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Document of The World Bank

FOR OFFICIAL USE ONLY

Report No. 87120-BR

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

PROGRAM DOCUMENT

FOR A PROPOSED LOAN

IN THE AMOUNT OF US$ 280 MILLION TO

THE STATE OF RIO GRANDE DO SUL

WITH THE GUARANTEE OF THE FEDERATIVE REPUBLIC OF BRAZIL

FOR A

STRENGTHENING FISCAL AND WATER RESOURCES MANAGEMENT

DEVELOPMENT POLICY LOAN

May 05, 2014

Economic Policy Unit Poverty Reduction and Economic Management Department Brazil Country Management Unit Latin America and the Caribbean Region

This document is being made publicly available prior to Board consideration. This does not imply a presumed outcome. This document may be updated following Board consideration and the updated document will be made

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BRAZIL -GOVERNMENT FISCAL YEAR Jan, 1 – Dec, 31

CURRENCY EQUIVALENTS

(Exchange Rate Effective as of May, 5)

Currency Unit = Brazilian Real US$1.00 = 2.23

ABBREVIATIONS AND ACRONYMS

ANA National Water Agency Agência Nacional de Águas BNDES National Bank for Economic and Social

Development Banco Nacional de Desenvolvimento Econômico e Social

CAGE Office of the Accountant and Auditor General

Contadoria e Auditoria Geral do Estado

CPS Country Partnership Strategy Estratégia de Parceria com o País CRH-RS Water Resources State Council of Rio

Grande do Sul Conselho Estadual de Recursos Hídricos do Rio Grande do Sul

DPL Development Policy Loan Empréstimo de Políticas de Desenvolvimento

DRH Department of Water Resources Departamento de Recursos Hídricos DRM Disaster Risk Management Gestão de Risco de Desastre EMATER/RS Technical Assistance and Rural Extension

Company of Rio Grande do Sul Empresa de Assistência Técnica e Extensão Rural do Rio Grande do Sul

FARSUL Agriculture Federation of the State of Rio Grande do Sul

Federação da Agricultura do Estado do Rio Grande do Sul

FEPAGRO State Agricultural and Livestock Research Foundation

Fundação Estadual de Pesquisa Agropecuária

FEPAM State Environmental Protection Foundation

Fundação Estadual de Proteção Ambiental

FRL Fiscal Responsibility Law Lei de Responsabilidade Fiscal GDP Gross Domestic Product Produto Interno Bruto GoRS Government of the State of Rio Grande

Sul Governo do Estado do Rio Grande do Sul

IADB Inter-American Development Bank Banco Interamericano de Desenvolvimento IBGE Brazilian Institute of Geography and

Statistics Instituto Brasileiro de Geografia e Estatísticas

IBRD International Bank for Reconstruction and Development

Banco Internacional para Reconstrução e Desenvolvimento

ICMS Value Added Tax Imposto sobre Circulação de Mercadoria e Serviços

ICR Implementation and Completion Results Report

Relatório de Conclusão e Resultados

INMET National Meteorology Institute Instituto Nacional de Meteorologia IPCA Consumer Price Index Índice de Preços ao Consumidor Amplo IPSAS International Public Sector Accounting

Standards Padrões Contábeis Internacionais aplicados ao Setor Público

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IRGA Rio Grande do Sul’s Rice Institute Instituto Riograndense de Arroz IRRF Income Tax Withheld at Source Imposto de Renda Retido na Fonte LDO Law of Budgetary Guidelines Lei de Diretrizes Orçamentárias LOA Annual Budget Law Lei Orçamentária Anual NCD Net Consolidated Debt Dívida Consolidada Líquida NCR Net Current Revenues Receita Corrente Líquida PFM Public Financial Management Gestão de Finanças Públicas PGE State Legal Counselor’s office Procuradoria Geral do Estado PIUMA Master Plan for Irrigation in the Context of

Multiple Water Uses in Rio Grande do Sul Plano Diretor de Irrigação no Contexto dos Usos Múltiplos da Agua no Rio Grande do Sul

PNAD National Household Survey Pesquisa Nacional por Amostra de Domicílios

PPA Multi-year Plan Plano Plurianual PROGESTÃO National Pact for Water Management Pacto Nacional pela Gestão das Águas RS State of Rio Grande do Sul Estado do Rio Grande do Sul SDPI Secretariat of Development and

Investment Promotion Secretaria de Desenvolvimento e Promoção de Investimento

SDR Secretariat of Rural Development, Fishery and Cooperativeness

Secretaria de Desenvolvimento Rural Pesca e Cooperativismo

SEAPA Secretariat of Agriculture, Livestock and Agribusiness

Secretaria de Agricultura, Pecuária e Agronegócio

SEFAZ Secretariat of Finance Secretaria da Fazenda SEMA Secretariat of Environment Secretaria de Meio Ambiente SEPLAG Secretariat of Planning, Management and

Social Participation Secretaria de Planejamento, Gestão e Participação Social

SOP Secretariat of Public Works, Irrigation and Urban Development

Secretaria de Obras Públicas, Irrigação e Desenvolvimento Urbano

SWAP Sector Wide Approach Abordagem Setorial Ampla TCE State Court of Accounts Tribunal de Contas do Estado de Rio

Grande do Sul TIUMA Territories of Irrigation and Multiple Uses Territórios de Irrigação e Usos Múltiplos WR Water Resources Recursos Hídricos WRM Water Resources Management Gestão de Recursos Hídricos

Vice President: Jorge Familiar Country Director: Deborah L. Wetzel

Sector Director: J. Humberto Lopez Sector Manager: Auguste T. Kouame

Sector Leader: Roland Clarke Team Leaders: Rafael Barroso/ Paula Freitas

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BRAZIL

RIO GRANDE DO SUL STRENGTHENING FISCAL AND WATER RESOURCES MANAGEMENT DEVELOPMENT POLICY LOAN

TABLE OF CONTENTS

LOAN AND PROGRAM SUMMARY

1. INTRODUCTION AND COUNTRY CONTEXT ............................................................................... 1

2. MACROECONOMIC POLICY FRAMEWORK ................................................................................ 2

2.1. RECENT ECONOMIC DEVELOPMENTS IN BRAZIL ........................................................... 2

2.2. BRAZIL’S MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY ..................... 5

2.3. RECENT ECONOMIC DEVELOPMENTS IN RIO GRANDE DO SUL .................................. 6

2.4. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY IN RIO GRANDE DO SUL 11

3. THE GOVERNMENT’S PROGRAM ................................................................................................ 13

4. THE PROPOSED OPERATION ........................................................................................................ 14

4.1. LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION ....................... 14

4.2. PRIOR ACTIONS, RESULTS AND ANALYTICAL UNDERPINNINGS .............................. 14

4.3. LINK TO CPS AND OTHER BANK OPERATIONS ............................................................... 22

4.4. CONSULTATIONS, COLLABORATION WITH DEVELOPMENT PARTNERS ................ 22

5. OTHER DESIGN AND APPRAISAL ISSUES ................................................................................. 23

5.1. POVERTY AND SOCIAL IMPACT ......................................................................................... 23

5.2. ENVIRONMENTAL ASPECTS ................................................................................................ 24

5.3. PFM, DISBURSEMENT AND AUDITING ASPECTS ............................................................ 25

5.4. MONITORING AND EVALUATION ...................................................................................... 27

6. SUMMARY OF RISKS AND MITIGATION ................................................................................... 27

ANNEX 1: POLICY AND RESULTS MATRIX ...................................................................................... 29

ANNEX 2: LETTER OF DEVELOPMENT POLICY ............................................................................... 33

ANNEX 3: FUND RELATIONS ANNEX ................................................................................................ 42

ANNEX 4: ASSUMPTIONS FOR THE FISCAL AND DEBT SUSTAINABILITY ANALYSIS .......... 43

The Strengthening Fiscal and Water Resources Management DPL was prepared by an IBRD team consisting of Rafael Barroso, Paula Freitas, Gunars Platais, Alberto Costa, Jimena Garrote, Catarina Portelo, Carolina Renart, Fábio Bittar, Joseph Kizito, Frederico Rabello, Angela Porto, Monica Porcidonio, Erwin de Nys, Gilberto Canali and Thadeu Abicalil.

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SUMMARY OF PROPOSED LOAN AND PROGRAM BRAZIL

RIO GRANDE DO SUL STRENGTHENING FISCAL AND WATER RESOURCES MANAGEMENT DEVELOPMENT POLICY LOAN

Borrower The State of Rio Grande do Sul (RS) with a guarantee from the Federative Republic of Brazil

Implementation Agency State Secretariat of Finance (SEFAZ)

Financing Data

IBRD Loan Amount: US$ 280 million with a sovereign guarantee from the Federative Republic of Brazil Terms: Commitment linked IBRD Flexible loan, with a variable spread, customized repayments, 29.5 years final maturity, 4.5 years grace period, with all conversion options selected and the Front End Fee and Premia for Caps and Collars capitalized

Operation Type Single tranche Development Policy Loan (DPL)

Program Development Objective and Pillars of the Operation

The Program Development Objective is to improve Government capacity to mitigate economic volatility in the State of Rio Grande do Sul by supporting measures to increase resources available to the government and to reinforce the Integrated Water Resource Management framework Pillar 1: Strengthening Fiscal Management Pillar 2: Irrigation and Water Resources Management

Result Indicators

Main results indicators are: • Percentage of tax expenditure measures under Government control

evaluated. Baseline (2012): zero, Target (2015) = 25 percent. • Increase in the share of tax arrears recovered within 60 days of their

generation. Baseline (2012): 20.8 percent, Target (2015) = 27 percent • Increase in the share of goods procured, expressed as a percentage of the

total value of goods, using price information from the electronic fiscal invoice database. Baseline (2012): zero, Target (2015) = 25 percent.

