Peru - Second Industrial Credit Project

Document of The World Bank FILE CoPy FOR OFFICIAL USE ONLY Repsi No. P-2995-PE REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE CORPORACION FINANCIERA DE DESARROLLO (COFIDE) WITH THE GUARANTEE OF THE REPUBLIC OF PERU FOR A SECOND INDUSTRIAL CREDIT PROJECT March 19, 1981 This docum hb a redricted disbibt,s id may be used by reciets ody i the pufmance of i their offieial dtki.ts contests may t oterwise be dbcowd withot Wrd Bank authorbato.  CURRENCY EQUIVALENTS The exchange rate is being adjusted daily roughly in line with the differential between domestic and international inflation. The exchange rate and currency equivalents in 1980 and as of March 1, 1981 were as follows: Currency Unit = Sol (SI.) Calendar 1980 March 1, 1981 US$1 = SI. 287.83 SI. 374.99 S/.1 US$ 0.0035 US$ 0.0027 S/. 1,000 = US$ 3.47 US$ 2.67 Fiscal Year January 1 to December 31 Abbreviations CERTEX Certificado de Reintegro Tributario a la Exportacion (Export Tax Credit Certificate) COFIDE Corporacion Financiera de Desarrollo (State Development Finance Corporation) ERP Economic Recovery Program FENT Fondo de Exportaciones No Tradicionales (Non-Traditional Exports Fund) FIRE Fondo de Inversiones Regionales (Regional Investment Fund of COFIDE) FONCAP Fondo de Bienes de Capital (Capital Goods Fund of COFIDE) FONEX Fondo de Exportacion (Export Fund of COFIDE) FRAI Fondo de Redescuento Agroindustrial (Agroindustries Rediscount Fund of COFIDE) MITI Ministerio de Industria, Turismo e Integracion (Ministry of Industry, Tourism and Integration) RNM Registro Nacional de Manufacturas (National Register of Manufactures)  FOR OFFICIAL USE ONLY REPUBLIC OF PERU SECOND INDUSTRIAL CREDIT PROJECT LOAN AND PROJECT SUMMARY Borrower: Corporacion Financiera de Desarrollo (COFIDE) Guarantor: Republic of Peru Amount- US$60 million equivalent Terms: Repayable in 17 years on a composite amortization basis, including 4 years of grace, at 9.6 percent interest per annum. Relending Terms: COFIDE would on-lend the proceeds of the proposed loan to ultimate beneficiaries in US dollar denominated subloans, either directly or through other financial intermediaries. The Government would assume for COFIDE the cross-currency risk (i.e. between the Bank's currency basket and the US dollar) for a premium of 1.5 percent p.a. on the outstanding amount to be paid into a special account within COFIDE. Subloans would have maturities of 4 to 15 years, including up to 3 years of grace, depending on the type of investment. The interest rate charged to the financial intermediaries would be 1 per- centage point above the base rate, defined as the interest rate of the proposed Bank loan plus the 1.5 percent premium for the cross-currency risk. The interest rate charged to intermediaries, as well as the premium to cover the cross-currency risk, would be periodically reviewed by COFIDE and the Bank during the commitment period of the proposed loan. Project Description: The proposed loan would help finance projects mostly in the industrial, mining and tourism sectors. It would contribute to the institutional strengthening of Peru's term-financing subsector by supporting the reorga- nization of COFIDE, further developing the project appraisal capabilities of COFIDE and other participating financial intermediaries, and promoting competition among the various financial intermediaries. The economic return for subprojects is expected to range between 15 and 40 percent. Special Risks: The proposed loan does not face any unusual risks. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - Estimated Disbursements: 1982 1983 1984 1985 (US$ million by Bank FY) Annual 8.0 21.0 20.0 11.0 Cumulative 8.0 29.0 49.0 60.0 Appraisal Report: Staff Appraisal Report No. 3238-PE, dated March 12, 1981.  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE IBRD TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE CORPORACION FINANCIERA DE DESARROLLO (COFIDE) WITH THE GUARANTEE OF THE REPUBLIC OF PERU FOR A SECOND INDUSTRIAL CREDIT PROJECT 1. I submit the following rep-rt and recommendation on a proposed loan to the Corporacion Financiera de Desarrollo (COFIDE) with the guarantee of the Republic of Peru for the equivalent of US$60.0 million to help finance a second industrial credit project. The proposed loan would be repayable over 17 years, including 4 years of grace, on a composite amortization schedule, with interest at 9.6 percent per annum. COFIDE would relend the loan proceeds in US dollar denominated subloans, either directly or through other financial intermediaries. The Government would assume for COFIDE the cross-currency risk between the Bank's currency basket and the US dollar for a premium of 1.5 percent p.a. The interest rates charged to financial intermediaries and to ultimate beneficiaries would be 1 and 4 percentage points, respectively, above the base rate, defined as the interest rate of the proposed Bank loan plus the 1.5 percent premium for the cross-currency risk. Onlending to financial intermediaries and the subloans to the ultimate beneficiaries would be at terms of 4 to 15 years including grace periods of up to 3 years, depending on the type of investment. PART I - THE ECONOMY 1/ 2. A basic economic report entitled "Long-Term Development Issues: Peru" (Report No. 2204-PE) was distributed to the Executive Directors on April 13, 1979. This part is based on the report's findings and on those of more recent economic missions to Peru. Country data sheets are attached as Annex I. Natural and Human Resources 3. Per. , the fourth largest country in Latin America, is divided by the Andes mountains into three distinct regions: the coastal region (Costa), with 46 percent of the population and where modern economic activity is concen- trated; the mountain region (Sierra) with 44 percent of the country's popula- tion; and the sparsely populated tropical rain forests east of the Andes (Selva). The country's rugged topography limits trade between the three regions. 4. Peru's natural resources include large deposits of minerals-- particularly copper, iron, silver, and zinc--located mainly in the Sierra and the southern Costa. There are also large phosphate deposits, located in the northern Costa. Petroleum resources found in the jungle areas and offshore are also substantial, but their full extent has not yet been ascer- tained. Another major natural resource is the large fishing potential in coastal waters, although the magnitude of the catch is subject to sharp fluctuations. Agricultural land is limited, and most of the soils suitable for intensive agriculture are already being farmed. 1/ This part is substantially unchanged from the Aviation Development Project President's Report of March 4, 1981 (Report No. P-2979-PE).  - 2 - 5. Crude oil is the dominant source of energy in Peru, supplying approximately 80 percent of Peru's commercial energy requirements. Although Peru's energy resource base is relatively diverse, with scope for expanding hydro and coal based power generation, petroleum is expected to be the major energy source in Peru through the rest of this century. After having been dependent on imported crude oil for many years, domestic oil production increased almost threefold between 1976 and 1979 to about 200,000 barrels per day, enabling Peru to export oil in substantial quantities (about 70,000 barrels per day). Despite this encouraging production trend, domestic consumption is rebounding after several years of stagnation, and Peru may once again become a net importer of petroleum in the mid-1980s unless new oil reserves are discovered and rational pricing policies adopted to contain demand growth. The Government has begun to address the problem vigorously. Prices for domestically consumed petroleum products were steeply increased, and new legislation was enacted offering special tax incentives to investors. Response to the tax incentives has been positive. 6. As a result of three decades of rapidly falling mortality rates, Peru's population growth accelerated during the 1930-1960 period. In the early 1960s, however, birth rates started a gradual fall, mainly caused by the urbanization process and by improved education. But with declining death rates, population has continued to grow at about 2.7 percent p.a. and is currently estimated at about 17 million. It is expected that population growth will fall only slightly to about 2.6 percent p.a. over the next 20 years, unless an effective demographic policy is adopted. The urban population is increasing rapidly at 4.5 percent p.a., and over 4 million people are concentrated in Lima. Given the structure of Peru's population, the labor force is expected to grow in excess of 3 percent per year during the next 20 years. Past Development Policies and Performance (1968-78) 7. The military Government, in office from October 1968 until July 1980, followed a development strategy aimed at promoting economic growth and improv- ing distribution of income and wealth, not only on the individual level but also between regions. To achieve these goals, the Government expanded the role of the State in the economy, changed the pattern of asset ownership, reduced foreign ownership of national resources, oriented industry and agri- culture toward production of essential goods for the domestic market, stimu- lated regional deconcentration, and reformed the educational system. Through nationalization and creation of new enterprises, the State took direct control of key economic sectors. Moreover, the Government imposed complex legislation to control the operations of the private sector. 