Uruguay - Second Industrial Credit Project

Document of i,E opy The World Bank IL C Y FOR OFFICIAL USE ONLY Report No. 3095b-UR STAFF APPRAISAL REPORT URUGUAY SECOND INDUSTRIAL CREDIT PROJECT November 18, 1980 Projects Department Latin America and the Caribbean Regional Office This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  URUGUAY APPRAISAL OF A SECOND INDUSTRIAL CREDIT PROJECT A. CURRENCY EQUIVALENTS Exchange rates Effective May 2, 1980: Selling rate NUr$ 8.77 = US$1.00 NUr$1.0 = US$0.1140 Buying rate NUr$ 8.75 = US$1.00 NUr$1.0 = US$0.1143 B. LIST OF ACRONYMS USED AID = US Agency for International Development BROU Banco de la Republica BCU = Banco Central del Uruguay CC = Coordinating Committee established for the first industrial credit project FFID Central Bank's Fund for Development Investment Financing GF = BCU's Guarantee Fund IDF = Industrial Development Sub-Fund of the Central Bank's FFID KfW West Germany's Kreditanstalt fur Wiederaufbau MIE = Ministry of Industry and Energy PAT = MIE's Program of Technical Assistance TRP = The Government's Tariff Reduction Program UA = Assistance Unit (Unidad Asesora) in the Ministry of Industry and Energy UNDP = United Nations Development Program UNIDO = United Nations Industrial Development Organization C. FISCAL YEAR January 1 to December 31  FOR OFFICIAL USE ONLY URUGUAY APPRAISAL OF A SECOND INDUSTRIAL CREDIT PROJECT Table of Contents Page No. I. THE INDUSTRIAL SECTOR A. Introduction .......... . ....................................* * 1 B. Recent Performance of the Sector ................. 2 Growth ..................2....................... 2 Exports .................... ........................... 3 Employment and Wages ....................... ... 4 Investment and Imports of Capital Goods .......... 5 Size of Enterprises .............................. 6 C. Principal Policy Issues.o-o-o.o.o.o.o ............ 7 Exchange Rate and Export Incentive Policies .o..... 7 The Tariff Reduction Program (TRP)............... 9 D. Medium-Term Outlook .o ......... o. ........... . 11 II. THE FINANCIAL SECTOR Ao The Financial System . . . ........ -. .o. . ........ . 14 The Banco Central del-Uruguay . ......... 14 The Commercial Banking System ........ .. 15 IFC's Investment Bank Project . ........ 16 B. Monetary Policy ......... ....... .. ... . ...... 16 Interest Rates .................................. ooo ...... 18 Lending Spreads . .........-......... 19 C. Resource Mobilization ..... o........ 19 D. Financing of Industry .... ...... 20 III. INSTITUTIONAL ARRANGEMENTS FOR THE PROPOSED PROJECT A. Arrangements Under the First Credit Project ...... 20 Background - .................... 20 Institutional Arrangements oo......... 21 This report is based on the findings of a mission which visited Uruguay in Feb/March 1980. The mission comprised Messrs. Nogales, Baskind, Alonso, Faillace, Lopez, and Johnson (all of the Bank). Subsequently Mr. Nogales returned to Uruguay in a post-appraisal mission in July 1980. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contenst may not otherwise be disclosed without World Bank authorization.  Table of Contents (Continued) Page No. 3. The Industrial Development Fund 9S999999aI99999 21 Need for a New Industrial Development Fund ...... 21 IDF Resources ........... ................... 22 Policies and Procedures ...... .................... 22 IDF's Currency Denomination and Interest Rate Policy * .............. ............... 23 C. The Unidad Asesora (UA) .......................... 23 Appraisal Work . ................. . .............. 23 Supervision Activities .... .. ... ....... 24 Personnel and Salary Policies .... .... ... 24 Techniical Assistance by UNDP/UNIDO ............ ..... 25 D. Participating Intermediaries ..................... 25 E. The Guarantee Fund ................................ 26 IV. THE PROJECT A. Objectives of the Proposed Project ............... 27 B. Project and Loan Description ......*... 27 C. Project Cost and Financing ........................ 28 D. Terms and Conditions of Subloans ................. 29 Interest Rates ................. O............................... 29 Procurement ...................................... 30 Disbursements ....... ... ......................... . 30 E. Accounts and Audits ........o..................... 31 F. Study of the Trade Liberalization in Uruguay ..... 31 G. Project Benefits and Risks ....................... 31 V. RECOMMENDATIONS ....................................... 32  Table of Contents (Continued) List of Annexes ANNEX 1 Industrial Sector Statistics Table l.l Supply &i Use of Resources, 1971-79 (current prices) Table 1.2 Supply & Use of Resources, 1971-79 (constant prices) Table 1.3 GDP Origin by Sector, 1971-79 (current prices) Table 1.4 GDP Origin by Sector, 1971-79 (constant prices) Table 1.5 Structure of Value Added in Manufacturing, Selected Years (current prices) Table 1.6 Structure of Value Added (in 1961 prices, at market prices) Table 1.7 Exports by Sub-sectoral Origin, 1971-79 Table 1.8 Principal Export Products, 1974-79 Table 1.9 Structure of Imports, 1975-79 Table 1.10 Exports, FOB, at Current and Constant Prices, 1975-79 Table 1.11 Imports, CIF, at Current and Constant Prices, 1975-79 Table 1.12 Index of Employment, 1975-79 ANNEX 2 Financial Sector Statistics Table 2.1 Banking System: Credit to the Private Sector Table 2.2 Banking System: Sectoral Lending to the Private Sector in Local Currency Table 2.3 Commercial Banks: Net Total Assets Table 2.4 Commercial Banks: Deposits of the Private Sector Table 2.5 Commercial Banks: Equity Table 2.6 Commercial Banks: Callable Obligations Table 2.7 Commercial Banks: Credit to the Private Sector Table 2.8 Private Banks: Sectoral Lending to the Private Sector Table 2.9 Private Banks: Income Statement  Table of Contents (Continued) ANNEX 3 OPerations Under the First Indus4tr3i. Cr4it Moi,ect Table 3.1 Aalysis of Subloans Approve4 throuh F7lI : Table 3.2 Intermediaries' Participation in FFID (1975-79) Table 3.3 FFID: Statement of Results, Cumulative, as of December 31, 1979 Table 3.4 FFID: Consolidated Balance Sheet as of December 31, 1979 Table 3.5 FFID: Balance Sheet -- Foreign Currency as of December 31, 1979 Table 3.6 VFID: Balance Sheet -- Local Currencies as of December 31, 1979 Table 3.7 FFID: Appraisal and Commitments as of December 31, 1979 Table 3.8 Ministry of Industry -- Organization Chart Table 3.9 Evolution of PAT's Professional Staff, 1975-79 Table 3.10 Financial Intermediaries' Participation as of December 31, 1979 ANNEX 4 Summary of UNDP Assistance to UA ANNEX 5 Pipeline of Subprojects Requesting Financing Under IDF as of June 30, 1980 ANNEX 6 IDF's Policy Statement ANNEX 7 Project and Loan Summary ANNEX 8 Estimated Quarterly Schedule of Bank Loan Disbursements ANNEX 9 Selected Documents Available in the Proiect File  I. THE INDUSTRIAL SECTOR A. Introduction 1.01 The Uruguayan economy is currently recuperating from the economic woes of the sixties and early seventies when per capita income declined, capital stock was run down and the economy suffered from severe balance of payments problems and a high rate of inflation. With a balance of payments crisis triggered by the oil price increase and closure of the EEC market to meat imports, as well as a deteriorating fiscal situati6n and accelerating inflation, stabilization had to be the government's first priority beginning in 1974. The high level of consumption in the previous decade had been achieved at the expense of investment and exports,' resulting in low overall growth, interrupted by periodic economic crises. Thus, a basic shift in economic policy was indicated and the government adopted policies, beginning in 1974, which placed greater reliance on the price mechanism to improve resource allocation and productive efficiency. Since then, private investment and non-traditional exports have been encouraged, the public finances placed on a sounder footing, and the operation of the financial system improved. This reorientation has resulted in steady growth in output, employment, and invest- ment, a favorable balance of payments with a sharp increase in reserves, and an improved fiscal situation. However, high inflation, averaging about 60% during 1976-79, continues to be a problem, although it has started to come down from 83% in 1979 to 50% (on an annual basis) in the first nine months of 1980. 1.02 Last year's economic growth of 8.4% was the highest in 33 years. The strongest sectoral performances come from industry (10.1%), domestic retailing (14.9%), construction (19.9%), and fishing (38.8%). In important respects, however, economic performance in 1979 was somewhat exceptional. Strong demand by Argentinian investors and tourists for relatively low-cost Uruguayan goods and fixed assets (mostly real estate) was a key factor contri- buting to the exceptional growth of industry, commerce and construction, but also led to an acceleration of domestic inflation. Since the peso appreciated in real terms (on an export weighted basis) by 14% in 1979, Uruguay has now shifted from being a relatively low-cost market to a moderately high one. Consequently, foreign investments and tourist expenditures are expected to be moderate this year. Nevertheless, a GDP growth rate in the 4-5% range seems feasible in 1980, still high by historical Uruguayan standards. 1.03 Recent government policies have placed increasing emphasis on the export-oriented growth strategy initiated in 1972. In December 1978, after many years of discussion, a major decision was taken by the government to restructure the industrial sector by encouraging efficiency through a Tariff Reduction Program (Decree 736/978). According to this Decree, all import charges of a tax nature will be combined into one single "global" tariff, which, in five years starting January 1, 1980, will be reduced each year in the same percentage from its starting level to reach a uniform level of 35% at the end of the fifth year. Most products that are not produced domestically have been subject to the 35% duty since January 1, 1980.  -2- 1.04 Many industrial firms will need to increase their operational effi- ciency in order to remain competitive with imports as the Tariff Reduction Program (TRP) is implemented. The proposed project is designed to encourage and support the government's efforts to implement the TRP and to assist industrial firms to adjust to the more competitive environment by providing term finance for equipment modernization and replacement and for capacity expansions. The project would build on the efforts initiated under the Bank's first industrial credit project (Loan 1176-UR, approved in December 1975) to create an effective institutional framework for industrial project formulation, appraisal and term financing. The focus of the first project on the expansion of Uruguayan non-traditional exports would be broadened to include assistance to industries serving the domestic market to enable them to become internationally more competitive and to expand their capacity in line with projected growth in domestic demand. B. Recent Performance of the Sector 1.05 Growth. After almost two decades of stagnation with output rising less than 1% p.a. between 1955 and 1974, manufacturing industry in Uruguay has developed a new dynamism with the annual growth in production averaging 7.5% between 1974 and 1979. The rise in output of more than 10% achieved in 1979 represented the largest annual increase since 1953. During the last six years, industrial growth performance exceeded that of the rest of the economy as GDP rose by about 5% p.a. As a consequence, industry's share in GDP has risen from 23.0% in 1973 to 26.6% in 1979 (Annex 1, Table 1.3). 1.06 The surge in economic activity which has recently developed is associated with the measures which the government has taken since 1972 and particularly since 1974 to reverse the previous inward-oriented strategy and to open the economy. Among the specific measures taken was the adoption of a new exchange rate policy (para. 1.17) which, at least through 1978, was combined with incentives for non-traditional exports to encourage an external orientation for industry. Further measures have included the lifting of con- trols on interest rates and on prices of a large number of traded goods, as well as the beginning of import liberalization. 1.07 Reflecting the impact of this movement towards a more open economy, the share of exports of goods and non-factor services in GDP grew from 13.7% in 1973 in current prices to 18.9% in 1977, but declined slightly in 1978 and even more so in 1979 (Annex 1, Table 1.1). In the latter two years there were sharp expansions in demand within domestic markets, although some of this probably reflected indirect exports stemming from purchases by the large number of Argentine tourists who have been visiting the country. The expansion of exports was highly concentrated among non-traditional manufactures based largely on local raw materials; as compared with 34% of total exports in 1974, these items accounted for 61% in 1979 (Annex 1, Table 1.8). Exports of manufactured products (excluding food, beverages and tobacco) represented about 15% of the gross value of comparable industrial output in 1978 as compared to some 7% in 1974.  -3- 1.08 Exports. Through 1977, the exports of manufactured goods played the major role in the expansion of industrial output, with relative increases in export volume well in excess of those in output. Beginning in 1978, domestic demand began to recover, and in 1979 the rate of growth of industrial output exceeded that of exports of non-traditional industrial products. Table 1.1: GROWTH QF INDUSTRIAL OUTPUT AND NON-TRADITIONAL EXPORTS Annual Increases in Volume of Annual Increases in Industrial Production Non-Traditional Industrial Exports (%) (%) 1975 6.7 25.2 1976 3.9 49.7 1977 6.2 19.6 1978 6.0 7.7 1979 10.1 2.9 Source: Staff estimates based on Central Bank data. 1.09 The main manufactured export products are based on wool and leather. Uruguay had traditionally been a major world exporter of both raw wool and hides and skins. In response to the recent exchange rate and export incentive policies, the country has now moved towards the export of more advanced manufactures of these items which are sold in the main developed countries' markets. This evolution has been most marked in the case of leather 1/ where there has been virtually no exports of raw hides since the early 1970s and the share of tanned leather in the value of total leather exports has declined from about 60% in 1974 to less than 25% in 1979. The growth items in this devel- opment have been leather garments and shoes which, because of their relatively high labor intensity, have had a significant employment-generating impact. In the case of wool, the structural change in exports has until recently been more moderate. Raw wool (including both greasy and washed) continues to represent a substantial share of trade in this category, although wool tops (washed and carded wool ready for spinning) and cloth have shown significant increases. However, in more recent years, and especially in 1979, there has been a substantial expansion in exports of woolen garments as world demand for these items appears to have risen, particularly after the mid-1979 energy crisis. These items are also important in generating new employment oppor- tunities. 1.10 Exports of other manufactured products, such as automobile parts, tires, paper, ceramics, cement and industrial chemicals have also shown rela- tively large increases. Many of these products are sold within the LAFTA region, particularly to Argentina and Brazil, and benefit from regional preference arrangements as well as from the special bilateral trade agreements 1/ Export incentives had been provided as early as the mid-1960s to favor the exports of tanned leather and products.  -4- established by those two neighboring countries. 1/ Exports to Argentina have risen most sharply in the last two years as the Argentine government's exchange rate policy has made imports relatively cheap and Uruguay's location has enabled it to take advantage of this situation. 1.11 As a consequence of the growth of manufactured exports there have been some modifications in the structure of industry. Export-oriented sub- sectors (e.g. textiles, clothing, shoes and leather products) increased their shares in total value added in the sector while those subsectors dependent upon the local market (e.g. metals, machinery and equipment) or traditional exports (e.g. food, beverages and tobacco) experienced declines. Table 1.2: VALUE ADDED IN MANUFACTURING BY PRINCIPAL SUB-SECTORS (% of total) 1970 1973 1978 Food, beverages and tobacco 36.7 37.3 32.1 Textiles, clozt.Ing, shoes 16.4 16.6 19.0 Leather products (excluding shoes) 1.5 5.0 7.6 Chemicals and petroleum 6.9 8.0 8.i Non-metallic minerals 7.4 5.6 9.1 Machinery and equipment n.a. 12.7 10.3 Base metals n.a. 2.1 0.7 Source: Annex 1, Table 1.5 1.12 Employment and wages. The recent expansion in industrial output and its particular composition has resulted in substantial employment generation. Since 1975, the increase in employment as measured by the Central Bank's index of occupation in industry, 2/ has remarkably paralleled the growth of the value added in manufacturing in constant prices. The major factor in this development has been the growth in the labor-intensive branches such as clothing, shoes and leather products. Based on sample data obtained in the Annual Survey of Industry prepared by the official census agency, it would appear that more than 40% of the increase in employment between 1973 and 1978 was accounted for by the clothing and shoe and leather products industries, which in the former year represented only about 15% of total industrial employment. Another 20% of the employment increment was due to the expansion in the automotive and parts industries, which have experienced both export growth due to the special LAFTA and bilateral trade agreements with Argentina and Brazil, and increases in domestic demand. 1/ See IBRD No. 2241-UR, Economic Memorandum on Uruguay, December 1978, p. 33. 2/ This index is based on a periodic survey of a sample of industrial firms, mainly medium and large size enterprises.  Table 1.3: EMPLOYMENT AND VALUE ADDED INDICES Employment Value Added 1975 100 100 1976 104.4 104.0 1977 110.9 110.3 1978 117.0 117.0 1979 128.3 128.3 Source: Central Bank. 1.13 The increase in industrial employment has played a major role in reducing the general level of unemployment in the Uruguayan economy. For the Montevideo area (representing more than 50% of the total population), the unemployment rate declined from 12.7% at the beginning of 1976 to 8.6% in the first quarter of 1979. By the end of 1979, there were indications of labor shortages in a number of areas, particularly in Punta del Este where the construction boom has been especially important. 1.14 The period has also been characterized by a sharp fall in real wage rates for those employed in manufacturing as a consequence of the persistently relatively high inflation. There have been, on the other hand, increases in average hours worked so that real wage incomes have not fallen as sharply. However, while the total wage bill for the sector has not changed significantly in real terms since 1975, as a consequence of the rapid growth of the sector the share of wage income in value added has tended to decline. Table 1.4: REAL WAGE AND INCOME INDICES IN THE INDUSTRIAL SECTOR (1975-79) Index of Real Wage Rates Index of Real Wage Income 1975 100 100 1976 93.6 96.0 1977 83.7 86.4 1978 82.3 85.3 1979 80.0 82.6 Source: Central Bank. 1.15 Investment and imports of capital goods. For the economy as a whole, gross investment has shown a sharply rising trend during the 1970s, increasing from 10-12% of GDP in the early years of the decade to about 15% in later years (Annex 1, Table 1.1). In addition, imports of capital goods have risen at an average annual rate of about 12% since 1975. However, no  - 6 - sectoral details are available to determine the relative movements for indus- trial and agricultural investment or for construction. There apparently have been a number of new export-oriented firms established in recent years but most of these (e.g. garments) have low fixed asset requirements. Interviews with executives of existing plants selling mainly in the domestic market suggest that the recent period of improved activity and profitability has permitted many enterprises to undertake important rehabilitation and moderni- zation programs. 