sometimes ites outright impossible.

4, This study should be inteipreted with caution since a key assumption was that capital per worker and technology is sinilaramong the countbies. If this is not the case, the differenoe in productivity between countries can be attributed either to the levelof technology, or the level of capital.

5. Capital per worker decreased by 46% rom 1977 to 1992 (i.e. to about half its peak value in 1977).

6. I is costly not only in terms of compensation but also in terms of lowered production due to disruptions by union protests.

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9.15 Finally, the low level of quality per worker is attributed in part to the inadequacies of the formalschooling system and in part to lack of on-the-job training. The quality of the schooling system is outsidethe realm of this report. However, a well-functioning labor market is also dependent on the trainingwhich firms provide for their workers. A firm has an incentive to tram its labor force since this enhanceslabor productivity resulting in additional income both for the firm and the worker. The firm's incentiveto provide training will depend amongst other things on the degreellevel of turnover expected from theworkers. To reduce turover, it is common to pay trained workers a higher real wage. But the currentwage structure instituted by collective agreements precludes this type of wage profile. In particular,seniority rules prevent the firm from setting wages according to productivity or level of training attained.As structral adjustment proceeds, and resources are reallocated, scarce skilled labor has to be rewarded.When skills are found in younger workers, as could be the case in Nicaragua, seniority rules make itdifficult to atract those workers.

C. THE INFORMAL SECTOR

9.16 Nicaragua has a very large informal secr. Available information shows that this sector hasincreased in size during the last decades and especially from the late 80s until the present. Recent datafrom FIDEG (July 1992) shows that the informal sector in Managua employed 65 percent of the workingpopulation in April 1992.7

9.17 Theurban informal sector has steadily grown during the last two decades (see Table 9.3). Thereare two distinct periods with strikingly different growth rates for the urban informal sector. From 1970to 1989, the informal sector increased slightly from a share of employment of 43.6 percent to 47.6percent. From 1989 to 1991, in only two years, a similar increase was observed in the share of theinformal sector. And, according to information for 1992, the share of this sector increased to 65.4percent of those working (i.e. by 25 percent).

TABLE 9.3EVOLUTION OF THE URBAN INFORMAL SECTOR

MANAGUA(S&ete Yemn)

Formal Informal Total

1970' 56A 43.6 100 01982 SS.0 4S.0 100.01985' S1.8 48.2 100.01989' 52.4 47.6 100.01991' 47.9 S2.1 100.0199?9 34.6 65.4 100.0

SOURE t and P3DBO (December1991) on the basis of a study of UCA, the percentages ae calated in elato to The lbor fotcc,> 1EC (1989) using daa fntm ESDNIC 85, the pere ntae cackulated with respect to the employed in U actvies except agiculture.They refer to the coutzy ex a whole.*4WA (199C) usiqg data from Encues de Coyuntua from Managua. Th pe_entgs ae calculed wh respect to the employed inM a. ey anavre ofth peretspof h 4 waves of the urveyunderaken in January, Jun, August and Decmbecr 1989.I and 6 FIDEG (July 1992) usig data fiom the houseold sveys in Magua conducted in June/August 1991 and Aprl 1992,repectively. Tey ae caultd a a percenage of the employed.* Unle otherwie noted. See 1985 for an exception.

7. The s btstical information available includes tabulations from ESDENIC 85, Encuest de Coyun d Managua 1989 andthe household surveys by PIDEG of 1991 and 1992. Except for ESDBNIC 85 and recent surveys done by FIDEG, theinformation refes to the Urban Informal Sector in Managu. According to INEC, in 1985 210,000 workers bclonged to theusal infonnal sector. As to the definition of the informal sctor, FIDEG includes independent worker, employers and

employees of fims with less than S worken and domestic service. INEC defins as informal all the firms, or organizations ofless than S workes, coluding independent professionals, state fima and religious organizations.

9.18 The explanation often given for the sudden jump in size of the informal sector, Is that thereduction in Government jobs through the labor reconversion program' and the privatization of statefirms created an excess supply of workers in the formal sector, which forced people to move to theinformal sector. However, if this were the real explanation one would observe a decline in informalsector wages that is not observed in the data. Another hypothesis is that growth in the informal sectorfrom 1989 coincides with the overvaluation of the Cordoba, and the liberalization of trade and foreignexchange, which lowers the cost of imports (in particular if they are smuggled), added to which theincrease in formal sector taxation, creates an incentive for workers to avoid taxes by moving to theinformal sector. In this case, the growth does not occur in subsistence level jobs, but in jobs that aresimilar in the formal sector but where it is possible to evade taxes.

9.19 There is evidence in some surveys that although the average worker of the informal sector isless educated and lives on subsistence wages, a large part of the sector is made up of tax-evading formalsector firms. While on avera workers in the formal sector earn more than their counterparts in theinformal sector, the earnings in the latter are in some cases no less or even higher than in the formalsector.' Clerical workers earn 33 percent more in the informal sector, while there are no importantdifferences in sales, domestic services, or blue collar wages (see Table 9.4). Most of the difference inaverage salaries between sectors are earned by professionals who by definition are mostly included in theformal sector and represent a high share in formal sector employment (36 percent).