8. The pattern of asset ownership in the economy changed drastically. Through nationalization, the share of foreign-owned assets fell sharply. A sweeping land reform redistributed 49 percent of the country's best farmland to workers' cooperatives benefitting some 30 percent of all rural families. Through other laws, industrial workers were given shares in their employers' firms and, in the mining sector, a share in profits. While these actions benefitted large numbers of Peruvians, they barely reached the poorest groups, which continue to live in abject poverty. It is estimated, for example, that almost three quarters of rural families--mostly "minifundistas" (those farming less than 2 ha) and landless seasonal workers--were not reached by social  programs. Moreover, subsidies were given to products that were more important in the consumption basket of high and middle-income groups than in that of the poorest groups. Artificially low prices for some products---such as mutton and cereals--actually hurt the poor who produced these items, and affected production nega'tively. Although many of the policies and structuaral changes carried out after 1968 were meant to achieve rapid growth and more equality, the cost of these measures proved to be excessive and their implemnentation inefficient. 9. Between 1968 and 1977, the Government followed expansionary fiscal and credit policies. A rapid increase in expenditures was not matched by a parallel increase in revenues. Public sector savings dropped steadily in relation to GDP from 4.4 percent in 1970 to dissavings of 2.6 percent in 1977. Major causes were the erosion of the tax base owing to excessive tax incentives, loopholes, weak enforcement, rising budgetary cost of subsidies for foodstuffs and petroleum products, and sharp increases in defense outlays. At the same time, public investment expanded rapidly and was increasingly concentrated on capital-intensive projects with long gestation periods and little immediate contribution to the growth of output or employment. 10. Pricing, interest rate and foreign exchange policies encouraged consumption and discouraged savings, exports and sometimes overall production. The problems were exacerbated by circumstances beyond the control of the authorities such as the sharp drop in the catch of anchovies, the fishing industry's mainstay, and the sharp deterioration in Peru's terms of trade between 1974 and 1978. As a result, aggregate demand considerably exceeded aggregate supply. Excess demand, in turn, led to strong inflationary pressures and widening external gaps. 11. Inflation accelerated from 5 percent per year in 1970 to 38 percent in 1977. Interest rates, however, remained substantially negative in real terms, discouraging financial savings and stimulating capital flight. Moreover, the exchange rate remained practically constant between 1968 and 19753 thus contributing to the overall disequilibrium. National savings fell dramatic- ally from 16 percent of GNP in 1970 to 8 percent in 1977, when they financed only about one-half of investment. 12. The growing disequilibrium was reflected in the balance of payments. The current account deficit averaged US$1.1 billion per year in 1974-77, equivalent to nearly 9 percent of GNP. To finance this deficit, Peru accum- ulated a massive external debt. At year-end 1977, Peru's total private and public external debt--including short-term indebtedness--stood at almost US$8.3 billion, equivalent to two-thirds of GDP and almost four times exports of goods and non-factor services. Much of this debt was contracted on fairly short maturities. Three-fourths of the US$6.4 billion long-term public sector debt (including undisbursed) was scheduled to be repaid over the 1978-82 period. 13. Following the 1968-74 period of rapid expansion during which GDP grew by more than 6 percent per year, the growth rate dropped progressively and became negative in 1977 and 1978. GDP (at constant 1973 prices) fell by 0.1 percent in 1977 and a further 0.7 percent in 1978. In this two-year  - 4 - period, GDP per capita dropped by over 6 percent and unemployment or under- employment is believed to have risen to almost 60 percent of the labor force, up from less than 50 percent during the early 1970s. According to Government estimates, the purchasing power of an average salary had fallen 40 percent by 1978 compared to 1970 and that of an average wage by over 16 percent. Stabilization Policies and the Economic Recovery Program (1978-80) 14. From 1975 on, several unsuccessful attempts were made to cope with Peru's deteriorating economic situation. By mid-1978 the economic crisis had reached grave proportions, with a drop in real GDP and inflation approaching 100 percent. Moreover, the private sector was finding it increas- ingly difficult to open letters of credit for new imports and the banking system's net international reserves had dropped to a negative level of US$800 million. Financial instability had reached the point where practically all economic activities were adversely affected. The public sector was fast approaching the point where it would no longer be able to fully service its external debt. Peru was no longer creditworthy. 15. Beginning in May 1978, the Government adopted a number of important measures aimed at strengthening public finances, improving the balance of payments and curbing inflation. It also reached an agreement with foreign commercial banks to reschedule US$185 million of principal payments due in the second half of 1978 until January 1979. Moreover, the Government negotiated a stand-by arrangement with the IMF for SDR 184 million. In July 1979, this stand-by was replaced by a new one for SDR 285 million in support of the same financial program. Peru's debt outstanding to the IMF as of January 31, 1981 amounted to SDR 617.5 million. 16. Major debt-relief operations carried out in late 1978 enabled Peru to reduce the debt-service burden for 1979 and 1980 by postponing repayment to the 1982-1986 period. In May 1978, the Soviet Union rescheduled the equivalent of about US$140 million of maturities originally due in 1978-80. These amounts are to be repaid over a 10-year period including three years of grace. In November 197E at a Paris Club meeting, the OECD countries agreed to reschedule 90 percent of principal payments due by the public sector to governments and guaranteed suppliers in 1979 (US$250 million) and 1980 (US$263 million). These amounts were to be repaid over a period of eight years, including three years of grace. The Paris Club creditors also agreed to reschedule 90 percent of the principal payments due in 1979 and 1980 on private sector debt guaran- teed or insured in the creditor countries (about US$30 million in each year). In addition, Peru negotiated smaller amounts of debt relief with non-OECD countries. At the end of 1979, however, in view of the improved balance of payments situation, the Government decided to forego the Paris Club debt rescheduling option for 1980. 17. As regards the large medium-term public debt to commercial banks, in keeping with an agreement concluded in December 1978, Peru repaid in 1979 the bulk of the US$185 million rolled over from 1978 (para 15 above). The agreement gave the Government the option of refinancing up to 90 percent of the maturities due in 1979 and 1980. Again, in view of the strong balance of payments performance, the Government decided not to take advantage of the rescheduling of 1979 maturities, thus obtaining slightly better terms on the refinancing of 90 percent of the 1980 maturities.  - 5 - 18. To overcome the economic recession, the Government adopted a more comprehensive Economic Recovery Program (ERP), which, in addition to the above-mentioned stabilization actions, included measures to open up the economy, promote non-traditional exports, strengthen the tax system by broad- ening its base, and generally improve the efficiency of resource allocation in the private and public sectors. Import liberalization was the most im- portant element of the ERP and is expected to have salutary long-term effects on the economy. The Government also drew up a public sector investment program that aimed at redirecting investment towards projects of clear economic priority and with positive effects on production and employment. In support of the ERP, the Bank approved a US$115 million program loan in May 1979. Progress in carrying out the ERP has generally been satisfactory. Performance in some critical areas--e.g., export promotion and import liberalization-- exceeded expectations. In other areas--e.g., improvements in the quality of public investment and in raising interest rates--progress was more modest. 