1.16 In mid-1973 the government adopted an industrial investment pro- motion law to encourage the growth of industries of "national interest". The main incentive is a reduction of the tariffs on imported capital goods to 10%. Since the establishment of the mechanisms for administering the law in early 1974, there has been a substantial flow of requests for obtaining its benefits. Table 1.5: APPROVALS UNDER THE INVESTMENT PROMOTION LAW (1974-79) Requests Approved Value of Fixed Investment Requests Received Number (Thousand US$) 1974 31 2 617 1975 44 19 24,365 1976 35 21 17,645 1977 69 44 37,059 1978 54 44 36,909 1979 56 43 42,763 Source: Unidad Asesora, Ministerio de Industria y Energia. 1.17 Size of enterprises. The latest published census of economic activ- ities was for the year 1968. In December 1979 a new census was undertaken but the results are not yet available. Some indication of the trends in the size distribution of enterprises can be obtained by analyzing statistics available from various sources; however, because the data are not completely comparable, they must be interpreted with caution. 1.18 During the 1960s, more than half of the workers employed in indus- try were employed in smaller enterprises with up to 49 employees. About one- fifth of the total were found among the firms with less than five employees. This was the period of high protection with production excessively diversified, serving a limited domestic market and unable to take advantage of economies of scale. By 1977, however, the smaller enterprises (under 50 employees) accounted for only two-fifths of the total employment in industry. This decline may be slightly overstated since the survey on which the distribution is based may have not been as comprehensive as the sources of the data for the 1960s. The trend reflected mainly the growth of the larger export-oriented enterprises. While many of these (e.g. leather products, garments) are not subject to economies of scale in production, the magnitude of output has to be relatively large to meet export requirements.  - 7 - Table 1.6: DISTRIBUTION OF INDUSTRIAL EMPLOYMENT BY SIZE OF ENTERPRISE (% of total) Size of enceiprises (Number of workers) 1960 1968 1977 1 - 49 52.7 55.1 39.6 Of which I - 4 19.8 n.a. 9.2 1 - 9 n.a. 41.2 n.a. 5 - 49 32.9 n.a. 30.4 10 - f 9 n.a. 13.9 n.a. 50 - 99 9.6 8.6 11.5 100 and more 37.6 36.3 48.9 Total 100.0 100.0 100.0 Source: Comision Coordinadora Para el Desarrollo Economico: 1960 from the Registro Nacional, 1968 from Censo Economico and 1977 from Direccion General de Estadisticas y Censos. C. Principal Policy Issues Exchange Rate and Export Incentive Policies 1.19 In 1972 the government introduced the policy of periodic mini- devaluations ("crawling peg") in contrast to the prior practice of irregular major devaluations. Since October 1978, the devaluations on a daily basis have been pre-announced first for a period of nine months and, more recently, for periods of six months in advance; in June 1980, the rates prevailing through the end of calendar year 1980 were fixed. The intention of this policy has been to use exchange rate policy to reduce inflation, as the pre-announced rates have generally been below the difference between domestic and international inflation. 1/ 1.20 From 1973 through 1977, the measures taken by the authorities provided in general a substantial depreciation of the real exchange rate, the only exception being in the year 1974. With the introduction of the pre- announced rates, the peso experienced a small appreciation in 1978 but a very large real appreciation in 1979 which brought it below the 1973 level. 1/ See the discussion on this aspect in the latest Economic Memorandum on Uruguay, Report No. 2706-UR, June 1980.  - 8 - Table 1.7: REAL EXCHANGE RATE INDEX AND EXPORT REBATES FOR NON-TRADITIONAL EXPORTS Index of Real Exchange Rate Export Rebates as % of (Export weighted) non-traditional exports a/ 1973 91.1 13.9 1974 88.8 17.3 1975 100.0 16.4 1976 104.5 17.3 (22.7) 1977 104.9 15.4 (20.0) 1978 102.9 13.9 (15.6) 1979 88.5 11.2 (14.3) Source: Staff estimates. a/ The data in parenthesis represent the ratio of export rebates to the total value of exports eligible for rebates; these data are only available since 1976. 1.21 The real exchange rate devaluation has played an important role in improving the international competitiveness of Uruguayan manufacturers, but the establishment of a number of incentive programs has also been critical in making Uruguayan products internationally competitive and exporting profitable. While a system of rebates for exports of selected non-traditional products had actually been initiated in the mid-1960s, it was not until 1972/73 that a new, more comprehensive system was developed. Under this program, the per- centage of the rebate ("re-integro") offered to exporters ranged as high as 46% for certain consumer goods products. The initial levels were set for a three-year period ending mid-1975, after which there would be annual reduc- tions. Reductions were introduced through mid-1978 but the rates established for 1978/79 were maintained through 1979/80. In June 1980, the Minister of Economy announced the intention of the government to continue the "re-integros" at the existing levels until the end of 1981. At that time, the rates would be gradually reduced to reach a uniform 5% level at the end of 1985, a level equivalent to the estimated burden of indirect taxes. This statement repre- sented the elaboration of a policy declaration made by the government in December 1979 when it announced its adherence to the new GATT Code on Sub- sidies and Countervailing Duties. 1.22 At the end of 1978, the Uruguayan authorities sharply curtailed "re-integros" for certain woolen and leather products exported to the United States, although retaining the program for exports to other markets. This measure was taken after the US Government moved to impose countervailing duties on imports of these items from Uruguay, and resulted in sharp declines in these exports to that market. In March 1980, following the adherence of the government to the new GATT Code, the authorities re-instated the previous levels of the export incentives for these items. As subsequently spelled out in the June 1980 policy declaration, these will be reduced to the uniform 5% level by the end of 1985.  -9- 1.23 Uruguay's production and exports of the particular items in 1979 were adversely affected by the suspension of the incentives, although some producers were able to shift their selling efforts to European markets and/or to increase sales to the domestic market. The reintroduction of the incen- tives in March 1980 is expected to have limited impact on exports in the current year, since the measures came too late in the "buying season" for a number of US importers. However, in the short run exporters of woolen products are expected to benefit most from the new situation since demand for these items appears to be relatively buoyant in spite of the recession in the US market. 1/ 1.24 As an additional measure to stimulate exports, highly concessional interest rates for financing both production for export and export shipments ("pre-anticipos") were introduced in 1976. Data are not available on the actual volume of such financing, but interviews with exporters indicate that the subsidy element was rather substantial, although it varied over time. In line with other measures adopted in the course of 1978 and 1979 to remove controls on interest rates, this system of financing was discontinued. The Tariff Reduction Program (TRP) 1.25 Import liberalization has represented a major objective of official policy since the early 1970s. A first important step was taken in 1975 with the elimination of import quotas, but the major task remained of overhauling the extremely complex import protection system which includes tariffs, surcharges, consular fees, port charges, arbitrary fixed product prices ("aforos") having no relation to actual prices and upon which the surcharges are applied, and multiple administrative requirements. In December 1978, a decree was issued establishing guidelines to reduce the overall level of protection through (a) consolidating all tariffs, surcharges and special taxes into a single global rate which would be lowered to a uniform 35% by 1985 on the basis of annual equal reductions beginning January 1, 1980; (b) unifying the administrative requirements which are currently supervised by at least three agencies of the government; and (c) eliminating the "aforo" system. 1.26 An interministerial committee was established with responsibility for working out the details of implementation which were to be elaborated in the decree incorporating the first of the annual equal reductions due on January 1, 1980. In the course of its work during 1979, the committee recom- mended immediate tariff reductions to the 35% target level for about 500 items which were not being produced locally, and substantial tariff reductions for a small number of items where price rises had occurred faster than justified by local cost increases. The committee also drafted anti-dumping legislation, including a system of countervailing duties which was submitted for further consideration by the government. 1/ In addition, to the "re-integros", exports of wool products benefit from a special "bonificacion" equal to 22% of export value.  - 10 - 1.27 The bulk of the committee's work was embodied in a decree pub- lished on January 14, 1980 which incorporated the tariff reduction for 1980, as scheduled in the December 1978 decree. A single tariff classification was defined and single tariff rates were established for these items incorporating the four previous components--the "normal" tariff, the surcharges, consular fees and port charges. However, because of administrative difficulties the components were separately identified, and in place of the expected single collection, each of the participating agencies would continue collecting its individual share. 