Ecuador - Fourth Small Scale Enterprise Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-5032-EC MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIVALENT TO US$50.0 MILLION TO THE REPUBLIC OF ECUADOR FOR A FOURTH SMALL SCALE ENTERPRISE PROJECT JANUARY 9, 1990 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY AND EQUIVALENT UNITS Country: Ecuador Currency Unit: Sucre (SI.) = 100 cents. US$1.00 (at appraisal - Jan. 1989) = S/. 461.29 (Official Rate) - SI. 520.00 (Free Market Rate) WETGHTS AND MEASURES Metric ABBREVIATIONS BCE Banco Central del Ecuador (Central Bank of Ecuador) BEDE Banco Ecuatorianc de Desarrollo (Ecuadorian Development Bank) BEV Banco Ecuatoriano de la Vivienda (Ecuadorian Housing Bank) BNF Banco Nacional de Fomento (National Development Bank) CD Certificate of Deposit CCT Comite de Cooperacion Tecnica (Technical Cooperation Committee) CEFE Centro de Formaci6n Empresarial (Center for Entrepreneurial Development) CENAPIA Centro Nacional para la Promocion de la Pequefa Industria y la Artesanla Nacional (National Center for Promotion of SSEs and Artisans) CENDES Centro de Desarrollo Industrial (Tndustrial Development Center) CFN Corporacion Financiera Nacional (National Finance Corporation) CONADE Consejo Nacional de Desarrollo (National Development Council) FENAPI Federaci6n Nacional de CAmaras de Pequeffos Industriales (National Chamber of Small Scale Industrialists) DFC Development Finance Company FOPINAR Fondo de Fomento para la Pequefia Industria y la Artesania (Development Furd for SSEs and Artisans) INEC Instituto Nacional de Estadistica (National Institute of Statistics) IESS Instituto Ecuatoriano de Seguridad Social (Social Security Institute) INSOTEC Instituto de Investigaciones Socio-Econdmicas y Tecnol6gicas (Institute for Socio-Economic and Technological Research) MICIP Ministerio de Industrias, Comercio, Integraci6n y Pesca (Ministry of Industry, Commerce, Integration and Fisheries) SECAP Servicio Ecuatoriano de Capacitaci6n Profesional (Ecuadorian Professional Training Service) SSEs Small Scale Enterprises TA Technical Assistance FISCAL YEAR January 1 to December 31  FOR OFFICUL USE ONLY ECUADOR FOURTH SMALL SCALE ENTERPRISE PROJECT Loan and Proiect Summarv Borrower: Government of Ecuador Beneficiarys Private Small Scale Enterprises (SSEs) involved in manufacturing (including agro-industry), industry-related services, fisheries, and tourism. Amount: US$50 million equivalent Terms: Seventeen years, including five-year grace period, at the Bank's standard variable interest rate and charges. Finhrncint Plan: CFN (through FOPINAR) US$ 9.0 million Financial Intermediaries US$ 7.0 million SSE Beneficiaries US$ 17.0 million Bank US$ 50.0 million TOTAL USS 83.0 million Economic Rate of Returnt Not applicable Staff Appraisal Report: Report No. 7691-EC This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without-World Bank authorizaton.  MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE REPUBLIC OF ECUADOR FOR A FOURTH SMALL SCALE ENTERPRISE PROJECT 1. The following memorandum, and recommendation on a proposed loan to the Republic of Ecuador for US$50.0 million equivalent, is submitted for approval. The proposed loan would be repaid over 17 years, including 5 years of grace, at the a Bank's standard variable interest rate and charges. It would help finance a Fourth Small Scale Enterprise Project. Background 2. Macro Performance. Ecuador has enjoyed average GDP growth of about 5? a year over the past twenty-five years, a record exceeded only by Brazil among the Latin American countries. This growth, more dyi.amic in the 1970s than ir. the 1980s, was mainly associated with the rapid development of the petroleum sector during 1973-82. High oil revenues and external credit financed both the expansion of domestic demand for manufactures and production capacity, while the expansion of the Andean market provided the basis for growth in industrial exports from less than US$50 million in 1975 to US$250 million in 1981. As a result, the manufacturing sector increased its share of GDP from 16.22 in 1972 to a peak of 19.42 in 1983. The expansion, however, could not be sustained when oil revenues dwindled, external credit dried up and various other shocks (the 1983 floods, the 1987 earthquake, the collapse of the Andean Market) hit the economy. As a result, GDP grew by an average of only 0.6? p.a. from 1982-87. 3. Ecuador's economic performance has been hampered by the country's misguided development strategy during the 1973-82 oil boom phase. Oil export revenues and large scale external borrowing led to an appreciation of the real exchange rate, which undermined the development of agriculture and export-oriented manufacturing. The stock of external debt expanded without a commensurate strengthening of Ecuador's non-oil export capacity. Similarly, public sector finances were allowed to become excessively dependent on petroleum revenues while tax concessions and subsidies expanded. Under these conditions, adjuastment to reduced external credit and oil price shocks of the 1980s has been particularly difficult. 