Colombia - Seventh Development Finance Companies Project

Document of FILE )p y The World Bank FOR OFFICIAL USE ONLY Report No. P-2345-Co REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE BANCO DE LA REPUBLICA WITH THE GUARANTEE OF THE REPUBLIC OF COLOMBIA FOR A SEVENTH DEVELOPMENT FINANCE COMPANIES PROJECT June 2, 1978 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Average Calendar 1977 April 30, 1978 Currency Unit m Peso - Col$ Col$ US$1 - Col$36.985 38.58 Col$1 - US$0.027 0.02592 GLOSSARY OF ABBREVIATIONS AID - Agency for International Development DDC - Department of Development Credit of Banco de la Republica DFC - Development Finance Company GDP - Gross Domestic Product IDB - Inter-American Development Bank IFC - International Finance Corporation OED - Operations Evaluation Department FISCAL YEAR January 1 to December 31  FOR OFFICIAL USE ONLY Page 1 of 2 COLOMBIA SEVENTH DEVELOPMENT FINANCE COMPANIES PROJECT LOAN AND PROJECT SUMMARY Borrower: Bianco de la Republica Guarantor: Republic of Colombia Beneficiaries: P'rivate Development Finance Companies Amount: IJS$100 million equivalent Terms: I'nterest at 7.5% per annum. Repayment in 17 years, including 4 years of grace. According ito a fixed amortization schedule based on the Bank's projection of the expected aggregate of the amortization schedules of the individual subloans to be made. Relending Terms: I---- nterest (Z) --------- Maximum Terms (Years) 1/ Purpose: Dollar Funds Peso Funds Maturity Grace 2/ To Sub- To Sub- To DFC borrower To DFC borrower Sub-loans 8 10.75 21-22 25 15 3 Equity Investments - - 20-22 not appl. 15 5 Technology Improvements - - 16 20 5 2 Pollution Control - - 16 20 10 2 Banco de la Republica would assume the peso/dollar exchange risk on peso funds and the cross foreign exchange risk on all funds. ProJect Description: Development of private industry through contri- bution of foreign exchange for loan and equity financing by Development Finance Companies of investment projects, including technological improvements, and pollution control, in manufac- turing, agro-industry, mining and tourism. 1/ Repayment terms are identical for sub-borrowers and DFCs, except in case of equity investments. 2/ Included in maturity., This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  Page 2 of 2 Estimated Disbursements: ---------------- US$ millions ----------------- FY79 FY80 FY81 FY82 FY83 Annual 10 28 38 22 2 Cumulative 10 38 76 98 100 Staff Appraisal Report: No. 2013b-CO of May 26, 1978.  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO BANCO DE LA REPUBLICA WITH THE GUARANTEE OF THE REPUBLIC OF COLOMBIA FOR A SEVENTH DEVELOPMENT FINANCE COMPANIES PROJECT 1. I submit the following report and recommendation on a proposed loan to the Banco de la Republica for the equivalent of US$100 million, the proceeds of which would be relent to development finance companies (DFCs) for the development of private industry. The loan would have a term of 17 years, including 4 years of grace, with interest at 7.5% per annum. It would be repaid according to a fixed amortization schedule based on the Bank's projection of the expected aggregate of the amortization schedules of the individual subloans to be made. PART I: THE ECONOMY 1/ 2. The latest economic report on Colombia (1548-CO) was distributed to the Executive Directors in May 1977. It assesses current developments and provides a medium-term perspective of the Colombian economy. An updating report is being prepared and is scheduled for distribution to the Executive Directors in August 1978. Country data sheets are provided in Annex 1. Background 3. During the past two decades substantial structural transformation has taken place in the Colombian economy. The country has made impressive progress in the transition from a predominantly rural and agricultural economy made up of largely self-contained regions to a more integrated urban industrial economy oriented increasingly toward international trade. This broadening of the country's productive base has been accompanied by rapid growth of nontraditional exports and development of a modern sector which relies to a considerable extent on imported inputs. From 1967 to 1974 GDP rose by an average of 6.5% per annum in real terms, well above the historical average of less than 5% (1950-67). Accelerated economic growth coupled with a decline in population growth brought about a rapid increase in per capita incomes. Increased investment and relaxation of the foreign exchange con- straint were the major factors responsible for this acceleration in growth. Merchandise exports expanded more than four-fold during this period, and, most significantly, nontraditional exports became an increasingly important source of foreign exchange earnings, in large part compensating the slow 1/ Substantially unchanged from President's Report, San Carlos I Hydro Power Project (Report No. P-2239-CO).  - 2 - growth of receipts from coffee exports. Much of this increase in non- traditional exports was the result of both product and market diversifica- tion attributable to the Government's export promotion program. Substantial medium- and long-term capital inflows to the public and private sectors for development projects helped sustain investment levels and enabled Colombia to maintain the favorable structure of its external debt. However, despite the substantial progress made during the past two decades, Colombia still has a long way to go on the road toward modernization; it still is essentially an underdeveloped country with a limited modern sector superimposed on a broad, traditional and poor base. 4. When the present Government took office in August 1974. the country was faced with a generally deteriorating economic situation--weakening balance of payments, loss of self-sufficiency in petroleum production, accelerating inflation, deterioration of the public finances, and reduced public invest- ment. GDP growth showed signs of slowing and unemployment was increasing, especially in the urban areas, reaching a peak of 13% in 1974. As a con- sequence, the new administration moved rapidly to introduce an economic stabilization program along with a set of reforms aimed at restoring the basis for long-term economic growth. In line with these goals, it initiated basic reforms of the fiscal, monetary and price systems. 5. To help strengthen the public finances, the new Government undertook a comprehensive tax reform designed to achieve a substantial improvement in the progressivity and elasticity of the tax system. Steps were also taken to correct major distortions which existed in the price system. Price controls on a number of important agricultural products were removed, thereby providing greater stimulus for increasing farm production. Far-reaching modifications in petroleum pricing policy aimed at regaining self-sufficiency in production of crude petroleum by improving incentives for exploration and exploitation were introduced. Concurrently, measures were taken to reduce the subsidy on local consumption of petroleum products, with the dollar equivalent price of gasoline being raised in successive steps by 150% between August 1975 to January 1977. 