Ecuador - Industrial Finance Project

Dammenz af The World Bank FOR OFFICIAL USE ONLY Report No. 5874-EC STAFF APPRAISAL REPORT ECUADOR INDUSTRIAL FINANCE PROJECT March 3, 1986 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 ollicial duties. Its contents may not otherwise be eisclosed without World Bank authorization.  ECUADOR STAFF APPRAISAL REPORT INDUSTRIAL FINANCE PROJECT CURRENCY EQUIVALENTS Currency Unit = Sucre (S/.) October 1985 December 1985 February 1986 tAverage Multiple Rates) (Unified Rate) (Unified rate) US$1 = S/.82 = S/.97 = S/.110 S/.1 = USS0.01 = USS0.01 = US$.009 S/.100 = US$12.19 = US$10.30 = US$9.09 Fiscal Year January I to December 31 Abbreviations BCE Banco Central del Ecuador (Central Bank of Ecuador) iIEDE Banco Ecuatoriauio de Desarrollo (Ecuadorian Development Bank) BEV Banco Ecuatoriano de la Vivienda (Ecuadorian Housing Bank) BNF Banco Nacional de Fomento (National Development Bank) CD Certificate of Deposit CENAPIA Centro Nacional para la Promocion de la Pequena Industria y la Artesania (National CenLer for Promotion of SSEs and Artisans) CFN Corporacion Financiera Nacional (National Finance Corporation) DFC Development Finance Company ERR Economic Rate of Return FOPINAR Fondo de Fomento para la Pequena Industria y la Artesania (Development Fund for SSEs and Artisans) FOPEX Fondo de Promocion de Exportaciones (Export Development Fund) INSOTEC Instituto de Investigaciones Socio-Economicas y Tecnologicas (Institute for Social, Economic, and Technological Research) MFF rlecanismo de Fondos Financieros del BCE (BCE's Financial Fund) MICEI Ministerio de Industrias, Comercio e Integracion (Ministry of Industry, Commerce and Integration) SECAP Servicio Ecuatoriano de Capacitacion Profesional (Ecuadorian Professional Training Service) SSEs Small Scale Enterprises TA Technical Assistance  FOR OMCIAL USE ONLY ECUADOR STAFF APPRAISAL REPORT INDUSTRIAL FINANCE PROJECT Table of Contents Page No. Loan and Project Sulmmarye ...........................0........ iii I. THE ECONOMIC S E T T I N G 1....... . ....................... A. Backgrounda ... ................... 1 B. Outlook uelook.. ..... . ............. 1 II. THE MANUFACTURING AND FINANCIAL SECTORS............O...... 3 A. The Manufacturing Sector...t........................... 3 Structure and Growth of Manufacturing................. 3 Industrial Policy Frame aork............. ............. 4 Unification of the Foreign Exchange Market............ 5 Regulations of the Industrial Incentive Law 5 Elimination of Quantitative Restrictions............. 6 Revised Tariff Structure . ........................ 6 B. The Financial Sector e c t or.... ...................... 7 Institutional Structure and Development......... 7 Main Insiuinst.................... 7 Developments .......... ....................... 7 Interest Rate Policy and Resource Mobilization........ 8 Performance.... .................. . 8 Government Action c t ln.. .. ............... 8 Further Action Required..................... 9 Recent Legal Reformseo.... .....9............... 9 C. Past Bank Lending and Strategy in Industrial and Financial Sectorse... . . .................. 9 III. THE PROJECT........................... 11 A. Project Objectives and Description.................... 11 Background... . . . 11 Project Objectives.je ..... 11 This report is based on the findings of an appraisal mission which visited Ecuador in June/July 1985. The mission comprised Mr. Howard Jones, Mr. Mario Reyes, Ms. Ines Garcia-Thoumi of the Industrial Development and Finance Division 1, LAC Regional Office, and Ms. Raundi Halvorson (Consultant). Ths document has a rested distribution and may be uswed by recipients only in the performance Lof their official dutie. Its contents may not otherwise be disckosd without World Bank authorization.  - ii - Page No. Project Description ****................ . . . . . *. ........*. 11 B. Participating Institutions......... ..................... 12 Private Flnancieras ................ .......... mess.... a. 12 Eligibility Crtra.......................12 Corporacion Financiera Nacional......................... 13 ..................... **...... .......................... 14 C. Project Costs and Financing Arrangements............... 14 Project Costs and Financing............................. 14 Loan, Subsidiary Loan and Subloan Terms ................. 15 Subproject Review....................................... 16 Procut...... 17 Disbursemeats...................o............ ............ 17 D. Project Benefits and Risks.............................. 18 Benefits ................ ............... .............. . 18 -?'ska........... S S~ Se.ee.S S.e...ee ...e S..e. .......... 18 IV. AGREEMENTS AND RECOMMENDATION ................*.............. 20 List of Annexes Annex 1 Average Tariffs and Dispersion-Current and Proposed..... 22 Annex 2 Terms of Reference for Technical Assistance............. 23 Annex 3 Financial Condition of Financieras (DFCs)G............ 29 Annex 4 Calculation of Real Return on Equity with a Nominal 4, 41 and 5Z p.a. Financial Spread Compounded Quarterly.... 43 Annex 5 Project Cost and Financ'-g Pl a n 44 Annex 6 Findings From Survey of Subloans - Fifth Development Banking Project (Loan 2096-EC)9..... 45 Annex 7 Estimated Schedule of Disbursementse..e.s...e.e.e.e..es 54 Annex 8 Trade and Industrial Sector Policy Reforms...orms....... 55 Annex 9 Bank Monitoring of Project Implementation..tation8286606 57 Annex 10 Selected Documents and Data Available in Project File ... 59 Annex 11 Schedule of Project Implementation...................... 60 Map of Ecuador  - iii - EOJADOR INDSTRIA cFINANCE PROJECT LWAN AND PRECT SUMARY Borrower: Republic of Ecuador Beneflciaries: Part A: The Government of Ecuador, which will receive foreign exchange to finance essential imports. Part B: Private Ecuadorian manufacturing or agroindustrial enterprises; the Central Bank (BCE); the Superinten- dency of Banks; the Superintendency of Companies; and financial intermediaries. Ahmut: US$115 million equivalent. Term: Repayable over 17 years on a fixed amortization schedule, including 4 years of grace, at the Bank's standard variable interest rate and charges. Relending Terms: The Borrower, through its agent, BCE, would onlend US$64.45 million equivalent in sucres from Part B of the loan to eligible financial intermediaries at variable positive real interest rates. Financial intermediaries would onlend these resources to project beneficiaries at the rates established from time to time by the Monetary Board. The intermediaries would receive a spread initially of 5% p.a. and BCE would retain a 0.25% fee. The revenues from the difference between the Bank's lending rate plus BCE's fee, and the interest rates charged to financial intermediaries, would be used by BCE, as agent, to cover the foreign exchange risk on the Bank loan; however, any shortfall would be made up by the Government, which would assume the foreign exchange risk and pay the commitment fee on the Bank loan. US$0.2 million equivalent from the proposed loan would be made available to the Superintendency of Banks, and US$0.2 million to the Superintendency of Companies on terms similar to those for subloans. US$.05 million would be lent to the Association of Development Banks on commercial terms. US$0.1 million would be made available to BCE as a grant. Project The objectives of the project would be to encourage trade, Description: industrial, and financial policy reforms; promote efficient industrial development; and strengthen regulatory agencies and the analytical capabilities of financial intermediaries. To  - iv - achieve these objectives, the loan would provide (i) US$50 million equivalent to finance essential imports in support of a series of measures to liberalize trade, industrial, and financial sector policies; (ii) US$64.45 million equivalent to financial intermediaries for onlending to industrial enter- prises to finance fixed assets and permanent working capital; and (iii) US$550,000 to finance programs of technical assist- ance to strengthen the analytical capabilities of the Central Bank and the financial intermediaries, and the regulatory capabilities o, the Superintendencies of Banks and Companies. Benefits: The project would support recent far-reaching industrial, trade, and financial sector policy reforms which would begin to reorient fundamentally Ecuador's model of industrial development and strengthen the capacity of the financial system to mobilize and allocate domestic resources more effectively. It would also promote development of efficient industrial enterprises. About 90 investment projects creating about 3,400 new jobs would be financed. Further benefits would result from the associated dialogue with the Government on resource mobilization, interest rates, and industrial policies. R4isks: The major risks facing the macroeconomic reforms which the project would support relate to their political sustainability and the maintenance of an attractive exchange rate for export promotion. At the institutional level, some financial inter- mediaries are in a weakened financial condition resulting from the economic difficulties of recent years. In order for these institutions to be eligible to use loan resources, they would have to meet eligibiliEy criteria designed to strengthen their financial structures and performance. To the extent that some of these institutions cannot participate, commitment of Bank funds could be delayed. Moreover, some participating finan- cial intermediaries may again experience financial difficul- ties which could delay subloan repayments. Technical assist- ance included in the project to strengthen regulatory agencies should limit this risk. Also, depending upon the rate of eco- nomic recovery in Ecuador and the potential short-term impact of import liberalization and interest rate reforms, demand for project resources for the credit component could slacken. However, even if loan disbursements slowed somewhat, project benefits arising from individual subprojects and the technical assistance programs should still be realized.  Estimated Costs Local Forelgn Total (USS million) Estimted Costs: Part A Imports LI 50.00 50.00 Part B Investment Projects 33.00 69.34 102.34 Technical Assistance 0.11 0.55 0.66 Total Project Costs 2/ 33.11 119.89 153.00 Financing PLan: Bank - 115.00 115.00 Financial Interme- diaries - 4.89 4.89 Project Beneficiaries 33.00 - 33.00 BCE, Superintendency of Banks, Superintendency of Companies, financial intermediaries 0.i1 - 0.11 33.11 119.89 153.00 Estimated Disbursements: 1987 1988 1989 1990 1991 1992 1993 -----(USS millions by Bank Fiscal Year)----- Annual 51.3 10.4 16.3 16.9 11.0 6.5 2.6 Cumulative 51.3 61.7 78.0 94.9 105.9 112.4 115.0 Rate of Return: The minimum rate for subprojects would be 122. 1/ The USS50 million included in this project represents about 2.5 percent of Ecuador's projected 1986 imports. The Bank and the Government are beginning discussions which could lead to cofinancing being sought in the context of this project. 