• Increase in the number of managerial cost reports prepared by Government agencies. Baseline (2012): zero, Target (2015) = 14

• New policy instrument to manage contingent liabilities made effective. Baseline (2012): No, Target (2015) = Yes

• Increase in the number of medium and small farmers that have adhered to the ‘More Water, More Income’ Program. Baseline (2012): 413, Target (2015) = 3,000

• Increase in the number of river basin plans prepared, approved by the respective river basin committees, including updated information on water availability and users per basin. Baseline (2012): 1, Target (2015) = 12.

• New hydro-meteorological stations installed in key river basins with information analyzed by the State. Baseline (2012): zero, Target (2015) = 80.

Overall Risk Rating

The overall risk rating is moderate. The main risks in this operation are of macroeconomic, environmental and developmental nature. However, none of these risk factors are considered to be major. Aspects relating to other risk factors are judged to be low.

Operation ID P148083

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IBRD PROGRAM DOCUMENT FOR A PROPOSED LOAN TO THE STATE OF RIO GRANDE DO SUL

WITH THE GUARANTEE OF THE FEDERATIVE REPUBLIC OF BRAZIL FOR A

STRENGTHENING FISCAL AND WATER RESOURCES MANAGEMENT DEVELOPMENT POLICY LOAN

1. INTRODUCTION AND COUNTRY CONTEXT 1. This proposed operation is a single tranche Development Policy Loan (DPL), in the amount of US$280 million to the Brazilian State of Rio Grande do Sul (RS). The purpose of this operation is to improve Government capacity to mitigate economic volatility in the State of Rio Grande do Sul by supporting measures to increase resources available to the Government and to reinforce the Integrated Water Resource management framework. The loan will help the State devise and put in practice policies and tools to manage water supply and demands, as a means to make its economy more resilient to the effects and impacts of droughts. On the fiscal side, it will support reforms to improve the Government’s capacity to mobilize revenues and promote expenditure savings, without cutting back services, while acknowledging the major constraints on fiscal policy in Rio Grande do Sul. By providing means to smooth and raise rural incomes, bolstering the revenue base and improving expenditure efficiency. This operation is contributing directly to the World Bank goals of eliminating extreme poverty and promoting shared prosperity.

2. Although Rio Grande do Sul has relatively favorable economic indicators, its recent performance lags that of other States in Brazil. The State Gross Domestic Product (GDP) per capita is estimated at US$14,110; 121.2 percent of the national average. However, from 2002 to 2012, the State has had an average growth rate one percentage point below the national average (2.6 percent vis-à-vis 3.6 percent). The volatility of GDP growth in RS is higher than in Brazil (0.034 versus 0.025), which leads to more volatile Government revenues and expenditures.

3. Contributing to this situation, there are two acute and interconnected problems: poor water resource management and structural fiscal deficiencies. On one hand, constant and severe drought episodes strongly impact agricultural production. Since agribusiness accounts for 30 percent of the State GDP, its higher volatility is transmitted economy-wide. This higher GDP volatility translates into slower growth, lower revenues, higher debt ratios and higher expenditures to make up for the effects of drought, all of which reinforce the structural fiscal deficiencies. The State’s institutional weakness on water resources management prevents it from stabilizing and increasing agricultural production, in particular irrigated agriculture, which is more productive and less prone to fluctuations. A reduction in volatility would lead to more stable GDP and higher growth rates. On the other hand, the structural fiscal deficiencies of the State which are the root of its low investment capacity and poor service delivery, reduces the State ability to autonomously tackle the water problem with its own resources. Thus, this operation addresses these two problems simultaneously, helping the State to generate the resources and capacity it needs to ease this constraint on growth.

4. The main water resource problem is the concentration in time and space of high rainfall. This concentration together with the scarcity of water reservoirs and irrigation facilities leads to recurrent episodes of severe droughts. In the last decade, drought episodes were recorded in five years and in 2012, drought affected 1.8 million people. The potential for irrigation to

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mitigate problems related to droughts is high. The geography of the State is favorable for the implementation of irrigation: availability of water in perennial rivers, irregular but high rainfall and adequate soil for mechanized crops. In fact, irrigation has been used in the State for more than 30 years mainly for the cultivation of rice in the South. However, the irrigation potential remains largely untapped due to a lack of investment in water and irrigation infrastructure, insufficient institutional capacity for water resource management, lack of hydro-meteorological, piezometric and water quality information and ineffective systems for granting water use rights leading to growing conflict between multiple uses of water resources.

5. On the fiscal front, Rio Grande do Sul has been constrained by high debt, low ability to mobilize revenues and high pressure for public expenditure. As a result, the State faces decaying public services and a lack of resources to invest. The investment ratio in the State is the lowest among all Brazilian states since revenues are used almost entirely to pay for current expenditures and its high debt levels prevent it from borrowing. The low ability to mobilize revenue is explained by relatively high exports (exempt from tax under Federal law), lower ICMS (Imposto sobre Circulação de Mercadorias e Serviços) tax rates than other states, and the extensive use of tax incentives. On the expenditure side, the higher demand is explained by higher1 budget earmarks and the high debt level.

6. This proposed operation responds to an urgent request to support Rio Grande do Sul. The request came both from the National Treasury Secretariat, the main Federal counterpart of the World Bank in Brazil, and the Government of the State of Rio Grande do Sul (GoRS). In addition, the World Bank and the Inter-American Development Bank (IADB) have agreed to partner to jointly support the Government program in the areas of fiscal and water resources management. This partnership will be for a total amount of US$ 480 million. While the partnership and initial engagement by IADB have framed the operation design, both institutions have retained their autonomy to support different prior actions within the overall Government program. A more detailed description of this coordinated approach is given in Section 4.4.

2. MACROECONOMIC POLICY FRAMEWORK 2.1. RECENT ECONOMIC DEVELOPMENTS IN BRAZIL 7. Over the last two decades, Brazil has made significant advances in terms of economic management, poverty reduction, and social indicators. Growth in employment and labor incomes, as well as the implementation of targeted social assistance programs have contributed to a reduction in the share of Brazilians living below the extreme poverty line of R$70 a month from 10.8 percent in 2001 to 4.3 percent in 20122, as well as a reduction in inequality as reflected in a fall in the Gini coefficient from 0.60 to 0.53 over the same period. 8. Brazil’s development is now at a crossroads. The country is gradually recovering from a slowdown that started in 2011. Future growth appears to be limited by structural bottlenecks in infrastructure, human capital, and poor financial intermediation compounded by a burdensome tax system and business environment. At the same time, a growing middle class is drawing attention to the ineffectiveness and inefficiency of public service delivery. Mass demonstrations

1 For example, in the State constitution 35 percent of state revenues are earmarked to education while the Federal Constitution requires 25. 2 Data from PNAD (national household survey) using the extreme poverty line of the Brasil sem Miséria program.

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in Brazil during June 2013 left little doubt as to the importance of good governance and effective service delivery in Brazil.

9. The recent economic slowdown now appears as much structural as cyclical. Initially, tighter monetary and fiscal policies in 2011 weakened domestic demand at the same time as external demand was dampened by protracted weakness and uncertainty in advanced economies and slowing growth in major emerging markets. However, as the slowdown continued throughout 2012, policy became looser and the external environment strengthened, structural factors such as the tight labor market and high cost of production, have become increasingly important. While the slowdown was felt across the board, it was industry that slowed most (industrial production declined by 6.4 percent between mid-2011 and end-2013) due to weak domestic demand, a relatively strong real exchange rate and the structural bottlenecks referred to earlier. The poor performance of industry was also mirrored in the weakness of investment demand.

10. Inflation remains high. Headline inflation reached 5.9 percent in 2013, accelerating to 6.2 percent in March 2014. Inflation is higher for goods whose prices are not controlled, running at 7.0 percent (compared with 3.4 percent for regulated prices) as well as for non-tradable goods (8.1 percent). The rate of inflation reflects in part capacity constraints, and a structurally tight labor market (due to skills mismatches and changing demographics). As a result, even at low rates of growth, demand-pull factors have played an important role. Cost-push factors such as automatic minimum wage adjustment and price shocks (especially food) have also contributed to inflationary pressure.

11. Fiscal and monetary policies responded to slow growth and high inflation. Over the past decade Brazil’s three-pillared macroeconomic framework (flexible exchange rates, inflation targeting and fiscal prudence) gained credibility. The fiscal stance has been loosened with primary surplus declining from 3.1 percent in 2011 to 1.8 percent in February 2014. However fiscal policy was tightened in February 2014 with the announcement of cuts of close to 1 percent of GDP to meet a primary surplus target of 1.9 percent of GDP. With inflation close to the 6.5 percent upper limit of the target range, monetary policy was also tightened and the interest rate has been raised by 375 basis points between April 2013 and April 2014 to 11 percent currently.

12. External instability has led the exchange rate to depreciate and became more volatile. The current account deficit widened to 3.7 percent of GDP in February 2014 from 2.4 percent in 2012. At the same time FDI failed to fully cover the gap reaching 2.9 percent. The difference was covered by portfolio investment which has reached 1.1 percent of GDP. The beginning of the tapering of monetary policy by the Federal Reserve has led to additional pressures on the exchange rate (as in other emerging markets). The Central Bank of Brazil responded with an intervention plan consisting of purchasing interest rate swaps and a foreign exchange repurchase program. While these interventions contributed to limiting exchange rate volatility, they also left the authorities with a non-deliverable short position with a notional value of US$ 84 billion as of February 2014. This compares to a stock of reserves of US$ 363 billion. Higher interest rates and reduced taxes on capital inflows also supported the currency.

