Public Disclosure Authorized Report No. 19747-BR Brazil ... · CEDAE Companhia Estadual de Agua e...

Report No. 19747-BR

BrazilRio de Janeiro: A City Study(In TwoVolumes) Volume l: Policy Report

June 19, 1999

Brazil Country Management UnitPoverty Reduction and Economic Manioernent UnitLatin America and the Caribbean Region

Document of the World Bank

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

CURRENCY AND EQUIVALENTS

Currency Unit: The RealR$1.14 = US$1 April 1998R$1.70 = US$1 May 1999

WEIGHTS AND MEASURES

Metric System

FISCAL YEAR

January 1 - December 31

Vice President: Shahid Javed BurkiDirector: Gobind T. Nankani

Lead Economist: Suman K. BeryTask Manager: Indermit S. Gill

ACKNOWLEDGEMENTS

This report was prepared by a team consisting of Indermit S. Gill (Task Manager, LCC5C),Shahid Yusuf (DECVP - Economic Growth), Joachim von Amsberg (LCC5C - Poverty), WilliamDillinger (LCSPR - Municipal Revenues and Expenditures), Braz Menezes (LCSFP - InstitutionalIssues), and Marcelo Neri (IPEA, Rio - Economic Growth and Poverty). The report was writtenunder the general supervision of Gobind T. Nankani (Director, LCC5C - Brazil CountryManagement Unit) and Suman Bery ( Lead Economist, LCC5C). The peer reviewers were HomiKharas (PRMEP) and Vitor Serra (LCSFP). Cristina Perez (LCC5C) provided assistance inpreparing report documents.

The team is grateful to many persons in the government and business and research community inRio de Janeiro, and to colleagues in the World Bank who provided help and guidance. We wouldespecially like to thank Mayor Luiz Paulo Conde, Mr. Renato Villela (Secretary for StrategicAffairs), Ms. Sol Garson Braule Pinto (Secretary of Finance), Mr. Andre Urani (Secretary ofLabor Affairs), Mr. Alvaro Albuquerque Junior (Secretary of Economic Development), Mr.Ronaldo Gazola (Secretary of Health), Mr. Sergio Magalhaes (Secretary of Housing), Dr. SoniaRocha (Advisor, Secretariat for Strategic Affairs), and Mr. Luiz Villela (Secretariat of Finance).We are also grateful to Ms. Claudia Dutra (Advisor, Secretariat for Urban Planning) and othermembers of a panel assembled by Secretariat for International Affairs (SEAIN) of the FederalMinistry of Planning and Budget to review this report.

While Rio Municipality officials, especially in the Secretariats of Strategic Affairs and Finance,provided wide-ranging assistance and encouragement for this study, this is not a joint report. RioMunicipality officials and the members of the SEAIN review panel also provided detailed andconstructive comments on an earlier draft of this report during two rounds of very fruitfuldiscussions, many of which have been incorporated. Nevertheless, neither the Municipality of Riode Janeiro nor the Federal Ministry of Planning and Budget are responsible for its contents; theviews expressed here are solely those of the World Bank.

RIO DE JANEIRO:A CITY STUDY

TABLE OF CONTENTS

ACKNOWLEDGEMENTS ................................................ I

ABBREVIATIONS AND ACRONYMS ............................................... III

EXECUTIVE SUMMARY ............................................... IV

CHAPTER 1: THE CITY: IT'S PAST AND ITS ASPIRATIONS ...............................................1I

1. Introduction and Objectives .................................................... 11.2 Dominance, Decline, and a Gradual Resurgence .................................................... 31.3 Forging New Partnerships: The Piano Estrategico ................................................. 4

CHAPTER 2: THE ECONOMY: A HOLLOWING MIDDLE ................................................7

2.1 The 60 Billion Real Question: The Composition of City GDP ....................................................72.2 A Smaller Part of Brazil: Share in National Employment and Eamings ....................................................82.3 The Past as Prologue: Implications of Dependence on Federal Transfers ...............................................92.4 Industry: A Vanishing Middle ................................................... 112.5 Services: Increasing Informalization ................................................... 122.6 Growth Leader: Infrastructure, Tourism, Business Services, or Industry? .............................................. 132.7 The Ingredients of an Effective Industr ial Revival ................................................... 16

CHAPTER 3: THE PEOPLE: SOME IN LEAKY BOATS ............................................... 23

3.1 The 400 Million Real Question: The Aggregate Poverty Gap ................................................... 233.2 Poverty Profile: It is Difficult to Tag the Poor ................................................... 243.3 Social Spending: Targeting the Middle Well, the Tail Poorly ................................................... 253.4 The Favela-Bairro Program: Missing the Worst Off? ................................................... 283.5 Targeting the Poorest: Payoffs and Costs ................................................... 30

CHAPTER 4: THE GOVERNMENT: FISCALLY SOUND, BUT STRAINING LIMITS ......................................... 33

4.1 The 4 Billion Real Question: The City Budget ................................................... 334.2 Expenditures: Taking on Too Many Responsibilities ................................................... 344.3 Revenues and Transfers: Adequate for a Restrained Govemment ................................................... 364.4 Debt Service, Pensions, and Healthcare Obligations: Climbing Rapidly ................................................. 384.5 Staying Within Limits: A Responsible and Responsive City Hall ................................................... 42

CHAPTER 5: THE AGENDA: STRATEGY FOR RAPID RESURGENCE ............................................... 45

5.1 Helping the Poor: With Targeted Transfers ................................................... 455.2 Fostering Economic Growth: With Remedial Interventions and Skepticism ............................................ 465.3 Recognizing Policy Interdependency: Pragmatism ................................................... 475.4 Building Institutional Capacity: Information, Strategy Formulaton & Evaluation ..................................... 48

REFERENCES ............................................... 49

Background Papers ................................................... 49Selected References ................................................... 49

Rio de Janeiro: A City Study iii

ABBREVIATIONS AND ACRONYMS

CEDAE Companhia Estadual de Agua e Esgotos: State Water CompanyCLT = Consolidac,o das Leis Trabalhistas: Federal Labor CodeCOMLURB = Companhia Municipal de Limpeza Urbana: Municipal Waste Management CompanyCSN = Companhia Siderurgica Nacional: National Steel CompanyFUNDREM Funda,co para o Desenvolvimento da Regiao Metropolitana do Rio de Janeiro:

Fund for Development of the Rio Metropolitan RegionFUNDEF Fundagao para o Estimulo e ao Fortalecimento da Educa,co:

Fund for Strengthening EducationIBGE = Instituto Brasileiro de Geografia e Estatistica: Brazilian Statistical AgencyICMS = Imposto sobre Circulag,o de Mercadoria e Servigos:

State Tax on Goods and ServicesIPEA = Instituto de Pesquisa Economica Aplicada: Institute for Applied Economic ResearchISS Imposto sobre Servicos: Municipal Services TaxINSS Instituto Nacional de Seguridade Social: National Social Security InstitutionMETRO = Companhia do Metropolitano do Rio de Janeiro: State Metropolitan Rail CompanyMRJ Municipio do Rio de Janeiro: Municipality of Rio de JaneiroPNAD Pesquisa Nacional por Amostra de Domicilios: National Annual Household SurveysPPV = Pesquisa das Padroes de Vida: Living Standards Measurement SurveyPROER Programa de Estimulo a Restructura,co e ao Fortalecimento do Sistema

Financeiro: Program for Restructuring and Strengthening the Financial SystemSUS = Sistema Unica de Saude: National Health SystemTELERJ = Telecomunicacoes do Rio de Janeiro SA:

Telecommunications Company of Rio de JaneiroTELEBRAS = Telecomunicac6es do Brasil SA: Telecommunications Company of Brazil

Rio de Janeiro: A City Study iv

EXECUTIVE SUMMARY

Background, Objectives, and Approach

i. After more than fifteen years of economic stagnation and rising crime and environmentaldegradation in the 1970s and 1980s, the city of Rio de Janeiro has experienced a revival in the1990s. Economic growth has resumed, poverty fell throughout the 1990s and, under an activistmayor between 1993 and 1996, Rio City began to noticeably improve its appearance. The word ofRio's rebirth has spread: tourism and trade have picked up, and Rio has again begun to entertainthoughts of joining the ranks of the world's premier cities.

ii. New Challenges. But the challenges Rio City faces today are different from those in itsformer glory days. For more than two centuries, the city enjoyed special status as the country'scapital or as an independent territory. Rio benefited from the prosperity that came with thisprivilege during times of public sector domination of a closed economy. While the city still enjoys aspecial place in Brazil, Rio's constitutional status in the federation is now the same as that of othermunicipalities, and it has to deal with higher levels of government accordingly. The country is nowmore open to competition from abroad, and Rio's businesses must compete in less protectedconditions. The city's experience with growth and decline has shown that some of the city's poorare unable to pull themselves out of poverty unassisted even during times of economic growth - arising tide may not lift all boats. A changed framework for intergovemmental relations within thecountry and Brazil's struggle to affect a serious fiscal adjustment imply that it is now neitherpossible nor in the municipality's interest to live beyond its means.

iii. Objectives. This report - written with the encouragement and support of Rio Municipalityofficials, especially the Secretary of Strategic Affairs - attempts to define the priorities for municipalaction to answer these challenges. It should be noted that despite the collaborative nature of theinquiry into these issues between City and World Bank officials, the views expressed here aresolely those of the World Bank. Based on an assessment of the city's strengths and aspirations,the report presents policies and programs that the municipality can adopt to restore and sustainbroadly based economic growth, fight poverty in the city through better use of the municipality'ssocial spending, and maintain fiscal discipline by setting appropriate boundaries for municipalactivity.

iv. Approach. The municipality has already made a good start in these matters by buildingtrust among the city's businessmen and civil society. The most concrete evidence of thisconsensus is the Piano Estrategico published in 1995, in which more than 750 personsparticipated. The current mayor's campaign document, Plano de Metas, published a year later,goes further in laying out priorities for municipal action, This report is written with the intention offurther sharpening the municipality's expenditures and programs. Towards that end, it examineswhether they are reaching those who most need the city's help, provides relevant experiences ofother cities and countries upon which Rio can base the design of such schemes, and assesses theresources that the city can realistically expect to have in doing these tasks.

Rio de Janeiro: A City Study v

v. Caveats. There is no generally accepted analytical framework for determining optimal orappropriate industrial policies for subnational governments, and this is especially true at the citylevel. The recommendations of this report regarding economic policy are derived from a reviewof the experience of cities that are comparable to Rio using relevant criteria. But despite the caretaken in selecting and surveying the experience of these cities to arrive at policy recommendationsfor Rio, they should be viewed only as indicative of policies that are likely to be effective. Onissues related to poverty alleviation and fiscal prudence, on the other hand, therecommendations of the report stand on firmer analytical ground.

Rectifying Imbalances in the City's Economy

vi. Lack of Reliable Statistics. Meaningful statistics on economic activity in Rio City - such asthe total GDP, its sectoral composition and growth, and the rate of entry and exit of firms in eachsector - are not available. With decentralization in an economy that is opening up to foreigncompetition, this paucity of reliable information is already an obstacle for the municipality indesigning cost-effective actions to foster activities that will bring prosperity to the city.

vii. Special features of Rio's Economy. The available estimates indicate that Rio City had aGDP of about $55 billion in 1997, or a per capita GDP of about $10,000. There are three mainfeatures of the composition of economic activity in the city. First, a high share of public sectoremployment: while this was about 12% for metropolitan Brazil, it was 17% (or more than 33%higher) in Rio City. Second, a low share of industry in total employment: this was almost 25% inother large Brazilian cities compared with less than 17% for Rio City (and only 19% for the Riometro region). Third, a normal share - by international standards - of services in employment:Rio's share was about 66%, compared with about 61% for metropolitan Brazil.

viii. Implications of a large public sector. Rio City's reliance on public employment and socialsecurity income makes it especially vulnerable to the fiscal austerity that Brazil is likely to undergoover the coming years. Public employment in Rio is relatively high paying (one in every four reaisearned by Rio's workers was from government coffers), and federal transfers to city residents arelarge (pension payments are the main source of income for about a quarter of income recipients).This loss will be keenly felt unless growth in high-paying private jobs takes place. Policy-makershope that trade especially tourism-related activities or high value added services such as financeand insurance will pick up the slack. But this is not happening on its own. While tourism will grow,Rio is still a long way from the stage at which it can depend largely or substantially on tourist-related income. As a point of comparison, Rio got fewer than 2 million tourists in 1996, a fraction ofLondon's 25 million visitors, and New York's 30 million. In the case of services, matters are evenmore discouraging, e.g., employment in financial institutions actually fell by 33% to 60,000 between1991 and 1996. As a point in contrast, London - with roughly the same population as RioMunicipality - had a financial sector employment of 800,000.

ix. Declining modern industry. The experience of large cities across the globe points to theimportance of having a thriving modern industrial sector that serves as the engine of economicgrowth. Rio's industry appears to be in trouble: modern industry is now only about 5% of totalemployment in Rio City (and less than 6% in the Rio metro region), as compared with almost 10%

Rio de Janeiro: A City Study vi

for the rest of metropolitan Brazil. Rio has steadily lost employment in manufacturing andconstruction: registered employment in the city fell from 400,000 to 350,000 between 1991 and1996, a period of relative prosperity.

x. What remains of industry is unbalanced. It is now widely held that many of the industrialfirms that haVe left Rio de Janeiro city are mid-sized firms with 10-100 employees, leaving behindan unbalanced industrial structure with a missing middle, While more than 80% of industrialemployment is in small establishments (and only 15% in medium-sized firms), more than 80% ofindustrial output is produced by large firms with less than 5% of the sector's labor force. If thistrend towards a weaker industrial sector is countered by growing employment in high value-addedservices and trade, there would be little cause for alarm. But in line with international experiencethat indicates that high value added services draw sustenance from - rather than compete with - athriving local industrial sector, Rio has lost ground here as well. The remedy for this downwardspiral appears to lie in an industrial revival.

xi. Elements of an effective industrial revivaL There is no simple recipe for fosteringindustrial growth in a city of Rio's size. The approach recommended in this report is a hybrid ofsuccessful strategies adopted in other cities (such as Hong Kong, Singapore, Shanghai,Barcelona, Miami, Los Angeles, and New York) and countries (such as Italy, Germany, Israel andArgentina). This includes the following. First, effectively utilize the available technical andprofessional skills, specific skills in garments, engineering and shipbuilding, and the pool ofunskilled labor. Second, lower entry barriers to all new firms, most immediately by simplifying therules for licensing of new businesses and assessment and collection of the services tax (ISS), bothof which can be done immediately by the municipality. Third, facilitate inter-firm networking and theadoption of open systems that encourage innovation and international orientation. Fourth, initiateor strengthen special efforts to attract one or two major international corporations that championsuch structures, and hence act as natural incubators for smaller firms. Fifth, efficiently managebasic city services particularly valued by business (such as garbage collection). Finally, co-operatewith state and federal governments to consolidate the recent advances in public safety,infrastructure and macroeconomic stability.

Assisting the City's Poor

xii. Helping those left behind is a municipal responsibility. Brazil's experience indicatesthat for every 10% increase in aggregate income, poverty rates fall by about 6%. This points to theimportance of solid and sustained efforts to foster economic growth. But the experience in Braziland in other countries has also shown that some people cannot take advantage of good economictimes to pull themselves out of poverty, and need a helping hand. In Brazil's decentralized system,the primary responsibility for helping the poor in Rio City may lie substantially with the municipalgovernment. So, while ensuring that all citizens are provided high quality public services atreasonable cost, the municipality must also provide a safety net for those who remain in poverty.

xiii. The nature of poverty in Rio. Rio City is fortunate in that it has a relatively low povertyratio compared to its periphery and other parts of metropolitan Brazil. Using household per capita

Rio de Janeiro: A City Study vii

income of R$86 as the poverty line, less than 16% of Rio's population is poor, compared with about21% for metro Brazil and other parts of the Rio metro area. Had Rio's poor been relatively easy to"tag" or characterize, the task of targeting interventions would be easier, In Rio City, however, anysingle indicator helps in identifying only a small proportion of the poor. For example, whilebecoming unemployed increases the likelihood of becoming poor, only 10% of poor householdheads are unemployed. Again, while household heads with less education are more than twice aslikely than those with at least 5 years of schooling to become poor, unemployed heads with 0-4years of schooling make up only 25% of the poor, compared with 70% with 5-12 years. Since thecauses or correlates of poverty are many, instruments suitable for combating poverty have to bewide-ranging. All indications are that the City Govemment is aware of this.

xiv. Evaluations of city programs. Our attempts - like the City's own efforts - to assess howmuch of Rio Municipality's expenditures benefit the poor were hampered by the absence ofrigorous evaluations of city programs. The municipal government would be well advised to institutean autonomous evaluation system to fill this void. Nevertheless, our findings indicate that only20% of the municipal budget is spent on programs with a special focus on serving the poor (basiceducation and health, social development, and urban upgrading), and preliminary estimatessuggest that less than 10% of the budget actually reaches the poor through these services. Thisratio is considerably smaller than the 16% share of the poor in Rio's population, though it must beadded that the estimates for determining government expenditure targeting are precarious andbased on assumptions that require verification.

xv. Varying coverage and targeting of programs. There is considerable variation in thecoverage, targeting, and per family benefits of these and other programs, often for justifiablereasons. Municipal spending on water and sanitation, solid waste disposal, and basic health isnecessarily untargeted and universal, and per family expenditures are small. Programs such asbasic education and urban upgrading are moderately targeted and their per family expenditures arelarge; the difference between these programs is that while basic education reaches more than 80%of the poor, the city's main urban upgrading program - Favela-Bairro - at best reaches 10% of thepoor. The third set of programs are poverty-targeted programs such as the Early Childhood (RioCrianca Maravilhosa) intervention and the Food Basket (Bolsa Alimentar), more than 70% ofwhose total spending goes to the poor, per family expenditures are moderate, but coverage of poorhouseholds remains below 30%.

xvi. Expanding selected poverty-focused programs. Increasing the coverage of the third setof programs is potentially the best alternative through which the municipality can help Rio City'spoorest, as long as leakage to the non-poor is kept low. A municipal project is underway to expandthe Early Childhood program to cover more of the poor. The Food Basket program could also beexpanded to reach a majority of the poor. This may require a shift from an in-kind to a cashtransfer mode to keep administrative costs low, which in tum requires instituting a system formeans-testing. Chile's experience indicates that the requirements of a successful system of cashtransfers to the poor requires systematic and regular household surveys to assess living standardsand the correlates of poverty, and an efficient and honest administration to implement the system.It is always a challenge to institute an accurate means-testing system, but is well within thecapabilities of ambitious and relatively sophisticated city government such as Rio if it goes aboutthis task determinedly.

