Ecuador - Small Scale Enterprise Credit Project

Document of F L L E CCO P Y The World Bank FOR OFFICIAL USE ONLY Report No. 2941-EC ECUADOR STAFF APPRAISAL REPORT SMALL SCALE ENTERPRISE CREDIT PROJECT May 23, 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.  CURRENCY EQUIVALENTS Currency Unit = Sucre (S/) Calendar 1979 March 31, 1980 US$1 = S/25 S/25 S/1 = US$0.04 US$0.04 FISCAL YEAR January 1 to December 31 LIST OF ACRONYMS BNF Banco Nacional de Fomento (National Development Bank) CBE Banco Central del Ecuador (Central Bank of Ecuador) CENAPIA Centro Nacional de Promoci6n de la Pequefia Industria y Artesania (National Center for Small Industry and Artisan Promotion) CENDES Centro de Desarrollo Industrial del Ecuador (Center for Industrial Development) CFN Corporaci6n Financiera Nacional (National Finance Corporation) FCPI Federaci6n de Camaras de la Pequenia Industria (Federation of Small Industry Association) JM Junta Monetaria del Ecuador (Monetary Council of Ecuador) MICEI Ministerio de Industrias, Comercio e Integraci6n (Ministry of Industry, Commerce and Integration) MFF Mecanismo de Fondos Financieros (Financial Funds Mechanism) SSE Small Scale Enterprise TCC Technical Cooperation Committee  FOR OFFICIAL USi ONJY ECUADOR STAFF APPRAISAL REPORT SMALL SCALE ENTERPRISE CREDIT PROJECT TABLE OF CONTENTS Page No. I. THE INDUSTRIAL SECTOR . ......................... ....... . I A. The Economic Setting .. ..... ....... ........ . 1 B. Manufacturing and the Small Scale Enterprise Sector 1 Growth and Structure of Manufacturing ........ .. .... 1 Industrial Policy * * ...........................**. . . . * * . 2 Small Scale Enterprises .......................*.. 3 Government Support of Small Scale Enterprises ..... 6 Technical Assistance to Small Scale Enterprises ... 7 C. Outlook and Prospects for SSE ........ ............. 8 II. THE FINANCIAL SYSTEM .... .o..-.o.. . . . .. ..- - .....*.*. . . . . . 9 A. Banking System . ................................... 9 Central Bank of Ecuador ...... * ... ....... . . . . . *. . . . 9 National Development Bank (BNF) ................o. 10 Commercial Banks (CBs) . ..................*. 11 Corporacion Financiera National (CFN) * ............ 13 Private Financieras (DFCs) ................. to 15 Interest Rates and Commissions .................... 16 B. Mobilization of Resources ...................... 18 Deposits ..........o................... oo...... oo ..o ....... o. 18 Credit ........................................... 18 Other Resources ... ..o.*.o ...................... . 19 C. The Financing of Industry ..... .................... 19 Financing of SSE ..... ...................... * . 20 This report is based on the findings of a mission composed of Messrs. M. Stoller, T. Hutcheson and J. Calderon-Rossell of the Industrial Development and Finance Division, LAC Regional Office which visited Ecuador during October/November 1979 and January/February 1980. 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.  TABLE OF CONTENTS (Continued) Page No. III. THE PROPOSED PROJECT . ............................... ... 22 A. Project Objectives and Institutional Structure .... 22 Background .................*...................... 22 Project Objectives ............. ................... 24 Institutional Structure ................. . .......... 24 B. The Fund for Development of Small Scale Industry and Artisans (FUND) ... .......................... 25 Establishment, Policies and Operating Regulations.. 25 Subproject Appraisal and Supervision .............. 31 Training .* ........................................ 32 Financial Structure ............................... 32 Projected Financial Results .... ................... 33 C. Potential Intermediary Institutions . .............. 34 D. Technical Assistance .............................. 34 IV. THE PROPOSED LOAN ...... ................................ 36 A. General Description ..... .......................... 36 Amounts and Terms . ............... . .36 Maximum Size of Subloan and Free Limit .... ........ 37 Procurement ....................................... 37 Commitment and Disbursement ....................... 37 Accounting and Auditing ........................... 38 B. Project Benefits and Risks ........................ 38 V. AGREEMENTS AND RECOMMENDATIONS ......................... 39  TABLE OF CONTENTS (Continued) Page No. ANNEXES (Continued) 1. Agreement between Central Bank of Ecuador and the Corporacion Financiera Nacional, March 18, 1980 2. Table 1 - Industrial Output, Employment and Productivity Table 2 - Industrial Structure Table 3 - Minimum Wages Table 4 - Financing of Small Scale Industry Table 5 - Sources of Total Credit (1970-78) Table 6 - Distribution of Credit by Institution and Sector (1978) Table 7 - Sources of Credit to SSE (1973-78) Table 8 - Distribution of Loans by Subloan Size Table 9 - SSE FUND: Estimated Balance Sheet Table 10 - SSE FUND: Statement of Estimated Sources and Uses of Funds Table 11 - SSE FUND: Estimated Results of Operations Table 12 - SSE FUND: Total Commitments and Distribution Table 13 - SSE FUND: Estimated Schedule of Disbursements Table 14 - SSE FUND: Expected Distribution by Sector, Jobs Created and Cost per Job Table 15 - SSE FUND: Proposed Schedule of Interest Rates and Financial Spreads 3. Selected Documents and Data Available in the Project File MAP  I. THE INDUSTRIAL SECTOR A. The Economic Setting 1/ 1.01 The Ecuadorian economy has since 1960 changed from a predominantly agricultural society in which about 70% of the population lived in rural areas to a more urban society in which 45% of the estimated 8.0 million current population are living in cities. The transformation of the economy was fueled by a high GDP growth averaging 5.5% p.a. in 1960-70. The main growth factors were the petroleum sector and industry, where a rapid import substitution process occurred. Although data are weak, it appears that agriculture was practically stagnant during that period. 1.02 The picture changed dramatically in the 70s. During 1970-79, economic growth accelerated to almost 8% p.a., boosted by the rapid exploita- tion of oil resources from 1972 onwards and per capita income reached US$960 in 1979. All economic sectors expanded substantially, including agriculture, which grew by 3.9% p.a. during that period. While Ecuador's oil-induced boom has been coming to a close, economic growth in 1979 was still 5.0%, and the growth perspectives in the medium- and long-term are good. For this potential to be realized, constraints should be removed and incentives to use resources more efficiently should be implemented. The most obvious measure is that of raising domestic prices of petroleum and its products, which are currently far below international prices. This would provide the Government with sufficient revenues to resume a high rate of oil exploration activities. Agriculture should be able to meet the growing domestic demand for food products and agroindustrial inputs, and to provide a substantial surplus for export. Meanwhile, industry needs to shift its resource use more toward labor and domestic raw materials. B. Manufacturing and the Small Scale Enterprise Sector Growth and Structure of Manufacturing 1.03 In line with overall economic expansion, industrial growth was high during the 1970s and accelerated in recent years. Manufacturing value added growth averaged almost 10% p.a. (measured in 1970 prices) and was substan- tially above GDP growth after 1975. Virtually all subsectors participated in this expansion, stimulated by fast growth of incomes, a favorable investment climate and, to a certain extent, the emergence of the Andean Common Market. Industry's share in GDP rose from 17.3% to 20.3% during 1970-79 but when oil is excluded from GDP, the share of industry shows an increase from 17.5% to 21.6%. The sector's contribution to employment is substantial, with about 340,000 industrial jobs accounting for about 13-15% of the total labor force. l A detailed discussion of the Ecuadorian economy and of its manufacturing sector is available in the report "Ecuador: Development Problems arnd Prospects" (Report No. 2373-EC) of June 18, 1979, on which this section is based.  - 2 - 1.04 Despite its rapid growth, the structure of manufacturing remains at a relatively early stage of development. Traditional activities such as food processing, textiles and wood processing accounted for about 51% of value added in 1977. The share of consumer goods in manufacturing value added increased slightly during 1970-77 whereas that of intermediate goods declined and the small share of capital goods remained unchanged. Industrial exports experienced a remarkable increase from less than US$20.0 million in 1970, to about US$290.0 million in 1977, when they accounted for about 10% of the gross manufacturing output and nearly 21% of total exports. While two-thirds of the increase in industrial exports was due to substitution of processed cocoa for raw cocoa exports, fish products, wood products and electrical appliances also achieved important increases. Industrial Policy 1.05 The Government has stimulated industrial development through fiscal investment incentives, tariff protection and, to a lesser extent, export promotion. Fiscal incentives include import duty exemptions or rebates for capital goods and intermediate products and partial income tax exemptions for reinvested profits. Fiscal incentives are higher for firms located outside the two main urban areas (Quito and Guayaquil) and for firms classi- fied under a List for Special Investments (LID). Industrial protection is mainly granted through the tariff system; the use of quantitative controls on imports has been restricted but Government entities and firms receiving fiscal incentives are expected to 'buy local' insofar as the goods required are domestically produced. Nominal tariff rates are moderate (from zero to 20-30%) for machinery and equipment and raw materials, but higher on consumer goods (mostly in the 50-70% range but much higher for some products, e.g. auto- mobiles). Also, a 30% surcharge is levied on imports of non-essential consumer goods and of some industrial inputs produced locally. 1.06 Export promotion policies emerged in the early 1970s. Exports other than agricultural raw materials and crude petroleum receive a tax credit ranging from 7-15% of the FOB value of exports, and firms in the LID receive an additional 3% export tax credit. The Government established also special export financing facilities for pre- and post-shipment financing and a temporary admission system for exporters. 1.07 Industrial investment partly induced through fiscal incentives and protection has made a significant contribution to industrial growth, modern- ization and diversification, but the incentives have also stimulated capital- and import-intensive forms of production, and the emergence of oligopolistic structures, mainly in import-substituting industries. On the other hand, export incentiv%s, with the exception of cocoa processing, have not been excessive and do not appear to go beyond mitigating the cost disadvantages sustained by Ecuadorian producers. However, the criteria used for allocating the export incentives has resulted in the bulk of export tax credits going to semi-processed goods and goods exported to the Andean Common Market (where they are duty-exempt) whereas newly exported products to third markets have received little or no incentive.  1.08 The Government is currently in the process of modifying industriaL incentives, tying them to criteria such as generation of value added, linkages with the rest of the economy, foreign exchange earnings or savings, and the composition of ownership of industrial firms, among others. The intended modifications will remove some of the shortcomings of the existing system but others will remain to be tackled. The Government might consider in this context restricting import duty reductions for capital goods and intermediate products, granting special incentives for employment expansion and for in- creased use of domestic raw materials, and providing relatively larger incen- tives to small scale firms. Small Scale Enterprises 1.09 Definition. Under the proposed Bank loan, Small Scale Enterprise (SSE) will be defined as firms engaged in industrial, services, touristic and commercial activities, as well as fishing and forestry operations, with assets of less than S/8.75 million excluding land and buildings. However, statistical data in Ecuador are not available for firms classified by asset size as above. Therefore, most of the information used in this report refers to 'small scale industries and artisan workshops' as defined in the annual survey of manufac- turing (firms employing less than 7 persons) or to 'registered small scale industry' as defined under the industrial incentive laws. 1/ 1.10 The information above has also been complemented with data from a recent survey of 555 firms located in and around Quito (Pichincha Survey). The Pichincha Survey offers an insight into the average size and structure of SSE as defined under the proposed Bank loan. Average employment per firm was eleven persons and average gross output was S/4.2 million in 1977. The firms had average assets of S/1.4 million (at estimated 1977 replacement cost) with an investment cost per job of US$5,200 (in 1977 prices). 1.11 Size and number of firms. There are an estimated 35,000-40,000 small scale industries and artisan workshops in Ecuador and only about 1,700 factory firms. 2/ The average size of factory firms is also small as in 1978 only 175 firms employed more than 100 persons and a mere 15 firms had more than 500 employees. Average employment in factory firms increased from 49 in 1970 to 56 employees in 1977. The size structure of Ecuadorian firms reflects the early stage of development of the manufacturing sector, with a small segment of modern import-substituting firms superimposed on a traditional sector where small firms prevail. 1/ Small scale industry is legally defined in Ecuador as firms with up to S/5.0 million in fixed assets excluding land and buildings. In practice a criterion of S/5.0 million in capital is sometimes used by the authori- ties who are currently considering changing the asset size limit to about S/9.0 million. 2/ Firms employing 7 or more persons.  - 4 - 1.12 During the 1970-1978 period, the number of both factory and small scale firms increased substantially as about 600 firms graduated into the factory category and an estimated 9,000 new small firms were established. The growth in the number of firms reflects: (i) the increasing urbanization and the growth in the size of the market; (ii) the vitality of the small enter- preneurial class in responding to available opportunities; and (iii) growing income levels resulting in growing and more diversified demand. 1.13 Output and employment. Small scale industries and artisan work- shops provided about 250,000 jobs in 1978, 75% of total industrial employ- ment and about one-third of industrial value added (Annex 2, Table 1). They are particularly important in wood processing, chemicals, printing, clothing and small metal products, whereas larger firms are more concentrated in the food and beverages, textiles and electro-mechanical subsectors where larger than average investments and technologically advanced processes may be neces- sary (Annex 2, Table 2). Small scale firms produce mainly consumer goods in the lower price and quality ranges. Thus, the Pichincha Survey found that only 18% of the respondents sold to other industries and practically none sold abroad. In order to grow in an increasingly sophisticated internal market, and to be able to participate more actively in the export markets (including the Andean Group countries) both directly and through subcontracting, small scale firms would need to improve product design and quality and to acquire other technical and marketing skills through increased technical assistance (para. 3.31) and financial resources. 1.14 Investment and productivity. In 1978, average annual output per employee was about S/227,500 in the factory firms and S/87,500 in small scale industries (as legally defined) applying for SSE benefits. 