1.28 In addition, although the principle of applying the tariffs to c.i.f. import prices was established, authority was given to the Minister of Economy to formulate a system of reference prices to establish tariffs for import items in instances where redundant protection was evidenced or when it was shown that dumping was taking place. By administrative decree in March 1980, a reference price system was established based on the prior "aforo" system. 1.29 The value of imports has risen steadily since the first petroleum price increase at the end of 1973; imports of goods and non-financial ser- vices represented 11-14% of GDP in the 1970-73 period, but since 1977 have exceedcP" 20%. During these latter years, however, the main elements in the import rise have been non-petroleum items (see Annex 1, Table 1.9). In 1979, the value of imports rose by alrost 60% over the previous year, more than half of that due to volume increases in virtually i1l categories of products other than petroleum. This expansion reflects in part the measures taken during 1979 1/ to reduce tariff protection. Nevertheless, there was a sliarp increase in actual tariff receipts as a percentage of the total value of imports. The number of items on which tariffs were collected rose from 4,000 in 1978 to 8,400 in 1979. For a number of products not produced in the country and not previously imported, cutting the previous prohibitively high tariff levels has apparently led to the emergence of new imports at lower (but still substantial) tariff rates. Moreover, for those imported products competing with domestic production, the high effective protection afforded by the prevailing system 2/ may have been eroded by the appreciation of the real exchange rate in that year, i.e., net effective protection may have been reduced. The study of the import liberalization process which is to be undertaken in connection with the proposed loan (para. 4.12) is expected to examine in more detail the precise nature of the impact of that process on these trade movements to permit better evaluation of policy alternatives. 1/ In addition to the measures cited in paras. 1.23 and 1.24, maximum surcharge levels were reduced twice in 1979. 2/ Average effective production in 1977, based on legal tariff rates and surcharges (i.e. not allowing for tariff redundancy) was estimated at 139%. See J.J. Anichini, J. Caumont and L. Sjaastad, La Politica Comercial y la Proteccion en el Uruguay (Montevideo, 1977).  - 11 - Table l.8: IMPORTS AND TARIFF RECEIPTS Indices - 1975 = 100 Tariff receipts- /as % of Total Imports Import Volume Import Value Import Value Excl. Petroleum 1975 100 100 8.2 12.2 1976 108.5 105.5 12.0 17.4 1977 123.6 131.2 14.0 19.5 1978 129.6 139.1 13.1 18.2 1979 170.1 221.2 17.8 23.6 Source: Staff estimates based on Central Bank data a/ Includes normal tariff, surcharges and consular fees. 1.30 Continued progress in meeting the timetable for import liberaliza- tion established in the decree of December 1978 is essential for the future viability of the Uruguayan economy and to avoid repeating the economic stagnation and social deterioration experienced in the twenty-year period after 1955. Thus the proposed project would be geared to finance efficient industrial, agroindustrial and tourism projects, within the framework of the government's import liberalization policies established in the decree of December 1978 and regulated in the decree of January 1980 (see para. 4.02). Moreover, the achievement of targets under the government's Tariff Reduction Program (TRP) will be analyzed in a study to be financed under the proposed project (para. 4.12), which will be reviewed between the government and the Bank not later than June 30, 1982, with the purpose of determining whether targets have been achieved allowing future subprojects to be financed under the project. If it were found that this is not the case, and that the situa- tion could not be expected to be remedied within a reasonable period satis- factory to the Bank, no further subprojects could be approved. D. Medium-Term Outlook 1.31 In mid-1980, the situation facing the industrial sector was beset by some uncertainty. On the one hand, the sector was apparently close to full utilization of capacity as a result of the fast growth conditions in the economy, and further increases in output were increasingly dependent upon new investment. A large number of enterprises were cautious, however, with regard to expansion plans. This was particularly the case for the export-oriented industries whose international competitiveness has been affected by the appreciation of the real exchange rate and the reduction of export incentives. Moreover, the recession in world markets raised some questions as to future demand growth. For a number of industries which have benefitted particularly from the relatively advantageous position Uruguayan products face in  - 12 - Argentine markets, or from the flow of tourists to Uruguayan resorts, the special problems of uncertainty over income growth in Argentina posed addi- tional obstacles to further investment plans. Similarly, industries which had become dependent upon exports to Brazil, particularly those items subject to preferential treatment under the bilateral agreement, were confronted in December 1979 with a major change in their competitive position as a result of the substantial cruzeiro devaluation and the general liberalization of Brazilian imports, eliminating the administrative basis for preferential treatment. 1/ In the early months of 1980, official trade between the two countries came to a virtual halt. 1.32 Among those industries primarily oriented towards the domestic market, major concern lies with the impact of the import liberalization program. Interviews with industrialists 2/ indicate that many had begun to undertake the ite..nssary modernization and rehabilitation programs to permit them to compete witih imports. Moreover, many had already begun the process of ad,usting their product mix, reducing the excessive diversification of output and tending to specialize in a smaller number of products. In this connection, a number of entrepreneurs felt that the liberalization measures would provide them with access to cheaper and better quality imported interme- diate goods, which in turn would enable them to compete more favorably with imports of finished products. 1.33 For the bulk of those enterprises serving the local market, the shift from the import-substitution industrialization strategy to a more open economy approach should not cause major dislocations. The size of the domestic matrket is relatively large and the population is mainly concentrated in one area. Under these circumstances, economically viable production is possible for a wide range of finished consumer goods and of many agricultural and construction inputs where economies of scale are not significant or where transport costs are important. Moreover, as evidenced by trade patterns during more normal periods, a good portion of Southern Brazil and parts of Argentina along the Uruguay River lie within a natural market area for numerous Uruguayan products. These enterprises will, however, require important invest- ment programs to modernize and improve efficiency and, as noted above, some have already begun that process. 1/ For example, certain imports from Uruguay were not subject to prior deposits, which were equivalent to a 50% tariff; eliminating the prior deposit system thus removes an important preferential position for the exempted items. 2/ A Bank mission visited Uruguay in December 1979 to study in particular the possible impact on existing industry of the liberalization program. Preliminary findings of that mission have been used in the discussion in this report. The full report of the mission is expected to be published later this year.  - 13 - 1.34 There are, nevertheless, a group of industries which have been dependent in part on excessively high effective protection and which are expected to have greater difficulties in meeting external competition under a more liberal import policy. Most of these are among consumer electric and electronic appliances and mechanical engineering branches and are based on importing components with low or no tariffs, while the final products are subject to high tariffs. Several of these enterprises have already begun to rationalize their production, specializing in one or a limited number of products, and some have been able to develop export capacity. These have included skill-intensive products such as dies, metal fasteners and simple agricultural tools which benefit from the availability of relatively inexpen- sive skilled labor in the country. 1.35 The most significant impact of these new policies would be to shift the terms of trade 1/ towards agriculture and to enco.re greater investment in, as well as diversification of, that sector. To some extent, this will lead to the production of many agricultural items which will be subject to further processing, particularly for export. Agro-industries are likely to be among the more dynamic manufacturing activities in the future and new projects will tend to concentrate in these sub-branches. Some examples which have already emerged are milk-based concentrated protein solids and a wide range of processed fruits and vegetables, as well as the entire group of processed fish and shellfish. 2/ 1.36 According to a recent survey of 99 medium to large industrial firms undertaken by the Ministry of Industry at the Bank's request, intended indus- trial investment in 1980-82 appears to be quite substantial when compared to previous years. The surveyed firms indicated planned investments for a total of US$208 million in 1980-82, primarily to modernize their plants, to improve product quality or to reduce operating costs. A further indication of a strong demand is the fact that the available funds under Loan 1176-UR to finance export-oriented projects were committed at a rate of US$1 million per month in the past six months, well above the rate achieved in earlier periods. PAT's pipeline of projects requesting financing amounted to US$46 million as of June 30, 1980 (see Annex 5). 