Speech

Luncheon address given at the Inter-American Development Bank conference "Financing water and sanitation services: options and constraints" by Anne O. Krueger, First Deputy Managing Director, IMF

November 10, 2003

Introduction

I'm delighted to be with you today. When I received the invitation from President Iglesias, I was keen to come and add my support for your discussions over the next couple of days.

You are addressing what we all know is a vital topic. The provision of water and sanitation is something which we in the United States—and, indeed, many countries around the world can take for granted. But in too many places in the world, clean water and adequate sanitation is lacking for large numbers of people. The poor, in particular, often have no, or only limited access to water facilities. As the world's population grows, so does the challenge of giving everyone access to this most basic of needs.

Better health, lower infant mortality rates, improved access to education, and rising quality of life—these are all, in a way, dependent on access to clean water and adequate sanitation. So I congratulate the IDB for organizing this conference, and for recognizing the importance of addressing, in a Latin American context, the way in which better facilities can be provided. The bank has a distinguished record in focusing on issues of substantive importance.

I want in a moment to talk briefly about some of the specific challenges that I think need to be addressed by countries wanting to improve the infrastructure for water provision. But first I want to say something about the broader economic context, and to explain why I think it is particularly important at this juncture to make the right decisions on infrastructure investment.

The economic context

As I am sure many of you are keenly aware, these are challenging times for Latin America. This is a region with abundant natural and human resources. Yet its economic performance has, all too often, been disappointing. Today, across the region, we see governments confronting the demands of their citizens for rapid economic growth, jobs and, yes, significant improvements in the provision of basic services; while, at the same time, political leaders also seek to achieve sustainable expansion and longer-term prosperity. Balancing what often appear to be competing pressures is no easy task.

Yet I think there is reason to be cautiously optimistic. The outlook for the global economy, while not without its risks, is probably more benign now that at any point in the past two or three years. There is a real prospect of a sustained upturn in the United States and in Asia; even in Europe there are tentative signs that the worst may be over. In Latin America too, the outlook for many countries seems more promising than it has for some time. The opportunity this improved climate presents must be seized by the countries in the region.

We are not looking at a return to the boom conditions that many of the world's economies enjoyed in the late 1990s. But that may be no bad thing. The aftermath of that period of rapid growth showed that too many governments around the world had become intoxicated with economic success. They had ignored a basic rule of good housekeeping, the need to make provision for leaner times. Instead of taking the opportunity of buoyant growth and tax revenues to restructure their economies and consolidate their public finances, they relaxed their guard. In too many cases around the world, budget surpluses were used to justify extra spending or as an excuse to delay painful reform.

The result, of course, is that the downturn brought a return to budget deficits—in some cases on an alarming scale—and a much more difficult environment in which to undertake reforms that have become far more urgent. Let us not be under any illusion. Finance ministers are no better at learning from others' past mistakes than the rest of the human race. So another boom period would, inevitably, lead governments once again to relax their guard. And lest people think this is unfair, let me include the private sector too: market practitioners are just as capable of economic intoxication as governments.

For that reason, then, a period of more modest but, with the right policies in place, sustainable growth could be just what many economies around the world need to press on with the economic reforms needed. Such reforms would provide a better cushion against future downturns and help foster growth in the long run.

And that is why for many countries in Latin America, this could be a turning point. The global downturn coincided with—or followed—a period of unusual turbulence for several countries in the region. Some are still struggling to recover from what were extremely painful shocks.

But the conditions are now in place for governments in Latin America to set a new course for their economies. In some cases that means building on past success, in others it will mean turning away from decades of erratic economic policies and performance. Economic prosperity in the region will depend on greater economic stability than it has hitherto enjoyed.

Providing a stable macroeconomic framework is no easy task. Sound economic policies must be politically feasible: democratic governments must always ensure that they have the necessary political support for policies and reforms that they believe need to be implemented. That is sometimes more difficult to achieve in Latin America because of the mistakes made by past governments. But it is certainly not impossible and all too often political leaders shy away from difficult decisions without understanding that the right results—economic success—will bolster support for reform, not undermine it.

But reform programs must also make economic sense. They need to aim at providing sustainable growth over the long term. That means prudent fiscal policies; manageable debt burdens; and sound monetary policy.

One problem is that in many cases governments—and economists—have not properly understood why previous reform programs have failed. Often it was not because such programs were too radical or politically unpopular but because they were lacking in ambition and implemented in a half-hearted way. Governments embarked on reform programs, but too often these were too limited in scope; labor market reform was often ignored, for example. In many cases, reforms were abandoned, or trimmed back, long before they had a chance to be effective. Governments tended to shy away from difficult confrontation, or were too impatient for results.