19. The Government's stabilization-cum-economic recovery program resulted in a strong improvement in public sector finances in 1979. Central Government revenues increased by 23 percent in real terms, while current outlays declined by 6 percent. Payments for wages and salaries alone fell by some 7 percent in real terms, partly as a result of a reduction in excessive civil service employment. Public sector current account savings rose from - 0.7 percent of GDP in 1978 to about 3.6 percent of GDP in 1979, and the overall deficit was reduced from 6.4 percent of GDP in 1978 to 2.9 percent in 1979. In spite of the good fiscal performance, however, inflationary pressures have remained strong, with consumer price increases of 67 percent in 1979 and of about 60 percent in 1980. 20. The implementation of stabilization measures and of the ERP had a positive impact on the balance of payments. Moreover, an increase in petroleum exports, substantial price increases for silver, copper, petroleum, and other commodities, as well as the relatively low level of imports because of the recession led to high overall surpluses of the balance of payments in 1979 and 1980. At year-end 1980, the net reserve position was estimated at about US$1.8 billion, equivalent to over 5 months of imports. Peru also made greater use of assistance from official bilateral and international sources thus improving the structure of its external debt. The short-term debt of less than one year, already sharply reduced from US$1.8 billion at year-end 1978 to US$1.1 billion at year-end 1979, is expected to be further reduced as the gradually improving economic situation permits new medium-term credit lines to be opened. Real GDP growth in 1979 was 3.5 percent. Growth of some 3 percent is estimated in 1980 owing, in part, to a drought which affected the agricultural sector. Outlook 21. In July 1979, the military Government promulgated a new constitution, written by a popularly elected constituent assembly. Elections were held in May 1980, and the transfer of authority to the Government of President Fernando Belaunde took place on July 28, 1980. The new Government faces a challenging economic and social situation. Although the stabilization-cum-economic recovery program (1978-80) has resulted in an improved financial situation and has laid  -- 6 - the ground for more efficient resource use, the present economic situation is characterized by a number of acute problems such as persistent high inflation, high un- and undererployment, stagnating agricultural and petroleum production, a deteriorated pattern of income distribution, food and petroleum subsidies, and an inherited rigid structure of Government expenditures with relatively low expenditures for economic and social purposes and high outlays for interest payments and defense. Peru also faces severe long-term problems like wide- spread poverty, poor state of health and nutrition, rapid population growth, severe water and land resource constraints, rapidly expanding demand for energy and potable water, and the low degree of integration between the different parts of the country. These problems call for urgent corrective measures. Tackling them all will be difficult given overall resource scarcity and particularly the very limited public sector resource availabilities. 22. The new Government has a capable economic team which is committed to economic efficiency, decontrol, promotion of the private sector, and policies conducive to a more equitable sharing of the benefits of development. During the first few months in office, the Government took important economic policy measures such as the elimination of import licenses, tariff cuts, major upward price adjustments--particularly for domestically consumed petroleum, power, and food items--adoption of higher interest rates, a new agricultural promotion law, and others. Moreover, it enacted a new petroleum law giving tax incentives to promote new petroleum exploration, and it is preparing programs to improve the situation in health, housing, and transport. Important efforts have also been made to work out a five-year public investment program that responds to the country's needs and resource availabilities. In this context, the creation in November 1980 of PROINVERSION, a committee attached to the Prime Minister's office and in charge of coordinating all efforts related to public investment including foreign financing, is an important initiative to improve the effi- ciency of resource use. 23. To tackle the most difficult short-term problems, inflation (running at over 60 percent per year) and the precarious public finance situation (with an overall public sector deficit equivalent to some 5 percent of GDP in 1980), the Government is following a restrictive financial program for 1981 with tight credit ceilings and limits to foreign indebtedness. 24. Based on cautiously optimistic assumptions with regard to economic management and commodity prices, the country is expected to have economic growth of about 5 percent per year and a manageable balance of payments situation during the next two years, with a continued gradual build up of international reserves in spite of heavy debt repayment obligations. The balance of payments situation could, however, become precarious, if the exportable surplus of oil declines and if imports further accelerate as a result of the import liberalization and economic recovery process. While measures are being undertaken to speed up petroleum exploration and to increase manufactured exports, these may not lead to the expected results in time to countervail the potential foreign exchange shortfalls. Against this background, there is a continuing need for official development assistance. Considering the above, a debt service ratio hovering around the 30 percent mark and assuming that the authorities continue the initiated course of economic policies, Peru is creditworthy for Bank lending.  - 7 - PART II - BAN-K GROUP OPERATIONS IN PERU 25. In addition to the US$58 million Aviation Development Project which the Executive Directors are expected to consider in late March, the Bank has approved 40 loans to Peru for a total amount of US$791.8 million, net of cancellations. About 28 percent of the Bank's lending to Peru has been for transportation (mainly highways and ports), 23 percent for agriculture, 18 percent for the energy sector, 11 percent for mining and industry, about 6 percent for education and urban development, and 14 percent for the US$115 million program loan of May 1979. 26. As of January 31, 1981, US$265.4 million was undisbursed on project loans (i.e., excluding the 1979 program loan) currently in execution. (Annex II contains a summary statement of Bank loans as of January 31, 1981, and notes on the execution of on-going projects.) Disbursements on Bank financed projects moved slowly in the 1976-78 period, primarily because of weak project execution capacity and a shortage of counterpart funds that worsened as the economy deteriorated during this period. In an effort to improve disbursements: (i) the Bank opened a resident mission in Peru; (ii) the Executive Directors approved modifications in the Education and the Lima/Amazon Corridor Projects (see Annex II for further details); (iii) the Government provided adequate counterpart funds in 1979 and 1980; and (iv) the Government also set up a special commission to monitor loan execution and resolve administrative problems. With these actions, the pace of disbursement is now increasing; about US$44.0 million was disbursed on project loans in FY1980 and US$29.1 million during the first half of FY1981. This compares with average dis- bursements of US$27.5 million during FY1977-79. 27. The main objectives of Bank lending to Peru have been to assist -a (i) the creation of the physical infrastructure needed to sustain and foster economic development; (ii) the expansion of productive capacity in crucial sectors; (iii) the consolidation of structural and institutional changes, particularly land and education reforms; (iv) the strengthening, through technical assistance loans and regular operations, of local capacity to prepare, implement and operate projects effectively; and (v) the improvement of living conditions for the urban and rural poor. In the past, Bank lending ,oncentrated on infrastructure in the transportation and power sectors. More recently, the Bank's emphasis has shifted to more directly productive fields -- mining, agriculture and industry -- to help Peru to strengthen its balance of payments. Lending for social projects has also grown. 28. The next operations that would be ready for the Executive Directors' consideration include projects in road improvement and rehabilitation, power engineering, small-scale industry, mining, urban development, and health. This program has been reviewed with the new Government and is in line with its priorities.  -8- 29. It is estimated that Bank loans constituted about 4.0 percent of Peru's total public external debt outstanding and disbursed at the end of 1979, and absorbed about 3.3 percent of the country's external debt service in 1979. Assuming increased recourse to long-term bilateral and multilateral aid by Peru, the Bank's share in the country's outstanding public foreign debt by 1985 could reach about 10 percent, and its share of debt-service would be around 4.5 percent. 