Rio de Janeiro: A City Study vm

Staying Fiscally Sound

xvii. Revenues adequate, but only for a restrained government. Rio Municipality's challengeis to fortify growth and alleviate the remaining poverty in the city within its resource envelope, viz.,without incurring additional debt. The city has an adequate revenue base of about R$3 billion,which is elastic because it is based mainly on ad valorem taxes that rise along with growth ofeconomic activity in the city and the state. But, as federal decentralization and state fiscal distresshave forced the two higher levels of government to reduce their roles, Rio City has moved into thebreach, This has stretched city fiscai and institutional resources almost to breaking point.

xviii. Rapidly growing responsibilities. The municipality has a monopoly on public primaryeducation, by virtue of its former status as the state of Guanabara. Since 1994, it has expanded itsrole in public health care by taking over 25 federal hospitals and clinics. The share of subsidies topublic health facilities in the municipal budget has risen by 50% since 1996. The city's expandedrole in primary health and education is consistent with the direction advocated by the 1988 federalconstitution, and the city should be commended for taking responsibility for the public services forwhich municipalities began receiving a greater share of the nation's tax revenues. But the city isalso the principal provider of streets, highways, and drains, and has been aggressively expandingthis role. The municipality took over the main federal highway and almost all of the state network,and built a major freeway and tunnel system from its own savings. The city already hasresponsibility for solid waste collection and disposal. Since water and sewer services are essentialfor urban management and policy, and the city has different priorities than those of the state-runwater authority, the city government has also entered the water and sewer business.

xix. Tightening resource constraints. Rio Municipality's expanding responsibilities come at atime of tightening resource constraints. To finance this expanding role of the municipality in anambiguous institutional framework, the city hopes to rely on debt financing of its development plan,though given the current economic environment it recognizes that this may not become a reality.The previous administration (1993-1996) managed successfully to finance an ambitious investmentprogram in 1995 and 1996 by saving during its first two years. But it could do so largely becauseof high and rapidly declining inflation rates that allowed the mayor to cut real salaries and takeadvantage of increases in real tax revenues. The current administration is operating in a radicallychanged economic environment with low inflation and growth, greater recurrent responsibilities inareas such as road maintenance and healthcare, and higher civil service pension obligations.While the city finished 1997 with an operational deficit of 6% of revenues, it did so by capitalizinginterest payments. Had interest not been capitalized, the operational deficit would have been 16%.

xx. Altematives to mortgaging the future. This strategy has resulted in the debt to netrevenue ratio rising steeply from 40% in 1995 to about 90% in 1997. While a sharp increase in thisratio occurred in 1996, the last year of the previous administration, it is the current administrationthat now owes the debt and is responsible for managing its consequences. Besides, while thecity's net debt increased by R$885 million during the four years of the Maia administration, it hasincreased by R$646 million in the first two years of the current administration. The analysis in thisreport indicates that this trajectory is not fiscally sustainable. If the city were achieve the level ofcapital spending proposed in its budget, the ratio of debt to revenues could top 100% in 1999,reach 125% by 2000, and 150% by 2002. Rio is at a crossroads. It can decide to continue down

Rio de Janeiro: A City Study ix

the path of aggressive expansion of municipal responsibilities and debt finance, or it can work withother levels of govemment to ensure that the demands of its citizens are met within its resourceconstraints. A promise to keep debt low can be bartered for better terms of finance for existingobligations; encouragingly, at the time of writing, federal-municipal debt re-negotiation talks hadbeen initiated. Cooperation with the state government in matters such as water and sanitation,mass transit, and public security can result in large payoffs in terms of quality of these services atlittle or no additional cost to the municipality. The municipality can then devote its resources andenergy to efficiently provide education, health, and basic city services, to launch modest but well-planned initiatives to foster economic growth in the city, and to look after its poor.

xxi. Efforts to make Rio de Janeiro an even more attractive and livable city are already underwayand many of them are paying dividends. While improvements in city services are essential to thecity's renaissance, prudent fiscal behavior is also critical. Good management of city finances isrewarded by private investors, and fiscal profligacy is now difficult to sustain as federal guaranteesare withdrawn. Efforts to ensure that Rio is dynamic, fair and solvent can lead quickly to a justlyearned reputation of a city that works and cares for its people, but does so within its means.Sustained for some time, these policies will catapult Rio into the league of "world cities".

Rio de Janeiro: A City Study 1

CHAPTER 1THE CITY: ITS PAST AND ITS ASPIRATIONS

1.1 Introduction and Objectives

1. As the capital of Brazil during the period between 1763 and 1960, the city of Rio de Janeiro(henceforth Rio City or Municipality) was accorded special administrative status. The city was alsoBrazil's wealthiest during this period, so Rio could assure its citizens a well-developedinfrastructhre and high quality social services with the lavish federal funding that came with thisstatus. The special treatment continued after the capital was moved to Brasilia: Rio City was giventhe status of a state, and many federal agencies stayed on in Rio. Rio's fortunes during the 1960sand early 1970s coincided with the Brazilian economic miracle and, while Sao Paulo emerged asthe richest metropolitan region, Rio prospered. But in 1975, Rio City lost its special status as theState of Guanabara, formally ending more than two centuries of special treatment for the city.1

2. Rio City did not adjust well to its new status. It slid into a decade of sluggish growth, risingpoverty, inequality and crime, and deteriorating public services. The 1980s were a "lost decade"for much of Latin America in terms of foregone growth and Rio was no exception. But Rio also lostits reputation as a vivacious holiday destination, and the city - famous until the 1980s for itscelebration of life - gained notoriety for increasing crime, slums, and environmental degradationinstead. The 1990s have been more kind. By 1994, aided by per capita income growth and lowunemployment, poverty in both Brazil and Rio City had fallen by more than 10 percentage pointscompared to the 1984 level. The Real Plan brought about another steep decline in poverty. Thesegains appeared to be one-off in Brazil and some regions even experienced a reversal of trend, butpoverty in Rio City continued to fall in 1995 and 1996. Rio has begun to entertain ambitions oftaking its place among the world's premier cities (see, e.g., Tolosa, 1995).

3. But Rio "re-entered" a world in the early 1990s that had changed vastly from the times inwhich it seemed to prosper almost effortlessly. The city must now manage its finances carefully:no longer are there abundant federal funds available to finance public services even if they areefficiently provided. The city's economy needs to be monitored and nurtured so that it can betterface its competitors: no longer are Brazil's borders closed to foreign merchants and manufacturers.Rio's natural beauty is not enough to assure a thriving tourism sector: it is no longer the only city inthe country that provides tourists with easy access to beaches and vibrant festivals. The demandsof citizens are increasingly harder to fulfil: no longer are high quality education and health servicesa matter of privilege or consumption but one of necessity in order to compete and grow, so thecosts of mistakes in basic education and health policy are higher than ever before. And theexperience of the city and the world has shown that the benefits of economic prosperity mayremain beyond the reach of the least fortunate: no longer can it be assumed that the benefits of

1 The peculiarities of history, geography and politics of Rio de Janeiro have also shaped state-municipal relations. Withnearly half the electorate, the municipality plays an important role in state politcs. Since Brazil's return to democracy,the Rio mayorship has served as a springboard to the post of governor. The last two governors were former mayors,and the most recent incumbent was a contender in the last gubernatorial elections.


economic growth will reach the city's most poor without carefully targeted municipal govemmentprograms.

4. The municipal govemment, which has in the past served primarily an urban planning anddevelopment role, is now being pressured to begin playing an important part in fostering economicgrowth in the city and in designing safety nets for the city's most unfortunate. This report is theresult of collaborative inquiry by the World Bank and Municipality officials to define the priorities forfacilitating this expanded role. The objectives of the study are to help the municipal governmentdevise policies and programs to:

* Restore broadly-based economic growth, and sustain it above the national average whilereducing its volatility.

• Fight poverty through better targeting, so that while aggregate poverty rates are reducedthrough faster growth, those remaining in poverty are provided appropriate assistance.

* Maintain fiscal discipline, by setting appropriate boundaries for City Hall that help toimprove the quality of municipal services while keeping the ratio of debt to current revenuebelow one.

5. This report is in two volumes. Volume I contains five short chapters dealing with, in tum,

- Rio's past and aspirations, documenting how the municipal government's primary partnerhas gradually changed from the Federal Government to Rio's own private sector, the mostrevealing indicator of this shift being the Piano Estrategico.

* Rio's economy, documenting how the city's fortunes are correlated with those of thecountry, how Rio's dependence on Federal transfers continues, and how middle-sizedmanufacturing and services have hollowed out.

* Rio's people, documenting how city services and special programs appear to benefit thelower middle groups more than the relatively rich but miss the very poor, who aredisenfranchised but an important factor in Rio's quest for a place among the premier citiesof the world.

* Rio's government, documenting how the city is taking on too many responsibilities andimplied recurrent expenditures relative to its revenue base and comparative advantage.

* Rio's agenda for the future, proposing selective actions for the municipal government toattain objectives related to the economic growth, poverty reduction, and fiscal discipline.

6. Volume 11 contains four chapters that were commissioned for this report, dealing respectivelywith, economic prospects and strategy for growth, poverty profile and poverty-related programs,selected government finance and expenditure issues, and institutional issues relating to municipal,state, and federal responsibilities. Readers are encouraged to refer to these studies for moreinformation. Volume I provides only the most basic results of the detailed analysis and policyimplications.


7. A word regarding the scope of this venture. This report was written for Rio Municipality.While others may find its findings useful, readers should keep in mind that its focus is on municipalpolicies and programs. Naturally, this implies that some critical (in terms of economic and socialoutcomes for the municipality) policy areas which are outside the core responsibility of themunicipal govemment are not dealt with here. Examples of these issues are labor regulations,principally a federal responsibility, and public security, which is primarily a mandate of the stategovernment.2 The neglect of these issues does not make them any less important as themunicipality's concem; it is simply a recognition of the fact that the municipal govemment cannottake unilateral action in these policy areas, and probably should not even if it could. Also nottreated here are environmental management matters, which involve all levels of government.World Bank (1996b) has examined the issue in some detail for the state of Rio de Janeiro,including the municipality, and the findings of that report remain valid (also see Box 2).

1.2 Dominance, Decline, and a Gradual Resurgence

8. After its establishment as the capital in 1763, Rio dominated Brazil's economy, culture, andpolitics. Brazil was unlike other European colonies since it was the seat of the Portuguese crownbetween 1808 until its independence in 1822, and benefited from cultural, academic, andinfrastructural investments and diversified foreign trade. One out of every two Brazilian city-dwellers lived in Rio in 1900, so Rio was - for all practical purposes - Brazil itself. It was also thelargest city in Latin America at the time. Rio's dominance of Brazil remained unchallenged until the1950s, when it was surpassed by Sao Paulo as the main economic power. With the strengtheningof the Minas Gerais and Sao Paulo political machines in the 1940s and 1950s, and theestablishment of Brasilia as the capital in the 1960s, Rio lost out politically as well.

9. The 1960s and early 1970s were not a bad time to lose predominance. Brazil was in themiddle of a "growth miracle" with annual rates of growth topping 10%, and Rio shared in itsprosperity. With the economic slowdown from 1975 until 1989, though, Rio's economy slid furtherback than those of others. Nevertheless, through most of the 1980s, Rio remained the culturalmecca for Brazilians. But rising crime and poverty soon came to dominate Rio's concem. Citiessuch as S3o Paulo, Curitiba, and Salvador caught up with and passed Rio. Today Brasilia has -against many odds - become the nation's political center, Sao Paulo is now the nation's economicand cultural epicenter, Curitiba has eamed the reputation of being Brazil's most livable place, andSalvador is now known for being the most "traditionally Brazilian" city. It may have taken four citiesto take the place of a single Rio de Janeiro at its zenith but, by the end of the 1980s, thissubstitution seemed to have been completed.

10. Rio began making a comeback around 1990. It's economic growth has surpassed (thoughonly moderately) the growth of Brazil in the 1990s, poverty rates have declined due to thestabilization since 1994, and the city's appearance and morale seem to have benefited from theurban development programs initiated by the Maia administration between 1993 and 1996. Recentinternational surveys have rated Rio the best place for doing business in Brazil and among the bestin Latin America.

2 A well thought-out project to study the roots of and remedies for crime and violence in Rio is nearing completionunder the Municipal Labor Secretary's direction.


11. The city's strengths are obvious: worldwide name recognition, extraordinary natural beauty,and a wealth of talent among its people. But some fundamental weaknesses pose a challenge.One is an inward-looking orientation, that is only now changing. Cariocas point out that Rio isunique among coastal cities in that it has "its face to the sea". Indeed, the sea, beaches, andlagoons figure prominently in the city's daily hustle and bustle and fully permeate the lives of itsresidents. But skeptists may argue with some justification that while the city always faced the sea,it also had its back turned to foreign ideas and influences until recently. The effects of limitedpenetration of English in a city that is a center of both finance and tourism, and years of relativeinattention towards the business world beyond the confines of the region cannot be ignored by acity in a rush to acquire the status of a "world city" (in the sense of Friedman, 1986, Tolosa, 1995,and Know, 1997).

12. This orientation may simply have been a reflection at the city level of inward-lookingeconomic policies adopted by the nation for several decades until the 1990s. With the changesinitiated in 1991, this is no longer affordable for any city in Brazil. As the city that has embodiedBrazil for more than two centuries, Rio will undoubtedly be at the vanguard of Brazil's globalintegration. And the main vehicle for this integration will be Rio's people and business, not itsgovernment. Nevertheless, the city government can help or hinder its citizens. Keeping a pulse onlocal activities and redesigning municipal policies and procedures in response to these demandsmay be more important today than maintaining special relationships with higher levels ofgovernment. Rio's Plano Estrategico is evidence that its leaders appear to have recognized this.

1.3 Forging New Partnerships: The Plano Estrategico

13. In 1996, during the final days of the Maia administration, a strategic plan for the city wasunveiled. More than 750 institutions and persons - drawn from government, business, and civilsociety - had participated in its creation. The plan consisted of a central objective3, seven broadstrategies, each of which on average had three sub-objectives, which necessitated a total of 61actions, to be implemented through 158 projects. Progress on the plan was to be overseen by afoundation set up for this purpose. The strategies to attain the central objective of the plan were:

* Improving access to formal employment, education and health services, and promotion ofsocial integration through programs for youth and vulnerable segments of the population.

* Improving environmental conditions and the condition of public lands.

* Decentralizing municipal administration functions, development of good citizenship, andimproving public security.

* Revitalizing the downtown area through urban renewal and improved transport facilities.

* Improving access to the city by land, air, sea, and telecommunications.

* Increasing competitiveness by improving infrastructure and other services and vigoroussupport for selected technology-intensive industries.

3 The central objective actually consisted of numerous and diverse goals such as improved quality of life, socialintegration, respect for public property, economic competitiveness, establishing Rio's leadership as a center forthought, and taking advantage of Rio's special connections with other countries to create business for Brazil.


Raising Rio's regional, national, and intemational profile by improving sports and culturalfacilities, tourist attractions, and through aggressive marketing campaigns.

14, What all this boils down to is the following. By all accounts, the Piano Estrategico was anunprecedented success as an exercise in consensus-building and partnership: that so manypeople and organizations agreed on a broad approach to economic development is by itself alaudable achievement. For the municipal government, the exercise also marks a break from thepast: from looking primarily towards the federal and state governments for assistance in itsendeavors to improve its citizens' economic and social welfare, to viewing the private sector andnon-govemmental organizations as more important partners in progress.

15. But to serve more effectively as a chartbook for the city's socioeconomic development, theplan needs to be supplemented by more work. The reasons are:

* Selectivity. Plano Estrategico documents leave questions of relative importance ofeconomic sectors, social urgencies and municipal actions unanswered.

* Costs. Second, there is little or no effort to estimate the costs of the various measures.

* Efficiency. Third, where specific projects are proposed, there is no discussion of whetherand under what conditions similar actions have met with success in other cities.

16. To better prioritize the use of the municipality's scarce financial and human resources,therefore, the plan must be augmented by analysis aimed at determining the relative importance ofmeasures agreed on by the participants of the exercise. Mayor Conde's 1996 campaigndocument, Plano de Metas clearly lays out his administration's priorities. The objectives are statedas improving employment prospects and the quality of life of Rio City's residents. The areasprioritized for focus are education, health, and transformation of slums into functioningneighborhoods, and the document clearly states the numerical targets within each of these priorityareas. Other areas for attention are transport, public safety, economic development, and cultureand tourism. The document also cautions against unrealistic expectations, and trying to addressdifferent problems using a single approach.

17. The Plano de Metas goes a long way towards operationalizing the consensus reached bythe Plano Estrategico. In further sharpening the municipality's expenditures and programs asinstruments to reach the objectives it has set for itself, three measures can help:

* first, an examination of whether they are reaching those who most need them or canbenefit from them;

* second, determining whether these programs have been designed using the relevantlessons from Rio's own experience and that of other cities or countries, and

* third, an assessment of the fiscal and institutional resources available to the city toensure that municipality officials are capable of successfully implementing thesemeasures.

This report, written with the assistance of Rio City's Secretariat of Strategic Affairs and othersecretariats, is designed to do this.


18. The report identifies three broad objectives: revitalize output and employment growth,provide basic public services and protect the city's most poor, while maintaining fiscal health of themunicipal government.

* On the issue of revitalizing the city's economy, the approach adopted by the report is toexamine the structure of city output and employment, identify the dependence of Rio'seconomy on national and state economic performance, list the sources of growth, and -based on these findings and the experience of selected cities in East Asia and NorthAmerica - discuss the policy options for the municipal government to restore broadly-based growth.

* On the issue of protecting the poor, the report documents the extent and nature ofpoverty in Rio municipality, evaluates the poverty impact of government spending onuniversal (e.g., health and education) and special (e.g., slum-upgrading) programs, andsuggests an effective and affordable approach to poverty reduction.

* On the issue of maintaining fiscal soundness, the report provides an assessment of thecity's expenditures, revenues, and debt, and evaluates whether municipal initiatives overthe last five years have moved the municipality onto an unsustainable trajectory.

Wherever possible, cost estimates of proposed actions are presented and relevant experiencefrom other cities and countries is provided.


