Establishing a Competitive Market Environment - All Documentsdocuments.worldbank.org/curated/en/414871468298149990/pdf/multi0... · Establishing a Competitive Market Environment July

Report No. 11446-PE

PeruEstablishing a Competitive Market EnvironmentJuly 22, 1993

Energy and Industry DivisionCountry Department ILatin America and the Caribbean Region

FOR OFFICIAL USE ONLY

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CURRENCY BOUIVALZNTS(As of June 30, 1993)

Currency Unit- Nuevo Sol (S/.)1

US$1.00 - S/2.03

S/.1.00 - US$0.4938

FISCAL

January 1 to December 31

ABBREVIATIONS AND ACRONYMS

Centromin Central Peru Mining Company (Empresa Minera del Centro del

Peru)Cerper Fisheries Certification Public Enterprise (Empresa Publica de

Certificacion Pesqueras)

COPRI Commission for Promotion of Private Investment (Comision dePromocion de la Inversion Privada)

CTS Compensation for Time of ServiceDGM General Directorate of Mines (Direccion General de Minas)

Epuep Peruvian Company of Fishery Services (Empresa Peruana deServicios Pesqueros)

Flopeuca Peruvian State Fishing Fleet Company (Empresa Estatal Flota

Pesquera Peruana)FMS Fisheries Management System

FONAVI National Housing Fund (Fondo Nacional de Vivienda)

FRMR Fisheries Resources Management RegimeHierro Peru Peru Iron Ore Mining Company (Empresa Minera de Hierro del

Peru)IMARPE Peruvian Sea institute (Instituto del Mar del Peru)INDECOPI National Institute for the Defense of Competition and

Protection of Intellectual Property

INGEMMET Geologic and Metalurgic Mining Institute (Instituto Minero

Geologico y Metalurgico)

IPSS Peruvian Institute of Social Security (Instituto Peruano de

Seguridad Social)

ITQ Individual Transferable Quota

Minero Peru Mining Company of Peru (Empresa Minera del Peru)

Pescaperu National Fishery Company (Empresa Nacional Pesquera)

Petroperu Peru National Petroleum CompanyRPM Mining Public Registry (Registro Publico de Minera)

SENATI National Training Service Program (Servicio Nacional de

Adiestramiento en Trabajo Industrial)

SOB State-owned Enterprise

Solgae Peru Gas Company (Compania Peruana de Gas)

TAC Total Allowable Catch

1 On July 1, 1991, a new monetary unit, the Nuevo Sot (S/.), was introduced at a conversion rate ofSI.1.00 * I/n.1.00. The so called Inti Milton (1/r.) --equivalent to one million [ntis(1/.1,000,000)-- was introduced on December 16, 1990 to simplify accounting and as a mans oftransition between the Inti and the Nuevo Sol. Exchange rates were unified in August 1990 and, sincethen, have been allowed to float.

FOR OFFICIAL USE ONLY

PERU

ESTABLISHING A COMPETITIVE MARKET ENVIRONMENT

TABLE OF CONTENTS

SUMMARY AND CONCLUSIONS. I

CHAPTER I INTRODUCTION .1

A. Objctive and Scope of the Study .1B. The Current Reform Program. 2C. Need for Additional Measures .4

CHAPTER 11 REMAINING ECONOMY-WIDE BARRIERS TO DOMESTIC COMPETITION. 7

A. Labor Market Constraints. 7

1. Legal Environment and Labor Stability. 72. Non-Wage Labor Costs .93. Impact of Rigid Labor Laws .104. Recent Reform Measures and Recommendations

for Further Reforms .12

a. Labor Stability .12b. Compensation for Time of Services (CTS .14c. Social Security and Other Contributfions .14d. Profit Sharing .16

B. Entry, Exit, Antitrust Policies, and Institutfonal Aspects .17

1. Entry ....... 172. Exit ....... 203. Antitrust ....... 224. Institutional Aspects .28

This report is based on the findings of a team that assessed economy-wide and sectoral competition andresource mobility issues in Peru, using the work done at Headquarters nd results of the field workcarried out during the May and June/July 1992 Privatizatfon Adjustment Loan and Privatizatlon TA Loanpreparation missions and of a June 1993 mission undertaken to discuss the findings/reconmnndatlons ofthe Green Cover Report nd to update the Infornution on new policy changes. For the *sction on NL borMarket Constraints", the report also utilized the White Cover report entitled: The Decline of the Valueof Labor in Peru: Causes and Remedles, the World Bank (June 1992). The team consisted of Tercan Baysan,task manager, and Luis Guasch (LATTP).

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 World Bank authorization.

CHAPTER IA ISSUES IN THE MINING, FISHERY AND HYDROCARBON SECTORS ........ 31

A. The Miing Sector ....................................... 31

1. Background ........................................ 312. Rocent Reo t .......f............................... 323. Recommn dat/ons .................................... 36

BA The fishries Swtor ...................................... 39

1. Background ........................................ 392. Recent Reforms ..................................... 403. Recommendations .................................... 42

C. The Hydrocabons Sector .................................. 44

1. Background ........................................ 442. Recent Reforms ..................................... 463. Recommendations .................................... 46

ANNEX TO CHAPTER III EVOLUTION OF FISHERY RESOURCES MANA GEMENT REGMES.. 60

SURIARY AND CONCLUSIONS

A. OVERVIEW

i. There is ample evidence that competition is crucial in inducing/foutering sustained improvements in productivity, quality, cost reduction, andresource allocation efficiency. It stimulates firms to modernizetechnologies, improve competitiveness, introduce new production lines, andsearch for new markets. In this respect, Peru's comprehensive economic reformprogram has taken major steps through its emphasis on markets, market-basedpolices and regulations, trade liberalization, and private sector initiativeand development. As a major component of its structural reform effort, Peruis currently implementing a comprehensive privatization program, which shouldenhance the extent of competition and production efficiency gains.

ii. However, to respond to and realize the efficiency gains expectedfrom these reforms, firms must be able to adjust their labor force, move theirresources into relatively more profitable areas, and exit activities thatappear no longer profitable. To facilitate such adjustments, the Governmentneeds to eliminate the existing policy-generated barriers to domesticcompetition and factor mobility.

iii. This report examines the existing generic barriers to labormobility, business entry, exit, and then discusses the key sectoral policyissues related to competition in mining, fisheries, and hydrocarbons sectors--the key sectors for production of tradables in Peru.

B. GOP'S CURRRNT REFORM PROGRAM

iv. The Government, after taking office at end-June 1990, initiated acomprehensive stabilization and structural adjustment program. While theshort-term objective of the program was to halt hyperinflation and lower therate of inflation to acceptable levels, its longer term objectives are torestore macroeconomic balances and increase efficiency in resource allocationand use.

v. Major structural reforms have been introduced in the key policyareas, with a view to removing market distortions and establishing acompetitive environment. Trade policy reforms included the elimination ofnon-tariff barriers and tariff exemptions, and Peru's tariff rate structurewas simplified to a two-rate system of 15% and 25%. Other important reformmeasures included the elimination of monopoly rights of state-ownedenterprises (SOEs), of most price controls, and of restrictions on foreigninvestment. Also, land property rights were strengthened, while, in labormarkets, provisions for layoffs and temporary employment have been broadened,and positive changes have been introduced in labor legislation. Given itsscope and speed, Peru's privatization effort is also a significantundertaking.

vi. In mid-1991, the Government expanded its structural reform programin a major way, by starting a comprehensive privatization oroaram. Since May1992, thirteen privatizations have been completed, yielding about US$235

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million in cash proceeds. The Government's objective is to privatize all SONsby mid-1995 when its term expires.

vii. The Government is also showing a serious effort in reforming thepolicy/legal and regulatory environment in all the key sectors before (or inparallel with) privatizations, to ensure that a pro-competitive environment iscreated and that inefficient state monopolies are not replaced by inefficientprivate monopolies.

viii. Peru's reform program is being supported by the InternationalMonetary Fund (IMF), the Inter-America Development Bank (IDB), and the WorldBank. In the area of privatization, Bank support is being provided throughtechnical assistance, financed by a Japanese privatization grant, the recentlyapproved Privatization Technical Assistance Loan (PTAL) and the Energy andMining Technical Assistance Loan (EMTAL). And, the implementation of s*ctoralprivatization programs will continue to be supported by the already approvedPrivatization Adjustment Loan (PAL), the Financial Sector Adjustment Loan(FSAL), and the proposed Electricity Privatization Adjustment Loan (EPAL).

C. NEED FOR ADDITIONAL MEASURES

ix. The economy's capacity to respond to these reforms rapidly willdepend on how quickly firms in Peru adjust and show supply response tochanging market conditions, increased import competition and exportopportunities. A strong response would, of course, help contain the short-term adjustment costs and ensure the sustainability of the structural reforms.While factors such as domestic and foreign firms' perceptions about politicaland economic stability and their ability to finance desired adjustments willbe important determinants of the economy's adjustment to the liberalizedpolicy environment, absence of any policy-generated barriers to competitionand factor mobility will also contribute strongly. In this respect, there areseveral areas at the economy and sectoral levels, where further reforms areneeded to facilitate firms' adjustments to Peru's structural reforms,strengthen the conditions for domestic competition and factor mobility,prevent monopolistic tendencies, and ensure efficient exploitation of naturalresources.

D. REKAINING ECONOMY-WIDE BARRIERS TO COMPETITION

1. Labor Market Constraints

x. Leaal environment and labor stability. A key feature of Peru'slabor legislation is the protection of workers' "labor stability". Thisprinciple was first introduced in 1970 in the Labor Stability Law, as part ofthe nationalist and populist policies of the military government. The lawestablished that after a trial period of three months, a worker would obtainjob "stability" and that dismissals would take place only when "grave faults"were committed. A dismissed worker, following a favorable decision on a legalaction taken against the dismissal, could ask for reinstatement orcompensation amounting to three months' salary in addition to accrued salariessince the dismissal. The Stability Law also established administrativeprocedures for closing of plants, reduction of shifts and days and hours ofwork, and for "massive" personnel reductions. In addition, the General Law ofIndustries, also issued in 1970, entitled workers, through the newlyinstituted "industrial communities", to a portion of the firm's profits in the

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form of shares, thereby giving workers participation rights in the ownership(up to 50%) and management of the firm.

xi. The Stability Law was modified several times during the last twodecades in order to introduce some flexibility in dismissals, hiring, andtemporary employment conditions. In each case, to afford one positive action,another aspect of the law was made more stringent, as in the case ofcompensation for unjustified dismissals, which was increased to 12 monthlysalaries. Notwithstanding these modifications, however, the principle ofprotecting employment stability has remained intact, and is also guaranteed byArticle 48 of the (1979) Constitution. Also, in practice, it has been verydifficult to prove "fair causes" for dismissals in the labor courts, becauseof the law's very narrow definition of fair causes. As a consequence, firms'ability to dismiss workers has remained severely limited, thus making laborcosts a part of fixed costs. Firms have also chosen not to use the provisionsof the law for massive dismissals under exceptional economic situations,because of the very lengthy and elaborate procedures. Indeed, paying workersfor their voluntary retirement has remained the preferred alternative forfirms in Peru, with the severance packages averaging US$6,500 per worker in1991-92 for SOEs and higher for private sector firms.

xii. Non-waae labor costs. A large number of forced savings schemesfinanced through high statutory payroll taxes have also significantlyincreased labor costs for employers. Under the so called "Compensation forTime of Service" (CTS), employers are required to contribute one monthlysalary for each year of service to a savings scheme, whereby accumulatedsavings are paid to employers as a lump-sum "severance payment" at the time oflayoffs, resignation or retirement. The scheme is costly and has majorweaknesses as a substitute for unemployment insurance, as a forced savingsprogram, and as a way of mobilizing financial savings.

xiii. Regarding social security (SS) programs financed by payroll taxes,employers' contributions to pension/health plans and the accident insurancesystem managed by IPSS (Instituto Peruano de Seguridad) had exceeded 16% ofwages until the reform measures of November 1991 (see below). In addition,employers had been required to contribute to the National Housing Fund(FONAVI) and the National Training Service (SENATI), at rates of 5% and 1.5%of wages, respectively. Also, in mining, labor costs are increased furthersince firms are required to provide housing, hospital and school services ifmines are located more than one hour from urban centers.

xiv. Impact of rigid labor laws. Since the early 1970s, jobopportunities and real wages in the formal sector have shown falling trends --average real wages have fallen by almost 60%. The high total cost of laborhas constrained employment generation in the formal sector and led to shiftsinto the informal sector. Moreover, efforts of firms to contain the growth oftotal labor costs, when downward adjustments in the level of employment couldnot be made, appear to have led to wage compression and declines in the ratioof skilled workers/total employment. The resulting compromise from thedesirable skill-mix must have had adverse effects on productivity of firms inPeru, as reflected in rising labor/output ratios. It seems that firms haveended up substituting capital for skilled labor, despite the high degree ofcomplementarity between the two.

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xv. These trends are harmful for labor, employers, and for theeconomy. Benefits of Peru's structural reforms will depend on firms' abilityto vary employment levels, skill-mix and, if necessary, exit certainactivities without incurring significant costs.

xvi. Recent corrective measures and recommendations for furtherreforms The new Government has attempted to address some of the labor market,issues, first through changes introduced in a new labor stability law enactedin November 1991. The most important change is that economic, technical, andrestructuring reasons can now be considered valid causes to initiatecollective dismissals. Also, the provisions of "fair cause" for individualdismissals was expanded to include, for example, low productivity. Morerecently, the Arbitration Law and the Law of Collective Agreements, Strikesand Unions were promulgated, providing a framework to resolve disputes betweenmanagement and labor.

xvii. Perhaps the most important recent positive development regardingthe Peruvian labor stability law, however, is the elimination of the stabilityclause in the draft new Constitution, abolishing the guarantee of the worker'sright to employment stability. The current draft of the new Constitutionsimply states that the law should provide "adequate protection" to the worker.It also eliminates the right of workers' participation in ownership andmanagement, while retaining mandatory profit sharing (the former change hadalready been made effective in late 1991 through a legislative decree).

xviii. Notwithstanding the recent changes in labor legislation, however,until the draft new Constitution is approved, the main issue of laborstability and the key restrictive stability conditions will remain, hinderinglabor mobility.

xix. With respect to payroll taxes/deductions, the Government alsointroduced changes in the CTS system in July 1991, requiring the employer todeposit every six months the CTS payments into a bank account owned by theemployee. This change has removed one major problem facing the employer inmanaging CTS payments, the uncertainty of the real value of CTS liabilitiesduring high inflationary periods. This was because the base for calculatingCTS was the last monthly earnings. However, despite the improvements effectedin its implementation --such as the removal of uncertainty regarding the realvalue of CTS balances, and the creation of a new source of long-term savingsfor the financial sector-- the CTS scheme still remains an economically costlyway of achieving the intended objectives.

xx. Other important reform measures include the changes in Peru's SSsystem, introduced in November 1991. First, the incidence of SS taxes hasbeen altered, with the employer's share falling from 12% to 2% and that ofworkers increasing from 6% to 16%. Second, workers can now choose someprivate pension and health service coverage beyond a basic coverage that is tobe provided by IPSS. Thus, the new law opens the way for competitiveprovision of SS services, providing more options for workers and competitivepressure on IPSS to be more efficient. Also, the employer's contribution tothe housing fund, FONAVI, has been reduced, while the employer's contributionto the industrial training fund, SENATI, has been eliminated, effective fromJanuary 1994.

xxi. RBclM At±nt

o Labor stability laws/regulations should be abolished, giventhat the stability clauses are the main stumbling block toany lasting improvement in labor market flexibility. A lesspreforable solution, but one that needs to be taken in anycase while the labor stability guarantee continues, would beto extend the probationary period from three months to, say,three years (as was the case in 1978-85); (the draft newconstitution, when adopted, will pave the way for theabolishment of existing labor stability legislation, therebyeliminating the need for less preferable solutions);

o the scope and use of temporary contracts and ofsubcontracting should be simplified and clarified in law andpractice, with a view to giving permanency and certainty tothese contractual forms of employment;

o the CTS should be replaced by a system of requiringemployers to give advance notice (e.g., three months) forplanned dismissals, or corresponding compensation. Ifpolitical considerations make this option difficult,reducing the CTS would be a second best solution;

- as an alternative to the CTS system, introduction of anunemployment insurance scheme could be considered when Peruestablishes strong and efficient tax and social securityadministrations, and when it achieves a satisfactory degreeof stability and maturity in its fiscal and social securitysystems;

3 among the payroll taxes, the earmarked contributions forhousing (FONAVI) are clearly distortionary levies, and theseshould be eliminated;

o it would be beneficial for the economy to continueindustrial training programs (with improvements towardssuccessful model programs) and their financing by thebeneficiaries; and

o mandatory profit sharing should also be eliminated. Ifemployers want to share their profits with workers becausethey expect a positive impact on productivity, then let themmake that decision without legally imposing it. on theother hand, given that the draft new Constitution guaranteesthe worker's right to profit sharing, a practical solution --when the new Constitution is approved-- would be to reducethe rates determining worker's share through amendments inthe relevant legislation.

2. Entry, Exit and Antitrust Policies

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xxii. Barriers to entry. In recent years, significant improvements havebeen made in Peru in the procedures and costs of registering and engaging ineconomic activities for small enterprises. Currently, there in a unifiedregistry procedure for small enterprises, whereby the whole process taken lusethan a month, and financial costs of foes and licenses is around US$200-300,which should not constitute a significant barrier to entry.

xxiii. However, the procedures and costs of entry by medium and largeincorporated firms still remain cumbersome. There are four steps required toform an incorporated firm (Sociedad Anonima) and enter into productiveactivities, each being regulated by a different article of the CommercialCode. Also, the structural plan of the potential entrant needs to be approvedby a commission in accordance with a separate decreel this is not a simpleprocedure. Also, because the Commercial Code was designed with thetraditional family or small enterprise in mind and has not evolved withrespect to incorporated enterprises, the formation of "open" companies (i.e.,Sociedad Anonima Abierta --SAA), whose shares are traded at the stockexchange, is regulated by a different decree. The exclusion of the SAA fromthe Commercial Code is unwarranted.

xxiv. It is recommended, therefore, that the Commercial Code should beamended to delete obsolete and inappropriate clauses, streamline proceduresfor timely processing of entry applications, and address contemporary issues,including the formation of SAAs.

xxv. Regarding financial access barriers to entry in the case of smallfirms and new entrants, the Government should also take steps to strengthenthe system of recording properties and the institution of property rights. Byproviding accessible information on property ownership, such measures couldfacilitate checks on "creditworthiness" and, thus, help reduce financialaccess barriers.

xxvi. Peru's new foreign investment law, enacted in August 1991,provides for a non-discriminatory environment for most forms of foreigninvestment, removing most barriers to entry that had existed for foreignfirms. In an effort to address legitimate concerns about the stability ofpolicies, specifically that of the tax regime, the law also guarantees foreigninvestors tax/policy stability for ten yearg, in exchange for a minimum amountof investment, if foreign firms choose such an option.

xxvii. While the option of tax/policy stability under investmentagreements is also extended to domestic firms in the new mining law, itappears that this may not be the case in other sectors. To the extent thatdomestic firms in some sectors are not granted the option of tax/policystability in exchange for a minimum investment program, then the resultingdiscriminatory implementation of this contractual policy stability guaranteecould create competitive disadvantages for affected domestic firms, when theGovernment introduces changes in the tax structure. This is a distortion thatshould be corrected while such a regime is maintained. Also, the Governmentshould consider removing the investment requirement as a quid pro quo, giventhat costs of monitoring agreed investments could become considerable. And,once Peru achieves macroeconomic stability and sustainability in thetax/policy environment, foreign firms may not need guarantees for thestability of taxation and other policies. At that stage, the option oftax/policy stability should be eliminated altogether.