4. Sector Characteristics. During the 1982-87 period, the average growth rate of manufacturing output dropped to 0.3? p.a. compared to 8.42 p.a. over the preceding five years. Consequently, Ecuador's level of industrialization fell from a 19.3? share of GDP in 1983 to 16.8? in 1988. The share of small scale enterprises (SSEs) in total industry value added increased, however, from about 36? in 1980 to 42? in 1987. SSEs' production is largely concentrated in labor-intensive goods, which comprise much of the country's comparative advantage. SSEs, defined as establishments with less than 50 employees, account for 742 of manufacturing employment. Available statistics indicate that SSEs create employment at only a sixth to a quarter of the costs in large firms of similar industries. Thus, because the cost of SSE employment creation is low, SSEs have generated virtually all of the additional manufacturing employment during the eighties. SSEs' larger share in employment than in value added is due to the SSEs larger average labor intensity. 5. Limited funding, coupled with t'.- high cost of credit delivery, high perceived risk, inadequate collateral ana accounting information are the main constraints in lendirg to SSEs; this situation has been aggravated by an ownership structure of the financial sector which has shown a close relationship between banks, development finance companies (DFCs), and large industrial/commercial groups.  - 2 - The SSE share of the banking credit system has been declining from 7.72 in 1981 to 4.52 in 1987. The other sources of financing include the entrepreneurs' own resources plus loans from suppliers and street-lenders. All these constraints have resulted in a higher cost of credit for SSEs than for large industr;. 6. Policy Framework. The industrial policy framework has been characterized by a high level of import protection and by policies that subsidize the cost of capital and raise the cost of labor. The tariff code and the industrial promotion law (which grants tariff exemptions from import duties for industrial inputs and capital goods, and gives income tax deductions for investment purposes), have resulted in major deviations in the rates of effective protection among sectors. Subsidized interest rates significantly lowered the cost of capital to business enterprises and, coupled with high taxation of dixridends, encouraged these enterprises to become highly leveraged. Labor costs have been raised by legislation that sets minimum wages above market clearing levels ana that increases the cost of labor mobility, thus exacerbating the factor price distortions implicit in financial and trade policies. 7. Ecuador traditionally has pursued strong protectionist policies. However, the various market distortions have a much greater impact on the larger industries operating in the formal sector than on most SSEs which benefit less from protection, are subject to a less restrictive labor market, and have less access to subsidized credit. An Industrial Sector Study, currently under preparation by the Bank, has concluded that key sectors with a high percentage of SSEs (food processing, textile and leather products, wood and furniture, metal products) have relatively low average rates of effective protection (between 202 and 302). The analysis also indicates that SSEs do not obtain major benefits from the industrial promotion law that exempts imports from tariffs because the majority of SSEs use few if any imported inputs. SSEs avoid labor stability regulations through temporary contracts or outright neglect that the Government is unable to counteract and which the employee is often unwilling to denounce. Minimum wages are lower for SSEs than for large industry. 8. The purformance of the financial sector in Ecuador from the point of view of resource allocation, institutional strength, and mobilization of domestic resources for long-term lending reveals several weaknesses. These date back to the 1970s, when the financial system grew rapidly, mainly because of the availability of external financing which domestic banks intermediated charging high margins for providing exchange rate guarantees for foreign loans to the private sector. Additionally, negative real intereet rates charged to final borrowers and attractive margins and commissions provided to intermediaries stimulated lending growth. This environment provided little incentive for financial institutions to mobilize domestic resources on their own, who became increasingly dependent on the Central Bank (BCE) credits and foreign borrowings for resources. The ensuing structural weaknesses of the financial system were compounded by easy granting of bank licenses, which in turn led to the establishment of many small, undercapitalized banks. 9. In the mid-1980s, the Government initiated a far-reaching program of financial reform to spur domestic resource mobilization and to strengthen financial institutions by allowing them to intermediate a larger volume of financial resources efficiently. Among the most important measures taken were: (i) creating a Certificate of Deposit with a freely determined interest rate; (ii) introducing adjustable rates on loans with resources from the BCE or internatio-al institutions; (iii) subsequent freeing of the interest rate on all deposit instruments, and freeing of interest rates on all lending instruments except BCE lines of credit and adjustable rate lending; and (iv) increasing the interest rates on BCZ credit to align them more closely with market interest rates.  