Table 9.4: AVERAGE LABOR INCOME IN THE FORMALAND INFOR1AAL SECTOR

(FIDEG Jun/Aug 1991)(In Cordobas Ore)

Pomal Sector informa Sector Raio

AVERAG INCOME 1,003 658 0.66

occupation*Professidulenician 1,416 952 0.67*Cl1er 903 1,203 1.33-Sales wofker 653 649 0.99-Service worker 738 562 0.76-Domatic sevic 342 317 0.93-Blue coll 720 693 0.96

-mamdktIving 1,192 659 0.55-Reba/Hatalcatau 780 661 0.85-caalwa/Hea1~ 700 467 0.67-Pound SerIe 720 584 0.81

Sow: PMDBO

9.20 In sum, the comparison of characteristics and earnings between the two sectors support bothhypotheses about the informal sector's character. The informal sector is an heterogenous sector. Somemembers have trouble finding work in the formal sector and so join the informal sector, earnig less thanthe formal sector counterpart. Others could have found a job in the formal sector but found it moreprofitable to join the informal sector, where they can evade state regulations and taxes. For example,

8. The masure of income for the formal sector might be biased downwards if frnge benefits are not included or monedizedin their monetuy income. By definition, informal woerkes do not receive fringe benefits, except for health care.

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businessmen from the commercial sector In Managua have expressed their concern about compettionfrom street vendors that willegallyu evade taxes, tariffs or permits.

9.21 At the same time the informal sector grew fom 52 percent in June/Aug 1991 to 65 percetof the total working force employed in April 1992, average income increaed in both sectors. While itincreased more in the formal sector (59 percent against 36 percent in the informal sector) it is due to thefact that the earnings of professionals increased on avage 125 percent during this period and that theshare of professionals in the Infiomal sector is exmey low. he fact that real wages increasedsubstantially in both sectors, contradicts the hypothesis that the increase in mal sector wages was onlydue to the presence of unions, indexation or government protection. If this were the case wages in theinformal sector would not have increased as much.

9.22 In terms of policy, these are important findings. Whie the informal sector serves as a cushionagainst recession and unemployment, it is increasingly a profitable sector that is starting to have thecharacteristics of the formal sector. Tbis poses a problem for the Government if it wants to prevent taxevasion. It is clear that with the existing inability to control tax evasion, an increase in the tax rate couldmainly tend to erode the base, through an increase in the size of the informal sector. Moreover, anincrease in the ability to detect and sanction tax evasion may have the effect of significantly reducingactivity in the informal sector, without necessarily increasing it in the formal sector. The most effectiveway to collect more taxes and decrease the size of the informal sector is to lower tax rates and at thesame time improve the tax administration.

D. UNIONS, COULECIVE BARGAINING AND THE LABOR CODE'

9.23 Nicaragua has a high level of unionition especialy in the public sector and in the firms thatwere under the control of the Stat during the Sandinista Period. From 1979 to 1990, the CentalSandinista de Trabajadores (CSI) which was created at the beginnming of this period, was the only union.Since the new Government took power in 1990, and after a law was passed in August 1990 stating thatany union with the support of 25 workers was recognized, other unions began to appear. However, onlyone contract can be negotiated in each work place and negotiations between the different unions arerequired.

9.24 There is no official data on the level of unionization or the share of workers that each unionrepresents. Some officials from the Ministry of Labor estimate that less than 50 percent of the unionizedlabor force belong to the CST, while the CST claims that they represent more than 60 percent. Theregistration of new unions in the Ministry of Labor is available and gives good information on currentunionization trends.

9.25 Table 9.5 shows the nmber of new unions and workers registered by the Union. There arecurrently two main Organizations that are formed by the Fedenrtions and Confederations. These are theFrente Nacional de Trabajadores (ENT, a Sandinis organization) and the Congreso Permanente deTrabajadores (CPT). CPT was one of the organizations supporting the political campaign of the cur ,ntGovernment. This Table shows the decreasing power of FNT. In 1990, of the new unions formed, 56percent belonged to FNT and 33 percent to CPT. In 1992, 30 percent belong to FNT while 36 percentto CPT. It is iteresting to mte, that in these two years, 55 or 7 percen of the new unions were notaffiliated to any Confederation. Ithe bottom part of Table 8.5 shows the number of new affiliatedworkers by union. In 1990, 65 percent of workers were affiliated to an FNT union, while in 1991, only34 percent.

9. Trade Union acronyms at explained at the bouom of Table 9.5.

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9.26 Whatever the numbers say about a relative decline in the power of FNT, the union is beingtreated with enormous respect, possibly reflctg its tedency to resort to violence to support its claims.'he FNT sets collective bargaiing agreements, prevents the layoff of workers, autd negotiates with theGovernment on the control of rms that are to be privatized. Some of those interviewed pointed out thatas long as FNT Is successful in getting its demands met using violence, other unions might start to actin that way so as not to lose members. The curet members of CPI, once strong supporters of the UNOand the Govrnment are beginning to resent the measures taken in favor of FNT members. The Unionsability to use violence or the threat of violence with great effect creates disorder in the labor market.Unions should have the feedom to strike and to defend their rights, without being allowed to resort freelyto violence. Th legal &famework for calling and implementing a strike should offer incentives to bothsides for preventdng strikas.

TABL;E 9J.: NEW UNIONS AND WORIERS REGISTERED DY CENTRAL UMON - 1990.1991

NEW UONS REGIM RED NW AFFITED WORKRSi1 1991 19 1991

TOrAL 591 172 41,016 10,004INT 333 51 27,020 3,433ATC 10 3 96S 429CSTW 170 21 12,775 1,377PET5ALUD 94 18 7,021 994UNE 59 9 6,259 633cFr 198 79 t0,2 4,1CUS 71 29 2,441 1,244CTN 60 26 3,2 1,757CGf 28 17 1;719 715CAUS 39 7 2344 605CINa 31 1i 1,440 788WAC* 26 29 2,169 1,432OT'RI 3 - 101 -

SOURCE. L4B , Seaey of Unos Afas.