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xxviii. Exit A significant positive step in the area of B&t has beenthe enactment of a new Enterprise Restructuring Law, which provides for aneffective framework to address the isuue of exit and bankruptcy forfinancially distressed enterprises.

xxix. Antitrust Rglicies. The enactment of an Antitrust Law and aConsumer Protection Law in November 1991, and an Unfair Competition Law inDecember 1992, as well as the creation of the National Institute for theDefence of Competition and Protection of Intellectual Property (INDECOPI) asthe institution in charge of implementing the legislation, have been importantsteps toward establishing an effective competitive environment in Peru.However, these new laws do have some important deficiencies. Also, thecurrent structure and mandate of INDECOPI raises a number of concerns. Theweaknesses, concerns and specific recommendations pertaining to them are asfollows:

o As of now, all price and quota agreements, and conspiracies, aretreated under the "rule of reason" criterion, whereby an action initself is not disallowed, but punished only if the intent orconsequences are found to be damaging or anti-competitive. Thisis unwarranted. Price/quota agreements, and conspiracies shouldbe judged "per se" illegal. Under "per so" treatment, an actionis disallowed and punished independent of intent and ofconsequences. Given that most agreements could have severeconsequences, the deterrent effect of "per so" treatment ofagreements is preferable. "Per se" cases ar- also easier and lescostly to litigate;

o in view of Peru's severe public resource constraints, it isimportant for the antitrust law to focus, at least initially, onmarket conduct/actions with significant and clearest harm tocompetition and consumers. In this respect, redefining the scopeof the law, with a view to giving more emphasis to cases that canbe treated under the "per se" rule and limiting the coverage ofdifficult and costly conducts that need to be treated under the"rule of reason" criterion is desirable. Once the enforcementauthorities gain experience and public resource constraints ease,then the antitrust law could be amended to cover more complexcases of anti-competitive conduct;

o also, given that Peru's recent comprehensive trade liberalizationmeasures will expose domestic producers of traded goods toeffective import competition, the antitrust legislation couldserve its purpose better if it were to focus mainly on conductrelated to non-traded goods/services markets;

o the law should provide guidelines for defining "relevant markets"in order to facilitate assessment of dominant firm and mergerissues and of market shares;

o among restrictive practices, those vertical restraints withclearly anti-competitive impact --certain types of franchisearrangements, market closures, and resale price maintenanceagreements-- that are not likely to have sufficient compensating

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effects in the form of efficiency gains should also be covered inthe Antitrust Law;

o agreements and practices in professional activities that have theeffect of restricting entry should be disallowed, and this shouldbe covered by the Antitrust Law, which is mute on the subject;

o the antitrust legislation should also provide for civil remediesand class action suits. The threat of class action suits byprivate parties, usually rewarding five times damages, increasesthe deterrence effect of the legislation;

o the Unfair Competition Law appears to be redundant, irrelevant andpotentially dangerous. It should be repealed;

o the current structure of INDECOPI is not suitable for itsefficient functioning, and it should be restructured in line withthe recommended changes in the above listed laws. ItsSecr-tariats should be integrated and certain Commissionscollapsed. It should operate with more flexibility in theallocation of its resources, channelling them to cases where theimpact on welfare is the largest. Its autonomy and resourcesshould be strengthened. Capacity of it. staff in handlingcompetition policy issues and carrying out market investigationsshould be strengthened. Attention should be paid to potentialconflict of interest among its members;

o the Consumer Protection Law, also enacted in November 1991, hasclauses that are vague. This deficiency should be corrected toensure its easy enforcement and deterrence effect, and to avoidthe risk of inhibiting competition and efficiency enhancinginitiatives;

o the current level of sanctions is inadequate to elicit the desireddeterrence effect of any competition legislation.

R. ISSUES IN THE MINING, FISHERY, AND HYDROCARBONS SXCTORS

1. The Minina Sector

xxx. Mining is one of the key sectors of the Peruvian economy,contributing about 5S of GDP and 45% of merchandise exports. Copper, zinc,lead, and silver are the most important mineral exports, with copper aloneaccounting for about 22% of merchandise exports in recent years. This alsoexplains why the sector's poor investment and output performance in recentyears affected the economy adversely. Severe macroeconomic instability, laborunrest, power shortages, and currency appreciation were among the factorsleading to the sector's poor performance. A serious deterioration in theperformance of SO3, which account for 40% of total sector output, was also amajor factor.

xxxi. Recent reforms. To vitalize the sector, the new Governmentinitiated a privatization program for the sale of mining SONs, and enacted anew mining law in November 1991 to deregulate mining and foster private

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investment and also an umbrella mining law --incorporating all mining relatedlegislation-- in June 1992. In addition, a part of mining areas reserved forSOBs was released for private sector exploration, a 10% export tax waseliminated, and a process of reorganizing and streamlining the sector agencie-in line with policy reforms has already started.

xxxii. Privatization of mining SOEs is underway. After the sale of twosmall SOEs, Hierro Peru was sold in November 1992 for US$120 million in cashand, more recently, Quellaveco, an underdeveloped mining property, was soldfor US$12 million. The latter two sales also included US$700 in investmentcommitments for future development and expansion. In 1993-94, larger miningSOEs Centromin and Minero Peru will be sold either in several units or intheir entirety.

xxxiii. The now Xining Law establishes an improved policy/regulatoryenvironment for private investment and sector development, with its strongemphasis on policy stability, reduced bureaucracy, transparency, exportcompetitiveness, discouragement of speculative holdings of exploration land,and the establishment of efficient sector institutions.

xxxiv. Under the new law, a single concession is granted on a "first-come-first-served" basis for both exploration and exploitation. It alsointroduced a "land-use fee" of US$2 per hectare/per year, with a penaltycomponent for delayed start of production. As such, the fee should not onlygenerate a continuous stream of revenues, but curtail speculative holdings ofmining land. Concessionaires can also choose to enter a contract with theState for a tax/policy stability guarantee, by agreeing on a minimuminvestment program.

xxxv. The law also allows (though not effective yet) the rebate ofdomestic indirect taxes for exports and domestic sales made at comparableinternational prices. When it becomes effective, this measure will put miningcompanies on a duty-free basis, thus removing an existing disadvantage vis-a-vie non-traditional exports. Mining companies are also allowed now: to deductinvestment costs of infrastructure that provide social services and excludesuch assets from the base of the 2% gross asset tax; and, deduct 30% to 80% oftotal contributions to health plans to offset the expenditures incurred in theprovision of mandatory health care services. Obviously, many of thesemeasures will improve Peru's export competitiveness in minerals. Indeed, inmany respectsr Peru's new mining law establishes entry rules and a policyenvironment that are comparable with the regime. of other mining nations.

xxxvi. Recommendations. Undoubtedly, these reforms constitute majorsteps toward establishing an open and competitive mining sector. Thefollowing recommended steps would strengthen this drive:

o To prevent the erosion of real value of land-use fees, they shouldbe linked to an appropriate US dollar-denominated index;

o regarding the implementation of a "minimum investment program" inmining in exchange for a tax/policy stability guarantee, as statedearlier, the Government should consider the elimination of theinvestment requirement and, when the conditions are right, thewhole system of policy stability guarantee could be abolished;

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o mining companies zhould be treated as "private providers" ofhealth services, and those providing full health care servicesshould be allowed to retain the total amount of health carecontributions, instead of the maximum 80%. Similarly, they shouldbe entitled to deduct from their income tax liabilities, in lieuof the cost of education services they are required to provide forworkers' children, an amount based on the cost of compulsoryeducation per student in the country. Consideration should alsobe given to shifting to workers at least part of the cost ofhousing services provided by the mining companies; and

o in privatizations, "minimum investment requirement" should not beincluded as a condition of sale, or as a factor in selecting thewinning bidder. Potential buyers of SOEs make their bids takingall the relevant economic factors into account, includinginvestment deemed appropriate. Investment requirements viewed assub-optimal will affect bidding prices accordingly. If theGovernment considers these requirements as "essential" for thepublic's support of sales, then such investment requirementsshould be kept at very low levels, so that they do not become adistorting factor.

2. The Fisherias Sector

xxxvii. The fisheries sector's share in total merchandise exports hasaveraged 15% in recent years. With about US$0.5 billion in export earnings,fishery exports rank second after mineral exports. Peru has 17% of the worldmarket for fish products.

xxxviii. The main speciae have been anchovy and sardines, which are usedpredominantly (over 90% of all catches) for fishmeal and fish-oil. The SOBsector is responsible for 37% of the total fishmeal production. The sectorhas declined significantly over the last 20 years as a result of stateintervention (e.g., large scale nationalizations), inefficiency of SOEs,limitations imposed on the private sector's participation in fishmealproduction and losses caused by the El Nino warm water current of the early1970z and the early 1980s. Among the six SOEc, the principal one isPescaperu, with 20 operational fishmeal plants.

xxxix. Apart from the inefficiency of the sector, there is a seriousproblem of overfishing of Peru's two key pelagic species --anchovy andsardines-- due to the absence of an effective Fisheries Resources KanagementRegime (FRMR) that would ensure biological mustainability as well as helpoptimize economic benefits for the country. The existing "open access" with"Total Allowable Catch" (TAC) system, while allowing competition in fishing,has encouraged an over-expansion of fishing and processing capacity, leadingto inefficiency and declining export competitiveness.

xl. Recent reforms. The Government has recently acceleratedstructural reforms in the sector. A new Fisheries Law was issued in December1992, providing a modern legal framework for the fishery sector and alsopaving the way for the introduction of a workable FRMR. In the policy area,important reforms include the elimination of the privileged position of SOEsin fishmeal production, wholesale distribution of fish, and quality control.

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The sector war also opened to foreign investment. And, preparations arecurrently underway for the privatization of Pescaperu.

xli. These reforms establish a freer and non-discriminatory environmentfor domestic competition, and they should also help strengthen Peru's exportcompetitiveness. The critical task that remains for the Government is tointroduce an appropriately designed FRMR and the needed regulatory framework.In 1983, New Zealand and Iceland introduced the so called wlndividualTransferable Quota" (ITQ) system, encouraging also the adaption of other"rights-based" fishery management regimes. The ITQ system has produced goodresults in terms of reduced fishing effort, extended fishing period, increasedquality, and substantial increases in revenues.

xlii. An ITQ, defined as a share of TAC, represents a right to catchthat proportion of TAC announced for a certain fish specie. When they areissued as permanent entitlements, ITQa constitute full-fledged propertyrights, and this is what constitutes a proper incentive for fishermen to beefficient. They have shown good results, because: TAC quotas safeguard fishstocks and ITQs eliminate the common property nature of fish stocks; and, thetranaferability of ITQs allows efficient fishermen to take over the fishingactivity. Key drawbacks of an ITQ system include concentration of ownershipof ITQs, fishing over quota and illegal fishing, discarding lower qualitycatch before landings, and catching of other fish species. The concentrationissue can be addressed through limits on ownership. Containing the extent ofother problems would require effective enforcement and judicial systems. Inthe Peruvian context, these problems will not be serious and it will bepossible to contain them through a relatively simple and cheap enforcementsystem. This is because only a few number of species need to be covered by anITQ system initially, and there are only a small number of landing spots.

xliii. Recommendations:

3 An ITQ system is recommended as an appropriate fisheriesmanagement system for Peru. ITQs should be specie-specific anddefined as shares in TACs;

o consistent with the new law, regulations and guidelines should beissued on the ITQ system; and

o the other two essential components of FRMR should also be put inplace: an enforcement system (i.e., a monitoring, control, andsurveillance mechanism) and a fisheries judicial systm.

o since, under an effective system, controlling the size andcapacity of the fishing fleet would be unnecessary, evencounterproductive, Article 24 of the Fisheries Law should also beamended;

xliv. Regarding the initial distribution of ITQs, the Government maychoose to sell ITQs to boat owners and processors through auctioning undercompetitive conditions; and, auctioning could also be restricted to only theexisting boat owners and processors, in recognition of "historical rights".Or the Government could distribute ITQs free to existing boat owners/fishermenon the basis of catch records of, say, last three years, as in New Zealand andNorway. This would again mean recognizing "historical rights" of the existing

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fishermen, by transferring to them all potential rents through ITQs. Thisapproach, as opposed to auctioning ITQs, would obviously mobilize more supportfor the adoption of an ITQ system. However, the Government could considercollecting a one-time fee from receivers of ITQs, and the proceeds could beused to meet the initial cost of modernizing the existing marine researchinstitute. The final decision will be a political economy decision,determining how the rent will be distributed. The option that in likely tofind the needed support would be desirable, since the early establishment of asound FRMR is important. In any case, a small annual fee should be seriouslyconsidered for ensuring a continuous flow of revenue for the sectorinstitutions.

xlv. Finally, it should be emphasized that, once an effective ITQsystem is put in place, the problem of excess fish processing capacity willalso disappear, as competitive pressures eliminate uneconomic excess capacity.Therefore, attempts to control entry/capacity expansion in the fish processingactivity should be avoided, since this would encourage monopolistic practicesand protect inefficient producers. Accordingly, amendment of Article 28 ofthe Fisheries Law would also be desirable.

3. The Hydrocarbons Sector

xlvi. Peru's oil and gas sector, which accounts for 5% of GDP,contracted sharply during the 1980g. Domestic production declined from195,000 barrels per day (bpd) in 1982 to 135,000 bpd in 1989, and the countryshifted from being a net exporter to a net importer (US$150 million in 1991).Known reserves also dropped by 50% due to sharp fall in exploration anddevelopment investments. Inappropriate pricing and legal/regulatoryframework, and a lack of competition were factors causing the sector'sdeteriorating performance.

xlvii. The sector has been heavily state-controlled. The major SOE,Petroperu, is directly responsible for 36% of domestic oil production and forthe supervision of the remainder, which is produced by foreign companies underservice contracts with Petroperu. Until recently, Petroperu had a monopoly onall trade (export and import), transport, storage, refining and retaildistribution of petroleum products. Many of these activities are carried outby wholly-owned subsidiaries. Petroperu also carries out many policy,regulatory, contractual, and tax collection functions normally handled bygovernment ministries/agencies in other countries.

xlviii. Recent reforms. The Government has implemented many reforms toderegulate the sector and encourage private investment, including theelimination of Petroperu'z monopoly over downstream activities and formalderegulation of domestic petroleum prices. In December 1992, the Governmentalso enacted a decree introducing some important, positive changes in theexisting system of taxation of petroleum products. Accordingly, the rate ofthe existing selective consumption tax (ISC) on petroleum products waslowered, while these products were made subject to the economy-wide 18% value-added tax, and the 10% tax on gross sales revenues of P-troperu was abolished.However, in order to avoid a fall in tax revenues and stabilize retail price.,the Government has maintained de facto control of ex-refinery prices, pendingthe implementation of the new legal framework for the sector which will

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redefine Petroperu's relationship with the Government, including the taxationof rents on Petroperu's domestic crude production.

xlix. A new draft hydrocarbons law has also been prepared and approvedby the Energy Commission of the Congress in June 1993. It in expected to bediscussed on the floor of the Congress soon. The new law would fullyliberalize the sector, transfer the policy/regulatory functions of Petroperuto the Government, and establish new contractual arrangements between theGovernment and petroleum companies. Further changes in the petroleum taxationregime are also being considered. The Government has also begun privatizingPetroperu's holdings. To date, 78 of Petroperu's 82 gas station have beensold for US$38.5 million, Solgas (the gas distribution company) was sold forabout US$7.5 million, and Petromar for US$200 in lease payments over 20 yearsplus a share in oil and gas extracted. Other holdings are expected to be soldin 1993-95. However, to proceed with remaining privatizations with a minimumamount of disruption and adjustment problem, certain actions need to be takenin a timely and appropriate sequence.

1. Recommendations:

o An early enactment of the new hydrocarbons law and its regulationsis important for establishing unrestricted competition in allpetroleum activities, defining the Government's policy making andregulatory role, liberalizing petroleum prices fully, andaccelerating the privatization process;

3 Petroperu's depots and marine terminals should be privatized asearly as possible to make liberalization of prices and foreigntrade effective; and

o the December 1992 petroleum taxation measures should becomplemented further by converting ISC into a special excise taxlevied on both domestically produced and imported gasoline anddiesel, with rates set such that existing distortions in domesticrelative prices of petroleum products are removed and thatsufficient revenues are collected. While Petroperu's existencecontinues, extraction of rents on its domestic crude productioncould be achieved through a surtax on Petroperu.

CHAPTER I

INTRODUCTION

A. OBJECTIVE AND SCOPE OF THE STUDY

1. Peru's comprehensive economic policy reform program, which theGovernment initiated in mid-1990, constitutes a major step toward economicliberalization. Through stronger reliance on markets, market-based policies andregulations, and on private sector initiative and development, it will helpstrengthen the economy's basis for sustained growth and employment creation. Itsemphasis on the establishment of a competitive environment is well-placed. Thereis growing evidence that competition is crucial in inducing/fostering sustainedimprovements in productivity, quality, cost reduction, and resource allocationefficiency.1 / It works as an effective force in stimulating firms to modernizeproduction technologies, introduce new production lines, and search for newmarkets.

2. The Government has been taking steps to promote competition. Withthe liberalization of foreign trade policy and adoption of a managed floatingexchange rate system, Peru has effectively opened up the economy to importcompetition. These measures also reduced substantially the policy-imposed biasesagainst exports.2/ Together with the deregulation and removal of price controls,they will promote export rivalry by stimulating competitive behavior among Peru'sexporters. Similarly, the Government's extensive deregulation and liberalizationmeasures in domestic markets improved conditions significantly for effectivedomestic competition.

3. Currently, Peru is also implementing a comprehensive oprivatizationprogram. Aside from eliminating the financial burden of state-owned enterprises(SOEs) on the budget, privatization should enhance the extent of competition.This will come about through increases in the number of producers in relevantmarkets and/or elimination of discriminatory implicit/explicit government supportto these enterprises. Privatization should also have a positive impact on theefficiency of the affected companies; the evidence indicates that ownershipmatters, particularly in competitive markets./

The World Bank, World Develoanent Report 1987; The World Bank, LiberaLizing Foreign Trade, (sevenvolumes) edited by Papageorgiou, D., Michasly, M., and Choksi, A. (Basil Blackwell, 1991); The WorldBank, "Competition Policies for Industrializing Countries", Industry and Energy Department (March 20,1989).

Exchange rates in Peru, which are determined largely by market forces, are currentLy depressed due toinflows of flight capital encouraged by high domestic reaL interest rates and drug money on the onehand and low import demand resulting from continued slow down in economic activity on the other.However, as economic growth recovers toward sustainable levels with the attairnment of mcroeconomicstability and business confidence, exchange rates should move towards their longer term ewulLibriumlevels. In the meantime, export industries will continue to be adversely affected.

See: Vickers, J. and Yarrow, G. "Economic Perspectives on Privatizatfon", Journal Of EconomicPerspectives, Vol. 5, No.2, Spring 1991; Vickers, J. and Yarrow, G. Privatization: An EconomicAnalysis, (Cambridge: MIT Press, 1988). Also, one of the key messages of a Bank conference held inJune 1992 on the welfare effects of seLLing public enterprises in Chile, Malaysia, Mexico and theUnited Kingdom was that "ownership matters".

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4. To realize the efficiency gains expected from the liberalization ofprices, foreign trade, financial and foreign exchange markets, as well as fromprivatization, firms must be able to adjust their output and employment levels,be able to move their resources into relatively more profitable areas or exitactivities that appear no longer profitable. To facilitate such adjustments tochanging market conditions induced by the structural reform program, Peru alsoneeds to eliminate the existing policy-generated barriers to market competitionand factor mobility.

5. The principal objective of this paper is to identify and examine someof the key economy-wide and sectoral barriers to competition and to factormobility in Peru, and make specific recommendations for their removal orneutralization.

6. In the discussion of sectoral policy barriers to competition, thepaper focusses on the mining, fisheries, and hydrocarbons sectors and,indirectly, on other manufacturing industries. The largest SOEs, except forelectricity, have been operating in these activities, and now are beingprivatized. Of these, the mining and fisheries are the major export sectors.Mining and hydrocarbons are also the activities where foreign investment hasconcentrated.

B. THE CURRENT REFORM PROGRAM

7. Immediately after taking office at the end of July 1990, the currentGovernment of Peru initiated a comprehensive macroeconomic stabilization andstructural reform program. The principal short-term objective of the program wasto halt hyperinflation and lower the rate of inflation to acceptable levels. Thelonger term objectives are directed at restoring resource balances to sustainablelevels and increasing efficiency in resource allocation and use. The reformprogram reflects a radical departure from the ad hoc and temporary nature of pastpolicy responses to macroeconomic imbalances and structural weaknesses of theeconomy.l/ Its stabilization component includes not only stringent short-termfiscal and monetary measures, but also reforms in the areas of taxation, publicexpenditures, interest rates, and the exchange rate policy. Its structuralreform package, which is still being broadened and deepened by a series ofactions since mid-1990, reflects a major shift in the Government'sindustrialization and growth strategy. Adopting an outward-oriented developmentstrategy based on comparative advantage, Peru's ongoing structural reform programaims at: (i) establishing a liberalized economic policy and regulatoryenvironment with a view to giving a dominant role to markets and competitiveforces in the allocation and use of resources, (ii) opening up the economy tointernational competition, and (iii) radically reducing the role of the publicsector in production activities in favor of a much greater role for the privatesector.

For a detaiLed review of the Government's poicy performance in the past, see: Larrin, F. and SeloWsky,M. The Public Sector and the Latin American Crisis, International Center for Economic Growth, (ICPPress; 1991), Chapter 6; and, Peru: PoLicies to Stop Hyperinflation and Initiate Economic Recoverv, TheWorld Bank (Washington, D.C., 1989; ISBN 0-8213-1213-8).