1/ Higher labor productivity in larger firms was associated with higher investment costs per job of about S/575,000 (US$23,000) compared to S/217,500 (TS$8,700) in small scale industries. Therefore, the ratio between capital cost per job and output per job (capital/output ratio) was similar (about 2.5) in the two groups of firms. During the 1970-1978 period, annual output per employee grew at a very high 5.4% p.a. in firms with less than 7 employees and at a satisfactory but lower 3% p.a. in factory firms. These high rates of productivity growth reflect the effect of: (i) growing demand; (ii) increasing use of installed capacity; (iii) improved technology; and (iv) increases in education, health and skill levels of the labor force. 1.15 Labor costs. Labor costs in factory firms in Ecuador increased at about 1% p.a. in constant S/ terms during 1970-74, below the 3% p.a. growth in productivity. However, since 1975, labor cost increases were 7.5% p.a. thus exceeding productivity growth, While no similar data exist on labor costs in small industries and artisan workshops, their higher productivity growth during the 1970-78 period probably kept pace with rising labor costs. 1/ The corresponding figure for small industries and artisan workshops of less than 7 employees was only about S/35,000.  -5- 1.16 In January 1980, minimum wages were raised by 100% for employees of larger firms, 50% for small scale industry and 58% for artisan workshops (Annex 2, Table 3). The impact of increased minimum wages is likely to be felt differently depending upon the firms' annual output per worker, produc- tivity growth and percentage of workers earning minimum wages. While the increase is higher in larger firms, the small proportion of workers earning minimum wages and the high output per employee (the new minimum wage would be equal to 23% of average output per employee) will cushion the impact of wage increases. On the other hand, after the wage increases, minimum wages would increase from 47% of average output per worker (in 1979) to 60% in the case of small firms, and from about 75% to 100% of the output per worker in artisan workshops. While enforcement of the new wage scale is expected to take place gradually, the increased wages will partly be translated into price increases (inflation is now expected to be about 15% in 1980 1/), whereas some firms will suffer a profit squeeze. 1.17 Location. Industrial activity is heavily concentrated in and around the cities of Quito and Guayaquil which together account for 78% of the total number of industrial firms, 79% of employment and 81% of output. Small scale industry and artisan workshops follow this pattern but they are less concentrated, with only 60% of the firms, accounting for 65% of employ- ment and 68% of output, in the two provinces. In recent years small firms have tended to decentralize even further as indicated by the fact that almost half of the new firms applying for small scale industry incentives are located outside the Quito and Guayaquil areas. 1.18 Financing. One of the most serious problems faced by small scale industry and artisans has traditionally been the lack of adequate credit, especially long-term financing. Given the overall structure of interest rates in Ecuador (para. 2.18) with ceilings on lending rates and unattractive deposit rates, small scale firms continue to be at a disadvantage compared with larger firms that provide commercial banks with profitable collateral business (e.g. letters of credit, guarantees and other commissionable opera- tions). Of all firms included in the Pichincha Survey, only 59% received short-term credit during 1979 whereas 70% resorted to some form of self-finan- cing to meet credit needs. This relatively low access to credit is documented by the Survey which reports that the debt to equity ratio of the reporting SSE was a low 0.5 to 1 compared with 1.7 to I for medium and large firms (para. 2.27). Only 12% of the total credit received by the firms in the survey was long-term credit, and most of it went to the relatively larger firms 2/ (paras. 2.25 and 2.26). Nearly one half of the term credit was provided by private banks and financieras, about 45% came from Banco Nacional de Fomento (BNF) and the remaining 5% from family and friends. The average long-term 1/ Initially estimated as 20% for 1980; the monetary authorities recently reported that the inflationary impacts of wage increases had been less than anticipated. 2/ This credit was highly concentrated in textiles, garments and metal products, and only 14 of the 22 sectors received any term credit.  -6- loan was for about US$85,000, substantially above the expected average sub- loan in the proposed project (Annex 2, Table 8). The firms reported the usual difficulties in furnishing adequate guarantees and providing the required financial information to the banks. Government Support of Small Scale Enterprises 1.19 Promotion of small scale enterprises ranks high in the Government's stated industrial strategy. The current five-year plan (1980-84) projects an average sector growth of 9.7% p.a., above the actual growth of 8.5% p.a. during the 1970-78 period. Also, the plan calls for the generation of 72,500 new jobs during the next five years, compared to the actual creation of between 35,000 - 45,000 jobs during 1970-78. The above projections appear to be overly optimistic, particularly with respect to employment generation, given the limitation of financial resources 1/ and of skilled and semi-skilled labor. 1.20 Major fiscal incentives offered to small scale enterprises include: (i) duty-free imports of capital goods and intermediate inputs not produced domestically; (ii) exemption from numerous small 'nuisance' taxes; (iii) exemption from property transfer taxes; and (iv) income tax exemptions for reinvested profits. In addition, the Government 2/ has been developing and leasing industrial parks for small scale enterprises, to facilitate their access to guaranteed energy sources and water, transport facilities and technical assistance services. 1.21 Nominal tariff protection for most small scale industry products is relatively high (in the 50-70% range) and, in addition, import duty re- ductions or exemptions on inputs tend to make available effective protection even higher. However, it appears that only a portion of the available pro- tection is actually used, as only 2,500 firms have registered with the Ministry of Industry, Commerce and Integration (MICEI) to benefit from the incentives granted by the small scale industry law. 3/ Also, many small scale enter- prises produce non-traded goods for a narrow segment of the local market, whereas the large number of firms and competition between them contributes to avoiding or reducing the potential inefficiencies allowed by the tariff structure. 1.22 Additional benefits offered to firms located outside the Quito and Guayaquil areas are only marginally higher than those offered in the two industrial provinces. Therefore, the lower concentration of small scale firms in Quito and Guayaquil should be attributed to other reasons, particularly higher orientation to small local markets. Overall, it appears that small scale firms take relatively little advantage of the existing set of incentives, as they have very small direct imports and small tax liabilities. 1/ The investment required to generate such employment would be about US$145.0 to US$155.0 million p.a. 2/ Through the Industrial Development Corporation (CENDES). 3/ Compared to more than 6,000 firms belonging to the regional small indus- try associations and to an estimated 35,000 to 40,000 small scale firms and artisan workshops in operation.  - 7 - Technical Assistance to Small Scale Enterprises 1.23 While the Government and private sector industrial associations have provided in the past a wide variety of technical assistance services to help improve SSE opportunities, efforts are thin, scattered and generally uncoordinated. 1/ The main organizations reaching SSE are the small scale industrialist associations (Asociacion de Pequenos Industriales) located in every province and coordinated by a Federation headquartered in Quito, and the National Center for Promotion of Small Industry and Artisans (CENAPIA) established in 1975 as a dependency of MICEI to support firms registered under the SSE and artisan incentive laws. 1.24 The associations are private institutions supported by membership dues but with official status. Membership in an association is obligatory for SSE wishing to register for incentive law benefits or to obtain SSE credits through BNF. The provincial associations have mainly focused on providing assistance to SSE in the preparation of applications for registra- tion and in dealing with Government ministries. Provincial offices, though lightly staffed are anxious to expand the services to their membership and appear to be logical centers around which SSE training and self-help initia- tives could be organized. While the Federation provided limited assistance in the past, it has recently changed its leadership and staff and has been taking a more aggressive role in development of SSE programs, including providing for some research on the needs of the sector. 1.25 CENAPIA's function is to promote the development and expansion of the SSE, encouraging geographic diversification and fostering the creation of new industrial centers in less developed regions of the country. To achieve its objective, CENAPIA provides seminars and courses to improve the managerial capabilities of SSE, extension services to improve in-plant production, marketing, accounting and management capability, preparation of industrial feasibility studies and assistance to SSE in preparation of credit and incentive program applications. In addition to its general program of assistance to SSE, CENAPIA currently provides support to the artisan program funded by the Inter-American Development Bank (IDB), appraises agroindustrial projects under the Bank Agricultural Credit Loan 1459-EC and is expected to play an important role in the credit component of the Bank's Guayaquil Urban Project. CENAPIA is clearly over-committed since all of these activities are currently being attempted with a total staff of about 50, of which only about 26 are professionals, mainly engaged in technical assistance activities. CENAPIA's small staff is spread over its headquarters in Quito and in seven regional offices. 1/ Reports by J.P. Allchin (Consultant), December 4, 1978; H.A. Molina (UNIDO), March 8, 1979 which are available in the project file, examine in detail the characteristics of Ecuador's SSE sector and the nature and quality of technical assistance services available to SSE. The UNDP is currently implementing a US$1.6 million program designed to upgrade technical assistance, especially to SSE metal mechanic trades which would be involved in subcontracting operations with Andean Pact industries.  - 8 - 1.26 Private consulting organizations have to date played only a small role in providing technical or managerial consulting services to SSE despite the fact that a pool of skilled, experienced professional capability exists and would be willing to assist small firms to solve detailed project planning or operating problems. While CENAPIA has indicated its willingness to help develop mechanisms for using available private consulting resources, the small scale enterprise fund to be created under the proposed project (see para. 4.01) could provide grants both to CENAPIA and to provincial associations and loans (para. 3.31) to small firms in order to finance the use of private consultants for project preparation and implementation. C. Outlook and Prospects for Small Scale Enterprises 1.27 One of the Government's major objectives in the 1980-84 period is accelerated industrial development to enhance the sector's contribution to output and employment and to strengthen the balance of payments. The strategy also calls for industry to replace petroleum as the leading sector in the economy. Attaining these goals would require development efforts based on intensified utilization of Ecuador's available natural resources in agricul- ture, fisheries, forestry and non-metallic minerals. Industrial policy should aim at improving the productive structure of the sector, removing price distortions in factor and product markets and improving the skill level of the labor force through appropriate training. While small scale enterprises have been assigned the task of providing employment on a unrealistically large scale in the 1980-84 development plan (para. 1.19), and some of the plan's targets may not be achievable, small enterprises can nevertheless make an important contribution within the limitations of available financial and human resources. 1.28 Development of the small enterprise sector will be subject to con- tradictory forces over the next several years. With higher minimum wages, a higher portion of investment would be allocated to capital goods and, in the short run, less would be devoted to working capital, inventory and other inputs which lead more directly to expanded output. Rising minimum wages could also cut deeper into profit margins of the relatively labor intensive small firms. Both small and large firms are likely to adjust to changes in factor-price ratios through: (i) increased mechanization; (ii) more sparing use of non-critical employees; and (iii) increased subcontracting and/or use of part-time and non-regular employees. On the other hand, with high overall growth in domestic demand (at least 7% p.a.) as a result of near full employment and growing incomes, total industrial output should be able to grow at about 10% p.a. If sustained over a five year period, such industrial growth rates would result in industry's share of GDP rising from 20% to 23%, fulfilling some of the Government's sectoral objectives. 1.29 The above sectoral growth would imply a growth rate of 8% to 9% p.a. for small scale firms, reflecting their ability to meet the growing domestic demand and their possible participation in exports arising from sectoral development programs in the Andean Market. Finally, SSE growth could further accelerate if: (i) the new Government's socially oriented programs achieve some income redistribution effects in favor of the urban and rural lower middle class; (ii) the differential minimum wage rates in favor of SSE improve their competitive position vis-a-vis the larger firms; and (iii) the Government continues its efforts to solve the infrastructure problems faced by smaller enterprises.  - 9 - IT. THE FINANCIAL SYSTEM A. Banking System 2.01 The financial system in Ecuador is comprised of the Central Bank of Ecuador (CBE), 29 commercial banks and the National Development Bank (BNF) and two specialized public sector banking institutions, namely the National Housing Bank and the Ecuadorian Development Bank, which serves to channel resources to selected public sector projects and to municipalities. In addition, the system has 11 savings and loan associations (asociaciones mutualistas), a cooperative bank, ten development finance companies, of which the publicly owned Corporacion Financiera Nacional - Comision de Valores (CFN), is the largest and 53 specialized financial institutions, mostly insurance companies and foreign exchange houses. The CBE, BNF, CFN, commercial banks (CBs) and financieras (DFCs) are presently involved in channelling funds to small scale industry and artisans. While financial institutions have concentrated almost half their offices, branches and agencies in the Guayas and Pichincha provinces, a substantial network of commercial banks and BNF branches and agencies have in recent years been opened in towns and larger villages around the country. Moreover, regional commercial banks are becoming more aggressive and are expanding on a national scale. 2.02 Banking, until recently a restricted, traditional and non- competitive activity, is currently undergoing change (para. 2.08) and several modern and aggressive commercial banks have emerged to compete for shares of the market. Price competition is inhibited by the structure of fixed interest rates, commissions and fees established by the monetary authorities and by the substantial illiquidity in the financial system. However, non-price competition does exist for available deposits and several major banks (e.g., Banco del Pacifico 1/, Banco Popular, Filanbanco and the Banco de Pichincha) have been aggressively seeking to expand short-term lending operations to SSE in keeping with the Monetary Council (MC) requirements that commercial banks maintain a fixed percentage of their portfolios in loans to the productive sectors and to support their expanding branch banking activities. Central Bank of Ecuador (CBE) 2.03 The CBE was established in 1927 as the Government's fiscal and financial agent with responsibility for implementing monetary and financial policies formulated by the MC. 2/ The main policy instruments regularly used 1/ Banco del Pacifico has developed a lending program to small artisans and commercial and services enterprise in Guayaquil which will serve to chan- nel US$3.0 million in Bank resources under the Guayaquil Urban Project. 