30. IFC commitments as of January 31, 1981 have been US$29.7 million (including US$15 million to the Southern Peru Copper Corporation for the Cuajone Copper Mining Project) of which US$15.4 million is held by the Corporation. A summary statement of IFC investments as of January 31, 1981 is presented in Annex II. 31. The other principal public agencies lending to Peru are IDB and USAID. IDB is expected to emphasize lending for agriculture, industry, mining, roads, and small scale irrigation. USAID is expected to stress rural development and health. Total loan commitments as of December 31, 1980 by IDB and USAID were US$652.4 million and US$348.6 million, respectively, and their shares of debt service as of end-1979 were both estimated at 0.6 percent. PART III - THE MANUFACTURING AND FINANCIAL SECTORS The Manufacturing Sector 32. Performance and Structural Features: By the end of the 1970s, the manufacturing sector accounted for roughly one fourth of Peru's GDP. Growth of the sector during the past decade largely depended on the domestic market and was subject to large fluctuations, which mirrored those of the whole economy. During 1969-74, sectoral production grew at an average annual rate of 6.6 percent in real terms, well above GDP growth of 4.8 percent. During 1975-76, sectoral growth slowed down to about 4 percent per year and during 1977-78, because of the economic crisis referred to in Part I of this report, it dropped to a negative 4 percent. During 1979-80, as the economy rebounded the sector resumed growth at annual rates of about 4 percent and 6 percent, respectively. Industrial investment fluctuated widely during the 1970s, doubling during 1971-75 and then dropping by 1978 to 25 percent below its 1975 peak. Investment in manufacturing came largely from public enterprises. 33. The manufacturing sector in Peru is diversified. Industrial policies pursued during the past decade led to a strong expansion of intermediate goods industries such as textiles and chemicals. In 1978, traditional consumer goods industries (food, beverages, and tobacco; clothing and footwear; furniture; and others) accounted for about 40 of manufacturing industry value added, the chemical and related industries (incl. petroleum refineries) accounted for another 30 percent, and metal processing industries for some 15 percent. About 85 percent of the industrial firms in Peru are small with less than 50 employees, but over 80 percent of production is concentrated in larger firms employing over 50 persons. Manufacturing is heavily concentrated in the Lima-Callao area, by far Peru's largest market. The Lima area accounts for  -9- about 70 percent of the number of firms, employment, and output. Other industrial centers of importance are Arequipa in the south as well as Trujillo, Chimbote, and Piura in the north. With the exception of Arequipa, industries outside the Lima-Callao area mainly process locally available raw materials such as sugarcane, bagasse, cotton, fish, and others. 34. While the private sector accounts for over 90 percent of the number of industrial firms and for about two thirds of output and employment, the State's role in manufacturing is substantial. State-owned enterprises accounted for one third of output in 1978, mostly in tobacco, paper, petroleum refining, cement, iron and steel, and non-ferrous metals. The new Government is firmly committed to promoting the private sector, including foreign invest- ment. It is also considering divesting itself of some of its industrial investments. Its general policy of decontrol (para. 22) is expected to result in the further revival of private investment, which started to pick up in 1979, and in a lessening of direct Government involvement in the industrial sector. 35. Labor productivity in manufacturing stands at about twice the economy-wide level, and employment in the sector amounts to slightly over 600,000 people or some 12 percent of total employment. Most of these jobs are provided by the informal sector and small handicraft firms, primarily in the form of self-employment. Less than half of the jobs are in modern indus- trial establishments. Employment in the modern industrial sector expanded roughly in line with production during the period of growth, but did not drop as fast as production during the 1977-78 recession. This was the result of labor legislation guaranteeing jobs, which also contributed to the sharp deterioration in real wages and salaries. 36. Institutional Framework: The most important institutions shaping sectoral development are the Ministry of Economy, Finance, and Commerce, which sets trade, tax, and overall economic policies, and the Ministry of Industry, Tourism, and Integration (MITI), which is responsible for the whole system of incentives. MITI is currently preparing a new industrial development law which would simplify the structure of incentives and include legislation concerning small-scale industries. Within the private sector, two trade associations stand out 'or their influence on public opinion and the design of sectoral policies: the Association of Industries and the Association of Exporters. 37. Industrial Policies: Until the mid 1970s, Peru followed the import substitution approach to industrial development providing high tariff protection-- supplemented by import prohibitions for a large number of products--generous fiscal incentives, and credit on relatively favorable conditions. Although export incentives in the form of negotiable export tax credit certificates (CERTEX) were introduced on a small scale in 1970, industrial development was inward- oriented and manufactured exports were relatively minor, amounting to some US$75 million in 1975 or roughly 1 percent of industrial output. Up to 1973, tariffs increased steadily. During 1973-79, they remained essentially unchanged, but were gradually eroded through widespread exemptions and the overvaluation of the sol during 1968-75/76. Beginning in 1970, tariffs were gradually replaced by non-tariff barriers including import licensing, prohibitions, state monopolies, and, in particular, the National Register of Manufactures  - 10 - (RNM). The RNM consisted of a list of industries that was maintained by the Direction of Industry within MITI. Imports competing with goods produced by industries on the RNM were banned. Out of the 4,600 items in the customs classification, about 40 percent were subject to non-tariff barriers in 1973, and this share had grown to about 60 percent by early 1979 (including about 1,400 items in the RNM). 38. A major reorientation of industrial policies took place in connection with the 1978 ERP, which was supported by the Program Loan. The complex system of non-tariff protection was dismantled and replaced by a new tariff system. In addition, more vigorous export promotion efforts were undertaken along with a more flexible exchange rate policy, which complemented an increase--introduced in 1976--in CERTEX. The first important liberalization measures were intro- duced in March 1979, when the RNM was abolished and replaced by a greatly reduced temporary list of import prohibitions, which by now have virtually disappeared. The new tariff structure became effective in December 1979. 39. These policy changes resulted in an important reorientation of industrial development, with the value of manufactured exports increasing from about US$100 million in 1976 (equivalent to 1.6 percent of industrial output) to almost US$700 million in 1979 (equivalent to about 8 percent of output). Textiles and fish products accounted for most of this increase. 40. The new Government has accelerated the import liberalization pro- cess by further eliminating administrative barriers (including the whole system of import licensing) and by reducing tariffs. At present, the unweighted average of tariffs is 34 percent, with the maximum tariff at 60 percent. The Government is committed to reduce tariffs further over a period of three to five years through successive, pre-announced cuts and to make the tariff structure more uniform with the ultimate goal of a flat rate. The Government revised the CERTEX system in February 1981 to make it more responsive to the goal of industrial development and growth of manufactured exports and to correct abuses which have crept into its use. Moreover, the devaluation process has been accelerated after July 1980 to bring it into line with the differential between domestic and international inflation. The continua- tion of these policies, together with the general process of decontrol, should provide the appropriate framework for sustained growth of industrial investment, production and exports. Similarly, mining and tourism -- activities that would also be eligible for financing under the proposed loan -- have good prospects over the next few years. The Financial Sector 41. Institutional setting: The financial sector in Peru includes the Central Bank, the Banco de la Nacion (the Central Government's bank and tax collector), 20 commercial banks (including six regional banks), five specialized development banks, COFIDE (the Government's major development finance institu- tion), 12 finance companies, 17 savings and loan associations, 20 insurance companies, and several small savings cooperatives and credit unions. Commercial banks account for about one half of the total assets of the financial system.  - 11 - 42. Until 1978 the Government played an increasingly important role in the financial system. It owned three commercial banks, the development banks, and COFIDE. in addItion, it regulated commercial bank credit channelled to priority sectors and regions. Since 1978, Government involvement has been gradually reduced, and the authority of the Central Bank in monetary matters has been reestablished. The main instruments of monetary policy at the disposal of the Central Bank are: setting legal reserve requirements; redis- count facilities and rates; fixing interest rates for all local currency lending by financial intermediaries, and for deposits and bonds; exchange rate policy; and -- to a limited extent -- open market operations. In recent years, the Central Bank also operated a number of special development funds, which were transferred to COFIDE in November 1980. 43. Banco de la Nacion, although authorized to offer the full range of banking services to the public, has concentrated on its initial function-- servicing the banking needs of the public sector and on tax collection. The commercial banks handle short-term banking operations. Three of the largest banks were nationalized in 1970 and placed under the control of Banco de la Nacion. Eight banks are private, four of which are small subsidiaries of foreign banks. Commercial banks currently have 690 offices, two-thirds of which are located in the Lima area. The industrial sector has traditionally received che lion's share of commercial bank credit. Confined by law to short-term lending, all but one of the domestic commercial banks have estab- lished finance company subsidiaries to provide medium-term financing. While the six regional banks operate as commercial banks focusing on the promotion of economic development in their respective regions, they are also authorized to make medium- and long-term loans. The five State-owned development banks provide specialized services for industry, agriculture, mining, and housing. Although these banks are authorized to accept deposits, they rely mostly on funds from the Central Bank and foreign borrowings. 44. COFIDE, established in 1971 as a State-owned industrial development institution, has focused on the financing of medium- and large-scale industrial projects, particularly those of public enterprises. Although COFIDE has been successful in mobilizing domestic resources by issuing high yielding bonds with special tax benefits, it has had to rely increasingly on foreign currency borrowings and Central Bank credit. Although initially it limited itself to direct lending operations, COFIDE started lending through other financial intermediaries in mid-1978. It has recently strengthened its wholesale credit function by setting up a specialized department for this purpose. Further analysis of COFIDE, its past operations, financial situation, and future role is provided in paras. 59-65. 45. The finance companies (financieras) were established to provide medium-term financing -- a service that cannot be offered by commercial banks under the banking law and that has not been offered in sufficient quantity and quality by the specialized development banks. In 1971, a new law was adopted bringing the financieras under Central Bank control and establishing minimum capital requirements for these. As a result, 31 out of the existing 37 finan- cieras disappeared. It was only in 1978 that commercial banks and other groups took a renewed interest in this activity. Since then, six new financieras have been set up. The financieras are expected to play an important role as retailers of ftnds under the proposed loan.  - 12 - 46. Resource mobilization and interest rates: Financial savings in Peru are mainly marshalled by the banking system, which at year-end 1979 held about 85 percent of all financial liabilities (including demand deposits) with the private sector. These financial instruments include savings and time deposits, various types of bonds, mortgage certificates, and certificates of deposit. The latter are both sol and dollar denominated. The non-banking system uses the same instruments (except dollar denominated certificates of deposit). In addition, insurance policies constitute an important form of financial savings, and bonds and stocks are issued in limited numbers by non-financial institutions. Except for COFIDE's high yielding type C bonds, bonds have not been widely used by financial institutions because they offered a maximum interest rate of 35 percent -- lower than for certificates of deposit and longer-term maturities -- and owing to the lack of a well developed secondary market. Certificates of deposit have been the main sources of funds for the financieras. 47. Since mid-1978, interest rates in Peru have been regulated by the Central Bank and the Government, which established a complex structure of rates differentiated by financial instrument, type of intermediary and sector of destination. During the seventies, deposit and lending interest rates in local currency were negative in real terms. At the end of 1980, effective lending rates (including tax) amounted to some 55 percent, close to the 1980 inflation rate of some 60 percent. Deposit rates, which are tax exempt, were in the 30 to 35 percent range, with some instruments, like certificates of deposit and time deposits over two years with financieras, at higher rates. COFIDE's type C bonds, trading at a discount price around 70 percent, had the highest effective yield (about 50 percent) of any sol denominated financial instrument in Peru. Negative real interest rates for sol denominated instru- ments and high interest close to LIBOR on dollar denominated certificates of deposit resulted in a dramatic shift towards the latter, which account for about 50 percent of financial savings within the banking system. 48. In December 1980, a law was passed eliminating the 17 percent tax on lending rates and giving the Central Bank authority to set interest rates for sol denominated operations. Subsequently, the Central Bank has made a full revision and simplification of the interest rate structure, including an upward adjustment of 20 percentage points for most deposit and lending rates, which has brought their effective rates to over 60 and 70 percent, respectively. If, as expected, the envisaged monetary and fiscal policies succeed in bringing inflation down to about 55 percent in 1981, interest rates would become highly positive in real terms. 49. Because of lack of coordination among institutions and competition using cost-free resources provided by the Government, some of the State development banks have been lending to the final borrowers at rates below the cost of the foreign resources to the Government. The ongoing reorganization of public sector financial institutions is expected to establish a consistent interest rate policy for term lending in foreign currency that would eliminate distortions in the allocation of resources and would help develop a healthy and competitive financial system.  - 13 - 50. Term Lending: The main institutions channelling term resources to the industrial and other productive sectors have been COFIDE, the State development banks, the financieras and, to a smaller extent, the regional banks. In addition, commercial banks were occasionally involved in term lending with special authorization by the Central Bank. The public sector plays the major role in term lending, with COFIDE and the State development banks accounting for 72 percent of total assets of institutions engaged in term lending. 51. The institutions involved in term lending supplemented their own resources with funds from the various rediscount facilities established by the Central Bank during the last two years,including the Agroindustries Rediscount Fund (FRAI), the Capital Goods Fund (FONCAP), the Regional Invest- ment Fund (FIRE), and the Export Fund (FONEX). FONEX supplements the Non- Traditional Export Fund (FENT) set up in 1972 by the state-owned Industrial Bank. Resources from these funds, partly supplemented by a US$14.7 million loan from USAID for FRAI, were channelled by different financial intermediaries through subloans at widely varying conditions, in both local and foreign currency. 52. Action has been taken recently to strengthen and coordinate the institutional framework for term lending by dividing control, wholesale, and retail functions among the Central Bank, COFIDE, and other financial interme- diaries. The Central Bank will concentrate on the definition and implementa- tion of financial policies and regulations affecting term lending including interest rates and terms. On November 13, 1980, it transferred the special funds for term lending (FRAI, FONCAP, FIRE, FONEX) to COFIDE. COFIDE now has responsibility, therefore, for domestic and foreign resource mobilization, wholesale credit operations with other financial intermediaries, and retail credit operations with final borrowers. The new organizational structure of COFIDE provides for a clear separation of its wholesale and retail functions. Retail credit operations will be handled through a wide range of financial intermediaries, both public (including COFIDE) and private, which will compete with each other having equal access to resources under uniform conditions. 