13. While concerns have emerged about the interventionist nature of recent economic policies, Brazil’s macroeconomic framework remains adequate and robust. In recent years, economic policy has appeared more interventionist. Attempts to control inflation by administering prices and reducing taxes, together with other discretionary tax incentives,

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subsidies to energy and state-owned banks as well as slower growth and increased social demands have reduced the primary surplus. This in turn has complicated the task of curbing inflation. Indeed this combination of factors underpinned the downgrade by Standard and Poor’s of Brazil’s sovereign credit rating to the lowest investment grade on March 24. However, recent fiscal adjustment and moves to accelerate the auction of oil and infrastructure concessions indicate a clear recognition of the importance of market-oriented policies by the Government. The downgrade is likely to strengthen the Government’s focus on such market oriented policies.

Table 1 - Brazil: Selected Economic Indicators and Projections: 2006 - 2017

14. Brazil’s financial system has remained sound and resilient. Following a period of rapid credit growth, asset quality indicators broadly stabilized during 2012 and recently reported some improvement. As of February 2014, around 4.3 percent of household loans and 1.9 percent of corporate loans were classified as non-performing. Lower interest rates in recent years eased pressures on borrowers, keeping delinquencies at manageable levels. A moderated increase in delinquency cannot be ruled out as interest rates in Brazil are rising. The banking system appears to be well-cushioned to withstand losses, with loan loss provision coverage at 170 percent of nonperforming loans as of December 2013, compared with 160 percent recorded last June as nonperforming loans fell. Moreover, the solvency ratio remained considerably above the 11

Indicator 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

National Accounts Real GDP Growth 6.1 5.2 -0.3 7.5 2.7 1.0 2.3 2.0 2.6 3.5 3.5

Gross domestic investment 18.3 20.7 17.8 20.2 19.7 18.2 18.4 18.5 18.7 18.9 19.2

External SectorCurrent account 1.6 -28.2 -24.3 -47.3 -52.5 -54.2 -81.5 -74.8 -73.2 -74.1 -78.9

Merchandise trade balance 40.0 24.8 25.3 20.1 29.8 19.4 2.3 7.8 19.8 22.7 21.5Exports (fob) 160.6 197.9 153.0 201.9 256.0 242.6 242.4 259.4 281.4 304.0 324.1Imports (fob) 120.6 173.1 127.7 181.8 226.2 223.2 240.1 251.6 261.6 281.3 302.6

Nonfactor services, net -13.2 -16.7 -19.2 -30.8 -37.9 -41.0 -47.5 -48.0 -51.5 -54.6 -56.1 Income and current transfers, net -25.3 -36.3 -30.3 -36.6 -44.3 -32.6 -36.4 -34.6 -41.6 -42.3 -44.3

Direct investment, net 27.5 24.6 36.0 36.9 67.7 68.1 64.0 60.0 61.7 64.8 68.0Portfolio equity, net 1 24.8 -7.3 39.7 43.9 16.0 3.3 2.7 3.4 3.5 3.5 4.2Gross international reserves 180.3 193.8 238.5 288.6 352.0 373.1 358.9 363.0 367.8 371.6 374.4Current account (% of GDP) 0.1 -1.7 -1.5 -2.2 -2.1 -2.4 -3.6 -3.5 -3.3 -3.1 -3.1General Government Total Revenues and Grants 35.7 36.9 34.9 37.2 36.6 37.2 37.2 36.9 37.2 37.1 37.2 Total Expenditure 38.4 38.2 38.0 39.9 39.1 40.0 40.5 39.7 39.2 38.8 38.5

Current Expenditure 36.6 36.0 35.8 35.9 36.7 37.5 37.7 36.9 36.4 35.9 35.5of which: Net Interest payments 6.1 5.5 5.3 5.2 5.7 4.9 5.2 4.7 4.7 4.1 3.4

Capital Expenditure 1.8 2.2 2.2 4.0 2.5 2.6 2.8 2.9 2.9 2.9 3.0 Primary Balance 3.5 4.1 2.2 2.5 3.2 2.1 1.9 1.8 2.7 2.3 2.1 Overall Balance -2.7 -1.4 -3.1 -2.7 -2.5 -2.8 -3.3 -2.8 -2.1 -1.8 -1.3 Gross Public Sector Debt 65.2 63.5 66.8 65.0 64.7 68.0 66.3 64.2 61.6 58.6 55.5

of which: Domestic Currency 60.6 58.4 63.2 62.1 62.2 65.4 63.2 61.0 58.2 55.2 52.2of which: Foreign Currency 4.6 5.1 3.7 3.0 2.7 3.1 3.1 3.2 3.4 3.5 3.3

Prices GDP Deflator 5.9 8.3 7.2 8.2 7.0 4.9 7.7 5.7 5.2 4.7 4.5 Consumer Price Index (eop) 4.5 5.9 4.3 5.9 6.5 5.8 5.9 5.8 5.5 5.3 5.0

Memorandum items: Nominal GDP (in R$ billions) 2661.3 3032.2 3239.4 3770.1 4143.0 4402.5 4836.4 5214.3 5628.1 6098.8 6596.4 Total External Debt (% of GDP) 17.5 15.9 17.4 16.4 16.2 17.9 18.8 20.8 21.0 21.4 20.6

Source: IMF, BCB, IBGE, EIU, WB Calculation

(in percent of GDP)

(annual percent change)

Projections

Note 1: Porfolio equity does not include debt securities

(annual real percent change)

(in percent of GDP)

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percent minimum regulatory requirement, at 16.6 percent in November 2013. However, rising private sector external debt levels, largely reflecting increased issuance of bonds by corporates and banks, have raised concerns about the capacity of some companies to carry their debt.

2.2. BRAZIL’S MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY 15. The growth prospects for the Brazilian economy remain muted, with 2.3 percent growth recorded in 2013 and a slightly lower growth rate expected for 2014 with a gradual increase to 3.5 percent thereafter. After a 3.5 percent monthly contraction in December 2013, industrial production recovered in the two consecutive months, reporting 1.1 percent growth in the last 12-months to Feb-2014. Consumer confidence stabilized in March after three consecutive drops. Investment, which declined in 2012, has rebounded in 2013 and will be aided by an increase in infrastructure investment and the preparations for upcoming mega events. The contribution of net external demand will likely remain dampened given global developments as well as the current crisis in Argentina, which is an important market for Brazilian manufactured exports. The depreciation of the Real should have a positive impact on the current account.

16. Inflation is expected to remain a challenge. A key factor is the role of the labor market which remains tight. It is characterized by low unemployment (5.1 percent in February), scarcity of skilled workers and labor hoarding due to low flexibility caused by structural issues affecting mobility and wage setting (such as indexation of the minimum wage to inflation and GDP growth). Government efforts to address skills gaps should help address some of these concerns in the medium term, although more will be needed to raise labor market flexibility. Other factors that may contribute to inflation include the pass-through of the recent depreciation of the currency and also the end of restraint of administrated prices, which have been running at 1.5 percent in 2013, but have started to rise as fuel prices are brought near to world market levels and energy subsidies are phased out. On the other hand, the recent monetary policy tightening will help subdue inflationary pressures. Inflation expectations also remain high, standing at 6.3 percent for the coming 12 months in early April.

17. The external environment continues to pose a risk to Brazil’s outlook for near-term growth. Continuation of an uneven recovery in advanced economies and a slowdown in emerging markets, may translate into lower external demand for Brazil’s exports. Like other emerging market economies, Brazil also remains vulnerable to market sentiment posing a continued risk to FDI and especially portfolio flows, particularly given the relatively high share of some government bonds held by non-residents and the possible impact of the unwinding of unconventional monetary policy in the US. Nonetheless, Brazil’s vulnerability to external events is likely to remain moderate due to its high reserves (US$ 363 billion), the low share of short-term debt in total external debt (around 21 percent), the large role of foreign direct investment (2.9 percent of GDP in Feb-2014) in financing the current account (-3.7 percent of GDP in Feb-2014).

18. Downside contingencies and social pressures for improved public services also pose risks to the fulfillment of fiscal targets. The achievement of primary surplus targets are in jeopardy if the growth rate of current expenditures is not curtailed and if activity turns out more sluggish than expected. Other potential fiscal risks include Government efforts to stimulate the economy through specific incentives for particular sectors, the subsidy to energy prices which cost around R$ 20 billion in 2013, sporadic tax relief for selected industries, and quasi-fiscal activities by the National Bank for Economic and Social Development (BNDES), which received

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R$ 39 billion in transfers from the Treasury in 2013. More generally, pressures for improved public services and mandatory payments for Congressional Budget Amendments may also create stronger expenditure pressures. Also, political tensions between Congress and the Executive and the coming election year pose further risks of pressures to the fiscal stance.

19. In spite of these risks and challenges, Brazil’s overall macroeconomic framework is currently adequate for the purposes of this operation. Brazil’s policy framework continues to provide the Government with the flexibility to respond to economic crises. While the continuation of inflation pressures and the recent deterioration of fiscal outturns have raised concerns, the authorities remain committed to inflation control and fiscal prudence. Gross public sector debt is expected to decline in the future, given the levels of the primary surplus, despite difficulties in maintaining fiscal balance in the face of large investment needs and popular pressures for improved service delivery. Moreover, flexible exchange rates and relatively large foreign reserves provide Brazil with a buffer to shifts in market perceptions and an associated turn-around in capital flows – as the recent episode of market turbulence has suggested.

20. Brazil’s medium to longer-term outlook will critically depend on its ability to tap into a large unrealized growth potential and remove structural bottlenecks. These bottlenecks include: the need to accelerate and strengthen the quality of human capital formation; reduce the tax burden; increase the effectiveness of public spending; raise public and private investment to address infrastructure bottlenecks; developing a private long-term capital market; a more flexible labor market; and a more agile business environment that promotes internal competition and external competitiveness. Addressing these bottlenecks would lay the foundations for productivity growth.