CHAPTER 2THE ECONOMY: A HOLLOWING MIDDLE

2.1 The 60 Billion Real Question: The Composition of City GDP

19. With 5.5 million citizens, Rio City has 43% of the state's population, crowded into just 3% ofthe state's area. Economic activity is packed in even tighter: in 1994, Rio City's GDP was 64% ofthe state total. Estimates of the city's GDP are unreliable: the most optimistic of these rangebetween $50-60 billion in 1997. Reliable numbers on aggregate production and income at the citylevel do'not exist in most countries, and Brazil is no exception. For the purpose of this report weuse these estimates, while recognizing that they are very approximate. Given the lack of reliableaggregate numbers, it should come as no surprise that good numbers on the sectoral compositionof output do not exist (though we report one set of estimates). Fortunately, annual householdsurveys can be used to report sectoral shares of Rio City's total employment of about 2.5 million,which provide the best available evidence on the composition of economic activity in themunicipality. Table 2.1 provides results from the 1996 PNAD survey.

Table 2.1The Public Sector is More Important Than Private Industry in Rio CitySectoral GDP, Employment, and Earnings Share, 1996Sector share Of Total S-Sare of Thtal shari of Total

GDP EMp~yiet 4anig

tndustry 33.9 6.5 15.9Modem 5.1 5.7Traditional 6.0 5.1Construction 5.0 4.6Extractive 0.3 0.5

services 65.0 66A4 60.1Distribution 25.2 21.8Productive 9.6 15.9Social & Other 31.6 23.2

Public Sector 17.2 .5 22,9Civil Service 7.8 11.1Enterprises 1.5 2.8Military & Other 7A4 9.0

Agdculture 1.0 0.6 0.3

Source: Employment and eamings are from the IBGE PNAD Survey; special tabulation by Marcelo Neri.Notes: Numbers are percentages, and are approximate.

20. From Table 2.1, three facts stand out. The first is that one out of every six workers in RioCity is a govemment employee and almost one out of every four reais earned by Rio's workerscomes from government coffers. The second is that industry has a smaller share than the publicsector in GDP and earnings: something to be expected of capitals such as Brasilia or Ottawa orCanberra, but somewhat surprising for the second-largest city in the most industrialized country inLatin America, which had 40% of the nation's industrial employment when it was the capital. Thethird is that employment in the city is overwhelmingly in the services sector. Globally, theimportance of services is normal for large cities; for Rio, it is a happy coincidence because Brazil's


constitution gives municipal governments many of the responsibilities for the regulation andtaxation of services. City officials cannot disclaim responsibility for the health of the city'seconomy: a full two-thirds of it can be influenced by how they regulate and tax services in the city.

2.2 A Smaller Part of Brazil: Share in National Employment and Earnings

21. Rates of growth of Rio City's economic activity have fallen short of those of the nationbetween 1960 and 1990. This is reflected in a decline in its share of employment from about 5% to3.25%, and in its share of national earnings from more than 12% to less than 7% during this period(see Table 2.2). During the 1990s, however, Rio City has outperformed the nation, as evidencedby a growing share of the city in national income and labor. Comparison of these trends with thosefor the Rio metropolitan region (not reported here) reveal similar changes.

22. Evidence from Federal Reserve Bank of New York (1997) indicates that the New Yorkmetropolitan area's share in the nation's employment also fell by almost 40% over the last fourdecades. But in contrast to New York, where the decline in income share was smaller than thedecline in employment share, the decline in Rio City's eamings share was greater than the declinein employment. This suggests the flight of high wage jobs from Rio City. Another relevant findingfor New York is that the relationship between national and metropolitan earnings and employmenthas strengthened considerably in recent years.4 It is possible that Rio and Brazil have alsoexperienced the same phenomenon: even as Rio contributes less and less to Brazil's aggregatewealth, their economic fortunes may be becoming more and more intertwined. Under currentconditions, therefore, municipality's growth prospects may be best proxied by those of the country.

Table 2.2Declining Shares in National Income and EmploymentNew York Metropolitan and Rio Municipality Earnings and Employment Shares, 1960-1996

1960 11.75 12.00 12.24 4.481965 11.25 11.501970 11.50 11.00 12.11 5.201975 10.25 9.501980 9.50 8.75 9.39 4.891985 9.70 9.00 --

1990 9.75 8.50 6.69* 3.24*1995 9.40 7.50 6.91 3.341996 -- -- 7.47 3.51

Sources: New York data are from Federal Reserve Bank of New York (1997). Rio city data are special tabulabion byMarcelo Neri from the Census (1960-1980) and PNAD Surveys (1993-1996). * indicates that numbers are for 1993.

23. But even if this is not true, the evidence appears to be that the city could - by institutingeffective policies for managing the municipal economy - outperform the country over long periodsonly by a relatively small margin, say at most two percentage points annually. Depending on

4 The elasticities of regional employment, personal income, and wages and salaries to their respective nationalmagnitudes in the 1970s were about 0.5, strengthening to 1.0-1.5 in the 1980s (see McCarthy and Steindel, in FederalReserve Bank of New York, 1997).


whether the country's rate of growth is 2% or 5%, this means the difference between doubling cityincome every 20 years or once in just a decade. Such an interdependence implies that anaggressive fiscal adjustment and debt reduction is in every sub-national government's bestinterests, but not recognizing it leads to each choosing a strategy which perpetuates debt andpostpones structural adjustment. Contributing to the nation's fiscal adjustment effort is in Rio'sself-interest: no appeal to the city's patriotism should be necessary. And given its prominenceamong the cities in Brazil, Rio's actions may encourage similar responses by other municipalities,possibly restoring Rio to the national leadership that it lost during the 1980s.

2.3 The Past as Prologue: Implications of Dependence on Federal Transfers

24. Rio is not unique in its dependence on federal govemment transfers to provide initial orperiodic impetuses for development: even seemingly "commercial" cities such as Los Angeles andMiami have relied heavily on federal spending in the past (see Table 2.3). The main differencesbetween these cities and Rio are that Rio's dependence continues until today, and that much of thefederal fiscal adjustment in Brazil is yet to come. There is little doubt that this will occur over thenext decade. This adjustment involves reducing wage and salary expenditures (by downsizingpublic administration or by privatizing public enterprises) and the public pension bill (by making thenational social security system less generous). To understand the implications of thesefundamental changes in the social contract between Brazil's government and its citizenry, thisreport attempts an examination of Rio City's dependence on these "transfers from above".

Table 2.3Cities as engines: spark plugs, fuel, and maintenanceFactors accounting for the success of selected large citiesCty Poation Main ftrparking Somae fctors fdelIn9 LUkely prospects for

9mietro regon) (mililons) earlygrowth recent success future success

Rio de Janeiro 10.5 Capital city Resurgence of Conditional: RevivingBrazilian economy, industrial growth, exploitingbetter management producer service linkages

Los Angeles 16.0 Military spending Geography, Good: much more diversified(CMSA) Latino immigration than commonly perceivedMiami 3.5 Military spending Geography, Good: Mutually reinforcing(CMSA) Cuban immigration finance, tourism, transportNew York 20.0 Trade Geography, Migration, Conditional: Still fiscally(CMSA) Federal programs, burdened by populist

Financial sector excesses of past mayorsHong Kong 6.0 British colony Geography, Conditional: Maintaining

(with policy of benign Chinese networks, govemment policy of "positiveneglect by colonizer) Excellent governance non-intervention"

Shanghai 13.0 Trade Geography, Good: broad industrial base,International trade human capital, location

Singapore 3.0 Geography Efficient government, Conditional: Investments ininvestments in skills, R&D and quality physical and

Chinese networks human infrastructureBarcelona 2.0 Geography Infrastructure Good: Export-oriented

investments, industry as economic base;special events expansion into logistics

Notes: See chapter 1 of Volume II. CMSA is consolidated metropolitan statistical area.

Rio de Janeiro: A City Study fo

25. It is no secret that Rio City depends considerably more than other Brazilian cities on publicemployment (see Table 2.4), especially on federal jobs and federal pensions. Thus, while 8.5% ofRio City's residents cited federal public employment as the main source of labor income, this ratiowas less than 4.5% for the country as a whole. This dependence is attributed to its past as thecapital, and the continued presence of many federal agencies and enterprises whose staff wasreluctant to move to Brasilia.

26. What is less well known, and hence the news in Table 2.4, is that the high public sectorshare in employment in Rio City is entirely at the expense of industry. This is not necessarily acause for concern: it can be attributed to Rio having moved on - a /a Hong Kong - to become a cityspecializing in modern industry and business services. Indeed, productive services do account formore of Rio City's employment: almost 10% compared with 8% for other metropolitan areas. Butthe finding that Rio City and the Rio metropolitan area have only about 5% of workforce in theirmodern industry (e.g., electronics, precision instruments and pharmaceuticals, as opposed totraditional manufacturing such as food and kindred products and metalworking) compared with thenational metropolitan average of more than 9% is more troubling. As (relatively high wage) federalgovernment employment in Rio falls to parity with comparable parts of Brazil, Rio City will have todepend mainly on modern industry and business services to preserve its reputation as a highwage, white-collar city.

Table 2.4Public Employment in Rio City is 33% Higher than the National Metropolitan AverageSectoral Employment Shares in Rio City, Metro Area, State, and Brazil, 1998

; t :r ~~~~~~~~~~~~pj: el, ngi ME=-

Modern 5.1 5.6 5.4 9.2Traditional 6.0 6.1 6.2 7.9Construction 5.0 7.1 7.9 6.9Extractive 0.3 0.4 0.7 0.3

0 Se rv00 02002 ic000t00 0 t;;; i 0:00 0 03t;00es 66it-.4r f5,1 82.2 80000 lt03j;00 V000 Sj061.400Distribution 25.2 24.8 23.6 24.6Productive 9.6 7.6 7.0 7.7Social & Other 31.6 32.7 31.6 29.1

Pub(k0S~xr 18.5000;0000000* 14.4 14.2 1Civil Service 7.8 7.1 7.8 6.7Enterprises 1.5 1.2 1.0 0.9Military & Other 7.4 6.1 5.4 4.8

Agilurde 07 010.3 3.28 ;1Source: IBGE PNAD Surveys, special tabulation by Marcelo Neri.Notes: Numbers are in percent, and are approximate.

27. Another "hidden" source of income for the city is federal pension payments. The Brazilianfederal social security system and public pension and survivor benefit systems are among the mostgenerous in the world. Workers with high levels of education - found in greater numbers in Riothan elsewhere - can "retire" with many years of productive life still ahead of them (see, e.g., WorldBank, 1998) with pension levels as high as their final salary levels, and these benefits are passedon to their survivors to continue on for many more years. Rio, as the preferred home of manyformer federal and state government employees and well-educated private sector workers, has


historically captured a lion's share of this expenditure. In 1996, 24% of the city's residents citedsocial security benefits as their major source of labor income. The ratio for Brazil as whole, at15%, was almost 40% lower. While these ratios may not change quickly, the aggregate incometransfers that they represent will fall as deeper social security and public pension reforms sliceaway at these benefits over the next decade.

28. No sub-national government in Brazil can completely ignore the effects of a deepening fiscaladjustment at the federal, state, and municipal level. But because of its special past, Rio City'spolicy makers must be especially aware of the likely effects of impending changes in public salaryand pension payments "from above". Its homegrown economic activity will have to step up todiminish the adverse impact. Unfortunately, industrial and service sector dynamism is on thedecline. Industry is increasingly polarized between a few large firms and a large number ofmicroenterprises, with few direct linkages. And the service sector has become progressivelyinformal and less dynamic.

2.4 Industry: A Vanishing Middle

29. It is striking how many successful cities - each known for a single high profile activity - areupon closer examination found to depend upon a broad base of economic activity for employment,a healthy share of which is invariably industry. Los Angeles is famous because of Hollywood andtheme parks, but in fact has thriving textiles and garments (the largest in the US), electronics, steel,automobile, food processing, toys, and consumer durables production. Barcelona, known for itscultural attractions, actually relies heavily on textiles, automobiles, pharmaceuticals, publishing,and graphic arts for high wage employment. Industry accounts for a good share of employment inMiami, which is thought of mainly as a gateway to the US for travelers from south and centralAmerica. Large, vibrant cities seem rarely to have small, stagnant industrial sectors (see, forexample, Williamson 1992).

30. Statistics on industry and trade are scanty. What information is available shows that the Riometropolitan region, especially Rio City, has been steadily losing industrial employment.Registered employment in mining, manufacturing, and construction fell from about 400,000 in 1991to less than 350,000 in 1996. While hard numbers are missing from the discussions on this topic, itmay safely be said that many of the firms that have vanished are small to mid-sized, definedroughly as those with 10-100 employees. There are three particularly worrisome aspects:

* There are few new entrants into light manufacturing, engineering, electronics, andmetalworking.

* More than 80% of industrial output is produced by large firms that employ less than 5%of the sector's labor force; more than 80% of sectoral employment is in small firms, withonly 15% in medium-sized enterprises.

* There is little evidence of subcontracting relationships linking small firms to largeproducers.

31. So Rio lacks the industrial backbone of dynamic medium-sized companies (e.g., in Germany


and Italy), which have risen from the ranks of small firms and serve as role models for starterenterprses. Such success stories are rare in Rio's manufacturing sector, but H. Stern andCompany provides an excellent example (see Box 1).

H. E

Brazil produces about 90% of the world's aquamarines, and as much as 75%trof the amests, tourmalines, ctines,and ther olo:red gems.: Brnging these gemns intotewolmarketto vie foraenton tdiands, emeralds,rubies, and sapphires has been HansSterm'stask sa 1945, when founddhiscoawith j$Heakdquree nfipanemna, H. Stem & Company niow has aot 175branches aroudthe woldand accunts for 0bout two-thirds f Brazil's gem trade But thefirm has teadfastly kept semi-precious gems,found:in aiXbunce d inci

Bazlbut o nmn othe*rcutries, sthe maofinAstayofte bsinss.0200j);0 20X0k0;i 0z ; 0it0

t0The company 0vertically integrated, haning every atitomminglishing, andng, to crafting and sales,Wealthier toraz are blitzed with inrmation onthefirm's prodcs-bousareprvided to guestschecking into top hotel in Rio, and the city is dotted wi gliyHS e.a treated to a visitto :the company workshops a ndmuseumX in; ipnema, which haXe become tourist attractions. Prces in Rio are lowerthanthosequoted in New ork. 0% of H. gStem's tl s certhe top10% cients,iating thehighX qualtyof gems and craftsmanship.:Each gem sold ome s g tee2fguaty, whis honoat H. Stem

The suess of the Company is attributableto th oqualeof its randa soun business strategy.t*00 H onesty and hard wrk.HansStem's initial succsay havein somemesue bn due to his honesty in

dealing with gem prosp4etors accustomed tobeing swfindled by gem dealers. Initial growth was driven by his old-tfasioe work e0thicMr temaznd hs mpoye are isaitobhadatwork kdurinEg C¢araval, when 0maney oter;: bu: sinsses slow or close don,09 ;A ;S f;i;S:ii:::V :

* QUaK4' and design. The quality of the comay prod is hig,0 and th firm uses a sprawl ngintemationatnetwork to ketl}ep iup wji.thchanesin fas;hio. :X 0 0 i t05:; : : : :i::Shrewd akn 0000 0s Using Rio as the sales center allowed the opany to target rich customers since the 1970swho ar na0turally large part of the imat for luixury good sc as epsive jewelry.

:* R ela on, orsTijs in ttimalklowedH. Stem& Co. to ete freign markqes, tus assurnng steadilygroin sal0t; es and profits even wen} the Brazilian anlr aioeconomny slumpd.000 000

H Stern may be a good model for ma Ri flg ent rs, butespally so foethose in fashiongarments, footwear adjewelry.

Box 1

32. To some in Rio, a city that hopes to specialize in high value-added services, rapidly losingindustry may appear to be a minor problem, potentially remedied by aggressive growth in financialand business services and tourism. But the experience of large cities worldwide indicates thatsustaining growth will be difficult for a city of Rio's size without a vibrant industrial sector thatcreates the impetus for growth of modern business services. The next section documents that theprice Rio is paying for a relative neglect of modem industry is the loss of high value-addedservices. At Rio's stage of development, the two are complements.

2.5 Services: Increasing Informalization

33. Gross aggregates do not tell the full story, and may lead to the wrong policy conclusions. Acase in point is that while industry has shrunk in Rio City, the service sector has burgeoned. Even


formal employment in services grew from 727,000 to 780,000 between 1991 and 1996, andinformal employment - fueled in large part by poor design of the benefits that payroll taxes fund -in the service sector has certainly increased by more than this. It may appear that the servicesector is compensating for the decline in industry.

34. This would be a potentially devastating conclusion for city officials to draw,

* The decline in modem industry has been accompanied by a decline in modern businessservices. Employment in financial institutions in the city, for example, fell from 90,000 in1991 to 60,000 in 1996. Rio City is hemorrhaging high value added industrial jobs andeven higher paying finance, insurance, and real estate (FIRE) employment.

* Distributive services - which are somewhat lower in the value added chain - were 25%of Rio City's total employment in 1996, about the same share as for metropolitan Brazilas a whole. Registered employment in retail and wholesale trade rose only sluggishlyfrom 255,000 to 275,000 during 1991-1996.

* One in three workers in the city work in social, personal and other services, a subsectorthat is highly informal with relatively low average productivity. This is where growth inservices is coming from. Business units in this segment start out small and generallystay that way, as individuals or as microenterprises.

35. While a large personal and social service sector is an important part of any city economy, itis hardly the alternative lifeblood to vigorously expanding modern services and industry.

2.6 What Could Lead: Infrastructure, Tourism, Business Services,or Industry?

36. Defining Rio City's objectives more narrowly than the Piano Estrategico as economic growthand poverty reduction, and given the institutional and financial resources at its disposal, the optionsavailable for faster growth can be defined as four strategies: infrastructure-led, tourism-led,business services led, and industry-led. As indicated by the experience of cities such asSingapore, Hong Kong, Seoul, and Los Angeles, the fourth is critical to Rio's success. This sectionbriefly discusses the relative merits of the first three, and points out the advantages of the fourth.The next section outlines the principal ingredients of a strategy that relies on the impetusesprovided by a dynamic industrial sector. Chapter 1 in Volume II deals with these matters inconsiderably more detail.

Not Infrastructure Led

37. Infrastructure itself - that is, civil works construction - cannot be the basis for economicgrowth. Recent research suggests that investment in infrastructure such as telecommunicationsand roads can spur growth by lowering the costs of doing business and increase the efficiency offirms (see Canning, 1997). Rio would definitely benefit from greater investment in water andsanitation. Telecommunications facilities are widely believed to pose serious bofflenecks to manybusinesses. And World Bank (1996) documents that an inefficient port system adds about 5% tothe cost of exports, reducing competitiveness and stunting the growth of trade in the region.