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8. Toward these objectives, some major stabilization and structuralreform measures have already been introduced in the key policy areas under amacroeconomic program being supported by the Bank, the International MonetaryFund and the Inter-American Development Bank (IDB). With respect to monetarypolicy, important steps include tight domestic credit and the de factoelimination of ceilings on interest rates. In the fiscal area, the Governmentadopted a cash-based budgetary system to manage its finances as an urgent fiscaladjustment measure; reorganized the tax and customs administrations; reducedincome tax rates, while eliminating exemptions to the corporate income tax;raised the value added tax (VAT) rate from 16 to 18% and broadened its base;removed subsidies and taxes on exports; continued periodic adjustments in utilityprices, following the August 1990 increases of 1,000% and 3,000% in utility andfuel prices, respectively; and eliminated wage indexation in public enterprisesand kept public sector wages under strict control, while freeing wages in theprivate sector.

9. As for exchange rate policy, the reform measures were significant:the unification of exchange rates and establishment of full convertibility in allcurrent- and capital-account transactions, with a managed floating exchange ratesystem. In the financial sector: a new banking law was enacted, strengtheningprudential regulations, promoting universal banking, and opening commercialbanking to foreign investment. The Government is also in the process ofprivatizing state-owned commercial banks and liquidating most of its developmentfinance institutions.

10. Major structural reforms with significant implications for incentivesand competition include: (a) trade liberalization: non-tariff barriers andexemptions from import tariffs were eliminated, and Peru's complex tariff ratestructure was simplified to a two-rate system of 15% and 25%; (b) monopoly rightsof SOEs were eliminated; (c) price policy: a significant reduction in pricecontrols was effected in August 1990, followed in June 1992 by the enactment of adecree formally liberalizing petroleum products prices; (d) foreign investors arenow permitted to remit abroad all net profits and royalties and to invest underany corporate form or joint venture; (e) land property rights have been broadenedand strengthened, corporations (including agrarian cooperatives) can now legallybecome private estates, and land now is freely transferable and can be used ascollateral; (f) labor market: some flexibility was introduced in the rigid laborlaws through amendments in November 1991 to broaden provisions for layoffs andtemporary employment, and in July 1992 the Government promulgated legislationunder which collective bargaining at the industry level can now be carried outwithout government interference and all aspects of labor contracts are subject tonegotiation every year, and in December 1992 an Arbitration Law was issued;however, additional actions are certainly needed to relax the still restrictivelabor laws (see Chapter II, Section A); and (g) a comprehensive privatizationprogram. Given its scope and speed, Peru's privatization effort is a majorundertaking.

11. In mid-1991, the Government decided to expand its structural reformprogram to include privatization, with the objective of privatizing all SOEs bymid-1995 when its term expires, to make the program irreversible. A legislativedecree (No. 674) was passed in September 1991, establishing the broad legal andinstitutional framework for privatization and authorizing a wide range ofprivatization methods. The decree also set up an inter-ministerial commission

(COPRI) to oversee the privatization program. The latter has appointed more than30 *pecial committees to propare/implement individual privatizations. And, sinceMay 1992, thirteen privatizations have been completed, yielding about US$235million in cash proceeds --excluding US$200 million in future installmentpayments for Petromar (Chapter III has further details). In 1993-95, theGovernment expects to privatize its larger, more complex holdings, including theremaining larger mining SOEs, the telecom holding., the oil company, the majorelectricity SOEs, the remaining state-owned banks, the Lima water company, andthe major manufacturing SOEN in fish processing, steel, and pulp and paper.

12. The Government is also showing a serious effort in reforming thepolicy/legal and regulatory environment in all the key sectors before majorprivatizations take place, to ensure that a pro-competitive environment iscreated and that inefficient state monopolies are not replaced by inefficientprivate monopolies. In this regard, the Government's privatization strategy withrespect to SOEs operating in activities that are generally characterized asnatural monopolies is: (i) to adopt an appropriate regulatory framework andpricing policies so as to promote sfficiency; and, where feasible, (ii) to sellthese companies in parts that correspond to distinct sub-activities, whileintroducing changes in the legal and regulatory environment to allow competitionin those sub-activities, where more than one firm could operate and compete(e.g., generation activity in the power subsector).

13. As pointed out earlier, Peru's reform program is being supported bythe IMF, the IDB, and the Bank. IMF's Rights Accumulation Program for Peru hasbeen followed by an Extended Fund Facility, approved in March 1993, and the IDBhas already approved several adjustment loans. In FY92, the Bank approved threeadjustment loans: a Trade Reform Loan, a Structural Adjustment Loan (SAL) and aFinancial Sector Adjustment Loan (FSAL), totalling US$1.0 billion. The first twoloans and the first tranche of the third were disbursed when arrears with theBank were cleared (in March 1993). In the area of privatization, Bank supporthas been (and will continue to be) provided primarily through technicalassistance, financed by a Japanese privatization grant approved in August 1991,and the Privatization Technical Assistance Loan (PTAL), approved in December1992. Under the SAL, the Government agreed with the Bank on sectoralprivatization strategies for the banking, mining, hydrocarbons, fisheries, power,telecommunications, transportation, industrial and water sectors. Implementationof these strategies is being supported by several Bank operations, including: (i)the Privatization Adjustment Loan (PAL), the first adjustment loan after arrearsclearance (approved in April 1993), which supports privatization andpolicy/regulatory reforms in mining, hydrocarbons, telecommunications, water,fisheries, and industry; (ii) the FSAL, which is supporting the privatization ofthe banks; (iii) the proposed Electricity Privatization Adjustment Loan, whichwill support privatization of the electric utilities and implementation of a newpolicy/regulatory framework for the sector; and (iv) an Energy and Mining TA Loan(approved in May 1993), which supports the implementation of new sectoralpolicy/regulatory responsibilities in a liberalized and privatized setting inenergy and mining.

C. NBED FOR ADDITIONAL MUASURES

14. GOP's structural reform program described above goes a long way inestablishing a competitive market environment. There are, however, several areas

at the economy and sectoral levels where further reform measures and changes areneeded to facilitate firms' adjustments to Peru's structural reforms, strengthencondition. for domestic competition and factor mobility, and effectively preventmonopolistic tendencies.

15. At the economy-wide level, perhaps the most important generic issueconcerns labor markets. Peru's existing rigid labor laws make employmentadjustments costly and difficult, creating a serious obstacle for firms that needto adjust to changing market incentives induced by the recent policy reforms.They also affect adversely cost competitiveness of Peruvian firms in exportmarkets.

16. The changes incorporated in the labor section of the current draftnew Constitution are important steps towards the efficient functioning of thelabor market. The key positive change that it will introduce, if it is approved,is the elimination of the "labor stability" clause (Chapter II presents thedetails). It will be important to monitor for possible amendments before it isofficially approved.

17. The old, seriously deficient bankruptcy law has been replaced by thenew law on "Enterprise Restructuring", significantly improving the climate andefficiency for exit. Jurisdiction has been given to a Commission within thenewly established National Institute for the Defence of Competition andProtection of Intellectual Property (INDECOPI).

18. There are four other areas where the Government has already takenimportant steps for improving the competitive environment, but additionalcomplementary actions appear warranted. The first two concern the entryregulations and the antitrust bill enacted in November 1991, where furtherchanges and/or refinements would be desirable for an effective competitiveenvironment. The last two concern institutional development. One is thecreation of INDECOPI. This institution has been given jurisdiction to implementall competition legislation. The other important institutional development isthe creation, within INDECOPI, of the Free Competition Tribunal (Tribunal de laLibre Competencia). It has jurisdiction to rule on appeals to judgements passedby the relevant Commission in INDECOPI. The appeal of these institutionaldevelopments is the bypassing of the mainstream judiciary apparatus, which isonly used as an organ of last recourse. Yet, notwithstanding these positivedevelopment., there are improvements to be made in the organization and mandateof INDECOPI.

19. Additional policy reform actions are also needed in some sectors toimprove conditions for market competition. In the mining sector, further changesin the conditions under which exploration and exploitation concessions aregranted and non-wage labor costs are financed would be desirable. Also, theremoval of minimum investment requirement in privatization needs to beconsidered. In the fisheries, adoption of an appropriate "fishery resourcesmanagement regime" appears essential to ensure compatibility between biologicalsustainability and competitive fishing/processing activities. And, in thehydrocarbons sector, de facto liberalization of domestic ex-refinery prices ofpetroleum products and additional changes in the existing petroleum tax systemappear desirable, taking account of the budgetary revenue needs and consistencywith the overall tax regime. Privatization of the state-owned company's

(Petroperu) holdings must proceed, with the storage facilities going first, inorder to make the liberalization of petroleum prices effective and introduceeffective competition in the domestic market.

20. It is important to emphasize that the report concentrates on the kYpolicy-generated barriers to competition and factor mobility, and on the mostimportant generic and sectoral competition-related policy issues. It does nottry to cover all the policy issues pertaining to, for example, Peru's labormarkets, neither does it try to be fully exhaustive with respect to entry, exit,and antitrust policies. Similarly, its recommendations are directly related tothe issues covered, and they are restricted to mainly proposed changes in therelated laws, regulations, and policies. The report does not go into details ofinstitutional weaknesses and bottlenecks, and does not cover ways of addressingenforcement problems.

21. Chapter II covers the economy-wide competition policy isxues andrecommendations, followed by the sector-specific ones in Chapter III.

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CHAPTER II

REKAINING ECONOMY-WIDE BARRIERS TO DOMESTIC COMPETITION

A. LABOR MARKET CONSTRAINTSI/

1. Overview. Peru's private sector considers labor immobility and costsa major problem affecting their operations and adjustment plans. Despite theGovernment's recent attempts to broaden provisions for dismissals, the existinglabor legislation is still too rigid and restrictive with respect to lay-offs,requiring lengthy and costly procedures for any employment reduction deemednecessary under changing market conditions. In addition, an excessive number ofcompulsory fringe benefits are pushing up labor costs in the formal sector,thereby putting firms in the latter sector at a competitive disadvantage via-a-via firms in the informal sector and foreign competitors not facing similarconditions. Under such restrictive labor market conditions, it will be verydifficult for the Peruvian firms to adjust their operations in line with thestructural reforms that have been taking place. Additional reforms in laborlegislation are necessary to facilitate labor mobility and industrialrestructuring induced by trade liberalization and other structural policyreforms. The fundamental problem with the existing key labor laws,notwithstanding the recent changes, is that they still maintain the sameorientation imbedded in their initial design, which is to protect the jobs of thealready employed few in the formal sector, rather than providing an environmentthat encourages growth of productive employment opportunities.

A.l. Leal Environment and Labor Stability

2. The general principle promoted and protected by Peru's laborlegislation is that workers are entitled to "labor stability". This principlewas first introduced in November 1970, in the Labor Stability Law (Decree Law18471), as part of the nationalist and populist policies of the militarygovernment which came to power in 1968. The law established that after a trialperiod of three months, a worker would obtain "stability" in his/her job and thatdismissals would take place only when "grave faults" were committed. Workers,when laid off, could seek legal action to get the decision declared unjustified.A dismissed worker, following a favorable decision, could ask for reinstatementto the job or opt for compensation amounting to three months' salary in additionto accrued salaries since the dismissal. The Stability Law also establishedadministrative procedures for closing of plants, reduction of shifts and of daysand hours of work, and for "massive" personnel reductions.

3. Also in 1970, the Government issued the General Law of Industries(Law 18350), which, among other things, introduced the institution of "industrialcoiunity", representing all workers in a firm. The Law entitled the workers,through these communities, to a portion of the firm's annual profits in the form

This section draws heavity on the White Cover report entitLed: The DecLine of the Value of Labor inPeru: Causes and Remedies, the World Bank (June 1992). Other sources of information incLude themission findings and the report: Peru: Economic and Sector Reforms to Sustain StabiLization and LaY theFoundations for Devetorment, the Wortd Bank, Green Cover (Report No. 10361-PE), February, 1992.

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of shares, thereby giving workers an increasing participation in the ownership(up to 50%) and management of the firm.

4. The Stability Law has been modified several times. At times, thesechanges reflected the Government's desire to soften the adverse impact of the Lawon employment creation and involved increased flexibility in hiring anddismissals, while at other times changes indicated a revival of paternalisticpolicies. In 1978, when the Morales Government launched a two-year stabilizationprogram, the probationary employment period provided for in the Law was extendedfrom three months to three years and the number of causes for dismissals wasincreased. To afford this, the amount of compensation for unjustified dismissalswas increased to 12 monthly salaries, and tighter limitations were brought ontemporary contract employment, part-time employment, and subcontracting.

5. In 1985, the Alan Garcia Government shortened the probationary periodback to three months, reversing the 1978 amendment, and it enacted in June 1986 anew law (Law 24514) to regulate labor stability. The latter maintained theprincipal features of the 1970 Labor Stability Law, and recognized nine seriousoffenses justifying dismissals.l/ To partially counterbalance the re-introduction of more rigid labor stability rules, in 1986 the Government alsointroduced a program designed to facilitate massive temporary employment (PROEM).This program permitted firms with one or more permanent employees to hiretemporary workers for a period of two years. De facto, PROEM extended theshorter statutory probationary period to two years. However, the transitionarynature of the program, which was extended for another two years in 1988, createdan element of uncertainty for the firms, leading them to undertake massivedismissals just before the extension of the program. In an effort to stabilizethe environment for temporary employment, a system of Fixed Term Contracts wasestablished at the completion of the PROEM program, with the issuance of DecreeLaw 18138.

6. Notwithstanding occasional modifications in the Labor Stabilitylegislation, the principle of protecting employment stability has remainedintact. And, in practice, it has been very difficult to prove the provisions of"fair cause" for dismissals in the labor courts, partly because of the Law's verynarrow definition of fair causes and partly because of the courts' own biases.As a consequence, firms' ability to dismiss workers has remained severelylimited, thus making labor costs a part of fixed costs. Furthermore, while theLaw has included provisions for massive dismissals under exceptional(economic/financial distress) situations, firms have usually chosen not to usethis route because of the very lengthy and elaborate procedures, which involvedthe Ministry of Labor, sector ministries, National Supervisory Commission ofEnterprises and Values, the Autoridad Administrativa de Trabajo and, then, theright to appeal to the Judiciary. Paying workers for their voluntary retirementhas remained the preferred alternative for the firms in Peru, even though it is acostly option. For the employment reductions undertaken recently, severance

V' Snam of these offenses include: refusal to work, absenteeism, drunkenness, stesling, illegal strike,unjustified refusal to take a medicaL examinatIon when medical conditions ff ect production. Note alsothat Law 24514 set the Level of comretion for unjustified dismissals to 12 saLories for three ormore years of services, six *slarfes for less than three years of service, and three salaries for lessthan one year of service --in ddition to the accrued ernings since the date of dismissal.

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packages have exceeded US$10,000 per worker, despite the downward pressure of theeconomic slow down on incentive packages needed to be of fered. V/

A.2. Non-Waae Labor Costs

7. While Peru's Labor Stability Law ham inhibited labor mobilitydirectly and increased labor costs indirectly, a large number of forced savingsschemes financed through high statutory payroll taxes have also significantlyincreased labor costs for employers in the formal sector, affecting theircompetitive position vis-a-vis firms in the informal sector and foreigncompetitors. These include a severance payment scheme, social security and othercontributions.

8. Under the so called Compensation for Time of Service (CTS), employersare required to contribute one monthly salary for each year of service to asavings scheme, whereby accumulated savings are paid to employees as a lump-sum"severance payment" at the time of lay-offs, resignation or retirement. It is aform of forced saving, in that out of 13 salaries for each year of service, onemonthly salary is capitalized to be paid to the worker when job separation takesplace. Until some changes were introduced in July 1991 in its implementation(which are explained below), the CTS created a lot of uncertainty for the firmswith respect to the real magnitude of their obligations. This resulted from thefact that the base for calculating CTS was the last monthly earnings. Sincethese obligations were being capitalized by employers in a highly inflationaryenvironment, it became very difficult to know what the real value of CTSobligations would be. It was a poor substitute for an unemployment insurancescheme. 4/

9. other important forced savings schemes include the standard socialsecurity plans financed through payroll taxes collected from employers andworkers. Before the reform measures of November 1991 (see below), employers'contributions to the social security and accident insurance system managed byIPSS (Instituto Peruano de Seguridad Social) exceeded 16% of the monthly wage,covering pension and health plans (6% each), and the accident/life insurance (1%-129 ); see Panel A of Table 1. In addition, until the introduction of very

In 1991, 10,340 workers were Laid off from the state-owned enterprises (SOEs), at a cost of US$66million (USS6,400 per worker), consisting of legalLy required severance payments (US$49 miLlion) andincentive packages (US$17 miLLion). Urnder the ongoing employment reduction progrm, 15,300 additionalworkers are expected to be Laid off from the 26 major SOEs prior to privatization. Expected cost isUSS148 million (USt9,640 per worker), including USS107 miLlion In severance payments and USS10.5million in incentives; (the 50X increase in the cost of Lay-off packages per worker reflects the higherproportion of workers with more years of service and, therefore, more accumuLated benfits in thelatter group). The current tight fiscal situation faced by the Goverrment, extremLy weak financialposition of SOEs, and the depressed state of economic activity have obviously weakened the power of theLabor unions and probably played an inportant role in the implementation of these voluntary retirementswithout a serious opposition and also in the contairment of the size of compensation payments.However, both the private sector representatives and govermnent officials agreed that the strongerfinancial position of private firms is a factor expLaining their larger incentive packages.

Note that under the CTS system, workers were also allowed to borrow from the accumulated savingsaccording to specific conditions and ruLes for repayment, which led to situations where the real valueof repayments were much lower than the principal borrowed, particularLy in periods of high infLation,due to poor indexation.

Higher rates appLy to blue collar workers and risky activities.

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recent changes (see below), employers had been required to contribute to theNational Housing Fund (FONAVI) and the National Training Service (SENATI) inmanufacturing, repairs/maintenance and installation activities, withcontributions amounting to 5% (with an indexed ceiling) and 1.5% of wages,respectively, i

10. Aside from these obligatory payments, the collective bargaining inPeru has established a tradition of two bonuses a year and vacation payments,making their payment by employers a common law, even though this is not requiredby law. These are estimated to increase wages by about 30%.7/

11. Some industries in Peru have also been subjected to special laborregimes, partly due to the nature of their activities and partly due to thestrength of the labor unions. For example, in the mining sector, the necessarilymore strict safety and health regulations contribute to higher labor costs.Also, mining firms are required to provide housing, hospital and school servicesif mines are located at more than one hour distance from urban centers. Costs ofthese services have increased steadily through the collective bargaining process,with the strong mining unions pushing up the non-wage labor compensation to about170% of wages in the mining sector.87 Similarly, the existence of strong unionshas increased minimum wages in the textiles sector and raised average wages inconstruction, fisheries and banking sectors

A.3. Imoact of Riaid Labor Laws

12. The impact of Peru's rigid labor laws and restrictions has beendetrimental for workers, the very group they were intended to protect. Since theearly 1970s, job opportunities and real wages in the formal sector have shownfalling trends --average real wages have fallen by almost 60%. The high totalcost of labor has constrained employment generation in the formal sector and ledto shifts into the informal sector.9 iThe informal sector's share in employmentrose from 15% in the early 1960s to well above 20% in the late 1980s, while theformal sector's share showed a decline.1 1/ Moreover, efforts of firms tocontain the growth of total labor costs, when downward adjustments in the levelof employment could not be made, appears to have led to wage compression anddeclines in the ratio of skilled workers/total labor force. The resultingdeviations from desirable skill-mix must have had adverse effects on productivityof firms in Peru, as reflected in rising trends in labor/output ratios. It seems

For details on the functioning of Peru's social security system and of SENATI, see: The Decline of theValue of Labor in Peru: Causes and Remedies, op. cit.

Peru: Economic and Sector Reforms to sustain Stabilization and Lay the Foundations for Develooment, op.cit., page 32.

The Decline of the Value of Labor in Peru: Causes and Remedies, op. cit., page 183.

The Decline of the Value of Labor in Peru: Causes and Remedies, op. cit., page 115. The latterdocument presents a detaiLed assessment of the impact of Peru's rigid labor Laws on eployment andproduction segmentation between the formal and informal sectors, and discusses irplications for laborproductivity and resource allocation efficiency.

Peru: Economic and Sector Reforms to Sustain Stabilization and Lay the Foundations for Develooment, op.cit., page 33.

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Table 1: Payroll Taxes: Social Security and Other Required Contributions

Tax Rate

Maximm - ..................Contributions Tax Base Employes EmpLoyer

A. Before November 1991

A. Social Sec. Contr.:

(i) Penaion Plan-IPSS \1 Monthly Wage 3.0X 6.0X

(ii) Health Plan - IPSS Monthly Wage 3.0X 6.0X

B. Other Contributions:

(i) Life/Accident Ins.-IPSS Monthly Wage - 1X-12X

(ii) SENATI \2 Payroll of those - 1.5X

covered

(iii) FONAVI \3 Monthly Wage 1.0X 5.0X

up to 8 UIT

B. After November 1991

A. Social Sec. Contr.:

a. Pensions:

(i) SoLidarity Contr. CIPSS) Monthly Wage xX \4 1.0X

Cii) Complementary Prog.