2/ The tax content of the project would be approximately USS9.2 million (9% percent of the cost of investments).  EUDOR STAFF APPRAISAL REPORT InUSTRIAL FIACE PRnFECT I. TEE ECOImWIC SETTD Ii1/ A. d 1.01 Since the 1960s, the Ecuadorian economy has changed from a predominantly agricultural to a predominantly urban society. From 1972 to 1980, the transformation of the economy occurred under the stimulus of growing petroleum exports and, to a lesser extent, the growth of the industrial sector. In that period, real GDP grew at an average rate of about 5Z p.a. and per capita income in 1983 prices (Atlas Methodology) rose from US$1,190 to US$1,420. 1.02 In 1981, however, the Ecuadorian economy's fragility became evident when the terms of trade for Ecuador deteriorated for the first time since 1974. GDP growth slowed considerably to 3.9% p.a., private investments declined by 11.6% and signs of capital flight appeared. GDP growth slowed further to 1.8% in 1982 and turned negative to -3.3% in 1983. Investment continued to decline and unemployment to accelerate. By the end of 1983 Ecuador was facing, as were most Latin American countries, one of the worst economic contractions since the Great Depression. Nevertheless, Ecuador complied with an IMF-supported adjustment program and avoided possibly an even worse income drop. 1.03 In 1984, Ecuador started to emerge from the recession mainly as a result o' increased oil exports and the recovery of agricultural production, which had decreased by 14% the previous year as a result of severe floods. Other sectors, however, still faced constraints: a contracted international demand for non-oil exports; reduced availability of imported raw materials; low local demand for manufactured goods; minimal new foreign lending; and depressed prices for oil, Ecuador's main export. Nevertheless, in 1984, real GDP increased by 3.4%, reversing the negative trend of the three preceding years. B. Outlook 1.04 The present Administration which took office in August 1984, is the second one to be democratically elected after nearly a decade of military rule. The Government's economic philosophy essentially supports the market as an efficient resour-e allocation mechanism, with minimal Government intervention in economic affairs. It sees the longer-run development of 1/ This section is based on the report: Ecuador: An Agenda for Recovery and Sustained Growth- - a World Bank Country Study, Report No. 5094-EC of October 5, 1984.  -2- Ecuador supported by vigorous, export-oriented agricultural and industrial growth, and recognizes the strategic importance of relative prices, including exchange and interest rates and import tariffs. The Government is also committed to strengthening private sector development, curtailing the role of public investment in activities which could be privatized, encouraging foreign investment, and Improving the efficiency of public investment and operations. 1.05 Since coming to office, the Administration has taken a number of important and politically difficult corrective measures: it has devalued the sucre again and unified the multiple exchange rate markets; it raised domestic petroleum pro-'ucts prices; it improved the interest rate structure; it successfully obtained a multi-rear rescheduling of its external debt; it took steps to liberalize trade; and it moved to free prices in the agricultural sector. It also mounted a campaign to attract foreign investment and subscribed to several investment guarantee schemes, incltuding MIGA. These are important measures in the right direction; they should encourage more efficient utilization of resources and stimulate exports, agricultural production and domestic savings and encourage foreign investment. 1.06 Because of the devaluations of the sucre in the past two years, which have raised the price of oil in sucre terms, oil exports amounted t.. 18% of GDP in 1985. Virtually all oil income accrues to the public sector. Despite the recent sharp drop in oil prices, the oil sector will continue to he essential to the economy. Adjustment to the loss of income (estimated to he close to half a billion dollars in 1986) will require faster shifts to non-oil sources of exports and fiscal revenues over the medium term. However, in the short run, oil still represents over half of current exports. Restricted fiscal revenues will require tightening of already frugal fiscal policies. An adequate flow of resources to the private sector from both domestic and foreign sources will he essential to support further recovery from the recent recession. Indeed, a public sector surplus mav well he required to ensure that the private sector can expand its activities. This delicate halance between public and private sector needs underscores the importance of good public sector management. The Rank's recent public investment review found Ecuador's ongoing program generallv a sound one, hut recommended that petroleum exploration and producrion he accelerated, and that no sizeable new projects be hegun for a few years; an updatt of the program reflecting reduced foreign exchange earnings and fiscal revenues will be needed. 1.07 Ecutador will almost surely continue facing a shortage of foreign exchange in the next few vears, given recent oil price declines. The Bank's most recent economic projections were made on a higher oil price expectation, and were consistent with both the Government's and the IMF's programs. The rovernment, along with both the Rank and the IMF, is now reviewing Ecuador's revised prospects. Tn view of the far-reaching economic effects of the most recent drop in oil prices, both the Bank and the IMF have scheduled economic missions to Ecuadur for Februarv-March 1Q86,to undertake further analysis. Nevertheless, It is already clear that Ecuador must likely quicken and deepen fts adiustment Program, while marshalling further external funds to assist its response to the oil price drops. Hence, the Government, the Bank, and the TMF are discuissing with Ecuador's commercial creditors the possibilitv of further financing. Because of Ecuador's determined efforts to adjust its economyW--and its creditors' positive responses so far--we believe Ecuadur remains creditworthy for Bank lending.  -3- II. TEE N&UANUACTJRIMG AND FINANCIA SECTORS A. The Manufacturing Sector 2.01 In recent years the Bank has been associated with extensive industrial and financial sector work in Ecuador. This has included (i) a 1982 study of ways to reduce overall effective protection in the industrial sector; (ii) a study undertaken under the Fifth Development Banking Project (Loan No. 2096-EC) of the industrial incentives system; (iii) a recently concluded Bank review of the financial sector; and (iv) recent discussions with the Government on trade, industrial, and financial policies. As a result of these efforts, an understanding of the major policy issues affecting the industrial and financial sectors has been obtained and discussed with the Government. This has formed the basis for measures which have or are to be taken on trade and financial sector reforms, some of the most important of which are being supported by the proposed loan. Structure and Growtb of Manufacturing 2.02 Manufacturing remains at an early stage of development. Activities such as food processing, textiles and wood processing still account for about three-quarters of manufacturing value added. Most production is sold in the domestic market and is highly dependent upon imported inputs. The sector has accounted for about 18% of GDP in recent years, and in 1983 employed about 320,000 workers (11% of the work force). During the economic expansion experienced from 1972 to 1982, manufacturing was Ecuador's leading growth sector, expanding at an average annual real rate of 9.5%. However, the growth of manufacturing value added, fell from 6.9% in 1982 to a negative 1.9% in 1983, reflecting the impact of economic recession, severe shortages of raw materials resulting from import restrictions and poor weather conditions, and the lack of foreign as well as domestic credit. As the economic recession continued, manufacturing value added continued to decline by about 2.0% in 1984. Preliminary estimates for 1985, however, indicate that manufacturing activities grew at a rate of about 2.5%. As a result, it is expected that capacity utilization (which averaged about 65% in 1984) as well as investment in fixed assets will increase. The manufacturing sector's contribution to exports has been minimal during the past decade. Excluding processed foodstuffs, shrimp, and fuel oil, manufactured exports never amounted to even 5% of total exports (or 15% of non-petroleum exports). This situation, which is largely due to the anti-export bias of the import substituting policies adopted by the country, has worsened since 1983, owing to the closure of the Andean Market--Ecuador's major market for manufactured exports--and Ecuador's failure to penetrate new ones. 2.03 More than 80% of manufacturing employment and of manufacturir., value added is generated by firms located in Guayaquil and Quito. Firms in the Guayaquil area account for the major shares of food, paper, and chemical industries, while firms in the Quito area concentrate on textiles, wood products, metal products, machinery and equipment. Lack of appropriate  - 4 - infrastructure for industrial development in the rest of the country has apparently prevented a wider geographical location of industry, offsetting the impact of Government incentives aimed at encouraging industrial growth away from the country's traditional growth centers. 2.04 Manufacturing industry is also characterized by a small, modern oligopolistic segment of import substituting industries that has been super- imposed on a largely traditional sector where small firms prevail. In most industries less than four firms control between 50 and 95% of the domestic market. This structure is largely the result of the administration and implementation of the Industrial Incentive Law, which induced investors to over-dimension their plants as a way to prevent the entry of competitors, since the existence of idle installed capacity could prevent the granting of incentives to new firms. To help remedy this and other problems, new regu- lations were issued by the current Administration in January 1985 (para. 2.10). 