38. But compared to most megacities in the developing world, the quality of availableinfrastructure in Rio City is adequate. Most required infrastructural improvements have beencompleted or are well underway:

* The new 21 km Yellow Line highway linking Barra da Tijuca to other parts of the city isalready functional.

* Metro, the city rail system, has been concessioned to a private operator, and service isexpected to soon improve.

* Major improvements in the suburban railway network Flumitrens are planned.

* Further improvements are expected in telephone service when TELERJ is privatized.

* Use of cellular phones has spread since the B-band auction by TELEBRAS in 1997.

* Rio's Teleport, pressed into service last year, has improved telecommunications.

* The ongoing investment in port facilities in Sepetiba Bay will improve service quality.

Very modest doses of infrastructural investments combined with better (road and sea) trafficmanagement are all that is needed to help growth along. These investments are unlikely, however,to result in a sustained increase in growth rates. Rio must look elsewhere for a growth leader.

Perhaps Not Even Tourism-Led

39. Tourism is a popular second option among policymakers in Rio and in other parts of Brazilsuch as the Northeast. The appeal is understandable: Brazil gets less than 2 million foreigntourists annually, less than neighboring Uruguay, so tourism is believed to have almost unlimitedpotential. In 1996, London had about 25 million visitors, New York pulled in 31 million tourists (whospent more than $13 billion), while Rio City had 0.5 million foreign visitors and 1 million from otherparts of Brazil. Besides, the majority of Rio's tourists spent only 2-3 days in the city, spending onlyabout $100 per day. Hotels and restaurants employed less than 100,000 workers in 1996.

40. Given Rio's natural assets, revenues from tourism are likely to grow rapidly as long as LatinAmerica enjoys economic prosperity. Though it has more potential as a growth leader thaninfrastructure, this report questions whether tourism is the growth leader that many of the city'swell-wishers seek. At least for the next decade or so, tourism will not provide economy-wideimpulses of adequate strength to pull along the economy on its own. It still has a very small shareof the city's employment and income, and the immediate potential for a leap in tourist-relatedrevenues is small. There are reasons also to believe that long-staying big spenders may not bedrawn to Rio in the near future because of:

* Hotels. Room prices are high even in relatively modest hotels, though the devaluationof the real in January 1999 may have lowered the price in foreign currencies somewhat.About two-thirds of hotel spaces are in the 4-5 star category and only one-third in the 1-3 star category, when in fact - given the profile of Rio's visitors - the ratios should bethe other way round. Besides, the number of large hotels belonging to internationalchains - which tend to have lower unit costs and attract a class of visitors who are likelyto spend more than $100 per day - is small.


Airfare. Air travel to Rio remains expensive, though the devaluation of the real maychange this. Until 1998, however, regulations, airport fees, and fuel costs had limitedcharter traffic to 5% of the total as compared with almost 50% in the US and Europe.

* Attractions. For the long-stay tourist, Rio still has to develop more sites and activitiesto offer. Beaches can be crowded or polluted, the cultural or historical spots in or nearthe city have not been brought into the main tourist circuits, and the tract of forest withinthe municipality has not yet been fully exploited.

* Crime. Since the 1980s, the city has acquired a reputation for crime and violence.Even in today's peaceful atmosphere, the favelas overlooking Ipanema and Leblonserve as reminders of Rio's documented social inequality and stereotyped lawlessness.

41. More aggressive overseas marketing (beyond the annual publicity for Carnava)) plussustained efforts to provide a greater range of attractions for tourists will increase their inflow. But- given Rio City's size - the gains are likely to be modest in terms of their contribution to Rio'soverall economy. Rio does not yet have the potential to join the league of major tourist centerssuch as New York and the Caribbean, and it will inevitably have to share the increased touristtraffic to and within Brazil with destinations such as Salvador. While tourism will almost certainlycontribute to Rio's growth if it continues to shed the disrepute earned in the 1980s, tourist tradeshould not be viewed as a potential growth leader for a large and ambitious city.

Nor Business Services

42. High value added services such as finance, insurance, real estate, accounting, marketing,consulting, publishing, and entertainment can be important sources of growth for big cities. Theseservices are the lifeblood of cities such as New York, London, and Hong Kong; all relied more onmanufacturing in the past. London, a city of about 7 million, employs 800,000 workers in businessand financial services. Cities serving as regional hubs of producer services have generallycapitalized on:

* Growth in sales due to the trend towards leaner organizations focussed on corefunctions, in large part facilitated by outsourcing services to other firms.

* The continuing appearance of new products and services with increasingly finer divisionof labor.

* The development of computer and telecommunications technologies which allowssuitably tailored services to be delivered to distant clients.

43. Cities that have emerged as profitable providers of producer services are believed to havedone so because they have started with a thriving and dynamic industrial base, or had a strategiclocation relative to other industrial bases. For example, more than 75% of the Hong kong economyis producer services, but this is largely the result of firms formerly classified as manufacturinghaving moved the core components of their business to mainland China or third countries, andbecoming reclassified as services.5

5 By keeping headquarters, accounting, marketing and research in Hong Kong, while moving production to mainlandChina or third countries, a manufacturing firm could be reclassified into services (Enright, Scott and Dodwell, 1997).


44. The hinterland that Rio City serves is still Brazil's industrial axis, so it remains well placed toserve as a national hub for business services. About three-fourths of Brazil's oil production comesfrom the Campos Basin off the coast of Rio State, and the headquarters of the national petroleumregulatory agency is in Rio City. This pattern - of Rio City providing the business services forindustry in Rio's hinterland - could, if nurtured, be replicated for other industries. During the lasttwo decades, however, industries in the region have concentrated around Sao Paulo; others havemigrated to Curitiba, Porto Alegre, Salvador and Fortaleza. And Sao Paulo has been the preferredlocation for business services for the last decade. The trend in Rio has been towards a growth inlow value-added personal and other traditional services, which have few spillover effects thatstimulate other sectors. The decline of business services has paralleled the shrinkage of themunicipality's industrial base. Traditional and personal services will, by virtue of their size,continue to drive growth in Rio City. But the resurgence of higher value added modern businessservices - to the point that they becomes a major source of growth in the municipality - will dependon renewed industrial development in and around Rio,

2.7 The Ingredients of an Effective Industrial Revival

45. The debate on local economic development policy has two sides - interventionists andskeptics. Interventionists base their arguments for activist policies on the existence of marketimperfections and the ability of local officials to avoid gross miscalculations. Skeptics believe thatsuch activism leads govemment to give away as tax concessions and subsidies more than whatthe city gets in terms of expanded economic activity. For large cities such as Rio de Janeiro, thereare additional reasons to be cautious:

"It seems plausible that the larger the place, the better the case of the skeptics.... it is easier to makevisible changes in the climate for location decisions in a small place than in a region like (New York),where a multibillion dollar investment program may not persuade anyone ... that transportation facilities,for example, have improved. Moreover, the information costs of reaching all or most potentialentrepreneurs can be extremely high in a large place. There are frequent reports in (the New York)area that most proprietors of small enterprses, actual or potential, are quite unaware of most incentiveprograms". Netzer, page 97, in Federal Reserve Bank of New York (1997).

A good starting point for Rio's policymakers would be to examine which existing policies are non-neutral or hostile to economic development, remedy this damage by policy reform and treat anyadditional measures - whether to offset market imperfections or countervail policies that cannot bechanged - with a healthy dose of skepticism.

46. The experience of cities in other countries with per capita GDP of less than $10,000suggests that modem industry is the main engine of city economic growth. For cities that havedeveloped an industrial base and supporting hinterland, making the engine stronger and smootherrequires a judicious mix of enabling policies and modest incentives. For Rio, which has lost someof the industrial base that it had developed, this report recommends an approach that has thefollowing key elements:

* Macroeconomic framework. Healthy rates of national growth, price stability, andmoderate to low real interest rates.

* City management. Efficient management of the city's infrastructure and essentialservices, and keeping municipal spending affordable given the city's budgetary


constraints. This is taken up in chapter 4: it is worth noting here that there is someevidence from the US that municipal investment in basic city services (such as timelygarbage collection and making schools better and safe) has high returns.

* Human capital. Effectively utilizing the available resource base, such as worker skills,university infrastructure, and exploiting the producer services mix.

* Entry barriers. Lowering entry barriers to all new firms, by reducing the costs ofcomplying with tax and regulatory requirements that are made more reasonable.

* Networking and "open systems". Municipal initiatives to correct possible marketfailures, potentially most prevalent in the market for industrial information. Governmentshave sometimes facilitated inter-firm networking, e.g., through municipal promotionalschemes for smaller firms that utilize selected large corporations as "nodes" andencourage greater international orientation.

* Large "linkage-intensive" firms as business incubators. In a world where othercities and states will continue to provide incentives for firms to locate production facilitiesin selected areas, the municipality may be left with no choice but to do the same untilword of the city's sound regulatory policies and other advantages spreads. Efforts tofacilitate the arrival or emergence of one or more major international corporations thatare known to champion "open systems" and thus act as natural incubators for small andmedium firms. If efforts to attract such firms are not successful, modest govemment-sponsored incubator programs may help some potential entrepreneurs overcome credit,space, technology and marketing constraints.

47. This section briefly discusses each of these. Before we go on, note also what the above listdoes not contain:

* Large investment incentives. These have not been shown to be effective, but havealways proved to be costly.

* Enterprise parks. Building of research or industrial parks, which have at best a spottyrecord.

* Venture capital. Government attempts to attract venture capitalists have not beensuccessful (Saxenian, 1994).

* Subsidized credit. Cheap credit to producers is costly for govemment but has notalways been shown to lead to sustainable job creation.

Resisting some of these popular (but costly or ineffective) programs can be a tall order for anyambitious city government. But in the discriminating world of "smart cities" in which Rio wishes tocompete and prosper, even mildly misdirected efforts have large opportunity costs.

Support for Macroeconomic Adjustment

48. As discussed earlier, in large cities such as Rio that are integrated with the nationaleconomy, economic activity in the city largely tracks the country's growth. Since 1994, Brazil hasenjoyed a period of increasing price stability: today, inflation appears to be a concern of the past.Combined with an aggressive privatization program, this has resulted in an inflow of foreign


investment second only to China among emerging economies. Rio has benefited from this too: ledby an aggressive privatization program, foreign direct investment in Rio state was a large part ofthe total. The decline in average protective tariffs from 27% to 11% between 1991 and 1997 hasalso exposed firms to the discipline of international competition.

49. The end of inflation has revealed weaknesses in some systems, principally publicemployment, social security, and labor regulations, and has contributed to the rising fiscal deficit ofconsolidated government. And the decline in protection has exposed Brazilian firms to Asianproducers, and led to the hollowing out of light, labor-intensive industries in large cities such asRio. Countering these adverse changes is not entirely within Rio's power as a municipality.Nevertheless, it can contribute visibly towards supporting the national fiscal effort - thus ensuring ahigher rate of national growth - and institute measures to make its own economy more competitive- thus pulling ahead of the national average.

Using Available Human Resource Endowments

50. In a world that is expected to reward skilled workers more, Rio's superior human resourcefacilities make it feasible to attain a growth rate that is higher than the national average. Accordingto the latest numbers compiled by UNDP, Rio City's education and health standards are among thehighest in the country, especially remarkable for a large and diverse municipality. The share of thecity's population with a university degree or equivalent is 17%, compared with Rio State's 10% andthe nation's 6%.6 City residents with less than 4 years of schooling are 17% of the population,compared with 26% and 43% for Rio State and Brazil. Besides having the capacity to producehighly skilled people in its educational institutions, Rio also has pools of skilled, semi-skilled, andunskilled labor to draw upon immediately and at lower cost than its competitors. Average laborcosts in Rio were R$530 per month in 1997, as compared with about R$700 in Sao Paulo.

51. Hence, from the labor market perspective, Rio has three advantages that it should exploit:

* Technical and professional skills. A supply of technical and scientific manpower thatis large by Brazilian standards because of the many universities and technical institutesin the municipality.7

* Sector-specific skills. Leftover skills and traditions in four industries that are now inretreat - apparel, footwear, engineering, and shipbuilding - which, if not allowed tolanguish for much longer, can be harnessed for a fresh round of industrialization.

* Unskilled labor. A large pool of unskilled and semi-skilled workers, many of whocurrently hold jobs in the informal sector or in low-paid services. Several industries thatcan reasonably be expected to flourish in the municipality such as electronics8, fashiongarments, leather goods, and jewelry have labor-intensive segments and would requiresizeable labor inputs.9

6 The corresponding ratio for Sao Paulo was 13%.7 Though Rio does less impressively compared with other cities in Brazil if judged by the performance of its students onstandardized tests.8 Contrary to common perception, the electronics industry depends on an array of assembly services conducted on abatch production basis by unskilled workers, such as wire-wrapping, attaching components to circuit boards, cableharnessing, and testing (Allen, 1992).9 These subsectors are important in Los Angeles, and garments continues to thrive in New York.


Lowering Entry Barriers

52. If there is any consensus in the field of regional development, it is that for large cities suchas Rio, govemments can best help industry not by creating enterprises or subsidizing their creationin an environment hostile to business, but by not doing things that create these conditions. Overthe years, cities like New York and Rio de Janeiro have created industrial deserts by erectingbarriers to business, and have some dismantling to do before launching interventions.

53. Entry by entrepreneurial new firms, which bring fresh ideas and the latest technology(Audretsch, 1996, and Roberts and Tybout, 1997), is fraught with difficulty even in developedcountries (Acs and Audretsch, 1993). Smaller companies in the US have to contend withregulatory requirements, health insurance for employees, expensive liability insurance and acomplex tax code. But these companies are usually blessed with access to capital and technicaland managerial skills. The registration and licensing requirements that a potential new entrant mustfulfil in Rio municipality can involve six months of red tape and an exhausting paper trail. Access toskilled managers can be tight, and credit is expensive. Improving access to credit and skilledworkers is not something the municipality can do in a hurry, but it can help to reduce red tape inlicensing, regulation, and local taxation, Hong Kong's tax code is marvelously simple, affordingmany firms the luxury of having part-time accountants and giving them an edge over their rivals inricher countries. Rio can give its own fledgling firms - which are struggling against Asian, US andEuropean competitors - a similar edge by drastically simplifying licensing and local tax procedures.

The Excessive Cost of Pollution Control

A systematic study of Rio State's environmental problemns and management systems in 1995 found that the licensingprocess and the general approach to environmental management was based on an inflexible bureaucratic mentalitythat focused not on environmental outputs but on micromanagement of detailed engineering aspects of individualplants. While targeted enforcement at only 1X0 plants in the state would address more than two-thirds of Rio'sindustrial pollution problem, FEEMA, the state environmental control agency was operating on a wider front with fewtechnical and financial resources.

An environmental management system that fails in its corefunctions, including the systematic oilection ofenvironmental data and speedy processing of permit applications, creates a tigh cost for business and undermrinesefforts to atrac investors. Preditability of environmenta regulations is most va(ued by businesses. The processing oflicense applications by FEEMA can take up to two years, forcng firms to either stay illegal or delay investments. Thelack of systematic enforcment also makes it harder for companies to comply with ISO norms or other requirements byustomers.

Efforts to decentralize environmental management within the state are now underway: the municipality will take overthe licensing of actvities that have local environmental impact Rio municipality would do well to expliitly incorporatethe lessons of the state government's experience in designing the rules for this licensing.

Source: World Bank (199614Box 2

54. It would be incorrect to assert that all industrial regulations could be simplified or that manyshould be eliminated. For example, some of these regulations were designed with environmental


protection in mind, and Rio should be especially protective of its natural beauty.10 But a recentstudy of Rio State's environmental management practices (World Bank, 1996b) has shown thatdue to poor pollution management, Rio suffers from both high costs of excessive pollution andexcessive costs of compliance with environmental regulations (see Box 2). A critical analysis ofRio municipality's regulations would be good first step in its efforts to help businesses.

Encouraging Networking and "Open Systems"

56. The points discussed above are the pillars of economic prosperity. The capstone for thesuccess of Rio's industrial economy would be the adoption of a structure that is inherently dynamicand competitive. Clothing and electronics might attract their share of start-ups, but only asadjuncts to a core of higher value added activities. Rapid growth that calls for the ability tointroduce new products with regularity - through a focus on market trends, close interaction withclients, rapid product development and effective marketing of new items - is best derived fromopen systems (see, e.g., Yusuf and Wu, 1997).

57. With a small number of relatively autonomous capital-intensive large firms and few mediumenterprises, there is limited scope for exchange of information and technical assistance amongcompanies. The size distribution of firms has been found to determine the scope for networking,and the "missing middle" in Rio implies that networking would be weak. So does the industrialcomposition: networking possibilities are greatest in electronics and engineerng and weakest inpharmaceuticals, petrochemicals, publishing, and metallurgy. In Rio City, printing, metallurgy, andchemicals are now three of the largest six employers within manufacturing.11 The shift in Rio'sindustrial structure towards capital-intensive and mature process industries could be leadingtowards a less integrated and intrinsically less innovative industrial system.

58. The "open systems" model is one of several forms of industrial organization that can beconsciously adopted, and may be most suited to Rio's existing industrial base, skill mix, researchinfrastructure and wage levels. There are several features of open systems conducive to efficiencyand innovation:

* First, an open networked structure blurs the distinction between large and small firms.In fact, the norm of such an organization is the medium or small size business. The stemcompany - be it Nike or Benetton or Sun Microsystems - designs the product with itssupplier, defines specifications for the items it needs and encourages its associatedbusiness and others to bid for contracts. This allows the stem company to remain smalland to concentrate on market research, product development, and strategy.

. Second, an open systems arrangement encourages new entry, promotes thespecialization of firms and builds sub-sectoral depth. Firms compete against each other,but also derive benefit from sharing knowledge through social or business networks,information centers or the circulation of employees.

10 For an interesting discussion of the policy implications of treating Rio City's natural beauty as a public good, see thearticle by Camargo in Kreimer, et.al. (1993).11 Food, clothing and footwear, and machinery are the other three subsectors.


* Third, a flexible industrial structure that draws strength from business and socialnetworking is well positioned to benefit from information technology and is likely tonurture many small, fruifful, joint research activities (Castells and Hall, 1994). Theincremental refinement of existing products and steady emergence of new productsrequires such interaction all along the production chain. The advantages ofcollaborative manufacturing have been noted for industries ranging from metalworking,to textiles, furniture and food products.

* Fourth, networking builds the trust that forms the basis for agreements on technicalstandards and certification. It reduces transaction costs because the need for formalcontracts is reduced. As a networked industry acquires a reputation for innovation andexport success, members get better access to banks and venture capitalists.

