Bolivia - Financial Sector Adjustment Project

Documeut of The World Bank FOR OFmCIAL USE ONLY Report No. Tr- i41-BO REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT IN AN AMOUNT OF SDR 50.6 MILLION TO THE REPUBLIC OF BOLIVIA FOR FINANCIAL SECTOR ADJUSTMENT May 20, 1988 This document has a festricted distribution and may be used by recipienXt only In the performance of their official duties. Its contents may not othewise be disclosed without World Bank authorization.  CURRENCY MQUnALTS Currency Unit - Boliviano ($b) US$1 - $b 2.2 (December 31, 1987) WUIGUTS AND kWASUES 1 hectare (he.) - 10,000 m (2.47 acres) 1 kilogram (kg) = 2.2 pounds 1 metric ton (m ton) - 1,000 kg GLOSSARY OF ABBREVAUIONS BA - Agriculture Bank BAMIN - Mining Bank BANEST - State Bank BANVI - Housing Bank BCB - Central Bank of Bolivia BISA - Industrial Bank CACEN - Central Housing Savings and Loan Board FENACRE - NationalWFederation of Credit Unions FERE - Special Fund for Economic Reaetivation GDP - Gross Domestic Product GSF - Vice Presidency for the Financial System IMF - International Monetary Fund Ml -M oney M2 - Ml plus quasi-money NBFIs - Non-Bank Financial Institutions NEP - New Economic Program PFMO - Public Financial Management Operation RRs - Reserve Requirements REPUBLIC OF BOLIVIA FISCAL YEAR January 1 - December 31  FOR OMCALM USE ONLY BOLIVIA - FINANCIAL SECTOR ADJUSTMENT_ CWDIT TAILE OF CONENTS Page No. CREDIT AND PROGRAM SUMMARY ................................... - iii PART I - THE ECONOMY ... ................................. PART II - FINANCIAL SECTOR PERFORMANCE AND STRUCTURE .................. 6 2.1 Disintermediation and the Shallowness of the Financial System .................................................... 6 2.2 Interest Rate Behavior ........................ .......... 8..#O8 2.3 Present Financial Sector Structure .. 10 PART III - MAIN FINANCIAL SECTOR ISSUES .............................. 12 3.1 Restoring Financial Depth ...... * ........................... . 12 3.2 Financial Condition of Banks ................................i1 3.3 High Financial Intermediation Costs ........................... 17 '.4 Inadequate Institutional Arrangements .. . ...................... 18 PART IV - THE PROPOSED FINANCIAL SECTOR ADJUSTMENT CREDIT ............ 20 4.1 History .......................................... o............... 20 4.2 Objectives of the Credit and Main Components .................. 20 4.3 Description of Main Reforms .. . . ..... 21 4.3.1 Maintenance of Market Determined Interest Rates ... 21 4.3.2 Institutional Strengthening ...... ... 21 4.3.3 Reducing the High Cost of Credit . . ..................... 27 PART V - CREDIT FEATURES .... . ..... 28 5.1 Credit Amount, Borrower and Implementing Agency ............... 28 5.2 Letter of Sectoral Policy ...............4.... 4 ..44 4............. 29 5.3 Credit Disbursement and Procurement ...........44 ......4444. ...... 29 5.4 Benefits and RIsks...... 4444.4.......................... 30 This report was prepared by Felipe Morris, based on the findings of a Post- appraisal Mission which visited Bolivia in November 1987. The mission comprised Messrs. M. Larrain (LATTF), F. Morris (Mission Leader, LATTF), J. Krasowski (IFC), G. Tabares (Consultant), Ms. M.C. Franco (LATTF). P. Miovic and W. Shaw (?A3Cl), contributed to Part I. An Appraisal Mission composed of Messrs. J.-Krasowski (IFC), A. De Juan (CECFP), J.C. Protasi (Consultant), G. Tabares (Consultant), and R. Vogel (AFTPN), visited La Paz in May 1987. 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 disclsed without World Bank authorization.  TABLE OF CONTENTS (contd.) Page No. PART VI - B ANK GROUP OPERATIOW5 AND STRATEGYY ......................... 31 PART VII - COLLABORATI ON W ITH THE IMF . ............................... 33 PART VIII - RECOMMENDATION .................. . *. .... .... .. .... 33 TEXT TABLES 1. Real Interest Rates and Financial Depth ................8 2. Banking System Interest Rates, Quarterly 1980-87 . . 9 3. Selected Financial Indicators for Private Commercial Banks .... 12 4. Profit/Loss Ratios, 1985-1987 ......................... . ...... 14 5. Loan Portfolio Provisions and Overdues . . iS 6. Impact of the Structure of Reserve Requirements ........ 16 TEXT GRAPHS 1. Selected Financial Indicators ... ... .. .....6 ANNEXES I. Key Macroeconomic Indicators . . ..... ........34 II. Supplementary Credit Data Sheet ................38 III. Government's Letter of Development Policy ..................... 40 IV. Policy Matrix ...............*........ 49 V. Technical Assistance Component . ................* ............. 52 VI. Guidelines for the Rehabilitation/Liquidation of Banks ....... 56 VII. Public Sector Banks . .................................. . 60  BOLIVIA - FINANCIAL SECTOR ADJUSMENT CREDIT CREDIT AND PROGRAM SUMMARY Borrower: Republic of Bolivia Amount: SDR 50.6 million (equivalent to US$70 million) Terms: Standard, with 40 years maturity Credit Objectives: The main objectivas of the proposed Financial Sector Adjustment Credit are: Ci) increasing confidence in the bpnking system and resource mobilization; (ii) strengthening the financial condition of banks; and (iii) reducing the high cost of credit. Achievement of these objectives will increase the overall efficiency of Bolivia's financial sector and enhance its ability to finance the working capital and investment needs of the productive sector. Credit Description: The proposed credit would support a set of reforms directed at reaching the three above-mentioned objectives. The reforms includes(i) maintenance of a coherent- macroeconomic policy aimed at continued stability; (ii) continuation of market determination of interest rates; (iii) strengthening banking supervision; (iv) improving banking regulations and accounting practices, including more stringent regulations on loan portfolio classification, provisions for loan losses, and on interest accruals on problem loans; (v) requiring external audits of banks by qualified auditors; (vi) establishment of an adequate mechanism to handle problem banks; (vii) resolving the Idedollarization' issue; (viii) compensating banks for their reserve requirements; (ix) rehabilitation or restructuring of public financial institutions; and (x) strengthening the Central Bank of Bolivia (BCB). In addition, there is a technical assistance component geared to strengthen the new Central Bank Vicepresidency (Gerencia del Sistema Financiero) charged with handling problem banks, providing support to the new Superintendency and assisting the restructuring of Banco Agricola (BAB). A policy matrix spelling out the objectives of the proposed credit, financial sector issues, measures already taken, measures to be taken under the credit, and proposed timing, is contained in Annex IV. Benefits: The proposed operation would increase the overall efficiency of the banking industry and thus enhance its ability to finance investment and growth. This would result from increased deposit mobilization, improved credit  - is - allocation and a lower cost of credit. Although it is very difficult to isolate the Impact of the proposed reforms from the influence of other economic variables, major contributions of the reform program will consist oft (a) greater transparency and depositor confidence through improved prudential regulation and supervision of banks, (b) more effective mechanisms to deal with problem banks thus reducing the economic costs of bank failures, (c) improved incentives for the rationalization of the structure of the financial system, and td) enhanced financial performance of banks contributing to reduction in spreads and lending interest rates. Within this framework, the cost of financial intermediation would be reduced by the increased volume of transactions handled by stronger, more efficient banks. The financial sector reforms are expected to increase discretionary resource allocation by the banking system, reduce operating costs and thus permit the resumption of productive investment through the availability of adequate financial resources at reasonable interest rates. Rlskss Two major risks associated with this credit relate to: (a) the possibility of setbacks in macroeconomic policies that would if 9rfere with the implementation of needed structur . reforms, including the banking sector reforms supportec. by the proposed credit; and (b) departure from the current policy of market determination of interest rates. These risks are mitigated by the commitment to stabilize the economy and to proceed with a broad program of structural reforms within a market economy framework which the Government continues to show. These reforms include, besides the banking sector reform, trade policy adjustment, public sector rationalization, and increasing the role of the private sector in the economy. The Government's current efforts at negotiating its foreign debt and at reformulating an economic stabilization program with the IMP also reduce these risks. In addition there are the following risks directly related to the banking sectors (a) the possibility of inadequate implementation of the reform prog-.am due to the lack of adequate Administrative capabilities to carry it out; and (b) the possibility of widespread and uncontrolled bank failures which would require the Government to bail banks out and abandon the reform program altogether. We are mitigating these risks by supporting the newly created Vice-presidency for the Financial System in the Central Bank and the Superintendency, through the Technical Assistance component. Estimated Disbursements: Except for the Technical Assistance component, the credit would be disbursed in two tranches. It is anticipated that the first tranche would be disbursed soon after credit  effectiveness. The second tr4nche is expected to be disbursed about six months after loan effectiveness. Funds for technical assistance would be disbursed in about 36 months. Disbureement of the entire credit is expected to be completed iithin three years of credit effectiveness.  REPORT AND 'ECOMHENDATION OF TEE PSESIDENT OF THE INTERNUTIONAL DEVELOPMENT AGENCY TO TEE EXECUTIVE DIL2CTORS ON A PROPOSED CREDIT TO TEE REPUBLIC OF BOLIVIA 'OR FINANCIAL SECTOR ADJUSTMENT 1. I submit the following report and recommendation on a proposed credit to the Republic of Bolivia for SDR 50.6 mill-on (the equivalent of US$70.0 million) on standard IDA terms in support of a program -'f Financial Sector Adjustment. PART I - TEE ECONOMY 2. An Updating Economic Memorandum is nr-r being prepared which will be presented to the Board in June 1988; a Policy Framework Paper is also being prepared in conjunction with the IMP. The following discussion is based on those documents and the findings of missions which visited Bolivia from August 1987 through February 1988. 3. Background. The Bolivian economy grew at a rapid pace during the 19709, when it enjoyed an average GDP growth of 5.4Z between 1970 and 1978. This boom was supported by an infusion of external capital, as lenders were encouraged by the rising prices of Bolivia's mineral exports. Net foreign lending halted abruptly, however, in 1979-80, when it became obvious that ,not only had Bolivia's foreign debt become excessive, but that much of the lending had been used for projects of doubtful value or for capital flight. 4. Despite rapid growth during the 19709, the increased role of the state and its declining effectiveness resulted in a severe misallocation of resources. Numerous state enterprises (active in many fields including mining, manufacturing, and transport) operated in a confused policy environment without controls or support. Political instability and lack of consistency in economic policy during the early 1980s exacerbated Bolivia's economic problems. In 1981, the government's policies led to a consumption boom. A sharp rise in imports was financed by an increase in arrears on amortization payments, a decline in reserves, and some new borrowings. Consumption was also supported by a largely unrecorded inflow of goods financed by earnings of the growing drug trade. Although the boom was choked off in 1982 because of 'the lack of official foreign exchange, the public sector deficit skyrocketed in the ensuing years, reaching 23.82 of GDP in 1984. Government expenditures mncreased rapidly to satisfy the needs of competing social groups, while escalating inflation reduced tax receipts and currency overvaluation led to a collapse of recorded exports. The government essentially lost control of the economy, which degenerated into hyperinflation in 1985. 5. On taking office in August 1985, the new government faced a very difficult economic situation characterized by a public sector that had grown excessively and severe imbalances in the fiscal and balance of payments accounts (partly on account of a substantial drop in tin prices). The main symptoms of the crisis were: (a) an increase in prices of about 24,000Z in the 12 months preceding August 1985, (b) a huge fiscal deficit financed through the inflation tax, (c) a current account deficit which stood at 6? of GDP in 1985, (d) a ratio of investment to GDP of only 3.62,  -2- 10.5 percentage points below the 1980 level; (e) a very high (US$3.5 'Allion) and unmanageable external public long-term debt, approximately equal in size to the country's GDP; and (f) deteriorating social conditions as a result of the precipitous decline in per capita income over the past five years. 6. Nev Economic Policy. The new government, facing an economy that had almost reached a point of chaos, moved swiftly and decisively to implement a far reaching stabilization program. This program, named the 'New Economic Policy", was announced in August 1985. It contained not only macroeconomic stabilization meatures, but also measares to liberalize trade, reform taxes, revamp administrative procedures and deregulate and partially privatize the public sector. It combined policy changes, such as freeing most prices (including the exchange rate and interest rates), reducing the fiscal deficit and implementing a tight monetary policy, with an opening of discussions with private foreign creditors over payments on its foreign debt, which had been suspended in 1984. The "New Economic Policy' was supplemented by additional measures, notably a comprehensive new tax law, a freezing of employment and wages in the public sector, elimination of quantitative import controls and a 202 uniform import tariff. 