(Private Adm. or IPSS) Monthly Wage (8X-xX)

b. Health Care:

(i) Solidarity Contr. (IPSS) Monthly Wage yX \5 1.0X

Cii) Cocplemntary Prog.

(Private Adm. or IPSS) Monthly Wage (8X-yX)

B. Other Contributions:

(i) Life/Accident Ins.

Accident Ins. -IPSS Monthly Wage - 1X-12X

Life Ins.

(Choice of provider) Monthly Wage .53X-1.46X \6

(ii) SENATI \2 Payroll of those - 1.52

covered

(iii) FOHAVI \3 Monthly Wage 1.02 5.02

up to 8 UIT

Source: "The Decline of the Value of Labor In Peru: Causes and Remedies", White Cover

(The World Bank; LAI), June 1992.\1 The Peruvian Social Security Institution: Instituto Peruano de Seguridad Social.

\2 The National Training Service in Industrial Work: Servicio Nacionel de Adiestramiento

en Trabajo Industrial.

\3 The National Housing Fund.

\4 The rate "x" represents the contribution to the IPSS that will finance a basic pension.

The rate is to be determined foLlowing actuarial studies.

\5 The rate y" represents the contribution to the IPSS that will finance a besic health

care. The rate is to be determined foLlowing actuarial studies.

\6 Workers can choose to pay their Life Insurance Premium to a private insurance conpany.

In that case, apLoyers wilL deduct the premium (ranging .53X to 1.46X, with higher

rates for blue collar workers and risky activities) from their contribution to the

IPSS required to cover risks associated with accidents on the job.

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that firms have substituted capital for skilled labor, rather than unskilledlabor, and this has reduced productivity, given the high degree ofcomplementarily between capital equipment and skilled workers.

13. These trends are harmful for labor, employers, and, of course, forthe economy. As policy-imposed labor market rigidities and excessive number ofpayroll taxes/forced saving schemes encourage a higher growth in the informalsector than what would be observed under a more balanced, less restrictive laborlegislation, resulting excessive fragmentation of production, inappropriatetechnologies, and inefficiencies will curtail the economy's growth potential,misallocate resources, and weaken domestic firms against foreign competition.

14. Peru's benefits from the structural reforms, including privatization,will depend very much on the capacity of firms to respond to changing incentives.To improve their supply response and their cost competitiveness, they must beable to vary their employment levels, skill-mix, and, if necessary, exit certainactivities without incurring significant costs.

A.4. Recent Reform Measures and Recommendations for Further Reforms

a. Labor Stability

15. The new Government, recognizing the need for reforming the rigidlabor laws and the system of mandatory fringe benefits, has taken some stepstoward a more flexible legal framework for labor relations. In November 1991,the Government enacted the new law of "Fomento del Empleo" (Decreto LegislativoNo. 728). This is the law that currently regulates labor stability, and isbasically a consolidation of the various existing labor legislation. It hasintroduced a few improvements, though not substantive. The most important one isthat economic, technical, and restructuring reasons can now be considered validcauses to initiate collective dismissal procedures. Also, the provisions of"fair cause" for individual dismissals was expanded to include among others, forexample, low productivity. However, certain provisions of the new law cannot beimplemented yet due to delays in the issuance of relevant procedures. Forexample, while it allows for a maximum turnover of 5% of the labor force eachyear --i.e., a firm can dismiss 5% of the labor force as long as it hires thesame percentage back with new workers-- such option cannot be utilized, since theprocedural rules have not been issued yet. Similarly, while dismissals ofadministrative, management, and advisory personnel (personal de confianza) areallowed and, in principle, easier, the relevant procedural rules for carrying outdismissals have yet to be issued.

16. Perhaps the most important recent positive development regarding thePeruvian labor stability law, however, is the elimination of the stability clausein the draft new Constitution, abolishing the guarantee of the worker's right toemployment stability. The current draft of the new Constitution simply statesthat the law should provide the worker for adequate protection against dismissalwithout cause. While the draft has been approved unanimously by the LaborCommission of Congress, it has yet to be discussed on the floor of Congress, butall indications show it will pass. The next step, presuming approval of the newConstitution, will be to monitor the law that will address that protection. Ofcourse, the issue of how the judiciary will rule on "dismissal without cause"still remains. In any case, this is a most welcome development.

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17. Additional positive developments include the passing of the AutomaticReadjustment of Compensations, D.L. 25541, (June 11, 1992), Arbitration Law,D.L. 25935 (December 10, 1992), and the Law of Collective Agreements, Strikes andUnions, D.L. 25593 (July 2, 1992). The first law eliminates the automaticadjustment for inflation of salaries and compensation. It eliminates (backward)indexation and, in doing so, reduces inflationary pressures. The other twoprovide for a framework to resolve disputes between management and labor. Theylimit the state intervention to exceptional cases and allow for an increasedparticipation of employees and employers in the solution to their conflicts. Italso democratizes the decision making process within unions.

18. With respect to sector specific actions, the mining companies havebeen allowed to contract out certain tasks to miners' cooperatives, giving themsome needed flexibility in employment adjustments in view of the vulnerability ofthe sector to fluctuations in international prices.

19. Notwithstanding these recent changes, however, the main issue oflabor stability still remains until the new Constitution is approved. In fact,all the key restrictive stability conditions which hinder labor mobility areretained more or less intact as they appeared in Law 24514 of June 1986. Asbefore, after three months of probationary period, workers gain stabilityfll intheir jobs, and similar compensations apply for unjustified dismissals. The dueprocedures for dismissing workers with stability are still elaborate, lengthy andcostly, and leave much to the discretion of the labor authorities and courts.The procedures for collective or multiple layoffs (covered in Chapter VII of DL728, under Title II) are even more elaborate. Seven steps (covered by Article88) are needed to reach a verdict. Ultimately the decision rests with theAutoridad Administrativa del Trabajo and, as before, that decision can beappealed to the Judiciary. In short, the recent changes in the stability law areinadequate for achieving mobility and efficiency in labor markets.

20. Also, under the current stability regime, while various contractualforms of employment provide flexibility and an often efficient alternative topermanent contracts, in practice the employer is often forced, through thejudicial system, to change those types of contracts into permanent ones,defeating the purpose and efficiency gains of those modes of contracting.

21. Recommendations. It is clear that abolishing the labor stabilitylaws/regulations altogether is the key step in removing the most importantstumbling block to any lasting improvement in labor market flexibility. Such alegislative action would be possible after the approval of the draft newConstitution, thus paving the way for repealing these laws.

22. Since the judicial system will continue to determine what constitutes,dismissal without just cause", it would be desirable to avoid repeating the poorrecord of judiciary in this regard. One practical solution is to establish aspecialized court, consisting of experts in labor law and of high repute in the

However, the probationary period can be extnded to six months if the work reqires a training andadaptation period. And, the period is extendable to one year in the case of managment staff nd otherpositions of trust.

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community, with exclusive jurisdiction to pass judgement on labor law issues, anentity similar to the 'Free Competition Tribunal" (soe below).

23. In addition, to increase flexibility in contracting of laborservices, it would also be desirable: (i) to simplify and clarify the scope anduse of temporary contracts and of subcontracting in law and practice, with a viewto giving permanency and certainty to these contractual forms of employment; and(ii) to extend the probationary period to a much longer time span than threemonths, say to three years as was the case during 1978-1985, especially while theConstitutional guarantee for labor stability continues.

b. Compensation for Time of Service (CTSI

24. In July 1991, the Government introduced changes, through a new decree(Decreto Legislativo 650), in the way the CTS system operates. Accordingly, theemployer is now required to deposit every six months the CTS payments into a bankaccount owned by the employee. Workers can choose the bank and, if they soprefer, they may leave CTS savings with their employer.11/

25. These changes certainly represent an improvement over the previousCTS system, in that, the uncertainty regarding the real value of CTS obligationsis removed. With the payment of CTS liabilities every six months, employers cannow determine their total annual labor compensations. 1/ Similarly, workerswill also have a better idea about the real value of their accumulated savings.Moreover, the financial sector obtains a significant source of long-termfinancial savings, and competition for these funds should result in their bettermanagement.

26. However, despite the improvements in its implementation, the CTSscheme weakens international competitiveness of Peruvian firms and remains aneconomically costly way of achieving the intended objectives. As a forcedsavings program, it amounts to setting aside for the workers about 7.7% of totalannual compensation --excluding social security and other contributions --(or8.3% of gross wages), reducing the amount of take-home wage. To tho extent thatthe amount of forced saving is more than what the optimal savings decision by atleast some employees would indicate, then the system has a welfare reducingeffect on workers concerned. And, as a way of mobilizing financial savings inthe economy, it is a rather costly approach, given the hitherto negative impactof the CTS and other forced savings schemes on total employment and real valueadded generation in the formal sector. Also, as a substitute for an unemploymentinsurance scheme, because of its proportional linkage to tenure, the CTS isinadequate in terms of covering those that potentially needs it the most, i.e.,unskilled and younger workers.

1> All banks and financial intermediaries under the supervision of the Banking Superintandbncy are allowedto operate these CTS accounts.

iV The new Law also define alternatives for the paywent of the CTS accumulated before Deceaber 1990. Theaqployers can pay these immediately or pay to the empLoyesc accounts over a period of ton years.Thus, depending on the expected rates of return on these funds and rate of increase of real wages,employers can make their decisions on these two options, taking into account the uncertainty pertainingto the future trends in real wages and the age and skiLl composition of their work force.

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27. Recommendations. It is desirable that the CTS be abolished, byreplacing it with a pre-1968 system of requiring employers to give advance notice(e.g., three months) for dismissals or corresponding compensation. If thepolitical economy considerations make this option very difficult to pursue in thenear future, as a second best alternative, reducing the CTS should-be seriouslyconsidered.

28. It should also be pointed out that while an unemployment insurancescheme may be desirable, its introduction needs to wait until such time when Peruestablishes strong and efficient tax and social security (SS) administrations,and achieves a satisfactory degree of stability and maturity in its fiscal and SS

systems.

c. Social Security and Other Contributions

29. In November 1991, the Government introduced important changes in

Peru's social security system through the enactment of the Law of "Consolidacion

de Beneficios Sociales" (Decreto Legislativo 688), establishing a system similarto the Chilean model. First, the incidence of social security (SS) taxes hasbeen altered, with the employer's responsibility falling from 12% to 2% and that

of workers increasing from 6% to 16%; the total rate is still maintained at 18%of wages (see Panel B of Table 1). Second, workers can now have, if they sochoose, some private pension and health service coverage beyond a basic coveragethat is to be provided by IPSS. They can also opt for private life insurancecoverage. Thus, under the new "complementary program", the worker, after making

her/his so called "Solidarity Contribution" to IPSS' pension and health careplans to meet a minimum coverage, can use the remaining SS contributions for

additional coverage from the private sector providers (Table 1). The rates ofSolidarity Contribution under the pension and health plans are to be determinedon the basis of actuarial studies. Although these minimum contributions to IPSS

appear to be a compromise for adopting a system of complementarily, because theexisting laws do not permit a full substitution of private programs, the newsystem is also attempting to ensure the financial viability of IPSS.15/

30. These are significant positive changes. Workers are now offered more

options in terms of private/public provision of SS coverage. The new law also

opens the way for a competitive provision of SS services; the private sectorparticipation should pressure IPSS to be more efficient.16/ Also, the incidence

of SS taxes on employers has been reduced with the recent changes. However, anadditional step appears desirable to reduce the number of payroll taxes.

31. Effective January 1994, the employer's contribution to the industrialtraining fund, SENATI, has been eliminated; SENATI will, however, continue to

exist as an institution. As for the earmarked contributions to housing fund,FONAVI, the employer's contribution has been reduced from 5% to 1% and that of

the worker increased from 1% to 9% (under D.L. 25981 of December, 1992).

16/ For an assessment of IPSS, see: The Decline of the Value of Labor in Peru: Causes and Remedies, op cit.

pages 195-227.

is Decrees 718 and 724 enacted in 1991 authorize the creation of private health care insurance andretirement fund systems.

- 16 -

32. Recommendations. The FONAVI contributions are clearly distortionaryand these should be eliminated. The provision of funds for housing should beleft to an efficiently functioning financial systm. Financing a subsidizedsocial program by raising the cost of labor is not only distortionary, but inbound to misallocate resources and cause competitive disadvantage for formalsector firms.1 7 /

33. On the other hand, significant returns to well designed trainingprograms and possibilities for internalizing benefits from increased humancapital would indicate that it would be beneficial for the economy to continuethese training programs (with improvements towards successful model programs,such as those of Germany and Mexico) and their financing by the beneficiaries.

d. Profit Sharina

34. The recent changes (through Decreto Legialativo 677 of October 1991)also eliminated the right of workers' participation, exercised through the"industrial or labor communities", in ownership and management. Effectively,these changes eliminated the power of the "communities" and, thereby, their defacto existence. However, the mandatory profit sharing with workers, when grossprofits (before taxes) exceed 10% of the firm's equity, is still maintained, withrates of 10% of profits in manufacturing industries (including fishing) andtelecommunications, 8% in mining, and 5% in trade activities. These features ofthe labor legislation are also reflected in the draft new Constitution, which,while eliminating the right of workers' participation in ownership andmanagement, has kept the right of workers to a share of profits of firms. Whilethe legal enforcement of profit sharing in in principle undesirable, it appearsto have been the price for the adoption of other positive measures in the draftnew Constitution, particularly the elimination of the labor stability clause.

35. Recommendation. There are no indications that, since its inceptionin 1970, the mandatory profit sharing has had any positive impact onproductivity. In effect, it amounts to an additional direct tax or increasedincome tax on profits, with the proceeds being diverted to workers and, thus,reducing investable funds. In principle, if employers want to share theirprofits with workers, because they expect a positive impact on productivity orthat they have more than one objective, then they should make that decision ontheir own, without legally being obligated.

36. Given that the draft new Constitution is maintaining workers' rightto profit sharing and leaving its regulation to appropriate laws, then perhapsthe practical solution to minimizing distortions associated with the mandatoryprofit sharing would be to reduce the relevant rates to lower levels.

IN FONAVI loans are highly subsidized, nd only a small portion is recelved by the contributing workers.And the recovery rate of the loans has been very Low since 1979; for further details, see: PeruEconomic and Sector Reforms to Sustain StabiLization and Lay the Foundations for Develorment, op. cit.,page 18.

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B. ENTRY, EXIT, ANTITRUST POLICIES, AND INSTITUTIONAL ASPBCTS

B.1. Entry

37. Public barriers to entry. An analysis of the extent of barriers toentry, particularly the artificial ones, is closely intertwined with theantitrust legislation (and enforcement) environment, since actions taken by firmsare to some extent molded by that legislation. An analysis of that legislationis presented below. 18/

38. The level of public barriers to entry in Peru has decreasedsignificantly in recent years, particularly those that dictated procedures forentry of small enterprises. Significant improvements have been made in theprocedures and costs of registering and engaging in economic activities for smallenterprises. As of now, there is a unified registry procedure for smallenterprises, whereby the whole process takes le than a month, and where thefinancial cost (fees and licenses) is around US$200-300, which should notconstitute a significant barrier to entry. Two years ago the procedure couldtake up to two years and the financial costs were significantly higher.l2/ Yetthe process still needs additional improvements. While the unified registryprocedure has greatly simplified matters, the resources devoted by the Governmentare not commensurate with the requirements for an efficient operation.Applicants, when registering or renewing licenses, often have to wait a full daybefore being served. The man-hours lost in unproductive uses are quitesignificant. Opening a few more windows would greatly reduce the waiting periodfor processing of entry applications.

39. However, the procedures and costs of entry by medium and largeincorporated firms still remain cumbersome. There are four steps required toform a Sociedad Anonima and enter into productive activities, each one with itsappropriate regulation: (i) Structural Plan and Operations; (ii) ShareSubscription Plan; (iii) Shareholders Meeting and Procedures and Rules; and (iv)Submission and Registry of Public Deed and Bylaws. Each of these four steps isregulated, by Articles 82 through 90 of the Commercial Code (Ley de SociedadesMercantiles). In addition, step (i) needs to be approved by CONASEV (ComisionNacional de Seguros y Valores), according to decree D.S. 089-87-EFC. And,apparently, this is not a rubber stamp procedure. While it is appropriate tosubject incoming firms to the scrutiny of an institution (CONASEV), to ensurethat they conform to appropriate regulations, it should be done in a timelyfashion and only on relevant matters, such as appropriate capitalization, debtand equity issues, and safety and rights of shareholders.

18/ There are two broad types of barriers to entry to economic activity, naturaL and artificial. Naturalbarriers to entry include: (i) economies of scale relative to market size; and (ii) non-duplicableresources. The former, when exclusionary, is addressed through regulation and the Latter, whenapplicable, by guaranteeing access to the resource. Artificial barriers to entry are divided intopublic and private. Public barriers to entry are those erected by governments, such as import tariffsand quotas, investment/capacity controls, zoning permits, patents, copyrights, exclusive franchises,and licenses. Private barriers to entry are those erected by the actions of firm, eitherintentionally, or as the unintended consequences of their actions. They Include productdifferentiation, capital costs and access, imposition of higher costs, exclusive dealings etc..

For a detailed assessment and specific examples of costs of entering the formal sector in Peru, see:Hernando de Soto, The Other Path: The Invisible Revolution in the Third World, (Harper & Row; 1989);particularly, Part 11, Chapter 5.

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40. There has been no evolution of the Commercial Code in regard toincorporated enterprises as they have evolved over time. The Commercial Code wasdesigned with the traditional family or small enterprise in mind, with limit. onthe transferability or liquidity of shares. With enterprises evolving toward themodern large corporation with a large number of shareholders and shares traded inthe stock market, a different enterprise emerged which the legislation did notaddress. Thus, the open (abierta) Sociedad Anonima emerges, different from theclosed (cerrada) Sociedad Anonima, and is characterized by increased governmentintervention to protect the right of small shareholders. As a result, theSociedad Anonima Abierta (SAA) is not covered in the Commercial Code and it isregulated by Decrees D.S. 003-85-JUS and 089-97-EF. The SAA is described ashaving its shares traded in the stock exchange, with a minimum of 30% of itsshares held by the general public (and minimum of 50 shareholders, each one withno more than 3% of total firm capital). Thus, the criteria to single them outfrom other types of organizations include the listing in the stock exchange anddiffusion of shares.

41. The exclusion of the SAA from the Commercial Code is unwarranted.Rather, an amendment of the Commercial Code to delete obsolete and inappropriateclauses and to address contemporary issues is needed.

42. Within the context of public barriers to competition in general andentry in particular, it should also be stressed that weakly formed and/oroutdated institutions that are responsible for the administration of competitionpolicies/laws and regulations could have adverse effects on domestic competitiondue to uneven and erratic implementation/enforcement. Also, a legal system thatdoes not work could constitute an entry barrier. An examination and assessmentof al; institutional aspects of Peru's competition policies in outside the scopeof this report; (only INDECOPI is discussed below, because of its majorimportance). However, it is worth emphasizing that adequately staffed andfinanced institutions/agencies are necessary to ensure efficient and neutralimplementation and enforcement of competition policies. Similarly, overzealousor vague laws/regulations governing entry and other aspects of market competitioncould become a source of problem themselves by demanding resources well beyondthe capacity of existing institutions or what could be made available fromalready stretched public resources --a problem that is currently very severe inPeru.

43. A most welcome improvement facilitating entry has been the recentcreation of a Commission within INDECOPI to facilitate entry and exit. It hasbeen given the responsibility and jurisdiction to overrule normal channels or therespective institutions, in the event of faulty decisions or lengthy delays.Thus, applicants who are unfairly denied entry or subjected to unnecessary delayscan apply to this Commission for a review of their case. In the event of afavorable review, the Commission can grant the enterprise entry into the desiredactivity. This can significantly improve the climate for efficient and speedyentry into economic activities. A number of very positive cases have alreadytaken place. A case in point has been an enterprise desiring to set up acommunications system in Cuzco. An application was submitted to thecorresponding Ministry in charge of licensing. Despite the elapse of over sixmonths, the Ministry failed to provide an answer. A complaint was submitted tothe Commission, and since the requested operation was in compliance with the law,the Commission granted authorization to begin operations.

- 19 -

44. Private barriers to entry. The direct entry costs are obviouslyweighed in the decision to engage in a commercial activity. But these are one-time costs. More important in the entry decision is the perception of theability to compete in a level playing field with established firms and earn atleast the opportunity cost of funds.

45. What are the main private barriers to entry in Peruvian markets?Capital costs and access to finance is one. It affects different potentialentrants differently. But, leaving aside equity or distributional arguments,from an efficiency standpoint, it does not matter who enters as long as theoptimal amount of entry takes place.