6. Economic growth slowed in 1975 and 1976, withi real GDP increasing by less than 5% in both years. This was the result of the stabilization measures adopted at the end of 1974, the effects of the world recession, reduced private investment, and, in 1976, a poor harvest stemming from adverse weather conditions. The stabilization program succeeded in reducing inflation from 27% in 1974 to 18% in 1975, but the expansionary impact of rising inter- national reserves caused by higher coffee prices and shortages of basic food items produced an acceleration of inflation to 26% in 1976. Private invest- ment declined in real terms during this period as a consequence of attempts to stabilize the economy through tighter fiscal and monetary measures. Public sector revenues and savings were strengthened as a result of the tax reform and of increased revenue from coffee export taxes. The balance of payments improved substantially in 1976, mainly as a result of an increasing trade surplus caused by higher world coffee prices. Consequently Colombia's net international reserves rose by nearly threefold, from US$437 million in 1974 to US$1,166 million in 1976.  -3- Recent Economic Performance 7. Growth and employmient picked up significantly in 1977, largely as a result of increased internal demand generated by the income effects of exceptionally high export receipts from coffee. GDP is estimated to have increased by 5.4%. This higher level of growth was distributed evenly over all sectors of the economy except non-coffee agriculture which was affected by the continuation of the severe drought which began in the second half of 1976. High world coffee prices during 1977 produced a record trade surplus and the balance of payments registered an overall surplus for the year of US$686 million. By year end, Colombia's net international reserves stood at US$1,852 million, equivalent to seven months' imports, the highest level in the country's history. Increased export receipts from coffee contributed to a further strengthening of public finances over that which had occurred in 1975-76. Increased receipts from taxes on coffee exports caused a substantial increase in the current surplus of the Central Government, more than off- setting unexpected slower growth in some of the country's other major taxes. 8. Expansion of coffee earnings combined with the shortages of basic food items led to an unprecedented acceleration of inflation during the first half of 1977. For the twelve month period ending in June 1977 infla- tion reached 45%. In an attempt to reduce inflationary pressure the Govern- ment introduced a number of fiscal and monetary measures aimed at curbing growth of coffee producers' disposable income, at further strengthening public finances and at slowing the growth of the monetary aggregates. Legal reserve requirements were increased, limits were placed on external borrowing, and Central Bank rediscounts were reduced. The coffee retention tax rate was doubled from 23% to 46%, and the system of delayed payments to coffee pro- ducers was used to further limit growth of coffee producers' disposable in- come. In order to increase aggregate supply and stem the rapid accumulation of foreign exchange reserves, import duties were reduced and the import licensing system was liberalized. In an effort to curb upward pressure on prices, the authorities temporarily discontinued their policy of periodic adjustments in the foreign exchange rate and in prices of petroleum products. The last two measures were only a temporary expedient to break the infla- tionary spiral. From July 1977, the Government has resumed periodic ex- change rate adjustments and in January 1978 increased the price of gasoline by 20%. The Government intends to continue to pursue policies that maintain Colombia's international competitiveness and that help regain petroleum self-sufficiency. 9. Another conflict between short-term and long-term objectives exists in the Government's interest rate policies. To avoid cost push effects, nominal interest rates were frozen during the period of accelerating inflation and real interest rates declined rapidly and became sharply negative. As a consequence there was a growing unwillingness on the part of the public to hold medium- and long-term financial assets, and investment funds had to be increasingly allocated by cumbersome administrative controls. The problem has become less serious as inflation has abated, but will require further attention by the Government.  - 4 - 10. The stabilization measures taken earlier in the year, the gradual decline of world coffee prices from June 1977 on, and the availability of more ample agricultural supplies on the domestic market resulting from both improved weather and increased imports, produced a dramatic slowdown in inflation in the second half of 1977. For the full year 1977, inflation was reduced to 29%. The Government's contractionary fiscal and monetary policies are contributing to further declines in the rate of inflation (through end- April 1978 the annual rate of inflation has declined to 16.5%). Lower inter- national coffee prices and rapid increases in imports are expected to lessen inflationary pressures from the external sector. Prospects for this year's agricultural output appear good; it is expected that in the coming months the rate of inflation will continue to slow down. Development Strategy and Prospects 11. The Government's development strategy, embodied in the 1975-78 development plan, aims at creating the conditions necessary for substantially increasing employment opportunities, particularly for the poorest segments of the population. It provides incentives for private sector investment in the least developed areas of the country and for the use of more labor intensive production techniques. Public sector investment specified in the Plan concen- trates on expanding and improving infrastructure and on socially oriented projects designed to alleviate rural and urban poverty. This includes compre- hensive integrated rural development and nutrition programs which directly benefit the lowest income groups of the population. Because of the importance of commercial agriculture in generating employment and expanding exports, Colombia's development plan assigns a high priority to providing farmers with credit and technical services required to increase output. In order to alleviate urban poverty, the Plan places emphasis on reducing migration to the cities by increasing employment in agriculture and through provision of improved services in slums of Colombia's major cities. These efforts are being complemented by policies and programs to encourage the development of small- and medium-scale enterprises and to decentralize industry away from the three largest cities. Special priority is given to the development of domestic energy sources to reduce the country's growing dependence on imported oil. 12. In the past three years substantial progress has been made in carrying out this strategy despite the economic dislocations occasioned by the world recession and the need to concentrate on short-term economic mar.agement. Most of the Government's development efforts during this period have focussed on improving the standard of living of the poorest 50% of the population, with a substantial share of the benefits of public sector expenditures accruing to this segment of the population. Provision of improved social services has been a major objective of the current administration. This is reflected in the increase in expenditures on education, health, water and sewerage, which rose from 33% of total expenditures in 1974 to 37% in 1976. Preliminary estimates show an even higher share spent on such programs in 1977. 