Drawbacks of the reform process

This is not the place for a detailed analysis of the disappointments of the 1990s. But I would like to make a couple of observations that bear directly on the issues I am addressing today.

The central issue is that Latin America has not significantly improved its longer-term growth performance; and it has shown few signs of achieving the greater resilience against external shocks that I think we all believe to be desirable. Without sustained growth, infrastructure investment is likely to be uneven and erratic.

Why has growth performance been so poor? One factor is that, in content, they often appeared to promise more than they delivered. Too often, policy reforms were not followed through. The second is that they were uneven in scope.

I think Mexico's Finance Minister Gil Diaz put his finger on it when he said just a few months ago that the policies undertaken in Latin America in recent years—with the exception of Chile—were "not even a pale imitation of what market economics ought to be....What has been implemented throughout [the] continent is a grotesque caricature of market economics".

This time, then, it is important for government to deliver full-blooded market reforms, carried out in an appropriate institutional framework. I don't need to dwell at length at what is needed. But it is probably worth spelling out the areas that governments need to tackle. Sound fiscal policies are essential—and that certainly must mean using the economic upturn to put government finances in order. It would be a grave mistake to use a period of more buoyant revenues to go on a spending spree, for example. Public debt burdens have long been a problem in Latin America and governments must take urgent steps to bring them down to sustainable levels.

And for reform at the macro level to succeed, it must be accompanied by wholesale reforms at the micro level. Labor markets need reform. Trade liberalization is essential, as is judicial and institutional reform.

One of the underlying causes of the public debt problems that many countries face is the persistent gap between governments' fondness for public spending—and public spending commitments—and their reluctance or inability to make tax collection more efficient and effective. There is often an ideological attachment to government ownership of assets and utilities that, at least in some instances, is misplaced.

In some cases, too, unwieldy, inefficient public utilities are obliged to charge artificially low prices. The result is a high debt burden, which the government either explicitly or implicitly assumes:and/or chronic underinvestment.

Underinvestment, of course, means neglect. Extending the working life of public utilities beyond what is reasonable simply ensures they become unreliable. Realistic user fees will, eventually, remedy such problems, although it can take time if proper charging is only introduced after an extended period of chronic neglect. User fees also ensure that the richer members of society pay for their consumption of public utilities.

Implementing such wide-ranging reforms requires courage. It requires tenacity. Above all, it requires effective leadership in order to win the necessary political and popular support for change. Few political leaders have both the desire and ability to push through often unpopular changes whose payoffs will only come long after they have left the stage. I'm not just speaking of Latin America here: only has only to look at the problems confronting Europe and Japan today to see the implications of postponing vital economic reform.

And before governments can persuade their voters of the need for far-reaching reform, they must themselves recognize the scale of the task they face. Before ordinary people can be convinced of the need for change, their political leaders must fully grasp the scale of what needs to be done.

The IMF, of course, can help. Nearly every country in Latin America is involved in a Fund program. Brazil, as I'm sure you know, is in the final stages of negotiating what we hope will be a new program that it sees as part of its exit strategy from reliance on Fund support. I was there last week and I was reassured by the government's determination to maintain sound policies and continue the program of reform aimed at accelerating economic growth over the medium term.

Alongside financial assistance, we in the Fund can also offer policy advice and technical assistance, often essential for governments embracing wide-ranging reforms.

Water and sanitation programs

We are less involved directly in sectoral issues of the kind you are concerned with at this conference. These are, in the main, the province of the development banks. But we do have views about how these issues relate to macroeconomic management. And there are some sound principles that we believe should be adhered to if policy is to succeed at both the macro and the micro level.

Often in the past, governments have seen the provision of infrastructure as a social service; as part of their efforts to help the poorest members of society. The IMF is as anxious as anybody to reduce the incidence of poverty. In humanitarian terms, it is indisputably desirable.

But it also makes economic sense if we harness incentives properly rather than rely on philanthropy. I think this also makes it easier to tackle problems effectively. Poverty is, after all, a drain on economic growth. Yes, at the human level, it means misery for those affected, and yes, that should concern us all.

But people who are poor are more likely to be unhealthy, to need medical treatment, to be hungry, homeless and jobless. Poverty hampers economic growth. It is in everybody's economic interest to reduce both the absolute number and the proportion of poor people in society. We all gain if everybody is better off.

But helping the poor does not mean that it makes sense to make services such as water and sanitation free at the point of delivery. Such an approach results in the chronic underinvestment I mentioned earlier, with all its unwelcome consequences. It is also a particularly inefficient way of providing assistance to the poorest in society, as I will explain in a moment.