2.3. RECENT ECONOMIC DEVELOPMENTS IN RIO GRANDE DO SUL 21. Rio Grande do Sul is the southernmost State in Brazil. It has a population of 11.2 million people in 2012, distributed in an area of 0.28million Km2. The State has 5.6 percent of the country population and 3.3 percent of the land area. State GDP amounted to US$151.7 billion in 2012 or 6.7 percent of Brazil’s GDP. Per capita GDP was thus US$14,110. Poverty and extreme poverty incidence are below the national average, but above the southern region average. In 2012, the incidence of poverty was 4.2 percent, while the figures for the region and the country stood at 3.7 and 9.4 percent respectively. For incidence of extreme poverty, numbers are 2.2, 1.9 and 4.3 respectively. More importantly, RS has failed to reduce poverty at the same rate as of the rest of the country. The annualized growth rate of the bottom 40 percent mean income has been 6.1 percent from 2004 to 2011.

22. The State of Rio Grande do Sul has significant regional diversity. The majority of the population and GDP is concentrated in the axis formed by the capital, Porto Alegre and the Mountain region. The Southern part is characterized by large landholdings dedicated to irrigated rice farming. The Northwestern and Center-West regions are characterized by the existence of small landholders and family-owned farms dedicated to rain-fed crops. These last two regions have been losing population and participation in State GDP, while all three regions have a higher incidence of poverty.

23. Services represent the largest sector in the economy. It accounted for 62.1 percent of the value added in 2010. Industry is the second largest sector with 29.2 percent, while agriculture is responsible for 8.7 percent. A key feature of the economy is the importance of exports. In 2012, exports represented 11.4 percent of State GDP and constituted 9.8 percent of Brazil’s

7

exports by July of 2013, positioning the State as the third largest exporter in the country, after the States of São Paulo and Minas Gerais.

24. The agricultural sector is of great importance to the State. Despite the small share of agricultural production (8.7 percent) in the State, its share is larger than the country average of 5.3 percent. Moreover, it is estimated that the agribusiness complex accounts for 29.5 percent of the State GDP3 and 17.2 percent of employment. For example, the tobacco, leather and shoes and the food industries purchase at least 80 percent of their inputs from local suppliers. The main crops in terms of area are: soybean, corn and rice; while in production value the order is soybean, rice and tobacco. The main agricultural exports in 2012 were soybean, meat and rice4.

25. Irrigation is by far the main use of water in Rio Grande do Sul. Nonetheless, less than 7 percent of rural properties have irrigation facilities, evidencing the high dependence of agriculture on rainfall. Favorable soil conditions and average yearly rainfall above 1,500mm provide a promising perspective for the expansion of irrigated agriculture. Soy and rice are cultivated on over 1 million irrigated hectares in the Southern and Southwestern regions. Although dry summers seem to have become more frequent in the last 12 years, they have not heavily impacted rice production as farmers have invested in water storage infrastructure.

26. Competition with the demand for human consumption occurs during summers with lesser than average rainfall. Dry summers seriously affect medium and small-size production and income in the Northwestern region where corn, soy and beans are the main crops, besides dairy production. The region shows a good potential for irrigated agriculture. During dry periods, urban water supply is hampered by competing uses and poor water quality requiring intervention from the authorities to guarantee proper water supply for human consumption. Other than agriculture, the State waters are used for power generation in the Northern region and for navigation. Both uses do not raise any major conflict with other water uses. Figure 1 – Brazil and Rio Grande do Sul GDP growth rates: 2003 – 2012

Figure 2 –Rio Grande do Sul GDP and Agriculture growth rates: 2003 – 2012

Source: IBGE and FEE Source: FEE

27. State GDP performance is highly correlated with agricultural production and thus with droughts. The volatility of GDP growth in RS is higher than in Brazil (0.034 versus 0.025). This volatility is explained by the agricultural sector, which is then transmitted to the whole economy (see Figure 1 and 2). Therefore, years of slower growth in the State than in the country 3 Fundação de Economia e Estatística, 2003. Notas metodológicas sobre o dimensionamento do PIB do agronegócio do Rio Grande do Sul. 4 Agricultural production and employment data are from 2012 and were obtained from IBGE.

-2.8%

2.7%

-1.8%

3.2%

5.2%

0.9%

-4%

-2%

0%

2%

4%

6%

8%

10%

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

RS Brasil

-40

-30

-20

-10

0

10

20

30

40

50

60

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

GDP Agriculture

8

are associated with more severe drought episodes, like in 2012, 2008 and 2005. In particular, the 2012 drought was the most severe in the last 60 years. Direct losses were estimated at more than US$2.7 billion (R$ 5.3 billion), according to FARSUL (Federation of Agriculture of Rio Grande do Sul). As a result, agricultural GDP shrank 27.6 percent and overall GDP contracted by 1.8 percent.

28. After a decline in 2012, economic activity rebounded in 2013 and the State is set to regain part of the previous year’s loss. GDP growth in the first nine months of the year stood at 6.6 percent vis-à-vis Brazil’s growth of 2.4 percent. Growth was pushed by the agricultural sector, which expanded by 48 percent in the same period. Industrial production increased by 6.4 percent from January to October, while growing 1.5 percent in Brazil in the same period. Broad retail sales grew 6 percent in the State and 3.4 percent in Brazil.

29. Debt levels are high for historical reasons. RS was one of the most indebted states in the 1990s, when the Federal Government renegotiated the state debts. The debt had originated from a strategy of avoiding fiscal adjustment by increasing debt since the 1980s. As a result, the total State debt amounted to R$ 51.7 billion in 2012 (equivalent to 218 percent of Net Current Revenues (NCR) and 17.4 percent of GDP), out of which 85 percent was with the National Treasury. In addition, debt service as a share of NCR is high, albeit declining. In 2008, it represented 18.4 percent of NCR, but has declined to 11 percent of NCR in 2012, in line with the limit set by Senate Resolution.

30. Rio Grande do Sul has been complying with the Fiscal Responsibility Law (FRL). Payroll expenditures as a share of NCR are 51.2 percent vis-à-vis a limit of 60 percent. The limit over new loans (16 percent of NCR) and guarantees (22 percent of NCR) were obeyed too. The Net Consolidated Debt (NCD) to NCR ratio has been over the 200 percent limit since the inception of the FRL. However, according to the law, RS has until 2016 to gradually bring this ratio down to 200 percent. Therefore, the debt limit for RS is set as a declining path, with the goal of reducing the excess between the NCD/NCR ratio observed in 2000 and the 200 percent threshold by 1/15th every year. Since 2008, the State has brought the debt ratio under this declining limit and is thus in compliance with the FRL (see Figure 3).

31. The State’s revenues are composed mainly of own source revenues. Total revenues reached R$ 32.3 billion in 2012, out of which 77 percent were from tax revenues and only 11 percent from transfers. Revenues fluctuated broadly in response to both national and subnational GDP. Extraordinary factors in 2007 (reduction of ICMS tax rates) and in 2011 (comparison base in 2010 was augmented by extraordinary revenues) explain deviations from this pattern. Revenues posted double digit growth in 2008 (11.8 percent) and 2010 (12.9 percent), years of great economic growth in the country, and showed slow or negative growth in 2009 and 2011.

32. The difficulty in mobilizing revenues translates in one of the lowest tax collection rates among Brazilian states. Tax collection as a share of GDP stood at 8.4 percent in 2012, ranking 22nd out of 27 states (see Figure 5). The low comparative tax burden is a reflection of the higher export and out of state sales share, wide use of tax expenditures and lower tax rates than other states. Out of four categories: energy, fuel, telecom and alcoholic beverages; RS has the lowest rate for two of them and the second lowest for the other two. In 2008, only 49 percent of the State’s industrial production was sold internally, leaving the full ICMS amount to the State. The remainder was either sold to other states (37 percent), leaving the State with only part of the ICMS, or was sold abroad (11 percent), which is tax exempt. Due to the revenue forgone as tax

9

expenditures, actual revenue represented only 65 percent of potential revenue in 2011.

33. The State’s main expenditure is compensation of employees (including both current and retired employees). It reached R$ 16.6 billion in 2012 (see Table 2) and has averaged a real growth rate of 3.8 percent from 2006 to 2012. Retired employees made up to R$ 7.2 billion in 2012 and the pension system registered a R$ 6.1 billion deficit in 2012. Headcount has increased 3 percent in 2012, but it is roughly at the same level as of 2006. Payroll expenditure has been growing above revenues since 2010, as a share of NCR it has grown from 47 percent to 51.2 percent, as a result. In terms of government functions, main expenditures are on health, education and public security.

Table 2 - Rio Grande do Sul Statement of Government operations: 2008-2012

Source: GoRS and WB calculations

34. Expenditures have grown as a result of mandates by Federal legislation, unforeseen demands and because of autonomous policy decisions. Health expenditures have increased by 86 percent in nominal terms from 2009 to 2012 and are expected to increase by 52 percent until 2014 in order to comply with the Federal legislation which has redefined health expenditures for earmark purposes5. A federally mandated minimum wage for teachers was also fixed by national legislation in 2008 however, current wage in the State is below the minimum. As a result, teachers’ wage will increase by 29 percent until 2014. Nonetheless, the State will still not 5 All states are required to spend 12 percent of revenues on health. Non-compliance with the health earmark and the teacher’s minimum wage can cause sanctions to public officials, but no fiscal sanctions are lifted upon the state.