46. Currently, the financial barrier to entry exists for a mixture ofstructural and circumstantial reasons. Little entry has taken place in Peruduring the last few years, primarily as a result of high real interest rates,exacerbated by the standard pattern whereby small and new firms face steeperinterest charges and more stringent credit rationing. Also, the usual linkagesbetween the real and financial sectors, through direct common ownership orinterlocking directorates among banks and snterprises, inevitably leads toinfluence and favoritism that works against outsiders or new entrants, oftenleading to market closure for them. That provides for absolute cost advantagesto incumbent or established firms. This is not a moot point. Examples ofactions taken by established firms to raise costs to new entrants are plenty,particularly when those new entrants are not part of main economic groups. Theyalso translate into mobility barriers across sectors.

47. However, the implied policy recommendation is not a subsidized creditline to small scale enterprises. To the extent that Peru's financial sectorimproves its efficiency in intermediation and financial soundness, and is able toattract increasing amounts of savings, access to the formal financial markets bysmaller firms will improve. In addition, the Government could also take steps tostrengthen the system of recording properties and the institution of propertyrights. By providing accessible information on property ownership, such measureswould facilitate checks on "creditworthiness", which could help reduce thefinancial access barrier to entry.

48. There are also valid concerns about the lack of transDarencv ofGovernment orocurement procedures. In so far as they arbitrarily favor somefirms, they create a cost or market advantage in detriment of competitors who areas or more efficient in the provision of those goods or services. That realityor perception unfavorably affects entry decisions.

49. Another private artificial barrier to entry arises from the practiceof "market reciprocity" among existing firms active in separate markets. It isoften prevalent in environments, like Peru, where the control and ownership ofmeans of production and financial services is tightly held among a relativelysmall number of individuals or groups. It is usually of the form "I will notenter your market as long as you do not enter mine." It is difficult to dealwith such informal agreements. However, often those agreements can be disturbedby the entry of foreian investment.

50. Foreion investment leaislation. The new foreign investment promotionlaw, enacted via Legislative Decree No. 662, on August, 1991, provides for a non-

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discriminatory onvironment for most forms of foreign invostment. The lawguarantees for ton years from tho date of investment agreement/contracts (i)stability of the tax regime in force at the moment of the execution of agreement;(ii) stability of the legal regime of free availability of foreign currency atthe most favorable rate and the right to remit abroad capital and profits; and(iii) stability of the right of non-discrimination relative to nationalinvestors. The latter refers to foreign participation in certain sectors oractivities, where as of now foreign firms are not allowed to operate or havecertain restrictions on the share of ownership. That clause allows them to betreated as domestic firms. The guarantee is only applicable to investments ofover US$ 2 million or US$ 0.5 million provided it generates more than twentypermanent jobs or exports over USS 2 million during the first three years. Theguarantee can be partially waived: in the event of a favorable (to the firm)change in the tax regime, the firm can void clause (i) and yet remain covered byclauses (ii) and (iii).

51. These restrictions are unwarranted. The law should provide foruniversal coverage of guarantees, independent of volume of investment,particularly of clauses (ii) and (iii). It is also unclear why a limit of tenyears is set. The guarantee should not have a time limit for clauses (ii) and(iii). There is also the issue of administrative cost of controlling suchinvestment agreements; these costs could be considerable. The tax regimestability clause is more questionable since it has a potential discriminatoryeffect, providing for unwarranted and unfair advantages to firms that havefulfilled any of the three conditions. A partially redeeming factor in theforeign investment legislation has been the passing of D.L. 757, removing anydiscrimination between foreign and national firms, in so far as both of themsatisfy the stated conditions on minimum investment, jobs creation or exportvolume rules. Domestic firms that comply with any of the three conditions arealso covered by the guarantees. Yet the potential for discriminatory treatmentstill remains in a broader sense. Suppose that the tax regime were to change tohigher rates, say because of budget pressures. Then, foreign and domestic firmsthat have qualified for that guarantee coverage would have an economic advantageover those firms, domestic or foreign, not eligible to be covered by theguarantee. This is unwarranted. (This issue is discussed again in Chapter IIIin the context of the mining sector.)

B.2. Exit

52. Bankru2t= Until recently, the exit of firms from industrial orservice activities was regulated by the Bankruptcy Law enacted in 1932, whichamended the Commercial Code of 1902. The law, and particularly its enforcement,was not suitable for today's environment. It made the process of exiting anindustry or service, complex, lengthy and overly costly, resulting in the tyingup of scarce resources, impeding their mobility to more efficient uses, inaddition to the deadweight losses incurred due to resources spent in the process.As a result, it was not unusual for bankrupt enterprises to linger for a numberof years before they are allowed to dissolve or they are dissolved. Theconsequences were clear. Liabilities and indebtedness continued to grow, whileasset values tended to decline, making bankruptcy socially costlier and moredifficult to achieve a fair repayment program. Compounding the problem, orperhaps as a reflection of the exit policy, has been the inappropriateinstitutional and enforcement structure to handle bankruptcy cases. It appears

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that there iu only one bankruptcy commissioner (rindico de quiebras) to process,analyze and pass judgement on bankruptcy applications in all of Lima. That alonehas been responsible for unwarranted lengthy delays, unfavorably affecting themobility of resources to more productive uses and clearly leading to wastefulrent-seeking activities.

53. Therefore, in this area, the enactment of Enterprise RestructuringLaw, D.L. 26116, on December 1992, and of its accompanying procedures(reglamento), D.S. 04493EF on March 1993 has been a significant positivedevelopment. The law provides for an orderly and rational framework to addressin a timely fashion the problems of insolvency and of financially distressedenterprises. The procedures can be initiated either by the petition of theenterprise itself (a "Chapter 11" type alternative), when it has lost at leasttwo-thirds of its equity, or by any creditors holding claims for at least 50Unidades Impositivas Tributaria.. The latter also includes employees holdingunpaid claims for social benefits. The standing Commission on Entry and Exitdecides on the petition and case for declaration of insolvency. Upon a positivejudgement, the Commission proceeds to call for the formation of a Board ofCreditors. This Board decides on one of three options: (i) allowing thecontinuation of the enterprise under a restructuring program for a period of oneyear (renewable upon prior approval by the Board); (ii) liquidation of theenterprise; or (iii) judicial bankruptcy proceedings. The new law also providesfor a priority ranking of the enterprise debts, with debts owed to employeesbeing at the top of the ranking. Apparently, in the past, shortage of funds tocover these liabilities had been one of the reasons behind the policy ofunwarranted long delays in the bankruptcy process. A preference for social andeconomic pressures on owners to come up with enough assets to cover the workerrelated liabilities had been the reason for such delays in handling bankruptcycases. The procedures set out in this new law and the composition of the Boardof Creditors, where employees are also represented, enable better handling ofthat issue.

54. This law has a number of very desirable features that ought tosignificantly increase the efficiency of the process in settling claims andspeeding the reallocation of scarce human and capital resources to moreproductive uses, while decreasing the administrative costs of the whole process.It allows the enterprise to continue operating whenever this is desirable. Ittakes the decision making powers away from a slow and ineffective judiciarysystem and empowers the Commission and Board of Creditors. It establishes aspeedy timetable and deadlines for each of the steps in the process, and allowsfor an effective interaction among all parties involved. The law has alreadybeen applied apparently quite successfully in a number of cases. A furtherevaluation and fine tuning of the procedures ought to be made in a year's time,once enough cases are processed, and there is enough information to passoperational judgement. But, as of now it has resolved, at least in the legalsense, a major bottleneck in the efficient functioning of enterprises.

55. However, this new law does not cover financial enterprises subject tothe supervision of the Superintendencies of Banks, Insurance and Pension Funds.This is a drawback and ought to be corrected. While, obviously, thoseinstitutions have to treated separately, it would be desirable to have anequivalent procedure to handle distressed financial institutions, since theimplications and consequences are even more serious for bankrupt financial

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institutions. Exit or restructuring, particularly for those institutions,becomes more difficult and costlier when it is not considered at an early stage.The incentives are on the wrong side, thus leading to increases in interest rateson deposits to cover for current claims and thus exacerbating the probl(OUand itseventual consequences.

56. In addition, the new law has not abolished the Law Decree No. 19525,enacted in 1972, which allows the Executive Branch of Government to forcecontinuation of business activities of commercial enterprises in bankruptcy ifconsidered of public need for the economy or for social interest. This is astate intervention to Public Law for bankrupt enterprises. It delays andinterferes with the retribution to the debtors. The first case, when it wasapplied in the bankruptcy case of Supermarkets S.A. in 1976, involved a privateenterprise in the food and basic stuff retail business. That enterprise,financially bankrupt, was forced to continue operations, by the Executive, whoargued that the public need for the service of the firm overrode the desire toclose down the firm. Further amendments or powers to the Executive were grantedthrough Law Decree No 20016 to extend those powers, beyond commercial activities,to bankrupt transport enterprises, cooperatives, etc., on the basis of overridingpublic good or service needs.

B.3. Antitrust

57. In November 1991, the Government enacted the Antitrust Law (DecretoLegislativo 701) and the Consumer Protection Law (Decreto Legislativo 716) and inDecember 1992 the Unfair Competition Law (D.L. 26122). The Antitrust Lawaddresses exclusively two issues: monopoly power and agreements, and restrictivepractices. The Consumer Protection Law, which is also associated with theantitrust legislation, concerns consumer protection issues. The UnfairCompetition Law is umbrella legislation attempting to cover any unfair actadversely affecting competition.

58. While the passage of such legislation has been quite desirable andhas further enhanced the enabling environment for private sector economicactivity, there are still a few issues that need to be addressed to achieve aneffective competitive environment. The enforcement and focus of the legislationis still an open question, since the agency in charge, INDECOPI, has only beenoperating for a few months and has yet to define itself. Below, some of theimportant reasons why an antitrust policy might be needed are given and basicprinciples of antitrust legislation are outlined. With this background, therecent legislation is then evaluated, with suggestions on how to improve it,taking account of Peru's serious resource constraints.20/

59. Antitrust legislation would complement liberal trade and investmentpolicies by ensuring competitive conduct by incumbents not only in domesticmarkets for non-traded goods and services, but also in those for traded products,where distribution services enter as inputs. Although Peru's recentcomprehensive trade liberalization and domestic deregulation measures, financial

It should be noted here that this report does not atteept to present an antitrust legislation upeckageNfor Peru, but rather takes the recently issued Law as given, and proposes changes for its i.provemnt.

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sector reforms, and the removal of price controls and of some public barriers toentry provide the foundations for a healthy competitive environment, these cannot be considered as a complete substitute for an effective antitrust policy.There are a large number of non-traded goods and services, either because theyare inherently nontradeables (e.g., domestic distribution services) and/orbecause of very high transportation costs (e.g., fresh vegetables and fruits,fresh dairy products, and sometimes bulky items such as metal ores, cement etc.).

60. As for its role, the objective of antitrust legislation should be todeter anti-competitive practices. By focussing on this objective, and excludingother --potentially conflicting and questionable populist-- objectives, such aspreventing the development of large enterprises and ensuring "fairness" in themarket place, an antitrust law could become an effective tool for promotingcompetition/efficiency as well as good business practices and ethics.

61. In countries like Peru, where severe public resource constraints willcontinue limiting legal and administrative capabilities for some time, it isparticularly important to ensure that the antitrust law is transparent, showsdefinitional clarity, leaving little room for interpretation and discretion bythe implementing agency, and is relatively easy to enforce. It should alsocreate a level playing field for all participants, focus on actions withsignificant and clearest harm to competition and consumers, and strike a balancebetween being overburdening (increasing transaction costs) and too general andvague having no impact.21/

62. While some business practices, such as price fixing, are clearlyanti-competitive, the effects of others, such as price discrimination, exclusivedealing or resale price maintenance, often depend on the context. Accordingly,two distinct legal criteria should and are often used to address thosedifferences among practices. One is the "per se" criteria, where an action isdisallowed and punished independent of intent and of the consequences. The otheris the "rule of reason" criteria, where an action in itself is not disallowed,but punished only if the intent or consequences are found to be damaging or anti-competitive.22 / While, the latter appears to be fairer and more conceptuallyappealing, it has its drawbacks. It significantly increases litigation costs andweakens the deterrence effect, which is the fundamental objective of legislation.Therefore, the tradeoffs should be considered. Indeed, when there are seriouslimitations on administrative and enforcement capabilities, it is highlydesirable to have initially a lean antitrust law that focusses mostly on thoseanti-competitive practices that could be treated under the "per se" rule --e.g.,mainly the horizontal restraint cases and only those vertical restraint cases

For further details and discussion, see: Kovacic, W. E., *Competition Policy, Econmic Development, andthe Transition to Free Markets In the Third World: The Case of Zimbabwe", Antitrust Law Journat, Vol.61, Issue 1, 1992.

There are various kinds of business conduct that might weaken or restrain competition, but couLd alsohave offsetting efficiency enhancing effects. These types of conduct present difficult antitrust casesand are usually treated under the "ruLe of reason" criteria, which expLicitly recognize that certaintypes of conduct could have positive effects on efficiency, thus offsetting any harm to competition.

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that are clearly anti-competitive.2/ And, after the implementing authoritiesgain experience and resource constraints easu, the antitrust law could be amendedto cover more complex cases of anti-competitive conduct that need to be treatedunder the "rule of reason" criteria.

63. The Peruvian antitrust legislation, while conforming with some of theabove stated principles, is deficient in a number of important areas for it to bea useful, pro-competitive and efficiency-oriented tool, and effectively inducecompetitive behavior. The main ones are discussed below.

64. Leaal treatment of business aareements. As of now, all price, quotaagreements and conspiracies are treated under the "rule of reason" criterion.Article 7 of Decree 701 enumerates an extensive (and somewhat vague) list ofexemptions of types of agreements that are allowed. Thus, to obtain conviction,it has to be proven that the purpose of the agreement was not covered by Article7, and therefore not justifiable. This is bound to cause problems for theeffectiveness of the law, as there is too much room for interpretation.

65. This is unwarranted. Price, quota agreements and conspiracies shouldbe judged "per so" illegal, notwithstanding the fact that one can find situationsor types of agreements that can be efficiency enhancing. One of them was thesubject of the Arizona vs. Maricopa County (1982) case in the US, whereby the3etting of maximum prices for medical procedures by physician groups helpedinsurers reduce uncertainty about potential claims, thereby creating a productiveefficiency, presumably of benefit to insurance purchasers. That price agreementscan yield efficiency is also shown in emerging conflicts over franchise-typeoperations. However, the rarity of those situations, coupled with the severeconsequences of most agreements, the ease of litigating "per se" cases, and itsdeterring effects, warrants the "per se" treatment of such agreements. This isnot an insignificant point. The incidence of all forms of agreement in thePeruvian economy has not been and is not negligible. They have been common insectors such as cement, fisheries, poultry, and transport.

66. At issue is how to quantify a dominant position. The standardprocedure is to associate it with market share. How to measure it and how tointerpret it is the core question in all cases concerning abuse of monopolypower, or of dominant position. After all, it is not unusual in certainenvironments that a firm with a 20% market share, can effectively dominate themarket. Moreover, the definition and measuring of market share can be a veryblurry undertaking, depending on how the market is defined.

67. It is of the utmost importance that guidelines be provided forassessment of market shares, and relevant range, particularly for dominant firm

Busirnss conduct that my weaken or restrain competition mong firm in a given market Is generallyclassified as a horizontal restrafnt. Important "horizontal restraints" include: price fixing,perallel pricing, output restraint, division of market, exclusionary practices, exchange ofinformation, predatory pricing, and restraints to entry. On the other hand, practices that may affectcompetition through arrangemnts/agreements in vertically-linked relationships (e.g., manufacturer-distributor) are referred to as vertical restraints. Examples include: excLusive dealings, refusal todeal, resale price maintenance, territorial restraint, price discriminatlon, premium offers, and tiedsales. For further details, see: Boner, R. A. and Krueger, R. The Basics of Antitrust Policy: A Reviewof Ten Natlons and the European Communities, World Bank Technical Paper No. 160 (Washington, 1991).

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and merger issues. Geographic demarcation., mourcem and destinations of supplyand demand, and closeness of substitute., all are factors to be considered whendefining the relevant market. The legislation is mute in this area.

68. Controllina Interest. It is often the came that while two firms, inthe same or related market, can be legally independent, a major shareholder(s) ofone of them has a "controlling" interemt in the other. In theme cases, for thepurpose of evaluating market power or dominant positions, those two firms in mostcases ought to be considered as one. The legislation does not address thatsituation and it should.

69. Market concentration ought to influence, but not dominate, antitrustdecisions. Moreover, although the line can become blurred, there should be adistinction between concentration arrived at through internal growth andconcentration arrived at through merger or protection. While the former could bethe result from superior performance and know-how and a reward of competitivepractices and thus desirable, the latter need not be so. The critical issue iswhether a merger is more like internal growth or more like a price agreement.The antitrust legislation could benefit from addressing merger issues. Inparticular, the issuing by the Commission, of non-binding guidelines about whattypes of mergers are likely to raise concerns and be closely scrutinized ordenied, is most warranted. Alerting with guidelines would reduce administrativeand litigation costs and hopefully act am a deterrent of clear cut cases, reducetransaction costs and thus be efficiency enhancing.

70. The principle described in Article 5, Clause d, regarding whatconstitutes an abuse of dominant position, outlaws pricing the same good higherdomestically than in markets abroad. The clause is inappropriate, particularlyif there are no protection or barriers to entry to the sector or natural monopolyconditions, and it should be removed. One can envision a whole net ofcircumstances where that pricing policy is efficient. It is perfectly acceptableto have different profit margins in different markets. The margins are triggeredby different demand elasticities. However, if there are barriers to entry orprotection, the policy should generally be to remove those barriers or theprotection.

71. On a related matter, it is also worth stressing that the antitrustlaw could serve its purpose better if it were to focus mainly on conduct relatedto non-traded goods/services markets, given that Peru's recent comprehensivetrade liberalization measures will expose domestic producers of traded goods toeffective import competition.

72. Decree 701 has a very limited coverage of restrictive practices.They are covered in so far as they are part of agreements among producers or as aresult of abusing dominant position, or am they entail forms of pricediscrimination. However, restrictions such as franchise arrangements, verticalrestraints and market foreclosure are not explicitly covered. Some of them areanti-competitive and of common usage, and can be covered under the "per so" rule;therefore the legislation should explicitly cover them. However, there aresituations where that type of arrangement would warrant exclusive dealing andtied sales (i.e., to guarantee quality), as a result of the existence of economicexternalities. In consequence, restrictions, particularly those emanating from

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franchise agreements, should be judged under the "rule of reason" criterion andtheir inclusion in the legislation could be deferred to a future date.

73. Resale price maintenance practices, a restrictive practice, is notaddressed in the legislation. There are valid defenses based on efficiencygains, for the practice of resale price maintenance, such as to establish anupscale and quality image for a product, and for products requiring laborintensive training of potential customers. Thus, in principle, a rule of reasoncriteria to judge that practice would be appropriate. However, possibilities forfacilitating litigation and those favorable occasions are few and sparse, and asthe unfavorable ones can significantly lessen competition, it is preferable touse the "per me" rule instead. The efficiency loss of that choice is smallrelative to the gains derived from a stronger deterrence effect, and from reducedtransaction costs.

74. Uneaual Treatment of Aaento. Clause (b) of Article 5 and Clause (e)of Article 6 of Decree 701 address unequal treatment of seemingly identicalagents. They state that unequal treatment by suppliers of all their dealers orcustomers is unlawful. It allows for some exclusions to the rule. That isappropriate, for there are numerous situations that warrant unequal treatmentfrom an efficiency standpoint. The exclusions are based on compensatingconditions. That is, dealers/customers with dissimilar conditions face unequaltreatment by the supplier in a compensating manner. A broader economicinterpretation --than what is stated through the exclusions-- of compensation isrequired. There are other differential situations that can warrant unequaltreatment, such as heterogeneity of agents, risk factors and different markets.In consequence, that action should be treated under the "rule of reason"criterion. The key element is the provision of equal terms to similar dealer. insimilar situations. In that case, heterogeneity would come from self-selection,and that should be not only acceptable but desirable.

75. Barrier, to entry and Drofessional activities. Agreements andpractices in professional activities, that have the effect of restricting entryand coordinating practices, should be disallowed. The current legislation ismute on the subject. A case in point is the notary profession. Since just aboutany document needs to be notarized, a concern has been raised about the shortageof notaries in Peru. Apparently, there are just 40 of them in Lima, clearly notsufficient by any standard and resulting in unwarranted delay. of businesstransactions, high costs (monopoly rents) and wasteful rent-seeking activities.It appears that a professional association is preventing the increase in thenumber of notaries. This is unwarranted. An effort should be made to free theentry of qualified individuals into that profession, or any other for thatmatter. The reglamento of D.L. 701, Antitrust Law, currently being written, isapparently addressing this issue, disallowing agreements and coordinatedpractices in professional activities. The language is important, since itmatters greatly if the violation is judged under a " per se" criteria oraccording to the "rule of reason".