2/ Charged with formulating the monetary policies of the country, deter- mining levels of interest rate, CBE credit, minimum reserve requirements, import deposits and a variety of other factors affecting the balance sheets of financial intermediaries. The Monetary Board is composed of 11 members, consisting of a Chairman appointed by the President of the Republic, Ministers of Finance, Agriculture, Industry, Commerce and Integration and Natural Resources and Energy, a representative of the National Development Council, and representatives of Sierra and Coast Chambers of Industry and Commerce, commercial banks, the General Manager of CBE and the Superintendent of Banks.  - 10 - by the CBE are: (i) bank reserve requirements (currently 31% on demand deposits and 12% on savings accounts); (ii) periodic setting of ceilings on bank credit operations (recently lifted); (iii) operation of rediscount credit lines (Annex 2, Table 6); (iv) open market operations (CBE securities including foreign-currency denominated bonds now account for about 50% of total stock exchange transactions); (v) prior import deposits; and (v) official interven- tion in the foreign exchange market. To ensure that a proportion of the available supply of resources moves to priority areas such as agriculture and SSE and to encourage financial intermediaries to participate in these more difficult lending operations, the CBE provides rediscount facilities for both short-term and longer term development credit to these sectors through the Financial Fund Mechanism (MFF) (para. 2.23) a discount window which was established in the CBE and is administered by its Operations Department. National Development Bank (BNF) 2.04 With assets of about S/20,400 million as of December 31, 1978, BNF is the largest bank in Ecuador accounting for about 9% of total credit (about S/50,000 million in 1978), and is the major source of credit for agriculture and for SSE. Founded in 1964 and wholly Government-owned, BNF's total loan portfolio was S/9,680 million at the end of 1978 while investments (largely in organizations producing farm inputs) were about S/1,270 million. 1/ In 1978 through its network of 72 offices, branches and agencies, BNF extended S/3,275 million in credit to agriculture and S/750 million in mainly short-term credit to SSE which accounted for about 75% and 18% respectively of BNF lending. Reflecting its mainly agricultural lending orientation, poor administration and collection procedures, the quality of BNF's loan portfolio is very low and arrears amount to a reported 19% of total portfolio. 2/ Actual arrears, however, are reported to be closer to 30% of portfolio as a substantial volume of development accounts are annually refinanced. 2.05 In August 1979, the new Government appointed a General Manager for BNF who has recently been attacking problems of administration and financial management 3/ and aims over the course of the next several years to improve the quality and efficiency of its lending and loan recovery operations. BNF's main financial problem remains its limited capacity to expand its resource base which in the recent past had depended firstly, on CBE's rediscount operations which has provided BNF with 35% of its total resources 1/ Currently, BNF is in the process of divesting itself of some of these investments. 2/ 1978 Annual Report of Superintendency of Banks. 3/ BNF has at the request of the Bank recently produced its first ever five-year cash flow plan. Provided for are a substantial program of portfolio recovery, portfolio write-offs and a realistic level of lending which might result in less dependence on continued Government contribution.  - 11 - and most of its profitable operations (CBE rediscounts BNF's loans at 3%) and secondly, on the Government's capital contributions (e.g., US$65.0 million in 1977-78). With the negative spreads between BNF's lending rates of 8%, 9% and 11% and recent LIBOR borrowing rates (16.5%) widened, the new Government has refused to assume additional LIBOR obligations on behalf of BNF. 1/ Thus, BNF's new administration has been actively seeking long-term development resources and for the first time in recent history, with approval of the MC, has taken steps to adjust interest rates upward. The KfW has recently granted BNF DM25.0 million loan to finance SSE projects, under which BNF would onlend at not less than 11% p.a. 2.06 Given its substantial network of branches and contact with small industry and artisans, it is expected that BNF would be a major channel for Bank resources under the proposed loan. During 1976-79 BNF had granted on average about 4,600 new loans p.a. to SSE averaging a low S/107,500 (US$4,300 equivalent) per loan of which only about 15% were long term. While substan- tial delays in BNF's loan approval procedures occurred in the past, BNF's management has reported that loan processing and review operations have been simplified and would be further improved. Its staff of about 2,300 has been mainly concerned with agricultural lending operations. Nevertheless, BNF also provides limited technical assistance to SSE, supplementing in some degree the efforts of the national SSE technical assistance agency, CENAPIA (para. 1.25). Commercial Banks (CBs) 2.07 The 29 commercial banks (five of which are foreign-owned) form the core of Ecuador's financial system. 2/ As of December 31, 1978, with assets of about S/59,000 million, they held almost 82% of the private finan- cial system's total resources and accounted for 66% of both total private bank credit and total loans to SSE. In 1978 commercial banks loaned S/9,364 million to industry with the average loan size a low S/305,000 (US$12,183 equivalent) reflecting the relatively small size of most Ecuadorian enter- prises (para. 1.11). Commercial bank industrial loans which accounted for almost 30% of total commercial bank lending were mainly short-term with less than 1% of loan operations and 6.4% of total amounts of credit for periods of more than five years (Table 2.1). Short-term lending is encouraged by the fixed structure of interest rates and by the relatively short-term (up to 24 months) for which MFF rediscounts are granted. 1/ During 1977-78 the Government assumed US$65 million in LIBOR obligations on behalf of BNF. 2/ The structure of the credit system is changing as financieras have reduced commercial banks' share of the credit market by about 10 per- centage points since 1970.  - 12 - Table 2.1: Commercial Banking System - Terms of Credit Granted in 1978 Amount in Loan Terms No. of Loans % S/ millions % Less than 90 days 73,180 31.0 6,796 23 90 to 180 140,046 59.3 16,233 55 180 to 365 16,129 6.8 3,269 11.1 1 to 5 yrs. 5,045 2.1 1,324 4.5 5 yrs. and over 1,921 .8 1,893 6.4 Total 236,321 100.0 29,513 100.0 Source: Superintendency of Banks 2.08 Several large traditional banks, the largest and most important of which the Banco del Pichincha, Banco de Guayaquil and Banco de Descuento, had for years dominated Ecuador's banking activities. In the past five years, reflecting the monetary authorities' efforts to expand the financial sector and the emergence of several competitive banks, the commercial banking system has been altered from its traditional mold giving it a broader base, an enlarged clientele and improved geographic spread. 1/ As a result, in recent years the traditional banks have been overtaken by the Banco del Pacifico (since 1979 the largest in terms of assets in Ecuador) while Filanbanco and Banco Popular have also gained substantial shares of the market. Perhaps more important has been the substantial growth of smaller banks, whose shares of domestic lending activity has increased. 2/ 2.09 The results of changes in the banking system have been significant. The more aggressive banks are reaching for newer types of lending oppor- tunities (e.g., consumer credit and SSE lending) that have in the past not been well served. Particularly relevant is the Banco del Pacifico's (BP) loan program that is oriented toward assisting artisan and small service enter- prise. Under this program BP lends SSE up to S/50,000 for working capital and/or fixed assets mainly based on personal signatures and a co-signer's affirmation. It is anticipated that Banco Popular, Banco del Pichincha, and Filanbanco will expand their activities in the consumer and SSE fields and that the aggressive regional banks (e.g., Banco del Azuay, Banco del Amazonas, and Banco del Austro) will respond to the competitive pressures of the major banks and expand short-term lending services to SSE. This group of banks would move toward longer term lending if resources were made available. 1/ About 150 new bank branches and agencies were opened during 1973-78. 2/ The five major banks had about two-thirds of assets and about 45% of total lending operations in 1978.  - 13 - Corporacion Financiera National (CFN) 2.10 CFN is the oldest and the largest financiera in the country. Wholly owned by the Government, its nine-member Board of Directors contains seven ministers of State and two private sector representatives ensuring that, though autonomous, its overall policies and operations are in accord with the Government's development strategy. As of December 31, 1979 CFN's total resources amounted to S/6,651 million, with equity equal to S/1,164 million. CFN's loan portfolio amounted to S/4,978 million and its investments in major industrial and agroindustrial projects were S/1,053.9 million. In addition to its substantial short-term operations, CFN remains the major source of medium- and long-term credit for the industrial sector (53.9% of 1978 credit). In 1978 almost 57% of CFN's total credit operations (S/2,339.5 million) went to industry. Its second major lending area was the financing of exports. Since 1972, CFN has been increasing its operations in export sector lending to both producers and distributors. 2.11 CFN's SSE Lending. In 1964 CFN established a rediscount facility (FUND) to finance working capital and fixed assets of SSE loans made by other financial institutions. Total volume of activity by the FUND has been rela- tively low and total assets as of December 31, 1978 equalled about S/105 million. 1/ In 1978 the FUND rediscounted a total of S/40.4 million in SSE loans (66% were for financing fixed assets). CFN's discount rate for partici- pating intermediaries other than BNF was 5% and BNF, which used 80% of the redis- count facility's resources, paid 3%. Maximum term of SSE loans made under the FUND regulations was ten years, including three years of grace with an interest rate of 9% to final borrowers. The average loan made was for five years and amounted to S/163,278 (US$6,530 equivalent). CFN's maximum rediscount opera- tion per client is currently S/1.0 million (US$40,000 equivalent) which is by regulation equal to 1% of the total resources available to the FUND. Operation of the FUND is currently carried out by CFN's Development Department staff on an ad hoc basis. In keeping with its present low volume of resources and lending and the simple objectives of its operations, the FUND has neither separate procedures, staff nor accounts. As a result, the FUND's portfolio collections (payments of interest and principal due from BNF and commercial bank participants) are frequently 30 to 60 days in arrears. 2.12 Financial Condition. For the past several years, CFN's net income has been low in relation to both its assets and capital 2/ and has added relatively few incremental resources in support of its growing responsibilities as the country's major industrial term lending institution. During 1979 CFN suffered a net operating loss of S/43.1 million, stemming from four main causes. Firstly, almost one half of CFN's resources were in the form of non-interest or very low interest earning assets of which about 35% are equity 1/ The FUND's portfolio of SSE operations was S/68.5 million in 1978 and expanded to S/78.3 million by December 31, 1979. 2/ In 1978 CFN's rate of return was only 4.4% on equity and less than 1.0% on assets.  - 14 - investments earning less than 2% p.a. 1/ Secondly, costs of CFN loan resources, 23% of which are in Eurodollars, 2/ have been rising sharply and by the end of 1979 the average cost of Eurodollar loans to CFN had increased to 16% p.a. Thirdly, despite sharply rising costs of financial resources, CFN had pursued lending policies which sharply reduced its earnings. Until early 1979 CFN has been charging 1 percentage point less than the legal maximum interest rates (14%, 15% and 16% depending upon terms) (para. 3.01) permitted under DFC III (Loan 1359-EC) and CFN's Board of Directors until recently had placed a 1% p.a. ceiling on fees for letter of credit and guarantee operations which is well below the allowable 4% p.a. rate. Also, CFN has conducted a substantial volume of such operations on behalf of AZTRA and other public sector companies in which CFN is the majority stockholder. Finally, CFN's management has taken few, if any, steps to expand aggressively what could be profitable letter of credit, guarantee, and repeater loan components of its banking business. Indeed, CFN has likely lost a share of this profitable market to more aggressive financieras. 2.13 To deal with the range of problems and opportunities, CFN's new General Manager (in office since September 1979) has already taken a number of short-term steps, including: (i) confirming the new policy of charging not less than maximum interest rates; (ii) limiting further investments in equity shares to the minimum consistent with prior commitments; (iii) applying the Government's capital contribution of US$20.0 million made in late October 1979 toward reducing CFN's short-term Eurodollar loans and sharply limiting additional Eurodollar borrowings; and (iv) seeking to expand the use of guarantees for long-term foreign loans to industry in place of direct loans from CFN which would have been financed using LIBOR resources. The measures taken by CFN's new management are welcome and necessary but by themselves not sufficient to restore CFN's profitability in face of the relatively high proportion of CFN's resource base which earns little revenue and the low earnings that its current long-term portfolio will yield for several years to come, given CFN's past low interest rate policy. 2.14 To restructure its financial base and in accordance with its cove- nants under Loan 1731-EC (Fourth Development Banking Project) 3/, CFN will 1/ Among these is a deficit ridden Government-owned sugar mill complex (AZTRA) whose shares were thrust upon CFN by previous administrations. This operation represents CFN's largest single long-term financial problem to be dealt with by a program of divestiture (para. 2.15). CFN is protected against similar overexposure by the Government's obligations under Loan 1759-EC. 2/ Including the risk on concessionary loans from institutions such as IDB, CAF, KfW, and USEXIM Bank, CFN's total foreign exchange exposure as of December 1979 equalled US$139.0 million. Under the Fourth DFC Loan the Government has agreed to hold CFN harmless for any foreign exchange losses. 3/ Under Loan 1731-EC, CFN agreed to prepare by June 30, 1980 two programs: (i) for limiting its exposure to foreign exchange risk (which will require that it reduce its Eurodollar liabilities); and (ii) for reducing its holdings in large risky public sector enterprises.  - 15 - have to: (i) pursue energetically with the Government the sale and/or divestiture of its large holdings in major Government-owned industrial institutions; and (ii) aggressively reduce high cost Eurodollar liabilities as they fall due. In addition to maximizing its current income, CFN would need to take steps to: (i) charge maximum commissions, as the market will bear, on letter of credit and guarantee operations; (ii) aggressively pursue expansion of profitable letter of credit, guarantee and repeater loan operations; (iii) improve the efficiency of export financing (FOPEX) operations leading to full and rapid rediscounting of such loans with the CBE; (iv) improve at the margin the average term structure of its loan portfolio thereby increasing average interest earned; and finally, (v) develop an improved financial information system continuously monitoring the effects of its policies and operations while improving the quality of future financial planning. 