2008 2009 2010 2011 2012 2008 2009 2010 2011 2012I. REVENUE 28,007.1 28,239.7 31,796.9 31,495.5 32,300.9 11.3% 11.1% 11.2% 10.6% 10.9%

Taxes 21,171.9 21,082.4 24,072.8 24,024.6 24,900.7 8.6% 8.3% 8.5% 8.1% 8.4%ICMS 18,000.0 17,394.4 19,426.1 20,069.7 20,730.5 7.3% 6.8% 6.8% 6.8% 7.0%IPVA 1,246.0 1,744.2 1,639.0 1,719.5 1,841.7 0.5% 0.7% 0.6% 0.6% 0.6%Others 1,925.9 1,943.9 3,007.6 2,235.4 2,328.5 0.8% 0.8% 1.1% 0.8% 0.8%

Social Contributions 1,448.7 1,507.9 1,564.6 1,739.4 1,778.3 0.6% 0.6% 0.6% 0.6% 0.6%Transfers 3,730.9 3,596.5 3,897.1 3,760.9 3,578.0 1.5% 1.4% 1.4% 1.3% 1.2%

Current Transfers 3,621.9 3,384.8 3,658.2 3,672.1 3,481.7 1.5% 1.3% 1.3% 1.2% 1.2%Capital Transfers 109.0 211.7 238.9 88.8 96.3 0.0% 0.1% 0.1% 0.0% 0.0%

Other Current Revenues 1,655.7 2,052.9 2,262.4 1,970.7 2,043.9 0.7% 0.8% 0.8% 0.7% 0.7%

II. EXPENSE 24,583.5 25,271.4 27,593.0 28,653.9 31,528.5 10.0% 9.9% 9.7% 9.7% 10.6%Compensation of Employees 13,623.3 14,019.9 15,048.9 15,678.5 16,615.8 5.5% 5.5% 5.3% 5.3% 5.6%Interest Payments 329.6 239.6 184.6 131.3 1,485.5 0.1% 0.1% 0.1% 0.0% 0.5%Other Current Expenditures 10,287.5 10,654.7 11,801.3 12,248.8 12,707.8 4.2% 4.2% 4.2% 4.1% 4.3%

Transfers to Municipalities 5,397.7 5,465.6 6,025.0 6,184.3 6,404.1 2.2% 2.1% 2.1% 2.1% 2.2%Goods and Services 4,889.9 5,189.0 5,776.2 6,064.5 6,303.7 2.0% 2.0% 2.0% 2.1% 2.1%

FUNDEB Net Loss 343.1 357.3 558.2 595.3 719.4 0.1% 0.1% 0.2% 0.2% 0.2%

III. GROSS OPERATING BALANCE (I - II) 3,423.6 2,968.2 4,203.9 2,841.6 772.3 1.4% 1.2% 1.5% 1.0% 0.3%% of NCR 16.0 13.9 17.4 12.0 3.2 16.0 13.9 17.4 12.0 3.2

IV. TRANSACTIONS IN NON-FINANCIAL ASSETS 818.3 781.5 2,177.0 1,164.2 1,223.2 0.3% 0.3% 0.8% 0.4% 0.4%Investiment in Non-Financial Assets 737.2 706.1 2,095.6 929.7 980.8 0.3% 0.3% 0.7% 0.3% 0.3%Investment in Financial Assets 81.1 75.4 81.4 234.5 242.5 0.0% 0.0% 0.0% 0.1% 0.1%

V. NET LENDING / BORROWING (III - IV) 2,605.3 2,186.8 2,026.9 1,677.4 -450.9 1.1% 0.9% 0.7% 0.6% -0.2%

VI. PRIMARY BALANCE (V + Net Interest Payments) 2,674.4 2,129.2 2,015.6 1,689.2 932.3 1.1% 0.8% 0.7% 0.6% 0.3%% of NCR 12.5 9.9 8.3 7.1 3.9 12.5 9.9 8.3 7.1 3.9

VII. TRANSACTIONS IN FINANCIAL ASSETS AND LIABILITIES -2,099.0 -2,198.4 -2,204.0 -2,201.5 -197.5 -0.8% -0.9% -0.8% -0.7% -0.1%New Loans 1,476.1 0.0 889.3 261.0 943.7 0.6% 0.0% 0.3% 0.1% 0.3%Amortizations, net (3,580.5) (2,234.3) (3,098.0) (2,467.7) (1,183.7) -1.4% -0.9% -1.1% -0.8% -0.4%Asset sales 5.3 35.9 4.7 5.2 42.5 0.0% 0.0% 0.0% 0.0% 0.0%

VIII. GROSS FINANCING NEEDS (Net Debt Service - VI) 975.2 47.5 1,071.1 790.3 1,634.5 0.4% 0.0% 0.4% 0.3% 0.6%% of NCR 4.6 0.2 4.4 3.3 6.8 4.6 0.2 4.4 3.3 6.8

VIII. OVERALL BALANCE (VI + VII) 575.4 -69.2 -188.4 -512.3 734.8 0.2% 0.0% -0.1% -0.2% 0.2%

R$ Million (2012 constant values) % of Subnational GDP

10

comply with the legislation. It is estimated that to bring the State into compliance would cost an additional R$ 2.5 billion. Lastly, from 2010 to 2012, as a response to the severe drought, the GoRS had to spend R$ 190 million to remedy its effects.

35. As a result of low revenue mobilization, expenditure pressures and high debt, public investment levels are the lowest in the country. Public investment, which accounts for both financial and non-financial assets, summed R$ 1.2 billion in 2012 or 5.2 percent of NCR (see Figure 6). Furthermore, the State’s own resources available for investments totalled only R$ 755 million in 2012, around 3.2 percent of NCR. Since the State is heavily constrained to borrow in the short term, the only possibility for the State to invest more is by increasing its Gross Operating Balance. Figure 3 – Net Consolidated Debt/ Net Current Revenues: 2006-2013

Figure 4 – Payroll Expenditures/ Net Current Revenues: 2006-2012

Source: GoRS Source: GoRS

Figure 5 – Brazilian States Tax Burden (as a % of GDP): 2012

Figure 6 – Brazilian States Public Investment (as a % of NCR): 2012

Source: STN. WB Calculation Source: STN. WB Calculation

36. Intergovernmental fiscal relations are adequate. Transfers are mostly rule-based, with the rules being written in the Constitution or laws. The rules are public and known in advance, and their application is overseen by the Court of Accounts. Under the Fiscal Responsibility Law and complementary Senate resolutions borrowing by States is prohibited if: (i) the Net Consolidated Debt exceeds twice the Net Current Revenue in the case of States or 120 percent in

190%

200%

210%

220%

230%

240%

250%

260%

2006 2007 2008 2009 2010 2011 2012 2013

NCD/ NCR Limit

51.2%51.9%

46.4%

49.4%

47.0%

48.8%

51.2%

43%

44%

45%

46%

47%

48%

49%

50%

51%

52%

53%

2006 2007 2008 2009 2010 2011 2012

12.1%

8.4%

5.8%

0%

2%

4%

6%

8%

10%

12%

14%

Mat

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Sul

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Serg

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Sul

Para

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Rio

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neiro

Rora

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Dist

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Fede

ral

25.1%

5.2%

0%

5%

10%

15%

20%

25%

30%

Espi

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Sant

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Pern

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Amaz

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Rora

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Alag

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Dist

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Para

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Mar

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Min

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Sant

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tarin

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rand

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Sul

11

the case of municipalities (ii) new credit operations exceed 16 percent of NCR; and (iii) debt service exceeds 11.5 percent of NCR. Borrowing is also prohibited if it violates the debt reduction schedules. Finally, bail-outs of subnational governments are prohibited and none has been registered in the last 15 years. State government fiscal accounts are under rigorous scrutiny of the National Treasury Secretariat. Revenues and Expenditures assignment are broadly matched with gaps being covered by specific transfers by the federal government mostly on education and health. The current debate over intergovernmental finance reforms will not change these characteristics in the next few years.

2.4. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY IN RIO GRANDE DO SUL 37. GDP per capita in Rio Grande do Sul has been maintained at around 120 percent of the national average. The challenge for RS is to maintain its position within Brazil, while being able to better leverage growth opportunities. These opportunities are emerging mainly in the shipyard and oil supplies production sectors around the Rio Grande port in the southeast of the State. Other growth opportunities are coming from the expansion of the pulp and paper industry, wind power and IT. On the other hand, traditional manufacturing sectors such as shoes, leather and furniture face challenges from competition with producers from low wage countries. Lastly, in agriculture the challenges are to expand irrigated agriculture, modernize rice production and incorporate small landowners from the Northwestern region in the agribusiness production chain.

38. Three scenarios were constructed to simulate the trajectory of fiscal and debt outcomes. The first or baseline scenario includes the most probable assumptions, incorporating the effects of changes in policies or rules that are already in place. The second scenario is a variation of the baseline, in which it assumes the same hypothesis as the baseline, except for an adjustment of the interest accrued on the renegotiated debt with the Federal Government. It is assumed that it will be adjusted starting in 2014 by changing the interest rate on debt to the consumer price index (IPCA) plus an interest rate of 4 percent, as provided in the draft law (PLC 238) in Congress (representing in practice a reduction in interest costs to the State)6. The third scenario is constructed as a worst case scenario where the State is hit by an external shock in 2014 and contingent liabilities materialize. The shock causes revenues to remain flat in nominal terms for two years, (an impact greater than any past shock) and the liability relating to the teachers minimum wage raises payroll expenditures in education by R$ 2.5 billion in that same year. Detailed assumptions for each scenario are provided in Annex 4.

39. The baseline projection shows a more difficult fiscal situation from 2013 to 2015. This is evidenced by the reduction in the operating balance to an average of 0.8 percent of NCR in this period as compared to an average of 10.9 from 2010 to 2012. This deterioration is the result of higher expenditures and revenue shocks. As a result, the maintenance of the already low investment level will depend more on external sources (loans and capital grants) in this period. The situation however is expected to improve from 2016 onwards since a few legally mandated expenditures will not increase as rapidly as in the past and the bulk of the wage increases would have been incorporated. The realization of these more benign fiscal outcomes depends on the Government carrying out a less expansionary fiscal policy. Due to legal and political limitations,

6 A more thorough assessment of the proposed changes can be found in the recent report Impact and Implications of Recent and Potential Changes to Brazil’s Subnational Fiscal Framework (P132347 and Report No. ACS5885). In short, the report shows that RS would be a net gainer from the reforms in both scenarios analyzed.