PNT- Futt Naacl*u de kw Tlo hjsdos. ib is fomd by to falowing Weeifions;: ATC-Aocac6a 4dTrabados41 Can,Q CST-C.ntal Sandina de Tnbjaor, FEISALUD-the hearkers union, andUNE-to publo aayeap unionCrr-Cogrs Permww 4. lo Thboms. I I fokd by sw folowing Conedonu oa:CUS- S- Unioa Sindisdl; Ce Ua.C fCaN-Cbu doIbjador Nscadagua; CGrlF)-Confideci6nGesel de Tubadorem and CAUS- Coibdszcidnde AOi4a y Unided SindiWal.CTNa-CentrA de Thb*dom de Nkagun AWtoua* WACwmwho adviin e Cen Unioa.

9.27 One of the most important results of trade union acdon are collective bargaining agreements. InBox 9.1 some of these agreements are analyzed, focusing on the large amount of fringe benefits includedin these agreements. Sometimes fringe benefit amounted to more than 100 percent of basic salary. Itis important to note that the collective bargaining agreements state the extra amount of benefits that arenot explicitly laid out in the labor code.10

10. r ample, the LAbor Code and its mform prect establish very gnerous vacation peiods, so acations are ot usuayncgoatd in Collbotive,Agr_set. While he law provides fr 15 dys of vacation a year atr only sit months of continuouswrk , pthe P' being coisidrd in Cofgs itabilib 26 days for every person with ln n 5 yearS of senory to 40days for persons with morc than 20 yais of seno*y.

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. . , X,,,~~~~oy. 9.1,. .

1 Fbwur aim Collectiv Sargsnn Aenatprvddyth nstof Labor (MfRAn Ws~~~~~~~~~pd o. tA.

and Octber 19 2andthuuioS a1, CN(CF) sad FE M,with no lear afiitbn. All U8tes agonoapoiefr a:uile Us ha. ken 4 toE peiaatnabersin each orgnmon an ofice £ phone, and i someoae etr foo and a hi trenb. boases,.a1though the law do not equle so. ty etbiUsh union qnoo W be colletd tha* thepayoL.

2 With repect to ige benefits, thwe contats hte me vuation, especithe a uulfirm, wclh -, lrs 1in-1kad bneflts tan th rg s In these are , swcial povisions dial" t h o rmis reaponslAe i. healti are of al its worke. Tbi provioa urn CO _ w fOt latk of ruie

from the MhWriy of Health (MINA) nd the Sol Suroit Itt ( BI) and soawof th a t.cidy, state lht Thesueltb swvo asswec subj ect to InsX_~ sine, Ihe lawi eqlc~ hr th fis; ind.hencthoX fim is oblied to tib«fle. M esiiz othe hath of the okr... The sgremtaiblsth Obligation of p d hg cncal elams cor twice'a year fr th uekc an MP/hihr fmly,

eimburnsment for medication that goes from 50% to 100% aordig tbo te cas and agmentm, ad patialor tqtal keWbw*vpkb for glasses..

:3 All of theeagremnsprovide frA abd and trnsoraionU fa Iheesaodl thesikm; Withtit. weption of seior stafwbo ar oldypsitilly. rinibwd; Tleiuba agmets abish.t thtfrm-pro. u*boms ad nhea Here tr is Wm iiios by tylp of wo*es iid.*W ai 4ome give asmany as 10 uraforms a year for cleii and domestic asen.i peonl. oe 2 uniform and 1 pair*of oesa year for most of their personnl. They also provide some other amenlies such as Chrim bgnum (i.e.15 eta days of salary or a food baata than e tuoy to atch worker) and sprt and some tcersationactvitiea paid by the fAm. In case of fth death of a fmily meea, mot frm ae obliged to pronie thecoffin and thi in le best came to prvide the ear, mass, chair coffee and food for ft people attending thefimeral. .

4 Some of the aggremcnt provide for materany wad delivey bhep in kind or money, and latcr:provide milk and the basic needs of the infant and some of die prodde free chuld are. With respec to:pensions, fte agreanents try to compeno for he curnt low pension gNen by INSSBI. and so establish apension to be given by the firm. For example, a public eantprise provides a very generous peasion tacaMOt be ks than 100% of the last salay inludingIwn tve; a prive fin provides a pension of 40% ofbasic salary and AWd.

9.28 With respect to hiring and firng decisions, collective agreements provide strict rles. Firstly, theyestablish "promotion from within the rank" at the hiring level; if there is a new opening the firm has toconsider the current employees mrst and if it want to hire an outside worker it has to prove that nobodyin the firm can perform the task In some cases, the firm can only hire new personnel through the union.Secondly, once a person is hired, the collecdve agreements provide 'labor stability' which means aworker cannot be fired unless a commission formed by workers and firm officials agrees to it. In thecase when the commission cannot agree, the Ministry of Labor is asked to decide. If the worker is fired,the fimi is obliged (with some exceptions) to pay a severance payment that ranges from 1 month for eachyear worked (with a maximum of 20 salaries), to 20 days of salary per year worked with a maximum of6 years. lThese clauses impede fims from hiring the most appropriate candidates and create a frameworkin which fims hire as few new workers as possible. This is particularly true because of the often violentopposition of unions to staff retrenchment, whatever the reasons. Ihe firm's overall pr "uctivity is

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lowered and firms tend to use more capital intensive techniques than would be sensible given Nicaragua'swage level, thus adding to unemployment and underemployment.