76. Civil Remedies. The Antitrust legislation should provide for civilremedies and class action suits. Private parties should be able to file suitsagainst parties for violations of the Act, and to seek compensation for damagesand losses. Otherwise, the limited human resources of INDECOPI or "ComisionMultisectorial de la Libre Competencia" will not be able to properly investigateand litigate the usual flow of cases without undue delays, and might be forced to

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be selective on the cases to prosecute. The latter could lead to wasteful rent-seeking activities, harming the deterrence effect of the Act. Also, theknowledge by firms of the rights of competitors and customers in litigation andin policing behavior can also act as a deterrent. The threat of clans actionsuits, usually rewarding five times damages, increases the deterrence effect ofthe legislation. While, this policy can lead to abuses and excessive litigation,the tradeoffs are significantly favorable to warrant the provision for civilremedies. For that purpose, Article 15 of Decree 701 should be amended to allowfor private parties as plaintiffs.

77. Consumer Protection Act. Consumer protection laws should focus onproblems of fraud, standards, health, and safety, which are matters related todeficiencies in consumer information. As such, these issues are not directlyrelated to competition. However, poorly designed and vague consumer protectionlaws could run the risk of inhibiting competition and efficiency enhancinginitiatives, and could also become a vehicle for restricting import competition.

78. Peru's Consumer Protection Act, while sound overall, shows an uneasyvagueness in its clauses, which does not bear well for easy enforcement ordeterrence. For example, the responsibilities of producers or manufacturers areunclear. To what extent should they investigate potential effects of theirproducts before making them available to the general public? On the other hand,extreme interpretations of some of the clauses could be overburdening, andsignificantly increase transaction costs. For example, Article 5, clause b,states the right of the consumer to receive from the manufacturers all necessaryinformation to be able to make a decision regarding purchase and use. Or Article15, where it is stated that the manufacturer/distributor must supply appropriate,sufficient and easily accessible information about the products. The range ofinterpretations and opportunities for disagreements is quite ample, and caninduce frivolous and unnecessary litigation, which is resource consuming, andwith minimum welfare effects.

79. Unfair ComDetition Law. The objective of the Unfair Competition Law,D.L. 26122, is to deter all acts against competition in economic activities.Articles 7 to 18 describe the type. of acts covered by this law. Article 7broadly describes the content of the subsequent articles. Article 8, 9 and 10address actions to create confusion, misleading actions, lies and improper claimsof geographical origin. Articles 11, 12 , 13 and 14 addrees slander practices,improper comparisons, and wrongful imitations and associations. Articles 15 and19 concern violations of trade secrets and proprietary information, andunauthorized reproduction of third party products protected under the CopyrightLaw. Article 18 addresses discriminatory treatment of consumers. Finally, whileArticle 16 concerns inducing breach of contractual relations by third parties,Article 17 sanctions competitive advantages obtained by breach of law.

80. The motivation, effectiveness and value added of this law arequestionable on a number of grounds. First, its broad mandate and the usualrange of disagreements in interpreting what constitutes an anti-competitiveaction is bound to elicit excessive and wasteful litigation on issues, withlittle impact on welfare. Second, this Unfair Competition Law is largelyredundant and thus unnecessary. Most of the unfair acts described thereinconcern either misinformation or improper use of information to the detriment ofconsumers or competitors (Articles 8, 9, 10, 11, 12, 13, 14, 15) or violations ofcopyrights, trade marks or intellectual property rights (Articles 15 and 19). To

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that extent, those actions are covered under the publicity law, consumerprotection law and copyrights and intellectual property legislation. Inparticular, the consumer protection law is vague enough to be able to cover alarge number of the unfair actions described under the Unfair Competition Law.Article 18 on discrimination, whenever unlawful, can be covered by therestrictive practices clauses of the antitrust law or under the consumerprotection law. Article 17 is derivative since it is induced through theinfraction of any other law. There is only one act (Articulo 16: Induccion a laInfraccion Contractual) out of the 12 considered in this law, which apparentlywould not be covered by the other laws described above. However this Articulo 16is dubious and unsound and whatever bite it has it is provided in the commoncivil or tort law. In short, it is unclear why this law was enacted.

B.4 Institutional Aspects

81. INDECOPI. The Government has created an umbrella organization, theNational Institute for the Defence of Competition and Protection of IntellectualProperty (INDECOPI), with the issuance of Decree Law 25868 (November 24, 1992).It is an agency responsible for the implementation and enforcement of thelegislation intended for establishing a competitive market environment and forprotecting consumers' welfare.

82. The creation of INDECOPI has accomplished a number of desirableobjectives. It has established a watchdog for competition and free markets. Ithas also brought under its umbrella a number of offices, previously dispersed andwith little visibility, concerned with regulation. and their enforcement,affecting the efficiency of markets. It operates with apparent autonomy.

83. INDECOPI in a self-contained institution. It investigates the cases,prepares recommendations, establishes hearings and passes judgement. TheTechnical Secretariats are in charge of the first two activities, while theCommissions are responsible for the latter two. Moreover, within INDECOPI, a"Tribunal de la Libre Competencia" has been established, composed of externaljurists of high repute. Its purpose is to serve as the appeal tribunal. A party,unsatisfied with the judgement passed by the relevant Commission can appeal itscase to this Tribunal. The mainstream judicial system remain, as the institutionof last recourse. A main advantage of this structure is that, by and large, itbypasses the traditional ineffective judicial system in rendering judgements.

84. It is an organization worthy of support, and it ought to start with awell defined, constructive, clearly pro-competitive and pro-efficiency mandate.It should: (i) direct and focus its activities towards conduct that is clearlysignificantly harmful to competition and efficiency and consumer welfare; (ii)establish priorities in subject and case selection; and (iii) achieve a trulyautonomous status, with an organizational structure that will make it mosteffective, given its limited resources.

85. An of now, there are a number of issues, discussed below, that are asource of concern for the effectiveness of INDECOPI in achieving its objectives.

86. Orcanization and Jurisdiction. There are seven separate andindependent Commissions and Technical Secretariats: (i) competition-antitrust;(ii) consumer protection; (iii) advertising; (iv) unfair competition; (v) dumpingand subsidies; (vi) technical standards and non-tariff barriers; and (vii) entry

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and exit barriers. This organization of INDECOPI is excessively andunnecessarily decentralized. There is significant overlapping of jurisdictionacross the aeven Commissions and Secretariats, particularly among consumerprotection, advertising and unfair competition. Theme three Commissions shouldbe integrated into a single one. Similarly, and with even stronger reasons, theTechnical Secretariatn for those three Commissions should be integrated. Thelevel of resources, both financial and human, are relatively scarce and shouldnot be spread thin. Moreover, the integration would allow focusing the emphasison the important cases, as measured by their impact on welfare, rather than onprocessing cases to keep each Secretariat occupied.2A/

87. As of now, each Commission-Secretariat has its own budget. It isunclear how the budget and resources are allocated acroos Commicsions-Secretariats. The allocation of resources into cases or areas ought to be drivenby their impact on welfare, and this is difficult to accomplish when budgets arelocked-in for each Commission at the beginning of the fiscal year. Integrationwould allow for a better use of the resources, since it would add flexibility inthe usage of funds. It would also eliminate potential frictional problems basedon territoriality or jurisdiction among Commissions-Secretariats, which havealready begun to surface.

88. A similar case for integration, albeit not as strong, can be made forthe technical standards and non-tariff barriers (NTBs) and the dumping andsubsidies barriers Commissions, with a resulting increase in efficiency. Afterall, part of the mandate of the former is assuring that the rules of free tradeare observed and controlling whether NTBn are employed by trading partners.Moreover, complementaritien and synergies from integrated Secretariats wouldfacilitate learning, teamwork and would deliver a better product.

89. Focu This is obviously an incipient institution, with limitedexperience, both conceptual and particularly practical, and as to be expected,without yet a focus on what a competition policy should be and on how best toexecute it. Therefore, it is advisable that INDECOPI focus in this early stageon fairly clear cases of anti-competitive practices with significant economicimpact, rather than on ambiguous casse that are potentially controversial andcould become damaging to its image and credibility. The vagueness of some of thelegislation, that INDECOPI implements, underscores the importance of developingthat focus.

90. Comoosition of Commissions. It appears that all of the appointedCommission members are individuals of high repute from the professional, academicand entrepreneurial sectors. The participation of members of the latter sectoris a source of concern for potential conflict of interest problems, real or

Part of the probLm is that the reLevant legisLation has been wected pieelmel over an extended periodof time. And with each piece, the legislation required the establishment of the relevant Commissionnd Secretariat. For exaiple, the Comission on Publicity has been operating for over 18 months ihile

the Commission on Antitrust for barely three months. Also, an imperfect indicator of the ifct of thedifferent Comissions and the potential for mfisaLLocation of resources with cooartmentalized budgets,is given by the following distribution of cases reaching various Commissions in their short period ofoperation: four per month on Antitrust, forty per month on Unfair Couqetition, twelve per month onPublicity. Out of 200 cases processed to date on Publicity issues, the majority have ben settled outof court, others through resolutions of the Comission and about 20 have reached the Tribunal of FreeCompetition.

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perceived. Apparently, not more than two or throe Commissions have one suchmember. Yet, even that should be avoided. Even though they would not behandling cases in their own sectors, they obviously contribute to shapedecisions, and by affinity, towards decision that they might want to see in theirown sectors. Thus, their objectivity could be questioned.

91. Santionc The effectiveness of competition policies rests on theextent of their deterrence of anti-competitive actions. The deterrence isinduced through sanctions. The current low level of sanctions --maximum fine ofUS$35,000-- is inadequate with little deterrent effect.

92. Budaet and Autonomy. A question remains about the Institution'sadministrative capacity to enforce the decrees. INDECOPI needs to operate withautonomy and adequate resources. The procedures concerning the appointment ofthe executive are consistent with those of an autonomous institution. The levelof resources is a separate question. The legislation does not address the extentof resources to be assigned to the Institution. This ought to be resolved. Anof now, one third of its funding comes from the revenues collected from thecopyrights and patents office. The rest are government transfers. It is unclearwhat criteria is used to determine the level of funding to be allocated toINDECOPI. Significant discretion by the executive branch on determining thelevel of INDECOPI funding can jeopardize its autonomy and political independence.To preserve its image, credibility and not to create perverse incentives, thefunds collected through fines imposed by INDECOPI ought to go to the generalgovernment budget and not to INDECOPI.

93. Judicial comDetence. Enacting antitrugt legislation is a step towardcreating an environment that facilitates competition. But, for it to beeffective and serve as a deterrent of unwarranted actions, it has to be crediblyand predictably enforced. As pointed out earlier, the burden of enforcementcould be eased at the beginning, by limiting the focus of the law mainly on anti-competitive conduct that can be treated under "per se" criterion initially.However, as the law is amended to cover more complex cases of anti-competitiveconduct, particularly those to be evaluated under the rule of reason criterion,effective enforcement requires further specialization and training. To thateffect, the establishment of the "Tribunal de la Libre Competencia" as aspecialized court is most appropriate, composed of jurists of high repute, judgesor pseudo-judges (professionals trained in law and/or economics) that can handlethe complexity of competition cases.

94. Rationalization and centralization of reaulatorv aaencies.Consideration should be given to further centralizing other regulatory and marketsupervision functions under INDECOPI, particularly those dealing with thehydrocarbons sectors, where there are no major regulatory issues, excluding theallocation of exploration and drilling rights. The rationale is that the issuescut across sectors, that there are economies of scale and that there is ascarcity of human capital. For other sectors, like utilities, the issues aremore complex and there are tradeoffs. Nevertheless, in the event thatintegration is desirable, the agency could have a number of small independentunits responsible for the regulatory aspects, such as pricing or tariff structureand revisions, for each distinct regulated sector.

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CHAPTER III

ISSUES IN THE MINING, FISHERY, AND HYDROCARBONS SECTORS

1. This chapter deals with the sectoral competition policy issues in themining, fisheries and hydrocarbons sectors, and makes recommendations foraddressing these issues.l/ In all of these sectors, the Government has alreadyintroduced significant reforms to open them to private investment and liberalizethe policy and regulatory environment, with a view to establishing competitive

markets and a neutral incentive structure. The Government's emphasis onincreased competition and private sector participation (both domestic andforeign) is reflected in its major privatization program --which also covers themajor SOEs operating in the three sectors-- and improved conditions for foreigninvestment. These structural reforms are expected to lead to improvedefficiency, competitiveness, and dynamism in these and other sectors of theeconomy, as firms undertake restructuring, modernization, and adjustments inscale, quality and product-mix. In this regard, changes/reforms in the labormarket and entry/exit policies, and in the antitrust legislation along the linessimilar to those recommended in this report would be instrumental in facilitatingand reducing the costs of such structural adjustments. At the same time,additional policy reforms in the mining, fisheries and hydrocarbons sectorsappear needed to complement and strengthen those already introduced.

A. THE MINING SECTOR

A.1. Backaround

2. Mining is one of the key sectors of the Peruvian economy,contributing about 5% of GDP and 45% of merchandise exports.2L/ Copper, zinc,lead, and silver are the most important mineral exports, with copper aloneaccounting for about 22% of merchandise exports in recent years. Notsurprisingly, therefore, the sector's poor investment and output performance inrecent years affected the economy adversely.

3. As in the case of other sectors, the massive macroeconomicinstability of the late 19809, widespread labor unrest, and power shortages andunreliability were among the factors behind the mining sector's recent poorperformance. In addition, this sector was particularly hurt by the foreignexchange controls and unfavorable rates that were maintained until mid-1990.However, a serious deterioration in the performance of the state-owned mining

Regarding other sectors, policy-related competition Issues pertaining to the agricuLture sector arecovered in: Peru: Agricultural Policies for Economic Efficiency, The WorLd Bank, Gren Cover (ReportNo. 10605-PE); the Financial Sector Adjustment Loan ddressed some of the key cospetitton issues inthe financial sector. Market restructuring, privatization nd pricing policy measures needed forincreased competition in the water, transportation and telecomunuications sectors have been discussedin the Privatization Adjustment Loan documents nd in the Goverrment's policy strategy letters uriderthe SAL. Finally, a planned Electricity Privatization Adjustment Loan will cover the mrketrestructuring/competition, pricing, and regulatory policy aspects related to the electricity subsector.

These figures exclude crude oil and its derivatives.

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companies, which account for 40% of total sector output, was also a major

contributing factor to the sector's recent decline. Overburdened with multipleobjectives, overstaffed, inefficient, and financially weakened, the mining SOEs

experienced neoative net investment and sharp output declines in the second halfof the 1980m 1

A.2. Recent Reforms

4. The new Government has enacted a series of measures to deregulatemining and foster private investment. These measures include: (i) the initiationof a privatization program for the sale of mining SOEs; (ii) enactment of a newMining Law and the issuance of an umbrella mining law, covering all mining

related legislation; (iii) release, for private sector exploration, of more thantwo million hectares of land previously reserved for the state companies; (iv)

the removal of a 10% export tax in December 19911 and (v) the initiation of thereorganization and streamlining of the sector agencies to conform their functionswith the new, liberalized policy/regulatory environment, and to enhance their

effectiveness in carrying out their responsibilities --such as, collecting/generating/disseminating relevant information, and managing concessions forprivate exploration and development. The major regulations for the new mininglaw have also been issued.

5. Privatization. Decree 647, enacted in July 1991, authorized majorityprivate sector ownership of SOEs in the mining sector, and the Privatization Law

(Decree 674), enacted in September 1991, has established the legal framework for

all privatizations. On this basiu, the privatization process is well underwayfor all mining companies. Following the sale of Minera Condestable (for US$1.3million) in May 1992 and Minpeco's US branch (for US$4.1 million) in September1992,-/ Hierro Peru was sold on November 8 for US$120 million in cash and, morere-cntly Qu-llaveco, an underdeveloped mining property, was sold for US$12million.i/ Minero Peru will be sold in several units during 1993-94, starting

with the Cerro Verde unit. Centromin will be privatized either in its entirety

or by component units in late 1993/early 1994. The Bank's Privatization

Adjustment Loan and the accompanying Privatization Technical Assistance loansupport the Government's privatization program, including the mining sector's.

6. Under private uector ownership and management, efficiency and exportcompetitiveness of mining SOEs should improve. And, the measures introduced bythe new Mining Law constitute significant step. toward attracting privateinvestment and its further development.

7. Leaal Framework. The new Mining Law (Legislative Decree No. 708 for

the Promotion of Private Investment in the Mining Sector) was enacted in November

W The three mjor SOEs in the mining sector --Centromin, Hierro Peru, and MInero Peru-- and theirsubsidiaries produce 40X of the lead mined in Peru, 38X of the zinc, and 100X of the iron ore. Thefirst two were estabLished in 1975 through nationaLizatlons, nd the third was created in 1970 asvehicle for new mining development.

Minera Condestable was sold on May 26, 1992 nd the US office of Minpeco (the State trading company)on September 7, 1992.

The sales of Hierro Peru and QuelLaveco also incLude commitments by the new owners to invest more thanUSS700 million for future development and expansion.

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1991 (and incorporated also in the umbrella law "Texto Unico Ordenado de la LayGeneral de Mineria" issued in June 1992). It establishes an improvedpolicy/regulatory environment for private investment and the sector'sdevelopment, with its strong emphasis/orientation toward: policy stability, lessbureaucracy, transparency, avoidance of policy-imposed costs that would hurtexport competitiveness, the discouragement of speculative holding. of land, andthe establishment of efficient sector institutions.

8. With respect to concessions, the system is based on granting a singleconcession for both the exploration and exploitation of minerals, unlike someother mining countries where mining (i.e., exploitation) concessions are grantedseparately from exploration licenses 6/ The new Law also retains the principleof "first-come-first-served" in granting concessions, which is used and acceptedworldwide.7/ However, unlike the previous system, it introduces a "land usefee" system, with a penalty component for delayed start of production. This feeshould generate a continuous stream of revenues and curtail speculative holdingsof land, which create an entry barrier.

9. The fee (or the "mining rate") established by the Law is $2 perhectare/per year, and it remains at this rate if production starts by the end ofeighth year from the date of filing of the request for a concession./ If thetitle holder fails to start production by the stated time, the fee increases fromthe first semester of the ninth year, to $4 with the addition of a $2 penalty perhectare/per year until the year in which the concessionaire satisfies the minimumproduction obligation.9/ Continued non-compliance with the minimum productionrequirement will increase the penalty rate, from the fourteenth year, to $10 andthe total rate to $12 per hectare/per year.l1/

10. Under certain conditions, the Law also guarantees mining companies:(i) tax and administrative stability and the right to operate under the sameforeign exchange laws effective when the operations started; and (ii) the sametreatment as other companies regarding the right to remit profits, free access toforeign exchange and free marketing of production, both abroad and locally.

In Bolivia, Chile, Colombia, Mexico and others, mining concessions are granted automatically toexploration licensees who are up to date in their fees and request the concession. However, in Brazil,the approvaL of the mining concession is Left to the discretion of the authorities.

7/ Concessions are granted for Land sizes ranging from 100 hectares to 1,000 hectares.

There is no separate mining concession fee. Also note that the mining rate is set at Si for the small-scaLe producers who are titleholders of non-metal concessions (ArticLe 29). Under the Law, small-scaleproducers are those with concessions covering up to 5,000 hectares and production/treatment capacitynot exceeding 350 MT/day in the case of metal or, and 500 MT/day in the case of non-metallic minerals(Article 45).

The Law defines the minimum production obligation in value term, equivalent in national currency of$100 per year/per hectare granted for metal substances, nd $50 for non-metalLic substances (Article28).

°Ot Concessionaires may be exempted frm the penalty if they could show that they have invreted at leastten times the amount of penalty in the previous year (Articlo 31). Also, the penalty rates are set athalf of the normal rates for the small-scale mining producers (Article 30).

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11. In order to be eligible for the tax and other policy stability,concessionaires must enter a contract with the State,'I/ submitting aninvestment orooram for the equivalent of US$2 million. 2 i/ With this contracted"minimum investment program", the Law then guarantees contractual stability inthese policy areas for a period of ten years, starting from the year in which thetitleholder prove. that investment has been made. The period of tax/policystability is extended to 15 years, if the minimum investment reaches US$ 20million (or US$50 million if it is undertaken by the exictino companies or bythose that buy state-owned enterprises) .U/

12. Regarding mining policies in other countries, land rental fees havebeen adopted in many mining countries. For example Australia, Canada, Chile, andMexico use exploration fees of US$0.80-2.00 per hectare and mining concessionsfees of two to thirty times higher per annum. And, some countries also have aone-time application fee (e.g., $500 in Australia) as a compensation forgovernment processing costs. In addition, Australia, Mexico, and Canada alsorequire minimum work of up to five to ten times the amount of land rental feesper year.14/ The basic principles that are guiding these rates, aside from therevenue objective, are that: the processing of concession requests for availableland should be done promptly and the processing and survey costs should berecovered through application fees; the land rental fees should be high enough toattract serious investors, while not discouraging newer/growing companies; andthe rates should be structured in a way that any extension of the explorationperiod beyond 5 or 6 years should become costly to prevent speculative holdingsfrom becoming entry barriers.