2.05 Prospects for sustained manufacturing output growth are dim if they continue to depend entirely upon the expansion of domestic demand. The current efforts of the Government to overcome the recent balance of payments crisis and inflation call for a restrictive domestic credit policy, which in turn will reduce the impact of domestic demand expansion as a source of growth in the short term. Export expansion and more efficient import substi- tution would have to provide the basis for new sources of growth. Thus, industrial prospects will depend on the speed with which past policies can be reformulated to assure the increased efficiency of industry and com'etitive- ness of manufacturing exports. Industrial Policy Framework 2.06 Current industrial incentives were established by the 1957 Law of industrial Incentives; they are also influenced by trade and foreign exchange policies. The core of the law emphasizes the development of import- substitution industries. Trade policies have provided high tariffs for final consumer goods and low tariffs for raw materials, intermediate, and capital goods. Protection from imports has also been provided through numerous quan- titative restrictions, import prohibitions and prior authorizations for imports. This policy framework, and, until 1982, the fixed exchange rate for inputs and machinery imports, provided high effective protection to domestic industry, encouraged capital-intensive industries, and hindered the develop- ment of export-oriented activities. Thus, the high levels of protection granted to industry encouraged the establishment of enterprises that do not take advantage of the country's natural resource endowment and that are economically inefficient. Recent World Bank estimates indicate that the cost to the country cf creating one job in the protected electric appliances and plumbing fixtures subsectors may be as high as five times the comparable cost to the country of creating one job in export activities, such as plywood production. These estimates -which indicate that for every job created mak- ing electrical appliances, four workers remained potentially unemployed-- illustrate the burden imposed upon Ecuador's work force by high protection.  - 5 - 2.07 The Administration, however, has begun formulating a new industrial development strategy aimed at fostering export expansion, more efficient import substitution, and more intensive use of domestic resources. Accord- ingly, important positive policy decisions have been taken in the areas of industrial and trade policies and some major measures already have been implemented. It is one of the objectives of the proposed project to provide resources to support the Government in dealing with the impact of these measures on the economy. The Government's program is described in the fol- lowing paragraphs. Unification of the Foreign Exchange Market 2.08 Between 1970 and early 1980, the official exchange rate appreciated by 40-48%. This combined with the multiple exchlange rate system which prevailed during that period introduced major distortions in the allocation of industrial resources, sy.tematically reducing the competitiveness of Ecuadorian exports and encouraging the development of inefficient import- substitution industries. Until September 1984, when all non-oil exports and most imports were transferred from the official foreign exchange market (where the rate of exchange was 67 sucres/USS) to the 'intervened" foreign exchange market (where the rate was 97 sucres/USS) manufactured exports were discriminated against, as only limited access to the higher "intervened" rate was permitted for export earnings. Import substituting industries however, not only benefitted from high protection granted through quantitative res- trictions, but also from access to the official rate to pay for imports of inputs and machinery, and from the additional protection granted by the premium on foreign exchange in the "intervened market. 2.09 The unification of the official and "intervened' foreign exchange markets, formally completed in November 1985, represents a major step in eliminating these basic distortions hindering a healthier industrial sector. Regulations of the Industrial Incentive Law 2.10 In an effort to streamline industrial incentives and encourage manufacLuring exports, more intensive use of domestic resources and better use of installed capacity, new regulations for the Industrial Incentive Law were issued in January 1985. Major reforms included: (i) granting of tax benefits based on export performance; (ii) reductions of income tax exonera- tions, especially for sectors with excess capacity, thereby eliminating a major inducement for the current oligopolistic structure of the manufacturing sector; (iii) introduction of progressive reduction and time limitations on tariff exonerations for raw materials and intermediate products; a maximum period of 4 years for existing enterprises, and of 10 years for new enter- prises, has been established. Under previous regulations, no reductions in tariff exonerations over time were required and, although the maximum period for obtaining benefits from the Industrial Incentive Law was 15 years, in practice, enterprises benefitted for indefinite periods, as these benefits were renewed automatically upon their expiration.  - 6 - Elimoation of Quantitative Restrictions 2.11 In order to eliminate basic distortions in the allocation of resources caused by quantitative restrictions, the Government has begun substituting tariffs for such restrictions. The first step was completed in March 1985, when import prohibitions that had been introduced in 1982, and which amounted to about 16% of 1981 imports, were eliminated. The Government is planning to remove the remaining import prohibitions and replace them with tariffs. The first step, which removed about 20% of the remaining import prohibitions, was implemented in January 1986. Furthermore, the Government has begun to reduce the number of industrial inputs subject to prior authorization for import, by lifting import licensing requirements for about 50 items in February 1986. Revised Tariff Structure 2.12 Until recently, major characteristics of the import tariff structure were: high dispersion, which discriminated against many types of manufacturing activities, thereby hindering efficient resource allocation; and the domestic market and discourage exports. It also attracted resources to manufacturing, thereby discriminating against agricultural production, and increasing the cost of some manufactured inputs used in the agricultural sector. In a first major step to lessen these deficiencies, a revised tariff structure was adopted by the Government in January 1986. Import tariff peaks were reduced from a maximum (including all surcharges) of 220% to 100%, and tariff dispersion was reduced so that over 75% of commodities now have tariffs 70% of less.2/ Based on these data, average tariffs and tariff dispersion have been reduced for all tariff categories by about 30% and 50%, respectively. The reductions in nominal tariff levels on final products, together with the progressive reduction of tariff exonerations on imported inputs and raw materials (para. 2.10), should reduce recent levels of effective protection significantly. Preliminary estimates indicate, for example, that effective protection for some textile products should decline from 120% to about 70%, and for footwear products from over 200% to less than 100%. 2.13 The Government plans to continue revising tariff levels in order to lessen the anti-export bias introduced by tariffs for which exporters are not adequately compensated, and to improve the internal terms of trade, particularly between the industrial and agricultural sectors. A unit to be established in the Central Bank to estimate and monitor shadow prices under the proposed loan will also minitor, in coordination with the Agricultural Policy Analysis Group to be financed under the recently aproved Agricultural Sector loan, changes in internal terms of trade and effective protection. The unit would also propose further tariff reforms. 2/ Except for tariff levels of a few items, which were under import prohibitions between 1982 and March 1985. These import prohibitions were initially replaced by tariff levels of up to 250%. The new tariff for these items ranges up to 125%, including surcharges.  - 7 - B. The Financial Sector Instltutionol Structure and Development 2.14 Main Institutions The main institutions in Ecuador's financial system are the Central Bank (BCE), 32 private commercial banks with about 285 branches; 3 state banks-the National Developmant Bank (BNF), the Ecuadorian Housing Bank (BEV), and the Er-'adorian Development Bank (BEDE)-and 13 fi- nance corporations, including the public National Finance Corporation (CFN). There are also 11 savings and loans associations; more than 25 insurance com- panies; various currency exchange offices and securities markets in Guayaquil and Quito. The Social Securicy Institute (IESS) is also a major depository for financial savings. As a group, commercial banks dominate Ecuador's fi- nancial system, and their outstanding loan portfolio represents 75 Z of total lending to non-bank borrowers. 2.15 Policy-making agencies are the Monetary Board, BCE, and the Super- intendency of Banks. The Monetary Board sets exchange rate, interest rate, and other financial policies which are implemented by the BCE and the Super- intendency of Banks. BCE also provides credit to financial intermediaries, including special discount credlt lines. The Superintendency of Banks super- vises financial intermediaries and is responsible for publishing statistical information on the banking system. 2.16 The principal vehicles for BCE's indirect lending have been the Fi- nancing Funds (Fondos Financieros), which were established in 1973 to develop and strengthen specific activities that the Government wanted to encourage. There are currently five Funds (three financed by BCE funds, one by Treasury budget funds, and one by foreign loans channeled by BCE), including one that provides medium-term loans to Small-Scale Enterprises. The Funds financed by domestic resources grant mostly short-term credit with a maximum term of two years, and interest rates to final borrowers that are among the lowest avail- able. 2.17 Developments The financial system grew rapidly in the 1970s, main- ly because bank ownership granted access to profitable BCE credit lines and because guarantees for foreign loans to the private sector grew rapidly and appeared profitable. Additionally, negative real interest rates charged to final borrowers, and attractive margins and commissions provided to interme- diaries, stimulated lending growth. However, such a situation provided little incentive for financial institutions to mobilize domestic resources on their own, and they became increasingly dependent on BCE credits and foreign borrowings for resources. The structurally flawed financial system which thus arose became all the more fragile because easy granting of bank licenses led to the establishment of many small, inefficient and undercapitalized banks. Between 1973 and 1984 the number of private banks increased from 21 to 32 and finance companies from 2 to 13. The system suffered grave liqui- dity problems beginning in 1983 as foreign resources dwindled and economic conditions deteriorated. Combined with the devaluation of the sucre, these  - 8 - factors diminished the ability of borrowers to meet dollar-denominated obligations guaranteed by the banks. To help financial intermediaries, the Government carried out a 'sucretization" program (Annex 3, para. 4) under which BCE assumed foreign debts and the participating institutions became obligated to repay BCE in sucres over a period of up to seven years. While this program enabled the immediate liquidity crisis to be managed, one of its legacies was that BCE credit in 1983 financed about 35% of the commercial banks' and up to 60 % of finance companies' portfolios. Interest Rate Policy and Resource Nobilization 2.18 Performance Official interest rates are established periodically by the Monetary Board. Judged by international standards, Ecuador has in the past been quite unsuccessful in mobilizing domestic financial resources. A comparison for 1980 of a standard measure of financial deepening (the ratio of money supply (M3) to GDP) for six Latin American countries and Nigeria, an OPEC nation, revealed that only one country exhibited less financial deepening than Ecuador. 