E. THE LABOR CODE

9.29 The new draft Code which is being discussed in Congress provides for a very inflexible labormarket. In some senses, the proposed Labor Code is a legalization of most of the provisions establishedin the collective bargaining agreements as descrbed in Box 9.1. The agreements now in effect in partsof the formal sector, will be extended to all of the formal sector, haming the smaller firms (that currentlyhave no unions at all). This will be a furher incentive for firms to operate in the informal sector. 'Memost affected will be the formal small firm sector that is presently expanding in Managua. In this sectorrelations between employers and employees are good, and they are using 'pay for perfbrmance" schemes.This sector can use incentive schemes since it is not ruled by collective bargaining agreements and hencehas room to implement these schemes. Entrepreneurs from this sector did not complain of havingproblems with labor productivity.

9.30 INCAE and the Consejo Superior de la Empresa Privada (COSEP) have stated their objectionsto the following proposals included in the draft Labor Code: 1) total immunity to union leaders fromsanctions or firing (ts exists today in the majority of the agreements); 2) lifting all procedures thatrestrain the unlon's unilateral power to declare a strike and cancelling the Ministry of Labor's ability todetermine the legality of the strike; 3) legitimizing the union's invasion of the work-place during a strike;4) paying workers during a strike; 5) ending the practice of arbitraton by the Ministry of Labor to solvedisputes; 6) legalizing strikes in the public sector; 7) increasing severance payments to a month's salaryper year worked with a maximum of fifteen months; 8) instituting seniority payments that range from 3percent to 20 percent of basic salaries; and 9) changing the "just" causes for layoff, restricting it to"serious" offenses.

9.31 A key objective of the draft Code is to decrease the costs incurred by Union members during astrike, increase the ease with which a strike can be called, and increase the entepreneurs costs duringstrikes. This will raise the costs of atteWpting to change from entement-based agreements toproductivity-based agreements. This is the opposite of what is required, since as they are, the collectivebargaining agreements (and the risk that the proposed labor code will be approved) favor a climate whereany investment by an entrepreneur becomes at once common property. It may not be surprising as theexisting collective agreements come from a time when capital was effectively considered to be theproperty of the people. Today, this constrains private sector investment. Under the present conditions,it is unlikely that a more flexible labor market will evolve in the near future.

F. WAGE INDEXATION AND THE "CANASTA BASICA"

9.32 Ihe workers and the Government pay special attention to the evolution of the prices of 53 items,called the "Canasta Basica" and calculated by the Statistics Institute (INEC). This Canasta has been usedsince the mid-eighties and is supposed to be composed of products consumed by a middle-to-low incomeclass family. The evolution of wages is constantly compared to the evolution of this index, and wheneverthere is an increase in the value of the Canasta there is pressure to increase wages to compensate for therise. This forces the Government to try to hold down the prices of the products in the Canasta throughdirect subsidies, controls or exemptions to laws or regulatons.

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9.33 Table 9.6 shows that the weights used in the official CPI and hence used in the Canasta Blsicahave changed substantially. In particular, food has a higher weight and clothing a much lower weight.This can be explained by the lowering of the standard of living since then. However, at variance withthis tendency when incomes go down, the share of education and transportation expenditures haveincreased. This can be explained by the reduction in Government subsidies in those sectors since 1985.

TABLE 9.6: STRUCTURE OF EXPENDITURE OF FAMILIES

URBAN MANAGUA

Concept 19S 1991 INFLATIONNEC FIDO Sept. 92/ SOpt 91

Food 56.S 60.6 -1.99Clothing 10.4 3.8 4.16Shoes 3.6 1.0 -Housing 5.6 6.1 49.92Furniue 7.1 6.3MedIa SeMce 2.4 1.1 19.21Education 0.9 3.0 31.37Tanporion 4.6 10.4 0.74Peomona hygine 7.4 7.1Other 2.0TOTAL 100.0 100.0 11.71

SOURCE: 1985 lNEC, 1991 PDMEG.* May not mm to 100 due to munding.

9.34 The hyperinflation that Nicaragua suffered during the second part of the 1980s raised theawareness of the purchasing power of wages, and since then wages have been implicitly indexed to theCanasta. Collective bargaining agreements do not mention indexation explicitly, since there is an implicitunderstanding between workers and employers about the updating of wages.

9.35 Looking ahead it's interesting to consider how wages will react to a devaluation. A devaluationaccompanied by expenditure reductton measures will bring a change in relative prices, increasing theprice of tradables with respect to nontradables, the composition of the Canasta is key in answering thisquestion. From the description above, it is clear that the Canasta is mostly composed of tradables, soindexation would suggest that wages will be adjustd by an amount similar to the devaluation. To lowerthis effect, the proportion of nontradables in the canasta should be increased. In Table 9.6, we see thatthe share of nontradables has increased from 1985 to 1991, except for medical services. So a canastawith lower weights for clothing and higher for housing and education would be desirable from amacroeconomic point of view, and a better approximation to reality. It can be observed in Table 9.6 thatthis basket, intensive in tradables, has been favorable for deindexation at a time of exchange rateappreciation (i.e. non tradables have risen in price more than tradables -compare housing and educationvs. food and clothing in Table 9.6).