13. Projections of Colombia's energy balance indicate an expanding deficit which could reach significant proportions by the early 1980s. To avoid the constraint on growth that shortages of energy would entail, the  - 5 - Government is giving high priority to the development of alternative energy sources. Major projects arie being developed to exlpaJl hLyd-oelectric power generation and incentives are being provided to pr-'ate companies for accele- rated exploration and exploitation of the country's hydrocarbon potential. Coal and natural gas are expected to provide an increasing contribution to the country's energy needs in the future. An energy development program, which would nearly triple power generation by 1986, has been drawn up by the Government, with estimated investment requirem-te.Ls of between US$6.0 and US$8.0 billion in constant 1976 prices. Given the long gestation periods of power projects, their execution must be initiated without delay if energy constraints on future growth are to be avoided. 14. The Government is making a major effort to accelerate growth of the agricultural and industrial sectors. In the past, Colombia has been largely self-sufficient in basic foodstuffs. However, an increasing food deficit is projected for the years ahead in the absence of major advances in food pro- duction. The Government is attempting to meet these needs through integrated rural development programs directed towards small farmers, through expanded farm credit, research, extension and marketing facilities and through improved farm management practices, including farm investment planning. Industry has been singled out as the leading growth sector for the future and the Government has adopted exchange rate, fiscal incentive, credit aLlocation, and locational policies intended to assure that the sector fulfills its role as a major con- tributor to employment growth and exports. 15. Given its strong resource base and its high level of international reserves, Colombia should be able to sustain annual real growth of no less than 6% over the period 1978-82. Private sector investment is expected to recover as inflation subsides and fiscal and monetary policies are eased. Public sector investment is expected to increase as restraints on such spending are lifted and major energy projects enter the executio-a stage. Non-inflationary increases in public sector investment spending depend Lo a large degree on continuing Government efforts to maintain high levels of public sector savings. In this regard, timely and adequate adjustment of tariffs on public services is especially important, and the Government has already gone a long way in the adoption of such policiLes. 16. Less buoyant terms of trade as world coffee prices decline from the high 1977 level and rapidly increasing imports to meet the requirements of expanding investment are expected to lead to a rencwed widening of the resource balance beginning in 1978. Assuming that economic growth accele- rates in the industrialized countries and that appropriate incentives-- particularly continuation of periodic exchange rate adjustments--are provided, nontraditional exports should resume the high rate of growth achieved in the early 1970s. Colombia is projected to require gross capital inflows of about US$3.7 billion during the five year period 1978-82. This inflow would enable Colombia to maintain an adequate level of foreign exchange reserves during the period. A significant increase in capital requirements is expected in the early 1980s when major additional projects in the energy sector will have to be initiated. To iachieve these Itargets, aLnnual gross capital inflow will have to increase from US$600 million io 1976 to over US$1.0 billion in  - 6 - 1982. While about half of Colombia's capital inflow is expected to be provided by official multilateral and bilateral sources, financing from commercial sources is expected to become increasingly important during the period as Colombia gains greater access to international capital markets. 17. Colombia's public external debt repayable in foreign currency amounted to US$3.3 billion at the end of 1976, or about US$2.4 billion exclud- ing undisbursed commitments. The Bank/IDA share of this external debt was 28.5% and is expected to decline to about 25% by 1982. Although the public debt service ratio fell during the past two years as export growth accelerated, this ratio is projected to increase from 9.5% in 1976 to about 11% by 1982. Balance of payments prospects beyond 1980 will depend among other factors on the timely development of domestic energy sources and on progress made in executing several natural resource-based export oriented projects currently under preparation. As a developing country, it is normal to expect Colombia to be a net capital importer, i.e. to have a deficit in its balance of payments on current account. However, to avoid an excessive growth in this deficit over the next few years, careful management of internal demand will be required. Given such management, it should be possible to prevent the external sector from again becoming a constraint on economic growth, and to maintain Colombia's present creditworthiness for external borrowing of substantial amounts on conventional terms. PART II: BANK GROUP OPERATIONS IN COLOMBIA 18. The proposed loan, the 75th to be made to Colombia, would bring the total amount of Bank loans to Colombia to US$1,878.2 million (net of cancella- tions). Of this amount, US$1,165.5 million is now held by the Bank; IDA made one credit of US$19.5 million for highways in Colombia in 1961. Disbursements have been completed on 46 loans and the IDA credit. IFC has made effective investments and underwriting commitments of US$53.7 million in 24 enterprises and now holds US$19.0 million. Annex II contains a summary statement of Bank loans, the IDA credit and IFC investments as of March 31, 1978. The Annex also contains summaries on the execution of the 23 on-going projects. 19. Since FY68, Bank lending in Colombia has become more diversified and has been concentrated on production-oriented programs and activities which carried social as well as economic benefits. Eight of the eleven agricultural loans have been made since then, eight of the eleven loans for industry, all three loans in the education sector, all seven loans for water supply and sewerage, one loan for a nutrition project and one loan for an urban develop- ment project. This compares with only nine loans since FY68 in the power and transport sectors. 20. Bank lending to Colombia in FY77 consisted of loans for rural devel- opment, agricultural credit, telecommunications, highways and small-scale industry, totalling US$281 million equivalent. In addition to the proposed seventh DFC project, the FY78 program includes the recently approved loans for nutrition improvement, water supply and sewerage, urban development,  - 7 - power generation and transmission, and the Cartagena export processing zone. Work is also underway on prcjects for further urban development, water supply and sewerage, power, transportation, mining, small farm development and agricultural credit for land reform beneficiaries for possible consideration by the Executive Directors during the next two years. 