59. There is no single recipe for bringing successful open systems into existence. Nonetheless,the experience of manufacturers in Tuscany and Lombardy in Italy, Denmark, and Baden-Wurttenburg in Germany offers some clues: business associations that work closely with municipaladministrations; industry-sponsored centers that provide member companies with guidance in theareas of forecasting market trends and offers technical services; and business schools that helpentrepreneurs get information on marketing, financial and accounting services (see Box 3).

Encouraging Innovative Business. Some Promising Schemes

Attempts to induce innovative business activity have led to a large number of schemes being tied worldwde. A few,t such as the following, appear promising and could - after more detailed review - be adapted to Rio City'scircumstances and fiscal constaints:* Business-Academic Linkages. Israel's industrial research consortia plan (Magnet) provides grants to groups

composed of at least two industrial corporations and an academic institution. The research must meet certaincriteria regarding commercial worth and those involved must demonstrate the capacity to do the research, anddevelop and market the product. Grants cover 66% of the cost of research. Academic institutions receive 80% oftheir costs from Government, the remainder from participating companies.

* Credit Guarantees. In Modena, Italy, a local consortium of 3,500 smell and medium sized firms has introduced aGuarantee System for credits obtained by the members. Each firm in the consortia pays a membership fee thatgoes to the fund and is supplemented by contributions from the municipal, regional and provincial governments.A committee comprised of local entrepreneurs screens applications from member businesses. Approved loanapplications are forwarded to commercial banks with a partial guarantee for the loan (Leonardi and Nanetfi, 1994).

* Research Coupons. Argentina is introducing a scheme to raise the level of research and the technologyintensity of small firms. A $20 rillion credit line will be established for local or foreign companies that undertaketo do research or contract with research institutes. Credit certificates - that would offset income tax liabiliSies - willbe allocated for up to half of project value. They are designed to help generate prvate financing.

* Technical Advisors. A scheme, also in Argentina, will pay half of the costs of technical advisers hired by smalland medium enterprises to solve technical problems and enable them to introduce new technology. The adviserswill work under the supervision of participating specialists fom local universities and research institutes.

Box 3


Enabling start-ups: "natural" and conventional business incubators

60. Finally, there are advantages to be had from the presence of one or more large companiesthat champion open systems and, in the style of Hewlett-Packard, foster an environment conduciveto informal networking. Referring to firms such as Asea-Brown Boveri, Nike, and Benetton, it hasbeen observed that in terms of their core activities these firms are small and local but, judged interms of contract workers, they are sprawling multinationals. A very small number of firmsconforming to this type - even a single major company - would push Rio into a higher industrialorbit. To the extent that efforts to attract such firms require municipal finances, they should be inplace of - and not in addition to - outlays for industrial parks and incubator schemes of the typethat the municipality is currently supporting (see Chapter 1 in Volume II).

61. The emergence of a few large companies in fast growing industries would provide a majorboost to economic activity in the metropolitan area. However, the gains in production, inemployment and in total factor productivity will come mainly from the entry and expansion of newenterprises, which - casual empiricism suggests - is happening only on a limited scale. The fewfirms in the medium-sized category operating in the municipal area points both to problems withentry of small enterprises and to constraints on their growth. Attracting a few large companies, inindustries that are known for spin-off and networking potential such as computers and garments,can provide the start of a virtuous spiral. But continuation of the spiral will depend on the evolutionof small and medium sized firms. The task of economic renewal will be facilitated if Rio quicklyeams a reputation for having a city government that cares for enterprises and families, but does sowithin fiscally prudent limits. Given the initiatives in the areas of private sector partnership andsocial programs during the last six years, Rio seems to be moving in the right direction on manyfronts. The next two chapters provide some guidance how this resurgence can be strengthened.


CHAPTER 3THE PEOPLE: SOME IN LEAKY BOATS

3.1 The 400 Million Real Question: Aggregate Poverty Gap

62. About 16% of Rio city's residents were poor in 1996, as defined by a commonly usedpoverty line of R$86 of monthly per capita household income. Complaints that this level of incomeis unrealistically austere may be justified. But even using this line, about 850,000 people can beclassified as poor in Rio City. And while the incidence of headcount poverty is lower in Rio than inmost other parts of Brazil (see Table 3.1), it is still significant and should be of concem to anygovernment, especially one of a wealthy city where rising prosperity has not always lifted allincomes uniformly. We use information from the 1991 Census, 1996 household survey (PNAD),and 1997 Living Standards Measurement Survey (PPV) to see what the government can or shoulddo to address this concem. Chapter 2 in Volume II deals with these issues in more detail.

Table 3.1Rio Municipality Has a Relatively Low Poverty RateHeadcount Povertv Ratios in Brazil's Metropolitan Areas, 1996Area Nuime of Poor Sweo P6p bew

Poetytne

Metropolitan Brazil 9,512,500 21.0%MA Belem 360,200 38.4%MA Salvador 914,700 35.1%MA Recife 872,900 33.1%MA Fortaleza 676,100 26.6%

MA Belo Horizonte 703,300 19.7%Brasilia 326,600 19.3%MA Sao Paulo 3,034,100 18.9%MA Porto Alegre 435,700 13.7%MA Curitiba 121,300 5.5%Source: IBGE/PNAD - 1996; special tabulation by Sonia Rocha.Note: The poverty line used is household per capita income of R$86 per month.

63. Using a poverty line of annual household per capita income of R$1000, one can onlyobserve this poverty ratio in a city with a per capita GDP of about R$10,000 if the incomedistribution is highly unequal. And, of course, it is: the richest 10% earned almost 45% of the city'saggregate income, while the poorest 20% of the population gets less than 5% of the city's income.The total transfer required to bring all the poor up to the poverty line (a measure that economistscall the "income gap") - and thus theoretically eliminate poverty in that year - is less than R$400million. This is about 10% of the municipal budget, and a little more than 0.5% of the city's GDP.Faced by such simple arithmetic, it is tempting to regard poverty in the city as an unnecessarytaint, which can be squashed simply by affecting an annual transfer to the poor.


64. This was precisely the thinking among social activists in New York city during the 1960s and1970s, and state social workers were urged to find ways to help the poor. They responded bypufting and keeping them on federally funded welfare programs, in effect creating a semi-permanent welfare underclass. Welfare rolls have gone up even during periods of economicprosperity and low unemployment rates: by 1990, New York City had more people on welfare than17 states combined! With the restructuring of federal transfer mechanisms for these programs,New York state and city have been paying a high price for this. Fortunately, Rio's policymakers arenot inclined to follow New York's example. But this leaves them with the difficult task of decidingwhat to do instead. What follows may provide some help in these decisions.

3.2 Poverty Profile: It is Difficult to Tag the Poor

65. An important initial task in assessing the poverty impact of government actions or designingremedial or preventive poverty-related intervention is to determine what observable attributes areassociated with poverty. One may find, for example, that becoming unemployed invariably leads toa person being classified as poor, or that single parents are almost always poor. Altematively, onecould determine that people living in certain neighborhoods are likely to be poor. If policymakerscan identify a small number of observable characteristics that are associated strongly with poverty,it makes the task of alleviating poverty simpler. Unfortunately, Rio City's policymakers will not getmuch help in this regard.

66. Table 3.2 provides a profile of Rio's poor. The pattern indicated is a policymaker'snightmare: the characteristics that are the strongest predictors of someone being poor usually helpin identifying only a small number of the poor. Most illustratively, while one out of every twopersons who are unemployed is poor, only one out of every ten poor persons is unemployed.Almost two thirds of the poor are actually either inactive or have jobs as formal sector employees.And while households headed by women, very young, illiterate, agricultural workers are more likelyto become poor, the typical poor head of household in Rio City is in fact a male, 25-45 years old,with 4-8 years of schooling, working in the service sector. What this means in plain language isthat the causes of poverty in Rio are many, which in turn implies that the instruments required tofight poverty are likely to be numerous. Location is one of the better indicators of poverty, but it isnot very reliable either. Section 3.4 below addresses the common but misleading stereotype thatresidents of favelas are always either poor or criminals.

67. Contrary to popular perception, in-migration is not an important phenomenon in Rio City forexplaining poverty.12 Recent migrants to the city are not likely to be any poorer than olderresidents. Poverty rates are 16% for non-migrants, but only about 10% for those who migratedduring the last four years, 15% for those who came between 5 to 9 years ago, and 12% for thosewho migrated earlier.

12 The municipality's population grew by less than 0.7% annually between 1980 and 1991, while Rio metropolitan andBrazil's population grew by about 1% and 2% respectively.


Table 3.2A Policymaker's Nightmare: Rio City's Poor are Difficult to TagThe Incidence and Mass of Poverty among Household Heads in Rio Municipality, 1996

P Rt h

All 1 6 100 100Sex of Household HeadMale 14 72 65Female 19 27 35

Age (Years)15 to 25 31 3 725 to 45 18 44 5445 to 60 11 31 23More than 60 12 21 17

Education (Years)0 28 6 111 to4 25 9 144 to 8 22 26 38 to 12 12 39 32More than 12 4 20 6

ColorWhite 10 62 42Black 24 38 56

Sector of WorkAgriculture 26 1 1Industry 12 13 10Construction 18 8 10Public Sector 6 16 6Service 14 62 .6

Sector of WorkInactive 19 26 2Unemployed 50 3 10Formal employee 15 28 28Informal employee 19 8 10Self-employed 11 16 12Employer 5 5 2Public Servant 6 12 5Unpaid 28 1 2

Source: IBGE/PNAD 1996; special tabulation by Marcelo Neri.Notes: Shaded cells indicate highest percentage in each category. By way of explanaton and contrast, a"dream" scenario for policymakers interested in targeted programs would be if shaded cells are in the same line.

3.3 Social Spending: Targeting the Middle Well, the Tail Poorly

68. Using new data from a recently compiled Living Standards Measurement Survey, completedby IBGE with assistance from the World Bank, we analyzed which income groups benefited mostfrom expenditures on education, health, and labor programs. We were particularly interested inknowing how much of this spending went to the poorest 20% of Rio's citizens.

Education

69. The Secretariat of Education, which administers a budget of about R$400 million (or 10% ofthe total budget), is responsible for almost all public basic education in the city. 640,000 students


attend these schools. Due to its former status as a state, Rio municipality is unique in that theresponsibility for basic education is not shared with the state government. Only 10,000 studentsattend state primary schools.

70. Two findings are relevant in deciding whether education expenditures are targeted to thosewho need them most. One is non-attendance, and the other is enrollment in private schools.Available estimates indicate that about 5% of city children do not attend school. Non-attendance ishighest among the poor: one out of every five children from the poorest decile group does not go toschool. Going up one step on the income ladder, this number is a still high one of every 10 for thesecond-poorest decile group (see Table 3.3). The municipality has a food program for about20,000 families that is designed to increase school attendance, but does not systematically trackwhich children are out of school and why.

Table 3.3Many Poor Children Do Not Attend School; Most Rich Children Go To Private SchoolsPrimary School Affendance in Percent by Income Decile, 1996

I 71 10 2

3 87 11 24 73 27 05 52 41 76 27 64 97 48 48 58 33 67 09 17 83 0

10 6 94 0Source: IBGE LSMSIPPV, for Rio Metropolitan Area, special tabulation by Jeffrey Hammer.Notes: Numbers are for Rio metro area; survey size insufficient for Rio Municipality calculations.Shaded area approximates the poor. Decile groups - 1 is the poorest - are computed using Rio data only.

71. At the other end of the income spectrum, most rich children go to private unsubsidizedschools. Public schools are perceived to be of poor quality, and those who can afford to, avoidthem. This quality gap results in education spending being well targeted to poor and middleincome groups: an impressive three-fourths of the city's education budget is spent on the bottom30% of the population. If the municipality succeeds in bettering public education without parallelincentives to the poorest families to enroll their children, this targeting is likely to become weaker.

Health

72. Municipal spending for health has averaged about R$320 million over the last three years, or9% of the total. In 1998, it equaled 11% of total expenditures. Health services are free foreveryone. Municipal emergency centers are used by most people, because emergency care is nottypically offered in private hospitals. Public clinics are also used by people from many incomegroups, because they are considered reasonably well-run. For non-emergency medical services,public hospitals and outpatient facilities are believed to be of poor quality, but are frequently used


by richer segments of Rio's populace anyway. As a result, municipal health expenditures are notas well targeted to poorer groups as is spending on basic education. The best available estimatesare that less than 40% of the municipality's fiscal effort gets to the poorest 30% of the population,but such numbers should not be treated as conclusive.

73. The poorest groups use health facilities less frequently than richer residents of themunicipality but, when they do, they use public and not private facilities. For example, only 7% ofthe poorest decile group reported that they used private providers. Since the poor appear to haveno alternative, the issue is not whether the government should or should not provide healthservices. Healthcare issues of concem to the city government are:

* All three levels of government provide primary care in the city, a consequence of thesystem being in transition to a system when all primary care would be a municipalresponsibility. In the meantime, overlaps and omissions in prmary care provisionreduce system efficiency.

* Municipal facilities do not charge even clients with private health insurance. Thus, unlikethe US, the municipality acts as primary provider and not residual insurer, even thoughthe municipality does get partially reimbursed by the federal SUS system.

* Rio city's public health services are of better quality than neighboring municipalities. Percapita expenditures in Rio - at R$45 per capita - are more than twice those in theBaixada Fluminense.13 So there is considerable use of Rio Municipality's healthservices by non-residents.

74. The simplest solution to these problems appears to lie in fuller cost recovery from richerpatients who are residents of the municipality and from all non-residents residents. This issue istaken up again in Chapter 4.

Special Social Programs

75. The municipality's social development secretariat spends 1-2% of its budget on programstargeted at specific population groups, most of whom are likely to be part of Rio's poor. In 1997,the city's kindergarten program reached about 26,000 children aged 1-6 years, public pre-schoolsreached another 53,000 children, a food basket distribution program helped 20,000, schoolsupport, youth training, and street children programs helped 5,000 kids aged 7-18, and 4,000disabled and elderly persons also received city assistance. Optimistic calculations indicate thatabout 50,000 poor benefit from city welfare programs, or about 5% of the city's poor.

76. Even without rigorous evaluation of the actual effects of these programs, it is reasonable toconclude that more should be done. Encouragingly, this is exactly what the city plans to do. Acollaborative program among the Secretariats of Education, Health, Social Development, andLabor (Rio Crianca Maravilhosa) which is supported by the World Bank, will add 40,000 children tothe daycare and pre-school systems by 2001. The danger in rapid expansion of such programs ifthey do not formally target poor children is that more and more of their benefits may go to the non-poor. Without a reliable system of means-testing, the municipality's exposure to this risk is high.

13 With the exception of Duque de Caxias, which had per capita spending of more than R$70.


Labor, Training, and Microenterprise Programs

77. Reflecting the importance accorded to improving employment by the current administration,Mayor Conde has appointed a special secretary for labor. The main programs being launched bythe labor secretariat are adult education and training, job search assistance for the unemployed,and microcredit schemes for self-employment promotion (see Urani, 1999, for an excellentsummary of the rationale and design of the interventions).

78. Participants in the first phase of Rio's adult education program - about 4,000 persons, morethan 60% of whom are women and almost two-thirds currently unemployed - complete theirprimary education in about 8 months. The cost is about R$600 per student, which is less than oneyear of conventional primary education. The secretariat estimates that the total target population isabout one million, when the program is extended to secondary and pre-university education.Microenterprise support programs have so far helped these firms meet bureaucratic requirementsand improve their marketing. The secretariat envisages expanding this program to help these firmsaccess credit. The rationale for municipality-sponsored job search assistance and training is thatthe government can reduce job-skill mismatches, and hence reduce unemployment.

79. Given the broad mandate for this report, these programs were not scrutinized in detail. Ageneral overview suggests that while these programs have many desirable features, there arethree likely shortcomings of the municipality's labor-related programs:

* The first is that intemational experience with govemment-sponsored training and self-employment programs has not been encouraging, so the organizers of these programsappear to be defying the odds. OECD countries, where some such programs have beenrigorously evaluated, have found that they tend to be expensive and largely ineffective(Dar and Gill, 1998). The energy and care with which these programs are beingimplemented in Rio City may, however, raise the chances of their being successful.

- The second concerns their focus on the self-employed (viz., the microenterprise supportprogram) or the unemployed (viz., the adult education, job search assistance andtraining programs) when they together form only about 20% of the total poor in themunicipality (see Table 3.2). When viewed in the context of their likely cost-inefficiency,it is not obvious that the beneficiaries of these programs are the most deserving of themunicipality's scarce resources and attention.

* The third concems the piggybacking of these programs on the Favela-Bairro or slumupgrading program that the city has become well known for. The programs thereforeoffer free training and subsidized credit to people who are already beneficiaries ofspecial programs to improve their housing. If favela dwellers form a large chunk of Rio'smost poor residents, these double or triple benefits could be justified. But, as wediscuss in the next section, this assumption may not always be valid.

3.4 The Favela Bairro Program: Missing the Worst Off?

80. The Favela-Bairro or slum-to-neighborhood program is undoubtedly the flagship of themunicipality's fleet of interventions. The program - which is sponsored by the Inter-AmericanDevelopment Bank - is held up as a symbol of creative and effective partnership between city hall,


local interest groups, and a multilateral development agency. The program figures prominently indiscussions of municipal policies, and understandably so. First, favelas are the most visiblesymbols of the city's socioeconomic inequality: shantytowns overlooking expensive penthousesand hotels evoke strong sentiments in visitors and residents. The Favela-Bairro program promisesan end to this jarring imagery by integrating these colonies into the neighborhood. Second,favelados are believed to be the poorest of Rio's citizens, and the program is believed to be aneffective and sustainable anti-poverty program. Finally, the program holds out hope for betterpublic safety in the city since it is believed that the program will reduce crime in and aroundfavelas.

81. There are 462 favelas in Rio City, with about 900,000 residents. Access to public services issignificantly worse in favelas than other parts of the city: public water and sewerage servicesreached 83% and 48% of favela households; compared with 97% and 94% for the municipality asa whole respectively. The Favela-Bairro program targets 60 favelas with a total population of220,000, and improves their access to water, sewerage, streets, and security. By design, theselected favelas have a somewhat better service coverage than others: the program focuses onmedium-sized favelas that already have some infrastructure so that complete urbanization can beachieved at costs that do not exceed US$ 4,000 per household.