13. By and large, Peru's new mining law establishes entry rules that arein line with the above stated principles and comparable with the regimes of othermining countries. However, one positive aspect of Peru's system is that thegranting of concessions is not linked to "minimum investment" requirements.Concessions are granted without restrictions, while minimum investments arerequired if the mining companies want tax/policy stability. Nevertheless, it isworth emphasizing that the public resource costs of monitoring minimum workrequirements could become considerable, especially if many companies choose tohave guarantees of tax/policy stability. Moreover, they could also createopportunities for corruption. Another important issue that might emerge inrelation to such a contractual stability arrangement concerns the possible non-neutrality of incentives when the regime is implemented in a discriminatorymanner in terms of its coverage of firms and sectors. (This issue is picked upagain below in the recommendations section).

IV Articles 7-16 of the Mining Low (Legislative Decree 708).

The mgnitude of minimm investment is set at half of this amount for samlL-scaLe mining.

Article 11.

IY Note that uctioning mining concessions as a way of gnerating up-front revenue does not appear to bepreferred by the mining countries. Possible *xplanations include costs of organizing frequentauctions, likelihood of collusion, nd political senitivity shown to the one-tim reven outcomes.There is also the issue of how uch informtion Is needed to hold auctions. Aveltable knowledge aboutthe country's mining potentil nd expected trends In the world mineral prices at the ti_m of auctionswould be factors affecting the results. However, only the mrket could tall how much such uctionswould generate.

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14. New measures affectina export comDetitiveness. The new Mining Lawhas also introduced measures that will improve export competitiveness of themining companies. A drawback system was introduced (though not effective yet),allowing mining companies to deduct domestic indirect taxes from their incometaxes, for both exports and domestic sales made at prices that are in line with

international prices. This regime will put mining companies on a duty-free basisand remove the existing disadvantage vis-a-vis the non-traditional exports. The

Law also allows the deduction from taxable income of costs of investments ininfrastructure that are considered as providing public service. Moreover, thelatter type of infrastructure, as well as assets used by the titleholders ofmining activities to provide obligatory housing, health, and education services,will no longer be considered as part of the tax base for the 2% gross assettax.1k/ Finally, under a transitory provision of the Law, mining companies wereallowed to deduct 55.6% of the total contributions made to the health serviceregime to offset the expenditures that they incur in providing obligatory healthcare serviceg.lI/ And under a recent Supreme Decree (No. 020-93-EM, issued inMay 1993), the latter temporary rate was replaced by a permanent rate structure,ranging between 30% and 80% according to categories of health assistance centersof the enterprises.

15. These measures should improve the cost competitiveness of Peru'smining companies in export markets. Indeed, they will help offset, to someextent, adverse effects on mineral exports of the prolonged appreciation of thereal exchange rate in recent years. This is important because, despite aconsiderable depreciation of the real exchange rate since March 1992, it might besome time before the real exchange rate reaches levels that should be observedwhen macroeconomic balances and real interest rates reach sustainablelevels .17/

16. Institutional restructurina. The sector institutions are presentlybeing streamlined. In general, the functions have been clarified and theresponsibilities have been distributed more rationally between the differentinstitutions, and their personnel reduced. Further improvements will be neededto enable the sector institutions to execute their responsibilities efficientlyand timely. This process is being supported by the Bank through the Energy andMining TA Loan (see Chapter I).

17. Regarding financing of the sector institutions, the new Mining Lawhas established a source for a steady stream of income for the two key sectorinstitutions. Accordingly, 30% of the funds collected from mining rates andpenalties, which are considered own-funds, will be given to Instituto GeologicoMinero (INGEMMET), and 15% to Registro Publico de Minera (RPM). The former

iF Article 2 of Decree 708.

For companies that do not provide surgery services, the reLevant rate is 44.4X

IZs Peru's export competitiveness is certainly reduced by the appreciation of the reel exchange rate.However, Peru has a fLoating exchange rate system, and intervention in the foreign exchange market bythe Government to reverse the situation could be detrimental to efforts *imed at stabilizing themacroeconomy, given the high extent of dolLarization and Limitations on how much the Goverrwent canimprove its tax revenue performance in the short-term. Therefore, it wouLd be prudent to let thestabiLization progrm nd economic recovery move the reaL exchange rate towards its sustainable level.

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agency iu responsible for geological surveys, mapping, mining research andtechnology. The latter, acting on behalf of the State, is responsible forregistering all mining rights, documents and contracts including legal andadministrative decisions related to mining rights, and for the management of theprocedures related to the registration of concessions.

18. Efficient and timely provision of services by these agencies willcontribute to the sector's development. Geological information being collected,generated, and distributed by INGEMOET is important for the Government in makinginformed policy decisions and entering mining contracts. Such information alsocontributes to the sector's competitive environment by filling a major gap,particularly for smaller mining companies which may not have in-house capabilityto carry out their own geological surveys, as done by larger enterprises.Indeed, to ensure their timely supply, some of the mapping and informationgeneration work should be contracted out to private firms. Similarly, anefficiently functioning RPM will help reduce the transaction costs for miningcompanies, which, in turn, will contribute toward their export competitiveness.

19. Undoubtedly, the Government's recent reform measures constitute majorsteps toward establishing an open and competitive mining sector. The followingrecommended steps would strengthen this drive.

A. 3. Recommendations

20. Indexation of minino rates. As currently defined, the mining rates(i.e., the land rental fees) to be paid by the exploration/mining concessionairesare fixed in nominal US dollar terms. Linking the mining rates to, say, the USexport price index or the export price index of Peru's major trading partners,should be considered.11/

21. Minimum work reauirements. As pointed out earlier, minimum workrequirements are generally instituted by mining nations to ensure that thetitleholders undertake exploration investments and start developing the newmines. These objectives could also be achieved with an appropriately designedland-use fee regime, without incurring substantial administrative costs ofmonitoring work requirements. Higher and rapidly rising penalty rates that comeinto effect after a reasonable period of exploration period (say 5 or 6 years,rather than 8) would push serious companies to move quickly anyway. And thosethat may have speculative motives would not be able to afford to keep the landfor long periods.

22. In Peru, however, minimum investment requirements are currentlylinked to tax/policy stability. But, the international mining companiesoperating in Peru do not see the minimum investment requirement as a problem,since the latter becomes a condition only if companies want to have thetax/policy stability. In fact, they see it as a condition that they would preferto satisfy to have the tax/policy stability guaranteed by the new Law as a ouidpro ouo under the contractual stability regime it has established. Such stance

BY Note that, in the absence of Indexation, erosfon of the resl voLue of land rentaL rates, because ofdeclines in the purchasing power of the doLLar, wI1L not onLy reduce their proceeds In resl term, butalso weaken the role of mining rates as a vehicle to discourage specuLative holdings of mining areas.

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on the part of international mining companies is not surprising given Peru's (forthat matter those of many developing mining countries) track record on sustainingpolicies. And, Peru may need to agree to such policy stability requests in the short-to medium-term in order to attract foreign investment. Nevertheless, after asatisfactory degree of macroeconomic stability is achieved and its sustainabilityis secured, economic recovery takes a hold, and the new tax regime is firmlyestablished, the Government should consider eliminatina the minimum investmentreauirement, since, under a stable policy environment, mining companies may notsee a need for a policy stability guarantee anyway (as observed, e.g., in Chile).This change would cut unnecessary administrative expenditures of monitoringmining investments and, also, would reduce transactions costs and possibilitiesof poor investment planning on the part of mining firms.

23. It must be emphasized, however, that none of the sectors shouldemploy discriminatory policies vis-a-vis other sectors in the economy. Clearly,there are many sectors where degree of risk is high, and policy instability is acommon concern for both domestic and foreign firms in all activities. Therefore,any discriminatory application of the tax stability regime should be discontinuedamong firms and across industries, while its implementation is deemed necessaryto encourage investment and stimulate growth. However, the best solution tolegitimate concerns of foreign and domestic investors about perceived uncertaintyof economic policies, including the tax regime, is to establish a stable policyenvironment and an incentive-neutral and equitable tax system. Requiring minimuminvestment for tax stability guarantees is not a practical long-term strategy,particularly when monitoring costs are considered.

24. Costs of obliaatory social services. Representatives of the privatesector firms in Peru --domestic as well as foreign-- stated that they need toprovide social services, whether they are required by law or not, because of ageneral lack of infrastructure in many mining areas. By raising labor costs,these services obviously are affecting export competitiveness of miningcompanies, to the extent that similar services are not directly provided by theemployer in other mining countries. There are certain steps that could be takento offset some of these costs, on grounds of incentive neutrality and equity intreatment with respect to SS programs or taxes. Such measures would certainlyhelp the sector's export competitiveness.

25. As stated above, under the new Law and a subsequent Supreme Decree,mining companies are now allowed to retain 30%-80% of total health care (HC)contributions (i.e., 8% by the worker and 1% by the employer), the highestretention rate applying to firms that are most likely providing full HC services.This is clearly an improvement, though it falls somewhat short of the desirablechange. That is, given that mining companies are required to provide HCservices, they should be treated as private sector providers of such services andbe allowed to keep aU of the HC contributions, if they are providing fullservices (i.e., including operations). Obviously, in introducing the 30%-80%retention range, the Government has decided to establish a HC contribution regimefor the mining sector that would be in line with the new complementary SS systemexplained in Chapter II, which incorporates a 1% obligatory "solidarity

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contribution" by the employer and the contribution of the worker to IPSS.12 /Accordingly, now, a mining company that is providing full HC services, will pay20% of the total HC contributions to IPSS, basically financing services providedgenerally to non-company workers. However, once IPSS adjusts to the new systemand its financial situation improves, allowing the mining companies with full HCservices to retain all of HC contributions should be seriously considered.

26. A similar argument also follows, in an indirect way, in the case ofeducation services. Given that taxes collected, including those paid by miningcompanies, are used also to finance education, mining companies should get somerebate for the expenses that they are incurring in the provision of schooling forthe children of their workers, say, in line with the average expenditure perstudent for compulsory education. They could deduct this from their income taxliabilities. Also, at least some part of housing costs could be shifted tolabor.

27. Privatization and investment re2uirement. The Special Committeesresponsible for preparing mining SOEo for privatization appear to have adopted astrategy of requiring potential buyers to undertake a certain amount ofinvestment as a condition of sale. The argument is that such a condition willensure that buyers will undertake investments needed to improve productivity ofthese enterprises. However, the issue is that the amount of required investmentmay not be consistent with magnitudes that potential buyers might consider asappropriate to maximize their long-term profits. Moreover, after taking over themanagement, a new owner will be in a better position to refine investment plans.

28. In the absence of any investment requirement, it could be safelyargued that buyers make their bids in buying a SOE on the basis of their expectedprofitability, taking account of expected price trends, sales, neededrestructuring/rehabilitation and/or expansion investments and other factors. Inother words, they would already have an investment program that they view asoptimizing when they make their price offers. To the extent that requiredinvestment is compatible (in terms of size and structure) with what is beingcontemplated by the potential buyers, then bidding outcomes, production andinvestment decisions of the buyers may not be affected by the investmentrequirements. Otherwise, investment requirements viewed as sub-optimal willaffect bidding prices accordingly. Moreover, such investment requirements mayalso create problems for the new owners down the line, particularly, if they turnout to be substantially off the mark (due to unanticipated variations in theworld prices, the development of lower-cost technologies, etc.). After all, oneof the reasons why privatization is taking place worldwide is the confirmedcomparative advantage of private firms in managing enterprises especially incompetitive markets.

29. Therefore, we recommend that, if the Government considers inv-stmentrequirements as "essential" for the public's support of sales, the authoritieskeep such investment requirement levels at very low levels, so that they do notbecome a distorting factor. Otherwise, they should not be included as acondition of sale, or as a factor in selecting the winning bidder.

IV This is simply because aLl activities wiLl be subject to the same minimum "basic" HC coverage to be"provided" by IPSS.

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B. TMN FISHERITB SECTOR

B.1. Backaround

30. The marine waters off Peru are among the richeut in the world, andprior to the 1970s, Peru was one of the world's top fishing nations. However,the sector has declined significantly over the last twenty years an a result ofincreased state intervention and losses caused by the El Nino warm water currentof the early 1970. and the early 1980s, which dissipated the important anchovycatch. The fisheries sector provides an important contribution to Peru's exportearnings, ranking second after mineral exports. Notwithstanding its decliningshare in GDP from about 1.9% in 1970 to 1.2% in 1990, the sector's share in totalmerchandise exports has averaged about 15% in recent years, with foreign exchangeearnings amounting to about US$0.5 billion and fishmeal exports accounting for85% of this. Peru has 17% of the world market for fish products.

31. The main species have been anchovy and sardines, which are usedpredominantly (over 90% of all catches) for fishmeal and fish-oil. The SOEsector is responsible for 37% of the total fishmeal production. Overallefficiency in the sector is low, with an average fish to fishmeal ratio of5.13:1, as compared to the worldwide average of 4.78:1. The public sectorinvolvemeht has been one of the obstacles in the sector's development,particularly due to limitations Imposed on the private sector's participation inthe processing activities and inefficiency in business management, which hurtPeruvian fisheries' competitiveness. 2g/ Until very recently, Pescaperu (theprincipal SOB) had a monopoly over the production of fishmeal directly from thecatches, and private firms were allowed to produce fishmeal only if they hadcanneries.2I/ This meant that, for fishmeal production, private firms had touse fish remains and/or fish unfit for human consumption. Some private firmsmight have chosen to invest (or over-invest) in cannery plants in order toproduce and export fishmeal.

32. Apart from the inefficiency of the sector, there is a serious problemof over-fishing, due to the absence of an effective Fisheries ResourcesManagement Regise (FRMR) that would ensure biological sustainability as well ashelp optimize economic benefits for the country. The existing "open access" with"Total Allowable Catch" (TAC) system,i/ while allowing competition in fishing,

The State controls six enterprises in the fishery sector. The primary enterprise, Pescaperu, wascreated In the early 1970s and soon thereafter acquired a monopoly in the fishmal industry throughtakeover of 99 fishmeal plants. Subsequently, as Pescaperu's financial probLems mounted, som of theseplants were either closed and/or their machinery was soLd to private firms, which were alLowed toproduce fishmeaL under certain restrictions (see the text). The company is presently losing USS16 forevery ton of fishmeal produced. It presently owns 20 operationaL processing units, one guanofertilizer plant, nd four fish-oil refineries. For dditional details pertaining to Pescaperu andother SOEs in the fisheries sector, see: Peru: Sector Reform and Investment Review, The World Bank,November 1990, Chapter Xi.

21V That is, if they were producing canned fish for human consumption.

W2' Under an open or free access system, there are no limitations on the size and number of fishingvessels; Licenses are Issued freely. And, the authorities try to achieve the biological sustainabilityobjective by setting limits on the total mount of catches, usually on anual basis, by establishingTAC levels for individual fish species. Marine biologists determine the magnitude of TACs. (See thearnex to this chapter for further details).

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has encouraged an over-expansion of fishing and processing capacity, leading toinefficiency and declining export competitiveness. Inefficiency results as boatowners compete with each other for catching a larger share of TACs throughincreased fishing *ffort.21 / That is, the cost of extracting a given amount ofTAC increases. Currently, Pescaperu's annual installed processing capacity isabout 9.5 million MT of fish, and it used only about 23% of this capacity in1991. The private s*ctor's fishmeal capacity is about the same (9.1 millionMT/year), and the realized capacity utilization was 43% in 1991. In fact,against the total installed processing capacity of 18.6 million MT/year, in 1991,the TAC of anchovy, sardines and mackerel together amounted to only 6.1 millionMT.2A/

B.2. Recent Reforms

33. The Government has recently accelerated structural reforms in thesector. An international conference was held in June 1992 to discuss theexperience of other countries in fisheries resource management and privatization,and to provide the basis for the preparation of the new fisheries regime and lawfor Peru. A new Fisheries Law was issued on December 22, 1992 (Decree Law25977). The law provides a modern legal framework for the fishery sector andalso paves the way for the introduction of a workable FRMR .2W

34. In the policy area, Pescaperu's monopoly of fishmeal productiondirectly from catches was eliminated, as was Epnep's monopoly of wholesale fishdistribution, and Cerper's monopoly over the supervision of the quality of fishproducts.2 i/ The sector was opened to foreign investment, and the privatesector was put on an equal footing with the SOE sector.27/ In addition,

Jr That is: engine size and hoLding capacity of vessels, fishing gear, fishing time, days at sea, andnuiber of vessels.

29 Sources: IMARPE and National Fishery Association.

zv Sowe of the basic principles incLuded in the new Fisheries Law are the folLowing: (i) Fishery resourcesbelong to the state, nd the Goverruent has a responsibility to regulate their exploitation; (ii)fishing activity will be nmnaged so as to ensure suBtainability, consistency with biodiversity andpreservation of envirormnt, nd optimization of economic benefits; (ili) to achieve these objectives,the Ministry of Fisheries could introduce alternative fishery anagement systems; (iv) artisanalfishery activities (which are small scale and for local consumption) will be supported -- exactly howthis will be done is not spelled out by the authorities; (however, it is clear that the Governmentshould avoid extending discriminatory incentives); (v) rules to be adopted for rational exploitationwithin the 200 mile Economic Exclusive Zone (EEZ) will also be extended to catching of migratingpecie in the international waters; and (vi) fishing by foreign vessels will be complementary to

domestic fishing activities and shall be subject to this law, its regulations, and internationalagreements.

iRS was established In 1970 with the monopoly of fish distribution at wholesale level, to ensure thesupply of fish for huwan corsumption, especially to low income groups. However, de facto, Epsep couldnot establish a complete monopoly because of financial constraints, which limited its networkexpansion. C aer, a previously privately-owmed firm which was expropriated in 1970 and given amonopoly over fish product certification.

A new decree related to the promotion of investment in the fishing industry (Legislative Decree 750)was enacted in November 1991 nd became effective in December 1991. The latter has eliminated mny ofthe barriers that affected the private firm, including Pescaperu's ionopoly over fishmeal production;some of these barriers had been established under the previous Fishery Law (Law 24790, in effect fromJanuary 19U8 until end-1992), including those on foreign investment. The Cenerat Framework L. forprivate investment promotion (Legislative Decree 757, enacted in November 1991 and effective since

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maritime work has been liberalized, resulting in lower port costs (which had beenthe most expensive in the world).

35. Privatization of the state fishery companies is progrossing quickly.The Government had already announced the liquidation of FlopescaAi/ And,following the announcement by the Minister of Fisheries of the privatization ofPescaperu in June 1992, preparations are currently underway for itsprivatization.

36. These reform actions establish a free environment for domesticcompetition, and they should help strengthen Peru's export competitiveness. Thecritical task that remains for the Government is to introduce an appropriatelydesigned FRMR and the needed regulatory framework. Under an ineffective "openentry/TAC" system, Peru's two key pelagic species --anchovy and sardines-- arefacing a serious overfishing problem, endangering the sustainability of yields.A new FRMR is needed to ensure biological sustainability within a competitiveenvironment, as well to promote economic efficiency in fishing. Various regimeshave been tried by the fishing nations, and since the early 1980s, the trend hasbeen toward establishing "rights-based" regimes, with an encouragingsuccess.29/

37. In 1983, New Zealand and Iceland introduced the so called "IndividualTransferable QuotaO (ITQ) system, paving the way also for the development ofother "rights-based" fishery management regimes.23/ The ITQ system, designed togive fishermen the proper incentives, has produced good results in terms ofreduced fishing effort, extended fishing period, increased quality, andsubstantial increases in revenues.

38. An ITQ, when defined as a share of TAC, represents a right to catchthat proportion of TAC announced for a certain fish specie. When they are issuedas permanent entitlements, ITQs constitute full-fledged property rights, and thisis what constitutes the proper incentive for fishermen. Principal reasons whyITQs have shown success in countries where they are being implemented include thefollowing:

(i) Quantitative controls (i.e., TAC quotas) safeguard fish stocks;

(ii) they eliminate the common property nature of fish stocks inharvestina activity by creating private real property rights;

December 1991) has estabLished the equality of conditions for SOEs and the private sector firms. And,the Foreign Investment Prootion Lav (Legislative Decree 662, enacted in Septewber 1991) has removedall sectoral restrictions, incLuding those of the fisheries sector, on foreign investment.

28/ Flooesca was created in the mid-1980s, with a fLeet of fishing boats, as a subsidiary to Epsep, withthe objective of suppLying the domestic market with frozen fish.

29/ See Annex to Chapter 111, for a brief review of the evolution of various fisheries management regims.

30/ Similar rights-based programs are now being adopted by other nations, incLuding Australia, Canada,Chile, Norway, and the U.S.A., depending on the nature of their coastal areas, enforcementdifficulties, diversity of species, etc. Spain and Chile, for example, have alLocated their coastalwaters to fishermen's cooperatives, thus establishing Oterritorlal uBe rights and relying on salf-policing by the cooperatives.