10. During the past two years. the Bank has supported a strengthening of the banking system and a rationalization of the interest rate regime through the Financial Sector Adjustment Loan (2897-EC, FSAL). The Bank approved the US$100 million FSAL in December 1987, released the first tranche (US$50 million) in January 1988, and the second tranche in (US$50 million) in September 1989. The present Administration has demonstrated a strong commitment to the objectives of the FSAL program, which is focussing on: (i) strengthening financial institutions (Fls) through improvements in the regulatory framework, upgrading the performance of the Superintendency of Banxs (EB) and gradually restoring the capital adequacy of these institutions; (ii) more efficient intermediation by restraining the growth of BCE rediscounts to FIs and by linking the interest rate on BCE funded credit to rv.rket- determined rates; and (iii) development of the capital market by improving t : conditions for variable interest rate lending, for the establishment of sho _-term and long-term market-determined interest rates, and for promoting the issuirig of equity finance by companies. 11. Issues and Reform. Facing an expected fiscal deficit of 102 of GDP in 1988 and inflation running at an annual rate of 80 to 902, the Government (which took office in August 1988) acted quickly to introduce fiscal measures and restrict monetary growth. These policy measures, aided by a rise in international oil prices in late 1988, allowed the Government to cut the 1988 fiscal deficit to about 5.1Z of GDP, about half of what had been projected at mid-year. Further measures on interest rates and exchange rates have been taken during 1989; gasoline prices have been raised monthly during the year. Indications are that the stabilization is succeeding. Preliminary figures for 1989 show that the consolidated non-financial public sector deficit was contained to about 32 of GDP in 1989. As a result of stabilization, GDP growth slowed down to between 0 and 12 and inflation was reduced to 541 in 1989 from 892 in 1988. Ot'ner performance criteria under the IMF standby were also met in December. For l99u, the targets are a fiscal deficit equivalent to about 22 of GDP, growth of 3 to 3.52 of GDP p.a., and inflation at 40? p.a. or less. 12. Ecuador's medium-term strategy calls for a more diversified structure of production and exports to protect the country against fluctuations in the international prices of oil and other traded commodities, and to establish a base for the post-oil era. At the core of Ecuador's structural problems is the need to shift resources from the production of non-tradeables, including public sector activities, into the efficient production of exports and competitive import substitutes. A step in this direction has already been taken with the substantial increase in the real exchange rate of the last two years. By late 1989, the gap between the official and free market rates had closed to within 5 percent. If Ecuador's potential in the medium-term is to be achieved, a strong and permanent trade reform, including basic industrial and labor policy changes, would be needed. * 13. To this end, the Government, after having addressed first fiscal and financial issues, is now implementing an income tax reform (which would align the cost of equity capital and the cost of debt capital) and preparing a trade and industrial policy strategy. The Bank is assisting the Government in the design of these reforms. The forthcoming Industrial Sector Study will provide the basis for the policy dialogue. 14. The changes in the interest rate regime, which the Government had introduced in the context of the second tranche release of the PSAL, have resulted in positive deposit and lending rates. The interest rates for certificates of deposit (CD) have been positive since April 1989, when interest rate reforms were introduced which increased the flexibility of the system and made it more responsive to market forces. Real interest rates for CDs are 4? at present. Also, ceilings on internationally funded loans to large scale industry have been removed--a measure  that goes beyond the requirements of the FSAL program. Furthermore, the Government has committed itself in a letter to the Bank to move the various sector specific interest rates, in uniform steps every six months, to the level of the market based commercial bank lending rate within less thaa three years. These adjustments are the result of a dialogue on financial matters between the Government of Ecuador and the Bank which started in the early 1980s. The Government's commitment to raise the interest rates for small scale industrial and agricultural lending to levels determined by the market goes significantly beyond the understanding reached under the FSAL. Rationale for Bank Involvement 15. The Bank is responding with this loan to the priority the Government is attaching