Table 3.4Less Than One Third of Rio City's Poor Live in FavelasHouseholds in Rio Municipality By Per Capita Family Income, 1991

De,le FavOa Isn- vla

1 - 1.2 107.62 47.7 112.33 39.5 122.14 32.4 129.05 25.9 136.56 18.6 144.37 11.9 150.98 7.0 157.99 2.4 162.8

10 0.8 164.0Total 237.4 1,387.4

Source: IBGElCenso Demografico 1991, special tabulation by Sonia RochaNote: Numbers are in thousands; shaded area approximates the poor.

82. From all accounts (rigorous evaluations have not yet been done), the Favela-Bairro programappears to be doing a good job as an urban upgrading project. It may not fare as well whenevaluated from a poverty alleviation standpoint.14 Using the same poverty line as that used toexamine the incidence of the city's social expenditures, there are more than twice as many pooroutside favelas than inside (see Table 3.4), living in irregular subdivisions, deteriorating housingprojects, or elsewhere. One in every five favela households is actually richer than the median city

14Again, it must be kept in mind that poverty alleviation was not the principal objective for Favela-Bairro. Themotivation for the project may have come from a program of urban beautification and upgrading, Rio Cidade, whichtargeted wealthier neighborhoods such as Ipanema. With Rio Cidade, the city risked criticism that it was onlyupgrading areas frequented by the elite, so in effect urban upgrading efforts were extended to neighboring, poorer,favelas. Therefore, while Favela-Bairro obviously targeted poorer areas than Rio Cidade, its roots were in urbanupgrading, not poverty alleviation.


household. Favelados are typically an entrepreneurial segment of the poorer population that hasrisked building houses on public lands without any title. The same entrepreneurial trait probablyenables them to earn enough to stay above the poverty line. And as currently implemented andreflecting its urban-upgrading focus, the Favela-Bairro Program actually targets the better-offfavelas. This further reduces its targeting effectiveness, viz., the share of benefits going to Rio'spoorest (as seen in section 3.5). With this program, the municipality appears to have chosen tohelp them instead of the poorest persons in Rio City outside of these relatively better off favelas,who may be more difficult to reach, or whom it tries to help through other interventions.

83. While the effectiveness of the Favela-Bairro program in terms of helping Rio City's worst offcitizens may be debated, the program has yielded important institutional benefits. The mainlessons leamed from the program are the importance of co-ordination among municipal agenciesin implementing an integrated services program, the utilization of a participatory approach in allphases and aspects, and the use of private sector firms in executing the projects (see Pamuk andCavallieri, 1998, for details).

3.5 Targeting the Poorest: Payoffs and Costs

84. Rio Municipality has emphasized urbanization and urban development programs, such asFavela Bairro and Rio Cidade, a city beautification project. This focus corresponds well to thestrategic objective of urban recovery and the traditional municipal responsibilities for urbandevelopment. Some of these projects can also have significant benefits for the poor, but they arenot consciously aimed at or particularly well targeted to the poorest population of the city.

85. In 1996, the municipality spent R$650 million for basic health and education, R$50 million forsocial development, and another US$50 million for poverty directed urbanization annually. Of thistotal of R$750 million (about 20% of the budget) in annual spending on social programs, aboutR$300 million were crudely estimated to reach the poor (or less than 10% of the year's aggregatebudget). While there are other municipal services from which the poor undoubtedly benefit,therefore, only one-fifth of the municipal budget is spent on programs with a special focus onserving the poor, and only one out of eleven reais spent actually reaches the poor through theseservices. If these numbers hold up against closer scrutiny and for other years, they would providea strong rationale for reforming these programs.

86. Figure 3.1 illustrates the relative importance of municipality programs in terms of per familybenefits (the size of the bubble), the degree of targeting, and the reach among the poor of themunicipality's programs. Three groups of programs can be identified:

Untargeted programs. Water, sanitation, solid waste, and basic health are almostuniversal, and so reach almost all the poor. Other than water and sanitation, theseprograms are not consciously targeted. It is likely that the share of the poor in theseexpenditures is essentially the same as the share of the poor in the population, viz.,about 20%.15

15 Water and sanitation services are usually provided by CEDAE, the state water and sewage company. Municipalinterventions in these areas are usually related to favelas and poor settlements.


• Moderately targeted programs. Programs such as basic education, urban upgrading,and early childhood interventions (kindergarten) have moderate targeting, varying reach,but highest per family expenditures.

* Well targeted programs. The food basket (Bolsa Alimentar) and few other socialdevelopment programs are well targeted. But, while per family expenditures aremoderately large, program reach among the poor is limited because they are small.

Program Benefits to Poor(Size of Bubble Reflects Per Family Expenditure)

100% Solid Wase Bas Ht

0o 80% Seag

C 60% -E

.~40% -Knegre

0%

0% 20% 40% 60% 80% 100%

Targeting (Share Going Only to The Poor)

Figure 3.1

87. While the city's management of basic services (water, sewage, solid waste, health andeducation) can be improved - sections 3.3 and 4.5 analyze these sectors in more detail - thepositions of the bubbles that represent these services will remain about the same. To best lookafter the city's poor without overextending municipal resources, Rio's policymakers would do wellto design and implement special programs that:

* reach a large share of the poor, i.e., are represented by bubbles to that are high.

* are well targeted so that leakage of program benefits to the non-poor is low, i.e., arerepresented by bubbles that are as far right as possible.

* imply transfers that are considerable, i.e., are represented by bubbles that are large.

The challenge is to do this without the perverse incentive effects of welfare schemes which NewYork city's experience in the 1960s and 1970s illustrates is a possible outcome.


88. One promising way of doing this would be to expand the two programs that are furthest tothe right - the food basket program or Bolsa Alimentar and the Early Childhood Program - keepingper family transfers the same (the size of the bubble) to help in ensuring that leakage to the non-poor remains small, so that the bubbles are moved vertically up. One of the pre-requisites of suchan expansion is a system of means testing. Box 4 below provides a summary of Chile's meanstesting mechanisms, which are considered among the most effective in the world. Anotherpromising instrument for helping the poor is an expanded slum upgrading program targeted atrelatively worse-off favelas, thus, in effect, moving the Favela-Bairro bubble to the right andupwards. This would likely imply higher costs, and the potential for leakages to the non-poor mayincrease. To lower both the public expenditure burden and the leakages to the non-poor ofexpanded urban upgrading efforts, (means-tested) cost recovery - if done well - provides apotentially effective solution.

-00-"-0------0-00-000--' 00';'07'7'Superargeting in hile0 : 0

vChile,a country of about 15 milSlon, has developed as refine :d system ofmeans testing called the '$iCaas' for thetargeting of ocialfprograms - a amily subtidy, ld age pensions, and housaingand water subsidies. Te system isbased on household visits by social worker toeverypotenfial beneficiary. Household surveys that: are used to refineinthe search- conductd aot evey woyers- cover housigcarateistics, emiployent andearnings, :income, welh dctlio*n, elth,andpaticpaonin socalprgrm. fA cmpterprogam uesasecretfula to conver tth rsuts ofthe oshlCdsuvyinto asor, whchdermines eligiiityfor social prorms. 0000 0

This systmhas beenin plcesince 197 disbasedonanea crudbsystemstarted in 1980. It has helped toefectiely taXetsoci ex tu 2imosti nt soca4l transer proramsare 0tothe poorest30)% of the population.fD0 :i000T 00fV ? 000; : ::: : : :

Chil eperinceshows thatmeanstestngcanbesucefullyused to and coverage of programsfound tobenefi th po, whiekeepinghighratesftareting Thecnditions arethe eof riable household surveysBd nefent4 andreaivel t publa4dministration.

Box 4


CHAPTER 4THE GOVERNMENT: FISCALLY SOUND, BUT STRAINING LIMITS

4.1 The 4 Billion Real Question: The City Budget

89. Rio Municipality - which has about 5.5 million people - spends a hefty R$4 billion annually.In Rio, health and education services absorb about onequarter of the total, streets, highways,housing and garbage collection take another quarter, pensions and debt service about one fifth,and other units of government the remainder (see Table 4.1).

Table 4.1Shifting from Physical to Social Investments: Old Politics or New Priorities?Rio Municipality Budget in R$ Millions, 1996, 1997, and 1998Secretariat Actual Spending (R$ Millions) Share of Total (0)Or Department

1996 199T 1998 1996 1997.8

.Eduation and Culture 401 417 576 11% 14%Basic Education 325 356 481 9% 12%

Health 253 291 420 7% 10%Medical Assistance 217 254 388 6% 9%

Pubic Works and Services 1036 443 239 29% 10%Streets and Highways 620 292 109 18% 6%Drainage and Erosion Control 211 81 68 6% 2%

Mayoral Cabinet 381 87 401 11% 11%Solid Waste (COMLUR3) 217 241 260 6% 7%

hlousing 55 125 157 2% 4%Slum Upgrading &Regularization 27 43 110 1% 2%

General Expenditures 520 585 724 15% 18%Pensions 404 446 538 11% 14%Debt Service (net of bond rollover) 80 104 117 2% 3%

Other lnits 360 355 414 10% 11%Legislature & Judiciary 127 170 184 4% 5%

Administrative Overh 139 156 150 4% 4%

Total Expenditures 3,535 3,275 3,860 100% 100%4

Source: Municipality of Rio de Janeiro, tabulation by Bill Dillinger.Notes: 1996 was the last year of the Cesar Maia administration (an election year).

90. One of Mayor Conde's campaign promises was to increase spending significantly oneducation, health, and slum upgrading (see Conde, 1996). Comparing actual spending in his firsttwo years in office with expenditures in 1996, the last year of the Maia administration, the mayorappears to have kept his word. The shares of education, health, and slum upgrading in the citybudget have gone up from 11 to 14%, 7 to 10%, and 1 to 2% respectively, a total increase of sevenpercentage points. This has been almost entirely at the expense of spending on streets andhighways, whose share fell by 12 percentage points. But - for those who believe that these shiftsreflect a much-needed shift in priorities from paying for services that the rich use relatively more tothose required more by the city's poor - two factors provide cause for caution:


First, 1996 was an election year, during which Mayor Maia spent a full R$1 billion oncapital works, including the Linha Amarela. The political cycle is typically marked by anexpansion of capital spending in election years (see Figure 4.1). A comparison of the1998 spending with expenditures during more "normal" years, e.g., 1994, would likelyreveal smaller changes in shares of education and health. A full confirmation of whetherpriorities have indeed changed will have to wait until 2000, the next election year.

* Second, 1998 is the first year of an increase in federal transfers earmarked for basiceducation due to a recent constitutional amendment. The new rules favor municipalitieswith high primary school enrollments, and Rio's enrollment ratios are among the highestin the country. The increase in outlays on basic education in 1998 - about R$125 million- was less than the increase in federal transfers for education.

Expenditures and Net Savings 1992-97

25000 20002500

3 :other expenditure|o 1000 _ investment

o 500 * personnelE 0 Ls | jnetsavings

10 1993 1994 1995 7-500

-1000

-1500 I

Figure 4.1

4.2 Expenditures: Taking on Many New Responsibilities

91. As federal decentralization and state fiscal distress have forced the two higher levels ofgovemment to reduce their roles, Rio City has moved into the breach. Although the city's previousadministration coped successfully with this expanding role - financing US$2 billion in capital worksfrom intemal savings - the economic conditions that made that possible no longer exist. Thepresent administration confronts the full burden of these responsibilities in more difficult economictimes. In addition, it must deal with looming longer term fiscal issues, particularly the rapid growthof the city's bond debt and a possible leap in pension costs.

92. The scope of Rio municipality's responsibilities and its ability to exercise them are defined bythe activities of the other two levels of government acting in its jurisdiction. At present, the federalgovernment plays only a minor role as a direct provider of public services. With the sale of theelectricity company (LIGHT) and the devolution of transport and health care facilities, the federalgovernment's direct role was limited to phone service, provided through a subsidiary of the federal


holding company, Telebras, that has been privatized. The federal government nevertheless playsimportant roles as regulator and financier. Federal legislation defines the tax base assigned to Riomunicipality and mandates some state-municipal tax sharing arrangements. It also imposesmanagement restrictions on the Municipality, the most important of which concern personnel: thefederal Constitution prohibits dismissals (except for cause, the definition of which has beenexpanded by a recent constitutional reform), prohibits nominal reductions in salaries, and requiresthe municipality to provide generous retirement benefits. The second role is as financier. Federalcurrent transfers to the municipality account for only about 5% of the city's recurrent revenue, butthe majority of the city's contractual borrowing is through federal agencies - particularly Banco doBrasil as the agent for rescheduled debt now owed to the Federal government, and CaixaEconomica FederaL

93. The provision of public services is mainly the responsibility of the state and municipalgovernments, whose roles change frequently. This is partly due to ambiguities in the federalConstitution. Brazil is unique in recognizing municipal government as a third tier of governmentwith the same Constitutional status as the states. States cannot compel or prohibit actions by themunicipalities within their jurisdictions. But the Brazilian constitution provides no clear division offunctional responsibilities between state and municipal governments. The federal Constitutionalmerely assigns to the states all responsibilities not explicitly forbidden by the Constitution, whilereserving for the municipios the power to legislate over subjects of local interest and provideservices of local public interest. Sub-national government thus consists of two equally "sovereign"levels of govemment with no clear functional boundaries.

94. The present division of functional responsibilities between the two levels of govemment isbased on an agreement in 1975 when the state of Guanabara was municipalized. The stateassumed control of secondary education in Rio municipality, which retained sole responsibility forprmary schools. The state also took responsibility for public security: the municipality does nothave a police, other than a force ("guarda municipaf') of about 4,000 for municipal parks andbuildings, traffic control, and prevention of property invasions. Municipalization brought about themerger of the city's water and sewer department with the state water utility, CEDAE. Otherfunctions were later taken over by one level or the other, e.g., rail-based mass transit became astate function following the decentralization of federal commuter rail services to Rio State and theconstruction of the Rio metro system. Today, the municipality's main responsibilities are:

* Education. Primary education is the responsibility of the municipal government.Spending on education accounts for about 22% of the budget and roughly 65% of thecity's active payroll. The municipality's monopoly on primary education is unusual inBrazil: the majority of primary education in the city of Sao Paulo, for example, isprovided by the state, and the state government of Rio de Janeiro is the principalprovider of primary education in municipalities outside of MRJ.

* Health. The city is the main provider of public health care through city-owned clinicsand hospitals. it has expanded this role by taking over federal health facilities: in 1994and 1995, it took over four hospitals and fifteen clinics and, as of February 1998,another six hospitals were to be transferred to the municipality. The city bears only partof the costs of these services; a federal insurance system -- Sistema Unica de Saude(SUS) - reimburses private and public health providers for part of the costs. SUSreimbursements fall far short of the city's actual costs, however, and subsidies to the


municipal clinics and hospitals constitute an increasing claim on the city's resources. In1996, subsidies to municipal clinics and hospitals were 8% of total expenditures,excluding overhead; in 1998, this figure increased to almost 12%.

* Roads and Drainage. The city is also the principal provider of streets, highways, anddrainage works in the city. As in health care, the city has been expanding its share ofthis sector. At the time of Rio city's municipalization, its highway network was dividedbetween the federal and state government. Since then the city has taken over theprincipal federal highway (Avenida Brasi) and almost all of the state network except therecently constructed Red Line (Linha Vermelha). Under the previous administration, thecity took responsibility - at a cost of about R$400 million - for the state's long-standingproposal to build a major freeway and tunnel system connecting the north and southsectors of the city (the Yellow Line). Spending on capital works consumed 24% of thebudget (excluding overhead) in 1996, but is budgeted for 17% of the 1998 budget.

* Garbage. The fourth major service provided by the city is solid waste collection anddisposal. Solid waste services are provided by a city enterprise, COMLURB, and morerecently by private firms, hired by the city in response to threatened labor action byCOMLURB employees. Solid waste services account for about 10% of city spending.The city also intends to enter the water and sewer business (see Box 5).

4.3 Revenues and Transfers: Adequate for a Restrained City Government

95. To finance these responsibilities, the city relies on taxes (about 60% of total municipalincome) and formula-driven intergovernmental transfers. The city's principal tax is on services(ISS) which contributed half of all taxes and almost a third of total current revenues in 1997 (seeTable 4.2). The largest contributors to the municipality's ISS collections are data processing,construction, financial services, and equipment leasing. The tax is assessed and collected by themunicipality, at rates that are set by the municipality but subject to a maximum fixed by federal law.

Table 4.2More From The Services Tax and Federal Earmarked Transfers, Less From Property Tax And FeesRio Municipality Revenues in R$ Millions, 1992 to 1997

Services Tax (ISS) Share 39% 43% 40% 36% 48% 47% 47%Property Tax (IPTU) Share 39% 33% 29% 28% 27% 26% 29%OtherTaxes& Fees 23% 24% 31% 36% 25% 27% 25%

Total Transfers 842 7 005 823 885 854 1,151State ICMS Share 82% 81% 84% 75% 74% 67% 48%State Motor Vehicle Tax Share 8% 8% 8% 14% 15% 15% 10%Federal Transfers Share 9% 11% 9% 11% 11% 18% 10%FUNDEF Share 0% 0% 0% 0% 0% 0% 31%

Other ASourGs 178 ;0:0; 1fj0.119. V00000000Xa:0000:184 33 65 426 222

ThtaI Current Revenues 2,066 1,662 ; 1 ,7\. ,2000 241W 2,464 3,041

Source: Municipality of Rio de Janeiro, tabulation by William Dillinger.Notes: 1992-1996 numbers are in constant December, 1996 reais. 1997 numbers are current reais.


The Need for Co-ordination: The Impasse Over Water

CEDAE, a company owned by the State Govemnment presently provides water supply and sewerage in 63 of Riostate's 81 municipalities, including Rio Municipality. The mayors dissatisfaction with CEDAE stems from differencesbetween the investment protides of the oomnpany and City Hall, ilustrated starkly by disputes on two issues: theFavela-Bairro (or Slum-to-Neighborhood) Prgram and the Recreo dos Bandeirantes development:

* Anong other services, the Favela-Sairro Program regularizes water systems that often have clandestineconnections to CEDAE water trunk ines, and replaces existig oen sewers with pipes that connect to CEDAEsewerage trunk lines to primary treatmt plants. The city intends to tUM over the upgred aset to CEOAupon completon. CEDAE would ten have the authority to impose water and sewer tarffl& in return for which itwould provide services and maintenance of the infrastucture, CEDAE declined to provide services or imposetariffs in favelas,

^ When housing sites were developed in Recreio dos Randeirantes, a rich area built to existing regulations, theywere to have septic tanks. Densities later proved too bigh for septic tanks, and residents pressured the mayor toask CEDAE to provide piped sewerage services, CEDAE declined, on grounds that the work was not a priority.The municipality built a sewerage system from its own funds, a intends to continue to own and operate thesystem as a municpal enterprise. The mayors concem is that he cannot legally charge for these servicesbecause CEDAE refused to transfer the sewere tariffs it collects (as a surcharge on the water it supplies toRecreio residents) to the municipality, or to pernit a separate murncipal tee

Residents in these neighborhoods suffered as a result, but Fe dispute also affected consumers in other parts of theRio metropolitan area. The former state govemment proposed to concession CEDAE operations in the entire Rio metroarea to a single operator who would be responsible for producion, transmission, colleeon, treatment and disposal for25 years. The concession agreement sfipulated increases in water and sewerage coverage, to reach 96% and 60%

I respectively within 5 years. Compliance with the contact was to be monitored by a state regulatory commission,I whose members are to be nominated by the govemor. The -mayor woud have had the nrght only to propose two

candidates to a odeliberative council", whose 13 members would also be nominated by the governor.