2.19 The poor past performance in resource mobilization is attributable mostly to the reluctance of prior Governments to adjust interest rates in response to chaages in expected inflation. Until 1981, the authorities maintained interest rates at levels below inflation. Thus, Ecuadorians increasingly chose more attractive savings alternatives (foreign financial assets or unregulated inter-company financial market assets) over deposits within the Ecuadnrian financial system. Since 1981, official interest rates on savings and time deposits were raised periodically, but until recently remained below domestic inflation. As a result, there was little improvement in private domestic resource mobilization. Also, high and variable rates of inflation and fixed interest rates made it impossible for Ecuadorian finan- cial institutions to make long-term loans without assuming unreasonable risks. 2.20 Government Action To spur domestic resource mobilization, at the end of 1984 the Government raised official interest rates and introduced large denomination (over one million sucres) Certificates of Deposit (CDs) bearing unregulated interest rates. This brought nominal official deposit rates to about 20-23% p.a. and effective lending rates to about 25-26% p.a. for loans up to two years, and 26X p.a. for loans over two years. CD rates are about 26% on twelve-month deposits; funds mobilized through such CDs are onlent for a similar term at about 30% p.a. These measures brought official interest rates to positive levels in real terms (inflation was about 14% p.a. for the six months ending December 1985). Moreover, in late August 1985 the Government issued new legislation to allow long-term financial instruments to carry variable rates to be adjusted at frequencies determined by the Monetary Board, and amended the laws governing banks and financieras and the Monetary Law as outlined in para. 2.22 below with the purpose of strengthening the financial condition of Ecuadorian financial institutions.  - 9 - 2.21 Further Action Requlred The changes in interest rates have begun to have a salutary effect on domestic resource mobilization; during 1985 real deposits in commercial banks rose over 25 % and savings deposits and CDs more than doubled in real terms. Furthermore, the introduction of variable interest rates should greatly facilitate long-term lending. However, future action will be needed to allow more automatic adjustment of interest rate levels, especially to reflect changes in the rate of inflation, which oscillated in recent years between 14% and 62% p.a. Moreover, high nominal interest rates present a problem for long-term loans. Traditional repayment methods for such loans result in debt service payments which are concentrated in real terms in the earlier years, imposing liquidity strains on borrowers. During the dialogue on financial policies, the Bank explored the possibility of introducing financial instruments which would provide for partial capitalization of interest. However, the Government believes that such action would be difficult to administer and may be less urgent as its anti-inflation program takes effect. 2.22 Recent Legal Reforms With the purpose of strengthening the financial condition of Ecuadorian financial institutions, amendments were issued in August 1985 to the laws governing financieras and banks, and to the Monetary Law. In addition to permitting variable interest rates on loans of more than two years term, these amendments included: (i) shortening of the minimum term of certificates of deposit issued by financieras from 270 days to 90 days, which they may now repurchase prior to maturity, and permitting the Monetary Board to revise these terms from time to time; (ii) establishing that total liabilities of financial institutions cannot exceed 15 times paid-in capital and reserves; (iii) requiring that the loans of any financial institution to any one person cannot exceed 25% of the institution's paid-in capital and reserves (there are several important exceptions to this exposure limit, including credits resulting from the sucretization, and credits of less than 180 days covered by adequate guarantees used to finance exports); (iv) requiring financial institutions to establish a reserve for bad debts equal to 10% of all accounts receivable; and (v) expanding the powers of the Superintendency of Banks as a supervisory agency. Past Bank Leading and Strategy in Industrial and Financial Sectors 2.23 The Bank has provided five loans for development finance companies in Ecuador. These loans total US$155 million, net of cancellations. The first four DFC loans (Loan 721-EC app-oved December 15, 1970; Loan 930-EC approved June 26, 1973; Loan 1359-EC approved December 28, 1976; and Loan 1731-EC approved June 19, 1979) are completed. The fifth loan (2096-EC) signed April 22, 1982), is fully committed and 92% disbursed. A Completion Report has recently been issued for the third and fourth DFC projects. Its main findings showed that by SeptembDr 1983, devaluation, recession, reduced consumer demand and public sector investment all reduced industry's ability to meet debt service payments on projects financed by DFCs. Inadequate financial sector policies and supervision by regulatory authorities, as well as weaknesses in DFCs' appraisal and supervision also contributed. The financial statements of DFCs therefore reflected sharply declining revenues  - 10 - and income. The profitability, liquidity, and financial structures of DFCfj weakened as portfolio problems mounted. These problems are being addressed under the proposed project. 2.24 The Bank has also made two Small Scale Enterprise (SSE) loans and is processing a third. The first (Loan 1879-EC) for US$20 million was approved in June 1980 and disbursed one-and-a-half years earlier than expec- ted. A second SSE operation (Loan 2221-EC) for US$40 million was approved in December 1982. Execution of the project has proceeded smoothly and the loan was 95 percent committed at end-1985. Board consideration of a third SSE loan for US$30 million is scheduled for March 1986. 2.25 In line with Government objectives, Bank strategy for the indus- trial sector is to support employment-intensive and export-generating indus- tries, as well as those making efficient use of local resources. The pro- posed project is designed to further the Government's objectives in the industrial sector, and to support progress on the broader aspects of Bank strategy, aimed at: (i) encouraging resource mobilization and more efficient resource allocation through financial sector reforms; and (ii) improving the industrial and trade policy framework to encourage more efficient industrial production.  - 11 - III - THE PROJECT A. Project Objectlves and Desc.iptton ,Bgd 3.01 The project was identified by the Bank in October 1984 and was pre- pared by the Government with the help of Bank staff. It was appraised in July 1985. Negotiations for the proposed project took place in Washington from January 15-22, 1986. The Ecuadorian delegation was led by Mr. Alfredo Crespo, Subsecretary of Public Credit. Project Objectives 3.02 The proposed project would (i) support changes in trade, industrial and financial policy; (ii) continue encouraging more efficient domestic resource mobilization and allocation throught an adequate interest rate structure; (iii) strengthen the financial condition of financial intermedia- ries; (iv) provide term credit for efficient industrial development; and (v) provide technical assistance to: the Government to derive shadow prices for more effective project evaluation; the Superintender_y of Banks and the Superintendency of Companies to strengthen their stupervisory capabilities; and financial intermediaries to strengthen their project evaluation capabili- ties. Project Description 3.03 The proposed loan would consist of two parts. Part A would finance essential imports in support of the series of measures which have been taken to liberalize trade, industrial, and financial sector policies, as outlined in paras. 1.15 - 1.20, 2.16 - 2.20, and summarized in Annex 8. These measures--which complement recent actions to improve resource allocation and the efficiency of the agricultural sector--would represent fundamental steps to reorient Ecuador's model of industrial development towards a more efficient one, and strengthen the capacity of the financial system to mobilize and allocate domestic resources more effectively. They are essential to promote Eucador's continued adjustment and growth, and are fully consistent with the Bank's policy dialogue. 3.04 Part B would provide long-term loan funds to finance a proj-ct with two distinct components: (i) financing of privately controlled Ecuadorian manufacturing firms for fixed assets and permanent working capital to ini- tiate permanent programs to export, or expand or reorient production for export; to establish efficient new enterprises; or to expand or reorient the productive capacity of existing firms; and (ii) financing of technical assistance to: help establish within BCE a mechanism to calculate and update a set of shadow prices for the economy; strengthen the supervisory capabili-  - 12 - ties of the Superintendency of Banks and the Superintendency of Companies by developing and giving training programs for their staff, establishing new management information systems, etc.; and strengthen the project evaluation capabilities of the financial intermediaries which are or could become eligible to participate in the project. B. Particlpating Iostitutions Private Finaenieras 3.05 As discussed in pars. 2.17, during the 1970. financial repression led to low domestic resource mobilization and heavy dependence on foreign borrowing. Much of this foreign borrowing was guaranteed by local financial intermediaries. By the end of 1982, foreign borrowing had been largely curtailed and economic conditions had deteriorated. The recession, combined with the negative effects of devaluation, put a number of firms in financial distress. Their high levels of indebtedness and inability to repay outstanding loans further weakened business demand and caused a deterioration in the financial performance of the financieras. The sucretization of the foreign private debt improved the debt structure of private borrowers and their liquidity positions; however, it caused a sharp deterioration of the debt/equity ratios of the financieras, from below 10 to 1 at end-1981 to between 15 to 1 and 25 to 1 at end-June 1984. Some of the financieras have subsequently obtained fresh capital contributions and capitalized earnings, thereby improving debt/equity ratios to between 14 to 1 and 19 to 1 at end-1984. 