53. Previous Bank Activities: Aside from a 1955 US$2.5 million loan for a cement plant, which was successfully completed, and a 1980 US$5.0 million for technical assistance to SIDERPERU, a public steel enterprise, the Bank has made a US$35 million first industrial credit loan to COFIDE in 1977. This operation got off to a slow start because of the 1977-78 recession in Peru and the requirement that the final borrower assume the cross currency risk. With Peru's economic recovery and the application of special disbursement procedures, which were designed to partially shield the ultimate beneficiary from the exchange risk, commitments under this project have picked up,and full commit- ment is expected shortly. In addition, Bank support of the ERP through the Program Loan of 1979 was instrumental in bringing about important changes in industrial and trade policies (see para 18). Moreover, the Bank has supported development in the mining sector through two projects: the US$39.7 million CENTROMIN loan of 1976 for mine water treatment and plant expansion and a technical assistance loan for the Bayovar phosphate project, approved in June 1980.  - 14 - 54. Under the first industrial credit project, 71 subloans for a total of US$31.9 million had been approved as of February 28, 1981. Disbursements as of January 31, 1981 amounted to US$19.2 million. The subprojects covered a wide range of subsectors, including chemicals (20 percent of the subloan amounts), textiles (20 percent), metals (15 percent), fish products (8 percent), metal products (7 percent), and others (30 percent). The economic rates of return of the subprojects for which such calculations were required ranged from 12 to 40 percent. The project helped to support an estimated total investment volume of about US$100 million, which created about 4,000 jobs. Most subprojects were in export-oriented activities, particularly in the textile, metal, and fish processing industries. During the last two years, COFIDE has onlent part of the loan's proceeds through other financial inter- mediaries. About one half of the total number and almost one third of the amount of the subloans committed under the project were made through this channel. PART IV - THE PROJECT 55. The proposed project was first discussed with the Bank in late 1979. It was prepared by COFIDE with the assistance of Bank missions in February and April 1980. Appraisal took place in August 1980, and a post-appraisal mission visited Peru in November 1980. The appraisal mission's report entitled "Staff Appraisal Report - Second Industrial Credit Project (No. 3238-PE dated March 12, 1981), is being distributed separately. Annex III contains a Supplementary Project Data Sheet. Negotiations were held in Washington from February 9 to 13, 1981. The Peruvian Delegation was headed by Carlos Neuhaus, COFIDE's Financial Manager. A representative of the Ministry of Economy, Finance, and Commerce also attended. Project Objectives and Description 56. Building on the achievements and experience of the first industrial credit project, the loan recommended in this report would continue to support investment subprojects in the industrial, mining and tourism subprojects sectors -- as well as to strengthen COFIDE's effectiveness as a development bank engaged in term lending. More specifically, it would (i) support COFIDE's new organizational structure, particularly with regard to the planned expansion of its wholesale function; (ii) facilitate equal access to resources by a large number of financial intermediaries thus stimulating competition and improving the quality of services; and (iii) improve project appraisal capabil- ities (including the economic analysis of projects) within both COFIDE and other financial intermediaries. 57. The proposed loan consists of a line of credit of US$60 million, which would meet about 25 percent of COFIDE's estimated demand for foreign resources over the next three years. COFIDE would channel the loan's proceeds, either directly or through other financial intermediaries, to the ultimate beneficiaries--public and private enterprises, mostly in industry but also in the mining and tourism sectors. During the past few years, loans from COFIDE to the industrial sector financed about 40 percent of sectoral investment, with the remainder being self-financed or financed from other banking sources, mainly from abroad.  - 15 - Project Execution 58. The proposed loan would be made to COFIDE with the guarantee of the Government. COFIDE would act as wholesaler and retailer of funds. Other financial intermediaries would have access to the funds via COFIDE in accor- dance with each institution's capability and financial soundness. Participating Institutions a. COFIDE 59. COFIDE, operating since 1971, has competent and experienced manage- ment and staff. Its project appraisal and supervision activities are adequate. COFIDE's comprehensive Policy Statement and Operating Procedures (approved during preparation of the previous project and periodically updated) are also generally adequate, but the expansion of its operations through financial intermediaries requires specific amendments thereto. The approval by COFIDE's Board of Directors of these amendments, in a manner satisfactory to the Bank, would be a condition of the proposed loan's effectiveness (Section 6.01(b) of the draft Loan Agreement). 60. At year-end 1979, COFIDE had total assets of S/.160.8 billion (US$643 million) including, inter alia, S/.45.6 billion (US$187 million) in net loans outstanding, S/.37.8 billion (US$15.1 million) in investments, and S/.65.6 billion (US$262 million) in guarantees issued on its own account. Its equity stood at S/.41.6 billion (US$166 million), and 93 percent of the paid-in capital was held by the Government with the balance held by indi- viduals and companies that had received COFIDE shares as compensation under the agrarian reform. By law, control of COFIDE rests with the Government, which exercises its authority through the Ministry of Economy, Finance, and Commerce, and COFIDE's Board of Directors. 61. Since mid-1978, COFIDE's operations have grown substantially in line with Peru's overall economic recovery. After having dropped from S/.19.3 billion (US$336.1 million) in 1976 to S/.8.3 billion (US$99.0 million) in 1977, COFIDE's operations -- including loans, investments and guarantees increased to S/.23.4 billion (US$149.7 million) in 1978 and S/.39.8 billion (US$177.2 million) in 1979. During the first half of 1980, the volume reached S/.28.5 billion (US$107.0 million). COFIDE has increased its operations to the manufacturing sector from 19 percent of its total operations in 1976 to 67 percent in 1979. Previously, substantial amounts were lent to the petroleum and power sectors. 62. COFIDE's overall exposure reached S/.156 billion (US$624 million) at year-end 1979, and S/181.4 billion (US$636 million) as of June 30, 1980. As of the latter date, COFIDE had 171 clients, of which 135 had received only loans and guarantees, 21 loans and equity investments, and 15 only equity investments. Of COFIDE's total exposure, 79 percent was to State enterprises (including 40 percent to basic industry companies which were nationalized between 1973-1979 and which are wholly owned by COFIDE) and only 21 percent to the private sector. On the whole, the quality and management of COFIDE's portfolio are adequate, although the large exposure to basic industries in the form of loans and equity investments constitutes a concentration of risk and limits COFIDE's flexibility. As of June 30, 1980, arrears over 90 days  - 16 - affected only 6.2 percent of the loan portfolio, and exposure to compauies in arrears constituted only 5 percent of COFIDE's overall exposure. Ii rode:- to reduce the risk 2ssociated with its exposure to basic industries and make COFIDE more flexible i.i its operations, the Government and COFIDE have agreed that COFIDE would divest itself of all its equity investments in basic indus- tries by December 31, 1981 and on tc-Ins and conditions satisfactory to the Bank. The enactment of legislation enabling COFIDE to do so would be a conditicn of loan effectiveness (Sections 4.10 and 6.01(c) of the draft Loan Agreement). 