As the steward of about 60% of the consumers in the concession area, the mayor found this arrangementunsatisfactory because he expected the conoessionaire's investments would not conform to City Hal's priorities. SinceRio city is relatvely well served (see Chapter 2 in Volume ll), it was likely that the concessionaire would give higherpriority to coverage expansion in Rios periphery Even in Rio City, th coverage targets could be met without

I expanding services to favelas. This problem can be taken care of by explicitly speciying coverage targets for the poor.Instead, the city govemment issued rival legislation to that in the Federal Constitution - upon which the stategovernment based is claim - which empowers th mayor to revise or revoke fte concession anywhere within municipalboundaries. These develments naturally made potential concessionaires hesitant, and threaten to delay or derail theconcession process, which is expeded to yield large efficiency increases for the entire metropolitan region.

The impasse in the water and sanitation sector stly ilustrates the problems associated with using city finances toremedy problems that are better solved by co-operation between the state and city govemments. With the city'sresources already stretched, the prudent solution would be to negotiate a settlement that would allow the state toprvatze CEDAE, while ensurng that e municipality's representation on the regulatory and deliberative bodies areincreased to reflect its importance., Encouragingly, stae-municipal negotatons on this matter have proceeded moresmoothly with the current state administraftion.

Box 5

96. In the early 1990s, ISS receipts were dampened by triple-digit inflation, as delays incollection reduced the real value of revenues by the time they were received, a phenomenonknown as the Tanzi Effect. With the rapid reduction of inflation to single digits between 1994 and1996, the reverse of this effect - combined with some improvements in collection - produced a realincrease in ISS collections. With inflation down to about 5% now, these reverse Tanzi effects havebeen exhausted. ISS revenues increased by only 3.0% in 1997 and 3.5% in 1998 in real terms, afar cry from the rates of revenue growth experienced during the years of reverse-Tanzi effects.


97. The city's second source of tax revenues is a property tax (IPTU), which are assessed oncapital value and adjusted for inflation. Receipts fell in 1993 (the first year of the Maiaadministration) when the effective tax rate was reduced sharply. The elimination of Tanzi effectsafter 1994 helped engineer a rebound in absolute terms, but the share of the property taxcontinues to fall. City officials reckon that the property tax base is undervalued, and plan toresurvey properties over the next three years. Service fees - the largest of which is a charge forgarbage collection - contributes another 15% of total tax revenues. These fees and property taxestogether contribute about a quarter of total municipal income.

98. Formula driven transfers from the state contributed 31% of the city's current revenues in1997. The most important of these is the city's share of the state government's value added tax(ICMS) collections. Under federal law, the state government must transfer a quarter of its ICMScollections to the municipalities in the state,16

99. Federal revenue sharing contributes another 6% of current revenues. About half of this isfrom the Fundo de Participagao dos Municipios, constitutionally mandated sharing of federalincome and industrial products taxes, and the rest is the retention of federal income tax on salariesof municipal employees. Under a constitutional amendment, beginning in 1998, 15% of the Fundode Participag5o will be allocated to a special education fund, FUNDEF, in each state. This moneywill be allocated among the state government and municipalities based on primary schoolenrollments, but has to be used to raise teacher salaries and improve schools. The rule favorsmunicipalities with disproportionately large primary school enrollments, and Rio's gain starting1998 will be about $354 million.

100. Generally speaking, Rio City's taxes and transfers put it in a comfortable situation. Whileproperty taxes are falling as a share of the total, there is no accepted "norm" for how much propertytaxes should be as a share of total revenues. In any case, by their very nature, property taxes arealways contentious and unpopular, and cannot be expected to grow in importance in a politicallycharged city. The municipality's reliance on ISS collections and ICMS revenue sharing gives it themuch-needed flexibility: as ad valorem levies, these taxes are relatively bouyant with respect togrowth in economic activity or price changes. And Rio's high primary school enrollment rates andthe city government's near-monopoly on public primary schools in Rio municipality will result in a10% increase in net revenues starting this year. The city's fiscal problems, if there are any, are notbecause of inadequate revenues.

4.4 Debt Service, Pensions, and Healthcare Obligations: Climbing Rapidly

101. Rising debt service, unfunded pension obligations and increased healthcare subsidies arethree of the main fiscal issues facing the municipality today.

16 75% of this is, by federal statute, distributed on the basis of value added, and the remaining 25% by a formuladevised by the state legislature. Since 1997, the city's share of the second component of the transfer has been nil.


Debt Service

102. Rio City confronts debt service obligations of indeterminate size. As of December 1997, totaldebt outstanding was about $2 billion, or almost 90% of revenue. About a quarter of this consistedof domestic contractual debt, mostly owed to the federal treasury for extemal debt reschedulingand to the federal housing and savings bank (CEF) for project loans. Another 6% is a Eurobondfloated in 1996 and due July, 1999. The vast majority - R$ 1.6 billion - consists of domestic bonds(see Merrill Lynch, 1996). This is where Rio's problems lie (see Box 6).

Sub-national Debt in Brazil

Domestic bond issues by sub-national governments have a controversial history in Brazil. The market is dominated byfour large state governments: Sao Paulo, Rio de Janeiro, Minas Gerais and Rio Grande do Sul. In response to states'difficulty in markeing their bonds, the federal government federalized most of the state bonds in 1994, and prohibitedall sub-national governments from issuing new domestic bonds, other than to refinance the principal and accumulatedinterest on existing debt.

The major bond-issuing states have now signed debt rescheduling agreements with the federal government that havethe following main features* States can transform their bond debt - along with some other liabilities - into long term (30 year) debt to the

federal treasury.* Interest is charged at a subsidized rate (6% in real terms, compared to the present ovemight rate of 20%).* Debt service is subject to a cap. If debt service on the newly rescheduled debt plus debts rescheduled under

earlier agreements, exceeds 13% of revenues, the excess amount can be deferred and capitalized into the stock.

In cash flow terms, these agreements are quite generous. Because debt service on earlier rescheduled debt is alreadyclose to 13% in most major states, the addibional amount they are required to pay is relatively small. Rio City's debtsituaton is different from the states in that its bonds continue to be marketable in the prvate domestic capital market.

Box 6

103. Rio and Sao Paulo are the only two municipalities which issue bonds. As of January 1998,about half of all bonds (R$ 750 million) were held by private pension funds, banks, and similarinvestors. Another R$400 million were held by the city's survivor-benefit fund (Previ-Rio) at marketrates. The rest were held by the Prefeitura itself. 17 City bonds carry a four year maturity and pay avariable interest rate equal to the overnight rate plus a spread (currently 0.15%). To remain in themarket, Rio does not market its bonds at their full maturity but instead floats them the overnightmarket, giving the purchaser the option to relinquish them on short notice. Interest is capitalizedand due at maturity.

104. Under existing federal tegislation, the city is authorized to roll over a fixed proportion of thebonds as they mature, issuing new debt sufficient to cover both outstanding principal andaccumulated interest. The proportion of bond debt that can be rolled over is determined by annualSenate resolutions. In each of the last two years, the Senate has authorized a 98% rollover. Atpresent, Rio is taking full advantage of this opportunity, rolling over almost all of its bond debt. As a

17 The city holds its own bonds as a hedge against future cash requirements. Because the city is prohibited fromissuing new bonds, it prefers to maintain its existing stock at the maximum level permitted by law. When the city hassurplus cash, it holds the bonds in its portfolio. When it requires cash, it floats them on the overnight market.


result, the city is paying very little debt service -- only the 2% amortization required by the Senate.The stock of debt stock, however, is growing rapidly due to the accumulation of capitalized interest.The debt is growing at a pace dictated by a high overnight rate. The real overnight rate was 22% in1994, and reached 25% in the following year. Although it fell to 16% in 1996, it has rebounded to20% in 1997. As a result, Rio's bond debt has doubled, in real terms, over the last four years.

105. Over the medium term, this constitutes a serious threat to the city's financial situation.Eventually, debt will have to be repaid. The longer the debt continues to grow through interestcapitalization, the higher the debt service will be when this occurs. If the city had begun servicingthe debt in 1998, interest payments alone would be about $300 million, or 10% of projectedrevenues. If the ovemight rate had stayed at 15% over the next five years, interest on the bondswould have been $400 million.

106. At present, the city is negotiating a federal debt agreement. While it is aware of its growingdebt obligations, the municipality's position is that it would enter into such an agreement only if theterms offered by the federal government are unfavorable. In fact, Rio City has considerably lesseligible debt than the major debtor states. In June 1997, the city had only R$124 million inpreviously rescheduled debt other than bonds, and service on this debt in cash terms is less than1% of current revenues. As a result, the standard terms of federal debt rescheduling would requirea major increase in debt service payments in cash. Rio would have to increase its debt servicepayments by roughly 12% of revenues, as opposed to the 1-2% of revenues for the major bondstates.

Unfunded retirement liabilities

107. The city is also facing the prospect of increasing retirement costs. Under the 1988constitution, Rio is obligated to provide an expensive package of retirement benefits to its civilservants. Retirement benefits are based on 100% of the exit salary of the retiree and are indexedto wage increases in the position the retiree occupied when working. The municipality isparticularly hard-hit by these terms, due to the large proportion of female teachers, who can retireafter 25 years of service, and have relatively long life expectancies during which they are eligible toreceive pension benefits. In 1997, payments to retirees constituted one-third of MRJ's wage bill(excluding staff in indirect administration). As Rio's retirement obligations are unfunded, pensioncosts are paid out of general revenues.

108. In principle, the municipality could confront an abrupt increase in these costs. The number ofretired staff increased by nearly 40% between 1993 and 1997, and payments to them now accountfor more than a third of the payroll. This may be a demographic trend, reflecting the aging of thecity's bureaucracy in a non-expansionary phase. But there may be another explanation for thegrowth in the number of retirees, however -- one that is strategic rather than demographic. Thegrowth in the number of retirees may be a transitory response to threatened policy changes. Since1994, the federal government has been considering scaling back the retirement benefits mandatedby the Constitution. This includes the imposition of a minimum age for retirement benefits and aminimum number of years of employment with the municipal government. Staff also fear the loss of


indexation of retirement benefits to wages of active staff, although this is unlikely to be part of thefinal reform package. The threat of reduced pension benefits has reportedly prompted a surge inretirement by staff meeting the existing criteria for retirement.18

109. If this is the case, the growth in the number of retirees will halt once the pool of potentialretirees was exhausted. Due to data constraints, it is not possible to determine which of these twofactors is more important. The city is undertaking an actuarial analysis of the city's pensionliabilities to resolve this question.

Health Care Subsidies

110. The city's health care costs also represent a potential fiscal risk. The problem of healthcarefinancing has its roots in constitutional reforms in 1988 and contemporaneous reforms in the healthfinancing system. Prior to the reforms, health insurance was provided only to workers whocontributed to the national system through mandatory employer contributions and payroll taxes.Payments were made directly to hospitals -- whether private or public -- on a per-treatment basis.Although reimbursements were less than actual costs, private hospitals willingly participated in theprogram, exploiting opportunities for over-billing to supplement legitimate receipts from the system.Two important changes in the system were introduced in the 1980s:

* First, the 1988 Constitution expanded the coverage of the system to include allBrazilians, whether they were contributors or not. This greatly increased the number ofpotential patients without increasing the system's revenues.

* Second, the system itself was reformed to tighten financial controls. While successful,this had the ironic consequence of shifting more of the patient load onto public hospitals.Having lost the opportunity to over-charge, private hospitals lost interest in govemment-insured patients. As a result, demand for treatment in Rio's public sector hospitals andclinics expanded rapidly.

111. The SUS reimbursement schedule is devised by the Ministry of Health, which establishesnationally uniform reimbursement levels according to type of treatment, MRJ is also subject to anabsolute ceiling on the total amount of reimbursements, based on population, installed capacityand a fixed amount intended to compensate the city for costs of treating referrals from neighboringmunicipalities. In total, Rio's reimbursements fall well below its treatment costs: SUS paymentscovered less than half the city's non-personnel health care costs over the last six years. Whenpersonnel costs are added, the proportion drops to 20%.

112. The city's decision to assume most of the federal hospitals in its jurisdiction will increase thisfinancial burden. During the transition period, the federal govemment is providing grants to coverthe non-personnel costs of federal hospitals. It is also paying the present staff of the hospitals asfederal employees until they quit or retire. These arrangements are merely transitional, however.

18 People often prefer to keep working even after they meet retirement criteria, since retiring entails loss of somesupplements and bonuses.


Operating grants are to be phased out. Similarly, when the existing hospital staff depart, themunicipality must replace them with employees on the municipal payroll. The only concreteproposal the city has for addressing this problem is to start charging other municipalities forreferrals. At present, surrounding municipalities refer patients to the city for more complicatedcases for which the city receives no compensation beyond the normal SUS benefits. The city'sintention is negotiate fee-for service contracts with each surrounding municipality. These would bebased on a fixed number of treatments to be provided, and would be payable in advance by eachmunicipality. The city has not determined the net revenues from such a proposal, nor does it knowhow it will handle referral patients once a municipality's ceiling has been reached.

4.5 Staying Within Limits: A Responsible and Responsive City Hall

113. Rio is at a fiscal turning point. Now in its second year in office, the Conde administrationfinished its first year with a modest operational deficit of 6% of revenues.19 This was financedthrough contractual borrowing (R$60 million) and the sale of assets (about R$100 million). Thesefigures exclude off-budget interest capitalization, however: when interest capitalization is included,the city's deficit rises to 16% of revenues. The prognoses for 1998 and the longer term are unclear,but it is clear that the city cannot sustain the momentum of the preceding administration.

114. The previous administration financed R$2 billion in capital investments from currentsavings. Changes in the economic environment will not permit the current administration to repeatthis performance. The Maia administration's response to the fall in tax revenues due to reductionsin property tax rates and abolishment of the city's business license renewal fee was to cutspending. Capital expenditures took the largest hit - falling from R$729 million in 1992 to R$168million in 1993 - but salaries also fell. Though the Constitution prohibits reductions in nominalsalaries, it is silent on the subject of cuts in real terms, and quadruple-digit inflation in 1993 and1994 made this feasible. Together with cuts in maintenance expenditures, this permitted the Maiaadministration to finish its first two years in office with a cash surplus of nearly R$1 billion, whichwas invested in high-yield municipal securities and produced R$226 million in interest earnings. By1996, inflation had fallen to single digits and the wage bill rebounded. But the Piano Real alsocaused an abrupt increase in revenues, due to the reverse-Tanzi effects noted earlier: currentrevenues increased 25% in real terms in 1994 and another 10% in 1995. As a result, the city wasable to continue to run current account surpluses in its last two years of office and undertake a $1.8billion capital spending program, financed largely from accumulated savings. 20

115. It is unlikely that the current administration will be able to duplicate this performance, giventhe new economic conditions in Brazil. With inflation now in single digits, the city's ability tosqueeze salaries is limited, even if it were desirable to do so. Major exogenous increases in taxrevenues are also unlikely, as the Tanzi effects of the Plano Real are unlikely to recur. Given thecity's reduced amount of cash, interest earnings are also likely to remain modest. The only goodnews for the city's revenue situation is the start of FUNDEF, the education participation fund.

19 Defined as current revenues less current and capital expenditures excluding amortization.20 Note that city's bond debt increased by R$ 941 million (in prices of December 1997) over this period, due to thecapitalization of interest.


New York's 50 Year Hangover: Uving With an Activist Mayor's Legacy

Taking advantage of a specal relationship with President Franklin Roosevelt, Fiorello La Guardia, New York's dynamicmayor between 1933 and 1945, harnessed funds from the New Deal - a massive fderal public works proram begunas a response to the Great Depression - to refurbish streets, parks, and pubric buildings. Between 1934 and 1938alone, New York received more than 1.15 bilion dollars for public works, which was used to hire half a miflion peopleand expand the bureaucracy. Under an efficient and motivated government, the money was used well. by 1939, NewYork was praised as having the best managed port in the world, highways were built crsscrossing the city, as well asschools, parks, low-income housing, and prisons.

The energy and accomplishments of La Guardias administraton blurred the less positive longer-term effects of theseactivities. And while later mayors should have been content to simply mranage what La Guardia had built, New York'spolitically charged atmosphere led each one to outspend his predecessor. To pay for its.generosity, between 1946 and1951, the city tripled the sales tax, raised the financial business tax four times, and imposed a 5% tax on hotel roomsand a 5% amusement tax. To protect voters from rising costs, tenants were afforded rent control, which in turnrequired higher taxes on businesses. Businesses began to leave. This was oompounded by growing expense andinefficiency of the civil service due to reforms initiated by La Guardia that gave officials job stability for life.

Taxes kept on being raised until the mid-1960s. When the city reached its fiscal limits, one mayor declared that"human needs are greater than budgetary needse, and his government would borrow rather than 4permit (its) fiscalproblems to set the limits of our commitments to meet the essential needs of the people.." . When borrowing limitswere reached, comptrollers bean clever accounting that allowed the city to borrow from its own future residents. By1975, the city was officially bankrupt Cit finances remained weak unfil the 1990s, and as the quality of services wentdown, crime and squalor went up. tn the 1980s, even huge financial sector gains could not reverse this decline. By1990, 60% of New Yorkers were saying that they would leave if ftey could.

Elected in 1990, Mayor Rudy Giuliani's administration has reversed these trends. The main reasons are:I* nnovative policies towards crime developed by sociologists, implemented by a vigorous police chief and a mayor

who follows statistics every day, have resulted in crime rates falling to their lowest level in three decades.Reorganization of the city bureaucracy has helped to increase its efficiency.

* Wall Street has boomed but, not taking this boom for granted, the cty has saved $500 million in case the stockmarket collapses.