21. The proposed Bank lending conforms closely with the Government's development strategy. To help Colombia develop domestic sources of energy, a substantial part of the proposed lending would be for hydropower. The Bank would also attempt to assist: the development of coal mines, which hold poten- tial in helping Colombia meet part of its energy requirements and in divers- ifying its exports. Bank involvement in the energy sector would help mobilize additional external financing as some of the projects would require co-financing. Other future loans would finance agriculture and industry to assist the Government in its efforts to raise overall productivity, income and employment, and to strengthen and diversify exports. Closely related to these objectives would be the proposed Bank Lending for transport infrastructure which aims at integrating more backward areas of the country into the modern economy. In this context, work is underway on a project to improve domestic airports. Finally, a relatively large number of loans in support of the Government's efforts to help the lowest 50% of the Colombian population are under prepara- tion. The recently approved urban development, and water supply and sewerage projects, as well as the proposed urban, water supply and agriculture projects, are principally designed to improve the poor's standard of living. 22. The operations of external lenders in Colombia are shown in Annex I. While IBRD, IDB, and AID provided about 75% of total external financing to Colombia in the 1961-72 period, their share has decreased since then to approximately 40%. Like the Bank, IDB and AID have given increased emphasis to social projects. For instance, the IDB has assisted projects in low cost housing, urban and rural development, agrarian reform, university education, water supply, and land erosion; in the future IDB proposes to assist Colombia in its plans to develop sources of domestic energy and to expand the activity of the productive sectors to help generate increased employment. AID has supported programs in educaition, urban development and small farm development. More recently, it has moved to small project loans aimed chiefly at improving the distribution of income. It is expected to phase out its aid program in Colombia in 1979 with the commitment of a US$6 million nutrition loan. PART III - THE INDUSTRIAL SECTOR IN COLOMBIA Industrial Growth 23. In Colombia, industry contributes about one-fifth to the gross domestic product, employs about the same proportion of the labor force, and produces about one-fourth of merchandise exports. Industry is a growth sector that has been largely responsible for the country's transition from a self-contained agricultural economy to an urban society intertwined with  - 8 - the outside world. Adequate natural resources, human skills available at a reasonable cost, entrepreneurial initiative and Government policies have all contributed to industrial progress. 24. Industrialization started after World War II with the aim of import substitution. By 1967, domestic production supplied the local market with most consumer goods, about two-thirds of intermediate products and well over one-half of capital goods. From then on, the Government adopted a set of more consistent policy measures to promote exports of industrial products, with a view to lessening the country's dependence on external earnings from coffee. Some of these measures refined the incentives existing previously, like tax rebates and duty exemption for inputs imported for use in export products; but the most important and successful policy measure was the introduction of frequent adjustments of the exchange rate, by virtue of which the pace of peso depreciation fully reflected differences between domestic and foreign price increases. 25. The results were spectacular. Investment in industry rose rapidly. Between 1968 and 1974, value added in the industrial sector grew at 8.6% per annum. Manufactured exports expanded from US$40 million to nearly US$390 million and, in 1974, earned the country more foreign exchange than coffee. The relative importance of the main subsectors - consumer goods, intermediate products and capital goods - did not change much; consumer goods continued to make up over one-half of the output. However, shifts occurred within the sub- sectors. Textiles and garments increased at the expense of food and beverages; chemicals and non-metallic minerals, both important exports, expanded rapidly; and mechanical machinery developed strongly from a relatively low base. The export promotion policy was accompanied by a gradual reduction in protective tariffs. During the 1968-74 period, effective protection averaged about 30% and at that level the manufacturing sector demonstrated reasonable capacity to compete. The exceptions were some older industries, like passenger car assembly and certain electrical and household appliances, which remained highly protected, continued to produce on a small scale and were not internationally competitive. 26. In 1975 and 1976, industrial exports suffered from the world recession. They were also affected by a substantial reduction in the tax rebates for exporters prompted by budgetary considerations. The Government tried to offset the effect of the latter measure by providing exporters with credit on more generous terms. The Government also moved the exchange rate more rapidly in 1975 but made lesser adjustments in 1976 to counteract the monetary effects of further accumulation of foreign exchange reserves, arising from the coffee boom, and encouraged imports by reducing tariffs and other obstacles to trade. The sharp drop in exports in 1975 and the consequent slowing down of the rate of industrial investment did not unduly affect manufacturing output. Some of the dynamism was lost but domestic demand fired by the high price of coffee replaced the sluggish export sales; and the lull in investment led to a rapid utilization of spare capacity.  -9- Decentralization Policy 27. Because of the country's difficult topography, several regional markets have evolved in Colombia. Consequently, industrial activities are more decentralized than elsewhere in Latin America. Nevertheless, the three largest urban agglomerations, Bogota, Medellin, and Cali account for 60% of value added in manufacturing and 64% of industrial employment. The rapid growth of these major cities has raised problems of congestion and strained the capacity of public utilities and urban infrastructure. 28. Faced with these problems, in 1975 the Government launched a decen- tralization policy aiming at promoting industrial growth in the secondary urban centers. Direct foreign investment in new enterprises was prohibited in Bogota, Medellin and Cali; access to credit was facilitated for firms established outside these cities; and steps were taken to upgrade the infra- structure in the secondary centers. The Bank has supported this policy by helping to finance telecommunications, water supply systems and other municipal services. In addition, under the sixth DFC loan and again under the proposed loan, several features have been included to support industrial decentralization projects. Employment in Industry 29. Between 1968 and 1974, employment in manufacturing expanded from about 700,000 to about I million. The rapid growth was largely the result of increased employment in labor intensive subsectors, such as textiles, garments, footwear and mechanical engineering, all leading components of the export drive. In 1975-76, manufacturing employment increased more slowly; however, the ratio between output and employment growth remained approxi- mately the same, indicating that the employment generating capacity of the sector has not deteriorated. 