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(iii) their transferability allows efficient fishermen to take over thefishing activity; and

(iv) in conjunction with TACs, ITQs establish sufficient certainty aboutpotential catches, thus allowing economic units to choose optimalamounts of factors (capital/technology and labor) and timing, whichin turn lead to cost-efficient fishing.

39. Concentration in the ownership of ITQs --both in terms of number ofoperating units and regional--ie a likely trend, and this is one of the drawbacksof an ITQ system. However, this tendency could be countered by introducinglimits on ownership, for example, as done in Alaska (1% for sablefish, and 0.5%for halibut). To limit regional concentration, special allowances fordisadvantaged areas, particularly for small fishing communities, are also beingused in some countries, though these would not be first-best solutions foraddressing regional development issues.

40. Other potential problems associated with an ITQ system include:fishing over quota, poaching,aU/ high-grading,U/ and by-catching.fl/Containing the extent of these problems would, of course, require effectiveenforcement and judicial systems.

41. In the Peruvian context, these problems will either be not so seriousor it will be possible to contain them through a relatively simple (and cheap)enforcement system. Principal reasons for this include: (i) the fact that onlyanchovy and sardines are currently the overfished species in Peru and an ITQsystem needs to cover only these (and, perhaps, also hake) initially; (ii) thereare only a limited number of vessel landing spots (about 10) along the 2,000 milePeruvian coastline for these pelagic species; and (iii) landing records, fishmealproduction and export data will provide sufficient information to verify catchrecords. These conditions make Peru a suitable place to implement an ITQ system.

B. 3. Recommendations

42. Given the Peruvian conditions, therefore, an ITQ system isrecommended as an appropriate Fisheries Management System (FMS) for Peru. Itachieves both the *ustainability and economic efficiency objectives in theexploitation of fishery resources. Some of the specific conditions andaccompanying measures include:

3t1/ Fishing illegally, i.e., without a quota allocation.

That Is, throwing overboard lower quality catch before landing.

Catching of species other than those covered by the ITQ regime.

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o Individual quotas should be established for each fish specie coveredby the ITQ regime.l/ and based on shares in TAC rather thanabsolute magnitude. .3/

o Consistent with the law, regulations and guidelines should be issuedon the ITQ system, establishing it as the (FMS) in effect.

o The other two essential componento of FRMR should also be put inplace: an enforcement system (i.e., appropriately designedmonitoring, control, and surveillance --MCS--mechanisms) and afisheries iudicial ystem. All three components are important for aneffective functioning of any FRMR.

43. Regarding the initial distribution of ITOs, the Government may chooseto sell them to fishermen (boat owners) and processors through auctioning undercompetitive conditions. This will transfer potential rents to the Government up-front. Another option, which was adopted in New Zealand and Norway, is todistribute them free to existing boat owners on the basis of catch records of,say, past three years.ei/ One advantage of this option, which could bejustified on the basis of "historical rights", is that it could generate theneeded support for the introduction of an ITQ system.37/ A third option is toauction ITQs to only the existing vessel owners and processors, thus recognizinghistorical rights and, at the same time, transferring potential rents to theGovernment. Another possibility involves the distribution of ITQc to existingboat owners/processors on the basis of historical rights, but for a one-time feeof, say, 10-15% of estimated potentials rents2 8/ to generate some financialresources to meet the initial cost of efforts needed to modernize and strengthenthe marine institute, IMARPE.a2 / The final selection will be a politicaleconomy decision by the Government. Choosing the option that is most likely tofind some support might be the practical route to follow, because what is reallyimportant is to establish a sound FRMR that will promote efficiency andsustainable exploitation. Collection of a small annual fee from vessel owners

ay In New Zealand, ITOs are both specie- and area-specific.

Given that TACs couLd fLuctuate for species covered by the FNR, it wouLd make sense to specify ITQs asshares rather than absolute amounts. New Zealand's initial ITO system was based on absolute amountsnd this created Legal problems when TACs were adjusted downward. Indeed, the fishery authoritiesbought back some ITQs. Subsequent adoption of a share-based ITQ system has Led to legal actionsagainst the authorities by the fishermen who were cleiming that their "property rights" were violated.

li' Some portion of ITOs couLd also be allocated to fish processors.

37J In any case, the existing fishermen could caim legal entitlement to ITQs on the basis of 'historicaLrights".

This marine research institute wIll play a crucial role in support of the FRMR by collecting andprocessing information on catches, gathering its own independent data nd making projections on stocksand yields, estimating yearly TACs, nd conducting scientific and technical research.

Note also that, even in cases where the government does not extract all potential rents, "coaonownership" and "frees" distribution of individual property rights in the form of ITQs could still becompromised if an effective FNS is implemented. Whole population couLd benefit from sustainable ndmore efficient *xploitation of fishery resources through increased value added and foreign exchangeearnings.

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and processors should also be considered to generate a continuous flow of revenuefor the sector institutions.

44. It should also be pointed out that once an ITQ system is put in placeand an effective MC8 mechanism is *stablished, the need for controlling thefishing effort should also disappear, since fishermen would use the moatefficient method of catching a specific amount of fish in each period anyway. Inthis regard, amendment of Article 24 of the new Fisheries Law should be seriouslyconsidered to eliminate such controls by the Ministry of Fisheries when an ITQsystem is introduced.

45. A related policy recommendation concerns the fishmeal Drocessinacapacitv There appears to be a shared view among at least some of the privatesector firms already operating in fish processing activity in Peru that there isexcess capacity in the fishmeal subsector and that some form of control overcapacity expansion should be introduced. There have been even suggestions madeby the private sector representatives that some of Pescaperu's plants should notbe privatized as whole units, but rather the equipment should be sold separately.

46. A policy of controlling entry or capacity expansion in the fisheryprocessing activity will lead to monopolistic practices and protection ofinefficient producers. Such an entry control is no recommended. Moreover,under an effective FRMR, competitive pressures will lead to dynamic adjustmentsin the fishery downstream activities, thus eliminating uneconomic excesscapacity. In this regard, amending Article 28 of the new Fisheries Law shouldalso be considered to remove the possibility of controls over processing capacitythrough regulations.

C. TEM HYDROCARDOUS SCTOR

C.1. Background

47. Peru's oil and gas sector, which accounts for about 5% of GDP,declined sharply during the 1980c. Domestic production fell from 195,000 barrelsper day (bpd) in 1982 to 135,000 bpd in 1989, and the country shifted from beinga petroleum exporter to a net importer (USS 150 million in 1991). Known reservesdropped by 50% from their peak level in 1982 to 300 million barrels (enough forless than 9 years at current consumption levels) as investments in explorationand development also declined sharply.

48. The sector has been heavily state-controlled. The major state-ownedcompany, Petroperu, is directly responsible for 36% of Peruvian oil production(40,000 bpd) and for the supervision of the remaining 64% which is produced byforeign companies under service contracts with Petroperu. Until recently,Petroperu had a monopoly on all trade (export and import), transport, storage,refining and retail distribution of all petroleum products. Many of theseactivities were carried out by wholly-owned subsidiaries, including Petromar(operating the nationalized ex-B-lco offshore fields producing 20,000 bpd),P-trolera Transoceanica (oil shipping), Solgas (liquified petroleum gasdistribution, with 40% of the market), and Serpetro (drilling service). Totalassets for these holdings (including Petroperu) amount to roughly US$885 million

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(1991 book value). Retail distribution used to be carried out primarily byprivate operators under Petroperu franchise.

49. In addition to its dominance in upstream and downstream activities,Petroperu also carries out many policy/regulatory functions normally handled bygovernment ministries/agencies in other countries, including: direct negotiatingand signing of all contracts and concessions with foreign oil companies forexploration/development; and collecting taxes from private operators on behalf ofthe Government.

50. The sharp decline in the sector was a direct result of an inadoquatepolicy, legal, and regulatory framework implemented by prior governments, whichprecluded competition and private investment, and controlled product prices beloweconomic levels, thereby contributing to a severe deterioration in the financialposition of Petroperu.4u/

C.2. Recent Reforms

51. The Government has implemented many reforms to deregulate the sectorand encourage private investment. Legislative Decree No. 655, issued in August1991, eliminated Petroperu's monopoly powers over downstream activities(importing, refining, storage, transportation, distribution) and modifiedprocedures in upstream activities to facilitate the contracting out ofexploration and development to the private sector. With respect to pricing, inAugust 1990, domestic gasoline prices were increased by 3000 percent. Retailprices for 84 octane gasoline are now roughly US$2/gallon, though a large shareof it reflects indirect taxes.- / In June 1992, a decree was issued, formallyderegulating petroleum products prices. However, the Government has maintainedde facto control over prices received by Petroperuil/, pending theimplementation of the new legal framework for the sector which will redefinePetroperu's new relationship with the Government, including the taxation of rentson local crude production and of profits. In December 1992, the Government alsoenacted a decree, which modified the existing system of indirect taxation ofpetroleum products (details are given below).

52. A new draft hydrocarbons law has been prepared and was approved bythe Energy Commission of the Congress in June 1993, following its review by theCabinet. It in expected to be discussed on the floor of the Congress shortly.The new law would fully liberalize the sector, transfer the policy/regulatoryfunctions of Petroperu to the Government, and establish new contractualarrangements between the Government and petroleum companies. Further changes inthe indirect taxation of petroleum products and taxation of rents in crude

The company currentLy has negative not worth nd has accumuLated Losses over the Last three years ofUSS 2 bilLion. As a result, it has been unable to finance normal maintenance nd expLorationexpenditures.

Net prices received by Petroperu (i.e., ex-refinery prices before domestic indirect taxes) haveremaired beLow import parity prices (i.e., cf prices plus 15X import duty) for most products.

42/ In ApriL-May 1993, Petroperu received an average price of US$0.45 per gallon of all petroLeu products,about 34X Less then the USS0.61 per gallon average internatlonal parity price. Part of this differencereflects the extraction of rent by the Goverrment on domestic crude production.

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production have been designed by the authorities, and their adoption is alsobeing considered.

53. In parallel with the policy/regulatory reforms, the Government hasbegun privatizing Petrop.ru's gas stations, asphalt refinery, and foursubsidiaries --Petromar, Solgas, Serpetro, and Petrolera Transoceanica. To date,78 of Petroperu's 82 gas stations have been sold for US$ 38.5 million. Solgaswas sold for US$ 7.5 million on August 21, 1992. Petromar was sold in February1993, for US$200 million in lease payments over 20 years, plus 21.13% of thecrude oil and gas extracted. In parallel, the authorities have examined optionsfor privatizing all of Petroperu, and they are expected to finalize shortly animplementation plan .4 2/

C. 3. Recommendations

54. To complete the liberalization of the sector, timely introduction ofthe planned reform measures is also important.

55. Leoaal/reaulatorv environment and comoetition. An early enactment andimplementation of the new hydrocarbons law and its regulations is important for:establishing unrestricted competition in all upstream and downstream activities;defining a new policy making and regulatory role for the Government in thesector, limiting the Government's role to determining sectoral policy, strategyand contracts with the private sector.il/ The new legal framework would alsofacilitate shifting Petroperu's relations with the Government to a fullycommercial basis (identical to private firms), and enable equal treatment ofprivate petroleum companies and Petroperu with respect to indirect/direct taxes,royalties and concession fees. It would also pave the way for fullliberalization of petroleum prices. These developments would also accelerate theprivatization of Petroperu's holdings.

56. ComDetition and privatization of the storace and handlina facilities.one of the most important steps that needs to be taken very soon, in order toestablish the necessary conditions for attracting private sector and promotecompetition, is to irreversibly deregulate before-tax ex-refinery prices. Unlessthis is done, the entry of private firms into the sector will be discouraged, andPetroperu'* monopoly position will continue. GOP appears to be contemplating anearly decontrol of petroleum prices, and this step will most likely take place atthe same time as the introduction of further changes in the petroleum tax regime.

57. While Decree 655 ended Petroperu's monopoly in refining and otherdownstream activities, it may take some time before the private sectorestablishes itself in these activities, including the critical areas of storageand handling facilities. Positive effects of the liberalization of foreign tradeand of eventual de facto freeing of domestic prices of petroleum products might

Potroperu's privatization, due to its size, nature of its activities, nd political sensitivityinvolved, is going to be a challnoing process for GOP.

Redefining the Govcrnment's roLe would also involve the transfer of Petroperu's functions as sectorpolfcy _ker, reguLator, tax coL ector and promoter, and as owner of the country's oilt resources to theGoverrwent.

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be restrained due to Petroperu's still dominant role in theme activities.Liberalizing imports may not help much, if private firms cannot have access tothe existing storage and handling facilities until new capacity is developed. Itin important, therefore, to privatize Petroperu's depots and marine terminals ina timely fashion.

58. A strategy for the privatization of these facilities --taking intoaccount their location, size, proximity to distribution centers and refineries--ha. been prepared by a Bank consultant and discussed with the Governmentofficials. The strategy also recommends that, in view of the possibility ofmonopolistic settings (say, due to the scale factors in marine terminals anddepots and conditions in certain locations), principles defining the right ofeiual accoss and appropriate pricing should be established under a legalframework. According to the Government's current schedule, these facilities areexpected to be privatized in the last quarter of 1993.

59. Taxation, the incentive structure and comoetition. In the short- tomedium-term, the strengthening of the tax revenue base and continuation of fiscaladjustment is a major concern of the Government, since improved budgetaryperformance will be crucial for sustaining the stabilization and structuralreform program. In this regard, tax revenues collected from the petroleum sector(over 30% of the central government taz revenues in recent years) are, of course,crucial. A loss of revenue from this sector could be detrimental to theadjustment process.

60. An efficiency-oriented tax system could be developed, taking accountof the Government's tax revenue constraint. Building on the recently introducedchanges, the Government is currently considering further changes in the existingsystem of taxation of petroleum products and rents on crude production. Timelyactions in this area are desirable, particularly in view of the ongoingstructural changes and liberalization in the sector and the importance of defacto liberalization of domestic prices.

61. Until the changes of December 1992, the system of petroleum taxesincluded, in addition to a 15% import duty: (i) two taxes, serving as road-usercharges, levied at 14% of the so called "net price"4A/ received by Petroperu;(ii) the "Impuesto Selectivo al Cunsumo" (ISC), which was levied on petroleumproducts in lieu of the valued-added tax and had been set at 134% of the netprice plus the latter two taxes; and (iii) a 10% tax on gross ex-refinery salesrevenues of Petroperu, introduced in January 1992. The ISC and 10% tax on saleshad worked an indirect mechanisms to extract rents on crude oil produced byPetroperu and contractors.

62. This tax system was obviously designed assuming Petroperu's monopolyposition. As the Government extracted rents through the indirect taxes, it leftlittle or no financial resources for exploration and development investments byPetroperu. It also distorted the relative price structure among the petroleum

Net price has been determined through negotiations between the Goverrnent and Petroperu, and, inprinciple, it is supposed to cover production, refining, transportation costs, and a "return" tocapitat.

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products by excluding diesel from the two road-user taxes and imposing an ISCrate below 134%.

63. In December 1992, the Government took some important steps in theright direction to improve this petroleum tax regime. First, it extended thecoverage of the 18% VAT to petroleum products. Simultaneously, it eliminated the10% tax on gross sales of Petroperu and lowered the rate of ISC. However, inorder to avoid a fall in tax revenues and stabilize retail prices, the Governmenthas also maintained de facto control of ex-refinery prices (before taxes). Thispolicy needs to be changed in order to allow ex-refinery prices to settle atlevels comparable with import parity prices, consistent with the allocativeefficiency principles. This could be achieved through additional changes in thepetroleum tax system, with a view to adopting a petroleum tax system that isconsistent with the overall tax regime, avoiding distortions in relativepetroleum prices and also meeting revenue objectives.A4/

64. To accomplish these, the December 1992 measures could be complementedby converting ISC into a special excise tax levied on both domestically producedand imported gasoline and diesel, with rates set such that existing distortionsin domestic relative prices of petroleum products are removed and that sufficientrevenues are collected. While Petroperu's existence continues, a part of therents associated with the production of crude oil could be extracted through asurtax on Petroperul (in the case of private companies, the Government's share incrude oil rents, in terms of royalties and/or production sharing arrangements, isnormally negotiated freely in line with international standards). Of course, thesame corporate profit tax, as applied to private petroleum companies and othersin the rest of the economy, should also apply to Petroperu.

65. Regarding special excises on gasoline and diesel, there are tworeasons for their imposition. First, it will meet the Government's legitimaterevenue concerns in the short- to medium-term, particularly if it is specific andindexed to inflation, so that revenues are insulated from changes in theinternational oil prices and exchange rates. The second reason, which alsojustifies its continued implementation beyond the time when tax revenues from thepetroleum sector are no longer an immediate issue, is that it would serve as acost-effective way of collecting road-user fees. As such, the tax should nothave a distortionary effect, in view of the strong demand-complementarity betweengasoline and roads.c1/ It would also be consistent with the "polluter pays"principle. However, once the tax revenue performance improves and the tax baseis expanded, the excise should be expressed as an ad valorem rate to avoidchanges in ad valorem equivalents.47/

lV As tax parameters are chnged, ceteris paribus, some changes in retail prices of petroleum products andprices of other goods/services are likely to occur. However, these should not be perceived as apossible cause of increased inflationary pressure, but rather should be seen as one-time adjustments.

This is also in line with the Ramsey rule of optimum taxation, which supports higher taxation of itemsthat are complementary to goods/services that are difficult to tax or simply cannot be taxed.Although, a full implementation of the Ramsey rule Is difficult due to its information requirement oncross-elasticities of demand, which also explains the general preference for uniform taxationprinciple, in cases like gasoline it provides a rational basis for higher taxation.

Note that the duty/tax drawback system that is in effect should offset adverse effects on exportcompetitiv n ss.

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66. A tax proposal along these lines has apparently been developed by theMinistry of Energy and Mining, with input from recommendations of Bankconsultants. Its early enactment would be a very important step in thestructural reform of Peru's hydrocarbons sector.

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CHAPTER IIIANNEX

EVOLUTION OF FISHERY RESOURCES MANAGEMENT REGIMES

1. Most fishing nations maintained an "open access/unregulated" regimeuntil the 1930O. It became clear, however, that this "free access" regime wouldlead to disastrous results, since it maintained the "common property" nature ofmarine resources and, thereby, encouraged over-exploitation as competition pushedthe rate of extraction above what was consistent with sustainable yields; this isa general problem with common Propertv resources.48/

2. Starting with the USA and Canada in 1930s, the fishing nationsstarted adopting an "open access/regulation" system. The objective was the"biological sustainability", and this was pursued by focussing on the protectionof fish stocks. Various measures included: an upper limit on total allowablecatch (TAC), as established by marine biologists, fishing stoppages duringspawning seasons, closure of nursery grounds, steps to protect juvenile fish,etc. These measures were effective in conserving the fish stock, but led toeconomically inefficient results, since they did not establish individualproperty rights. As a result, fishermen, in the process of trying to increasetheir share in TAC, continuously increased the "fishing effort"4 9 / by increasingtheir physical capital, which leads to a high cost fishing in extracting a givenamount of TAC.

3. With the general adoption of the 200 mile Economic Exclusive Zone(EEZ) in 1976, the fishing nations started introducing fisheries managementregimes based on "restricted access and regulations". These regimes, in additionto pursuing biological sustainability through the TAC, have tried to restrict thefishing effort through restrictions on inputs and investment, and limit entrythrough licensing in order to achieve cost efficiency. However, problems havecontinued, because of the excess capacity that had already existed anddifficulties of enforcement and costs involved. The restrictions introduced havebeen usually weakened by the fishermen's ability to expand uncontrolled inputsgoing into the fishing effort. The fundamental problem is that this type of FRMRalso fails to eliminate the common property nature of fishery resources inharvesting and, therefore, also leads to inefficient fishing activity.

4. In the early 1980s, the fishing countries have started adopting"rights based" fishery resources management regimes, starting with the"Individual Transferable Quota" (ITQ) system introduced by New Zealand andIceland. (ITQ regime is discussed in the main text of Chapter III.)

For a detailed coverage of issues related to fishery resources management, and experience with variousregimes, see: Loayza, E. in collaboration with L.M. Sparague, A Strategy for Fisheries Devetopment,World Bank Discussion Paper 135 (1992); and the foLLowing papers presented at the World Bank Symposiumon Fisheries Resources Management in Lima, Peru, during June 22-23, 1992: Arnason, R. "Theoratical andPractical Fisheries Management"; Arnason, R. "Icelandic Fisheries Management"; Hannesson, R. "Trendsin Fisheries Management": Hannesson, R. "Fisheries Management: the Norwegian Experience"; Clark, 1. N."Fisheries Management: the New Zealand Experience"; Neher, P.A. "Fisheries Management: The CanadianExperience". Copies of the Symposium papers could be obtained from LAlEI.

"Fishing effort" refers to engine size and hoLding capacity of vesseLs, size and technology of fishinggear, number of vessels, fishing time, and days at sea.