1.37 The actual implementation of these investment programs will depend upon continued favorable market trends. Maintenance of overall domestic demand growth at reasonably high levels will provide considerable stimulus to those industries serving the domestic market. Further growth of the export- oriented industries can, however, be affected by any continued divergence between domestic and international inflation which is not offset by nominal devaluation. While there are indications that total export value was continuing 1/ In the statistical sense, the share of industry in GDP may experience some decline in the immediate future due to the existing price distortions which overvalue manufacturing activities particularly if expressed in international prices. 2/ See also the list of new projects in the pipeline for the proposed credit line, Annex 5.  - 14 - to increase in the first semester of 1980, export performance varied consid- erably among the different subsectors and overall there appears to have been a decline of 5.7% in volume. Exports of wool and woolen products continued to show some rise due to generally good world market conditions for these items and there appears to bavi been some recovery in exports of leather products, excluding shoes. Buoyant domestic demand for construction materials such as cement and ceramic products appears to be reducing supplies of those items available for export. II. THE FINANCIAL SECTOR A. The Financial System 2.01 The banking system in Uruguay comprises the Central Bank of Uruguay (BCU), 3 state banks (Banco de la Republica, BROU, the Mortgage Bank and the Insurance Bank 1/), 21 private commercial banks and 17 casas bancarias. Casas bancarias are new institutions that have been allowed to establish since 1977, to engage in all operations open to commercial banks, except obtaining deposits from Uruguayan residents and offering checking account facilities. The financial system comprises, in addition, several small insurance companies (life, fire and maritime transport) and the Montevideo Stock Exchange (MSE). 2/ Currently there are no development banks in Uruguay. 2.02 The Banco Central del Uruguay was established in 1966 with responsi- bilities for formulating ind executing monetary and credit policy, supervising and controlling the banking system, issuing currency and managing international reserves. Until 1966, BROU was in charge of central banking activities, and while most of these functions are now in the hands of BCU, BROU remains in charge of some fiscal activities for the government (e.g. collection of some excise duties and tariffs) and some official foreign exchange transactions. 3/ BCU presently has 720 employees, and is organized in five operating divisions (Financial Management, Economic Studies, Foreign Transactions, Administration and Accounting, and Controller of the Financial System), and three advisory units (the Legal Department, the Internal Auditing Department, and the General Secretariat). In addition to its central banking functions, BCU has administered 1/ The Mortgage Bank provides long-term housing financing. Its portfolio with the private sector amounted to NUr$2,516 million as of December 31, 1979. The Insurance Bank has a monopoly on labor, accident and property insurance in Uruguay. 2/ MSE was established in 1923. Its role in mobilizing financial resources to productive enterprises has been declining over the last two decades. Total transaction during 1978 amounted to NUr$1.091 million (about US$156 million equivalent), of which only about 10% represented trading of private enterprise of common shares. 3/ Also, BCU has no regulatory powers on BROU's activities.  - 15 - various development credit lines (industry, agriculture, livestock and fishing) from international or bilateral institutions and a guarantee fund (para 3.16) established under the first industrial credit project. 2.03 The commercial banking system. Commercial banks were severely affected by several Uruguayan economic crises in the 1963-74 period, when the total number of private banks decreased from 81 to 21 as a result of financial failures or mergers to avoid bankruptcies. In 1965, the government issued a prohibition against establishing new private banks to help minimize financial difficulties to existing banks. This prohibition has tended to inhibit competition among banks, which in turn has affected the quality and variety of banking services. The new government's financial and monetary policies, on the other hand, have been reversing the trend by liberalizing the financial sector (para 2.06), which has given new momentum to the banking system. Competition and Ltr,t volume have substantially increased since 1974, spurred in part by the recent establishment of casas bancarias. To further encourage competition, the government is presently preparing a proposal to permit establishment of new banks and induce all banking institutions to serve as multi-service banks. 2.04 Since the government started major liberalization reforms in 1975, the banking system in Uruguay has been showing a new dynamism characterized by a rapid growth of deposits and financial assets (averaging 10% p.a. in real terms in 1974-79). The commercial banking system's credit to the private sector has grown by 123% in real terms since 1974. As of December 31, 1979 the system's credit outstanding to the private sector amounted to NUr$19 billion (US$2.2 billion), which is equivalent to 34% of GDP compared to only 18% in 1974. The private commercial banks were responsible for most of the growth, and as a result, BROU's participation in the financing of the private sector decreased from 54% in 1974 to 29% in 1979. The recently established casas bancarias have also participated actively and accounted for 5% of total private credit at the end of 1979. Table 2.1 below illustrates the chang- ing structure of the commercial banking system over the past six years. Table 2.1: THE COMMERCIAL BANKING SYSTEM CREDIT OUTSTANDING TO THE PRIVATE SECTOR (in current NUr$ Million) 1974 1977 1979 Amount % Amount % Amount % BROU 444 54 2.159 43 5.576 29 Private Banks 372 46 2.782 56 12.561 66 Casas Bancarias - - .031 1 .882 5 Total 816 100 4.972 100 19.019 100 Source: Mission estimates upon BCU and BROU data.  - 16 - 2.05 IFC's investment bank project. IFC has recently approved an investment in a new merchant banking-type institution, incorporated as a casa bancaria (SURINVEST), mainly to help to develop underwriting and leasing operations in the Uruguayan financial market. It will also undertake lending operations (short and long term) mainly to the industrial sector. SURINVEST, in which IFC holds a 20% equity participation, has an initial paid-in capital of NUr$ 30 million. It is expected to increase the availability and number of alternative sources of term credit to the industrial sector and increase the scope and volume of financial instruments available to the investing public. SURINVEST would be eligible to participate under the proposed project (para. 3.13). B. Monetary Policy 2.06 The monetary and credit policies of the government have been an integral component of the economic measures taken since 1975, aiming to open the economy and improve resource allocation and growth through elimination of most price controls, trade liberalization and opening of the financial system. The principal monetary and credit measures have been (a) elimination of (i) controls of interest rates and indexation; (ii) rediscounting operations; (iii) all BCU's subsidized credit; (iv) minimum reserve requirements; and (v) taxes on financial operations; (b) establishment of a legal framework to allow Uruguayan residents to hold foreign assets and perform transactions in any foreign currencies; and (c) elimination of a dual exchange rate system under which transactions on imports, exports and service of public foreign debt were exchanged under a "commercial" rate and all other transactions under a "financial" rate. These measures have made Uruguay one of the freest finan- cial markets in Latin America and have substantially encouraged resource mobilization, as shown by the increase in financial assets held by the non- banking private sector, from 34% of GDP in 1974 to 44% in 1979. However, because the opening of the financial sector occurred much faster than the opening of the goods and services sector (trade liberalization), the resulting increased monetary supply has exacerbated inflationary pressures (inflation of 58% in 1977, 45% in 1978 and 83% in 1979). 2.07 One of the few major regulatory measures that have been main- tained on the private banking system is the minimum capital requirement. Commercial banks are required to maintain a minimum equity of NUr$ 40 million (US$5 million equivalent) and casas bancarias NUr$ 24 million (US$3 million equivalent) 1/. A further important requirement is that commercial banks and casas bancarias shall maintain a debt-equity ratio below 20:1 starting on January 1, 1981, and prior to that date below 30:1. The capital require- ment are not expected to pose great difficulties for most commercial banks, since their total existing equity exceeds the requirements as of January 1, 1982 in current terms, and eventual adjustments for inflation on minimum equity requirements are not expected to pose serious difficulties. 2/ 1/ The minimum equity shall be maintained as follows: (i) before July 1, 1980, not less than 40% of the total; (ii) before January 1, 1981, not less than 60%; and (iii) on January 1, 1982, 100%. 2/ Private commercial banks have presently higher indexed assets (NUr$ 13 billion) than liabilities (NUr$ 8 billion), which protects them for inflation.  - 17 - For casas bancarias, however, the minimum capital requirement present a more serious problem, because their total existing equity (NUr$ 94 million) is presently only 26% of nominal requirements as of January 1, 1982 (NUr$ 355 million). Several casas bancarias may be unable to meet these requirements, and would have to merge with other institutions or close busi- ness. However, since casas bancarias presently account for only 5% of total banking assets, their difficulties might not create a major obstacle for the development of the financial sector. 