63. Comparative balance sheets for 1976-79 show COFIDE with an adequate financial position (with a long-term debt to equity ratio of 2.7 to 1 in 1979) as well as a satisfactory liquidity situation (with a current ratio of 2.3 to I in 1979). However, COFIDE's profitability, although improving during recent years, has remained low because of high provisions for bad debts (necessary to offset low provisions made prior to 1976), low interest spreads and charges -- particularly on foreign currency loans to State enterprises -- and low charges on guarantees on its own account. Net profits before taxes amounted to only 2.3 percent of the average amount of assets in 1979; net profits after taxes were equivalent to 7.4 percent of equity -- well below the opportunity cost of capital in Peru. In line with the Government polic'7 to raise interest rates to positive levels in reai. terms, COFIDE's management has approved a new structure of interest rates and guarantee fees that will allow a more adequa,e return on equity. Under the new structure, COFIDE's basic lending rate for local currency loans was set at 58 percent p.a. (including annual commiss.ions); since interest is paid quarterly, COFIDE's effective rate is over 70 percent. Moreover, a margin of 3 percent p.a. above the resource cost to COFIDE applies to foreign currency loans and guarantees. These measures are expected to contribute to a further improvement of COFIDE's profitability to some 15 percent on equity bv 1984. To further strengthen its performance, COFIDE would introduce a management information, control and performance evaluation system satisfactory to the Bank by December 31, 1981. By the same date, it would also put into effect a satisfactory policy of provisions for losses related to equity investments (Section 3.08(b) of the draft Loan Agreement). 64. As part of the realignment of public sector financial institu- tions (para. 52), COFIDE has gone through a fundamental reassessment of its role. In this regard, on September 23, 1980, COFIDE's Board of Directors approved a new organizational structure with three major operating divisions: finance, operations, and financial intermediation. The new financial inter- mediation division has been partly staffed with personnel experienced in dealing with other financial intermediaries as a result of the transfer to COFIDE of four funds previously operated by the Central Bank (FRAI, FIRE, FONCAP and FONEX). 65. During the project's commitment period (four years), auticipated overall economic recovery and COFIDE's expanded role in lending through financial intermediaries are expected to result in a substantial increase in COFIDE's operations. Assuming a conservative growth rate of loan approvals of 5 percent p.a. in real terms, combined with the new structure of interest rates and the divestiture of equity investments in basic industries, the Bank estimates that COFIDE's financial position will remain adequate and that its  - 17 - return on equity will gradually improve. COFIDE's debt/equity ratio would be limited to 5 to 1 (Sections 4.04 and 4.06 of the draft Loan Agreement). It is expected, however, that this ratio would not be reached during the next four years. b. Other Participating Intermediaries 66. The financial intermediaries eligible to participate under the proposed loan would be those legally authorized to undertake term lending in the industrial, tourism, and mining sectors. At present, these include the financieras, regional banks and State development banks, which have been eligible to participate under Loan 1358-PE since mid-1978. In keeping with its Policy for Financial Intermediation, before signing contracts of partici- pation with eligible intermediaries, COFIDE would ensure that these followed sound financial practices and possessed project appraisal capabilities. COFIDE's financial intermediation division would periodically monitor their compliance with these criteria and conditions. 67. While the participating financial intermediaries have developed some project appraisal capabilities (including the ability to do economic analyses for projects financed with resources from COFIDE or the various Central Bank funds), these capabilities vary widely and need to be strengthened. COFIDE would help participating financial intermediaries through seminars and special technical assistance as well as through the process of reviewing subproject appraisal documents. COFIDE sponsored a pilot appraisal seminar with Bank/IFC assistance for its own staff and staff of other financial intermediaries in January 1981. Terms 68. The proposed Bank loan of US$60 million would bear an interest of 9.6 percent and be repayable within 17 years, including four years of grace, on a composite amortization basis. The Government would guarantee the loan. Since COFIDE may not incur any foreign exchange risk under its Policy Statement, the Government would assume the cross-currency exchange risk (i.e. between the currencies being disbursed and the US dollar) in exchange for a premium of 1.5 percent p.a. on the aggregate amount of subloans outstanding. The premium would be reviewed periodically by the Government, COFIDE and the Bank and adjusted, as needed, with the consent of the Bank. The proceeds of the premium would be deposited in a special account to be opened by COFIDE. The accrued exchange differentials would be calculated annually, and the Government would cover any shortfalls that might occur in the account. Signing of an agreement, satisfactory to the Bank, between COFIDE and the Government on the mechanism to cover the cross-currency risk would be a condition for loan effectiveness (Sections 3.02 and 6.01(a) of the draft Loan Agreement and Section 2.02(b) of the draft Guarantee Agreement). 69. Subloans would be denominated in US dollars. The repayment obliga- tions of the financial intermediaries and of the ultimate beneficiaries would, therefore, be in dollars, irrespective of the currencies in which the Bank loan or the subloans were actually disbursed. COFIDE would, however, repay the Bank under the usual currency pooling arrangements. Subloans would have terms ranging from 4 to 15 years, including up to 3 years of grace, depending  18 - on the type cf investment (Section 2.08 (b) and Schedule 3 of the draft Loan A.greement). Actual maturities are expected to range mostly between 7 and 12 years. The interest rate charged to the ultimate beneficiaries would be 4 percentage points above the base rate, defined as the interest rate of the proposed Bank loan plus the 1.5 percent premium for the cross-currency risk. For prime customers, COFIDE and the other financial intermediaries might accept a lower spread, e.g. 1 percentage point less. COFIDE would on-lend to financial intermediaries at 1 percentage point above the base rate and, in add;.ticn, charge a commitment fee of 1 percent (Schedule 3 to the dcaft Loari Agreement). The spreads of 3 to 4 percent in the case of COFIDE and up to 3 percent in the case of financial intermediaries should be sufficient to cover all administrative costs involved in the different types of operations and to allow a reasonable profit. These spreads are in line with COFIDE's current practice and with those of the term lending funds recently transferred to COFIDE by the Central Bank. The interest rates on sublopns would be reviewed periodically by COFIDE and the Bank (Section 4.08 ot the draft Loan Agreement) to take account of fluctuations in the international capital markets and domestic credit demand. 70. Subprojects would have to be financially and economically viable. The direc-r lender would prepare a complete evaluation of the proposed subproj- ects, including the calculation of an economic rate of return for all sub- projects requiring Bank financing of US$250,000 or more (Section 3.07 of the draft Loan Agreement). All subloans made directly by COFIDE requiring more than IUS$1 million in Bank funds as well as those made by other financial intermediaries requiring more than US$500,000 in Bank funds would be subject to prior review and approval by the Bank (Section 2.02(b) of the draft Loan Agreement). To ensure the distribution of industrial credit over a satisfactory number of recipients, there would be a cumulative limit of US$5.0 million on the total financing to a single enterprise or group of related enterprises out of the proceeds of the proposed loan (Section 2.02(c)(iii) of the draft -oan Agreement). Disbursement and Procurement 71. The terminal date for submission of subprojects would be June 30, l984, and the closing date for disbursements would be June 30, 1985. Procure- ment for subprojects would be in accordance with standard practice for DFC loans. The financial intermediary (or COFIDE in the case of direct loans) would require ultimate beneficiaries to obtain price quotations from a reason- able sample of qualified suppliers for major pieces of equipment. Following the approval of individual subloans, COFIDE would monitor the procurement of items to he financed under the Bank loan in order to ensure that the items were reasonably priced and appropriate for their intended purpose. COFIDE would also provide the Bank with the rationale for procurement decisions in all subloan appraisals. COFIDE has assisted its clients by putting together financial packages which blend Bank resources provided under Loan 1358-PE with export financing from supplier countries, generally having favorable interest rates but with tied procurement. The proposed loan wculd permit a continuation of COFIDE's efforts to expand and diversify procurement sources for its borrowers and to provide them with attractive financial packages.  - 19 - 72. Disbursement procedures would be similar to those under the first loan to COFIDE. The loan proceeds would be disbursed against: (a) 100 percent of foreign expenditures for directly imported goods and services; (b) 70 percent of expenditures for imported goods purchased from domestic distributors; and (c) 50 percent of the ex-factory cost of locally produced equipment and 35 per- cent of civil works expenditures. Project Benefits and Risks 73. Ihe proposed loan would increase significantly the term financing available for investment projects in the industrial, tourism, and small and medium-scale mining sectors. It would provide financing for an estimated 100 subprojects with total investment costs of about US$120 million. It is expected that about half of the loan proceeds would be used by COFIDE for direct subloans. These are expected to range in size from US$500,000 to US$4 million, The other half would be on-lent through other intermediaries, most of whose subloans are expected to fall below US$500,000. Direct employ- ment generation is expected to be about 4,000 jobs, based on an estimated average investment cost per job of US$30,000. Indirect employment generation is expected to be important, although difficult to quantify. Most subprojects are expected to have an economic rate of return in the order of 15-40 percent. 74. The proposed loan would support COFIDE's expanded function as a wholesaler of term resources. Other financial institutions providing term resources would also be strengthened and competition encouraged. Moreover, the project evaluation and supervision capabilities of the participating intermediaries would be improved. Thus, the project would have a significant institution building impact on the Peruvian financial sector. 75. The project does not involve unusual risks regarding the attainment c its major objectives. However, the ongoing changes of Government policies-- psrticularly the opening up of Peru's economy--while salutary in the longer run, could create some short-term dislocations with initially lower than uraticipated levels of economic activity. The institutional changes within COJFTDE may also limit at the outset its processing capacity and, therefore, the level of loan approvals in 1981. The quality of COFIDE's management and the speedy implementation of the reorganization, however, are expected to keep the institutional risks to a minimum, and the prospects for continuing economic tecovery in Peru appear to be good. PART V - LEGAL INSTRUMENTS AND AUTHORITY 76. The draft Loan Agreement between COFIDE and the Bank as well as the draft Guarantee Agreemeut between the Republic of Peru and the Bank and the Report ar.d Recommendations of the Committee provided for in Article III, Section 4(iii) of the Bank's Articles of Agreement are being distributed to the Executive Directors separately.  - 20 - 77. These draft agreements conform to the normal pattern for loans for development banking projects. The main features of the Loan and Guarantee Agreenments are referred to in the text of this report and are listed in Section III of Annex III. Special conditions of effectiveness would be: (i) the signing of an agreement between COFIDE and the Government, satisfactory to the Bank, on the mechanism to cover COFIDE's cross-currency risk; (ii) approval, by COFIDE's Board of Directors, of an amendment of its policy statement and operating procedures, in a manner satisfactory to the Bank, to enable it to engage more effectively in financial intermediation; and (iii) enactment of legislation needed to enable COFIDE to divest itself -- by December 31, 1981 and in a way satisfactory to the Bank -- of its equity investments in basic industries. 78. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECOMMENDATION 79. I recommend that the Executive Directors approve the proposed loan. Robert S. McNamara President Attachments March 19, 1981 Washington, D.C.  - 21- ANEX I Page 1 of 5 TABLE 3A PERU - SOCIAL INDICATORS DATA SHEET PERU REFERENCE GROUPS (WEIGHTED AVE GES LAND AREA (THOUSAND SQ. KM.) - MOST RECENT ESTIHATE) TOTAL 1285.2 AGRICULTURAL 305. 5 HOST RECENT MIDDLE INCOME MIDDLE INCOME 1960 /b 1970 lb EST-MATE lb LATIN AMERICA & CARIBBEAN EUROPE GNP PER CAPITA (US$) 230.0 410.0 730.0 1562.9 2749.5 ENERGY CONSUNPTION PER CAPITA (KILOGRAMS OF COAL EQUIVALENT) 445.0 619.0 649.0 1055.9 1641.4 POPULATION AND VITAL STATISTICS TOPULATION, MID-YEAR (MILLIONS) 10.2 13.5 16.8 URBAN POPULATION (PERCENT OF TOTAL) 46.3 57.4 65.6 63.4 53.9 POPULATION PROJECTIONS POPULATION IN YEAR 2000 (MILLIONS) 29.0 STATIONARY POPULATION (MILLIONS) 57.0 YEAR STATIONARY POPULATION IS REACHED 2090 POPULATION DENS ITY PER SQ. XM. 8.0 11.0 13.0 28.1 77.2 PER SQ. DI. AGRICULTURAL LAND 33.0 44.0 55.0 81. 7 129.5 POPULATION AGE STRUCTURE (PrRC!rT) 0-14 YRS. 44.2 45.0 42.9 41.4 30.6 15-64 YRS. 52.0 51.9 53.4 54.7 61.1 65 YRS. AND ABOVE 3.8 3.1 3.7 3.9 8.2 POPULATION GROWTH RATE (PERCENT) TOTAL 2.6 2.8 2.7 2.7 1.6 URBAN 4.7/ 5. Q 4.5 4.1 3.3 CRUDE BIRTH RATE (PER THOUSAND) 47.0 43.0 39.0 34.8 22.8 CRUDE DEATH RATE (PER THOUSAND) 19.0 15.0 12.0 8.9 8.9 GROSS REPRODUCTION RATE 3. 1j 2.9 2.8 2.5 1. 5 FAMILY PLANNING ACCEPTORS, ANNUAL (THOUSANDS) .. .. USERS (PERCENT OF MARRIED WOMEN) .. .. FOOD AND NUTRITION INDEX OF FOOD PRODUCTION PER CAPITA (1969-71-100) 96.0 102.0 85.0 106.9 113.1 PER CAPITA SUPPLY OF CALORIES (PERCENT OF REQUIREHENTS) 95.0 99.0 97.0 107.4 125.3 PROTEINS (GRAMS PER DAY) 62.0 61.0 59.0 65.6 91.0 OF WHICH ANIMAL AND PULSE 27.0 25.0 24.0 33.7 39.6 CHILD (AGES 1-4) MORTALITY RATE 28.0 20.0 16.0 8.4 4.3 HEALTH LIFE EXPECTANCY AT BIRTH (YEARS) 48.0 53.0 56.0 63.1 67.8 INFANT MORTALITY RATE (PER THOUSAND) .. 122.Oje .. 66.5 55.9 ACCESS TO SAFE WATER (PERCENT OF POPULATION) TOTAL .. 35.0 47.0 65.9 URBAN .. 58.0 72.0 80. 4 RURAL .. 8.0 15.0 44.0 ACCESS TO EXCRETA DISPOSAL (PERCENT OF POPULATION) TOTAL .. 36.0 .. 62.3 URBAN .. 52.0 .. 79.4 RURAL .. 16.0 .. 29.6 POPULATION PER PHYSICIAN 2251.0/ 1859.0 1556.0 1849.2 1030.1 POPULATION PER NURSING PERSON 2205. f 738 0 745.0 1227.5 929.4 POPULATION PER HOSPITAL BED TOTAL 424. 0 470.0 547.0 480.3 289. 7 URBAN .. 425.0 RURAL .. 3144.0 ADHISSIONS PER HOSPITAL BED .. 19.0 .. .. 17.0 HOUSING AVERAGE SIZE OF HOUSEHOLD TOTAL 4.9 4. 9/h . URBAN 4.8 5. *j.. RURAL 4. 9 4. 7/h AVERAGE NUMBER OF PERSONS PER ROCU TOTAL 2.3 i.9j .. URBAN 2.0 1. 7i RURAL 2.7 2.4/h ACCESS TO ELECTRICITY (PERCENT OF DWELLINGS) TOTAL 26.0 32.1/. URBAN 50.7 54. 3 *h RURAL 4.0 2.7/h  - 22 - ANNEX I TABLE 3A Page 2 of 5 PERU - SOCIAL INDICATORS DATA SHEET PERU REFEREOCE GRO1UPS (WEIGHTED AVERAGES - MOST RECENT ESTIMATE) - MOST RECENT MIDDLE INCOME MIDDLE INCOME 1960 /b 1970 /b ESTLMATE /b LATIN AMERICA & CARIBBEAN EUROPE EDUCATION ADJUSTED ENROLLIENT RATIOS PRIMARY: TOTAL 83.0 107.0 110.0 99.7 105.9 MALE 95.0 114.0 115.0 101.0 109.3 FEMALE 71.0 99.0 106.0 99.4 103.0 SECONDARY: TOTAL 15.0 30.0 52.0 34.4 64.0 MALE 18.0 34.0 56.0 33.5 71.1 FEMALE 13.0 26.0 48.0 34. 7 56.9 VOCATIONAL ENROL. (% OF SECONDARY) 20.0 17.0 23.0 38.2 28.8 PUPIL-TEACHER RATIO PRIMARY 34.0 40.0 40.0 30.5 29.4 SECONDARY 12.0 23.0 23.0 14.5 26.1 ADULT LITERACY RATE (PERCENT) 61.0 .. 72.0 76.3 CONSUMPTION PASSENGER CARS PER THOUSAND POPULATION 8.0 17.0 18.4 43.0 84.6 RADIO RECEIVERS PER THOUSAIID POPULATION 110.0 137.0 131.0 245.3 192.2 TV RECEIVERS PER THOUSAND POPULATION 3.0 30. 0 38.0 84.2 118.5 NEWSPAPER ("DAILY GENERAL INTEREST") CIRCULATION PER THOUSAND POPULATION .. 124.0 96.0 63.3 93.0 CINEMA ANNUAL ATTENDANCE PER CAPITA .. .. .. .. 5.7 LABOR FORCE TOTAL LABOR FORCE (THOUSANDS) 3187.8 3909.3 4980.4 FEMALE (PERCENT) 21.0 20.7 23.9 22.2 30.4 AGRICULTURE (PERCENT) 53.0 45.0 39.0 37.1 37.0 INDUSTRY (PERCENT) 19.0 20.0 21.0 23.5 29.3 PARTICIPATION RATE (PERCENT) TOTAL 31.3 29.1 29.2 31.5 40.9 MALE 49.2 45.8 45.3 48.9 55.9 FEMALE 13.2 12. 1 12.8 14.0 26.2 ECONOMIC DEPENDENCY RATIO 1.5 1. 7 1.6 1.4 1.0 INCOME DISTRIBUTION PERCENT OF PRIVATE INCOME RECEIVED BY HIGHEST 5 PERCENT OF HOUSEHOLDS 39. Oj i . HIGHEST 20 PERCENT OF HOUSEHOLDS 64.4/i 61.0/h LOWEST 20 PERCENT OF HOUSEHOLDS 2.5/i 1.9/h LOWEST 40 PERCENT OF HOUSEHOLDS 8. 0/i 7.0L/h POVERTY TARGET GROUPS ESTIMATED ABSOLUTE POVERTY INCOME LEVEL (US$ PER CAPITA) URBAN .. .. 235.0 RURAL .. .. 180.0 190.8 ESTIMATED RELATIVE POVERTY INCOME LEVEL (US$ PER CAPITA) URBAN .. .. 293.0 474.0 RURAL .. .. 200.0 332.5 385.8 ESTIMATED POPULATION BELOW POVERTY INCOIIE LEVEL (PERCENT) URBAN .. .. 49.0 RURAL .. .. Not available Not applicable. NOTES /a The group averages for each indicator are population-weighted arithmetic means. Coverage of countries among the indicators depends on availability of data and is not uniform. /b Unless otherwise noted, data for 1960 refer to any year between 1959 and 1961; for 1970, between 1969 and 1971; and for Most Recent Estinate, between 1974 and 1978. /c 1956-61; /d 1960-65; /e 1970-75; /f 1964; /g 1962; /h 1972; /i Personal income within labor force. Most recent estimate of GNP per capita is for 1979, all other data are as of April, 1980. October, 1980  - 23 - ANNEX I Page 3 of 5 'tFT'TffoNS OF SOoCIALINDICATt'ORS Osr.s 1oi.o