3.06 During appraisal, the financial condition of the six largest private financieras which participated in the Fifth Development Banking Pro- ject (Loan 2096-EC) and Corporacion Financiera Nacional (CFN) was examined in detail, including their latest external audit reports and analyses of their loan portfolios. The external audits of these financieras have been carried out by Peat, Marwick and Mitchell or Price Waterhouse & Company. In the last years, the audit reports have been received by the Bank on a timely basis except for the 1984 audit report for COFIEC which was delayed. Clean audit opinions were issued during the period for all the financieras except for FINANSA (1983) and CFN (1983) for which qualifications were made concerning the recoverability of certain loans and the adequacy of the reserves for bad debts. In both cases appropriate corrective action has been taken. Also, the status of a number of subprojects financed under the loan was reviewed. The private financieras studied wore ranked according to selected financial criteria, profitability, portfolio quality, etc. Based on these factors, three of the private financieras were considered to be in relatively good financial condition at end-1984; three others would need to take major steps to increase capital and loan loss provisions in order to qualify for participation in the proposed loan.  - 13 - Eligibility Criteria 3.07 Eligibility criteria have been established for participation in the proposed loan in order to assure that only financieras meeting certain finan- cial standards participate, and to encourage the fJnancieras to take steps to improve their financial condition, including obtaining new capital contributions from shareholders. Participating institutions would have to maintain a debt/equity ratio of not more than 15:1 as of the end of 1985; this would be reduced annually, declining to 12:1 at the end of 1988. Financieras would also have to meet annual targets with respect to interest coverage, liquidity ratios, and exposure limits which were agreed during negotiations. In order to obtain fresh capital resources for the financieras, improve their financial structure and mobilize domestic resources, each eligible financiera would be entitled to ulse US$9 equivalent from the proposed loan for each dollar increase in its equity after January 1, 1985, to finance subprojects. However, no single financial intermediary could commit more than 50Z of the loan amount available for sublending under the project. In order to provide the financieras with an adequate return on equity in real terms, the initial financial spread on subloans would be 5% p.a., and interest would be required to be charged quarterly. The adequacy of financieras' spreads would be reviewed semi-annually by the Borrower and the Bank and adjusted, if warranted, to take into account changes in inflation levels and their cost and capital structures. Corporacion Flnanciera Nacional (CFN) 3.08 Established in 1960, CFN is the oldest and largest development finance company in Ecuador and the major provider of medium- and long-term credit to the industrial sector. CFN is wholly Government-owned. Although its policies and operations must conform with Government development objec- tives, CFN is relatively autonomous in its day-to-day operations. At end- 1984, CFN's total assets were about US$200 million equivalent with equity of about US$35 million equivalent. CFN's financial position deteriorated in recent years as a result of: (i) an increase in non-earning assets due to the sucretization; (ii) liquidity problems due to Government delays in reim- bursing CFN for foreign exchange losses; (iii) low returns on equity invest- ments; and (iv) deterioration of its loan portfolio. 3.09 During project preparation, a plan of action for strengthening CFN financially and institutionally, so that it could meet the same eligibility criteria for participating in the proposed loan as the private financieras, was discussed with CFN and the Government. As a result, the Government and CFN have recently taken a number of important steps. CFN reorganized its loan administration and established units responsible for collection and for  - 14 - restructuring problem companies. Loan recoveries have improved and a number of companies have been restructured. Moreover, in December 1985, the Government took steps to increase effectively CFN's capital by some US$40 million equivalent. Finally, CFN has taken steps to sell a number of its equity holdings. These steps will greatly improve the financial structure of CFN and greatly ameliorate its recent liquidity problems. The capital increase would reduce CNF's exposure in Aztra (a sugar company which has suffered continuing financial losses) from 41% to about 19%, and greatly reduce its exposure in other companies. The standard loan provisions on exposure for all participating financial intermediaries would also apply to CFN. 3.10 A plan of further actions agreed for CFN requires (i) CFN to maintain its efforts to improve credit collections and strengthen the financial condition of its clients; (ii) the Government and CFN to take, by June 30, 1986, all necessary measures spelled out in the decree authorizing the capital increase required to legally effect the increase referred to in para. 3.09; (iii) CFN to avoid making loans or capital contributions to Aztra unless the funds for such purposes are provided by the Government as a capital contribution or grant to CFN; and (iv) CFN to engage by June 30, 1986, consultants to strengthen its financial and accounting systems. In addition to the standard eligibility criteria for all financieras, CFN would need to fulfill all agreements under the plan of action to continue to be eligible to use the credit component of the loan. Sonitoring 3.11 At present, the Financial Policy Unit of BCE establishes and moni- tors credit discount limits for commercial banks and financieras. Eligibi- lity and determination of the amount of participation of the financieras would be governed by criteria agreed with the Bank and applied by this Unit. The financieras would be required to have their accounts and financial statements audited, in accordance with appropriate auditing principles con- sistently applied, by independent auditors acceptable to the Bank; they would be required to furnish to the Bank and to the Financial Policy Unit of BCE, not later than four months after the end of each fiscal year, certified copies of their audited financial statements. C. Project Costs and Financing Ar-angements Project Costs and Financing 3.12 Part A of the loan would provide USS50 million equivalent to finance the foreign costs of about 2.5% of Ecuador's projected 1986 A  - 15 - imports. 3/ Since all policy actions which the loan would support have been taken, the full US$50 million under Part A would be available for dis- bursement upon loan effectiveness. Part B of the loan would finance subpro- jects and technical assistance. The total investment cost of subprojects is estimated at US$102.3 million. This includes an estimated US$69.3 million in foreign costs, and US$9.2 million of import duties and sales taxes. In addi- tion, technical assistance would zost some US$660,000 (US$240,000 each for the Superintendencies of Banks Prad Companies, US$120,000 for BCE, and US$60,000 for financial intermediaries) making a total cost of US$103 million. Part B of the proposed loan would provide US$65 million equivalent, or about 632 of the total cost of subprojects and technical assistance and 93% of foreign exchange costs. Beneficiaries would finance about 32% and financieras about 5% of such costs. Loan, Subsidiary Loan and Subloan Terms 3.13 The proposed loan would be made to the Republic of Ecuador at the Bank's standard variable interest rate and charges. It would be repayable over 17 years, including 4 years of grace. The Government, through BCE as its agent, would onlend the proceeds from Part B of the loan to eligible financial intermediaries for subprojects, except for the portic.:s for tech- nical assistance. For the latter: (i) US$100,000 from the loan would be mad!e available to BCE as a grant to carry out a study on shadow pricing; (ii) US$200,000 from the loan would be made available by BCE to the Superin- tendency of Banks, and US$200,000 to the Superintendency of Companies to carry out their respective technical assistance, and would be repaid on terms similar to those for subloans; and (iii) US$50,000 would be lent on commer- cial terms by BCE to the Association of Development Banks for the finan- cieras' technical assistance. Terms and arrangements for repaying the tech- nical assistance costs to BCE would have to be acceptable to the Bank. 3.14 The remaining US$64.45 million equivalent from Part B of the pro- posed loan would be onlent in sucres to financial intermediaries at variable positive real interest rates as they are determined from time-to-time by the Monetary Board. Financial intermediaries would onlend these resources to project beneficiaries at the rates established from time-to-time by the Mone- tary Board. The intermediaries would receive a spread of initially 5% p.a. BCE would retain 0.25% p.a. fee to cover its costs of administration. The revenues from the difference between the Bank's lending rate plus BCE's fee, and the rates charged to the financial intermediaries would be used by BCE, as agent, to cover, in whole or in part, the foreign exchange risk on the Bank loan. However, any shortfall would be made up by the Government, which would take the foreign exchange risk and pay the commitment fee on the Bank loan. On the basis of current official rates (25% p.a.) which would be applicable to subloans, there is an ample spread over the current World Bank 3/ The Bank and the Government are beginning discussions which could lead to cofinancing being sought in the context of this project.  - 16 - lending rate to cover the difference between domestlc and world inflation (the expected foreign exchange risk). However, this relationship is likely to change if lending rates are lowered or inflation levels change signi- ficantly. To the extent that the Government continues the recent trend to- wards market-based interest rates, interest rate adiustments should he more responsive to such differentials. Signing of a fiscal agency agreement bet- ween the Government and BCE, satisfactory to the Bank, would he a condition of loan effectiveness. 