9.36 It is advisable to drop the practice of following the Canasta altogether, since it leads to thefollowing distortions. First of all, the Government is reported to keep the prices down by different

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means, distrting all of the markets involved. Secondly, if real wages are not in line with productivityin Nicaragua, either wages should go down or productiviy should increase. If Indexation prevents wagesfrom adjusting, and the business environment and the excessive regulatory rigidity of the labor marketprevents productivity from rising, then unemployment wIll remain high, and any growth that occurs willbe in the informal sector where by definition neither the indexation nor the labr market regulations areenforced.

Payrl Taxes

9.37 The social security system has faced a clear deterioration in the number of affiliates that reacheda peak in 1987 with 312,000 members and decreased to 215,000 affiliates by the second semester of1992. The current payroll taxes are: employers (12.5 percent), employees (4 percent) and theGovermnent (1.5 percent). It is highly undesirable to raise them to help alleviate INSSBI's financialproblems. Firstly, contributions to the system will decrease even more with a, nigher tax rate unless areal increase in benefits is foreseen. Secondly, the current high rates of unemployment andunderemployment could increase with an increase in these taxes. An in depth study of the Social SecuritySystem is needed to suggest solutions to its current problems.

G. RECOMMENDATIONS

9.38 To increase intemational m=e,tiveness, thte Goverment should follow a three-fold strategyaiming at: a) increasing productivity, b) increasing labor mobility; and c) eliminating indexation. Inturn, these objectives should be pursued by: a) changing the legal framework of the labor market; andb) changing the incentive structure in the pay schedule.

9.39 Develop a coherent legal framework for the labor market: The labor market in the formal sectoris ruled by the unions and their power to enforce the inherited collective agreements. Under these, theentrepreneur has very little choice on whom he can hire, dismiss, or how much he should pay. If thereis excessive regulation, on one side, we observe a lack of clear rules on the other (or the enforcementof them). Unions are taking violent measures without fear of disciplinary action. A first step is todeclare strikes that use force or violence ilegal, and assure that punitative action will be taken if theyoccar. Future investment will continue to be limited if there are no clear rules or if excessively rigidrules hinder the management of human resources. This will only serve to decrease productivity andunemployment, and increase the number of workers in the informal sector.

9.40 Change the incentive structure in the pay schedule The current situation of large fringe benefitsmakes it difficult for enterprises to introduce profit-maximizing pay schemes which are badly needed toincrease productivity, Fringe benefits should be monedzed, seniority payment minimized and incentiveslinked to productivity should be introduced. Layoffs based on low productivity should be legalized. Asystem where workers are rewarded just on the basis of seniority and where they cannot be dismissedremoves most of the incentives for productive performance. This is an extremely important issue sincehigher standards of living will only be achieved when productivity increases.

DATA ANNEX

A. MACROECONOMC DATA

B. PROJECTIONS

C. LABOR MARKET DATA

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BURMP S I.OSSIU1 2.ve1la. 12.6 14.5 25.1 21.1 24.0 27.3 30.5 34.1 381 4.voltua (thoiu. 2l;) 3,676.6 2,64s.3 3,743.0 40194.4 4.6*3.0 5,07S.2 3,411.2 3.919.7 6,393.3 6.904.7Unit Price (US$118O) 3.5 5.8 6.7 5.0 3.2 3.4 5.6 5.8 6.0 6.2

my T30tfUL0 20.1 9.6 23.8 26.9 30.4 33.6 34.8 40.4 44.5 46.O-AtTDItONhL 60.1 33.0 64.5 69.6 76.9 6S.7 93.1 102.4 112.3 122.6

tDWBs CZ?

-- w C0W 223.3 29s62 193.4 20.6 214.1 21S.6 21.S5 228.0 234.1 144.5fliROLII & OflvATIU 114.6 121.4 120.9 127.7 235.5 336.4 144.1 151.3 *38.3 147.0Iu1U*ZATZ own0 222.4 236.3 237.4 *31.S 263.3 27m.3 290.0 304.1 317.3 334.7CAPITAL OOIw0 190.6 221.8 219.6 233.5 248.0 266.0 261,0 303.2 320.9 385.6or= ~~~~~~~0.2 8.7 0.1 0.1 0.1 0.1 0.1 0.1 0.3 0.1TOrAL A73.4 661.7 173.2 619.3 840.9 9.5 9.3s 9s.S 1,030.3 1,91.7

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g�g� g� *vi� g;n riot riot mi mist **;ir 0.,:; 6..a..� 550 3� I�S

oo 0'o 0'0 0*O 0�O **0 061 *o me sw.szy hIpuw:suo IS 3U0£@�9*�Z CLTr PIL6 C916 5*T*g '109 1W�1 �9I £9C11 *5� *JWSZZY 5100 me me me me me *.o **.::: aw� �(o*sfl (mg) (rot) (o01) me rot mat (61) (r!�:?) (f;.-)SSAZ*S*U 9s1 �p.o: i:e: L1� �9Li I1�S p119 t*91t.1 9*i56 *99tt t991't ohz�rrau

00 *o *o me me oo se me rs�1 Cr961) SflSSDD asi tiara00 00 0.0 0.0 00 *e mo me o�o eoi;'�.nw tat*�tw£*� �u.:Zm� qo.q00 00 00 00 00 00 *0 569 00 p�ldwo *�w*;i�0.01 00L @09 O�0 009 06i 0.0met; ocu *�u mc�: rosi oegg ;.pg mist 9*g5L r�oe0111 0*tlt OLtI r�0t **iit v;:: :*uou Pest 559 e.e: P1.4@tU 060 0*ift @L4$ 659w 1*L� t�96 V1�, *'sie ritesiss �,sg its: P495 9�gg mres ?*5� 640$ *£91 e6�g *�U.u.3Uq.1�PG E,tg) (mci) (Pie) (Pie:) tVcrc� (r*u�) (��Lt) W901 LIII iIT�tflOP03 �L1 (rut) (PLc) (PL9r) (roll (PLcs) 1) (t*iL9) (S*099 �N000�W 1V.U4�

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vtsi pcti £*hh1 P591 5161 6551 mu; £*S19 P509 0.61995L Pu PSi PiP 4*59 £:L 15L 011 L£l PII0015 **5j5 oizs ose; PuS rso: ;uss £105 ret� P099 flu5514 #��93U500 00 00 00 00 mo me *.* 0.0 *a;sd.i pun*�moss o*e:s 0*sZl 050 IL;; i,o; �*�;g Ls� g**� � *�u.inLw� zo�:jSC 54 iG 3.4 £4 36 T* £S £6 e;d,.�q �o;�w�(eoou (reo:) Em�iz) (.54K) (PLc:) (miii) (s4 w) 4'..,) (r;�) Cr059) U�OM1 U1�TA 135

(rear) (rsss) (rc?�) (P019) (1.919) (meEt) (m0S9) (S'osc) (p�t9) (P1cc) SIMVIYU RDILWSrSmets e*:�w resi Psi: iosr £*gu vu; s*.u pitt ins;: sam IS .;zodux*5iT 9S11 P911 1*O11 P901 6�0t ooo Pie 3*99 POL u.s bos'3o4121055) (p�J (IWS) (6 Ii) (9�) (O65) (c's:) (3'::) (osc) (P96) UOUVhVg 9*0L.TLG *Lt6 �OLS rrrs 0i6t P9PL �wu reiP rcc� inE� o1) .1304359'40s *.g� g*uet :ec iseg r*isg 5.10$ 90fl m's: t'cu (101) 9530d13(c*ig:) Ivus) (PuSS) (in9R) (n;ot (rut) (g�g�) (PL lv) (5o91) (P561) 3�I1VtVt aGYIL

…�0005 6601 6661 £661 9661 6661 9661 5661 566, 16�-- …nfleflbflnfe*ee*n.�.

(eJvtT@4 30 IS US)TTIMIumva us. i�uy�w- WoouYolS 'Pri iiIYL

tUL3 .S.3.s UICIRA - CdOLIM? OKTtU c = uuUAU PLtC UM

1991 1992 1993 1994 LOS S n9X 1997 1o90 1t99 2060aHullIu* do Cofdobee)

TOTAL RICYIU 1.369 21.31 3,368 4,29) 3,134 5,649 6,546 7, U1 7,174 .0632cuwt0t 2et emDU 1.624 2,360 3.349 4.270 3.I09 5 $s10 52 7 to10 o ,135 *.591Tax tt.w. of gral..womrment 1,614 2.190 2,620 3,413 4,114 4,10) 3,292 3,8S0 6.416 7.073bIt..: I'm.o 257 M1 SS$ 44 3363 40) 67 743 61 M0TaSso ron 0t I ""it" 7S6 1.099 1s52 1.914 2.321 2,426 2,953 3.246 3,542 3,69?TUMs an nerntio Tnal 8 7 36s 4" 491 5 0 03s 976 1.133 1.26S 1.454ftber S99 615 9 no5 551 420 SOS 135 144 63910at rwe" me 0.0. 116 III 24)5 "9 ass Sol 432 64* 239Cerativo surplaw of n 97 IS9 405 36 642 723 603 666 oi

Capital pev .u is II is 23 17 so . 36 .6 41Ooal (Itto. 16 Is 21 25 to 31 34imbUe taprlse 2 2 3 4 5 5 8 S I 7

lOYAL UPYSJD1T USTI1 S. 4.3),? 4,06 5,541 6,177 6,705 7,330 0,120 ,43cw:it..t *".Attvve 1t . 2,414 2,53 3,10 3,339 3 926 4.284 4,1 3:130 30497Com.umptias 5.701 1,41 186 2.117 3,4*9 3.730 3.027 3,3273 3,509 3.753&Bta* Ealawl t 0,00 75 5 630 932 1.092 1,216 1,341 1:443 1,533 1,647Goias sad *le w 1,042 1126 1,032 2,t15 I1,34 1,513 1.605 1,31 1,971 2.111paymooto 0~~2 23 469 601 663 693 70 910 992 1.061Ottd4 *e ;t Zlne. P.t.) 822 t2 350 6 7 7 N 0 9 on #sa".s debt *0 J63 419 St? 63S 485 6SO 902 903 1.05sut current travelers tO t. Otb 100 252 322 369 456 505 554 594 629 671caI t:l .p.odlture 594 95 1.434 1,761 1,962 2,230 2.501 2,752 2,996 3,246fluo Capitol frort1ou s27 010 1,149 1,232 1,308 1.3I 1733 1,931 2,100 2.234General Overnmnaat 1ts *34 474 565 655 756 847 931 1.024 1.10O1.511* 3strtp? es 1441 455 615 661 133 022 907 994 1,016 1.Z6capita, tranaftre (e.g .2 3335 5 7 }29 394 672 1746 021 096 o7Not Leudig 68 31 0 a 0 a 0 0 0 aCOuNIW ACCMOINT IPICT= C-) 139) 145 096 1,161 .550 10m1 2,244 2,411 2,705 3,095OV Lt PuICl sIum OAt) (36) (0) 11 C7) (371) (403) (329) (223) (304) (255) (112)

forere4 Pete 084 0 990 934 1,034 1,0U2 1,005 1.181 1.267 1.344OVERAIL bUICM K (3 Arm ORAMS 347 ( s1t 77 60 7SS 61 076 1,012 1.232nI*AcmMW B IOUK (347) 23, (121 ) (77) (9 (7S3) 041X) (07S) (1.012) (1,232)P.erle 3rowrdg 31 1 092 416 29 2?6 29 330 342 334 355Dome I o t (901 t ) (339) (616) to") f1*049) (so191) (1,2A0) (1,347) (1.586)