7. Implementation of the program was seriously threatened by the decline in the price of Bolivia's two major exports (tin and natural gas) in 1986. The dollar price of Bolivian exports of tin fell by 412 and of natural gas by 12S in that year. Bolivia's recorded export receipts declined to $672 million in 1986, about $40 million below the 19&s level and 392 below the level achieved in 1980. However, the government adhered to its stabilization policies, despite this severe external shock. Inflation was running at an annual rate of below 10 by the last quarter of 1986. The nonfinancial public sector deficit was roughly equal to zero An 1986. The exchange rate was unified and remained roughly stable against the dollar in real terms (although the Boliviano is considerably stronger than it might be in the absence of the cocaine trade). These restrictive policies, necessary to restore order within the economy, plus the severe terms of trade decline, resulted in a fall of 3.32 in output in 1986. 8. Recent Events. Some recovery was seen in 1987, when GDP is estimated to have risen by 2.42, a rate of increase which remains below the 2.82 rate of population growth. By mid-1987 there were signs of a pick-up in the economy, especially in services, while other sectors such as mining, energy, and agriculture, either continued to decline or stagnated, and private investment remained depressed. This led the Government to pursue a more activist role in the economy. As a result, the Government announced a Reactivation Decree (Supreme Decree No. 21660) in July 1987. The objectives of the Reactivation Decree were to (a) reduce unemployment; (b) increase export growth, particularly of non-traditional products; (c) reorient industry, to the extent possible, to substitute for imported goods behind a uniform and low level of protection; (d) improve the regulatory framework of the fi.ancial system: (e) settle the problems of external debt to private creditors; (f) increase the supply of housing to people of low to medium incomes; and (g) improve the efficiency and effectiveness of the public sector by streamlining key procedures and institutions involved in the areas of procurement, disbursement, and public investmenti  -3- 9. As a result of measures adopted under the Reactivation Decree, progress has been made in stabilizing the private banking system, by equalizing reserve requirements between dollar and boliviano accounts, strengtbening supervision of banking practices, and assuming the debt of the three major State banks (as well as liquidating the Banco de Vivienda) which othervise would be in serious difficulties. Also, administrative measures have been taken to improve development planning and economic management, particularly in the Ministry of Planning and Coordination. 10. The Reactivation Decree also provided for support to the private sector through a US$100 million Special Fund for Economic Reactivation (FERE). Sixty percent of the fund was-intended for badly needed working capital to industry, agriculture and mliing (US$20 million to each sector). The remaining 402 would finance for construction of inexpensive bousing. However, the disbursementa from the fund were delayed, and the fund was finally suspended at Congress' request due to doubts about the fairness of its allocation. The Government has revised the fund's operating procedures and increased the size of the fund, but now lacks tb.w capital necessary to finance the fund's activities. 11. The Government has moved fozcefully to assist some victims of recent economic reversals. With the support of the international donor community, an Emergency Social Fund has been established to provide employment through public works projects and lessen the deterioration in living standards. By the end of 1987, the ESF reached a commitment level of US$40 million, which is expected to grow to US$50 million a year in 1988 and 1989. However, further urgent action is needed in the areas of primary (and particularly tural) education, health and sanitation. Increased external resources would facilitate improvements in social conditions without endangering the Government's fiscal and monetary targets. 12. The Government has made substantial progress in regularizing its relations with its external creditors, after stopping payment on most external loans in 1984. Bolivia and its commercial bank creditors have agreed to a plan under which Bolivia would buy back its debt (at around 11 of face value), using funds provided by donor governments. Bolivia also intends to offer a debt-equity swap program. In this way, the Government hopes to retire a large portion of its private debt. In June 1986 the Paris Club agieed to a rescheduling of $400 million of bilateral debt on generous terms. A further Paris Club rescheduling is expected after conclusion of negotiations with the IMF. 13. Despite the considerable improvement in macroeconomic policies since August 1985, the government faces additional difficulties in achieving a stable macroeconomic environment. Some of these can be traced to external factors. Bolivia's short term difficulties in making debt service payments are due in part to the build-up of arrears on payments for natural gas exports in 1986 and 1987; these arrears totalled $120 million in February 1988. Recent declines in oil prices will shortly lead to a decline in the price of natural gas exports, as these prices are adjusted periodically to reflect conditions in the oil market. In addition, a fall in the demand for cocaine in the US market and increases in the amounts supplied have reduced illegal inflows of foreign exchange, further depressing internal demand.  -4- 14. The Government also faces a difficult challenge in managing the budget. Despite the dramatic fall in the budget deficit in 1986, the Government has yet to ,ut its fiscal accounts on a sustainable basis. The budget deficit was eliminated in 1986 in large part by building up arrears to both external and internal creditors, and by linking payments to receipts available at the time of disbursement. This has introduced a measure of instability and uncertainty into the domestic financial system. In 1987, the public sector cash deficit is estimated to have increased to 8.6Z of GDP, over-shooting the target of 62 of GDP. This deficit was financed by continuing to build up arrears to the domestic private sector, by borrowing from the banking system, by loans from official external creditors, and by not paying interest to private source creditors. While the Government has undertaken plans to reduce the deficit in 1988, a wage settlement with the Trade Union Confederation of 161 (about five percent above the rate of inflation), and the recent leveling off of tax receipts indicate that reducing the deficit will be a difficult task. 15. Substantial progress must also be made in establishing a stable financial environment for private sector development. Low levels of savings and uncertainty over prospects have limited the supply of capital to firms. This has resulted in rates of interest which greatly exceed the rate of inflation. High real interest rates have in turn reduced investment plans and constrained current production by making it difficult and expensive to obtain necessary working capital. At the same time, a shortage of counterpart funds needed to speed up the use of the already committed external funds has limited the execution of the public investment. program. The Government requires additional resources to carry through its investment program and to respond to any unexpected domestic financial shocks. Without sufficient reserves, the Government could be forced into excessive monetary creation in order to avoid financial instability, and in the process probably increase inflation. For all of these reasons, the country would benefit from a rapid infusion of external untied capital. 16. Medium-Term Prospects. Bolivia faces very difficult prospects over the medium term. It is burdened by an extremely high level of external debt, approximately equal in dollar value to its GDP and about six times the value of its dollar exports. Debt coming due to bilateral creditors will have to be rescheduled on more favorable terms, and debt due the private banks must be reduced, either througn the debt buy-back plan, debt-equity swaps, or further negotiations. Tin and natural gas accounted for 651 of Bolivia's legal merchandise exports in 1986; the country remains vulnerable to changes in market conditions for these two commodities. In addition, COHIBOL the State mining company, exported almost nothing in 1987 and it remains to be seen how production and exports recover as the new restructured COMIBOL resumes its operations. At the same time, the decline in per capita income from an already very low level since 1980 means that more resources must be devoted to social programs. The country's administrative machinery remains weak, reflected in poor implementation of the public investment plan. Despite the important efforts undertaken since August 1985 in achieving macroeconomic stability, much work remains to be done to ensure stable long-term growth. 17. This credit supports Bolivia's mediam-term adjustment program for 1988-89. This program is aimed at consolidating stabilization efforts and  shifting the focus of economic policies toward the achievemeat of a sustainable rate of growth and viable balance of payments through export diversification, higher domestic savings, and price stability. The targets of the program includet GDP growth of 3-4Z per annum, inflation at around 102 per year, a fiscal deficit at 4-SZ of GDP by 1991, and a monetary and foreign exchange policy aimed at retaining reserves. This will require further adjustments in public expenditures and revenue collection to reduce the budget deficit and allow sufficient expansion of credit to the private sector without exceeding the limits of the monetary program. An appropriate exchange rate policy must be followed to protect reserve levels and avoid a bias against the production of tradeable goods. A tentative working agreement has been reached between the Bolivian Government and the IDF on an ESAF. This agreement will help to ensure that the Bolivian Government continues the sound macroeconomic policies evidenced over the past three years, a necessary condition for the success of this credit. 18. Projections of the key macroeconomic variables and of the balance of payments are shown in Annex 1. The projections assume average annual GDP growth from 1988-90 of 42, which would permit a slight rise in per capita consumption. We consider this a miaimum rate of growth, essential to obtain the political conseuass necessary for sound economic management and to allow some recovery in social conditions from the income declines ,f the early 1980s. To support this rate of growth and assist in the diversification of the investment program away from tin mining, both public and private investment would have to increase sharply over the next three years. 19. Increased investment would be financed by higher savings from domestic private and public sources, and through continued inflows of external capital. Gross domestic savings is assumed to rise from 3.4X of GDP in 1986 to 8.32 in 1990. To achieve the necessary rise in public savings while maintaining essential services will require a major resource mobilization effort. Increased taxes, along with import tariffs (minus export rebates) and revenues from YPFB, the national petroleum company, should result in an increase in revenues. However, the government's recurrent expenditures, iJ--luding increased efforts in the social sectors and interest payments on -e4ternal debt, are likely to leave insufficient resources for public investment financed out of domestic sources. 20. Therefore, a major portion of the public investment program will have to be financed from abroad for the foreseeable future; the current account deficit is projected to remain at about 112 of GDP for the next three years. As Bolivia is not expected to receive any funds from private financial institutions, capital inflows are provided entirely from official sources. Funding from bilateral and multilateral institutions is expected to fall short of total capital requirements in 1988189 by $122 million a year, not including the funds which would be provided under this credit (see Annex I, page 4). In 1990, the amount of additional finance required rises to $188 million, despite the fact that this projection assumes not. only strong export performance and modest increased imports, but also further rescheduling of bilateral debt under the Paris Club. Clearly, international donors will need to substantially increase their assistance, and provide that assistance at very concessional rates, if Bolivia is to avoid a severe shortfall in foreign exchange, with damaging consequences  -6- for the country's growth prospects. Given such support and no further ezternal shocks, the medium-term program outlined above is feasible and sustainable. PART 1I - PINANCIUL SECTOR PERFORMANCE AND STRUCTURE 21. The Bolivian banking system in the 1960s and 1970s was characterized by steady growth of about 72 per year and the emergence and development of medium and long-term credit lines. This progressive trend came to an abrupt halt in the early 1980s, as a result of a series of economic events which included: (a) a sharp reduction in economic activity (GDP contracted by 16? between 1981 and 1985, and a further 2.9? in 1986); (b) the 1982 'dedollarizationt and (c) hyperinflation. These events and the extreme instability and drastic policy reversals which have taken place since the early 1980s have resulted in a weakened financial sector characterized by shallowness, high real interest rates, insufficient credit to the productive sectors, and overdimensioning (both in terms of personnel and branches). GRAPH 1 SELECTED FINANCIAL INDICATORS (1 980=1 00) 140 120 "'- Credit 1001 - Real M2 n 80 d e f + Branches x 40 20 * Personnel 80 81 82 83 84 85 86 87 Year 22. Graph 1 provides summary indicators of financial sector performance and structure between 1980 and 1985. Deposits and credit contracted rapidly in the early 1980s, and have yet to recover their real levels of 1981. In spite of the rapid contraction in bank business, the number of branches was not reduced. Adjustments in personnel were also delayed, and significant reductions were not made until 1986-87. 