2.15 CFN's new General Manager and other members of its management team generally agree with the Bank on the conclusions reached and the tasks to be accomplished, a 1 CFN has taken the initial organizational and procedural steps to expand the more profitable aspects of its banking operations, while improving its financial management. It was recognized that the sale of equity holdings or the establishments of special funds for the retention of such holdings on behalf of the Government cannot be accomplished in the short-term and a continuous process of divestitute and/or recapitalization would be required to begin to repair the effects of earlier investments. Under urging from CFN's Manager, the Board of Directors has already taken initial action to increase CFN's fees for letter of credit and guarantee operations, by permitting such fees to be increased from the current 1% p.a. maximum to 2% p.a. for all CFN's clients including its public sector clients. CFN should continue to strive to lift all ceilings on fees and commissions to provide for flexible financial management and during loan negotiations the Bank would seek agreement on a schedule for CFN's Board of Directors lifting restraints on fees and commission charges by June 30, 1981. Private Financieras (DFCs) 2.16 Among financial institutions, the growth in number and size of private financieras' operations has been most dramatic. Until recently there were but four financieras. 1/ By the beginning of 1979 there were nine in operation and seven applicants awaited approval. Growth of private financieras was encouraged by: (i) less than stringent entry require- ments; (ii) ceilings imposed on commercial bank portfolio growth; 2/ and (iii) availability of international credit which was rapidly and profitably applied toward guarantee operations. As of December 31, 1978 financieras' total assets were about S/8,000 million equal to 11% of the private banking system's total assets. With 60% (S/8.0 billion) of financieras' credit going to industry in 1978, they accounted for almost 30% of total credit to the sector. Financieras made a modest 8% (S/227.0 million) contribution toward providing credit to SSE in 1978, though these credits, like most others granted by financieras, were mainly short- and medium-term loans (i.e., about 1/ Corporacion Financiera Ecuatoriana (COFIEC), Financiera Nacional S.A., Financiera de Guayaquil, and Ecuatoriana de Financiamiento. 2/ Imposed in 1978 and recently lifted.  - 16 - 87% of financieras' loans carried maturities of less than one year). Concentra- tion on short-term lending is fostered by the rigid interest rate structure, the scarcity and relatively high cost of term resources, all of which have continued to sharply reduce the flow of term resources to private financial intermediaries. Financieras have also focused upon expansion of letter of credit and guarantee operations where commission and fee charges are ample for profitable operations. Only COFIEC, the oldest and largest of private finan- cieras and a long time user of Bank loan resources continues to make medium- and long-term loans. Under the Fourth Development Banking Project, new financieras are expected to extend longer-term loans to the industrial sector, but their ability to do so will be greatly restricted as long as the present interest rate structure makes it virtually impossible for them to mobilize domestic medium- and long-term resources. 1/ Interest Rates and Commissions 2.17 Ecuador's monetary authorities have historically preferred to maintain a structure of fixed and relatively low interest rates. This resulted in: (i) providing substantial subsidies to selected groups of farmers, SSE and others able to obtain rationed but inexpensive credit; (ii) dampening resource mobilization by commercial banks and financieras and accelerating growth of housing banks (Annex 2, Table 5); (iii) heightening the role of the CBE in mobilizing and allocating resources (para. 2.23); and (iv) by late 1979 and early 1980, leading to substantial capital outflow in response to higher interest rates abroad. 2.18 The maximum nominal interest rate for lending in Ecuador is 12% p.a. (Table 2-2). Adding allowable commissions of 2%, 3% and 4% p.a. for loans with more than 3 years, 5 years and 8 years maturity respectively, yields rates of 14-16% p.a. on medium- and long-term loans compared to inflation averaging about 12% p.a. 2/ from 1977 through 1979. In addition, the effec- tive rate on mortgages is currently about 16% p.a. and interest rates on foreign loans guaranteed by local financial institutions (including letters of credit) are set at LIBOR (or US prime rate) plus 4% p.a. (1% per quarter). In contrast, loans from the Financial Fund Mechanism (IIFF) are offered at 9% p.a. and export promotion loans at 8% p.a. The new government has reviewed the general interest rate structure to determine what further changes would be necessary to broaden domestic resource mobilization and has under discussion a recommendation to increase savings rates by up to 4 points and loan rates by two to three points maximum. 1/ Under the DFC loans, the Bank played a substantial role in moving mone- tary authorities toward a more rational interest rate policy with respect to term lending. Under the Fourth Development Banking Project, the Bank focused upon the broad issues associated with capital market development as a result of which BCE has established a capital market study unit and adopted an initial program of study satisfactory to the Bank. 2/ Interest rates under Bank lending programs vary significantly; DFC loans bear rates of 14%, 15% and 16%. The agricultural loans are at 11% and interest rates for the credit component of the Guayaquil UJrban Project will be 12%.  - 17 - Table 2.2: Maximum Annual Interest Rates and Commissions Private Private Sav. and Operations BNF Banks CFN Financieras Loan Assoc. I. Lending: - 12% 12% 12% Small Industry and Artisans 9% - - - Financial Funds Mechanism a/ 9% 9% 9% 9% FOPEX - - 8% - II. Central Bank: Advances and rediscounts bI - - - 8% Industry 4% c/ 7% 7% - FOPEX - - 4% - Financial Funds Mechanism Rediscounts 3% 3% 3% 3% III. Borrowing: Savings - 6% - - 7% Deposits with a maturity of: 31-180 days - 7% - - 8% 181-360 days - 8% - - 9% more than 360 days - 9% - - 10% IV. Commissions on selected operations: a. Loans for agriculture, mining, fishery, industry and tourism with maturity of: 3 - 5 years 2% 2% 2% 2% 5 - 8 years 3% 3% 3% 3% 8 years 4% 4% 4% 4% b. Guarantees - 4% - 4% a/ Includes specific programs in agriculture, livestock, agrobusiness, small industry and tourism. b/ In case of operations outside Quito and Guayaquil, the interest rates are 2% less for private banks and 1% less for BNF. c/ Small Industry. Source: CBE  - 18 - 2.19 Interest rates offered to savers vary considerably. Savings ac- counts and certificates of deposit paid by commercial banks yield 6%-9% p.a., while Savings and Loan Associations pay 7%-10% p.a. for the same type of accounts. CFNT bonds with 10 years nominal maturity (but with a legal guarantee to be repurchased at par on sight) bear an interest rate of 8%. Government and monetary stabilization bonds of 30 to 180-day maturities earn about 11% (taxfree), yield the highest effective rate and dominate the bond market. Ten-year mortgage bonds without repurchase guarantee bear a nominal rate of 12% but currently yield around 14% or more. These and other wide variations in lending and in mobilization rates result in wide variations in the flow of resources and in the financial margins earned by financial institutions. Participating financial intermediaries have margins of 3% p.a. and 6% p.a. depending on the size of the borrower under the Bank's Agricultural Credit Loan, and earn gross margins of 3.5%, 4.5% and 5.5% on loans depending on loan maturity under the Fourth Development Banking Loan. To engage the full participation of the banking system under the SSE credit a structure of interest rates and financial margins would be required that harmonizes with existing rates and provides financial intermediaries with incentives appro- priate to the risks involved (Annex 2, Table 15). B. Mobilization of Resources Deposits 2.20 Total deposits in Ecuador's private banking system available for lending grew at 15% p.a. during 1970-78, supported mainly by a 20% p.a. growth in demand deposits (from about S/3.0 to S/18.5 billion) as savings accounts grew by only 8% p.a. and declined in real terms during 1976-78. In keeping with: (i) the differential interest rates paid by commercial banks and savings and loan associations (S&L) to depositors for the same type of pass- book and term accounts (Table 2.2); (ii) the S&Ls' more aggressive promotion for savings accounts; and more importantly, (iii) the prospects of depositors obtaining mortgages, deposits in S&Ls increased sixteen-fold (from S/270 million to S/4,362 million) in 1970-78 compared with commercial banks' slower deposit growth (from about S/1.2 billion to S/5.7 billion) 1/. Thus, the percentage of savings deposits to total commercial bank deposits available for lending declined from 40% to about 25% of total during 1970-78 while demand deposits increased from 60% to 75% of the total. More recently (1978-79) as liquidity tightened, commercial banks increased their efforts to expand time and savings deposits which grew 12% p.a., slightly better than the 11.6% rate of inflation. Credit 2.21 Overall credit growth during 1970-78 was 29%, slightly higher than the 24% average growth of GDP. Newer financial institutions played more important roles as sources of credit. By 1978 private financieras provided 16% of the total credit (Annex 2, Table 6) compared with 3.7% in 1970, while 1/ BNF and financieras each also increased deposit accounts by S/400.0 million in 1970-78 diverting an approximate S/800.0 million from possible deposits in commercial banks.  - 19 - the share of credit provided by S&Ls, the BNF and the NHB also grew substantially. By 1978 commercial banks' share of the credit market had declined to 66% from about 83% in 1970. Other Resources 2.22 Bond sales and other debt instruments issued by private financial institutions provide only small amounts of resources and account for about 10% of total liabilities of both financieras and commercial banks. While the growth of these instruments had been substantial in 1970-75, more recently limitations on interest rates and competition from CBE's open market operations has reduced the annual growth of bond sales. A major area of credit growth has been in guarantee operations which have caused the contingent liabilities of private banks to increase from S/1,675 million to S/14,750 million in 1970-78. Total guarantee balances of private banks and financieras now equal to about 30% of these institutions' total credit balances and provide income from commissions equal to net portfolio earnings. The sharp growth in mainly foreign financing (on LIBOR terms) involved in guarantee operations reflects the substantial liquidity constraints imposed on domestic financial markets and the low levels of savings intermediation due to the system's low and inflexible interest rate structure. 2.23 Financial Fund Mechanism (MFF). The larger role of the CBE as a source of total national credit (from 31% to 45% during 1970-78) is evidenced by the rapid expansion of CBE's rediscount and credit operations, from S/3,181 million to almost S/23,900 million during 1970-78. The major components of the CBE's rediscount operations in 1978 were export financing, (S/6,755 million) 1/ and its expanding commercial sector rediscount operations (up from 28% to 48% of the total during 1970-78). Industries' share of total CBE discount operations declined from 33% to 23% in 1970-78 as commerce expanded in importance. Even so, CBE's discount operations for industry have grown by S/1,000 million p.a. since 1974. They currently amount to about S/5,200 million p.a. and account for an estimated 30% of industrial credit. In 1978 the CBE's MFF rediscount operation handled S/2,950 million in loans (equivalent to US$118.0 million) for periods of up to two years. During 1978 the average MFF rediscounted loan was for less than 180 days and was used to finance working capital. Except for small annual reflows of the US$4.5 million balance on the United States Agency for International Development (AID) SSE credit granted in 1972, the TIFF has no term resources for industry. MFF's SSE rediscount facility has not been able to meet fully the requests for rediscounts under the quotas allocated to financial intermediaries. C. The Financing of Industry 2.24 The growth of credit to industry from 18% to 25% of total credit during 1970-78 has been in line with the pace of industrial sector expansion (para. 1.03), and in 1978 total credit to industry reached S/16,631 million, 2/ 1/ Equal to 35% of total discount financing. 2/ Loans to commerce and agriculture and livestock represented 40% and 19% of total credit respectively.  - 20 - of which 20% went to SSE. The increase in the number and type of financial institutions lending to industry and CBE's program for financing industry were the major contributing factors to this growth and in 1978, the CBE provided about S/5,000 million or one-third of the resources committed by financial intermediaries to finance the industrial sector. Financing of SSE 2.25 During 1978 total credit received by small scale industry and artisans amounted to S/2,855 million (US$114.0 million equivalent) of which commercial banks provided 67%, BNF 25% and private financieras 8%. Almost 85% of these SSE credits were short-term. About one-half of the SSE credits granted were made under monetary regulations providing that 20% of bank loans be made to the productive sectors. About 30% was provided by commercial banks over and above their quotas confirming that in the Ecuadorian environment commercial banks have been seeking SSE clients and could be expected under appropriate conditions to participate in a credit program seeking to channel additional long term resources to SSE enterprise. 2.26 The results of a survey of 555 small scale industrial firms in the Quito area provides an interesting insight into the sources and types of credit available to SSE (Table 2.3). About 74% of the sample of small industrial enterprise reported having had access to credit mainly through commercial banks (49%), with the BNF (16%) and financieras (7%) distant second and third sources. Suppliers' credits proved to be important to SSE, account- ing for 20% of loans and almost 28% of the total amount of credit. Family lending amounted to 4%, while credit involving money lenders accounted for only 3.0% of total credit at interest rates reported to have averaged 38.5%. Interest rates charged by commercial banks and other formal sources of credit ranged between 9% under the CBE's MFF program, and 12%, the,maximum interest rate for short-term loans by commercial banks and financieras under the non-MFF component of portfolio. Long-term credit was available to only 12% of the total. Table 2.3: Sources and Terms of Credit to Small Scale Industry in Pichincha, 1978 (Thousands of S/) Sources of Terms of Credit-a/ % of Financing No. of Total Total SSI Loans % Short Medium Long Credit Credit Commercial banks 214 49.2 165,538 1,035,585 25,072 295,195 48.5 BNF 69 15.9 5,630 20,088 34,042 59,765 9.8 Financieras 32 7.4 17,892 38,155 10,070 66,117 10.9 Fam. & branches 19 4.4 6,239 445 4,000 10,684 1.8 Informal lenders 13 3.0 6,059 2,350 - 8,407 1.4 Suppl. Credit 88 20.2 157,834 10,100 - 167,934 27.6 Total 435 100.0 360,190 174,723 73,184 608,097 100.0 a/ Short-term loans average 6 months, medium-term 25 months and long-term 60 months. Source: A.N.D.E., Study of Small Scale Industry in Pichincha 1979.  - 21 - 2.27 Both large and medium size manufacturing companies in Ecuador are substantially equity financed. Medium size firms' resources include 46.3% short-term and 17% long-term debt compared with 40% short-term and 20% long- term debt for larger firms (Table 2.4). Both large and medium size firms showed greater ability to command term resources than SSE. Table 2.4: Financial Structure of Manufacturing Companies, 1976 (S/ million) Medium-Size Large Companies a/ Companies b/ S/ % S/ ASSETS Current 17,684 55.2 2,373 62.3 Fixed 12,048 37.6 1,437 37.7 Other 2,308 7.2 - - Total 32,040 100.0 3,810 100.0 LIABILITIES Short-term debt 12,956 40.4 1,765 46.3 Long-term debt 6,525 20.4 656 17.2 Total 19.481 60.8 2,421 63.5 Quasi Equity c/ 411 1.3 228 6.0 Capital and retained earnings 12,148 37.9 1,161 30.5 Total Equity 12,559 39.2 1,389 36.5 Total Liabilities & Equity 32,040 100.0 3,810 100.0 Debt/equity ratio 1.6:1 1.7:1 a/ 589 larger incorporated manufacturing companies with average total asset size S/54,397 million. b/ 611 small manufacturing companies with average total assets of S/6,235 million. c/ Enterprises' long-term debt to owners. Source: Superintendencia de Companias, Annual Statistical Report 1979.  - 22 - Reflecting the low amounts and percentage of term credit (17%) medium size manufacturers had more resources invested in accounts receivable and working inventories. Notable was the fact that both the largest and medium size firms had about 38% of their assets in machinery and equipment (after depreciation), though the smaller firms had somewhat greater labor force per fixed assets investment. 2.28 Senior operating officers and credit managers of a sample of Ecuador's most important banks 1/ estimated that a term lending program to SSE in the total amount of US$30.0 million would be appropriate to satisfy incremental term credit requirements of SSE during the projected commitment period (para. 4.06). Banco del Pacifico and Banco Popular each estimated that their banks could commit about US$3.0 million in SSE credits during 1981-83 and the estimates of Banco del Pichincha and Filanbanco range from US$1.0 to US$4.0 million. On the basis of estimates obtained from private financial institutions (including financieras who estimated an aggregate need for about US$3.0 million) and an assessment of BNF's capability to successfully manage an incremental US$10.0 to US$12.0 million in SSE operations 2/ a loan program of US$30.0 million (including a Bank loan of US$20.0 million and US$10.0 million equivalent in counterpart financing) was deemed appropriate, especially since the mechanisms for channelling funds under this pilot project are untested. III. THE PROPOSED PROJECT A. Project Objectives and Institutional Structure Background 3.01 The proposed project would represent the Bank's first direct support for the development of the small scale industry and artisan (SSE) subsectors in Ecuador. 3/ Starting as early as 1972 the Bank explored the prospects of 1/ Banco de Descuento, Filanbanco, Banco de Guayaquil, Banco del Pacifico, and Banco Popular, domestic banks which are likely to participate in the project and Bank of America and Citibank which are foreign banks not likely to participate. 2/ Requiring expanded loan promotion, supervision, review and collection procedures. 3/ Other Bank operations affecting the industrial and SSE sectors include: (i) three previous Bank loans to the industrial sector totalling US$47.6 million and committed through the Corporacion Financiera Nacional and Corporacion Financiera Ecuatoriana de Desarrollo S.A. which helped to finance 84 mainly medium size and large projects, the average subproject and subloan equalling US$4.7 and US$1.1 million respectively. A fourth Bank loan (Loan 1731-EC) of US$40.0 million to finance industrial develop- ment recently signed will be channelled through an expanded group of financieras (who also have access to US$3.0 million equivalent under the Third DFC Loan 1359-EC); (ii) Bank Loan 1459-EC (Agricultural Credit Project) includes a US$3.0 million small scale agroindustry component; while (iii) the Employment Generation Component (about US$3.0 million) of the Guayaquil Urban Development Project (Loan 1776-EC) will support short- and medium-term lending in support of commercial, service and artisan enterprise, mainly in the Guayaquil Urbanization Area.  - 23 - an SSE project in Ecuador which was precluded by Government interest rate policy on SSE credit and the excessively slow progress in the disbursement of an existing small (US$5.1 million) Agency for International Development (AID) credit. By 1977: (i) the SSE sector had experienced substantial growth of new firms and considerable investment demand; (ii) term resources for SSE had begun to dry up as BNF's credits to SSE declined by 12% and AID's credit had become a narrow stream of loan reflows; (iii) the Government had begun to show substantial interest in supporting further SSE sector growth by encouraging and funding programs to strengthen several institutions supporting SSE development; and, finally, (iv) monetary authorities had indicated a willing- ness to reconsider the 9% interest rate ceiling imposed on SSE lending since 1973, allowing financial intermediaries to charge SSE the same positive interest rates on term loans as were applicable to term lending to industry in general. Consistent with these developments, the Government indicated to the Bank its interest in exploring a project oriented to SSE. 3.02 In early 1978, at the request of the Government, the Bank began preparing an SSE project comprising a credit component and an associated technical assistance services program. Consistent with project objectives (para. 3.04) broad based participation by commercial banks, financieras and the Banco Nacional de Fomento (BNF) were to be encouraged. To service the projected SSE operation, which could include up to 20 financial inter- mediaries, a fully integrated second tier rediscount facility would be required to perform a range of program promotion, project evaluation, rediscount and loan supervision tasks. Such a facility would depart from traditional CBE arrangements under which responsibility for sector loan administration is split between the CBE and the project units established within sectoral ministries. To ensure efficient project execution and avoid the divisions of project responsibilities that had plagued past loan operations 1/, the Bank explored with the General Manager of CBE prospects for establishing a new facility within the CBE to handle the total SSE operation. The CBE's response, though preliminary, was positive. Following resignation of the General Manager in the wake of the national elections in 1979, CBE's senior management rejected the proposal. 3.03 To avoid the difficulties encountered in past unintegrated lending programs and in keeping with the Government's suggestion that the Bank loan be channelled through CFN, the Bank explored with MICEI and CFN staff an SSE pro- gram, based upon establishment of a second tier facility within CFN, which was examined and approved by the Minister of Industry, Commerce and Integration and the General Manager of CFN. Subsequently, following loan appraisal in December 1/ A number of Ecuador's financial intermediaries had expressed doubts that an SSE operation could function effectively as a split operation of the type used by the AID SSE project which was launched in 1972 and admin- istred by the CBE's MFF and MICEI. The AID credit was not finally dis- bused until 1977 and only then with massive involvement of AID in the execution of the project.  - 24 - 1979 1/, the Minister of Industry, Commerce and Integration resigned and the question of institutional arrangements was reopened, with the CBE maintaining the position it had the sole right to perform project rediscount functions as part of its mandate to maintain monetary controls. Following intensive discus- sions involving the highest Government levels, CFII and CBE finally negotiated and signed an agreement on March 18, 1980 (Annex 1), under which CBE would serve as disbursement and collection agent for the project (paras 3.12-3.13). Project Objectives 3.04 The project is designed to support the Government's industrial strategy and to assist it in its developing a dynamic SSE sector in support of its employment, income and geographic redistribution objectives. The project would assist the Government to achieve these objectives by: (i) Helping to ease the scarcity of term financing on reasonable conditions for small scale enterprises and artisans (on a broad geographic basis), thereby encouraging both expanded output and improved income distribution while creating additional job opportunities in urban centers and smaller rural towns; (ii) Helping to develop within the banking system an improved capability to promote, appraise and supervise small scale lending operations on a profitable basis; (iii) Providing a structure of interest rates for SSE lending, which is more consistent with market rates and risks and costs involved with SSE lending, thereby expanding prospects for increased resource availability to SSE; (iv) Expanding the institutional and financial capacity to deliver technical assistance services and, by encouraging broader parti- cipation of SSE in the process of program design, helping to improve the quality and relevance of technical assistance available for SSE; (v) Assisting SSE to improve the quality and thoroughness of their investment planning. Institutional Structure 3.05 An expanded and restructured Fund for Small Scale Industry and Artisan Development (FUNID) and a unit to administer the FUND would be estab- lished by CFN to execute this project. CFN has in accordance with its Organic Law, been operating since 1964 a facility which rediscounts loans made by 1/ The Bank began an extended process of project identification and prepara- tion in 1978 with five missions assisting in preparation during a period when a number of changes in key staff in ministries and financial institu- tions took place. Following appraisal and further Cabinet changes, post appraisal missions in February and Mlarch helped to complete institutional arrangements.  - 25 - commercial banks and financieras to small scale enterprise (para. 2.11). With only about US$4.0 million in total resources available, CFN's annual SSE financing level had since 1974 averaged a modest US$1.1 million. Mloreover, the rediscount facility had been operating on an ad hoc basis functioning without clear policy or procedures or full-time staff. Because of its limited resource base and the restricted number of financial intermediaries using its facility, CFN's SSE operation had little overall impact on the level or quality of credit available to SSEs. 1/ In response to the new Government's policy of assistance to SSE, CFN is seeking to expand its resource base and to create an aggressive small scale enterprise rediscount operation without undertaking alteration of its basic Organic Laws. 3.06 To accomplish the above, a second tier financial mechanism would be operated by CEN in conjunction with the CBE (para. 3.10) to provide part of the financing for term loans made by financial intermediaries helping finance investment projects of small scale enterprise. Although all commercial banks and financieras including BNF would be eligible to participate in the project as the FUND's financial intermediaries, about half of the approximately 20 potential eligible commercial banks and financieras are interested in expanded SSE operations based upon term lending and would be expected to participate in the project. All participating intermediaries would be required to enter into participation agreements with CFN (para 3.30). The intermediaries would assume the full credit risks on subloans and would service their debt to CFN's FUND in accordance with fixed amortization schedules, irrespective of the status of their collections from SSE. Technical assistance to participating SSE would be provided by CENAPIA, regional SSE associations, non-profit institutions, consultants or others who would help SSE with project preparation and implementation (para 3.31). B. The Fund for Development of Small Scale Industry and Artisans (FUND) Establishment, Policies and Operating Regulations 3.07 The FUND's expanded and revised lending and technical assistance program would be approved and adopted by resolution of CFN's Board of Directors which would also adopt as condition of loan effectiveness: (i) Statement of Policy (para 3.08); (ii) Operating Regulations and Procedures (para 3.09); and (iii) an Organizational Structure and Staffing Plan (para 3.10), all these to be satisfactory to the Bank. 3.08 Policies. The FUND's overall objectives and its rules for their implementation are set forth in the form of a Statement of Policies prepared by CFN and agreed by its General Manager in draft form (Annex 3). It speci- fies, among other things: (i) the types of enterprise to be financed; (ii) the 1/ The Banco Nacional de Fomento (BNF) accounted for about 80% of total rediscounts, which were onlent to SSE at 9%.  - 26 - FUND's financial structure and criteria for its financial operations; (iii) the types of projects that the FIUND would be prepared to finance; (iv) the types of services that the FUND would perform; (v) criteria for participation by financial intermediaries; (vi) personnel and staff development; and (vii) provisions to ensure adequate technical assistance for project partici- pants. The draft policy statement which provides a satisfactory basis for the FIJND's channelling of Bank funds to SSE under the proposed project was reviewed during negotiations and approval bv CFN's Board of Directors would be a condition of loan effectiveness. 3.09 Operating Regulations. The draft Statement of Operating Regulations and Procedures agreed to in principle bf CFN's management establishes guidelines and detailed procedures to be followed in all important aspects of the FUND's operations (Annex 3). Included are: (i) procedures for processing of loan applications, rediscounts, disbursements, and other operations designed to speed up disbursements; (ii) criteria for establishing branch and agency operations and their regulations; (iii) project appraisal procedures and free limits within the system; (iv) standards and methods for project supervision; (v) project and post-project evaluation; (vi) procedures governing participation by financial intermediaries; and (vii) operation of the technical assistance coordination component. At negotiations, the Bank and CFN agreed on modifica- tions in the Operating Regulations which reflect the CBE's role as financial agent for the FUND (para. 3.12). Approval of the Operating Regulations by CFN's Board of Directors would be a condition of loan effectiveness. 3.10 Organizational Structure and Staffing. CFN staff has prepared a draft organization chart and staffing plan for the FUND's operating unit (Annex 3) on which agreement was reached between CFN and the Bank during negotiations. Under the proposed organization the FUND's operations would be headed by a Unit Chief who would report to CFN's Manager of Loan Operations. 1/ CFN's General Manager has appointed a well qualified Unit Chief of the FUND. In keeping with its policy to open new job opportunities in the managerial and technical ranks to its most competent younger professional staff, CFN will provide the Unit with trained technical staff mainly from its Development, Financial and Legal Departments. In addition to directing the project evalua- tion, supervision and technical assistance coordination and administration functions of the FUND's operations, the Unit Chief would help branch managers 2/ establish SSE rediscount units, train personnel in implementating program policies and procedures and be responsible for promotion and evaluation of overall FUITD operations (para. 3.24) and preparation of its financial plans. Prior to loan effectiveness, CFN would adopt a satisfactory organization and staffing plan. 1/ Currently having overall responsibility for project evaluation and recommendations for approval or disapproval of all CFN industrial lending and export promotion rediscount operations. 2/ To encourage geographic dispersion of loans, CFN's major branch offices which have proven capability to evaluate industrial projects would be authorized to approve rediscounts of SSE loans to be made by participating financial intermediaries located in their geographic region up to the branch's free limit.  - 27 - 3.11 Portfolio administration, record keeping and financial accounting would be handled for the FUND by CFN's Departments of Portfolio Control and Accounting which handle such work for CFNT's other funds. These organizations and staffing arrangements would be adequate to enable CFN to carry out the project during the first two to three years. As the volume of SSE operations grows and additional operating experience is gained, CFN would augment the Unit's staff, if required, to expand the FUID's activities. 3.12 Disbursement and Collection. The Central Bank of Ecuador (CBE) which will serve as fiscal agent for the Government, will, for a fee of 1/8% of FUND disbursements, serve as disbursement and collection (financial) agent for the FUND. To fulfill that function the CBE has agreed to establish a facility outside of the MFF operations which would execute rediscount and collection operations upon approval by CFN (Annex 1, Agreement of Mlarch 18, 1980 between CBE and CFN). On the basis of the FUND's documented request, CBE would debit 1/ or credit the appropriate financial intermediary's account without further intervention in the approval process. 3.13 To facilitate the financial agency operations of the CBE and to manage its ordinary financial affairs, the FUND would establish and maintain in the CBE a Project Account consisting of two sub-accounts, a Project Loan Sub-Account (PLS) and a Project Management Sub-Account (PMS). The PLS would be used to: (i) channel to the FUND withdrawals from the Bank's loan account made by the CBE; and (ii) channel to the Government the FUND's scheduled repay- ments of principal and interest. The PMS will be used for all other transac- tions of the FUND including, inter alia, the disbursement and collection of the FUND's loans to financial intermediaries, the purchase and sales of negotiable instruments, the payments of staff salaries and other operating expenses. As the Project Account will be fully managed by CFN, transfers between the two sub-accounts will be made at the FUND's discretion. Assur- ances were obtained during negotiations that the above arrangements would be reflected in the Subsidiary Loan Agreement between CFN and BCE, and that six months after effectiveness and from time to time as the Government, CFN, CBE or the Bank shall request the operating mechanisms established for the financial agent would be reviewed. 3.14 Terms and Limits of Financing. The FUND would focus upon financing small scale enterprise, placing special emphasis on making resources avail- able to the very smallest artisan craft types of operations. Existing firms having fixed assets excluding land and buildings, of less than US$350,000 equivalent at the time of subloan approval, or new firms to be established with fixed assets not exceeding that amount would be eligible for financing by the FUND. This criterion corresponds approximately to firms of up to 25-30 employees and includes most firms which have had little or no access to term credit from the banking system. The FUND's maximum financing for any one investment subproject and enterprise would be limited to US$300,000. 2/ Both 1/ Having been authorized to do so in advance by the participating financial intermediary. 2/ Article 39 of CFN's Organic Law as interpreted by its General Counsel restricts the small scale industry and artisan fund from lending in amounts greater than 1% of its resources available from time to time which, following the Bank loan, would equal US$30.0 million equivalent.  - 28 - limits could be reviewed from time to time and revised by the Bank in agreement with CFN. The FUND would not approve financing for companies which it judged to have reasonable access to alternative local or foreign sources of financing on adequate terms. 3.15 Only loans to private sector enterprises would be eligible for discount from the FUND, which would finance the purchase of fixed assets and working capital, the installation of industrial equipment and services, the construction of industrial buildings and of commercial facilities associated with productive capacity, and finally,the preparation of pre-investment studies and technical assistance services associated with investment projects. Projects eligible for financing would have to involve the creation, expansion or modernization of the productive capacity of enterprises involved in small scale manufacture, artisan workshops, agroindustry, fishery, forestry, tourism or investment for mechanical services, or specialized transport closely related to industry. In its allocation of scarce resources, the FUND would primarily finance projects which generate employment, increase the use of local natural resources, generate export receipts or efficiently substitute imports. 3.16 To ensure that a significant part of project resources benefit the very smallest enterprises, given the limited experience of financial interme- diaries with term lending to this group and the higher risks and costs asso- ciated with such lending, the FUND would: (i) provide financial intermediaries with a higher spread to cover such costs and risks and as a financial incentive to lend to the smallest SSE (para. 3.20); (ii) coordinate with the regional associations of small enterprises and CENAPIA, the Government technical assistance agency, providing them with incremental resources to finance assistance to small scale enterprise in the preparation of projects to parti- cipating financial intermediaries (para. 3.32); (iii) approve the rediscount loans to the smallest enterprises within 48 hours after presentation of simplified documentation by financial intermediaries at an authorized CFN office; 1/ (iv) carry out extensive promotion to encourage participating institutions to undertake SSE lending programs modelled along the lines of the Banco del Pacifico and BNF programs. It is anticipated that as a result of the combination of monetary and program incentives plus technical assistance in project preparation, a substantial number of the loans made and a reasonable proportion of the resources committed under the project would be for loans amounting to less than S/l.O million (equivalent to US$40,000) (para. 3.28). 3.17 Appropriate maturities and grace periods would be established for each subloan. Maturities would average about 6 to 7 years and the maximum grace period would be three years. Normally, the FUND would not approve subloans to firms able to repay their debt in less than 25 months, since banks would be expected to finance such loans from their ordinary resources or from the Central Bank's short-term loan rediscount facility, the Fondos Financieros. 1- I 1/ Using the FUND's available cash flow as a revolving fund. The subloarn review process by CFN could be ex post.  - 29 - 3.18 The FUND would participate jointly with the financial intermediary and the final borrower in the financing of specific subprojects. The FUTD would rediscount 90% of subloans for approved subprojects and the financial intermediary would finance the balance. The subloans would not exceed 80% of project costs for new firms nor 90% of total project costs for expansion. In view of the expected high volume of SSE lending and the large number, varied nature, and small size of subloans (Annex 2, Table 8), the Bank would reim-- burse the FUND for a standard percentage (about 67%) of the FLTND's disburse- ments for individual sub-loans, which would be equal to estimated foreign exchange costs--about 53% of total subproject cost, 1/ given that an expected 75% of subprojects financed are likely to be expansions. With respect to technical assistance subloans, or for technical assistance services associated with subproject preparation and implementation, up to 90% of such service costs would be financed by the FUND with the financial intermediary and borrower contributing equally to cover the balance. 3.19 Interest Rates. Subloans financed by the FUND would be denominated in Sucres. Interest rates and fees charged by participating financial inter- mediaries are subject to: (i) the limits established by the Monetary Board; 2/ (ii) the need to harmonize lending under the SSE project with Bank loans in Ecuador and other available lines of term credit; 3/ (iii) the need to provide financial intermediaries and CFN with appropriate financial spreads; and (iv) the provision for an interest rate structure which could be reasonably expected to be positive in real terms over the life of the project. In line with those principles, CFN is proposing to establish an interest rate of 12% which is the maximum allowed by law. In addition, it would charge the maximum commission of 2% p.a. for loans bearing terms of over 2 and up to 5 years, 3% p.a. for loans of between 5 to 8 years and 4% p.a. for loans bearing terms of 8 years and longer. Interest rate on loans to the very smallest firms (fixed assets of less than S/625,000, excluding land and buildings) would be a flat 12% p.a. regardless of terms which would be consistent with the conditions established for micro enterprise under the Bank's Guayaquil Urban Project. 1/ Based upon studies of import components of small scale industry investment among a sample of 2,500 firms registering under the industrial incentive laws during 1962-68 and a sample survey of about 550 members of the Pichincha Federation of Small Scale Industry during 1978. 2/ Regulation 927-76 promulgated on November 9, 1976. 3/ Guayaquil Urban Project, small scale industry loan component (Loan 1776-EC), IDF Fourth Industrial Credit (Loan 1731-EC), agroindustry loan component of Loans 1459-EC and 1644-EC.  - 30 - 3.20 The cost of SSE FUND rediscounts to financial intermediaries would vary depending on asset size of the borrowing enterprise (see Annex 2, Table 14). For loans to SSE with fixed assets (excluding land and building) greater than S/625,000, financial intermediaries would pay 10% for the FUND's resources which would allow spreads of 4.0, 5.0 and 6.0 points to the interme- diary depending upon subloan terms. Loans to SSE with assets of less than S/625,000 would yield financial intermediaries a 6 percentage point financial spread regardless of loan term to compensate financial intermediaries for the higher risks and costs associated with loans to the very smallest enterprises and to offer financial incentives to intermediaries to expand their volume of small project financing at longer terms. The FUND expects to receive an average interest rate of about 9.4%-on its rediscounts allowing an adequate margin over its estimated 5.7% blended cost of resources 1/ to cover adminis- trative and other costs, as well as contributions for technical assistance to SSE (para 3.31). 3.21 The above interest rates and spreads would be reviewed not later than 18 months after the date of effectiveness and from time to time there- after, and modified by agreement between the Bank, CFN and monetary author- ities as necessary to ensure that project objectives are met and to reflect changing market conditions (para. 2.18) and inflationary trends. Inflation between 1977-1979 averaged just above 11 percent. For 1980-1982, projections are somewhat more difficult, given insufficient knowledge about the impact of increased minimum wages, and prospective increases in gasoline prices and interest rates, all of which could take effect beginning in 1980. Central Bank's initial estimates are for inflation of 14-15 percent. This would make the 15 percent average interest in the proposed program slightly positive or zero as a minimum in real terms. Subproject Appraisal and Supervision 3.22 Subprojects financed by the FUND would vary in complexity and size, ranging from very small artisan subprojects requiring total investments of several hundred dollars, to small size industrial subprojects typically involving investments of several hundred thousand dollars. 2/ Thus, in line with the general appraisal guidelines, the depth and sophistication of subproject appraisal and review would be varied to fit the size and nature of subprojects. 3/ Financial intermediaries, in cooperation with subborrowers, would be responsible for preparing subproject appraisals. The FUND would review these appraisals and approve financing for those subprojects it judged to be technically sound, financially viable and economically efficient. To ensure uniform quality and content in subproject appraisal, the FUND plans to 1/ Assumes a US$20.0 million Bank loan at 8.5% and US$10.0 million in FUND capital (Annex 2, Table 15). 2/ The average subloan would equal about US$50,000 (Annex 2, Table 7). 3/ Different methodologies would be applied to appraisal of subprojects in the up to US$40,000, US$40,000 to US$150,000, and US$150,000 to US$350,000 ranges. But data for the Subproject Data System would be collected on all subprojects.  - 31 - adopt and issue general appraisal guidelines offering standard definitions and where appropriate methodologies for financial calculations for each of the three main project size clusters in accordance with the FUND's Operating Regulations (Annex 3). Adoption of satisfactory guidelines would be a condition of loan effectiveness. While more standardized appraisal reports would tend to evolve in the longer term, initially each intermediary, working within the general guidelines could develop an appropriate system taking into consideration its loan analysis procedures and internal operating requirements. Summary project forms and applications for rediscounts would be prepared by CFN. 3.23 Financial intermediaries would be responsible for making periodic supervision visits to firms receiving Bank funds and for maintaining records adequate to indicate the progress of subprojects. The intermediaries' super- vision responsibilities as defined in the Operating Regulations would be clearly specified in the participation agreements which intermediaries would sign with CFN. The performance of intermediaries in subproject supervi- sion would be systematically monitored by the FUND's supervision unit, in accordance with its operating procedures, which requires that a relatively large sample of subprojects be visited. It is anticipated that financial intermediaries, which would bear the full credit risk under the project, would revise their current supervision procedures to conform with those specified in the participation agreements. The supervision procedures provided for in the FUND's procedures envisage a satisfactory schedule of supervision visits often linked with technical assistance. It is anticipated that as financial intermediaries become more experienced with appraisal and supervision methods a reduction would be made in CFN's supervision sample size. Final approval of supervision guidelines as part of the Operating Procedures would be a condition of loan effectiveness. Training 3.24 To further prepare FUND staff and those of participating interme- diaries to better understand SSE project preparation and appraisal requirements and techniques and supervision requirements and standards, CFN will prepare a brief orientation program focused on industrial project preparation, evaluation and supervision for the FUND's staff and that of interested financial institu- tions. During loan negotiations an understanding was reached on a schedule for preparation of a training program, the outline of which would be reviewed with the Bank during July/August 1980. Financial Structure 3.25 The FUND would function in accordance with CFN's regulations as a separate financial operation with its own financial resources and would estab- lish separate financial accounts for the FUND, the operating results of which would be periodically consolidated into CFN's accounts. The FUND's initial resources would be composed of: (i) use of the proceeds of the proposed Bank loan to the Government of US$20.0 million equivalent; (ii) a counterpart con- tribution of US$6.0 million equivalent to be made available by the Government; and (iii) CFN's existing small scale industry operating assets consisting of its portfolio of rediscounted SSE loans and cash and other liquid assets equal  - 32 - to an estimated US$4.0 million 1/, raising the FUND's total initial resource base to US$30.0 million equivalent. It is contemplated that net revenues would be positive in each of the project years and that about US$2.7 million in accumulated earnings would be added to the FUND's resources during 1981-85. 