30. Compared to many other Latin American countries, industrial wages in Colombia are fairly low. Some comparative advantage in labor costs may have been lost recently because of the slower adjustments in the exchange rate but Colombia still remains highly competitive in the Latin American context. While non-wage benefits have increased over time and practically caught up with wages proper, total labor costs per unit of output in manufacturing have not risen in real terms in the past few years. Industrial Finance 31. Colombia has a relatively well developed financial system, charac- terized by institutional specialization. It consists of a variety of financial entities, including commercial banks, public development banks, DFCs, agri- cultural and mortgage banks, savings and loan corporations, and mutual funds. In June 1977, commercial banks accounted for about 45% of total credit, and savings and loan corporations, together with public development banks and the DFCs, for another 35% irn roughly equal parts. In lending to industry, the  - 10 - commercial banks and the DFCs may supplement their funds by rediscounting loans to medium-size and small enterprises with the Industrial Finance Fund and loans to the larger enterprises with the Private Investment Fund. Both these rediscounting facilities are operated by Banco de la Republica. 32. Until 1974, the Government exercised a high degree of control over the financial system, influencing the amount of credit accruing to its various specialized segments. Agriculture, housing and the public sector were generally favored to the disadvantage of industry and commerce. Different interest rate ceilings were imposed on different transactions and the right to issue tax exempt or indexed debt instruments granted to one or another category of institutions. This distorted the distribution of funds within the system and led to the development of an active extra-bank market. The Government which assumed office in August 1974 took steps to reduce the extent of controls. Interest rates were gradually raised and rate differentials reduced. Tax exemption and monetary correction features were restricted, to bring yields into better balance with competing instruments and thus encourage trading in private corporate securities. Subsequently, in 1975, the DFCs were authorized to engage in short-term operations, issuing 90-day certificates of deposit and relending the funds to meet working capital needs of industry. These reforms stimulated the growth of financial savings, largely removed discrimina- tion among various categories of institutions and instruments, and - with inflation declining - brought about positive interest rates in real terms. 33. In the past 10-15 years, Colombian industry had to rely increasingly on borrowed funds to finance fixed assets and working capital. Equity finan- cing declined steadily. Depreciation allowances continued to be based on historical costs and have not reflected replacement values, which have risen rapidly with inflation; the tax system did not fully distinguish between real and inflation related profits; and retained earnings have shrunk owing to the tendency of many companies to pay out a high proportion of profits as dividends, to compensate shareholders for the effects of inflation. Moreover, the behavior of industrial stocks on the Bogota and Medellin stock exchanges provided no inducement to finance investment through new share issues. By 1975, industrial investment was financed to the extent of 65% by borrowing, to the extent of 30% by depreciation reserves and retained earnings, and to the extent of about 5% by increases in share capital. 34. Between 1974 and 1977, the proportion of credit made available to industry by the financial system expanded from 20% to 26% of the total. Commercial banks presently account for about 62% of credit outstanding to industry but the bulk of their lending is short term. Public development banks and the DFCs supply about 36% of industrial credit, four-fifths of it in medium- and long-term loans; they are the leading lenders for invest- ment in plant and equipment. The three public development banks, the Industrial Development Institute, the Corporacion Financiera Popular and the Corporacion Financiera de Fomento Agropecuario, are responsible for about 40% of lending to industry by all development banks. The 18 private DFCs handle about 60% of the total. Other sources of investment funds are foreign suppliers' credits and the extra-bank market, where short-term money may cost 3-4% per month.  - 11 - The Outlook for Industrial Investment 35. With strong internal demand and the recovery of Colombia's export markets, prospects for industrial expansion appear promising. The recent decline in manufacturing investment, and the consequent utilization of spare capacity, call for new investment to support additional production. To ensure the rate of growth, regarded as necessary, capital expenditure on fixed assets in the order of US$] billion equivalent per annum would be required in 1978-80. The DFCs participating in the Bank's loans for industrial develop- ment are likely to be called upon to finance approximately the same 10% to 12% of fixed investment in manufacturing as in the recent past. This would imply borrowing an amount of US$100-120 million equivalent per annum during 1978-80, or about US$300 million over the next two and a half years. The proposed loan of US$100 miLlion would represent one-third of this amount. Bank Role in the IndustriaL Sector 36. The Bank has extended financial assistance to Colombian industry for 15 years now. In 1963, it made a loan to Acerias Paz del Rio for a steel mill project. In the same year, it cooperated in the setting up within Banco de la Republica of the Private Investment Fund, which attracted financial support for industrial development from several members of the Consultative Group for Colombia. In the 10 years from May 1966 to March 1976, the Bank made six loans, totalling US$242.5 million, to Banco de la Republica for industrial investment by the DFCs. These loans were charac- terized by rapid commitment and smooth disbursement, evidencing both strong demand and efficient utilization. Meanwhile, in June 1972, the Bank granted to Colombia a US$60 million development program and export expansion loan, of which US$20 million was allocated to a large number of financial institutions (including the DFCs) for on-lending to agricultural and industrial enterprises engaged in producing minor exports. In January 1975 and September 1977, the Bank lent US$5.5 million and US$15 million, respectively, to Banco de la Republica for CF Popular to finance the establishment, expansion, renovation and relocation of small privately-owned industries. Finally, a loan of US$15 million for the Cartagena Industrial Export Processing Zone project was recently approved by the Executive Directors. Its purpose is to expand and diversify exports, as well as foster employment in one of the very poor regions of the country. 37. Through these operations, the Bank has made a contribution to the expansion of the industrial sector of the Colombian economy. However, indus- trial growth was not the only objective of Bank lending. The Bank has given support to the Government"s efforts to promote and diversify Colombia's manufacturing exports, and to spread the benefits of industrialization to the secondary urban centers throughout the country. In doing so, it aims increas- ingly at stimulating the establishment of medium-size and small privately- owned enterprises in the depressed regions of Colombia and at creating new employment opportunities iEor the poorer segments of the population.  - 12 - PART IV - THE PROJECT Background 38. The proposed loan would be the seventh made for industrial develop- ment in Colombia, with private development finance companies (DFCs) as inter- mediaries. It would raise the Bank's total lending for this purpose to US$342.5 million and would further stress certain features gradually introduced with the last three loans. 39. The first of the DFC loans dates back to 1966. It was made to Banco de la Republica, the central bank, for the use of the five original DFCs established in five major urban agglomerations between 1959 and 1964, with the aim of providing long-term capital to private industry. While Banco de la Republica was the Borrower, the Bank reserved for itself the approval and supervision of subloans made to the industrial enterprises and maintained a close working relationship with the DFCs. 40. In 1971, on the occasion of the fourth DFC loan, the Government proposed that the number of beneficiaries be expanded, so as to promote industrial growth in regions other than those where the original DFCs were operating. The Bank was receptive to the proposal, which coincided with the recommendation of the first operations evaluation mission to Colombia that the Bank should encourage a wider distribution of the loan proceeds, 1/ but decided that it would only be feasible if the Borrower would assume at least a part of the administrative burden: reviewing project appraisals, approving the subloans, and supervising the operations of the newly participating DFCs. This change in the role of Banco de la Republica took effect when the fifth loan was made in 1973, with the proceeds being available to seven DFCs. 41. Further changes followed in 1976 and shaped the nature of the sixth loan. Economic issues, like export performance and employment opportunities, were emphasized. The institution building efforts shifted from the DFCs to Banco de la Republica. Export and decentralization projects and projects sponsored by medium-size enterprises, were designated for preferential treat- ment. Incentives were also introduced for technological improvement of produc- tion processes. The number of participating DFCs was raised to eight. 42. In September 1977, Banco de la Republica approached the Bank for a further loan to assist the DFCs in the private sector in meeting the foreign exchange costs of productive industrial projects. An appraisal was carried out in Colombia in November/December 1977 and negotiations took place in Washington in May 1978 with a delegation headed by His Excellency Virgilio Barco Vargas, Ambassador of Colombia to the United States. The delegation comprised Mr. Antonio Gutierrez, representing Banco de la Republica, and the Presidents of the five original DFCs. A Staff Appraisal Report is being circulated to the Executive Directors separately. 1/ OED report entitled "Bank Operations in Colombia, An Evaluation" (Report No. Z-18) of May 25, 1972.  - 13 - 43. The present approach to lending for industrial credit programs reflects the suggestions made in OED performance audit reports of October 1974 and October 1977 on the first four DFC loans. Broader industrial and financial sector issues are being emphasized. The Bank is supporting Government policies of expanding industrial exports to lessen Colombia's dependence on coffee and relax further the foreign exchange constraint; and Government endeavors to raise employment in the smaller urban centers by assisting in the establishment and expansion of private medium-size and small industries. The Bank is further striving to ensure that the DFCs are provided with adequate domestic resources for medium- and long-term lending for industrial plant and equipment, and is beginning to engage in a dialogue with the Government on possible capital market reforms that might favor investment in industry. The institutional aspects of DFC projects, which deeply concerned the Bank in making its early loans, are presently of somewhat lesser relative importance; and the institution- building efforts now focus on the Department of Development Credit of Banco de la Republica, rather than on the original five DFCs directly. At the same time, more DFCs may be brought into the system. Objectives 44. Building on the results of the sixth DFC loan, the proposed loan is designed to: first, help finance projects fitting into the framework of the Government's export: promotion and regional decentralization policies, and with respect to other projects give preference to those put forward by medium-size and small enterprises; second, strengthen the capacity of Banco de la Republica to review projects and exercise supervision over the activities of the newly participating DFCs; and, third, support the DFCs as sound long- and medium-term lending institutions, capable of securing additional share capital and debt resources to finance industrial investment. The proposed loan would assist the Government's efforts of promoting labor intensive projects (the Government defines as "labor intensive," projects with an investment cost per job not exceeding US$25,000 equivalent) and projects sponsored by "open companies" (i.e. companies in which 30% of share capital is in the hands of shareholders holding each no more than 2% of the shares). The objective of employment creation is implicit in the preference given to projects put forward by medium-size and small enterprises; and many export- oriented enterprises borrowing the proceeds of the proposed loan would be "open companies." At least 200 industrial projects are expected to receive financing under the proposed loan. Project Components and Relending Terms 45. About US$85 million of the proposed loan would be used by the participating DFCs for providing privately-owned industrial enterprises with long-term loans to meet the foreign exchange cost of productive projects in the subsectors of manufacturing, agro-industry, mining and tourism. As under the sixth loan, and in accordance with the objectives of the proposed loan, special attention would be given to export 1/ and decentralization 2/ projects, 1/ Export projects are defined as generating net foreign exchange earnings within five years of starting operations. 2/ Decentralization projects are those located outside of Bogota, Medellin and Cali, and their zones of influence.  - 14 - and preferential treatment would be extended to medium-size and small enter- prises, whose total assets did not, as of December 31, 1977, exceed Col$150 million. 1/ Enterprises presenting export or decentralization projects for financing would qualify for peso denominated loans at 25% interest, irrespec- tive of the amount of their total assets. The peso loan option would also be available for other productive projects sponsored by the smaller enterprises. On the other hand, the larger companies would have to borrow with a dollar clause at 10-3/4% interest, and assume the peso/dollar exchange risk, in order to finance projects outside the export and decentralization categories. 46. The proposed loan would seek to improve the distribution of indus- trial credit through a set of ceilings on the use of Bank funds, namely: US$4 million of the proceeds of the proposed loan for any group of related enterprises; and US$4 million in the aggregate of the proceeds of the proposed loan and the previous loans for any group of related enterprises, with the exception of companies presenting export or decentralization projects where the ceiling would be US$8 million. 