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TI LS.3.52 U 1MU * CCSOl&TDt O1PA = Of TM II uI L F C $WMort..... ... . . .S. fb*l ....

e... .... .. .. ..1991 Mf lots 1994 t19s 19t 199 tt logo :to(IKllos. ef 1900 CorJo.gTOmL I95I3 4.235 4,599 5,317 53411 $*,63 3,74 6 ,07 4,343 6,63s 4.sS1CarnIst Imtm. 4,194 4,58$ 5.290 5,362 5.603 3,44 6,066 4,333 6,606 6,696tex rew * of S1.8w. mut 3 713s 3,0 4.03 4:0S 4,514 4,725 4,917 53.61 S411 S.679Direot Tmx*. 5912 SSE 53555 384 00 429 655 gig itsTaew on gode A sewrSec 1,U10 1,95t as,33 .412 8,343 2,609 2,744 .2.f6S 8.to S71.r., on Internati o rl d. 623 630 1 77 774 as? 09 s 1.061 1,169Othet 689 740 561 596 10 de2 633 446 661 674Goatee revo. 0.0.1 266 35 367 36 is9 401 40 417 426OperativSurplus of n 19V4 347 722 70 104 t26 746 763 779 793C*4r¢af TreaSlir- s16 0 0 0 0 0 0 0 0 0Capltol ro u so 31 27 so 0 so 31 3* 32 93ceerel ver meat 31 27 24 24 25 is 26 26 27 27Nblle fatt*tVi"e 4 4 U6 is 34

T0f"Z WUI?D2J S,320 3.71 S,33 3,629 3,5 67 5,613 3,4669 3,22 6,067 6,177currate zxdttc , 4,331 4,310 3,4 3,916 1,903 3,94 3,901 4.209 4,326 6,413Cemptleo i3.917 3,374 2,74 266 2,674 2,7*4 2,813 2.85 2.956 1,018ge u S S*rUee 00 13517 1,365 1,236 1,I73 1,98 1,222 1,244 1,271 1.297 1,323Ogoo. d ...,Ae.. 239 2.08 1,537 1,494 1*476 1,511 1,566 1,613 1,*62 1,695°i,tex.s Yamdbte 6t9 4'6 9 760 729 469 653 $02 "'7 657ft au..t1o d.bt (I=. .L .) 4 14 74 7 7 7 .7 I 7 7fout ig UKt Its 414 62S 7"3 722 669 46 794 629 o50llt Cur t tesefere (G0 to Otbe 460 449 461 450 500 06 313 523 531 $33CDCttl .0edtutr 754 1,472 1,902 1,711 1,664 1,669 1#406 1*713 1.741 1,764Ps 9d .apttel fiet.. 400 1,217 1,298 1,197 1,165 1.170 1,164 1.202 1.220 1.232Goserl Sovocsn t 341 533 533 549 550 541 572 383 395 601M*e ft rprl_ #7 663 762 64 6J6 610 613 *19 625 431CeeIto l tsfer (0.0.) 0 196 60S 514 499 499 504 311 521 332et L.Wft 134 36 0 0 0 0 0 0 0 0Cer Acwwr PDCtf ( 355) 258 1.536 1,464 1700 1,900 2,065 2,124 2,260 2,485O0UU. WtICI? .)1 F3 GRMTS (16083 (1,1621 (339) (216) #61 426 443 371 754

to g agrt 2.036 1.031 1,527 1,202 1,112 1,067 1,006 1,040 1,066 1 t,0oQUtL OICIt ( 61 OAUMt 951 (151) " 84 1.77 1,34s 1.456 1,463 1,640 I,83M

n . ST soon (3) 1 1 (76) (o94 (177) (1,346) (1,436) (1 ,843 (1.640) ( 1,33)Toni" Uvtwtft ~(36 1,663 is (207Y) (205) (294) (329) (9105 (504) (55SI9)(91S 3 (1,332) 60) (777) (9721) (1.034) (1,107) (1.073) (f.36) (1.274)_ __e._.._.�_ __ .. ,__ . … .a .f-.- -

c 19 f, s * - Sol *- X-t $,-C S't c t'ool, 'Pt "20106-t- t-t gt- 9'-_ f`v- $,V- 1 O-g. cl- t*._ 019 20NM ;11 _tSol *t vv 9'v S-t J-t o-i ef -19 08' O-S Wm =" ) AWIA9- I -S z-Ls I'S v-s $It i's Ol t 011 m ozw*-0- 1'1- S-l- c-t- 011- L't' S*? li- L'- -z_ $3090 mmW uU thX-Z 211 '11 sl ' l11 9t'1 v-Ot '*6 '9 III got, &DIM &%1: * Wm0-0 0-0 010 0'0 0'0 0-0 0'0 Ole v'0 0'1 sm"nt*Is 61' $-W #3 0°'0 O- t-t 91- PIT 0-0 43je" T031 v4-9t t- ?,ttt t-st 1-s1 -lt 'Wtt *lot PItt -S9 goYUU151W 7FIM911 Ol 9t 6'2 Olt To$ 1-g t'g 0O' $It *2004SX 40Bt-t W-t b' *'t 1st SI III It lot 't0 't9 9T- 2892001%I t t V; t 1 t' ° g 1 tot I'd Cs .0 awas§J "4"ve-tr SIR 11st Olo St b'1 if 1-91 Sstt C0'Wt 061,4 W:0t-IZ *-tt 6#Z9 -tt9 V-6 4-" 4*-t 9,Ss slot -log awD_A"AI$