2.1 DISInTZRNEDI&TION AND THE SRALLOWVESS OF THE FINANCIAL SYSTEM 23. The most striking symptom of the impact of macroeconomic policy on Bolivia's financial system was the demonetization and disintermediation process which occurred between 1982 and 1985. Rapid inflation, inappropriate exchange rate policies, and forced elimination of  domestically held 4illar assets and liabilities resulted in a dramatic reduction of the real size of Bolivia's financial system. 24. Financial depth can be measured by the ratio of a real monetary aggregate (such as M1 or M2) to GDP. Ml is defined to include currency and demand deposits, while M2 also includes quasi-money (peso and dollar- denominated time deposits). These ratios have fluctuated widely. M1IGDP peaked at 12? in the first quarter of 1978 and reached its valley at 2.3S in the first quarter of 1986. M21GDP also peaked at 22Z of GDP in the first quarter of 1978 and reached its valley in the third quarter of 1985 (3?) at less than one fifth of its 1981 level. The rapid acceleration of inflation between 1980 and 1985, combined with controls on interest rates, strongly reduced the incentives to hold domestic financial assets. By mid- 1985 total deposits in the banking system stood at the equivalent of US$68 million, less than one-tenth of what they had been in December 1981 (US$725 million). In addition, the share of total credit going to the public sector rose even more dramatically over the same period, from just over one-third to almost three-quarters. 25. Since 1976 Bolivia's financial system had operated on a dual currency basis w'ch both peso and dollar-denominated assets and liabilities coexisting within the domestic financial market. Inflation combined with overvaluation of the domestic currency in the early 1980s--as a result of a fixed exchange rate, with sporadic devaluations which did not compensate for deteriorations in purchasing power parity--resulted initially in a shift away from peso denominated financial instruments toward dollar denominated and real assets. The dollarization of the Bolivian economy reached a peak in the third quarter of 1982 when about 90S of total time deposits in the banking system were dollar denominated. 26. In November 1982, financial institutions were required to accept repayment of their US dollar denominated loans in pesos at the highly overvalued official exchange rate. Dollar deposits were likewise converted to pesos at the official exchange rate, which relieved financial institutions of some of their losses from the conversion of dollar loans. Elimination of dollar assets and liabilities from the financial system, however, greatly increased incentives for capital flight and accelerated the disintermediation process. 27. The New Economic Program (NEP), announced in August 1985, brought high real interest rates, restored dollar assets, and boosted confidence which produced a substantial rise in the stock of real deposits. As a result, M2/GDP increased significantly, averaging 102 during the last three quarters of 1987. The data alao shows similar trends for M1/GDP and for real Ml and M2. While there has been a remonetization since mid-1985, this has mostly occurred in dollar deposits. As of August 1987, peso deposits accounted for only 29Z of total bank deposits. Another important fact to highlight is the slowdown in the real growth of peso deposits since mid- 1986.  Table ls REAL INTEREST RATES AND FINANCIAL DEPTH (end of period) 1980 1981 1982 1983 1984 1985 1986 1)87 In percentagess Real deposit rate:a In $b b/ -24.8 -42.7 -32.7 -58.9 -88.5 -23.5 -13.3 23.5 In USS b/ -1.4 9.6 .. .. 0.9 7.4 13.5 13.9 Real lending rate:a In $b b/ -18.5 -38.5 -26.0 -52.1 -87.7 21.0 40.8 44.7 In USS b/ .. .. .. .. .. 12.8 21.4 27.3 Ml/GDP c/ 9.6 10.4 8.2 6.7 6.2 3.2 3.0 3.2 M2/GDP c/ 16.2 17.7 14.1 10.1 7.5 4.7 6.7 8.5 In 1980 $b '000: Real Ml 11.8 12.3 10.4 7.5 6.2 4.5 5.0 5.2 Real HZ 19.9 21.0 17.9 11.3 7.5 6.6 11.2 13.8 _/ Deflated by the CPI, 1980 m 100. b/ Annual interest rates. _0 September 1987. Sourcess Central Bank and IBRD staff estimates. 2*2 INTEREST RATE BEHAVIOR 28. Interest rate policy in Bolivia during the first half of the 19808 was characterized by controls imposed by the Government on lending and deposit rates. Both-deposit and lending rates were strongly negative in real terms. The tremendous inflationary pressures which started in 1982, and subsequently accelerated in 1984 and early 1985 led the Government to lift controls on lending rates and to set a floor on deposit rates in March 1985. Finally, in August 1985 all interest rates were freed. Because liberalization took place in a highly distorted environment, real interest rates initially rose to very high levels. 29. As the stabilization program reduced macroeconomic disequilibria, the general level of interest rates in Bolivia declined somewhat and began to follow international interest rate movements, but at a substantial premium. Dollar returns to deposits in Bolivia exceed those abroad by a factor of 2. 30. As shown in Table 2, monthly real interest rates, particularly dollar lending rates, have been very high for most of the last two years. interest rates on deposits in bolivianos (around 30? per year recently) are much higher than rates on dollar deposits (16 to 18? per year), reflecting expectations about Bolivian inflation and exchange r2tes. Real lending rates exceeded 202 per year in dollars and 40X per year in bolivianos  -9- during 1986 and 1987. High real lending rates, which reflect both high deposit rates and large spreads, hinder the resumption of investment. 31. The public demands high passive rates in order to deposit in the banking system for the following reasons: Mi) the domestic financing of the large public sector deficits which has crowded out resources available to the private sector and sets a very high floor for domestic interest rates; (ii) the public's lack of confidence in economic performance over the medium- and long-term, resulting in additional pressures on interest rates in the form of risk premia; and (iii) the financial system's weak financial condition, where banks' liquidity needs lead them to pay higher rates to attract deposits (this also implies depositors will demand a risk premium leading to still higher rates). In addition, substitution between deposits denominated in dollars and in pesos is highly sensitive to interest rate differentials and to expectations--which include the credibility of the Government's economic program. The substantial difference between interest rates on dollar deposits in Bolivia and those abroad are a reflection of the risk that dollars might be again converted to pesos at an unfavorable exchange rate. Table 2: BANKING SYSTEM INTEREST RATES, QUARTERLY 1980-87a (Z, end of period) Nominal interest rates Real interest rates Active Passive Active Passive Spread Sb US$ $b USS $b US$ Sb US$ Sb USS 1984 I 69.0 .. 45.0 .. -75.8 .. -79.2 .. 3.4 II 157.0 .. 140.0 5.0 -29.5 .. -34.1 0.6 4.7 III 157.0 .. 140.0 5.0 -75.5 .. -77.1 0.7 1.6 IV 157.0 .. 140.0 5.0 -87.7 .. -88.5 0.9 0.8 1985 I 34.6 .. 20.0 5.0 -82.8 .. -84.7 1.3 1.9 II 44.6 .. 25.0 5.0 -89.9 .. -91.3 1.2 1.4 III 386.5 18.0 120.0 10.0 180.9 14.2 27.0 6.5 153.9 7.7 IV 232.1 16.8 110.0 11.2 21.0 12.8 -23.5 7.4 44.5 5.4 1986 I 223.3 20.4 129.5 14.0 137.4 16.8 68.5 10.6 68.8 6.2 II 98.1 22.6 48.9 15.0 66.3 20.7 25.1 13.2 41.3 7.5 III 79.6 22.0 39,7 15.0 71,7 20.0 33.7 13.1 38.1 6.9 IV 65.8 23.0 33.4 14.9 40.8 21.4 13.3 13.5 27.5 8.0 1987 I 50.8 23.6 28.9 15.1 41.1 20.9 20.6 12.6 20.5 8.3 II 49.3 25.8 27.5 15.5 40.7 21.2 20.2 11.3 20.5 9.9 III 53.5 32.1 31.0 18.2 44.7 27.3 23.5 13.9 21.2 13.4 a/ Annual rates. Sources: Central Bank and IBRD staff estimates.  - 10 - 32. Concerned about the negative effects of continued high real lending rates on economic activity, the Government decided to provide short term relief to borrowers. For this reason the Decree for Economic Reactivation of July 1987 established a Reactivation Fund (FERE), with an annual interest rate to the final borrower on dollar linked development credits channeled through the Central Bank of LIBOR plus 5, which although strongly positive in real terms is below rates currently paid by banks on their dollar linked deposits. FERE was discontinued due to allegations over the fairness in its distribution, but the directed credit mechanism continues in place for credits from official foreign sources. 33. Since the problem of high lending rates remain, the Government is contemplating providing debt relief to the productive sectors through two mechanisms. First, creating within the monetary program a fund to be operated by the Central Bank to refinance outstanding liabilities of productive enterprises to t.he commercial banking system. The Central Bank estimates that it would need about US$20 million to finance the interest rate subsidy required to provide rediscounts for this purpose. Second, it would provide additional liquidity by expanding access to the foreign lines of credit available for economic recovery at LIBOR plus five percent, as defined in the Reactivation Decree. In order to expand access to these lines, new funds for free-standing working capital would need to be made available in the short run, and modifications would be reqeired in the terms and conditions of existing credits. It would also imply the re- establishment of the FERE line of credit from the Central Bank. However, these mechanisms for increasing liquidity to the private sector would only be useful in the context of a coherent macroeconomic policy and if the additional liquidity provided is within the credit limits implied in this macroeconomic framework. Otherwise, the additional liquidity will be used to finance capital flight rather than economic-reactivation. 2.3 PRESENT FINANCIAL SECTOR STRUCTURE 34. Bolivia's financial system is mostly composed of private commercial banks, specialized development banks and public banks. As of November 1987, Bolivia had 13 private commercial banks, of which 10 are classified as domestic and three as foreign. In the past there was a larger number of foreign banks but recently two have closed, and those that remain are largely inactive, basically maintaining their status and trying to collect some overdue loans while waiting for better times. The commercial banking system was shaken in 1987 by the closure of three private domestic banks by the Central Bank, due to fraud and solvency problems. This follows several years in which no domestic commercial bank closed or became inactive. 35. Bolivia has three private sector specialized development banks, of which only one, the Industrial Bank (BISA) is very active. Specialized development banks in Bolivia are distinguished from commercial banks not only by their objectives but also by the fact that they are not permitted to receive deposits from the public and consequently must depend for resources beyond their own equity capital on BCB rediscounts or international loans. The scarcity of such resources during the early 19809 has resulted in a considerably diminished role for these institutions.  - 11 - 36. The pubLic banks consist of the Central Bank (BCB), and three other bainks with specific development objectives: the State Bank (BANEST), the Agriculture Bank (BAB), and the Mining Bank (BAMIN). There was another public bank, the Housing Bank (BANVI), which was liquidated in 1987. The three remaining development banks are in need of basic restructuring. BANEST and BAB play important roles in the Bolivian financial sector, while BAMIN is a relatively less important bank. The Government a few months ago voted for the partial privatization of BAMIN to make it more efficient. Decisions on BAB and BANEST have yet to be made. 37. In addition to banks, the financial system is composed of Non-Bank Financial Intermediaries (NBFIs) which include the Central Housing Savings and Loans Board (CACEN) and its affiliated Cooperative Savings and Loan Associations; the National Federation of Credit Unions (FENACRE) and affiliated Credit Unions, and insurance companies. There are also informal markets which provide financial services such as linking companies with excess funds to others requiring funding and providing guarantees. These informal markets, which mostly operate in dollars, are estimated to have grown very rapidly in recent years. 38. Table 3 shows the evolution of some important indicators for the private commercial banking system during the 19809. The figures show the overdimensioning of the Bolivian financial system which resulted from the shrinkage in activity between late 1982 and mid-1985. Total deposits in August 1987 stood at 80S of their level in December 1981, and their real growth has slowed down considerably in recent months; the loan portfolio has almost reached its December 1981 level. Capital and Reserves (C&R) grew continuously. While asset revaluation remains C&R's largest growth component, it has declined from 89? of total C&R in December 1986 to about 68Z in September 1987. The reported ratio of loan portfolio to C&R continues to be low in the books, but is not meaningful because the loan portfolio includes bad loans and the denominator is inflated by a revaluation of assets which does not reflect actual market values.  - 12 _ Table 3: SELECTED FINANCIAL INDICATORS FOR PRIVATE COMMERCZAL WMKS (in $b millions of 1980) Dec. Dec. Dec. Dec. Dec. Aug. Dec. Aug. 1981 1982 1983 1984 1985 1986 1986 1987 Total Assets 16.4 17.3 9.9 5.4 10.2 10.6 13.7 7.9 Total Loan Portfolio 10.3 9.0 3.9 2.0 3.4 5.6 7.5 10.1 Other Assets 6.1 8.3 6.0 3.4 6.8 5.0 6.2 -2.2 Total Capital and Reserves 1. 2.8 1.6 1.1 2.6 1.4 1.9 2.1 Capital & Reserves/ Portfolio (I) 14.6 ;- 30.8 41.8 53.4 77.0 25.1 26.0 20.4 Total Deposits 10.7 9.0 5.0 1.8 2.3 4.6 6. 8.6 Pesos Deposits 8.4 8.9 5.0 1.8 1.5 2.2 2.7 2.5 Dollar Deposits 2.2 0.1 0.0 0.0 0.8 2.4 3.8 6.1 Peso Deposits/ Total Deposits (Z) 79.1 98.4 - - 66.8 48.2 41.5 29.2 Refiuancing by c Central Bank 1.6 1.2 0.4 0.4 1.0 1.7 1.8 1.8 Sources: Central Bank and IBRD staff estimates. PART III - w IN FINANCIAL SECTOR ISSUES 39. Four main issues affect the ability of the financial system to contribute to Bolivia's economic recovery: (a) the need to deepen the financial system through restoration of confidence in medium- and long-term economic policy and in ;the soundness of financial institutions; (b) the weak financial condition of an important number of public and private banks; (c) the high cost of financial intermediation; and (d) lack of adequate institutional arrangements to design and implement prudential regulation and to handle problem banks. 