3.15 Subloans for fixed assets (machinery, equipment and civil works) would be made for up to 12 years, including up to four years of grace, and, for permanent working capital for up to six vears, including up to two vears of grace. Lending terms and grace periods for individual subloans would take into account the economic life of assets to be financed and the repayment capacity of sub-borrowers. The maximum cumulative subloan amount from Bank- funded sources per sub-borrower or group of related firms would he USS5 mil- lion equivalent. It would be a condition of disbursement for anv subloan that the participating financial intermediary had signed a Subsidiary Loan Agreement with BCE acceptable to the Bank. 3.16 The Government has agreed to maintain interest rates on all loans to the industrial sector, with maturity exceeding two years, at levels which are positive in real terms, and which, after July 1, 1987, are also adequate relative to deposit rates, as measured by criteria agreed with the Bank. The Government would review with the Bank the adequacy of the level of lending interest rates at least semi-annually beginning October 1, 1986. It would also review semi-annually with the Bank the adequacy of domestic financial resource mobilization, based as well on criteria agreed with the Bank. The adequacy of spreads would also be reviewed on these occasions. If, during any of these reviews after July 1, 1987, the levels of lending interest rates, spreads, or domestic financial resource mobilization were inadequate, and the Government and the Bank were unable to agree on remedies for this, then the Bank would have the right to withhold financing of fresh subloan commitments under the proposed loan. Subproject Review 3.17 A review of a number of subprojects financed under the Fifth Devel- opment Banking Project, indicated that, although subproject evaluation had improved since previous DFC projects, areas for improvement still exist. For example, the analysts of management and markets should be strengthened, greater allowances should be made for contingencies in financing plans, loan terms and grace periods should better reflect project life and implementation schedules, and greater attention should be given to macroeconomic risk factors. A format listing all matters to be dealt with in subproject evalua- tion reports has been discussed and agreed with the financieras. All subpro- jects submitted to the Bank for financing would be required to follow the agreed format. In addition, a technical assistance component would be included in the project to offer training courses to staff of the financieras arid CFN to upgrade their capabilities, especially in market, financial and  - 17 - economic analysis of projects. Based upon experience under the Fifth Devel- opment Banking Project, the following free limits for Bank review of subpro- jects have been agreed for the various financieras: CFN - US$2 million; FINANQUIL - US$1 million; COFIEC, FINANSUR and ECUFINSA - US$0.5 million; FINANSA and FINIBER - US$0.35 million. The free limits would be increased or decreased during project implementation once the Bank had reviewed the first four subprojects of any given financiera, and depending upon whether the Bank was satisfied that the project evaluations submitted had been performed ade- quately. Financieras other than the above would have no free limits until the Bank was satisfied with the project evaluations submitted. An economic evaluation would be required for each subproject with (i) a total investment cost exceeding US$1 million, or (ii) a subloan exceeding the free limit for the financiera involved. The minimum required ERR would be 12%. Procurement 3.18 For Part A of the loan, procurement for any item over US$5 million would be by ICB following standard Bank procedures. Items costing less than US$5 million equivalent would be procured following normal procedures of the purchaser. For Part B, the financial intermediaries would satisfy themselves during subproject appraisal that procurement items were suitable for the res- pective investment project and reasonably priced, and that the beneficiaries had canvassed the main available sources of supply and were purchasing from advantageous sources. These procedures would conform to normal commercial practice for DFC-type projects. As under the Fifth Development Banking Pro- ject, informal international or local solicitation of offers would be fol- lowed for any purchase over US$250,000. Consulting services and goods for technical assistance would be procured in accordance with Bank Guidelines. Dlsbursements 3.19 Bank disbursements under Part A of the loan would be for 100% cent of the c.i.f. costs of eligible imports, but only for goods for which payment was made within 120 days from the date on which they were landed in Ecuador. Eligible imports would be all goods except those normally excluded under Bank policy-based loans, such as alcohol, tobacco, armaments, etc.; goods financed by other Bank loans; and expenditures under contracts costing less than US$50,000 equivalent. Disbursements under Part B of the loan would be for: 100% of the direct foreign expenditures for imported goods and services to finance fixed assets (machinery and equipment) and permanent working capital (inventories, raw materials); 70% of local expenditures for imported goods procured locally; and 35% of local expenditures for locally produced goods and services and for civil works. These percentages would reflect the direct and indirect foreign exchange cost. Disbursements under the technical assistance components would be for 100% of the costs of consulting services and equipment, excluding local taxes, local subsistence costs, and import duties. Disbursements under both Part A and Part B of the loan, except for technical assistance, would be made against Statements of Expenditures (SOEs). These would be certified for Part A disbursements by BCE, and for  - 18 - Part B disbursements by the financieras. The supporting documentation for SOEs would be retained by the financieras and BCE and made available to Bank missions for review. To facilitate disbursements, a Special Account of US$15 million equivalent would be established in BCE. The Special Account and SOEs would be subject to annual audits carried out by independent auditors accept- able to the Bank. A schedule of estimated disbursements based upon the standard profile for IDF operations is given in Annex 7. The final date for submission of subloans would be December 31, 1988, and the Closing Date for the loan would be December 31, 1993. D. Project Benefits and Risks Benefits 3.20 At the macroeconomic level, the industrial, trade, aLAd financial sector policy reforms which the project would support represent fundamenital steps to reorient the model of industrial development pursued ir. recent de- cades in Ecuador, and strengthen the capacity of the financial system to mo- bilize and allocate domestic resources more effectively. These policy changes are essential to promote Ecuador's continued economic adjustment and growth. Tn the medium-term, by promoting exports, improving the internal terms of trade between industry and agriculture, and promoting development of domestic resource-based industries which Ecuador's comparative advantage can support, the trade and industrial sector reforms should stimulate demand for agricultural products, promote urhan and rural employment and help improve the living conditions of the country's poor. The proposed project would also provide long-term resources for financing efficient industrial enterprises in Ecuador and help them adapt to the rnew policy framework. About 90 investment projects costing an estimated IJSSlO2.3 million and creating about 3,400 new jobs would be financed. Further important benefits would result from the continued dialogue with the Government on interest rates and industrial poli- cies which affect the environment in which industrial enterprises operate. Financial policy reforms should in the longer-run reduce the reliance of financial i;itermediaries or, the Government atnd the Bank for resources. Risks 3.21 The major risks facing the macroeconomic reforms which the project would support relate to their political sustainability and the maintenance of an attractive exchange rate for export promotion. Although the policy re- forms supported by Part A of the proposed loan have'already been taken, the Government will likely be under continuing pressure to modify or reverse them until they demonstrate widespread, tangible benefits. So far, the new Government has maintained its original policy objectives despite resistance to liberalization. Maintenance of an adequate exchange rate, which will be critical for the success of the trade liberalization measures and export expansion, is being closely monitored by the IMF. Both the Bank and the Fund have coordinated their analyses of export incentives so that the positions of the two institutions are consistent.  - 19 - 3.22 At the institutionel level, some financial intermediaries are in poor financial condition and may be unable to meet the eligibility criteria in order to use loan resources to finance subprojects. As a result, commit- ment of Bank funds could be delayed. In addition, participating financieras may again experience financial difficulties which could delay repayment of subloans to BCE. Technical assistance included in the project to strengthen regulatory agencies should limit this risk. Also, depending upon the rate of economic recovery in Ecuador and the potential short-term impact of import liberalization and interest rate reforms, demand for resources from the credit component of the project could slacken. However, even if loan disbursements were somewhat slower than forecast, project benefits arising from individual subprojects and the technical assistance programs should still be realized.  - 20 - IV. AGREEMENTS AND ECOMMEATION Agreements 4.01 During loan negotiations, agreement was obtained and understandings were reached on the following: (1) With the Government on: (a) Establishing a variable interest rate for subloans (para. 3.14); (b) Maintaining interest rates on all loans to the industrial sector, with maturity exceeding two years, at levels which were positive in real terms, and which, after July 1, 1987, were also adequate relative to deposit rates, as measured by criteria agreed with the Bank. The Government would review with the Bank the adequacy of the level of lending interest rates at least semi-annually, beginning October 1, 1986. It would also review semi-annually with the Bank the adequacy of domestic financial resource :aobilization, based as well on criteria agreed with the Bank. The adequacy of spreads would also be reviewed on these occasions. If, during any of these reviews after July 1, 1987, the levels of lending interest rates, spreads, or domestic financial resource mobilization were inadequate, and the Government and the Bank were unable to agree on remedies for this, then the Bank would have the right to withhold financing of fresh subloan commitments under the proposed loan (para. 3.16); (c) Financial intermediaries would have to continue to meet agreed eligibility criteria tailored to improve their individual financial conditions in order to have access to loan resources. In order to encourage their increased capitalization, for each US dollar equivalent increase in their equity after January 1, 1985, intermediaries would have access to US$9 equivalent from the loan to finance subprojects. However, no single intermediary could commit more than 50% of the loan amount available for sub-lending under the project (para. 3.01); (d) A special plan of action to strengthen CFN financially and institutionally wold be maintained in effect as a condition of CFN's participation in the project (para. 3.08); (e) The initial 5% spread on subloans for participating financial intermediaries to be charged quarterly and arrangements for reviewing the spread as inflation and the cost structure of the financial intermediaries changes (para. 3.06); (f) The plan of action to strengthen CFN financially and institu- tionally as a condition of participation by CFN in the loan (para. 3.09);  - 21 - (g) Arrangements for the Financial Policy Unit of BCE to monitor eligibility criteria for participation in the proposed loan (para. 3.11); (h) External auditing for the financieras (para. 3.11); (i) The format to be followed in subproject evaluation reports and the free limits for participating financial intermediaries (para. 3.17); (j) Procurement procedures to be followed (para. 3.18); and (k) Disbursement percentages for subprojects; arrangements for the Special Account, auditing of SOEs (para. 3.19). (2) With CFN on the plan of action as a condition for its participation in the loan (para. 3.09). 4.02 Condition of loan effectiveness is that the Government and BCE enter into an agency contract satisfactory to the Bank (para. 3.14). 4.03 Condition of Disbursement for any subloan is that the participating financial intermediary had signed a Subsidiary Loan Agreement with the BCE acceptable to the Bank (para. 3.15). Resco~maPdation 4.04 With the above agreements, the proposed project would constitute a suitable basis for a Bank loan of US$115 million to the Republic of Ectuador on the terms and conditions outlined in Chapter IV.  - 22 -- ANEX 1 ECUADOR STAFF APPRAIS,.L REPORT INDUSTRIAL FINANCE PROJECT Average Tariffs and Dispersion of Current and Proposed Tariff Structure Mean Standard Deviation Tariff Section Current Proposed Current Proposed I. Live animals and related products 114 69 99 49 II. Plants and vegetables 83 52 97 48 III. Edible oils 117 69 98 46 IV. Food products and tobacco 143 92 81 40 V. Mineral products 18 15 36 19 VI. Chemical products 16 14 25 17 VII. Rubber 51 36 47 26 VIII. Hides, leather 90 61 77 32 IX. Wood, cork 94 59 72 38 X. Paper, pulp 69 47 84 43 XI. Textiles and clothing 93 68 73 39 XII. Footwear 159 100 71 31 XIII. Glass, ceramics 74 57 63 39 XIV. Precious stones 134 91 91 38 XV. Metal and metal products 52 37 49 30 XVI. Machinery 40 27 43 24 XVII. Transport equipment 45 36 47 46 XVIII. Scientific and opt. instruments 60 44 43 33 XIX. Others 113 77 36 25 Source: Manual Arancelario del Ecuador, Central Bank Propuesta Arancelaria, MICEI August 1985  - 23 - ANNEX 2 Page 1 of 6 ECUADOR STAFF APPRAISAL REPORT INDUSTRIAL FINANCE PROJECT Terms of Reference for Technical Assistance 1. Terms of Reference for the Superintendency of Banks The consultant(s) would review the legal responsibilities, organization, staffing, data processing equipment and software, and the analytical work and reports prepared by the Superintendency of Banks (SB) and would: (a) Review and make recommendations to revise the financial data and reports required to be supplied by commercial banks to the SB; (b) Conduct training courses for staff of the SB in credit and financial analysis of commercial banks and in overall bank review procedures; (c) In the course of carrying out the training of SB staff, identify personnel who could carry out similar training courses in future as part of a permanent program of training in the SB; (d) Provide guidance and on-the-job support to SB staff in the examination of a number of the larger commercial banks; (e) Advise the SB on the standardization of reports prepared by SB examiners and analysts and in their distribution and use within the SB; (f) Assist the SB in the use of its inspection manuals in carrying out its work programs for supervision, and advise the SB on the use of its staff and its training policies and programs; (g) Advise the SB on the requirements of the new law which specifies new procedures for establishing reserves for doubtful accounts and also advise on procedures for classifying loans and banks by financial condition, operations, etc. (h) Review existing bank regulations and make recommendations to the SB with a view to simplifying them and eliminating those which no longer have practical utility; (i) On the basis of the information to be supplied by commercial banks and other financial institutions, assist the SB in identifying appropriate computer equipment and software and  -24 - ANNEX 2 Page 2 of 6 developing programs to assist SB analysts in the storage, retrieval and analysis of this data for analytical purposes and for reporting to management of the SB. 2. Terms of Reference for the Superintendency de Companies The consultant would review the legal reponsibilities, organization, staffing, data processing equipment and software and the analytical work and reports prepared by the Superintendency of Companies (SC) in order to develop with the Superintendencia: (a) The SC's needs for computer equipment and software in order to handle its data management and analysis requirements over the next few years; (b) The SC's needs to develop systems for inspectors to organize and control the collection and review of financial and operating data on companies; Cc) Terms of reference for consultants to design and implement new data management and analysis systems, including training programs for staff; and (d) Courses to train staff of the SC in analysis to determine the financial condition and performance of companies in the principal subsectors in which Ecuadorian companies operate. The consultants would give an agreed number of courses for SC staff. 3. Terms of Reference for Estimates of Shadow Prices for Project Appraisal in Ecuador Objectives 1. First, to derive a set of shadow prices for Ecuador to facilitate more effective project economic evaluation by the Ecuadorian's financial intermediaries. 2. Second, to train a local team to be able to understand the rationale and mechanics of the calculation of shadow prices. As a result, the local team should be able to update the set of shadow prices at regular intervals so as to include the impact of changes in the country's economic environment, as well as changes introduced by modifications in economic policy. Work Program 3. The function of the set of shadow prices to be estimated is to make possible more consistent estimates of shadow prices, which in the past have been ignored or have tended to vary from project to project, depending on the particular assumptions favored by the project analyst, and his/her choice of which goods and factors require shadow pricing.  - 25 - ANNEX 2 Page 3 of 6 4. The consultants, with the suppert of the local team, should collect the basic data needed to compute and establish a set of shadow prices. To compute shadow prices, the Squire-van der Tak approach should be considered as the first alternative in choosing the methodology to be used. This method has the advantage -- vis-a-vis the use of an economy-wide shadow exchange rate - that, by computing conversion factors for major on-tradable commodity groups, it focusses on specific adjustments to be made to remove distortions in relative prices of the particular non-traded goods involved in a project. 5. While a separate conversion factor should, in theory, be defined for each non-tradable good, it is neither feasible nor necessary to do so in practice. Thus, grouping non-tradables will be expected and estimates of standard conversion factors will be sufficient in valuing minor non-tradables. Valuation methods to be used, for tradables have to be included as well. In grouping goods, however, it has to be considered that the error in the estimation is likely to be greater, the greater the degree of aggregation used. The evidence from the countries in which many conversion factors have been estimated suggests considerable variations across sectors and commodities. It would be expected that estimates to be calculated should include general conversion factors -- for: (a) traded inputs, (b) machinery, (c) equipment, (d) non-traded inputs, (e) raw materials, (f) capital, (g) labor, including conversion factors for rural labor, unskilled urban labor, and semi-skilled and skilled labor, (h) major non-traded services such as transport, electricity, commerce, civil construction and other, (i) demand-price, (j) supply-price, and (k) consumption. Desaggregation of the above conversion factors would be desirable and it would depend on the availability of information and its relevance for economic project evaluation in Ecuador. 6. The consultant in estimating shadow prices should consider the main methods available: (l) decomposition of sector cost of production, (ii) use of data on trade tariffs and subsidies, and (iii) input-output analysis. However, the input-output method might be considered as the first alternative given: (i) the existence of an updated I-0 matrix in Ecuador, and the feasibility of its desaggregation, (ii) its major advantages vis-a-vis the other method, i.e.; (a) it allows the estimation of a greater number of conversion factors, (b) it can be used to trace out, in a consistent manner, the implications of a policy change on the whole set of conversion factors, and (c) it facilitates updating. Personnel and Responsibilities 7. The Government will hire five man-months of foreign consultant services. The consultant - who will have primary responsibility for establishing the first set of shadow prices as well as for training the Ecuadorian counterpart - should be an economist with substantial experience in computing shadow prices along the lines established in paragraphs 4-6. The Government will provide a counterpart of four economists to be trained by, and work full time with, the consultant. The  - 26 - ANNEX 2 Page 4 of 6 Government will also provide office space, administrative services, computer facilities and additional resources as required for the completion of the study. Reports and Timetable 8. The consultant will report to the Director of the Office of Economic Studies of the Central Bank of Ecuador, who will have overall responsibility for the study's implementation and coordination. Progress of the study will also be monitored by the Bank during regular supervision missions and/or missions related to the proposed Sixth Development Banking Project. The study will commence in early 1986, and will take about five months. A progress report will be presented two months after the study has started, and a draft report will be presented 30 days after the consultant has finished the field work. The draft report will include the value of the different shadow prices computed for the e .nomy as well as detailed annexes describing the methodology, data, computer program, etc. The object of these detailed annexes is to provide a well documented basis for the continuation of the empirical work by the Ecuadorian team. The final report, which will include comments of the draft report received by the consultant from the Government and for the World Bank, is expected to be completed by mid-1986. 