91o 9-0 t-O CIO t-0 CIO 910 t-O t-O t-O =60 nIMUV0-§ GIG CIO 0-0 GIG 0.0 oo00 0-0 1-0 GI to seuW4 vws6-C Olt t't 't0 t-t0 9.- %-1t -tl opg 9-t A t so on "Tweedb1.9 t19 91t C19 C99 1t kst fil Got I-t Tat ewo" xn9.9 10 %It 9s I,$ log I's *It $' CI SMOI,$ s 1 IPIS C's t's - .* 'C$, ef l* $IC g qv*m 0"" o *,m,0 Sl S. Ct SIg 911 PIl St I Ct fli ttli z t 9tt ttTA0 I spos "**"

6-L9 *let 0'et 6-tg 't Ole?fi flit T'99 S191 U" TOAD P "u"^#,EC t-gg **Wtt Olt$ S1p 61" PI"s slog $lo z2-OC C C t-ffs 10"I PIKC #,lt $ff 9`1c Vte I've -OC Cli aKn =

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00o1 $461 e*t MI fft noCt V"t Soot 96UI t041.. ______ ----- ----___ --___..._..---...--.. _.._. _ _ _ _ _ ._ ._ _ _ ,_ * _ ,_,_.,,.... _._ *.._... ..

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TAMLA P.4.1* IICAAU - SNMMY AxOlOUT W M 3M 3 SYS=

1991 1992 13 199 199 19'4 1297 m9s 1999 2000

(HiUieme of Cordoba*)

Mr al S *8B3?s (0,#$$ 4*19253) 01,954) (34.27) (48.377) (4661) (O 3.392) (14,531S) (53 027) (60.4311get lttmtoTAtie1 14e6Y 6 169 9219 979 a.0as 1132P 31,343 1,56 :2.019 21,641lIbd £ Loeg Ten, m oreign Limb. 309X,1 81,922 32n,0 37,706 43 405 47.90 31.735 36,10 60.006 $4,135on7 UEmtt o 48273 214 ZS%6j 34,409 39,73 4,68U 50,985 BA,913 59,773 63,480 66,739,vt Doaeotle C,ate .9$3 3.00 3.922 4,430 4,809 5.47 5,410 3.323 5.477 S.432Public sector *,'11 501 (31) (64s) (.5$34) (2.563) (,774) (4,9921) 1 (7,926)Prt~~~mt. S..to~~~~ 8,616 S 2,993 3,953 SO7 .4 301 914 1085 1.1 13.358Wot 0th.: &eomta 127.1 19.6S a 0,487 35,333 41,080 45;506 4U,503 53,950 56,003 61,307mQlST UL13U1TI1S 1,291 1613 3,454 3,036 351$t 4,S17 4,S21 5,238 5.f4S3 6.251

KMIae (WO "I s6 us 1.204 1i3s6 1. 77 1 ,02 2.176 2.229 2,608Suell-ft 3 570 976 149 1'532 2,144 2z349 2,7116 3.06 3.2124 %562Tise Depoette lta19 391 404 343 641 a71 991 1.06 1,114 .,364Lmlo. 1i loerais CurroWc 3t78 s83 1,06 1,290 1,505 1.679 1,617 1.611 2,110 2.218

(Vhiome. .f 196-0 Crdsb.e)

1!1113ASSes(171) (310 (56.635) (54 710) (34 .60) (13282) (56.931) (36,169) (56,839) (55,946)ret me I akioal lein2zve 143 1,4) 1,460 1,1*5 1,341 1 464 1,633 1.t96 2.4483*d 6, Lo Term orerign LImb*. 53.423 47.149 56:,231 56.230 53,955 56.622 56.393 57.622 56.613 56,396M27r DcE"fC *SS27 35.153 49.615 60,83 59,293 59.1537 66,0* 59,8s9 .1,SS6 62.159 1.1130not Pomestic Crodit 10,s1 7l58 6,951 60 6,491 .96 5.99 5,63 5.024Pnbj*a S*or 2.695 1.091 (33) (966 (01.978 (63.0640) (4.114m 314 (4.207 (7.551)"tOltt, Sect.: 1,2t 6,43? 7 ,006 ) 72 6,171 9,531 10.012 11L1i 3 11.571 12.355not otber ic.ounte 44,943 42,00? 34,03t5 2,91 52,938 53,916 S5.062 S5.3S6 36.79S 36,706ONKW=SD LtAatzgs S345 3.905 4,#50 4,52S 4.526 5.12t 4.*28 5,306 5,340 5,782

amml" (m) 1s4T7 1.603 1,706 2,79 6 1.79 2,304 3,9) 8.244 2,1U3 2,437QTelo 1tey 1.417 2,09 2,644 2,7312 2,767 3.021 2,963 3,1533 I .5 ,295Time Deposlts 491 641 717 60S 67 1,032 P1,4 1,122 I,09I 1.744tLjb. la Foreign crrec ntoo 1,23S 1,27 1,924 1.940 1,969 3.881 2.031 2,066 2.051_ ..... __b____w. ........................... _ ...___ __--__-__-__________ ..........................................................a. ..... ____

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