3.1 RESTORING FINANCIAL DEPTH 40. As indicated earlier, macroeconomic instability has not only demonetized the economy, but has also resulted in disintermediation affecting banks and other non-bank financial intermediaries, and has inhibited the establishment of a securities market. Not only have real financial savings declined, but the maturity of financial assets has shortened dramatically. At present, maturities of over 30 days are considered long term in Bolivia. As a result, the use of capital market instruments has been discouraged. 41. The lack of confidence in the financial system and the ensuing demonetization has also resulted from the public's perception that the financial system is unsound, and that the banking regulators (i.e. Central Bank and Superintendency) are unable to anticipate and solve problems in the sector. This perception was reinforced in 1985 and 1986 by protracted  - 13 - legal disputes over the authority of the Central Bank to liquidate the' Banco de Credito Oruro. 42. Comparison of real interest rates and monetary aggregates for the 1980s in Bolivia (Table 1) shows that financial savings do respond to the real level of interest rates, although the return to positive interest rates since 1985 has not fully reversed the reduction in the ratios of m1 and M2 to GDP or that of real Ml and real M2. This would suggest that the public either expects higher inflation in the future or that the returns on dollar-denominated assets (a large component of M2) are not large enough to compensate for the risk of maintaining them in the domestic financial system. 43. The remonetization of the economy and the deepening of the financial system will require a three pronged approach. First, the maintenance of a flexible interest rate policy, such as that currently followed by the Government. Second, economic policies conducive to macroeconomic stability, which will include efforts at balancing the fiscal deficit and at achieving a viable balance of payments. Finally, there is a need to restore the public's confidence in the banking system through strengthening their financial condition and improving the regulatory environment. 3.2 FINANCIAL CONDITION OF BANKS 44. The country's economic and financial difficulties of recent years coupled with the dramatic changes in economic policies have weakened considerably the financial condition of most banks. The stabilization policies implemented since August 1985, while necessary, have caused a drastic change in relative prices which predictably brought about recession and unemployment hurting banks' portfolios. Rising real costs and diminished earning assets have put a tremendous squeeze on the ability of the banks to remain profitable. Analysis of available financial information for private domestic commercial banks for 1905 through 1987, shows a continuous decline in their return on equity and a weakening of their loan portfolios. The actual situation is even worse, however, since published financial statements reflect insufficient bad loan provisions and include accrued but unpaid interest on doubtful loans. 45. Profitability. As of September 1987, seven of the twelve private domestic commercial banks were reporting losses.1 Their annualized losses amounted to 8.6? of net worth, and cumulative losses amounted to 28Z of net worth. Since net worth is very likely to be overvalued, as indicated above, losses in fact account for a larger proportion of the system's net worth. The main reasons for bank losses are (a) the very high operating costs of banks (such costs for the 9 month period between January and September 1987 amounted to 122 of the average loan portfolio, a very high level by any standard); (b) the large percentage of unproductive assets, and (c) the high level of unremunerated reserve requirements. 1/ In November 1987 the Central Bank liquidated two of them.  _ 14 - 46. Losses have been very high for foreign banks, basically because they have reduced their operations dramatically. The private domestic comercial banks have also experienced negative profitability throughout the period. The ratio of losses to capital and reserves for all private banks (including the specialized banks) was 19? in 1985, 11Z in 1986 and stood at 92 as of September 1987 (Table 4). While on average the performance of the private banking system has not been good, there are significant differences between the performance of individual banks, ranging from banks which are well managed and are making profits to others which are poorly managed, undercapitalized and are losing significantly. Table 4: BOLIVIA - PROFIT/LOSS RATIOS, 1985-1987a (in percentages at end of period) March June Sept. 1985 1986 1987 1987 1987 Profit/Loss Ratios Total Private Banks -19.3 -11.0 -3.9 -3.6 -8.5 Private Domestic Commercial - - Banks -3.9 -8.1 -0.5 .1.5 -6.7 Private Foreign Banks -165.0 -144.1 -134.7 -127.9 -151.3 Private Specialized Banks 1.2 -0.8 3.1 7.8 3.5 al As a percentage of capital and reserves. 47. Loan Portfolio. The quality of the loan portfolios and contingent assets of Bolivia's private commercial banks is poor. In September 1987 banks declared as overdue 8.1? of their total portfolio. This figure, while lower than those reported in the previous two years, is still high particularly because of the rollover of non performing loans. If figures were adjusted to portray the status of the loan portfolio more realistically, the banks' capital erosion and current losses would increase tremendously. The most worrisome problem about overdues is the extent to which bad debts (even those declared by the banks) seriously compromise the net worth of the banks. Total overdues (less provisions) amounted to 60? of net-worth in February 1987, and increased to 92S in September 1987. If we only consider loans overdue over 30 days, the figures are 27? in February and 36Z in September, which still show a significant deterioration. The loan portfolio has deteriorated because of the weak economy, but also due to the high lending rates which results in high risk borrowers which do not have alternative sources of finance and are more likely to fall behind in their payments.  - 15 _ Table 5: LOAN IORTFOLIO PROVISIONS AND OVERDUES Overdue Total portfolio (30 days or more) Provisions (In $b millions of 1980) (Z) (X) December 1983 3.9 17.5 NIA December 1984 2.0 13.4 1.3 August 1985 0.9 N|A N/A December 1985 3.4 13.0 2.5 June 1986 4.6 9.8 2.6 December 1986 7.5 7.4 N/A February 1987 3.5 8.3 7.1 September 1987 10.2 (August) 8.1 3.5 N/A - Not available. 48. Net Worth. The book value of the equity base of the Bolivian commercial and specialized banking system (private banks plus BANEST) amounted to US$84.5 million as of September 30, 1987. Of this 10.1? belonged to BANEST, 70.8? to private commercial banks and 19.1? to specialized banks. The book ratio of the system's total deposits to its equity appears to be extremely low (4.8:1). However, the capital of the banks is estimated to be grossly overstated since: (a) fixed assets amount to about 942 of the system's equity, but are carried on the books at prices well above actual market values; and (b) the quality of the system's loan portfolio has deteriorated, compromising a substantial proportion of its capital and reserves (for which adequate provisions have not bee: made). 49. Operating Costs. Bank operating costs are very high in Bolivia. The monthly ratio of operating costs to average total deposits stood at 1.4Z during the first nine months of 1987 for the private domestic banks. In 1986, monthly operating costs iveraged 1.22 of the average portfolio. These are extremely high figures by international standards (about four times higher than the average OECD and non-inflationary developing countries). 50. There are three major reasons explaining why operating costs are so high in Bolivia: (a) the substantial demonetization and disintermediation of funds experienced during the early 19808, has caused operating cost to represent a growing proportion of intermediated resources. As a result of the process of demonetization and disintermediation there is also an excessive number of financial institutions and branches, given the present size of the financial market; (b) the extremely short maturitv of financial contracts which is typical of economies characterized by high and variable inflation, and uncertainty. In Bolivia in spite of a significant reduction in inflation, there are practically no deposits with maturities  - 16 _ longer than 30 days. The continuous rollover of most operations represents an extra burden on administrative costs and staffing; (c) the high overheads in the system due to the expansion which occurred during the hyperinflation period. At that time banks increased their staff and operational costs to deal with a very special economy. Once their business declined, banks were not able to reduce costs concomitantly. Staffing was cut by over 20Z in 1985 and some offices were closed, but business declined at even higher rates. 51. Reserve Requirements. The high level of reserve requirements (RRs) in Bolivia is another important factor contributing to the poor financial condition of the banking system. As part of the Reactivation Decree, the Government adopted a new reserve requirement structure which eliminated the bias against time deposits denominated in bolivianos (by equalizing the reserves required on both boliviano and dollar time deposits at 10X), and reduced RRs on demand deposits (from 40S to 202). The objective was to introduce a new structure that would correct previous distortions while maintaining monetary neutrality. However, due to an increase in the ratio of dollar deposits to total deposits, the new structure has increased average reserves (Table 6), impacting negatively banks' finances. The increase in average reserves occurred because reserve requirements on dollar deposits were increased from 0X to 10?. Estimates show that the new schedule of RRs has increased average reserves by an equivalent of 5? of total deposits, amounting to over $b 6 million per year, forcing banks to increase lending rates to somewhat ameliorate the reduction in revenues. niaket WAM OF MIe STECMe OF ERIIE RIBJw$ (in b dillitn; 5) R.. req. Rb. re. Rduc- Totnl before afttr Average tio In Average r,duc- Decree Decree Increae annual revenue. anual Implicit tion in I 2 ..._ 21MS0 In lending due to deposit tax on reenuse Tpc of Value I Value S Value re"rves rates lncresa rote totl d" to Peqito OP/SO/8? (X) (2) ()-(1) ) a In RR () a RR b ob b Sight LC 85,4SC 40 26,186 20 18.098 -18,093 49 -4,416 0 0 5.206 Seving 72,191 16 11.551 20 14,488 ,ZOSS 49 1,415 25 2,88 8,S87 Fised Term 479,407 5,194 47,941 42.747 11,2W8 4,S40 7,909 in L: - WO/MV 88,9C0 8 2,712 1% 8,890 e78 49 882 27 49 997 I n LC - VJIV 81,087 8 2,482 10 8,108 821 24 149 14 261 447 In FC 414,480 0 0 10 41,448 41,446 26 10,776 15 8,780 6,46S Totl 817,064 42,981 75.472 82,541 8,257 7,428 14.851 J/ anco Castral do Bolivia, Jume 197. / Caidering tht even without lega reserve requirement. the bunko wuld have to aint,'n a technical reearve of aft averae of 105 en eight deposit. nod 45 an saving nd fiised-Ura depoatt.. LC a 1oel currles PC * fRoreign cur-rency (dollar); WO/V - without Indexation clause; WlW - wIth Indesatien clans.  - 17 - 52. Dollar Liabilities. Financial institutions have substantial uncovered US dollar liabilities to foreigners arising from the forced conversion of dollar deposits and loans (dedollarization of 1982). These were to be covered by BCB through a system under which financial institutions were to make peso deposits at the Bolivian Central Bank (BCB) equivalent to their foreign dollar liabilities, at the official exchange rate, and the BCB was to assume responsibility to provide the foreign exchange to service these obligations. However, the BCB and the Bolivian Government subsequently used a series of devices to avoid accepting these deposits and hence to avoid responsibility for providing dollars to service foreign debts, despite court decisions favoring certain Bolivian banks. Several Bolivian banks would be insolvent if required to service their dollar liabilities in the absence of an effective mechanism to assist them to cover the exchange losses. 53. Finances of Public Sector Banks. The three remaining public sector development banks--BANEST, BAB and BAMIN--have been found to be insolvent by recent studies done by independent auditors and consultants. BANEST shows the weakest management and financial condition of the three public development banks. BANEST was last studied in July-September 1986 by consultants financed under IDA's Public Financial Management Operation credit. The consultants recommended the liquidation of BANEST, not only because of its insolvency and lack of profitability, but more importantly, because its functions could be ' best perforzfed by other financial institutions. Neither the Executive nor the Congress accepted this recommendation. The audits of BAB pointed out the following problems: serious operating inefficiencies, inadequate controls, a loan Itortfolio that was more than half delinquent and inadequate provisions for loan losses on loans ard for uncollected interest. An adjustment of BAB's net worth to reflect its true financial condition would show an overwhelmingly negative position. BAMIN was also found to have major operating and financial problems, but since it is a smaller bank relative to BAB and BANEST, it has been much easier for the Government to reach agreement on its restructuring. For more details on the finances and managerial problems of BAB and BAREST refer to Annex VIII. 3. 