to the development of the SSE sector because of its contribution to the medium-term strategy of diversification into non-traditional tradeable goods, efficient industrial development and socio-economic objectives: entrepreneurial development, upgrading of labor skills, and employment creation. Lending to SSEs supports enterpri3es that absorb the less skilled segments of the manufacturing labor force, a key source of the country's comparative advantage. The loan has been designed, in the context of a broader adjustment program and complementary to the interest rate progress, to further the productivity and competitiveness of small industrial firms. It would build upon the success of three previous projects in maintaining a Bank association with Ecuador's smll scale enterprise sector through the Development Fund for SSEs and Artisans (FOPINAR) which has been ranked among the very best apex institutions of its kind by a recent Bank study of seventy small and medium industry (SMI) projects. An analysis of SSE financing suggests that without FOPINAR, SSEs' access to term financing would have been virtually non-existent. SSEs have performed very well under three previous Bank loans. Lending has growr. rapidly in FOPINAR's eight years of operation, reaching nearly 5,000 SSE beneficiaries and maintaining a high repayment record, with only 3? in arrears at the end of 1988, compare, with 10? for large industry. Continued Bank involvement through this project, buttressed by a novel technical assistance program, would help to provide the support the small entrepreneurs need to diversify and expand production, while addressing the main constraints on the growth and development of SSEs, namely a lack of term finance and the paucity of appropriate technical assistance. The loan would have a catalytic function in demonstrating to the banking sector and its clientele the profitability of lending to SSEs at market-determined interest rates. Project Objectives 16. The proposed operation would help enhance the contribution of SSEs to industrial development. Specifically, the loan would help modernize and expand production by: (a) facilitating the access of SSEs to formal credit; (b) promoting lending to SSEs by participating financial intermediaries (PFIs); (c) providing more focused and integrated technical snd managerial assistance support to increase the productivity of eligible SSEs and reinforce coordination among organizations that provide technical and financial assistance to the small firms; and (d) further strengthening the management and technical skills of participating financial institutions that provide credit to SSEs. Efforts will also be made to promete actions toward improving the environment and enhancing the role of women in business activities. Environmental safeguards will be built into FOPINAR's Statement of Policy and Operating Procedures. Specifically, approval of subprojects related to wood processing with potentially damaging effects from deforestation would require a satisfactory environmental assessment. With regard to the rcle of women, the Bank will, during execution of the project, pay particular attention to identifying barriers to women's opportunities to participate more fully in SSE activities, and to developing action plans to improve their access to credit and to technical assistance.  Prolect Description 17. To achiLeve these objectives, the proposed project would comprise: (a) a credit component of US$50 million to finance SSE fixed assets. permanent working capital (both associated and free-standing), and subproject related technical and managerial expenditures; and (b) a technical assistance program of US$1.6 million equivalent, of which US$1 million would be financed by the Corporacion Financiera Nacional (CFN) and by a grant from the Inter-American Development Bank (IADB). and US$600,000 by local counterpart funds. Enterprises involved in manufacturing (including agro-industry), industry-related services, fisheries, and tourism would be eligible. The total project cost, estimated at about US$83 million equivalent, with a foreign exchange component of US$50 million (602), would be financed as follows: SSEs 201, the PFIs 8?, Bank resources 602, and CFN--through FOPINAR--the remaining 122. The Bank and CFN resources (FOPINAR loan) should finance a maximum of 72? of total project cost. Of the FOPINAR loan, 85? would be financed by the Bank and 15? by CFN. An amount not exceeding US$5 million (10? of the loan) would be available retroactively for financing expenditures made after December 13, 1989. A breakdown of costs ard the financing plan are shown in Schedule A. Amounts and methods of procurement and of disbursements, and the disbursement schedule, are shown in Schedule B. A timetable of key processing events and the status of Bank Group Operations in Ecuador are shown in Schedules C and D, respectively. The Staff Appraisal Report No. 7691-EC, dated January 9, is also attached. Onlending and Disbursement Procedures 18. The Republic of Ecuador, using the Central Bai.k (BCE) as its agent, would onlend the proposed loan resources in Sucres to CFN, on the same maturity as the Bank's loan (17 year repayment period, including 5 years of grace). CFN, using FOPINAR as a second-tier mechanism, would rediscount all subloans made by financial intermediaries to eligible SSEs. The onlending rate has been set initially at the 90-day certificate of deposit rate. Beginning on July 1, 1990, it would be adjusted in uniform steps every six months to reach the market-determined commercial bank lending rate by June 30, 1992. The onlending rate would include a maximum spread of 6? p.a., for financial intermediaries, depending on the size of the subloans, and a spread of 2.5?, for FOPINAR to cover its operating costs and part of the technical assistance activities. CFN would pay in turn a service fee of .125? p.a. to BCE. The spread is to remain fixed during the life of the subloan. 