3.26 Table 3.1 shows the proposed financing plan for the project. Table 3.1: SSE Project Financing Plan a/ (in US$ million) Total Percentage Foreign Local Contribution of Total SSE Fund GOE Capital Contribution - 6.0 6.0 16 CFN Capital Contribution - 4.0 4.0 11 TBRD Loan 20 - 20.0 53 Financial Intermediary - 3.3 3.3 9 Project Sponsor (minimum) - 4.2 4.2 11 Total Project (minimum) 20 17.5 37.5 100 a/ CFN would also provide an estimated US$325,000 in technical assistance grants during 1981-84 from the FUND's estimated net income. 3.27 The FUND is expected to commit its total resources in about three years starting with US$6.0 million equivalent in year one and averaging US$12.0 million equivalent per year thereafter (Annex 2, Table 12). A best estimate of the type of subprojects that the FUND would be likely to finance and based on an analysis of a sample of some 8,000 SSE projects that had been financed by the banking community during 1972-78 is shown in Annex 2, Table 14. 2/ On the basis of the experience of the recent past, the focus of project investment is projected to be in consumer goods. The projected continued growth of small metal products and wood industries would result in this sector accounting respectively for 18% and 16% of total investment, while food and related products would account for 18% and textiles and wearing apparel for 10% of total investment. 1/ Total assets of the existing SSE fund equal approximately US$4.0 million, of which about US$3.1 million are rediscount portfolio and the balance cash and other liquid assets. Some of the rediscounts would be repaid during the course of loan processing and some new rediscounts made, thus, the final balance between cash and portfolio is approximate and the final value of total resources would be approximately US$4.0 million. 2/ Which is not unreasonable given the essential stability in structure and growth trends of SSE (paras. 1.11-1.13).  - 33 - 3.28 With respect to number and size distribution of loans 1/ it is anticipated that approximately 625 small scale enterprise loans would be made over the project's three year commitment period. Based upon: (i) BNF's recent SSE lending experience (about 5,000 loans averaging S/125,000 were made to SSE in 1978); and (ii) the incentives granted under the program for lending to the very smallest SSEs (Annex 2, Table 8), it is contemplated that about 40% of loans averaging S/200,000 in size would be made to the micro SSE. It is contemplated that almost 70% of the number and 27% of the amount of the loans would be disbursed for loans of less than S/l.0 million with an estimated average loan size for the entire project of S/1.3 million (US$52,000 equivalent). Projected Financial Results 3.29 The FUND's projected financial results for 1981-85 are shown inI Annex 2, Tables 7-9. The FUND's financial program was designed so that it could earn a net income starting in 1981, its first full year of operations, 2 based upon: (i) use of the available components of its US$6.0 million, Govern- ment counterpart funds to generate short-term investment earnings; and (ii) income earned by CFN's existing US$3.1 million (equivalent) SSE loan rediscount portfolio which constitutes CFN's contribution to the FUND's capital. Earnings from short-term investments and the original SSE rediscount portfolio could equal an estimated US$400,000 equivalent in 1981, which when combined with an estimated US$226,000 in interest income from the proceeds of the Bank loan would be sufficient to cover the estimated financial cost of US$136,000, operating costs of US$164,000 equivalent, and contribute to technical assistance and net revenues of the FUND. As the SSE loan rediscount portfolio under the Bank loan grows along with disbursements, the FUND's financial performance is likely to improve, resulting in a projected 3.4 percentage point average financial spread and a low projected 1.5 percentage point average operating cost during 1981-85 (Annex 2, Tables 10, 11). The FUND is projected to earn a satisfactory net income of 2.5% on total assets, as almost all assets (except the revolving cash fund), yield financial returns. Given the FUND's very low leverage (i.e. its initial debt to equity ratio is .1.6:1), its estimated average 5.5% earnings on capital for 1981-85 are adequate for the start-up years. 3/ With the proceeds of its net revenues, the FUND would make an annual contribution to finance technical assistance to SSE participating in the project and to advance a broader objective of raising the quality of overall technical assistance. It is anticipated that during 1981-85, the FUND would have to contribute about US$450,000 towards these objectives (paras. 3.31-3.35). 1/ Based upon an analysis of data on loan size distribution in commercial banks, Banco Nacional de Fomento (BNF) and CFN. 2/ In the context of CFN's projected operating loss for 1980-81, its manage- ment placed high priority upon the avoidance of losses by the FUND. 3/ During 1985 earnings on capital and retained earnings are projected to rise to 7.6%.  - 34 - C. Potential Intermediary Institutions 3.30 The Banco Nacional de Fomento, and all commercial banks and financieras legally established and operating in Ecuador, would be eligible to use the FUND's SSE loan rediscount facility. To participate in the project, an eligible institution would have to meet the requirements established under the participation agreements. These would provide, among other things, that the participants would: (i) maintain or contract staff capable of perform- ing satisfactory project appraisals; (ii) supervise projects to ensure that resources were being used for the purposes intended and that projects were progressing on schedule; (iii) ensure that procurement and disbursement provisions were met; (iv) adhere to terms of lending and repayment of loans; (v) maintain adequate records on Bank-financed projects; and (vi) provide the FUND and the Bank with such information as they would reasonably request. Receipt by the Bank of a satisfactory agreement between CFN and a participating intermediary would be a condition of loan disbursement to such intermediary. Included in BNF's participation agreement would be a requirement that BNF harmonize its term lending rates under the recent D14 25.0 million KfW loan to finance term SSE credit with Bank lending rates. BNF's management has agreed in principle to take such action which would involve their: (i) using KfW resources only for smallest short or medium term credits of under US$3,500 (capacitation credit) at 11%; or (ii) making KfW resources available for regular term loans at rates equal to those charged under the Bank loan. D. Technical Assistance 3.31 The FUND, in conjunction with MICEI and the Federation of Chambers of Small Industry (FCPI) would channel amounts on a grant basis to meet technical assistance needs. Such amounts would depend on the FUND's annual operating results. The purposes of such assistance would be to: (i) facilitate access to credit funds by smallest SSE; (ii) assist in the development of subprojects in priority subsectors; and (iii) bring small scale entrepreneurs directly into the planning for and implementation of technical assistance programs through participation by their Federation. 3.32 A technical assistance coordinating committee to be called the Technical Cooperation Committee (TCC) would be established with a representa- tive of MICEI, the President of FCPI and the manager of the FUND. The TCC would set policies for financing and coordinating technical assistance programs, and would consider and approve funding of proposals for such programs presented by CENAPIA, or by the regional small industry and artisan chambers. Administration of the resources, in accordance with TCC decisions, would be the responsibility of the FUND, which would assign a professional to manage such programs. The FUND would develop initial procedures for preparation and review of proposals and for control of technical assistance subprojects in consultation with TCC. In evaluating requests for funding of technical assistance programs, expected impact, conformance to policies established by TCC, and coordination with other sources of technical assistance would be important criteria. Proposals approved and funded by TCC would be executed by  - 35 - the entity concerned under a simple contractual arrangement with CFN on behalf of the FUND. This competitive basis for access to project resources for technical assistance is intended to provide: (i) incentives for performing well in the delivery of technical assistance services; (ii) access to resources for the variety of private, non-profit entities offering such services, as well as the public sector's main agency (CENAPIA); (iii) opportunity for feedback from project beneficiaries through their associations or through their participation in the approved technical assistance subprojects. A preliminary estimate of potential technical assistance programs during 1981-85 indicates the need for about US$0.5 million equivalent which would provide for about 45 manyears of assistance under the project. 3.33 In addition, individual SSEs could obtain subloans under the project for direct contracting of private consultant services. Although this is expected to account for only a small portion of credit demand, the mechanism would permit particularly the larger of the SSE to finance technological and/or management improvements affecting their productivity through use of consultant services. 3.34 Initial priority beneficiaries of the technical assistance programs would be potential subborrowers outside of the Guayas and Pichincha provinces with total assets (excluding land and buildings) of under S/1,000,000. To participate in the programs CENAPIA would submit to TCC a proposal for assistance to these SSEs in the preparation of subprojects and for diagnostic and referral services to ongoing programs in general training, marketing and basic technology of priority sectors. 3.35 The technical assistance component of the proposed project would be implemented through an agreement between CFN and MICEI, and between CFN and FCPI. The first of these two agreements would include the nomination of MICEI's representative to the TCC (provisionally MICEI's Director of Small Scale Enterprise Division), and the contribution of MICEI for sharing the costs of CENAPIA's initial program(s) under the project. The FCPI agreement would include the formalization of participation of the Federation and its chambers in implementing the project and the nomination of the FCPI represen- tative to the TCC. CFN and MICEI plan to prepare draft agreements for review by FCPI during late July/early August and to sign final TCC agreements after loan signing. IV. THE PROPOSED LOAN A. General Description 4.01 Amounts and Terms. The proposed loan of US$20.0 million would be made to the Government of Ecuador at the Bank's prevailing interest rate (presently 8.25%) and standard commitment fee of 3/4 of 1% p.a. The Govern- ment, through BCE, with whom it would sign a satisfactory fiscal agency contract, would on lend to CFN on equal terms and conditions. CFN in turn would make the proceeds of the loan available to its Small Scale Enterprise Fund (FUND), to be channelled to small scale industry and artisans through  - 36 - financial intermediaries that meet the FUND's conditions for participation (para 3.30). The foreign exchange risk on the proposed Bank loan would be borne by the Government without charge. Subject to review not later than 18 months after loan signing, no single financial intermediary could commit more than US$12.0 million in FUND resources. To ensure that the FUND had adequate net revenues to perform its operating and technical assistance functions and to expand future SSE lending operations, the Government agreed during negotiations to assume the commitment fee. 4.02 As the expected large number of subloans would make a composite amortization schedule for the Bank's DFC operation impractical, and in order to provide more resources to SSE lending, the loan would be repaid in equal installments over a fixed 17 year term, including 4 years of grace. With the average term of subloans expected to be lower than the proposed loan maturity, this would entail a roll-over of Bank funds which would be used by the FUND for further SSE subproject financing in accordance with its Policy Statement, which would be approved by the Bank. To capitalize the FUND: (i) the Govern- ment would make available to the FUND US$6.0 million equivalent in counterpart resources in three installments, the first of US$3.0 million to be a condition of effectiveness, the second installment of US$1.5 million by June 30, 1981, and the final installment of US$1.5 million by October 31, 1981. To assure that the Government's contribution would be made in accordance with the agreed upon schedule, the Bank would not authorize withdrawal from the loan account beyond US$10.0 million if the June 30, 1981 installment of Government capital contribution had not been made and beyond US$15.0 million if the final Octo- ber 31, 1981 installment had not been deposited in the FUND's account; (ii) CFN agreed at negotiations to maintain within the FUND its portfolio of discounted SSE loans (currently equal to US$3.1 million equivalent) plus cash and liquid assets which are a part of its existing SSE Fund's asset structure (currently about US$900,000 equivalent), the total amount of which is expected to equal an estimated US$4.0 million; and (iii) the net revenues accruing to the FUND would remain part of its resources. 4.03 Subloans would carry minimum interest rates of 12%. Subloans to SSE with assets of less than US$25,000 equivalent (excluding land and buildings) would be made at the 12% interest rate irrespective of the subloan's terms and consistent with loans to artisans and shopkeepers under the Guayaquil Urban Project. Subloans to SSE with assets larger than US$25,000 (equivalent) would include a commission of 2%, 3% and 4% for terms of greater than 2 to 5 years, 5 to 8 years, and 8 years and over respectively, resulting in 14%, 15% and 16% lending rates which is consistent with the rate structure under IDF Loan 1731-EC. Participating financial intermediaries would be given a financial spread of 6% to encourage industrial credits to the smallest enterprise and spreads of 4%, 5% and 6% respectively for the balance of SSE, depending upon loan terms to encourage further term lending (paras. 3.19-3.20). While these spreads are lower than the current 6% available to financial interme- diaries under the MFF rediscounting facility, it is anticipated that they would be adequately attractive to financial intermediaries whose access to the MFF facilities are at best limited and uncertain. Interest rates and spreads could be modified by agreement between the Bank and CFN after a review not later than 18 months from loan signing (para.2.18).  - 37 - 4.04 Maximum Size of Subloan and Free Limit. The FUND's maximum subloan for any one investment project would be US$300,000 and the maximum size for any one investment enterprise would be US$350,000 in fixed assets (excluding land and buildings). These limits could be modified by agreement between the Bank and CFN to conform to anticipated changes in SSE law. All subproject appraisals submitted by financial intermediaries would be reviewed by the FUND. The first loan over US$50,000 from each FI would be submitted to the Bank for review and comment. 1/ All subloans above US$250,000 (the free limit) would require Bank approval. CFN would impose an initial free limit of US$150,000 upon its participating financial intermediaries which would be subject to review by the Bank and CFN not later than six months after effec- tiveness and adjustment from time to time and an ERR calculation would be prepared, generally by FUND staff, for all projects above this free limit using standard Bank guidelines for DFCs. This procedure is expected to result in review by the Bank of a sample of subloans covering about 12% of the loan amount, which would be adequate, given that CFN's skilled appraisal department would review between 50 and 60 free limit projects accounting for about 40% of the loan resources. To help further improve CFN's operations the Bank would supervise the proposed loan closely and review ex-post, in the field, a significant sample of the smaller subprojects. 