3 HIGB FINhJCIAL INTzEMEDIATION COSTS 54. A striking feature of the present economic situation in Bolivia are the large spreads between deposit and lending rates (Table 2). Real spreads in both cases have fluctuated widely, particularly for bolivianos. Spreads vary between boliviano and dollar operations, being higher for boliviano operations. In the thArd quarter of 1987 real spreads on dollar operations stood at 13.4Z, while that for bolivianos was 20.1X (on an annual basis). Some people argued that one important reason for higher spreads for boliviano operations was the reserve requirements on boliviano deposits in contrast to dollar deposits for which there were no reserve requirements. As mentioned in para 45 above, in July 1987 the Government decided to remove this differential by establishing a uniform reserve requirement for all types of time deposits, however, the dollarization of the economy has continued as well as the spread difference. 55. Large spreads result froms (a) non-remunerated reserve requirements, (b) banks' attempts to cover their high operating costs and  - 18 - their losses, and (c) policy induced distortions. The new reserve requiremei s in place since July 1987 have impacted negatively bank finances, putting pressure on spreads. A partial remuneration of reserve requirements would reduce this pressure. Spreads are also large because the actual volume of operations is too small relative to the present banking infrastructure. Bolivia's banking system has an infrastructure prepared to handle a much larger volume of operations. During hyperinflationary times in the early 1980s, despite a substantial drop in business, banks managed to generate profits by concentrating in speculation and by capturing a substantial proportion of the inflation tax. Once the stabilization program was put in place (and inflation was reduced), the low volume and high cost of operations became a real problem. Banks have attempted to adjust to the new economic environment, but this adjustment has only been partial. Adjustments have come through reductions in personnel, which were insufficient, and rot by disposing of physical infrastructure. Finally, policy induced distortions, such as inadequate institutional arrangements for supervising and regulating the banking system have reduced competition and not facilitated an adequate disclosure of financial information on banks to the general public. The lack of competitien a,d the inadequate dissemination of financial information, permitted the weak banks to set the floor on interest rates and spreads. Faced with liquidity problems, weak banks increased rates to attract deposits, and were followed by stronger banks, thus leading to high spreads. 3.4 INADEOUTST INSTITUTIONAL ANGENTS 56. The problems of the banking system have been largely compounded in recent years by the weak position of the Central Bank and its organizational deficiencies. Major problems have been found in banking supervision (particularly in the loan portfolio classification system, accounting rules, information disclosure, and supervision of public banks), in the enforcement of banking regulations, and in the handling of ailing banks. 3anking SuPervision and ReRtulations 57. Insufficient Banking Supervision. The major problem affecting banking supervision is that the current Banking Law of 1928 contains an excessive focus on formal controls to the detriment of assessing the overall solvency of the financial institutions. Banking superintendency functions were carried out by the BCB--through its Banking Supervision Department--which traditionally concentrated on compliance with BCB regulations, while analysis of loan portfolio quality and operating efficiency was largely overlooked. In addition, the department was not properly staffed, partly because of poor salaries relatir to the private sector. Finally, the financial analysis done of the available information was poor and did not permit an accurate appraisal of the evolution of the financial condition of each individual bank. As a result, supervisors were very limited in their capacity to take timely actions to stop unsound financial practices. S8. Aware of the inability of the Banking Supervision Department to perform an appropriate banking supervision role, the Government through the  - 19 - Reactivation Decree has re-established the Banking Superintendency as an independent Government agency, and currently (with IDA assistance under the Public Financial Management Operation) is developing a comprehensive organizational and regulatory framework which would allow it to fully assume its functions during the first semester of 1988. Howeve-, in order for the Superintendency to be able to perform an effective supervisory role it has to be assigned certain functions which will require a new Superintendency Law. The Government is working on the preparation of a draft law for the Superintendency which sill be presented to Congress shortly. 59. Strengthening banking regulations is extremely important to improve the functioning of the Bolivian banking system. The banking system currently operates under confusing and often conflicting laws and regulations. The Government has already started tightening banking regulations, particularly with regard to loan provisions and accrual of interest, minimum capital requirements, loan concentration, and information disclosure. The main inadequacies in regulations relate tot (a) Inadequate Loan Portfolio Classification System. The Superintendency required provisions for potential loan losses only with respect to past due loans. As a result, potential losses associated with risky loans that remain current were not provisioned. This resulted in inflation of profits and the banks' equity base (on the books). (b) Rollover Practices. Rules on interest accruals allowed banks to continue accruing interest as long as loans were not overdue. This encouraged banks to rollover loans, regardless of the repayment capacity of --the borrower. More stringent rules regarding rollovers have been issued. (c) Recavitalization. Regulations permit banks to lend to their own shareholders, to finance required capital increaseti of up to SCX of the pre-existing capital base. This kind of capital increase could raise conflicts of interest and does not address adequately the Banks' need for fresh capital. (d) Loan Concentration. Current regulations on lending to related parties are confusing and even contradictory. Banks cannot lend more than 202 of their equity to any single borrower in the case of loans with maturities below one year. This limit increases to 1OZ of total bank assets in the case of loans with maturities over one year. The latter is a very large limit since banks--depending in how leveraged they are--could lend an amount equivalent to their equity to a single borrower. Also, the definition of financial conglomerates is not precise. Nandlinx of Ailina Banks 60. In 1987, for lack of an alternative mechanism or policy to deal with ailing banks, the Central Bank used liquidation as the solution to some problem banks it had to face during the year. Since BCB's objective has been to maintain stability and confidence in the system while  - 20 - attempting to strengthen the financial sector and promote its redimensioning, it has been forced to compensate most depositors at a substantial cost. There is clearly a need for alternative mechanisms to handle the rehabilitation of ailing banks, which can be more effective and less costly. The Government is aware of the need, and with IDA's assistance is developing specific criteria and procedures to make decisions on whether a bank should be saved or liquidated as well as on modalities of possible bank work-outs. PART IV - THE PROPOSED FINANCIAL SECTOR ADJUSTMENT CREDIT 4.1 HISTORY 61. The proposed credit is the result of a program of financial sector work which IDA initiated in FY86. That year, recognizing the difficulties faced by the financial system and the critical importance of having an efficient financial system for the mobilization of deposits and the delivery of credit to support stabilization efforts, the Government requested IDA assistance to study and support a program of reforms in the financial sector. In June 1987, IDA issued a report entitled "Bolivia Financial Sector Study". At the request of the Government, IDA was concurrently preparing a Financial Sector Adjustment Credit for Bolivia. The recommendations of both the report and of credit preparation work were extensively discussed with the Government, and many of them were incorporated in the Reactivation Decree of July 1987. 4.2 OBJECTIVES OF THE CREDIT AND MAIN COMPONENTS 62. The Government is aware of the serious problems affecting the financial system and since August 1985 has been implementing a series reforms to solve them. These reforms include the liberalization of interest rates and the exchange rate in 1985, and the announcement of important changes to strengthen banking supervision and regulations as part of the Reactivation Decree of July 1987. However, despite these reforms, the fragility of Bolivia's financial system and its inefficiency hinder the country's economic prospects. The serious financial difficulties In a large number of banking institutions and the low level of resources mobilized by the banking system have resulted in scarce and costly credit for the private sector, thus limiting investment and growth. .63. The proposed IDA credit supports the continuation of the Government's reform efforts designed to achieve the following objectieas (i) increase depositor confidence in the banking system and deposit mobilization; (ii) strengthen the financial condition of banks; and (iii) reduce the cost of credit. In addition, the credit prevides technical assistanc3. to support various aspects of banking supervision, rehabilitation and liquidation. The Technical Assistance Component (TAC) consists of four build!n9 blockss (i) support from consultants to assist GSF in reviewing the financial condition of banks and in preparing rehabilitation plans as required, assist in the drafting of a new Banking Law, assist the Superintendency, and work on UAB's restructuring; (54) funding for the external audits of banks to be done based on the financial statements of July 31,1988; (iii) training; and (iv) purchase of computer equipment. The total cost of the technical assistance component is  - 21 - estimated at US$2.4 million. Details of the TAC are provided in Annex V attached. A policy matrix spelling out the objectives of the proposed credit, financial sector issues, measures already taken, measures to be taken under the loan, and proposed timing, is contained in Annex IV to this report. 4.3 DESCRIPTION OF MATN REFORMS 64. The government's program for financial sector reform can be grouped in the following three areass (i) market determination of interest rates, (ii) institutional strengthening, Including improvements in the regulatory and supervisory framework, in tne mechanisms to handle ailing banks and in the operations of public development banks; and (iii) reductions in the cost of credit. 4.3.1 Maintenance of Market Determined Interest Rates 65. Recent Measures. Interest policy in Bolivia during the 1980s was characterized by controls imposed by the Government on lending and deposit rates. In August 1985 all interest rates were freed, except for term credits. The Government recognizes that an important objective of the financial reform program is to continue to allow interest rates to be determined by market forces and that attempts to control interest rates rather than attacking the causes of high interest rates would be counterproductive. It is concerned, however, that the persistence of high real interest rates, despite two years of macroeconomic adjustment, poses a serious danger to maintenance of the productive sectors of the economy, and consequently to the health of the portfolio of the banking system. 66. Further Actions. The Government has decided to maintain market determination of interest rates, and address the problem of high lending rates to the productive sectors by reactivating the FERE line of credit from the Central Bank and devising a mechanism through which the Central Bank could refinance a portion of the outstanding liabilities of the productive sectors, thus providing short-term relief. The Government has accepted IDA's arguments that the various measures to be implemented under the reform program, such as improving the mechanism to deal with problem banks, the resolution of the dedollarization issue, and the remuneration of reserve requirements, together with greater fiscal discipline, should contribute to alleviating the underlying factors that lead to high deposit rates and spreads. IDA also indicated that attempts to administer spreads at this time, when they reflect high costs of intermediation, could lead to undesirable financial pressure on the banking system, already under financial stress. Preliminary IDA estimates indicate that when fully implemented, the proposed banking sector reforms could result in a reduction in spreads ranging from 5 to 8X. 4.3.2 Institutional Strenathenina Strentthenina Banking Supervision 67. Recent Measures. With assistance of funding from IDA's PPMO credit, in December 1987 the Government established an independent Banking Superintendency. The Superintendency ha' assumed all the supervisory  - 22 - functions previously performed by the Banking Supervision Department of the BCB. The new Superintendent was also named in December 1987. 