12

this would be translated into a slower growth rate in payroll for employees other than education and public security and a slower growth rate in goods and services expenditures other than health.

40. The expected debt trajectories under the two first scenarios are sustainable. The NCD to NCR ratio is expected to fall under the 200 percent threshold in the short term in both the baseline and in the PLC 238 scenario. In terms of debt to GDP, the ratio currently around 16 percent will decline constantly over time, reaching less than 10 percent by 2025 and 2024 in scenario 1 and 2 respectively. The debt deleveraging would occur roughly at the same pace as in recent years, but would occur even faster in the second scenario due to better refinancing terms. In addition, in the PLC 238 scenario the debt residual with the Federal Government7 to be refinanced would be much lower, thus translating in a lower debt service burden. For example, in 2028 the debt service is expected to take up 12.5 percent of NCR in the baseline scenario and 9.4 percent if the draft law is approved.

41. In the worst case scenario, the NCD to NCR ratio is expected to breach the FRL limit, however the State would be expected to undertake tougher adjustments and bring debt back into compliance with the FRL. The debt ratios would experience a shift upwards until 2023, declining afterwards even without any adjustment measures. However, due to the binding debt limit embedded in the FRL, the State would be unable to borrow more and thus forced to adjust its budget and get back in compliance with FRL faster than anticipated by the projections. Lastly, it is worth noting that even in this scenario, the debt to GDP ratio always remains below 30 percent, evidencing that even in this worst case considered, the debt would still be manageable. Figure 7 – Net Consolidated Debt (as a % of NCR): 2008 - 2030

Figure 8 – Net Consolidated Debt (as a % of GDP): 2008 – 2030

Source: GoRS and WB calculation Source: GoRS and WB calculation

42. Risks to the baseline scenario relate to changes in the intergovernmental fiscal framework and contingent liabilities. The State would be a net gainer from the intergovernmental reforms under discussion. ICMS revenues would grow in net terms and the State would see its oil royalties revenues increased with the change introduced by law, but

7 Starting in 1997, most state debts were refinanced by the Federal Government for 30 years with a cap on debt service. Any payments in excess of the cap would be capitalized, the so-called residual, and paid in 10 years with no cap, after the original maturity date.

0%

40%

80%

120%

160%

200%

240%

280%

320%

2008 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030

Baseline PLC 238 Worst Case Scenario FRL Limit

-2%

2%

6%

10%

14%

18%

22%

26%

30%

2013 2015 2017 2019 2021 2023 2025 2027 2029

Baseline PLC 238 Worst Case Scenario

13

currently suspended by the Supreme Court. The main contingent liability relates to precatórios8, whose definitive payment rules are being discussed in the Supreme Court, which might demand a faster payment schedule than the current one. In addition, unknown contingent liabilities might become new precatórios in an amount higher than the forecasted one. Another relevant contingent liability is the implementation of the teachers’ minimum wage, which is incorporated in the worst case scenario. In addition, this minimum wage has an adjustment rule that makes it grows above inflation every year, adding pressure to the Government budget. Other important contingent liabilities might arise from the civil servants retirement scheme.

Table 3 - Rio Grande do Sul Statement of Government operations: 2013-2020

Source: WB calculation

43. In conclusion, the GoRS’s expenditure program and fiscal arrangements between the Federal Government and the GoRS are adequate for the purpose of this operation, and the GoRS’s debt has been assessed as sustainable, although not without risks, in a very adverse environment.

3. THE GOVERNMENT’S PROGRAM 44. The Government’s program is embodied in its Multi-Year Plan (PPA) 2012-2015. The overarching Government objective is to induce sustainable growth, reducing social and regional inequalities. The plan was constructed around four axes: (i) investment, employment and income growth, (ii) regional development, (iii) improve quality of life and eradicate extreme poverty; and (iv) improve citizenship and promote republican and peaceful values. The plan has 13 objectives, including objectives 3.1 and 2.3, which are respectively: to strengthen the State’s investment capacity; and to strengthen economic, logistical and energy infrastructure, while 8 Precatórios are judicial claims filed against the state where a judgment was issued against it (that is, GoRS lost the case). As a result, the state has to pay a court-ordered amount of money in reparation

2013 2014 2015 2016 2017 2018 2019 2020 2013 2014 2015 2016 2017 2018 2019 2020I. REVENUE 37,196.5 40,965.8 43,933.9 47,345.2 51,021.9 54,994.1 59,287.0 63,892.1 11.2% 11.4% 11.4% 11.4% 11.4% 11.4% 11.4% 11.4%

Taxes 28,542.3 31,596.0 34,081.8 36,695.3 39,510.4 42,542.7 45,811.4 49,321.2 8.6% 8.8% 8.8% 8.8% 8.8% 8.8% 8.8% 8.8%ICMS 23,849.3 26,483.4 28,559.7 30,755.0 33,118.9 35,664.6 38,405.9 41,357.9 7.2% 7.4% 7.4% 7.4% 7.4% 7.4% 7.4% 7.4%IPVA 2,065.4 2,228.3 2,403.0 2,587.7 2,786.6 3,000.8 3,231.5 3,479.8 0.6% 0.6% 0.6% 0.6% 0.6% 0.6% 0.6% 0.6%Others 2,627.6 2,884.3 3,119.0 3,352.6 3,604.8 3,877.3 4,174.0 4,483.4 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8%

Social Contributions 2,018.7 2,252.0 2,441.5 2,620.0 2,813.1 3,022.4 3,252.8 3,485.6 0.6% 0.6% 0.6% 0.6% 0.6% 0.6% 0.6% 0.6%Transfers 4,171.6 4,715.4 4,801.5 5,198.8 5,626.4 6,095.3 6,605.1 7,159.1 1.3% 1.3% 1.2% 1.2% 1.3% 1.3% 1.3% 1.3%

Current Transfers 3,971.6 4,315.4 4,601.5 4,998.8 5,426.4 5,895.3 6,405.1 6,959.1 1.2% 1.2% 1.2% 1.2% 1.2% 1.2% 1.2% 1.2%Capital Transfers 200.0 400.0 200.0 200.0 200.0 200.0 200.0 200.0 0.1% 0.1% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0%

Other Current Revenues 2,463.8 2,402.4 2,609.2 2,831.1 3,072.1 3,333.7 3,617.7 3,926.2 0.7% 0.7% 0.7% 0.7% 0.7% 0.7% 0.7% 0.7%

II. EXPENSE 36,647.9 40,836.1 43,952.8 47,012.2 50,389.1 54,028.3 57,965.3 62,026.1 11.0% 11.4% 11.4% 11.3% 11.2% 11.2% 11.1% 11.1%Compensation of Employees 18,862.1 21,041.8 22,812.6 24,480.2 26,284.9 28,240.5 30,392.6 32,568.4 5.7% 5.9% 5.9% 5.9% 5.9% 5.8% 5.8% 5.8%Interest Payments 2,431.9 2,861.0 3,095.9 3,319.0 3,558.2 3,812.8 4,066.1 4,310.1 0.7% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8%Other Current Expenditures 14,525.2 16,016.4 17,057.8 18,150.2 19,400.9 20,741.2 22,177.4 23,715.5 4.4% 4.5% 4.4% 4.4% 4.3% 4.3% 4.3% 4.2%

Transfers to Municipalities 7,352.4 8,146.0 8,784.6 9,459.8 10,187.0 10,970.0 11,813.2 12,721.2 2.2% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3%Goods and Services 7,172.7 7,870.4 8,273.2 8,690.3 9,214.0 9,771.2 10,364.2 10,994.3 2.2% 2.2% 2.1% 2.1% 2.1% 2.0% 2.0% 2.0%

FUNDEB Net Loss 828.8 916.9 986.5 1,062.9 1,145.1 1,233.7 1,329.2 1,432.2 0.2% 0.3% 0.3% 0.3% 0.3% 0.3% 0.3% 0.3%

III. GROSS OPERATING BALANCE (I - II) 548.5 129.7 -18.9 333.0 632.9 965.8 1,321.7 1,866.0 0.2% 0.0% 0.0% 0.1% 0.1% 0.2% 0.3% 0.3%% of NCR 2.0 0.4 -0.1 0.9 1.7 2.3 3.0 3.9 2.0 0.4 -0.1 0.9 1.7 2.4 3.0 3.9

IV. TRANSACTIONS IN NON-FINANCIAL ASSETS 1,373.6 1,500.2 947.2 1,369.2 1,660.8 1,989.4 2,137.7 2,296.3 0.4% 0.4% 0.2% 0.3% 0.4% 0.4% 0.4% 0.4%Investiment in Non-Financial Assets 1,115.0 1,228.0 658.5 1,064.4 1,338.3 1,648.5 1,777.2 1,915.2 0.3% 0.3% 0.2% 0.3% 0.3% 0.3% 0.3% 0.3%Investment in Financial Assets 258.6 272.2 288.7 304.8 322.5 340.9 360.5 381.1 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1%

V. NET LENDING / BORROWING (III - IV) -825.1 -1,370.6 -966.1 -1,036.2 -1,027.9 -1,023.6 -816.0 -430.3 -0.2% -0.4% -0.2% -0.2% -0.2% -0.2% -0.2% -0.1%

VI. PRIMARY BALANCE (V + Net Interest Payments) 1,498.5 1,375.9 2,009.1 2,156.1 2,397.3 2,649.6 3,103.5 3,725.8 0.5% 0.4% 0.5% 0.5% 0.5% 0.5% 0.6% 0.7%% of NCR 5.4 4.5 6.1 6.1 6.3 6.4 7.0 7.8 5.4 4.5 6.1 6.1 6.3 6.5 7.0 7.9