4.05 Procurement. The loan funds would finance the foreign exchange costs of mainly locally procured and limited quantities of directly imported equipment, materials and services. The financial intermediaries and CFN would satisfy themselves that procurement items were suitable for the respective investment projects and reasonable priced and that the beneficiaries had convased the main available sources of supply and were purchasing from advan- tageous sources. Whenever justified, items would be procured on the basis of several quotations, in accordance with standard practice for IDF-type projects. Since it may be difficult or relatively costly to obtain quota- tions from several suppliers in the case of the small orders that are expected to comprise the majority of procurement operations, the solicitations of offers would be expected mostly for the few relatively larger procurement contracts. Consulting services for project preparation or technical assistance services used in conjunction with SSE subprojects would be open to local professional consulting firms prequalified by the FUND and terms of reference subject to their review. 4.06 Commitment and Disbursement. The final date for the submission of subloan proposals would be December 31, 1983 and the closing date for disburse- ments would be December 31, 1984 (Annex 2, Table 13). The Bank would reimburse the FUND for 67% of the FUND's total financing of subprojects on the basis of a certificate of expenditure submitted by the FUND. The supporting documents would be retained in Ecuador for inspection during Bank supervision missions. 1/ Enabling the Bank to check initially that appraisals of SSE subprojects are appropriate in focus and depth without delaying the approval process.  - 38 - 4.07 While the Bank normally does not reimburse for subproject expendi- tures made more than 90 days prior to receipt of the subloan request, in line with prior Bank experience under small scale industrial credit programs, using the two tier system, this limit would be raised to 180 days to compensate for the longer time periods involved in the approval process. 4.08 The CBE has agreed to serve as financial agent for the project (in addition to its fiscal agent function on behalf of the Government) for a fee of 1/8% (Annex 1). As financial agent, its main operational respon- sibility would be to serve as the rediscount and collection facility for the FUND crediting and debiting the financial accounts of participating financial intermediaries (para. 3.12). 4.09 Accounting and Auditing. CFN would establish and maintain separate accounts for the FUND. Currently, the accounts of CFN and its special funds and accounts (including FOPEX) are prepared by CFN's accounting department and reviewed and audited by its internal auditor, the Superintendent of Banks and its external auditors. The audit of the FUND's separate accounts by indepen- dent external auditors, satisfactory to the Bank, would be part of the audit of CFN's accounts and audit reports of a content and in a format satisfactory to the Bank would be submitted to the Bank not later than 5 months after the close of each fiscal year. 1/ B. Project Benefits and Risks 4.10 This initial pilot project is designed to help create an institutional setting within CFN and financial intermediaries for the efficient channeling of financial resources to the SSE sector. At the same time the program would be used to help restructure the quality and orientation of technical assistance services to SSE. Thus, it is expected that the Bank loan would start to make a significant contribution to the growth and rational development of the geographically dispersed SSE sector. 4.11 The proposed loan would contribute to filling a major gap in term financing of SSE projects in Ecuador and is expected to help finance through CFN about 625 subprojects with an estimated total cost of US$37.5 million equivalent (Annex 2, Table 14). Total financing under the SSE credit project including the Bank loan, contributions of the government, and CFN would provide about 15% to 20% p.a. in incremental term credit to the rapidly growing SSE sector over the expected loan commitment period (1981-83) and would thus contribute significantly to the anticipated 8% p.a. sector growth. 4.12 Given the high labor component of both the traditional (wood, textiles and food) subsectors and modern metal mechanics operations which would receive about 60% of total resources applied to subloans under the project, it is expected that about 4,300 new jobs would be created at a relatively low cost of US$8,700 per job (in 1978 prices) 2/. The modern subsectors into which increasing numbers of the newly skilled Ecuadorian entrepreneurs have been moving, are expected to provide about 25% of new job opportunities. 1/ Consistent with audit provisions under Bank Loan 1731-EC. 2/ Compared with US$23,000 per job created for industry in general.  - 39 - 4.13 Risks. This being a pilot project it poses some special implemen- tation risks and is likely to involve, at least initially, relatively high supervision costs because of the untested administrative arrangements, espe- cially with regards to CBE's serving as the subloan rediscount and collection agent for the project. Should CBE be unable to function in an agile and flexible fashion private financial intermediaries might withdraw from the project which could lead to a slowing down in rate of loan disbursement and a shortfall in the FUND's projected net revenues and its ability to finance technical assistance. The danger of delays in subloan financing should be reduced by the agreed upon procedures which would be incorporated in the subsidiary loan agreement between CFN and CBE, and the agreement reached during loan negotiations on a mechanism for periodic review of the operations and procedures of the FUND and CBE's financial agent activity. Agreements between CFN and participating financial intermediaries will specify the role of each of the signatories and the links between them and CBE. The project represents an initial effort towards making term credit and improved technical assistance available to SSE. The importance of these objectives and the steps being taken to ensure successful project implementation justify accepting these risks. V. AGREEMENTS AND RECOMMENDATIONS 5.01 During loan negotiations, agreements were obtained and understandings reached on the following: (a) With the Government of Ecuador, on: (i) the terms and conditions of the proposed loan including the review thereon (Chapter IV-A), the procedures for making available the proceeds of the loan to CFN, interest rates on subloans (para. 3.19), free limits (para. 4.04), and commitment and disbursement (para. 4.06-4.07); (ii) the provision of US$6.0 million equivalent in counterpart funds to complement resources of the Bank loan and CFN's existing FUND resources (para. 4.02); (iii) assuming the foreign exchange risk between the currencies of disbursements and the Sucre and payment of the commit- ment fee (para. 4.01); (iv) the fee to be charged by CBE and the administrative mechanism to be established for disbursement and collection on behalf of the FUND (paras. 3.12, 3.13 and 4.08).  - 40 - (b) With the Government and CFN, on: (i) making available to the FUND the proceeds of the Bank loan (paras. 4.01-4.02); and (ii) the Government making available to the FUND US$6.0 million equivalent as paid-in capital according to an agreed upon schedule and the Bank authorizing withdrawal from the loan in accordance with this schedule (para. 4.02); (iii) the date by which agreements satisfactory to the Bank would be signed between the Government and CFN, and CFN and FCPI with respect to TCC operations (para. 3.35); (iv) reviewing the efficiency of the CBE's financial agent mechanism six months after effectiveness and from time to time thereafter (para. 3.13). (c) With CFN, on: (i) the content and status of the draft CFN resolution authorizing the restructuring of the FUND with its own organization, staffing (para. 3.07), expanded financial resources (para. 3.25) and separate accounting; (ii) the FUND's-policy statement (para. 3.08), operating regula- tions and procedures (para. 3.09), appraisal and supervision guidelines for the FUND and participating intermediaries (paras. 3.22 and 3.23); (iii) the FUND's initial organizational structure and staffing and the status of hiring the FUND's unit Chief (para. 3.10); (iv) a suitable schedule for a training program for staff of the FUND and of selected financial intermediaries (para. 3.24); (v) the Board's lifting restraints on CFN's commission and fee structure on financial services (including guarantee and letters of credit) by June 30, 1981, allowing CFN to charge maximum allowable limits (para. 2.15); and (vi) drafts of participation agreements to be signed by BNF and other financial intermediaries (para. 3.30). 5.02 Conditions of loan effectiveness are that: (i) CFN establishes the FUND in its new form (para. 3.07) and adopts satisfactory: (a) Policy Statement (para. 3.08); (b) Operating Procedures (para. 3.09); Organizational Plan (para. 3.10); and Project Appraisal and Supervision Guidelines (paras. 3.22 and 3.23) for the FUND;  - 41 - (ii) CFN's FUND receives US$3.0 million equivalent as a permanent resource (para. 3.25); (iii) the Government and BCE enter into a fiscal agency contract satisfactory to the Bank (para. 4.01); and (iv) CFN and CBE enter into a subsidiary agreement satisfactory to the Bank (para. 3.13). 5.03 Condition of disbursement by the Bank of the loan beyond US$10.0 million and beyond US$15.0 million would be the Government's scheduled payments of its capital contribution to the FUND by June 30 and October 31, 1981 (para. 4.02). 5.04 Condition of disbursement by CFN to a participating financial intermediary would be signature of a satisfactory participation agreement between CFN on behalf of the FUND and such intermediary (para. 3.30). 5.05 Recommendation. With the assurances and conditions indicated above, the project is suitable for a Bank loan of US$20.0 million equivalent.  - 42 - ANNEX 1 ECUADOR SMALL SCALE ENTERPRISE CREDIT PROJECT Banco Central del Ecuador Office of the General Manager Agreement on Basic Aspects of the Loan Program for Small Scale Industries to be Financed by the World Bank 1. Under a World Bank loan for US$20 million to the Government of Ecuador, the latter will be responsible for the exchange risk and all other obligations arising from the loan agreement. 2. The proceeds of the World Bank loan will be deposited into a project account to be maintained at the Banco Central del Ecuador, the financial agent of the Government of Ecuador. 3. As all credit transactions related to this international loan are to be administered by the Corporaci6n Financiera Nacional, that agency will accept the counterpart funds for the projects, for which purpose it will maintain said funds in an account in its name with the Banco Central del Ecuador. 4. The Corporaci6n Financiera Nacional will be the project's executing agency and will onlend the loan proceeds. It will also approve the investment plans and credit applications. Once these requirements and all others estab- lished by the World Bank in this matter have been met, the Corporaci6n Financiera Nacional will request the Banco Central del Ecuador to make the rele- vant disbursements, into the accounts of the financial intermediaries partici- pating in the operations in question. The financial intermediaries will in turn authorize the Banco Central del Ecuador to debit their accounts auto- matically for all loan commissions, interest and principal repayments, when due. The Banco Central del Ecuador will debit the credit funds without any further procedures, after the request is received, and all external formalities fulfilled, in the proportion of two-thirds from the special account representing the proceeds of the World Bank loan, and one-third from the counterpart funds in the Corporaci6n Financiera Nacional's account. On each due date, the Banco Central del Ecuador will, as mentioned above, debit the pertinent amounts to the participating financial intermediaries and credit them in the same proportions from whence they came to the project and counterpart accounts. The Banco Central del Ecuador will at no time be responsible for credit risks, which are to be borne by the participating financial institutions and the Corporaci6n Financiera Nacional, in that order.  -43 - ANNEX 1 5. The Banco Central del Ecuador will receive a commission of one- eighth of one percent for acting as financial agent. Quito, March 18, 1980 /s/ Mauricio Davalos G. /I/ Modesto Correa San Andres General Manager General Manager Banco Central del Ecuador Corporaci6n Financiera Nacional  ECUADOR: SMALL SCALE ENTERPRISE CREDIT PROJECT Industrial Output, Employment and Productivity (Value Added in millions of 1970 Sucres) 1970/78 Growth 1970 1974 1977 1978 No. % No. % No. - No. % % Factory Firms a/ eurm ana Large) Value added 3,734.0 65.8 5.,549.0 71.3 7,685.0 70.1 8,689.0 70.0 11.1 Employment ('000) 48.1 19.3 66.4 24.0 87.4 26.0 89.2 26.0 8.0 VA/Emp. 77,630.0 83,584.0 87,929.0 97,410.0 3.0 No. of firms 982.0 1,253.0 156.0 1,667.0 6.8 Small and Artisan Value added 1,937.0 34.2 2,229.0 28.7 3,295.0 30.0 3,724.0 30.0 8.5 Employment ('000) 201.5 80.9 210.0 76.0 249.0 74.0 253.8 74.0 3.0 VA/Emp. 9,613.0 10,614.0 13,232.0 14,672.0 5.4 Total Manufacturing Value added 5,671.0 100.0 7,778.0 100.0 10,980.0 100.0 12,413.0 100.0 10.3 Employment ('000) 249.4 100.0 276.4 100.0 336.0 100.0 343.0 100.0 4.1 VA/Emp. 22,739.0 28,140.0 32,640.0 36,189.0 b/ 6.7 Factory VA/EMP Artisan VA/EMP 8.1 7.9 6.7 6.6 a/ Factory firms are those which employ eight or more workers, thus they also include some firms that would be classified as small scale industry and artisan firms under small scale industry incentive laws. b/ In current US$ value added, US$10,513 per employee (SSE = US$1,380, factory = US$9,130). Source: CBE M"  - 45 - ANNEX 2 Table 2 ECUADOR: SMALL SCALE ENTERPRISE CREDIT PROJECT Industrial Structure: Output of Total and Small Scale Industry and Artisan Workshops (SSE) (% of Output) Total Total Registered SSE Pichincha Industry SSE a/ Survey b/ 1970 1977 1978 1978 Consumer Goods Food, beverages, tobacco 34.2 35.2 17.0 17.8 Clothing, footwear 0.6 0.9 11.1 8.7 Wood furniture 1.1 1.7 3.2 5.5 Paper and printing 9.3 9.0 3.8 10.3 Final chemical, plastic & rubber products 10.0 11.4 8.9 14.6 Other 3.3 2.9 2.5 1.9 Subtotal 58.9 61.1 46.5 58.8 Intermediate Goods Textiles, leather 13.4 13.3 7.1 1.2.8 Wood 3.5 2.5 4.7 3.0 Chemical products 8.0 6.8 5.3 6.5 Non-metallic mineral products 4.4 4.5 6.4 2.2 Basic metals 1.4 1.3 0.1 - Subtotal 30.7 28.4 23.6 18.5 Capital Goods Machinery and equipment) 15.6 11.0 Metal products ) 10.5 10.5 14.3 11.7 Subtotal 10.5 10.5 29.9 :22.7 Total Industry 100.0 100.0 100.0 100.0 a/ 2,500 firms registered for benefits under the Ley de Fomento de la Artesania y Pequena Industria (SSE). b/ Survey of 555 members of the Federation of Small Industries, Pichincha province (Quito). Sources: CBE, MICEI and FCPI.  - 46 - ANNEX 2 Table 3 ECUADOR: SMALL SCALE ENTERPRISE CREDIT PROJECT MINIMUM WAGES (S/ per month) Nominal .Real Real mini- Real Minimum Wage, Minimum Wage, mum Wage, Minimum Medium and Price Medium and Registered Wage, Large Firms Index Large Firms SSI Firms Artisan Firms 1970 832.0 100.0 832.0 832.0 832.0 1971 1040.1 109.9 946.4 946.h 757.1 1972 1043.9 118.3 882.4 882.4 705.9 1973 1043.9 132.3 789.0 789.0 631.2 1974 1662.3 162.6 1022.4 1022.4 766.8 1975 2120.0 186.3 1137.9 1137.9 864.8 1976 2501.3 205.4 1217.8 1217.8 925.5 1977 2301.3 231.2 1081.9 1081.9 822.2 1978 2601.3 261.8 993.6 993.6 753.1 1979 3351.7 287.3 1166.6 1166.6 886.6 1980 6603.4 339.0 1/ 1947.9 1483.1 1363.5 1/ Assuming 18.0% p.a. inflation in 1979-80.  - 47 - ANNEX 2 Table 4 ECUADOR: SMALL SCALE ENTERPRISE CREDIT PROJECT Financing of Small Scale Industry (Thousands of Sucres and Percent) Short Term Medium Term Long Term Average Average Average Size of, Percent of Size of Percent of Size of Percent of Total Percent of Loan, Subsector Loan, Subsector Loan, Subsector Credit Sector Subsectors Total Total Total Total Total 1,364.4 59 1,294.2 29 2,032.9 12 6006097 100.0 Food 1,048.3 37 745.9 28 3,003.3 35 51.063 8.4 Beverages 833.3 43 3,000.0 24 4,000.0 33 12300 2.0 Textiles 887.2 49 910.7 38 1.243.6 13 66,233 10.1 Garments 14512.4 76 14321.3 22 1,600.0 2 66,044 10.8 Leather 125.0 9 2,583.5 91 - - 54667 0.9 Footwear 1,301.5 91 302.5 9 - - 7J113 1.2 Wood Products 449.1 39 744.2 29 1,320.0 32 12.621 2.1 Furniture 1,132.8 61 1;887.5 26 14825.0 13 29.