68. A comprehensive organizational and regulatory framework is being developed for the recently established independent Banking Superintendency. The new Superintendency will be strengthened by adequate staffing, computer equipment and training provided by the Technical Assistance components under the PFMO and under the proposed credit, 69. Further Actions. In order to perform an effective supervisory role, the new Superintendency should be assigned the following functions: (a) to grant licences to banks to operate in the market, (b) to promulgate norms and rules with regards to loan portfolio classification, accrual of interest, provisioning, and loan concentration; (c) to enact minimum capital regulations; ld) to implement a system of fines and sanctions for lack of compliance with regulations, and (e) to establish an accounting plan and manual. In addition, the Superintendency should have financial independence to guarantee autonomy in its decision making process and to be able to hire qualified personnel. The Superintendency is currently able to regulate in all these matters because the present legislation does not explicitly prohibit it from doing so. However, since the legislation does not give a clear mandate to the Superintendency in all these matters, some of its decisions could be challenged by banks. Therefore, in order to strengthen the position of the superintendency and guarantee its financial autonomy, the Government will issue a Supreme Decree containing the Operating Regulations (Reglamento) of the Superintendency. In addition, the Government will prepare and present, to its Congress, draft amendments of the existing bank supervisory legislation, satisfactory to IDA, allowing the Superintendency to permit an intervened bank to continue functioning, and enhancing the Superintendency's powers to apply severe sanctions and fines to banks not complying with norms and regulations. The Government will issue the Supreme Decree and present the draft amendments to Congress before Second Tranche Release. Im=rovinE Bankina Regulations and Accountina Practices 70. Recent Measures. As part of the reform program, the Central Bank has already started tightening banking regulations. For instance, under the Reactivation Decree 21660 of July 1987, it adopted more stringent regulations in respect of loan provisions and interest accrual on overdue loans, modified leverage and minimum capital requirements to strengthen the capital base of banks, introduced more stringent loan concentration rules, and increased requirements for information disclosure by banks. 71. Furthermore, in December 1987 the Superintendency modified the norms with regard to loan provisions and interest accruals, to take into consideration the actual quality and recovery risk of the loans. The Government: (a) established a uniform system for the evaluation and classification of the loan portfolio not only based on the repayment status of the loan, but also taking into consideration the repayment  - 23 - capacity of the borrower (based on an assessment of its financial condition), and the cash value of the collaterals; (b) required banks to make provisions not only with respect to past due loans but also with respect to risky or doubtful loans that remain current. These latter provisions will be required according to the repayment capacity of the debtor, the adequate use of the credit for the purposes granted, the situation of the economic sector to which the debtor belongs, and the cash value of the collaterals; and - (c) require banks to stop the accrual of interest not only on overdue loans, but also on those loans which are classified as deficient or gloss" based on the classification criteria in (a); and (d) instructed external auditors to classify portfolios of audited banks taking into consideration the criteria described in (a). 72. Further Actions. The Government, recognizing that the General Law of Banks of 1928 was too vague concerning recapitalization, decided to include in the Reactivation Decree an article which established limits on the credits which a bank can grant to finance investors, including own shareholders, to recapitalize the bank--thest credits can not exceed 50S of the audited net worth of the bank as of July 31, 1987. The Decree also indicated that these credits would only be provided if the borrower obtains a guarantee from a different bank. Further recognizing that this kind of capital increase could raise conflicts of interest and not address adequately the banks' need for new capital, the Government will issue a new Supreme Decree eliminating the possibility of recapitalization through lending to shareho'ders. In addition, the Superintendency will issue regulations requiring banks which have such credit outstanding to achieve punctual collection thereof, and prohibiting the refinancing, rescheduling or renewing of such credits. The new Decree and regulations will be issued before credit effectiveness. 73. Current loan concentration regulations, as established in Supreme Decree 21660, allow banks to lend up to 102 of total assets to any single borrower as 'long as the credits have maturities shorter than one year. Loan concentration rules will be tightened to limit credit granted to a single borrower to no more than 202 of a bank's capital and reserves, regardless of the maturity of the loans. The Superintendency will issue the necessary resolution before Board presentation. Similarly, the Superintendency will also issue a resolution to improve the definition of financial conglomerates. Article 141 of the General Law of Banks contained a very precise and comprehensive definition of financial conglomerates or related parties. Supreme Decree 21660 provided a less comprehensive definition. The new' regulations will indicate that Article 82 of the Reactivation Decree is a complement of Article 141 of the General Law of Banks, rather than a substitute. This will make the rules on lending to related parties more restrictive and will reduce the possibility of evading loan concentration regulattons.  - 24 - External Audit of Banks by Qualified Auditors 74. Recent Measures. In order to facilitate the task of assessing the real financial situation of banks, the Central Bank has made mandatory comprehensive audits of all banks, to be carried out twice a year by qualified external auditors contracted by the Superintendency. One of the audits will be paid by the Government (Superintendency or Central Bank) and the other by the banks themselves. Initial audits were carried out in respect of banks' financial statements of July 31, 1987. 75. Further Actions. Considering the budgetary limitations of the recently established Superintendency, the Technical Assistance Component will finance the external audits to be done based on the June 30, 1988 financial statements. These audits will give special attention to the assessment of the status of the loan portfolios. Istablishina an Adequate Mechanism to Handle Problem Banks 76. Recent Measures. In order to expedite--in the most cost-effective way--the solution of both the overdimensioning and the widespread solvency problems affecting the banking system, it is important for the Government to have an effective and flexible mechanism to handle ailing banks. Existing procedures, as defined by the General Law of Banks of 1928, permit the Superintendency to Initiate liquidation procedures when a bank is not complying with the solvency and operating criteria defined in the Law. The Superintendency is also entitled by Law to suspend the liquidation procedure and allow the bank to renew operations when the causes which originated the liquidation are overcome. 77. Renewal of operations and rehabilitation of a bank that has started liquidation procedures is very difficult, especially when confidence in the system is weak. The decision on whether to liquidate or rehabilitate an insolvent bank should therefore be made prior to formal intervention and be based on a comparison of financial costs and externalities affecting each alternative. The Government is in the process of introducing regulatory and procedural changes to ensure that the Central Bank and/or the Superintendency have the capacity to carry out a rehabilitation program for insolvent banks when liquidation is not considered desirable, before the initiation of liquidation procedures. The rehabilitation programs would involve financial and other restructuring. Whenever the owners of the bank prove unable to capitalize the bank as required for its viability, mergers or acquisitions supported by BCB's financial assistance would be contemplated. 78. To this end, as part of its reorganization, in December 1987, the Central Bank set up an administrative arm (Gerencia del SistemA Financiero) to try to anticipate banking crises and provide financial assistance to problem banks, particularly when liquidation is not desirable. The Gerencia del Sistema Financiero (GSF) will be the liaison with the Superintendency, receiving audit reports from external auditors and from the Superintendency, and analyzing the situation of the banking system.  - 25 - 79. Further Actions. The Government has prepared a set of guidelines for the functioning of the GSF, particularly of the unit which will deal with bank rehabilitation. The GSF will have the followxing characteristics: (a) It will be run by experienced professional management, and consist of three special divisions, one in charge of bank administration (rehabilitation), the second one charged with analyzing the banking system and being the liaison with the Superintendency, and the third in charge of regulating and promoting open market operations (b) It will be financed by the BCB and will have the legal power to undertake a wide range of activities in order to rehabilitate banks or assist in their liquidation, in close collaboration with the Superintendency, on a case-by-case basis, at lowest cost to the BCB. Guidelines for action by BCB have been developed in consultation with IDA to ensure that the proposed changes are sufficient and that GSF has a clear mandate on its role. Bank rehabilitations will be done in accordance with these general guidelines. Rehabilitation would involve recapitalization, management improvements, and in some cases change of ownership. In any event, one of the guiding principles will be to avoid bailing out existing shareholders. 80. The guidelines (see Annex VI) have been agreed with IDA. In addition, the Central Bank is reviewing its Statute to incorporate the functions of the GSF, particularly those related to bank rehabilitation. The Government will issue a Supreme Resolution approving the new Statute of the Central Bank before credit effectiveness. The Government will also issue, before credit effectiveness, a Supreme Decree authorizing the Central Bank to purchase assets from commercial banks, as part of its efforts to rehabilitate banks, subject to an obligation on the part of such banks to repurchase such assets, at par plus interest. 81. The proposed GSF will work closely with the new Superintendency. The Government expects that the GSF will be fully operational before credit effectiveness. The proposed credit will provide technical assistance to support staffing, equipment and training needs for GSF. A major element of the technical assistance will be to contract consultants to assist GSF management in the initial bank rehabilitation programs to build up local expertise. 82. In addition, the Government is contemplating the feasibility of establishing in the medium term a mechanism for sharing with banks the costs of handling problem banks, perhaps in the form of a partial deposit insurance scheme. Restructurint of Bauco Minero. Banco Agricola and Banco del Estado- 83. Recent Measures. Due to poor financial and operational condition of the three major public sector banks (Banco Agricola - BAB, Banco del Estado - BANEST, and Banco KMnero - BAMIN) are in need of basic restructuring. The Government has agreed to support a basic restructuring of the three institutions. The Government has already started a partial  - 26 - privatization of BAMIN, which has a new board with majority private participation which will acquire majority ownership over time. In addition, several commissions have been created to plan and implement BAMIN's reorganization. The Government has assumed all of BAMIN's foreign debt so that the new bank starts from a more solid base. Further diagnostic work and formulation of revised operating procedures will be supported under the Project Preparation Facility of the proposed IDA - financed Mining Sector Project. 84. Further Actions. The Public Financial Management Operation (PFMO), approved by IDA in 1987, provides technical assistance to review and recommend proposals to restructure the Banco Agricola (BAB) and Banco del Estado (BANEST). The Government will create a policy group which will be responsible for preparing and presenting to IDA satisfactory plans of action and implementation schedules for the restructuring of BAB and BANEST. The policy group will be chaired by the Minister of Planning and will also be composed of the Ministers of Finance and Agriculture, the President of the Central Bank, the Superintendent of Banks, and the Presidents of BAB and BANEST. The plans of action will cover the following aspects: (a) autonomy of the management and board of the institutions f a political influence (particularly regarding credit allocatioi), (b) description of functions, (c) new collection policy and plan to accelerate collection of past due loans, (d) new lending policies, ie) program for the recapitalization of the respective banks, and (f) rehabilitation program and implementation schedule aimed at achieving the financial viability of the institutions. The creation of the policy group and the presentation to IDA of satisfactory Plans of Action and Implementation Schedules for the restructuring of BAB and BANEST are conditions for Second Tranche Release. 85. The BAB is to be restructured into an operationally sound, autonomous and financially viable entity providing a full range of services to agricultural areas lacking adequate commercial banking services. To date, technical assistance has been provided to recommend alternative restructuring plans for BAB, which stress the efficiency of credit, bank management and self-sufficiency. The policy group will evaluate these strategies. Although there are still a number of unresolved key issues concerning the manner in which the bank is to be restructured, it is expected that the Government will covmit itself to a plan of action shortly, and begin implementation during the second half of 1988. Before second tranche release, the Government will have furnished plans of action acceptable to IDA for its restructuring. Consider;ng that the funds required for technical assistance to restructure BAB exceed those provided under IDA's PFMO credit, the TAC under the proposed credit will provide additional funding. 86. Also, as agreed under the PFMO, BANEST is to be restructured to become an operationally and financially viable development bank. Until recently, however, no assistance could be provided to formulate a realistic proposal for BANEST's restructuring given the fundamental lack of consensus in the Government as to the bank's size and mandate. With the recent decision that BANEST will provide banking services both to the public and private sectors, however, work can proceed on designing an action plan to address the bank's main problems and make it a viable credit institution.  - 27 _ The restructuring of BANEST will require a recapitalization effort to meet the capital standards required by the Superintendency. 87. The rehabilitation of these public sector banks is not expected to imply a significant fiscal burden beyond what already exists, since the Government would eventually have to cover the accumulated losses of these banks. On the contrary, it is very likely that prompt action to restructure these institutions will reduce losses. Strengthenin. the Banco Central de Bolivia (BCB) 88. Recent Measures. With technical assistance support from IDA (under the PFMO credit), IMP and IDB, the Government is undertaking a comprehensive plan to strengthen the BCB. The program will strengthen bank supervision, and improve other areas of BCB operations, such as accounting, controls, management information systems, the economic studies Department, staffing and training. The Government is also reorganizing and strengthening, with technical assistance from the IDB, the Development Credit Department (DCD) of BCB which has been hindered by several problems and has frequently been unable to channel development credits from international agencies effectively. The reorganization of the DCD will aim at eliminating inefficiencies, streamlining operations and speeding up loan processing. Some of the important measures will include: streamlining DCD's previous responsibility for approval of loan proposals submitted by financial intermediaries; stricter enforcement of loan repayment from financial intermediaries to the BCB, and ensuring that development credits are channeled through solvent institutions by enforcing appropriate eligibility criteria for participating intermediaries. 4.3.3 Reducing the High Cost of Credit 89. Various measures described earlier such as strengthening banking supervision, improving the mechanism to handle ailing banks and some stringent banking regulations will help reduce the cost of credit. This reduction would come from an increase in deposit mobilization through the banking system because of increased confidence, and through a reduction in the overdimensioning of the system. In addition the high cost of credit may be reduced through a resolution to the dedollarization issue and through the remuneration of reserve requirements. Resolution of the 'Dedollarizatioun Issue 90. Recent Measures. Because of the severe impact on the solvency of many private banks derived from the Idedollarization' decree of November 1982, the solution of this issue is vital to the rehabilitation of the banking system. The potential losses from having to service their dollar denominated liabilities would exceed the equivalent of many banks' total capital and would make it very difficult for the other banking reform measures to restore solvency to the system. The Government and BCB recognize the importance of removing this impediment to banks' solvency and will endeavor to compensate the banks for their deposits made at the Central Bank in respect of their foreign obligations. For this purpose, under the Reactivation Decree the Government announced that it will issue dollar denominated bonds that can be exchanged for the Bolivian currency  - 28 _ deposits made at the Central Bank in 1982, in order to repay their obligations to foreign banks. Furthermore, in March 1988, after reaching an agreement with foreign creditors on the repurchase of Bolivian debt at discount, the Government issued the regulations necessary to make this solution effective. 91. Further Actions. To encourage expeditious resolution of this matter, the Government has agreed to issue regulations, through the Superintendency, giving banks until September 30, 1988, to accept dollar- denominated bonds in exchange for Boliviano deposits of such banks in the Central Bank, in accordance with Articles 49 and 50 of the Reactivation Decree. Remmneration of Reserve Reauirements 92. Recent Measures. In July 1987, the Government modified the reserve requirement structure to eliminate the bias against peso deposits as compared to dollar denominated accounts, and to reduce the high level of reserve requirements which affected demand deposits. The objective was to introduce a new structure which would have a neutral impact on the money supply and on the choice of currency and lending capacity of the banks. However, due to an increase in the ratio of dollar deposits to total deposits, the new structure increased total average reserves, impacting banks' finances negatively. 93. The Government has decided to compensate banks for the impact of these additional average reserve requirements by remunerating them partially. The Government has implemented--in consultation with IDA and the IMF--a policy of allowing banks to fulfill one-half of their reserve requirement with negotiable certificates issued by the BCB bearing market rates. This particular measure has the additional advantages of: (i) establishing a market in government securities (which could be an important element for the future development of a broader capital market), and (ii) establishing open market operations--an important instrument of monetary policy not presently available to BCB. This mechanism was implemented through a Central Bank resolution on December 11, 1987. PART V - CREDIT FEATURES 5.1 CREDIT AMOUNT. BORROWER AND D4PLEMENTING AGENCY 94. A credit of SDR 50.6 million (equivalent to US$70.0 million) is proposed in support of the significant advances which the Government has made and has agreed to make in adjusting its financial sector policies. The credit would include the financing of complementary technical assistance. The borrower would be the Government of Bolivia; the implementing agency would be the Central Bank.2 2/ The Bolivian Government has initiated talks with potential donors regarding co-financing of the proposed credit.  - 29 - 5.2 L8TER OF SECTORAL POLICY 95. The basis for the credit is provided by a Letter of Sectoral Policy (Annex III) in which the Government declares its commitment to adopt and implement the previously mentioned reforms. In particular, this lettert Ci) describes the Government's macroeconomic and banking sector objectives; (ii) indicates the reforms intended to meet these objectives; and (iii) includes a timetable for the implementation of these reforms. 5.3 CREDIT DISBURSEMENT AND PROCUREMENT 96. The proposed credit would be disbursed in two tranches (excluding the Technical Assistance component). Considering that the Government has moved swiftly in carrying out most of the suggested reforms the first tranche will be for US$45 million, while the second tranche and the TAC will disburse the remaining US$25 million. The slower disbursement for the Technical Assistance component will permit IDA supervision of the credit to extend for about 36 months. Disbursement of the first tranche would be possible upon credit effectiveness. The credit will become effective when: (a) all legal requirements are met; (b) all conditions for credit effectiveness included in the policy matrix have been complied with; and 5C) IDA has been furnished evidence satisfactory to it that the Government's macroeconomic policy framework is consistent with the banking sector reform program being supported by this credit. The second tranche release will be subject to the following conditions: (a) issuing of a Supreme Decree, satisfactory to IDA, enacting the Reglamento of the Superintendency; (b) issuing of regulations necessary to make effective a solution to the "dedollarization' issue; (c) presenting to Congress satisfactory draft amendments to banking legislation with regard to bank interventions and sanctions; (d) furnishing IDA satisfactory plans of action and implementation schedules to restructure BAB and BANEST; and Ce) evidence of satisfactory performance in maintaining a macro economic framework consistent with the financial sector reform program. 97. The bulk of the credit (US$67.6 million) would apply to lOOS of the c.i.f. costs of eligible private and public sector imports. Eligible imports would be all goods except those normally excluded under Bank policy-based lending, such as alcohol, tobacco, 'and armaments; and goods financed by other Bank loans or IDA credits. The remainder of the credit (US$2.4 million) would be disbursed for technical assistance to GSF and the Superintendency, including training, computer equipment, consultants" services, and funding for the external audits of banks for July 1988. Disbursement of this latter part of the credit will be independent of tranche release. The closing date of the credit would be December 31, 1989. 98. All contracts for the procurement of general imports and of imports to be used as inputs in the manufacturing of exports to cost the equivalent of US$5.0 million or more shall be awarded through international competitive bidding. Contracts costing under the equivalent of US$5.0 million would be procured through the normal procurement procedures of the importing entity. Private sector importers would use normal commercial practices while public sector importers would follow standard Government practices, which ensure reasonable prices. The procurement of equipment  - 30 - under the TAC will be done under local competitive bidding procedures vaich are satisfactory to IDA. Consultants to be financed with the proceeds of the credit will be employed in accordance with the principles and procedures set forth in the 'Guidelines for the Use of Consultants by World Bank Borrowers and by the World Bank as Executing Agency, published by the Bank in August 1981. 99. All disbursements would be made against a statement of expenditures to be submitted by the BCB. BCB, in turn, is expected to undertake the screening process to ascertain that the above conditions have been met and to disburse the credit on the basis of documented import payments from the commercial banke. 100. BCB will maintain separate accounts to record and monitor credit disbursements and repayments. All records and accounts related to expenditures financed under the proposed credit including those for statement of expenditures, would be audited each year in accordance with sound auditing principles by independent auditors acceptable to IDA. 5.4 BENEPITS AND RISKS 101. Benefits. The proposed operation would increase the overall efficiency of the banking industry and thus enhance its ability to finance investment and growth. This would result from increased deposit mobilization. improved credit allocation and a lower cost of credit. Although it is very difficult to isolate the impact of the proposed reforms from the influence of other economic variables, major contributions of the reform program will consist of (a) greater transparency and depositor confidence through improved prudential regulation and supervision of banks, (b) more effective mechanisms to deal with problem banks thus reducing the economic costs of bank failures, (c) improved incentives for the rationalization of the structure of the financial system, and (d) enhanced financial performance of banks, contributing to reduction in spreads and lending interest rates. Within the framework, the cost of financial intermediation would be reduced by the increased volume of transactions handled by stronger, more efficient banks. The financial sector reforms are expected to increase discretionary resource allocation by the banking system, reduce operating costs and thus permit the resumption of productive investment through the availability of adequate financial resources at reasonable interest rates. 102. Risks. The major risks associated with this credit relate tot (a) the possibility of setbacks in macroeconomic policies that would interfere with the implementation of needed structural reforms, including the financial sector reforms supported by the proposed credit; and (b) departure from the current policy of market determination of interest rates. These risks are mitigated by the commitment to stabilize the economy and to proceed with a broad program of structural reforms, within a market economy framework, vhich the Government continues to show. Structural reforms include, besides the financial sector reforms, trade policy adjustment, public sector rationalization, and increasing the role of the private sector in the economy. The Government's current efforts at negotiating its foreign debt and at reformulating an economic stabilization program with the IMP also reduce these risks. The proposed credit  - 31 - stipulates that for Board presentation, credit effectiveness, and second tranche release, the Bank shall be satisfied that the macroeconomic policy framework is consistent with the Government's financial sector reform objectives. 103. In addition there are the following risks directly related to the financial sector reform program: (a) the possibility of inadequate implementation of the reform program due to the lack of adequate administrative capabilities to carry it out; and (b) the possibility of widespread and uncontrolled bank failures which would require the Government to bail banks out and abandon the reform program altogether. These risks will be mitigated by supporting the newly created Vice- presidency for Financial entities in the Central Bank and the Superintendency, through the Technical Assistance component. PART VI - BANK GROUP OPERATIONS AND STRATEGY 104. The Bank Group has been actively involved in Bolivia since 1964. However, there was a hiatus in lending operations from 1980 to mid-1986 because of poor economic. management and the resulting deterioration in creditworthiness. When the government launched a far-ranging stabilization and adjustment program in late August 1985, the Bank Group responded quickly and positively to the program with technical assistance and IDA credits. It also reactivated the Resident Mission in Bolivia with the appointment of a new Resident Representative in October 1986. Further, it resumed the Bolivian Consultative Group, dormant since 1977, with a first meeting in December 1986 which foc'ised on the government's economic program, external financing requirements, and measures needed to improve project implementation. A second meeting is scheduled in May 1988 which will focus on a public sector investment program for 1988-90. 