47. Up to US$10 million of the proposed loan would be used by the DFCs to make minority equity investments in industrial enterprises undertaking export or decentralization projects, and in medium-size enterprises carrying out all types of investment projects. This use of Bank funds would go some way towards strengthening the capital structure of selected industrial firms. For 10-15 years now, Colombian industry has found it very difficult to attract share capital because real profits were declining in an inflationary environ- ment. (An equity financing component of US$5 million has already been included in the sixth DFC loan; about one half of it has been used by two companies sponsoring important projects in the depressed northern coastal region.) Funds for minority e'quity investments would be relent to the DFCs in pesos with grace periods longer than those for subloans and at interest rates varying from 20% to 22% 2/, taking into account economic merit and project risks as assessed by Banco de la Republica. Equity investments in any single enterprise, or group of related enterprises, would not exceed US$2 million equivalent in the aggregate of the proceeds of the proposed loan and the sixth DFC loan. 48. The use of Bank funds for equity investments would be in line with the recent resolution of Colombia's Monetary Board requiring the DFCs to hold at least 10% of their assets in the shares of new or reorganized companies. In this context, the Bank has been informed by the Monetary Board that it would consider extending beyond October 31, 1978 the present time limit for compliance with the resolution for those DFCs participating in the proposed loan which have not yet met the 10% target. A longer period for compliance 1/ Approximately equivalent as of December 1977 to Col$100 million under the sixth loan. 2/ Additional loan amounts used for equity investments would carry standard subloan terms.  - 15 - with the resolution would ensure a more complete appraisal of the companies, in which the equity funds would be invested, and a better assessment of their earning prospects. 49. Up to US$5 million of the proposed loan would be used to finance tech- nology improvement and pollution control projects. (Technology improvement was introduced in the sixth loan as an experimental component; by the end of 1977, US$1.4 million had been used for industrial quality control and laboratory test equipment, and for transfers of relatively advanced technology, for 15 projects producing mainly chemicals and basic metals.) A promotional effort will be made to encourage investment in technological improvements, which would contribute to making Colombian exports more competitive in foreign markets. Subloans would be in pesos, at 20% interest, for a maximum term of five years. They would be subject to a limit of US$250,000 per project. Pollution control equipment was included in the technology component of the sixth loan during the commitment period. Under the proposed loan, the preferential interest rate of 20% would be applied to subloans for control of pollution caused by machinery and equip- ment installed before the end of 1977; these subloans would have a maximum term of 10 years. In new projects, pollution control equipment would be financed as part of the investment and at an interest rate of 25%. No more than US$500,000 per enterprise would be used for pollution control at preferential rates. 50. Under the proposed loan, the limit for subloans not requiring the Bank's prior approval (the "'free limit") would be as follows: (i) US$1.5 million equivalent for projects submLitted by the five original DFCs, which participated in the Bank's loans since 1966; (ii) US$500,000 for projects appraised by the two DFCs which were added under the fifth and sixth loans; (iii) US$250,000 for projects presented by the DFC, which participated for the first time in the sixth loan on a limited basiLs, and by any new beneficiary; and, (iv) US$500,000 for all projects involving equity investment. However, Banco de la Republica would ask for the Bank's prior approval for the first two projects presented by each newly participating DFC. Technology improvement and pollution control projects would not call for prior approval by the Bank which, however, would monitor the use of funds. 51. Summary of Re-lending Terms ---------- Interest (%) --------- Maximum Terms (Years) 1/ Purpose: Dollar Funds Peso Funds Maturity Grace 2/ To Sub- To Sub- To DFC borrower To DFC borrower Sub-loans 8 10.75 21-22 3/ 25 15 3 Equity Investments - - 20-22 not appl. 15 5 Technology Improvements - - 16 20 5 2 Pollution Control - - 16 20 10 2 1/ Repayment terms are idLentical for sub-borrowers and DFCs, except in case of equity investments. 2/ Included in maturity. 3/ 21% for decentralization projects and 22% for projects located in Bogota, Medellin and Cali, and their zones of influence.  - 16 - The interest rate spread accruing to the DFCs on peso subloans would be 4% for decentralization projects and 3% for projects located in Bogota, Medellin and Cali, and their zones of influence. As about 40% of the amount of the loan is expected to be applied to decentralization projects, these spreads should favorably influence the profitability of the DFCs, which has declined in the inflation climate of the past few years. Under the sixth DFC loan, about 80% of the proceeds were committed with a spread of 3%. 52. Present estimates of the rate of inflation in Colombia in the next 2-3 years (i.e. during the commitment period of the proposed loan) point to a gradual decline. The end of the boom in coffee prices, strict control over the money supply and plentiful food supplies resulted in checking price increases in the latter part of 1977. In the first four months of 1978, prices rose at an annual rate of 16.5%, and although the price rise for the full year will probably exceed this rate due to seasonal factors, infla- tion is likely to remain below 23%. Subsequently, inflation is expected to decline gradually to about 18% in 1980. Based on these estimates, the real interest rate would amount to about 2% on subloans for which funds were committed in 1978 and would be higher on subsequent commitments. Neverthe- less, as such estimates are inevitably conjectural, to ensure the maintenance of positive real rates of interest during the commitment period of the loan, the draft Loan Agreement provides for a review of the interest rates on subloans denominated in pesos. This review would be carried out with the Guarantor, the Borrower and the beneficiaries twelve months after the signing of the proposed loan or upon the commitment of 40% of the loan amount for peso subloans, whichever occurs earlier (Section 3.04(b)(xiii) of the draft Loan Agreement). Moreover, the Subsidiary Loan Agreements between Banco de la Republica and the participating DFCs would require that, in the event of inflation accelerating beyond 23% per annum, measured on the basis of a six- month moving average, the DFCs refrain from making further commitments out of the proceeds of the loan until an appropriate interest rate has been agreed to between the Government, the Bank and Banco de la Republica (Section 3.04(b) (xii) of the draft Loan Agreement). Procurement and Disbursement 53. Procurement would conform with standard practice under DFC loans. The DFCs require their clients to obtain quotations from a reasonable sample of qualified suppliers for major items of equipment. Banco de la Republica monitors closely the purchases made under its loans, in order to ensure that the items are reasonably priced and appropriate for their intended purpose. 