VII. TRANSACTIONS IN FINANCIAL ASSETS AND LIABILITIES 922.7 1,397.6 966.1 1,036.2 1,027.9 1,023.6 816.0 430.3 0.3% 0.4% 0.2% 0.2% 0.2% 0.2% 0.2% 0.1%New Loans 1,441.0 1,615.5 1,742.0 1,958.5 2,215.9 2,387.4 2,429.4 2,294.2 0.4% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.4%Amortizations, net -563.3 -565.5 -826.0 -974.9 -1,243.3 -1,421.9 -1,674.4 -1,927.9 -0.2% -0.2% -0.2% -0.2% -0.3% -0.3% -0.3% -0.3% Amortizations received 17.3 18.3 19.3 20.2 21.2 22.3 23.4 24.6 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Amortizations paid 580.6 583.8 845.3 995.2 1,264.5 1,444.2 1,697.8 1,952.5 0.2% 0.2% 0.2% 0.2% 0.3% 0.3% 0.3% 0.3%Asset sales 45.0 347.6 50.1 52.6 55.2 58.0 60.9 64.0 0.0% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

VIII. GROSS FINANCING NEEDS (Net Debt Service - VI) 2,886.9 3,312.0 3,801.2 4,167.2 4,668.4 5,095.0 5,593.8 6,083.9 0.9% 0.9% 1.0% 1.0% 1.0% 1.1% 1.1% 1.1%% of NCR 10.4 10.8 11.5 11.7 12.2 12.4 12.6 12.7 10.4 10.8 11.6 11.8 12.3 12.4 12.7 12.8

VIII. OVERALL BALANCE (VI + VII) 2,421.1 2,773.5 2,975.2 3,192.3 3,425.2 3,673.2 3,919.4 4,156.1 0.7% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% 0.7%

R$ Million (2012 constant values) % of Subnational GDP

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ensuring environmental sustainability, are the most relevant to this operation.

4. THE PROPOSED OPERATION 4.1. LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION 45. The policies supported by the proposed operation are fully in line with the PPA. The Program Development Objective (PDO) of this operation is to improve Government capacity to mitigate economic volatility in the State of Rio Grande do Sul by supporting measures to increase resources available to the government and to reinforce the Integrated Water Resource management framework. The PDO, is therefore, fully aligned with the Government’s strategic objectives as outlined above. More specifically, this DPL contributes directly to the Government’s objective 3.1 (to strengthen the State’s investment capacity) and 2.3 (to strengthen economic, logistical and energy infrastructure, while ensuring environmental sustainability). In addition, this proposed operation will also contribute indirectly to three other government objectives, which are: raise the rate of investment growth, employment and income; promote regional development; improve the quality of life and eradicate extreme poverty.

46. The fiscal pillar will contribute to strengthening the State’s investment capacity, while the irrigation and water resources management pillar will support strengthening economic, logistical and energy infrastructure, while ensuring environmental sustainability. The fiscal pillar aims to promote savings in expenditures or increase revenues, which will ultimately increase the resources available for investment. The irrigation and water resource management pillar will focus on promoting sound irrigation policies and strengthening the State Water Resources Management System, enhancing capacity for planning and operation of water infrastructure. This operation is connected with the Bank’s broader goals since it aims to reduce macroeconomic volatility which disproportionately hits the poor, while the second pillar is targeted to more impoverished regions and families in the bottom 40 percent of the income distribution.

47. The Implementation and Completion Results Report (ICR) for the last Rio Grande do Sul DPL provided two critical lessons for this operation. The first is the need for a strong social coalition for structural reforms. In particular, in the last DPL the Bank supported a bold reform program, some parts of which could not be fully implemented due to lack of support in the State legislative and organized civil society groups9. Therefore, this operation tries to focus on measures that are feasible to implement in the short term and are likely to be sustained. The second lesson is on the timing of the loan. This operation will support the Government through the last year of the current Governor and also the beginning of the next administration and in a period of fiscal stress, allowing the Government to maintain public investments and the Bank to maintain a policy dialogue with the next Government. A general lesson also applicable to this operation is the importance of reinforcing Government ownership of the operation.

4.2. PRIOR ACTIONS, RESULTS AND ANALYTICAL UNDERPINNINGS Pillar I. Strengthening Fiscal Management

48. The common theme of the fiscal pillar is to increase revenue and promote expenditure savings. The policy actions aim to increase revenues, not by raising tax rates, but 9 The reform of the civil service pension system that was supported by the first DPL, but not implemented during the DPL was later implemented by the current administration.

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by improving collection efficiency. On the expenditure side, this pillar supports policy action that seeks to generate expenditure savings. These savings can be obtained in the short term, through actions on procurement policy, or in the long term through actions on costing, tax expenditures and contingent liabilities.

49. The prior actions in the fiscal management pillar build upon components of the Bank’s previous DPL, by supporting complementary policy actions. With the first DPL the Bank helped the GoRS to adopt more modern procurement techniques and estimate the cost of its tax expenditure measures. Following up, this operation is supporting the improvement of mechanisms by which the public sector surveys the prices practiced on the market and the gradual implementation of tax expenditures benefit analyses.

50. The GoRS is one of the most transparent and advanced states in Brazil in the estimation of tax expenditures. With Bank support, the State has started to estimate and publicize annual amounts of tax expenditures broken down by several classifications. The high amount of tax expenditures is a particularly acute problem for Rio Grande do Sul given all other constraints it faces to mobilize revenues. The Government has a broad mandate to assess the effectiveness of tax expenditures.

51. The Bank will thus support the Government in enacting a policy to assess new tax expenditures gradually. Currently, tax expenditures pledges are received by SEFAZ and analyzed with no standard procedure and then submitted, although not formally, to the Secretary and the Governor for decision. The Government wants to improve this process by issuing a legal rule to determine that all tax expenditures pledges are evaluated ex-ante and contain: (i) a clear objective and (ii) at least one effectiveness indicator. In addition, the GoRS will commit to periodically reevaluate these tax expenditures measures and the result of such evaluations would have to be formally submitted to the Secretary. This policy will be effective for new tax expenditures, but is expected to encompass most of the tax expenditures over time since current tax expenditures have expiration dates and would have to go through the new process to be renewed.

• Prior Action #1: The Government of Rio Grande do Sul has improved its assessment procedures for new tax expenditures.

• Results: Percentage of tax expenditure measures under Government control evaluated, according to the new procedures.

52. The stock of tax arrears in Rio Grande do Sul is high. Tax arrears amounted to R$ 30 billion in 2012, which is equivalent to 121 percent of annual tax revenues. This problem is not limited to Rio Grande do Sul. In São Paulo, the ratio between tax arrears and tax revenues reached 185 percent in 2012. Some of the causes behind such a high ratio are out of the control of the State such as the slowness of the judicial system and the difficulty to sequester assets from delinquent taxpayers. However, other reasons behind the poor performance of collection of tax arrears in Rio Grande do Sul, such as inefficiencies in the procedure to enforce payments, can be addressed by the State.

53. The GoRS has taken several initiatives to expedite the collection of unpaid tax obligations. For example, tax agents were asked to accumulate small value claims against the same debtor before filing judicial claims. In addition, SEFAZ has resorted to alternative and more cost-effective collection methods. These initiatives are guided by a number of strategic

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guidelines. These guidelines include: expediting actions of the Secretariat as soon as arrears are incurred, expediting internal work flows in order to reduce time required for internal processing and focusing efforts on the cases with highest recovery likelihood and highest values. All these guidelines exist as tacit knowledge, but are not formalized. New formal operating procedures will need to be developed to institutionalize these policies. The prior action supported by the DPL will help SEFAZ consolidate all its tax arrears efforts in one policy document, making explicit the strategic directives and requires the preparation of an operations manual for tax arrears enforcement. As a result of its implementation, it is expected that not only tax arrears recovery will increase, but also the policy will become institutionalized and sustainable. It is expected that such policy will increase revenue by R$45 million per year.

• Prior Action #2: The Government of Rio Grande do Sul has established procedures to guide the recovery of tax arrears, reducing processing time and prioritizing cases with high values and high probability of recovery; and criteria to measure results of tax arrears recovery actions.

• Results: Increase the share of tax arrears recovered within 60 days of their generation. 54. Rio Grande do Sul has made advances in procurement practices with Bank support. In the previous DPL, the Bank supported the strengthening of the central procurement unit, which promoted the adoption of more modern procurement methods such as reverse price auctions and price registry. Subsequently, the unit was elevated to the category of undersecretariat and new permanent staff was recruited. In addition, this central unit has been carrying out analysis to substantiate decisions about the cost effectiveness of grouping and consolidating procurement processes, as well as, policies to increase the participation of small and medium enterprises in Government purchases.

55. The next step to improve procurement processes is to work on how the Government obtains price information to conduct its procurement processes. Currently, the State has no structured price survey to inform its procurement processes. Therefore, the employee responsible for the procurement process has to conduct a phone survey with three suppliers, identifying himself and thus biasing the survey. As a result, procurement processes in general start with prices set at a level higher than the average market price, which depending on the competitiveness of the process might lead the Government to purchase items above market price. In order to resolve this asymmetry of information, the GoRS is drawing on the electronic fiscal invoice database that registers the price of all transactions subjected to ICMS taxation in the State. This information is being passed to public employees in charge of procurement and used to set initial prices and also to negotiate further discounts in the final price in case these prices diverge significantly from the ones in the database. The Government has used this information on a pilot basis and in order to expand its usage, is gradually including bar code information in its procurement catalog. Therefore, it will be able to match the bar code it has on its procurement catalog with the bar code provided by the suppliers and make sure the correct price information is being used. In order to do that, the Government is resorting to Federal regulations which require that some classes of products like pharmaceuticals to have bar code. By doing this, it is also addressing legal constraints to wider use of such information namely the claim that requiring universal product coding information from suppliers deters wider competition. The existing mandatory use of bar code in the market is sufficient for the Government to achieve the proposed results.