There is, in fact, a strong case for charging users fees for such services, and fees that properly reflect the cost of provision. There is also a strong case for privatizing the provision of such services, or at least encouraging private sector participation. Authorities need, at the least, to ensure that both public and private utility companies fully cover their costs, including the costs of new infrastructure investment. It goes without saying that providing appropriate incentives for company managers is also crucial.

Apart from anything else, there is a good pragmatic reason for this. As I'm sure you are all aware, leaving long-term capital investment to be funded from general current revenue is a hazardous exercise. It puts actual expenditure on capital projects at risk in two ways. In the first place, it means such spending is always having to compete with alternative demands on limited government resources. Long-term projects are invariably less appealing than short-term spending commitments that promise quicker results. That can mean that large projects are delayed, or postponed: chronic underinvestment is, all too often, the result.

One frequently-heard objection to user fees for something as basic as water is that they hurt the poor. Poor people have far less disposable income; user fees for water and sanitation have a disproportionate impact on them, encroaching on income they need for other basic items like food.

This is true, of course. Penalizing the poor in this way is indefensible for humanitarian reasons, as well as being counter-productive for the reasons I mentioned earlier. But the sensible solution is not to make water free for everybody.

It sounds fair—and that is why it is such a politically attractive position to adopt. In practice, though, such poorly-targeted social policies are mis-guided. Everybody benefits, even those who do not need help. Middle-class and rich people can easily afford to pay for water provision. Indeed, in extreme cases, where the very poorest don't have proper access to water the middle and upper classes are the only ones who benefit from public provision.

Applying user fees and then separately giving direct subsidies to those in need would bring two distinct advantages. The poor would get the help they need—and probably more than they get from free access. And governments would find that public expenditure control became easier because they were no longer subsidizing those on middle and higher incomes.

Water is a special case

None of this is to deny that water brings with it special problems. Because of its essential role in sustaining life, water is special. Involving the private sector in water provision is politically far more contentious than for most utilities.

There are special economic factors, too. Water provision has an unusually high ratio of fixed to variable costs. Some components of the water supply infrastructure have engineering economies of scale. It is difficult to inject competition into many parts of the supply process. And the lives of water sector assets are very long. Some of you might be familiar with the example of New York, which is currently constructing the first new water supply pipeline for more than a century: a process that will have taken decades to complete—and, I might add, is nowhere near finished.

These factors have implications for pricing, of course, making it difficult to set user fees at the appropriate level, even once these have been accepted in principle. In practice a large proportion of the revenues from such user fees are quasi-rents. Water companies can operate for many years without recovering their fixed costs. But if the quasi-rents are not paid, investors will not recoup their investments, and it will be difficult to persuade new investors to come forward with funds. The result, of course, will be significant underinvestment.

Such underinvestment is a problem even when water provision is a purely public sector exercise. Governments in industrial as well as developing economies see relatively little political gain either from water investment—because of the very long time lags involved—or from reform of water provision. For that reason, any reform has, for them, to impose few political costs. In Chile, for example, water privatization was delayed by the Pinochet government because it wanted to complete privatization of other sectors first. When a new government came to power in 1989, it was opposed to the private ownership of water assets and an opportunity for reform was lost.

I know that several countries are currently examining ways of reforming water provision, or have already embarked on a program of change. I know too how difficult this is, given the political sensitivities. As I noted earlier, the detail of such reform programs is the province of the development banks.

But the Fund takes the view that governments, wherever possible, should charge user-fees to finance such investment. Of course, the provision of a safety net is important, in order to safeguard the interests of the poorest in society. Too often, though, mis-directed public spending has benefited those who least need help at the expense of those who need it most. The same applies to artificially low—or even zero—prices that, in the end, have public expenditure implications.

The result is to discourage investment in the short-term, penalize citizens who need and want better water facilities and force taxpayers—still, in many countries, a relatively small base—to underwrite the costs of investment when it is, belatedly, forced upon the authorities.

Conclusion

The fact that you are all spending two days discussing these issues tells me two things. The first is that there are no easy answers to the question: how to provide one of the most important public goods in a fair and efficient manner. This is an area of great political sensitivity and of economic complexity. It is clear from the study that the World Bank did a few years ago that there is no one answer, and much may depend on individual national circumstances.

The second thing this conference tells me is that at least some people—and here, I include the IDB—realize this issue needs to be high on the political and economic reform agenda. I agree—and I'm encouraged to see so many of you here.

Now I encourage you in your efforts to address what is for many citizens in your countries a matter vital to their individual well-being and, in consequence, their national prosperity.

Thank you very much.