105. The status of Bank operations in Bolivia is summarized in Annex I. Total lending to date stands at US$690.7 million, consisting of 14 loans for US$275.0 million and 22 credits totalling US$268.8 million. Thirteen of the 14 loans are fully disbursed; 14 credits have also been fully disbursed while the remaining 8, consisting primarily of new operations, have US$146.9 million undisbursed as of December 31, 1987. Bolivia has repaid the Bank US$100.0 million and thus has a total estimated outstanding of US$469.4 million. 106. Past Bank Group lending has been quite far-ranging and diverse, with an active involvement in several sectors, notably transportation and hydrocarb'ns, where the Bank played a key role in developing Bolivia's gas export potential. Other sectors where the Bank has been actively involved are power, mining (largely credit operations for the private sector), water supply, and urban. Our record in agriculture has been mixed, with some successful operations in earlier years focussed on the livestock sector; three more recent rural development projects have, however, faced serious implementation problems. Execution of many ongoing projects was affected adversely by the general economic and political instability, the shortage of local funds, changes in Government personnel and periodic suspension of Bank disbursements. As a result, the conclusions of recent Project Preparation Appraisal Reports (PPARs) have been quite negative, and notably for a 1980 Structural Adjustment Loan.  - 32 - 107. While no new operations were approved between 1980 and May 1986, the Bank provided substantial technical assistance through its economic and sector work which was focussed on critical impediments to Bolivis's development. Many recommendations resulting from these efforts provided the basis for the current Government stabilization and structural reform program and underpin specific programs now under active preparation. Specific efforts included a 1981 comprehensive study on rehabilitation of COMIBOL, the state mining company, proposals for minmg tax reform, analyses of mining investment laws and fiscal reserve, a proposed reorganization of the troubled Agricultural Credit Bank (BAB), studies oi pricing issues for agriculture, a sector paper on transport, an energy assessment, and a program proposing a full overhaul of auditing and procurement practices. 108. Since FY86, the Bank has been rebuilding the lending program -ith operations aimed at supporting the government's structural adjustment and stabilization program and rehabilitating and reconstructing key sectors to restore economic growth. Two IDA-financed operations, the Reconstruction Import Credit (RIC I) for US$55 million and RIC II for US$47.1 million are providing quick disbursing financing for priority imported equipment, spare parts and other inputs needed in mining, agriculture, industry, energy, power and transport. Comilementary support to the energy sector is being provided under the Vuelta Grande Project for US$15 million and Power Sector Rehabilitation for US$6.8 million. The La Paz Municipal Development Credit for US$15.0 million will contribute to improvements in municipal management, rehabilitate urban transport and other urban infrastructure, while also providing temporary employment opportunities through public works. Two credits for the Emergency Social Fund are also supporting emergency relief and employment generation programs stemming from the depression and economic measures taken by the government. Another project complementary to the Financial Sector Adjustment Credit is the Public Financial Management for US$11.5 million, which has been providing technical assistance to the newly established Ministry of Taxation and to the Office of Controller General of the Republic, to the Central Bank and other institutions in tax administration and banking supervision. 109. Our strategy is to assist the Government to: (a) sustain the implementation of the macroeconomic stabilization program and carry through structural adjustment reforms including specifically a change in the economic role of the state; (b) rehabilitate and restructure the agriculture, industry, mining, and hydrocarbon sectors with the view to diversifying exports and achieving efficient import substitution; (c) reconstruct and rehabilitate essential infrastructure to minimize bottlenecks to increased production and to support increases in private investment; (d) support major increases in public and private investment notably through strengthening the public investment program, enhancing the private investment climate through appropriate policy measures, and reforming the financial sector; te) alleviate the direct social impact of the economic adjustment program, especially on lower-income groups; and (f) reintroduce discipline in public sector management and administration to support the effective execution of the economic reforms and management of the economy.  - 33 - 110. IFC was not active in recent years, but has recently recumed its operations in Bolivia. As of November 30, 1987, it had equity convertible loans and loans in the country totalling US$19.6 million. It has provided equity and loans totally US$10.5 million through the Industrial Bank, S.A. as well as US$0.4 million to Plasmar, a manufacturer of plastic products; US$2.3 million to Molino Andino, a food processing industry and US$1.2 million to Cia. Minera, Concepcion. All of IFC's investments have been disbursed except for the recently approved loan to the Industrial Bank, S.A. IFC plans to continue its promotion efforts and has so far identified a number of potential mining projects. Other priority areas include: hydrocarbons, in particular oil and gas exploration and associated activities such as transport and downstream processing facilities (an oil and gas production project with Tesoro Petroleum has been preappraised); industry, with emphasis on export-oriented projects; and development banks. It will also explore possible use of innovative investme=t approaches that would particularly benefit medium-sized investors. PART VII - COLLABORATION WITH THE IMF 111. Bolivia has established good relations with the IMF. A one-year standby arrangement was approved on June 19, 1986. The mid-term review was approved by the IMP Board on December 15, 1986. The arrangement lapsed in July 1987, before completion, with an undrawn balance of SDR 17.3 million. On December 15, 1986, the IMF Board also approved access to the Compensatory Financing Facility (SDR 64.1 million), and a 3-year Structural Adjustment Facility for SDR 18.14 million (the first year allocation was disbursed). On the same day the IMP Board discussed a joint World Bank/IMFlGovernment three-year Medium Term Policy Framework Paper (also discussed previously by the Bank Board on November 25, 1986). In June 1987 the Government and the IMF started discussions on a possible Extended Finance Facility, but it was never brought to a conclusion due to uncertainty on domestic policies and continuous delays in reaching agreement with Argentina on gas export prices. The Bolivian Government is currently holding discussions with IMF staff on an Enhanced Structural Adjustment Facility supported by a 3-year program. A tentative working agreement has already been reached. IMF support would be instrumental to maintaining a macroeconomic framework consistent with the financial sector reform program. 112. The Bank will continue the collaboration that it has followed with the IMF in the previous stages of this project. There have been detailed discussions with Fund Staff on the proposed credit. PART VIII - RECOMMENDATION 113. I am satisfied that the proposed credit would comply with the Articles of Agreement of the Association and recommend its approval by the Executive Directors. Attachments Barber Conable President Washington, DC May 20, 1988  - 34 - AN=EX I Page 1 BoLr#U - KEY NCRONIIC DXOATa 1rn x,aa 194 rISS uws- 1187 iUl loa 1V0 1"1 199S WEY tAROSI@NIC DCATRS rnP 0,oU Rate -4.8 -6. 0 -0.8 -1.i -2.9 2.4 4.2 4.4 4.1 4.0 4.0 95Y 0ro.i Rme -4.1 -7.0 -0.2 -1.2 6.2 1.6 8.9 4.4 4.4 4.8 4.8 90'qCa,lta CroH Rate -4.7 -9.5 -2.9 -.9 -4.7 -12 1.1 1.8 1.6 1.8 1.5 Con. ptlSo/cepitt Growh Rate -10.0 -1.5 -7.1 .8a 8.0 -0.1 -2.6 0.1 0.1 0.8 0.8 Db0t Service Cin US1) 2B7.0 284.0 82I.0 471.0 872.7 850.1 87.8 840.4 8m.0 4s7.7 544.0 Cebt SavviceMSm 81.0 81.6 a7.9 8.0 50.8 S4.8 47.7 40.7 40.2 47.8 87.4 DO" 5.rICe01 8.1 e.9 8.0 U.2 a.e 7.8 6.9 6.0 1.1 7.S 6.8 Grs lonvetaent/0P 0.7 8.5 5.7 15.0 8.0 9.5 12.6 18.8 i4.0 14.4 15.4 Do..tlc Saving/coP 14.4 13.7 - 0.8 15.1 8.4 2.8 5.7 7.0 0.3 9.4 12.2 I;ticai SavIlge/GoP 7.9 9.4 4.0 7.6 -2.7 -4.7 0.4 1.9 0.6 8.1 7.8 :arginl Natioal Savings Rat 0.1 0.8 -4.9 9.6 -188.5 42.1 -110.8 424.2 95.1 46.5 20.7 Pu*bIia I.veetment/00P 6.5 4.6 5.1 8.5 4.7 5.4 7.0 7.4 7.0 0.0 0.6 private UavealeetlW 5.0 2.0 1.6 8.6 4.9 4.9 5.4 5.0 6.1 6.4 8.7 Ratio of Pubit/Privato Investment 180.1 22.i 190.8 97.2 96.5 111.2 180.8 2=.2 7.0 125.8 12.8 GvrYnWmt Revenw.agP 11.S 10.4 4.1 8.0 17.8 15.8 1s.5 15.8 15.6 18.2 15.8 GovereONet Eapeid*ituree/9P 19.0 15.9 19.6 20.7 21.0 21.8 21.s 22.1 22.1 22.2 20.8 Ostiest C-) or SurpIlu (C) / 90P -12.2 -14.9 -17.6 -7.5 6.4 1.1 1.9 2.8 2.8 2.1 2.6 xpeort Croth Rate -4.8 -5.9 4.4 -11.9 5.8 -7.5 9.6 J.5 5.6 5.7 7.4 eaPovta/cP 15.8 18.4 10. 6 8.9 10.8 18.5 17.4 17.7 18.0 10.8 17.8 imrt Growth Rau -86. 2.2 -10.4 44.8 20.0 2.7 8.2 8.7 8.0 8.0 0.6 I"ort*ef0P U.2 10.5 7.7 1.0 19.5 19.6 19.8 19.7 19.6 19.6 19.8 Current Accut (in UlS ell.) -219.1 -204.1 -194.5 -8.4 -42.5 -1e 419.2 -85.9 -8.2 -94.9 -6.S Current Acowunt/9P -4.8 -4.9 -44.0 -7.2 -10.8 -.4.1 -11.9 -U.1 -10.1 -9.1 -7.4  @W Pae Cai tat W 470 (WN aillie ast current Fria") Actual Frail1.. Projoeted es02 it" 1964 iees 1986 1967 lee 1989 1990 1 *1 192 198 1994 1998 A. Exports of Goods WFS 004.0 052.2 812.0 710.1 6*3.6 sse.0 694.9 781.8 080.4 00.8 959.4 1087.8 1`.O 1878.8 1. Narediadia, (PF0) 827.7 768.1 724.8 612.1 864.6 470.0 S48.0 616.1 8.8 789.0 789.2 6.0 96O.1 108?.6 2. Non-Factor Services 76.8 97.1 67.6 90.0 117.0 129.0 149.9 165.2 12.1 199.8 220.2 241.5 264.9 290.5 e. aporta of Goods and WS 660.7 685.5 897.1 664.8 658.6 920.8 1086.2 1226.6 1218.5 109.0 189.0 1441.6 2880.7 62.6 1. Narchandlee CIP) 496.0 485.5 409.6 564.2 711.6 778.4 869.2 947.0 1084.8 1100.8 1144.6 1218.9 16.9 16.8 2. Mu-Factor Servicee 184.7 200.0 7.5 110.6 142.0 1A8.4 167.0 2180.8 14.2 20e.2 214.4 227.7 241.C 286.0 C. Ramorrce b lane 25.8 166.7 214.9 45.8 -190.0 -29.8 -41.) -847.8 -88.1 -2 -8.99.0 -34.1 -805-. -247.8 0. Net Factor 1iceps -489.1 -411.0 -481.2 462.8 -279.5 4804.1 -29.9 -009.6 -12.6 412.0 -S2.8 -848.5 -88. -497.2 1. Factor Reetpta 14.4 40.8 8L0 16.0 12.4 54.8 84.0 S2.0 34.0 S5.0 86.0 06.0 40.0 42.0 2. Factor Pay_ete 473.8 457.6 467.2 s78.s 291.9 888.4 81.9 541.6 546.6 847.0 861.8 8S6.5 418.3 459.2 (interest pateeta) 412.0 541.9 8a 151.8 122.7 181.8 208.4 218.0 226.9 248.7 250.7 201.4 275.1 2ae.8 E. Nat Private Trenefra 16.7 40.2 21.8 14.5 17.0 20.0 20.0 28.0 26.0 2e.0 solo 82.0 54.0 86.0 F. Current Account Slanca -19.1 -04.1 -194.5 402.5 -62.5 418.9 -419.2 -68.9 -424.7 -004.2 404.9 -70.6 -.0 408.5 0. LIng-T*re Cpital Inflw 2M.1 50.2 189.6 816.1 411.2 465.5 619.2 564.8 687.5 867.0 487.7 686e.4 612.6 663.5 1. Dirpet inveatent 81.0 6.9 7.0 10.0 10.0 20.0 25.0 40.0 46.0 56.0 60.0 65.0 70.0 7s.o 2. Oficial Tranefera 2S.8 66.0 6S.7 65.5 82.0 107.9 180.0 18i60 142.0 148.0 184.0 100.0 168.0 172.0 8. Mat LT Losn -19.1 S1.X -178.7 -118.1 -40.4 -80.6 188.8 114.5 70.5 148.8 W?.4 173.2 171.0 210.2 a. oloburaesba 210.9 507.5 159.8 200.6 810.5 801.8 406.8 84S.S 668.9 429.4 465.6 482.9 484.2 448.6 b. Rhmant 875.8 454.5 84.8 518.7 850.9 882.1 240.0 280.8 2A8.4 260.9 366.2 280.7 268.2 25.4 c. Other (root) -14.7 -1.5 -1.2 . . . . .. . . . 4. Other 1/ 862.4 878.8 281.6 858.7 8a596 848.4 298.4 274.8 827.0 19. 8.i 240.i 206.0i 168i H. Toul Other tem (nt) -7.8 -18.7 207.9 S.S 88.0 Us.s 78.0 75.0 78.0 75.0 48.0 48.0 48.0 46.0 1. Met SIort-Ter, C*pitl -147S. -115.9 100.8 24.5 W9,0 104.5 48.0 45.0 48.0 4S.0 45.0 48.0 48.0 48.0 2. Erore and Olemiene 49.7 100.2 2n.4 51.6 -86.s 77.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 S. W*sid Argantim Go. Reclpto 0.0 0,0 0.0 -20.6 4.1 -96.0 0.0 80.0 8o0.0 80.0 0.0 0.0 0.0 0.0 1. Chai_e In Na tserve 0s.8 -1215.4 -178.0 49.2 -17.7 62.9 -75.0 -4.0 4-7.8 47.8 -87.8 -12.8 -12.8 0.0 1. Nt Credit froe the DU 10.6 8.1 -25.5 -12.4 92.6 -18.8 10.8 -5.9 -47.8 -47.8 -7.8 -12.8 -12.6 0.0 2. other Rerve CHan4, 78.2 -2e8.5 -147. -86.8 -110.8 76.7 -68.$ 0.0 0.0 0.0 0.0 0.0 0.0 0.0 (- indicate Incrset Sihree of GDP (carrent UN): 1. _Resurc Blame" 4.75 4.06 58 s 1 .5x -4.46 -7. -e.as 6 -61 -1 48 -4.63 -4.9 -4.4 -4.93s 4.s 2. Toal Interee PSunMte 8.71 8.8S 9e.8 8.63 2.06 2,83 4.06 8.06 8.71 87 8.75 8.61 8.5t1 8. 5S 8. Curr"t Account lblant -4.65 4.95 -4.8 -7.28 -10.# t -15,11 -11.96 -10.1 -9.11 -1.2# -4.2# -.85 -7.411 4. Lt CapItal Lflow (Ine 0) 4.93 12.2 4.01 7.05 9.61 9.ff 11.91 9.95 *.85 8.63 10.15 8.63 7.95 6.051 S. Nat Credt free the DF 0.2# 0.13 -0.65 4.83i S.15 O.8 0.28 -0.15 -O.S6 -0.6 4.65 -0.2F -0.#5 0.03 MP (at current SI) 4740.0 4102.0 40. 4206. 482.8 4698.4 5189.5 6666.7 6186.8 6629.4 S626.2 7:18.9 779.8 I1.4 Foreign Ec._g Reserves 1. Drops Int'l Roer"e eirAs Gold 144.6 189.8 204.4 284.8 471.4 2. Gold ((owt. valuatio) 87.4 87.4 S7.9 8.8 87.8 S. Oroe_ i_eave tocl. Gold 2/ 182.0 176.7 266.8 272.6 609.2 4. Or. t'l 9ea. tonMinthe of rport Of goode 4.4 4.4 8.4 5.9 8.6 Ebalngeo Rote" (L0JW/W69) 1. "M. Off.X-Rato (IS rh) 4.0 2M0.0 2178.0 441.9 1962.0 2. XNRte for CP Converslon 92.0 #29.0 41S8.0 88.8 1922.0 1/ For 1962 to 19B7. rfare to Exceptioenl finecing; fr 1908 enardmor the ent.4ee reast Mot o; L 2/ In 1968, Includee t reduction of reserve iabilities af the Central Bank th the converreln of aor tao det of S 869.9 WIton into m_dium tor- debt. Soarces Central 8nd of OMN i'*, 1W and t_lealen _st_gtew.  -36- AOEX I VU< - status of Vwl d Gn" w O p Page 3 1. Sateicnt of Wold Bik 1m ana MA credts (as of qmzy 31 1988) am or ( :elll n ) Credit Fiscal tk ID Usbured t1..uber Year %orwer .Uiais of US.. dlars) 13 and 14 credits fully dlsbuued 250.0 100.9 - 940 1979 Bldivia Ntiotal Minwral Euploation Fid - 7.5 4.5 1587 1978 Bolivia Hlghuay aintanaoe 25.0 - 0.1 1703 1986 lBolivia Rsoouatruction Isport Credit - 55.0 31.9 1719 1986 Bolivia Uielta Oraeds - 15.0 10.6 1809 1987 Bolivia Pblic Financial ly