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• Prior Action #3: The GoRS has mandated the use of price information from the electronic fiscal invoice database as a reference price to inform its procurement processes of goods.

• Results: Increase the share of goods procured, expressed as a percentage of the total value of goods, using price information from the electronic fiscal invoice database.

56. The GoRS is at the forefront of developing a costing policy applied to the public sector. Rio Grande do Sul, like other Brazilian states, is developing its costing policy to comply with Federal legislation following the International Public Sector Accounting Standards (IPSAS). However, the GoRS is in a more advanced implementation stage in relation to other states. Moreover, its policy allows the State to deal with the issues of expenditure efficiency and cost-effectiveness using more advanced techniques. One of the advantages is the creation and utilization of the cost center concept, which allows the State to allocate a larger share of its costs in a direct way, avoiding cost apportionment to overhead expenses. In addition, since the cost center is the lowest administrative level (there are around 20,000 cost centers in the GoRS) it is easier to match cost and services and retrieve early cost-effectiveness figures, even before the State moves to the actual costing of public services, which is the next step planned.

57. The objective of the costing system is to generate information for Government agencies that can be of managerial use. The challenge however is to promote behavioral change and foster the use of costing information for budget and public management improvement. Therefore, the GoRS through its internal control agency is requesting that all line secretariats that have implemented the costing policy and system for more than a year in 2014 – 14 in total – to produce a managerial report using costing data to be included in the agencies’ annual report. Moreover, the report would necessarily highlight the practical effect of the cost analysis (expenditure reduction, productivity increase, etc) and would also be published in the State Transparency Portal.

• Prior Action #4: The GoRS has mandated all of its agencies that have implemented the Cost Policy and System for more than one year to prepare, as part of their annual report, a managerial cost report.

• Results: Increase in the number of managerial cost reports prepared by Government agencies.

58. A related debt problem is the issue of contingent liabilities. The two main sources of contingent liabilities in the State are judicial claims regarding labor contracts of public employees and taxes and social contributions that are not paid in a timely fashion, becoming a contingent liability because the moment of the payment is uncertain and the value and form of payment might be disputable. This last problem is more prevalent in the so-called indirect administration which encompasses public foundations and state owed enterprises, which have more autonomy and less oversight from State Treasury, even though they are not fully autonomous institutions. Currently, the State lacks control and oversight over the managerial decisions that are a potential source of contingent liabilities. Moreover, the State also lacks proper control over the contingent liabilities that are in a more advanced stage, i.e., judicial actions that are being discussed and can generate new and unforeseen expenditures to the State. This lack of control and information compromises the State’s fiscal management since policy decisions might not be effected due to last minute expenditures generated by contingent liabilities.

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59. The GoRS has instituted a working group to propose a policy to manage contingent liabilities. The overall policy directive is on control and prevention, avoiding the creation of new liabilities. The policy will aim at identifying and monitoring contingent liabilities as well as estimating their impact. This will require new work routines from internal control and PGE as well as a systematic flow of information between PGE and SEFAZ. It will also set the appropriate measures to mitigate its impact and create a decision mechanism for policy actions that might generate contingent liabilities. Lastly, accounting rules in the process of implementation will require that such liabilities be recorded in the balance sheet and might be part of the Net Consolidated Debt capped by the FRL, highlighting the importance of this policy. The development and implementation of such policy will result in a more comprehensive understanding of the State fiscal situation and reduction in the accumulation of future contingent liabilities.

• Prior Action #5: The GoRS has created a policy to identify and estimate the fiscal risks created by contingent liabilities, and prevent and mitigate their fiscal impact.

• Results: New policy instrument to manage contingent liabilities made effective. Pillar II. Irrigation and Water Resources Management

60. This pillar has the objective of promoting sustainable irrigation and strengthening the State Water Resources Management (WRM) System. It supports policy actions that promote adequate strategic planning for sustainable irrigation aimed at generating income and economic development. From the water resource management perspective, it supports policy actions that strengthen water resource management institutions, planning and tools, enhancing integration among the water resources management system and its multiple users.

61. GoRS has made efforts to improve water security and to enhance irrigation planning and implementation. In Rio Grande do Sul, irrigated agriculture and increasing water storage capacity are significant means of preventing seasonal water scarcity related to drought. The State has since taken important policy decisions, notably the elaboration and approval of the State Irrigation Policy. Given the importance of irrigated agriculture to the State, it has become clear to the GoRS that will be critical for the State to integrate this policy with the State’s water resources policy as well as with future proactive and coordinated drought preparedness initiatives.

62. The State Irrigation Policy responds to a long-lasting demand from the agricultural sector to have a comprehensive irrigation policy. The Law sets the principles, objectives and instruments (including research and development, technical assistance to water users, information system, etc) for the State intervention and priorities. It establishes that the irrigation policy must be implemented in accordance with the principles of the State water resources policy; and uses the river basin as unit for planning and implementation. Priorities include production of food and special support to family farmers and areas of lower income and social development, also focusing on areas under low or irregular rainfall distribution.

63. The Law also establishes a statewide ‘Master Plan for Irrigation in the Context of Multiple Water Uses in Rio Grande do Sul (PIUMA) as a key planning mechanism for irrigated agriculture. This Plan requires the participation of the different entities of the State Water Resources System (i.e. the State Water Resources Council – CRH-RS, the river basin committees, and the Department of Water Resources – DRH), in consultation with the entities

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representing the irrigators. The Plan includes a diagnosis of the current condition of irrigated agriculture and its potential for sustainable growth, based on a set of parameters including projections of water availability and demands of other water users. Importantly, it is expected to propose guidelines and priorities for the granting of water use rights and environmental licensing for the irrigated agriculture sector. The Law envisages that more detailed irrigation plans will be elaborated as a result of the PIUMA, at the level of the Territories of Irrigation and Multiple Uses (TIUMAs). Said irrigation plans need to be aligned with the WRM plan of the river basin, in which the corresponding territories are situated.

64. The State Irrigation Law establishes an Irrigation Policy Management Council. The Council is composed of nine entities (SEPLAG, SOP, SEMA, SEAPA, SDR, SDPI, IRGA, FEPAGRO and FEPAM) and has a wide-range mandate that includes: (i) coordinating and integrating the actions of the public sector related to irrigation, (ii) establishing the norms and decrees to implement the State Irrigation Policy, (iii) approving the PIUMA and its subsequent more detailed irrigation plans for each territory (TIUMA) defined within a river basin, (iv) consolidating and coordinating the public irrigation programs, projects and actions at the State level to implement the Irrigation Policy, and (v) managing the State Irrigation Fund established by the Law.

65. The State Irrigation Policy will be implemented through different programs, projects and actions to be established by law or regulation. One of the initiatives is the ‘More Water, More Income’ Program10 that was created by law upon approval by the State Assembly in May 2013 to promote the use of irrigation methods, as a way to enhance drought resilience of the agricultural sector, in order to increase the productivity and income of smallholders and medium-size farmers (i.e. maximum irrigated area of 100 ha per producer). Its main features comprise: (i) support for granting environmental licenses and temporary rights for water use, including for small water storage ponds (i.e. surface area below 10 ha) to facilitate initial procedures for access to credit, and (ii) subsidies11 for irrigation equipment and the construction and/or enlargement of small water storage ponds for irrigated agriculture12.

66. The More Water, More Income Program activities focus on the Northwestern region, where it is estimated that only two percent of the agricultural production and three percent of farmers currently use irrigation techniques. The Program aims at achieving an additional 100,000 ha of irrigated area in a period of three years. In addition, the Program foresees training and capacity strengthening of: (i) engineers, to ensure adequate designs of irrigation projects, and (ii) agricultural producers, to ensure efficient irrigation practices and a rational management of water, including during drought and limited water availability conditions. In the next two years, it is expected that the Program will benefit over 3,000 medium

10 The Program was instituted in March of 2012 by Decree; it became a law upon approval by the State Assembly in May of 2013. The State Irrigation Policy Management Council will ensure that the program is made compatible with the State Irrigation Policy Law, ensuring alignment with the Policy’s principles, objectives and guidelines. 11 There are three lines of credit available with payment periods varying from eight to twelve years. The Government will reimburse the first and last annual installments of the financing in a proportion of 100% for small family farmers; 75% for medium size farmers and 50% for other farmers. In addition, subsidies will be calculated over a maximum amount of R$ 500 thousand loan and the amount of subsidies that the Government is allowed to commit in every given year is capped at R$ 45 million. 12 The temporary environmental licenses and water rights are granted under these special circumstances with the objective of facilitating the application procedures for access to credit. The full process for receiving environmental licenses and water rights will need to be followed for renewal of the licenses and rights after four years.

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and small farmers located in the Northwestern region of the State.

• Prior Action #6: The GoRS has reinforced its commitment to sustainable irrigated agriculture practices by aligning its ‘More Water, More Income’ Program with its Irrigation Policy and its Water Resources Policy.

• Results: Increase in the number of medium and small farmers that have adhered to the ‘More Water, More Income’ Program.

67. The implementation of the State Irrigation Policy will need to be consistent with the State Water Resource Policy. This requires a coordinated planning effort between irrigation and water resources management both at the State level (PIUMA with the State Water Resources Plan) and at the level of the river basin and sub-basins (territorial irrigation plans with the river basin plans). At the project level, the use of water for irrigated agriculture will require the previous grant of water use rights by the DRH. In addition, practic