2.08 The debt equity limitation, on the other hand, could impose some hardship even for commercial banks, since their current debt is greater than the maximum debt allowed on January 1, 1981 and January 1, 1982 (see Table 2.2 below). Unless commercial banks increase their equity above minimum require- ments, they would be forced to decrease their debt liabilities, and therefore their outstanding portfolio. Thus, the D/E requirement could impede the development of new long-term credit operations, because commercial banks would prefer to use their available growth capacity for short-term operations. Table 2.2: MINIMUM CAPITAL REQUIREMENTS AND DEBT-EQUITY LIMITATIONS TO COMMERCIAL BANKS AND CASAS BANCARIAS (in current NUr$ million) Capital Requirements Debt-Equity Limitations Minimum Existing Maximum Debt Existing Capital Debt Allowed for Minimum Equity a/ Requirement b/ Nominal capital Requirements Commercial Banks (Consolidated) Dec. 31, 1979 772 - 17,613 23,160 July 1, 1980 - 292 - 23,160 Jan. 1, 1981 - 438 - 15,440 Jan. 1, 1982 - 731 - 15,440 Casas Bancarias (Consolidated) Dec. 31, 1979 94 - 1,247 2,820 July 1, 1980 - 142 - 4,260 Jan. 1, 1981 - 213 - 4,260 Jan. 1, 1982 - 355 - 7,100 a/ As determined by the Central Bank after adjustments on revaluation, inflation and provisions, which accounted to 87% of nominal equity as of December 31, 1979. b/ Assuming that Central Bank requirements will be also 87% of nominal requirements. Source: Mission Estimates upon Central Bank data.  - i8 - 2.09 To encourage long-term operations by the banking system, under the minimum capital and debt-equity limitations suitable incentives for longer term lending operations appear necessary. Only 3% of the banking system's portfolio las had maturities over 360 days during the past six years, and short term operations are presently much more profitable than long-term operations. This imbalance is likely to continue as long as the policy of slow pre-announced devaluation is maintained (para. 1.19). In order, to encourage long term lending operations by banking institutions, assurances were obtained at negotiations for the maintenance of the Guarantee Fund (para. 3.16), which enables the intermediaries to deduct amounts covered under such Guarantee Fund from their total debt, for purposes of the estima- tion of their debt/equity ratio. Such an exemption would tend to diminish distortions in the maturity profile of the banking system's portfolio, by providing the necessary marginal profit incentive to commercial banks to increase their long-term portfolio. 2.10 Interest rates. In Uruguay, interest rates have been positive in real terms in the past few years, reflecting the credit supply constraints in the past under a highly controlled financial sector. As shown in Table 2.3 below, the average real interest rate was about 4.7% in 1976, 6.6% in 1977 and 6.8% in 1978. This trend was reversed in 1979, when the average real interest rate was -16%, mainly as a result of a higher proportion of US dollar-denominated loans in the banking system's portfolio. In 1979, US dollar-denominated loans earned a lower effective peso interest rate (about 44% p.a., see Table 2.3) than peso-denominated loans (60% p.a.), due to the policy of slow devaluation that has been followed by the government. However, inflation declined from 83% in 1979 to 50% in the first semester of 1980 (on an annual basis), while nominal interest rates on the average have been maintained close to their 1979 levels. As a result banking system loans yielded again slightly positive real interest rates, but still a wide gap remains between the effective cost of dollar- and peso-denominated loans. 2.11 Due to the policy of slow devaluation with exchange rates pre- announced by the Central Bank for several following months, banks in Uruguay are able, without taking any foreign exchange risks, to contract short-term foreign loans in US dollars at an interest rate of a few points above LIBOR, which presently have an equivalent cost in local currency that is well below inflation. In 1979, while the cost of such foreign resources was about 40% in peso terms, they in some case were re-lent as peso-denominated loans with interest rates of about 60% p.a., leaving a substantial spread to interme- diaries. For this problem to be resolved, continued progress in bringing down the rate of inflation or a faster devaluation of the peso would be required in the medium term.  - 19 - Table 2.3: INTEREST RATES (IN PERCENTAGES) (As of December 31 of each year) Local Weighted Inflation Average US Dollar Denominated Loans Currency Loans Average Rate Real Nominal Devaluation Adjusted Nominal Interest (Wholesale Interest Rate Rate Rate Rate Rate Price Index) Rate (dollars) (pesos) (pesos) (pesos) 1976 12.0 46.5 64.1 55 57.7 50.6 4.7 1977 13.2 35.0 52.8 65 60.2 50.3 6.6 1978 14.0 30.0 48.2 69 58.6 48.5 6.8 1979 20.0 20.0 44.0 60 51.2 80.4 -16.2 Source: Mission estimates, using IMF data and Central Bank statistics on interest rates of 5 major private banks. 2.12 Lending spreads. The negative real interest rates on deposits in local currency have induced the public to increase their deposits in foreign currency, affecting in turn the peso-dollar composition of the banking system's lending portfolio. US dollar-denominated loans increased from about 25% of total loans in 1977 to 52% at the end of 1979. In addition, banks have been making short-term peso-denominated loans using resources deriving from dollar- denominated deposits, since with the policy of pre-announced devaluations there is little risk in this practice. This, in turn, has made banking institutions more dependent on the relatively smaller spreads (6% average on US dollar loans) of foreign-denominated loans and, through competition, has forced down the spreads on the peso-denominated loans closer to the average spread on foreign loans plus devaluation. In 1979, the spread on foreign loans averaged 6% p.a. and on peso loans 24% p.a. (which is close to 6% in dollars plus 20% devaluation). Competition can be expected to further reduce the 6% spread in dollars to around 3-4% in the next 2-3 years. The subloans envisaged under the proposed project would not carry a fixed spread to the intermediaries. Final interest rates, and therefore spreads, would be negotiated between the intermediaries and the subborrowers. Competition between intermediaries is expected to result in average spreads on subloans that are in line with those prevailing generally in the banking system (i.e. in the range 3-4%). However, in the event that the average spread under the project subloans exceeds 4% p.a. for an extended period, the need to establish an adequate fixed spread for future subloans would be reviewed with the government. C. Resource Mobilization 2.13 Liberalization of interest rates and currency denomination on local transactions has enabled Uruguayan banking institutions to attract substantial short-term foreign capital inflows in the past four years, sharply increasing the capacity of the banking sector to finance private sector activities. Net foreign capital inflows have increased from US$190 million in 1976 to US$215 million in 1978 and US$386 million in 1979. As of year-end  - 20 - 1979, the BCU estimated that commercial banks held three-fourths of foreign capital inflows in form of short-term deposits and that 22% of total deposits in the private banking system were held by non-Uruguayan residents. Also, local deposits have been encouraged to grow, mostly in the for'i of US dollar- denominated deposits (para 2.10). As a result, the commercial banking system's lending portfolio to the private sector increased its size in relation to GDP from 17% in 1974 to 34% in 1979. 2.14 On the other hand, the private sector has been unable, so far, to increase its direct mobilization of resources from the private non- banking sector, through issuance of notes or stocks. The new IFC project (SURINVEST), however, is expected to play a major role in helping to develop direct mobilization of resources by the private non-banking sector by carry- ing out underwriting operations. Given the new policies of the government, which encourage competition in the financial sector, it is expected that issuances of notes and common stock by private enterprises can develop sub- stantially in the near future. D. Financing of Industry 2.14 The industrial sector, as the rest of private sector activities, has benefitted from the growth of the financial system in Uruguay since 1974, by increasing its total borrowing outstanding at 19% p.a. in the 1974-79 period. Such a growth in industrial borrowing has permitted higher investment in the sector and the positive growth of industrial exports and value added (10.1% in real terms in 1979). Despite the rapid growth of borrowing, most firms are not highly leveraged and have additional borrowing capacity. A sample of industrial firms reviewed by the appraisal mission 1/ showed a relatively low average debt equity ratio of 1:1. However, about 96% of outstanding credit to industry had maturities below 1 year as of June 1979, and it is estimated that only a very small proportion of loans have maturities of more than 4-5 years. Nevertheless, industrial credit has a better maturity structure than the rest of credit to the private sector, due mostly to the still modest but useful role played by BCU through its Fondo Financiero para el Desarrollo (FFID) (para. 3.02). III. INSTITUTIONAL ARRANGEMENTS FOR THE PROPOSED PROJECT A. Arrangements Under the First Credit Project 3.01 Background. The Industrial Development and Export Promotion Project (Loan 1176-UR), which was approved in December 1975, originally had two components: (a) US$20 million to be used for financing imported raw materials used by Uruguayan exporting industries; and (b) US$10 million for financing industrial export subprojects. Due to slow utilization 1/ UA in the Ministry of Industry analyzed a sample of 55 medium industrial enterprises that had already obtained credits or were in the process of obtaining credits. Since the sample is skewed towards higher indebted firms, it was surprising to find that these firms were financing as much as 51% of their new investments in 1978-79, with their internal cash flow generation.  - 21 - of the first component, and to the improved balance of payments position of Uruguay, US$14,156,240 was cancelled on February 28, 1977 and the pre- viously disbursed funds under that component (US$10.34 million equivalent) were transferred to the subproject financing component. Of the total of US$20.8 million subsequently available under the second com1ynent, US$18.3 million had been committed by August 15, 1980 for the financing of 30 sub- projects, with a total investment cost of US$32 million. 1/ The net foreign exchange impact of the subprojects financed under the loan is estimated to amount to US$56 million, 2/ equivalent to 1.8 times the total investment costs and to 3.1 times the Bank's resources, which would indicate that the objective of financing efficient industrial exporting industries can be satisfactorily achieved. 3.02 Institutional arrangements. Under the first credit project, the BCU established the Fondo de Financiamiento de Inversiores para el Desarrollo (FFID) in November 1975, to channel long-term resources through the banking system for financing private industrial projects. Initially, the resources channeled by FFID were the US$20.8 million from the first credit project and US$4.6 million from AID's agroindustrial loan (528-T-026). 3/ Subloans were appraised by a staff of the Programa de Asistencia Tecnica (PAT) in the Ministry of Industry and Energy (MIE), and subsequently reviewed and approved by an interinstitutional committee (the Comite Coordinador, CC) with represen- tatives of the BCU, the Ministries of Finance and Industry, and the Planning Office. As an incentive to intermediate long-term loans, financial institu- tions were allowed to obtain guarantees, up to 60% of FFID subloan amounts, from a Guarantee Fund (GF) established by the BCU, also under the first project. This two-tier credit system proved itself a viable mechanism in Uruguay for financing efficient industrial projects. B. The Industrial Development Fund 3.03 Need for a new industrial development fund. While FFID operations have overall been successful, its organization and lack of integrated policies have prevented it from providing a continuous flow of resources to the produc- tive sector. Each of FFID's lines of credit has been governed by its own regulations and relending conditions. Credit lines that were incorporated after the Bank's first industrial credit and AID's agroindustrial loans required institutions other than PAT to appraise subprojects with different 1/ Additionally, FFID approved 13 technical assistance subprojects totalling US$0.23 million equivalent. 2/ The net foreign exchange impact was measured by estimating the net present value of net foreign exchange benefits (foreign exchange revenues minus costs) in constant prices and discounted at a 10% annual discount rate. 3/ Subsequently, other lines were incorporated into FFID: an 1DB loan (US$15 million) for meat packing subloans and a KfW loan (US$26.6 million equivalent) for fisheries subloans.  - 22 - appraisal criteria and standards. 1/ Moreover, FFID has not had local funds to supplement its foreign credit lines and permit financing of local costs. Now that the two most active and successful credit lines (AID's and the Bank's first industrial loan) have been fully committed, BCU intends to establish a new Industrial Development Fund (IDF) as a sub-fund of FFID with new operating policies and procedures that will be common for all lines of credit under the sul-7und, and a new revolving fund mechanism to allow local cost financing. IDF would be used for industrial and tourism financing, including small scale enterprises. IDF subloans would be intermediated by participating commercial banks and casas bancarias, appraised by Unidad Asesora, and approved by the CC. 3.04 IDF resources. IDF resources would amount initially to US$52.20 million, as follows: (a) US$4.75 million in permanent resources originating from the government and the BCU's original counterpart contributions of US$2.25 million to the AID agroindustrial loan and US$2.5 million to the Bank's first industrial credit loan; (b) US$29.45 million equivalent from resources from the proposed project; and (c) US$18 million from the Bank of America's credit line, 2/ recently made available by BCU for industrial lending. The availability of funds to IDF as called for under (a) would be a condition for loan effectiveness (para. 5.02). Loan recoveries, plus interest and fees income, would be used to service IDF's debt, and remaining balances plus IDF equity resources to finance local cost components of investment projects. BCU would ensure that IDF's permanent resources value be maintained in real terms, and protected from a possible devaluation of the Uruguayan peso. IDF's cash resources would be maintained in convertible foreign currencies or in securities expressed in the same currencies. 3.05 Policies and procedures. IDF would operate in accordance with its operating policies and procedures, which would be satisfactory to the Bank (Annex 6). IDF resources to be channelled through participating financial intermediaries would be used to finance: (a) fixed assets and permanent working capital for efficient industrial and tourism projects, (b) feasibility studies for industrial or tourism projects considered for financing under IDF, and (c) technical and managerial consulting work to be contracted by industrial firms to increase their productivity and efficiency. IDF loans would be expressed either in local or foreign currency, but IDF would not assume any foreign exchange risks. Terms of IDF subloans would be determined taking into account the subprojects' financial needs and debt servicing capabilities, as well as the subprojects' productive lifetime. IDF would not charge any spread over the borrowing costs, since its administrative costs would be covered by BCU's budget. 1/ The IDB loan for meat packing industries required subloans to be appraised by the Instituto de Carne, and the KfW loan for fisheries by the Instituto de Pesca. 2/ BCU contracted a US$37 million loan from a group of international banks, syndicated by the Bank of America, of which US$18 million will be made available for industrial financing. This loan is expected to finance mainly foreign costs of subprojects, but in accordance with BCU's policy could also cover local cost financing needs.  - 23 - 3.06 IDF's currency denomination and interest rate policy. IDF's sub- loans would carry floating interest rates, in line with IDF's cost of resources and market rates. Subloans expressed in US dollars would be onlent to financial intermediaries at an interest rate equal to LIBOR 1/ plus 1% p.a., and carry--ig a commitment fee of 3/4 of 1% on undisbursed amounts. The interest rate to final subborrowers will be freely negotiated between the intermediaries and the subborrowers. Since both interest payments and princi- pal repayments for all subloans would be made semiannually, the base LIBOR for a semester would be estimated as the arithmetic average of rates outstanding on the last 30 days previous to the payment date. Subloans expressed in local currency would be subject to indexation of principal based on changes in the price index "al por mayor" as determined by the Central Bank in its Boletin Estadistico. Interest due by the intermediaries to IDF at the end of a six-months period would be 0.5% p.a., and by the subborrowers at an interest rate to be freel.- n-3gotiated between the intermediaries and the borrowers, to be charged upon the principal outstanding at each repayment date. Principal and repayment installments would be adjusted at the end of each period, by using the change in the price index during the six-months period but permitting a lag of two months to allow sufficient time for the publication of the price index by BCU. The Bank subloans and those from IDF's own resources could be expressed either in US dollars or in pesos, in a mix to be freely selected by industrial borrowers, to accommodate their expectations on inflation or devaluation. C. The Unidad Asesora (UA) 3.07 The export and agroindustrial subprojects financed by FFID were required to be appraised by the PAT, a technical unit established in April 1975 in the Ministry of Industry, under the supervision of Unidad Asesora (UA), which has been in charge of administering the Investment Promotion Law of 1974 (para. 1.16).. In light of the important operational role placed by the government on UA and the need to ensure a reliable and expeditious evalua- tion and approval mechanism under the Bank's First Industrial Credit Project, the government decided to place PAT under the direct authority of UA, which now reports directly to the Minister, Subsecretary and General Director of the Ministry of Industry (Annex 3, Table 3.8). The relationship between UA and PAT, however, is presently not clear. Duplication of responsibilities between the president of UA and the director of PAT have created frictions and adminis- trative difficulties. At negotiations, therefore, assurances were obtained from the government on a reorganization of UA, which will: (a) incorporate PAT fully into UA as the projects studies area; (b) nominate one of the three members of UA as head of the projects studies area; and (c) assign to the President of UA the responsibility for coordinating all UA activities. 3.08 Appraisal work. UA has progressively improved its appraisal capability. By 1977 UA had already acquired the respect of the financial intermediaries for the high quality of its appraisal work. Financial and administrative aspects of sponsoring enterprises have been thoroughly treated, and have resulted in several cases in programs to restructure or strengthen administrative, personnel or financial management aspects of the firms. 1/ London Interbank's offered rate for 180-day maturity funds.  - 24 - Economic analysis, including employment and balance of payments impacts, have had a sound treatment and provided a firm basis for resource allocation. In addition, UA has had to provide a considerable amount of assistance to enterprises in project formulation, to provide an adequate basis for subsequent appraisal. 3.09 Uruguay's inflationary environment requires a much more detailed and complex financial analysis than is normally the case. Thus, UA's project formulation and appraisal work has proved to be very manpower inten- sive, which has limited its processing capacity. The average subloan has taken between 4 and 8 months for UA to appraise. To channel a larger volume of resources and reach a larger number of enterprises, UA is planning to delegate as much as possible of the work on promotion and project formulation to financial intermediaries. Several intermediaries have indicated their willingness to play a more substantial role in project promotion and formula- tion provided that they receive an adequate spread (para. 3.14) to cover the associated costs. 3.10 Supervision activities. UA's project supervision activities have, so far, consisted mainly of checking whether resources lent were actually used for intended purposes, plus some follow-up on subborrowers whose finan- cial situation was relatively weak. By 1978, 9 out of the 16 subborrowers financed by the Bank loan had required this latter kind of supervision, which still proved to be effective because of the small number of subprojects involved. With the acceleration in the demand for Bank financing since late 1978, however, the need to more clearly define intermediaries' supervision responsibilities and better organize UA's supervision activities became apparent. UA has now established separate units covering promotion, appraisal and supervision, but the supervision unit still remains weak. To strengthen supervision under the proposed project, intermediaries would carry out a periodic follow-up of the enterprises' financial condition. In addition, UA's supervision manuals and guidelines would need to be revised, and its supervision staff increased by at least one professional financial analyst. During negotiations on the proposed project assurances were obtained from the government that such actions would be taken prior June 30, 1981. 3.11 Personnel and salary policies. Inadequate salary levels have led to high turnover of UA's professional staff. Turnover in 1975-79 averaged annually one-fourth of total staff. 1/ Difficulties in recruiting professional staff, particularly engineers, have also been directly related to low salary levels. Upon recommendations of Bank supervision missions, the Ministry of Industry reviewed salary requirements for UA's staff and decided to establish a new salary structure starting on March 1, 1980. The new salary levels, if maintained constant in real terms in the future, appear to be adequate and competitive with salaries for similar positions in the Uruguayan private 1/ While average staff number in 1975-79 amounted to 11.4, annual termina- tions averaged 2.75 (24% of 11.4 staff).  - 25 - sector except in the case of engineers whose salaries are still about 25% below competitive levels. 1/ The government has indicated its intention that the salaries of UA's professional staff, including engineers, would be maintained at adequate levels to permit attracting and maintaining reasonably qualified and experienced staff for carrying out the tasks envisaged under the project. 3.12 Technical assistance by UNDP/UNIDO. Through a UJNDP technical assistance program (URU/75/013), two experienced financial analysts, one industrial engineer/economist, and one market analyst were financed by the UNDP and managed by UNIDO, who have been instrumental in the development of UA's overall technical expertise and training of local staff. Both UNDP and UNIDO have expressed their satisfaction with the results achieved in the first technical assistance program and have recently signed with the government a new contract for a second program to continue providIng assistance to UA through 1981 (Annex 4). Under the new technical assistance program (URU/78/013), UNDP/UNIDO would provide further assistance to UA in subproject appraisal and supervision by conducting periodic seminars for UA personnel and preparing manuals and guidelines. UNDP/UNIDO would provide a total of 144 man-months of expert services to UA, and the total UNDP contribution would amount to US$493,300 over the 1980-81 period. The government's cost-sharing contribu- tion would be an additional US$284,544, of which US$135,000 would be financed through the technical assistance component of the proposed project to cover foreign exchange costs (para. 4.04). D. Participating Intermediaries 3.13 A total of 19 intermediaries (14 commercial banks and 5 casas bancarias) intermediated industrial subloans under FFID in 1975-79 (Annex 3, Table 3.2). The seven most active institutions accounted for 60.3% of total loans approved, with an average participation of 8.6% for each interme- diary and ranging between 6.7% and 12.6% for the least and most active, res- pectively, which indicates the wide and relatively well-distributed share of long-term lending among the various intermediaries. Banking institutions in Uruguay have been competing actively in channeling FFID's long-term subloans, aiming to establish long-term relations with industrial clients. Furthermore, several banks (Panamericano, Real, Pan de Azucar and SURINVEST) are presently interested in establishing the necessary infrastructure and administrative mechanisms to carry out promotional activities by which they would opportunely identify firms willing to carry out new investment projects and help them in the formulation and implementation of such projects. 3.14 Under the proposed project, financial intermediaries would be required to carry out promotional work and project-formulation assistance work. The latter would consist of: (a) helping the industrial clients in preparing adequate terms of reference for consultants, ensuring that project 1/ As determined by the appraisal mission when comparing with salary levels of the private sector, compiled by Price-Waterhouse for the government and reported in March 1979.  - 26 - formulation will be adjusted to UA's guidelines; and (b) follow-up of consul- tants' work during formulation, including review of interim reports to verify coverage and adequacy of treatment of the project's most critical aspects; and (c) reception from the consultants of adequate formulation work that satisfac- torily analyzes the technical, financial and economic aspects of the subprojects. 3.15 Financial intermediaries would be required to sign Participation Agreements with BCU that establish their responsibilities for intermediating IDF resources. The contents of such agreements were agreed upon during loan negotiations, and the signing of agreements with at least two inter- mediaries will be required for effectiveness. Intermediaries would be required by the participation agreement to: (i) observe all the IDF's poli- cies and regulations; (ii) promote financing by IDF; (iii) give their approval in principle, subject to approval by the Coordinating Committee, to the subprojects and subloans before their submission to UA; (iv) ensure that the financial resources proposed to finance the subprojects are sufficient to meet the actual requirements of those subprojects, including contingencies; (v) supervise the correct use of the funds by the subborrower and the general functioning of the beneficiary company, without prejudice to supervision by UA or BCU; (vi) issue periodic reports on the progress of the subprojects financed, noting any irregularity detected; (vii) keep proper records of the subloans financed out of IDF resources; (viii) comply with all reasonable requests for information from IDF; (ix) comply with IDF's terms of financing and repayment on each subloan, even if the final borrowers have not met their financial obligations to the intermediary when due; (x) pay into IDF immediately all advance payments received from the subborrowers; and (xi) provide guidance to the customers in preparing and monitoring pre-investment studies needed for subproject preparation and liaison and coordination with UA in the formulation, processing and monitoring of the subprojects. E. The Guarantee Fund 3.16 Under the Bank's first project, the BCU also established a Guarantee Fund (GF) that, for a one-time 2.5% fee, covered 65% of the subloan amounts to the participating intermediaries in case of default by final borrowers. In the five-years period 1975-79, only one subloan defaulted under the system. The GF played a useful role in inducing intermediaries to become involved for the first time in long-term operations, without excessively increasing their collateral requirements to subborrowers. It was a prerequisite of the GF that collateral value would not exceed 200% of the original subloan amounts. In 1979, the BCU broadened the GF to cover any intermediary's loan with terms above 2 years, and in addition increased the coverage percentage from 65% to 75%. As a result, the GF has received many requests for all types of loans, mainly mortgage loans by the Mortgage Bank. While the risk for the GF could have been increased since FFID's requirement that loans be appraised was eliminated, on the other hand, risks to the GF have been diversified by increasing the number of covered loans and by allowing different types of loans to be covered. During the preparation and appraisal of the proposed project, the need for maintaining the GF was thoroughly analyzed with the BCU, which finally concluded that it should be maintained, to continue its role for inducing financial intermediaries to engage in long-term operations. Thus, assurances were obtained from the government that the GF will be maintained at least during the disbursement period of the proposed loan, including the feature that portions of the loans that are guaranteed by the GF will be excluded by BCU in the calculation of the debt/equity ratio of banks and casas bancarias (para. 2.09).  - 27 - IV. THE PROJECT A. Objectives of the Proposed Project 4.01 AL