19. While the onlending rate t, final beneficiaries of the loan would be positive, there would initially be a difference of 11 percentage points compared to the commercial bank lending rate for large industries. This difference will be reduced in line with the schedule of adjustments towards the market-determined commercial bank lending rate; it will be eliminated at the latest by June 30, 1992 and considerably earlier if the present trend of declining inflation, and consequent decline in nominal interest rates, continue.1 The Central Bank would cover the exchange risk; this is justified because the small scale entrepreneurs do not have revenues in foreign exchange and because of the movement towards market oriented interest rates under the loan in the context of a freely floating exchange rate. 1/ Lending at the CD rate will, under current circumstances, imply a subsidy by the Central Bank if measured against its cost of funding and the intermediation spreads. This subsidy cannot be calculated with precision in view of uncertainties about future exchange rate adjustments (inflationary expectations apparently are below present rates of inflation). The subsidy will eventually be eliminated in line with the adjustments towards a market-determined lending role.  -6- Agreed Actions 20. Agreement has been reached on the following: (a) beginning on July 1, 1990, the onlending rate on all long term loans to small scale industry iv to be adjusted in uniform steps every six months to reach the market-determined con.nercial bank lending rate by June 30, 1992; (b) CFN is to oversee the implementation, by all financial intermediaries, of an interest capitalization scheme acceptable to the Bank that would be offered as an option to final beneficiaries. CFN's Board of Directors will have approved the scheme by loan effectiveness. It will be implemented by July 1, 1990; and (c) appropriate procedures and administrative structures are to be established and a core team to be employed by loan effectiveness for the strengthening of FOPINAR's Technical Cooperation Committee to ensure efficient execution of the Technical Assistance Program. Benefits 21. The proposed project would help integrate the SSEs more effectively into industrial development by increasing their productivity and competitiveness. The coordinated package of financing and technical assistance would stimulate production and provide the needed term financing. On the basis of experience under the previous three SSE loans, the proposed project is expected to finance some 4,500 investment subprojects, costing about 11$83 million and generating about 14,500 new jobs. It is also ;expected that about 402 of subprojects financed would be in the industrial centers of Pichincha and Guayas, which contain a high concentration of the urban poor in Ecuador. Better services to SSEs, as well as efficient subloan and subproject implementation, would result from the institutional support provided to FOPINAR. More than 1,000 enterprises would receive direct tecthnical and managerial assistance. A further 1,500 firms would benefit from training and extension activities. Risks 22. One main risk can be identified: that high inflation and continued recession, coupled with the introduction of market-determined interest rates on subloans, could reduce loan demand and cause a slower pace of commitments and disbursements under the proposed operation than in the previous three SSE loans. The Goverment's comriitment to stabilizing the economy and its success in reducing the fiscal deficit and inflation augurs favorably for a resumption of economic growth with relative price stability in the medium-term. The expected strengthening of the economy combined with the favorable outlook for SSE development should sustain strong demand for financing under the loan. Recommendaticn 23. I am satisfied that the proposed loan would ccmply with the Articles of Agreement of the Bank and recommend that the Executive Directors approve the proposed loan. Barber B. Conable President Attachments Washington, D.C. January 9, 1990  Schedule A ECUADOR FOURTH SMALL SCALE ENTERPRISE PROJECT ESTIMATED COSTS AND FINANCING PLAN I' Estimated Costs: Local Foreign Total ------CUSS million)------ I. Investment Projects 3?.0 50.0 83.0 Total Project Cost 33.0 50.0 83.0 II. Technical Assistance Program 0.6 1.0 1.6 Total Program Cost 0.6 1.0 1.6 Financing Plan: Local Foreign Total