* The eoortomic expansion in the nation has helped, but better business environrment has also attracted one-half toone million immigrants to the city between 1990 and 1997, infusing the economy with renewed dynamism.

Even excellent management and good luck in the 1990s have not ted New York out of the danger of being financiallyand administratively overstretched. La Guardia's legacy is proving difficult to shake off.

Sources. Siegel (1997), others.Box 7

116. But the city appears to retain an ambitious investment program. The city's strategy is tofinance much of this program from borrowing. According to the 1998 budget, 60% of the city'sinvestment program would be financed from debt. Planned externally-financed investments forMayor Conde's term total $2 billion - $800 million from the federal treasury and $1.2 billion fromexternal resources - to go to primary education (28%), an urban beltway (20%), environmentalprotection (17%), slum upgrading (15%) and assorted programs (20%).21

21 These ambitions are generally tempered by reality. The fact that the city has a large list of projects for which it isseeking financing does not necessarily mean that an aggressive debt financing strategy is being pursued. Since someof the externally financed investments plans do not receive adequate funding, the city prepares a large portfolio to beused as and when financing opportunities arise.


117. In times of heightened expectations, it is difficult to resist expansion of the municipalmandate. Box 7 describes how, led by good intentions, New York fell into a similar fiscal trap. Butfor Rio, this strategy is not financially sustainable even over the next few years. How and when itruns into trouble will depend upon a number of factors, which Table 4.3 summarizes as follows:

* Scenario 1 illustrates the impact of the city's 1998 budget strategy, extended over thenext five years. Relying heavily on borrowing would cause the stock of debt to rise to152% of revenues by 2002, and debt service would be almost 20% of revenues. Even incash terms, debt service would consume roughly 10% of revenues. Under theseconditions, it is unlikely that Rio would be able to continue to obtain long-term credit, atleast from the private market.

* The second scenario is more sustainable fiscally, but this sustainability is achieved bylimiting capital expenditures to current savings. This would result in stabilization of thedebt to revenue ratio, but would reduce capital spending to about 12% of revenues.22

* A bond workout on the same terms as for state governments (scenario 3) would furtherreduce funds for capital investment, as debt service obligations would rise in cash terms.

Table 4.3Keeping Debt-to-Revenue Ratios Below One Leaves Little Scope For New BorrowingAltemative Fiscal Scenarios, 1997-2002

Ct; 0. Oyy y ., 19$? 1998 lCx99g Z00 0 -1 +00 000 200100 2l00 i'i0000002 &

Capital spending as % of revenue 20 26 19 22 21 20DebtServiceas%ofrevenue 14 12 18 16 17 19- of which capitalized 9 6 7 7 8 9

Net stock of debt as % of revenue 89 94 108 124 138 152

, X f2Sc 2 N Debt Agrement No l4e ;or winCapital spending as % of revenue 20 9 6 11 12 12Debt Service as % of revenue 14 10 15 11 11 12- of which capitalized 9 6 7 7 8 9


Capital spending as % of revenue 20 9 2 8 8 9Debt Service as % of revenue 14 7 11 7 6 6- of which capitalized 9 0 0 0 0 0


Source: Special calculations by William Dillinger. All numbers are percentages.

118. The city's fiscal strategy will ultimately have to be a variant of the third scenario, A strategybased solely on new borrowing is not fiscally viable, nor is one that would allow bond interest tocapitalize perpetually. The city has to stop the growth of debt. It might be argued that since thecity's existing debt is relatively low, some growth in the stock of debt is permissible. The highinterest paid on the bonds, however, suggests that the city would do well to keep its debt as low aspossible. Even if the city were to freeze the stock at its existing level, this would cost almost one-fifth of revenues to finance, It is unlikely that any city expenditure would have a rate of return highenough to justify the cost of borrowing.

22 The drop in 1999 reflects the cost of paying off the city's Eurobond debt.


CHAPTER 5THE AGENDA: A FASTER, FULLER RESURGENCE

5.1 Helping the Poor: With Targeted Transfers

119. The poor will continue to rely more on some services than richer residents and the citygovernment - without abandoning the principle of universal access and efficient provision ofessential city services to all its residents and visitors - should shift the focus of some programsfrom universal coverage to serving the poor more effectively. Given the nature of poverty in thecity, the strategy should involve small to moderately sized programs, tightly coordinated by CityHall but delivered through the private sector, non-governmental organizations, and decentralizedcity departments:

* Slum upgrading. Programs such as Favela-Bairro should be continued, but labeledcorrectly as urban upgrading projects so that they are not expanded at the cost ofprograms that may be better targeted to Rio's poor. Urban upgrading programs aimed atpoorer slums, perhaps accompanied by (means-tested) cost recovery from the non-poor, can also be an effective instrument for helping Rio's less fortunate residents.

. Integrated early childhood program. The municipality should move forward inimplementing the proposed integrated early childhood development program, RioCrianca Maravilhosa. The objective of the program is to provide services to children andfamilies to address developmental needs of children in an integrated manner.Additionally, the city should expand the Mae e Crianca (Mother and Child) Project asplanned, taking care to keep per family transfers approximately the same but increasingits reach among the poor.

Incentives for school attendance. A major effort should be undertaken to increasebasic enrollment rates among the poorest fifth of Rio's population. The municipalitycould consider - preferably as a pilot program - a variant of the Bolsa Escolar programcurrently being implemented in other municipalities in the Federal District, Sao Paulo,and other states, which provides grants to low-income families who send all theirchildren to school. The municipality must be careful to weigh the fiscal costs of suchprograms with their likely benefits, based on an evaluative examination of existingprograms in other cities such as Brasilia.

* Targeted cash transfers. Altematively, an expanded school grant program could bebuilt upon the small Bolsa Alimentar (food basket) scheme and form the comerstone ofa broadened municipal poverty alleviation strategy, combining the objectives ofincreased school enrollment with direct assistance to the poorest households.' It isdoubtful whether a scheme like Bolsa Alimentar - which entails in-kind transfers that aretypically more expensive to administer - could be expanded cost-effectively. Forswitching the program to a cash transfer, a reliable system of means targeting such asthat for Chile's "Ficha Cas" would be required to prevent large leakages to the non-poor.

* Labor programs. The labor-related programs of the municipality leave serious gaps,especially for the non-favela poor and those who do not belong to the special groups -such as the unemployed - who have been identified for assistance. Possible elements


of an expanded social protection program of the municipality could be:

(a) A broader education grant program for low-income households.

(b) A modest monthly bolsa of about R$50 designed to reduce adult illiteracy.

(c) A guaranteed employment program at wages below minimum salary levels inareas with high transport costs for non-residents. At a monthly salary of 50% ofthe minimum wage, a program for 200,000 individuals - or one from each poorhousehold - could reduce headcount poverty to 10% at a cost of about $250million annually even if a quarter of the benefits leaked to the non-poor.

120. In its zeal to help the poor through targeted programs, though, the government should notforget that economic growth will remain the most important factor in reducing poverty in the city -by encouraging higher work participation, by helping the working poor earn more in formal andinformal activities, and by reducing unemployment. In Brazil, for every 1% increase in aggregateincome, poverty rates have fallen by 0.7%. If the economy grew at 4% annually for the nextdecade and Rio grew at the same rate, poverty in the city would fall from 15.6% to 12.6%. If Brazilgrew at 5%, and Rio grew at two percentage points above this, poverty rates would fall to below10% by the end of the decade. It is to policies that would ensure such growth rates that we turnnow.

5.2 Fostering Economic Growth: With Remedial Interventions and Skepticism

121. An industrial revival is most likely to lead to the broadly based growth that - by reducingaggregate poverty rates in the city - would buttress the municipality's actions to help those whoremain poor. The growth of modern industry will also put the city onto a trajectory that can lead toit relying more on higher value added business services in the future. And, since modern industryis likely to be export oriented, this would allow Rio to diversify markets and have a relatively stablegrowth path. Besides the suitability of this approach in terms of what type of growth it wouldengender, it has the advantage that Rio has many of the preconditions already - an adequateinfrastructure, a pool of skilled workers, and an industrial tradition. The remaining agenda isrelatively modest in terms of financial requirements, but ambitious in terms of institutional reforms:

* Licensing. Simplify city licensing procedures, learning from the state government'sexperience in designing and enforcing environmental regulations for businesses.

* Taxes. Dramatically streamline the assessment and collection of city taxes such as theservices (ISS) and property tax (IPTU).

* Networking. Foster networking by city support for organizations such as Riosoft,especially in fashion and other apparel, footwear, electronics, engineering, andshipbuilding - which have particularly good potential in Rio - while encouraging anexport-oriented outlook,

* R&D. Encourage a research-industrial focus by providing incentives for universities andother research institutions to work closely with firms through municipal pump-priming ofR&D activities as well as investment by new firms. Some examples that could beadapted to suit Rio are Israel's Magnet plan, the Modena (Italy) Credit GuaranteeSystem, and Argentina's tax offset and technical consultancy schemes.


* "Natural incubators". Aggressively recruit one or two large firms that champion opensystems, quicken innovation, and induce the culture of networking. For Rio, it isimportant that these firms are in sectors with proven backward and forward linkages withmetropolitan activities. For example, pharmaceuticals and beverages have few suchlinkages; computers and fashion clothing have strong linkages. These firms will act asnatural incubators for smaller firms, and encourage growth in business services.

* Basic services. Support or solicit federal and state government efforts to rapidlyimprove the quality of services valued by businesses such as airports, railways, andtelecommunications (federal) and public security and water and sanitation (state).

5.3 Recognizing Policy Interdependency: Pragmatism

122. None of these measures are likely to be as effective in the continual creation of jobs in highvalue added sectors as the efficient delivery of basic services, viz., ensuring safe streets, quick andorderly mass transit, clean water and effective sanitation, timely garbage collection, and soundhealth and education services. A growing number of urban policy experts (see, e.g., Siegel, 1997)believe that delivering these services at a reasonable price may be the most important thingmayors can keep their eyes on. As discussed above, because some of these services are federalor state responsibilities, Rio municipality cannot assure this by itself. But co-ordination problemsbetween levels of govemment exist in all countries, and should not be used as an excuse forinaction by the municipality. Given the importance of these services for businesses, residents, andvisitors, the municipality's efforts to resolve problems of policy co-ordination may actually have thehighest rates of return.

123. To ensure productive relationships with the federal and state governments, the municipalityshould be willing to make some tradeoffs, agreeing to make some changes in municipal policy inreturn for:

* Fuller access to federal resources for development of tourism, better financing terms forexisting municipal debt, improved regulation by federal government agencies, and bettermacroeconomic growth prospects.

* Better coordinated and more efficiently delivered state government services such aspublic security, mass transit, water and sanitation, and environmental management.

* Adequate compensation for healthcare services provided by Rio's facilities to residentsof other municipalities.

124. The steps that the municipality can take to affect these outcomes are:

* Debt. Reduce the debt to net revenue ratio and restrict new borrowing only to financingthose projects where the rates of return clearly exceed interest costs.

* Fiscal discipline. Take full advantage of any changes in the constitution regardingpersonnel and pensions. The municipality can support fiscal adjustment efforts initiatedby the federal govemment by controlling the growth of city pension expenditures, andreducing municipal employment where prudent, including poorly performing primary


school teachers and health care workers.

* Water and sanitation. Remove legal obstacles to the concessioning of the state watercompany CEDAE, in return for greater municipal representation on the regulatory anddeliberative agencies.

* Mass transit. Support for the privatization of the suburban railway Flumitrens, in returnfor clarification and agreement on city and state responsibility for traffic control andregulation of buses in the municipality.

* Public security. Support for state public security improvement programs, in return forstate financial and institutional support for implementing the policies recommended bythe city crime and violence project.

* Environmental management. Smoothly taking over municipal responsibilities fordesigning and enforcing regulations for licensing of activities with local environmentalimpact, in return for an output-oriented agreement to treat general environmentalpollution in the municipality as a priority area.

* Health. Continuing to serve residents of other municipalities in city health facilities, inreturn for a state government guarantee for repayment by other municipalities for theshortfall in SUS reimbursements to the city.

5.4 Building Institutional Capacity: Information, Strategy Formulation,and Evaluation

125. The City needs to better respond to the deepening decentralization from the federal level tostate and municipal governments, and to implement policies for better targeting of povertyalleviation programs, facilitating economic growth, and smoother coordination of activities withhigher levels of government. A municipal govemment that has functioned largely as urban plannerand developer has now to expand into becoming a major player in both economic and social areas.To ensure that these functions are carried out efficiently, the capacity of the municipal governmentshould be strengthened in selected areas. The priority areas are:

* Managing incentives and programs. Designing and implementing municipal policiesto improve the competitiveness of city businesses, especially by tackling the problemsfaced by small enterprises.

* Policy coordination. Dispassionately determining appropriate responses to problemsof coordination of policies with the federal and state governments.

* Evaluation. Systematic and regular evaluation of costs and effectiveness of policies,expenditures, and special programs, the efficiency of city services with an emphasis ondetermining the effects of these policies on the city's poor and small businesses.

. Information. Collection and dissemination of up-to-date, relevant, and detailedinformation on the city's economic trends and poverty levels.


REFERENCES

Background Papers

Dillinger, William. 1998. "Rio Municipality: Maintaining Fiscal Health

Menezes, Braz. 1998. "Rio de Janeiro: Is Institutional Change Possible?"

Von Amsberg, Joachim. 1998. "Rio: Poverty in the Municipality".

Yusuf, Shahid, and Marcelo Neri. 1998. "Rio: Economic Prospects and Growth Strategy'.

Selected References23

Acs, Zoltan J. and David Audretsch (eds.). 1993. Small Firms and Entrepreneurship: An East-WestPerspective, Cambridge University Press, New York.

Audretsch, David. 1995. Innovation and Industrial Evolution, MIT Press, Cambridge, MA.

Canning, David. 1997. "Does Infrastructure Cause Growth?" Harvard Institute for InternationalDevelopment, mimeo., Cambridge, Massachusetts.

Conde, Luiz Paulo. 1996. Conde - PFL Prefeito: Piano de Metas. Campaign Document.

Dar, Amit, and Indermit Gill. 1998. "Evaluating Retraining Programs in OECD Countries: LessonsLearned", World Bank Research Observer, Vol. 13, No. 1, February, pp. 79-102.

Enright, Michael J., Edith Scott, David Dodwell. 1997. The Hong Kong Advantage. Oxford UniversityPress.

Federal Reserve Board of New York. 1997. Economic Policy Review, Vol. 3, No. 1, Special Issue on theNew York Economy in the National and Wodd Arenas.

Friedmann, J. 1986. "The World City Hypothesis", Development and Change, Vol. 17, No.1.

Gilbert, Roy. 1995. "Rio de Janeiro: the Make-up of a Modem Megacity." Habitat Intemational, Vol. 19,No. 1, pp. 91-122.

Grosh, Barbara and Gloria Somolekac, 1996. "Mighty Oaks from Little Acorns: Can MicroenterprisesServe as the Seedbed for Industrialization?" World Development, Vol. 24.

Harris, Nigel. 1997. "Cities as Engines of Economic Growth and Development." Urban Strategy Workshop,World Bank, Washington, DC.

Henderson, Vernon. 1997. "Extemalities and Industrial Development," Joumal of Urban Economics, Vol.42, No. 3.

Huff, W. G. 1994. The Economic Growth of Singapore. Cambridge University Press.

Knox, Paul L. 1997. "Globalization and Urban Economic Change", Annals of the American Academy, No.551, May.

23 Please see end-of-chapter reference lists in Volume il of the report for more comprehensive listings.


Kreimer, Alcira, Thereza Lobo, Braz Menezes, Mohan Munasinghe, and Ronald Parker. 1993."Towards a Sustainable Urban Environment: The Rio de Janeiro Study," World Bank Discussion Paper 195,Washington DC.

Leonardi, Robert, and Raffaella Nanetti (eds.). 1994. Regional Development in a Modern EuropeanEconomy. The Case of Tuscany. Pinter Publishers, London.

Merrill Lynch & Co. 1996. Offering Memorandum: Municipality of Rio de Janeiro.

Pamuk, Ayse, and Paulo Cavallieri. 1998. "Alleviating Urban Poverty in a Global City: New Trends inUpgrading Rio de Janeiro's Favelas," in Habitat Intemational, Vol. 22, No. 4, pp. 449-462.

Piano Estrategico. 1996. Piano Estrategico da Cidade do Rio de Janeiro: Rio Sempre Rio.

Saxenian, Annalee. 1994. "Silicon Valley", Technology Review.

Schmitz, Hubert and Bernard Musyck. 1994. "Industrial Districts in Europe: Policy Lessons forDeveloping Countries?" World Development, Vol. 24.

Scoft, Allen. 1992. "Low Wage Workers in a High Technology Manufacturing Complex: The SouthemCalifornian Electronics Assembly", Urban Studies, Vol. 42, No. 3.

Scott, Allen J., and Edward Soja (eds.). 1996. The City. University of California Press.

Siegel, Fred. 1997. The Future Once Happened Here: New York, D.C., L.A., and the Fate of America'sBig Cities. The Free Press.

Tolosa, Hamilton. 1995. 'Rio de Janeiro: As a World City," Discussion Paper No. 3, Conjunto UniversitarioCandido Mendes.

Tolosa, Hamilton. 1996. "Rio de Janeiro: Urban Expansion and Structural Change," in The Mega City inLatin America, by A. Gilbert (ed.).

Urani, Andre. 1997. "The City Hall Policy of Labor and Income Generation in Rio de Janeiro," December.

Urani, Andre. 1999. "Trabalho, Renda e Desenvolvimento Economico Local: As Apostas da Prefeitura doRio de Janeiro," Draft report, Secretariat of Labor, Municipality of Rio de Janeiro.

World Bank. 1996. The Custo Brasil Since 1990-92, Report No. 15663-BR, Latin America and theCaribbean Region, Washington, DC.

World Bank. 1996b. Managing Environmental Pollution in the State of Rio de Janeiro, Report No. 15488-BR, Latin America and the Caribbean Region, Washington, DC.

World Bank. 1998. Brazil: From Stability to Growth Through Public Employment Reform, Report No.16797-BR, Latin America and the Caribbean Region, Washington, DC.

Yusuf, Shahid, and Weiping Wu, 1998. The Dynamics of Urban Growth in Three Chinese Cities.Washington, DC: Oxford University Press for the World Bank.

Public Disclosure Authorized Report No. 19747-BR Brazil ... · CEDAE Companhia Estadual de Agua e...

Documents

Transcript of Public Disclosure Authorized Report No. 19747-BR Brazil ... · CEDAE Companhia Estadual de Agua e...