4. Outline of Courses for the Evaluation of Industrial Projects Course I - Project Evaluation with emphasis on market Analysis, and on the Financial and Economic analysis of Projects. Day I Market Analysis Consumer Analysis - consumer needs, market segmentation, the purchasing process, market research and data collection. Analysis of the competitive environment - market structure, basis of competition, institutional constraints. Day 2 The marketing plan - product design, pricing, distribution, promotion (marketing strategy) Demand forecasting - techniques and considerations for forecasting sales. Day 3 Financial Analysis AM Methodology for financial projections for a 'greenfield' project - income statements, balance sheets and funds flow statements, cost and benefit streams and calculation of the financial rate of return (FRR).  - 27 - ANNEX 2 Page 5 of 6 PM Methodology for financial projections for an expansion project - cash flows with and without t-he project, incremental cost and Sensitivity Analysis benefit streams and FRR. Day 4 Economic Analysis AM The concept of economic analysis Identifying relevant costs and benefits - transfer payments, contingencies, sunk costs, externalities. PM Pricing Traded Inputs and Outputs - Deducing Border Prices. Day 5 Economic Analysis (continued) AM Nontraded Inputs and Outputs Conversion Factors Shadow Prices PM Calculating the economic rate of return Economic cost and benefit streams, discounting Sensitivity analysis and interpretation of results Short-cut methods. Days 6 and 7 Review of case studies which illustrate the main elements of the financial and economic analysis. Day 8 Review of analysis of actual cases prepared by course participants (or groups). Day 9 Financial and economic analysis by individual course participants (or groups of participants) of a problem case. Review and discussion of model solution to the problem case. Day 10 General review and discussion of methodologies for financial and economic analysis of projects. Evaluation of course by participants. Course II The Use of Computers in the Financial and Economic Analysis of Projects Day 1 General review of the methodology for financial and economic evaluation of projects. AM Financial rate of return calculations PM Economic rate of return calculations  - 28 - ANNEX 2 Page 6 of 6 Day 2 General description of the project evaluation model - data requirements, entering and editing data, reports. Day 3 Demonstration of the application of the model for a sample project - sensitivity analysis. Day 4 Use of the model to evaluate a project using data supplied by the participants - sensitivity analysis. Day 5 Review and discussion of model solution to the problem case. Evaluation of course by participants.  - 29 - ANNEX 3 Page 1 of 10 ECUADOR STAFF APPRAISAL REPORT INDUSTRIAL FINANCE PROJECT Financial Condition of Financieras (DFCs) Background 1. The Ecuadorian financial system suffered grave liquidity problems beginning at the end of 1982 as the availability of foreign resources dwindled and economic conditions deteriorated. These factors deeply affected an already structurally flawed financial system. During the 1970s the domestic financial system had been repressed by ceilings on deposit and lending rates. These ceilings led to a poor record of domestic resource mobilization and a dependence on foreign lending guaranteed by local financial intermediaries; when the recession developed and devaluation became necessary, these guarantees placed great pressure on the intermedia- ries. By the end of 1982 it was clear that the recession in the Ecuadorian economy, the persistence of inflation, combined with the negative effects of devaluation, had created financial distress in a large number of enter- prises. Their high indebtedness and inability to repay outstanding loans to the banking system had in turn caused a weakening in business demand and in the financial condition of the DFCs. 2. To refinance their clients and continue income-earning activity in the face of a shrinking base of long-term resources, the DFCs resorted to increased use of short-term credit, and to expanded use of the Central Bank's (BCE) rediscount lines and special credit facilities. However, these credit lines, which carried high interest rates, coupled with long-term lending at rates fixed in the past, contributed to a narrowing of the spread between interest income and interest expense, from about 4.5% on average in 1981 to 2% in 1983. 3. The narrowing of the spread was aggravated by the DFCs' declining earning capacity due to a significant change in their asset structure. In the early eighties the DFCs were heavily involved in guarantze and letter of credit operations in foreign exchange. In a guarantee operation a foreign credit was arranged by an Ecuadorian financial intermediary with a foreign bank. The financial intermediary then provided a guarantee, charging a 4% fee. During the 1980-1982 period, guarantees accounted for between 25% and 50% of the operations of financieras, averaging 45% for the financieras as a group. Loans accounted for between 35% ard 70% of operations (average 40%) and acceptances and letters of credit operations averaged 15%. Average earning assets amounted to between 90% and 95X of the total assets of the DFCs. This structure changed dramatically after the devaluation and subsequent sucretization program (see para. 4 below) mainly due to two factors: the elimination of the guarantees as a  - 30 - ANNEX 3 Page 2 of 10 profitable line of business and the introduction of the exchange risk commission. By the end of 1983, exchange risk commissions averaged 20% of total assets, resulting in a decrease of average earning assets to 70% of total assets. 4. The devaluations in 1982 and 1983 imposed a severe burden on the financial system. The sucretization mechanism was established by the BCE in March of 1983, to help ease this burden. Under the sucretization mechanism (Monetary Board Resolutions 047-83 and 048-83 of March 1983) USS1.2 billion in private sector registered foreign debt was assumed by the BCE. The resolutions imposed upon the financial intermediaries the obligation to pay BCE (i) an amount equivalent to the debts' principal in Sucres (at the current exchange rate) carrying an interest rate of 16% p.a. plus an annual fee of 1/2% on undisbursed balances, and (ii) an exchange risk commission equal to between 70% and 100% of the principal under (i) above, intended to cover the expected exchange losses associated with future devaluations over the period of the credit. Simultaneously, the financial intermediary and the private enterprises were to negotiate a Sucre loan under terms similar to those given to the financial intermediary by the BCE. The principal of the Sucre loan and the exchange risk commission were to be paid over a maximum term of three years including 1-1/2 years of grace. In October 1984, the terms were extended to a maximum of seven years including 4-1/2 years of grace.l/ No interest, however, is payable to BCE on the portion of the sucretized loan representing the exchange risk fee, and the intermediaries are not permitted to charge interest on this amount to their borrowers, thus they effectively receive no spread on this portion (on average 46% of the total of sucretized loans). 5. As a result of the sucretization program, private borrowers have a better cash flow and debt structure but financial intermediaries have seen their liabilities increase several-fold, resulting in a sharp deterioration in their debt/equity ratios, which reached levels between 15 to 1 and 25 to 1 in June of 1984 from 7 to 1 to 10 to 1 at the end of 1981. However, a number of financieras have subsequently increased their capital base by obtaining fresh capital contributions as well as 1/ In mid-October 1984, it became evident that most Ecuadorian enterprises would be unable to pay the debt as scheduled under the original sucretization program. The terms of the sucretization were extended to seven vears, with 4-1/2 years of grace, but the other conditions were left unchanged. While this extension clearly has alleviated the repayment problems of debtors, it seems to have been too generous with respect to the cost of the loans (the exchange risk fee was not increased but the exchange losses would now increase given the longer new repayment periods). Moreover, the BCE would not only be confronted with a large portfolio of long-term assets which would inhibit the reallocation of resources but also with losses that would have to be covered by Central Government revenues, or alternatively by inflation taxes.  - 31 - ANNEX 3 Page 3 of 10 capitalizing earnings. Thus the debt-equity ratios as of December 1984 have improved substantially in some cases, and the financieras which participated in the Fifth Development Banking Project (Loan 2096-EC) have lowered their debt-equity ratios to between of 14 to 1 and 19 to 1. Similarly, their profitability has suffered since their fixed costs continue increasing with inflation while their ability to make new loans is restricted given their already high debt/equity ratios. 6. During appraisal the mission reviewed the financial position of the DFCs2/ which are participating in Loan 2096-EC. The seriousness of the condition of individual financieras varies with differences in the degree of deterioration of their portfolios, financial structures and the management of their funding requirements and lending operations. A detailed analysis is given below. Individual financial statements, asset adequacy analysis, and estimated loan loss provisions based on each DFC's loan portfolio data, are available in the project file. Profit margin summaries for individual DFCs are attached as Annex 3, Table 1; selected financial ratios for all the DFCs are presented in Annex 3, Table 2; and the financial eligibility requirements to participate in the proposed loan are outlined in Annex 3, Table 3. Financial Condition of the DFCs 7. Key financial data for the six leading Financieras (excluding CFN which is analyzed separately) are given below: 2/ Corporacior Financiera Nacional (CFN), Compania Ecuatoriana de Desarrollo S.A. (COFIEC), Compania Financiera Nacional S.A. (FINANSA), Financiera Ecuatoriana de Financiamiento S.A. (ECUFINSA), Financiera Ibero-Americana S.A. (FINIBER), Financiera del Sur S.A. (FINANSUR), and Financiera Quayaquil S.A. (FINANQUIL).  - 32 - ANNEX 3 Page 4 of 10 Key Financial Data, December 1984 FINANQUIL ECUFINSA FINANSUR FINIBER FINANSA COFIEC -