54. The loan proceeds would be disbursed for: (i) the total foreign exchange cost of imported goods; (ii) the c.i.f. cost of imported goods purchased off-the-shelf, or 60% of expenditures for such goods whenever the c.i.f. cost cannot be ascertained; (iii) 35% of ex-factory price of locally produced equipment and of construction costs; and, (iv) 75% of expenditure on technology improvement. The above percentages reflect average foreign exchange costs determined mainly by a review of past DFC loans to Colombia and are in line with comparable figures elsewhere. The proposed loan is expected to be fully disbursed by December 31, 1982.  - 17 - The Role of the Borrower 55. The proposed loan calls for consistent strengthening of Banco de la Republica supervision over the DFCs participating in the Bank's loans. The functions of Banco de la Republica in the context of Bank lending for the DFCs have become much more substantial during the past five years. In the first four loans, Banco de la Republica played a rather limited role: it channeled the loan proceeds to the five participating DFCs and screened the projects to make sure that they conformed to the Government's development priorities. The original five Corporaciones Financieras: Colombiana, Nacional, de Caldas, del Valle and del Norte, all counting the IFC among their shareholders, had conducted their operations under close Bank Group supervision and have gradually achieved satisfactory standards of project appraisal and follow-up, and of operational decision making. 56. As additional DFCs joined the program in the fifth loan, the func- tion of guiding and assisting them became the responsibility of Banco de la Republica. Furthermore, Banco de la Republica assumed responsibility for the review and approval of all projects appraised by the new DFCs and of the large projects submitted by the original five DFCs. In future, Banco de la Republica is expected to be even more intimately associated with the affairs of the participating DFCs, helping the new DFCs that join the program to up- grade their appraisal and supervision capabilities as well as their disburse- ment procedures. 57. Development banking activities of Banco de la Republica are entrusted to its Department of Development Credit (DDC). DDC administers the official lines of medium- and long-term credit available primarily to agriculture and industry, including Bank DFC loans. In the past five years, DDC has achieved satisfactory proficiency in reviewing industrial projects appraised by the DFCs, owing in part to a Bank-supported training program, and has assigned to this task competent staff in adequate numbers. However, the rapid transfer and promotion of high-ranking personnel in charge of supervision of the DFCs has affected the performance. During the negotia- tions, the Bank was informed that Banco de la Republica had set up a unit within DDC, exclusively concerned with the supervision of DFC activities (Section 4.05(b) of the draft Loan Agreement). The Bank has also agreed with Banco de la Republica on a revised statement of operating policies and procedures to be followed by DDC in discharging the responsibilities of Banco de la Republica in the context of the proposed loan. A draft of that statement is annexed to the Staff Appraisal Report. The Participating DFCs 58. Eight DFCs wouldl be the beneficiaries of the proposed loan from the start and additional ones may join during the commitment period. Of the eight, the five in which 1FC is a shareholder have participated in the Colombian DFC loans from the beginniLng of the program in 1966; two, CF de Occidente and CF de Santander, were full participants under the fifth and sixth loans; and the eighth, CF Aliadas, became an intermediary under the sixth loan on a limited basis. The seven DFCs are located in seven regions of Colombia, marked by differences in natural resources, human skills, and business tradition. The eighth, CF Aliadas, was established three years ago in Medellin, where CF Nacional has been in existence since 1960.  - 18 - 59. The eight DFCs, which would participate from the start in the proposed loan, are predominantly Colombian-owned. The shares of the five original participants are relatively widely held, with the exception of one in which the National Coffee Federation holds the majority of stock; the three more recent participants are more closely held. To check any tendency of some majority shareholders to channel resources of some new DFCs primarily to other companies which they control, total financial exposure in any group of related companies would be limited under the proposed loan to 50% of the equity of each DFC. This would complement the 25% exposure limit per enterprise, contained in the policy statements of all DFCs. 60. The DFCs have capable and experienced management and staff. Some recent changes in top positions are not expected to affect significantly the effectiveness of operation, with the exception of CF de Occidente, where changes in senior management have been frequent and may have affected the quality of operational decisions. Banco de la Republica has reviewed the situation and its conclusions have been embodied in a "plan of action". Sufficient progress in carrying out the plan of action would be a condition of loan effectiveness for CF de Occidente (Section 6.01(c) of the draft Loan Agreement). 61. In order to contribute to the most efficient use of scarce resources, the Bank has consistently encouraged the DFCs to improve their project appraisal. In appraising projects, the DFCs aim at ensuring technical, financial and economic viability. Under the sixth loan, economic rate of return calculations based on "border prices" were required for all projects calling for subloans in excess of US$250,000; this requirement would be continued under the proposed loan. Project appraisals prepared by the original five DFCs are soundly based and thorough. Technical and economic evaluation has been strengthened; marketing analysis has improved but remains relatively weaker. Project execu- tion is being supervised effectively, particularly in the case of projects financed by the Bank and Banco de la Republica. The quality of appraisals and supervision carried out by the three newer DFCs is not yet fully satis- factory and calls for close review and upgrading by Banco de la Republica. 62. At the end of September 1977, the seven full participants in the Bank's sixth loan held loan portfolios totalling about US$300 million equiva- lent. This amount represented about 25% of credit outstanding to industry by the financial system (excluding extra-bank lending). About 80% of the total had benefitted manufacturing, and the rest mining, agro-industry and service industries; and distributed by region, about 75% had gone to enter- prises located in and around Bogota, Medellin and Cali. Short-term loans accounted for 27% of the total, a three-fold increase in less than three years. Investment in equity has proceeded slowly and cautiously because of the risks involved, the difficulty of selling shares in Colombia's thin stock market and the long gestation period for new enterprises. 63. Between December 1974 and September 1977, the composite debt/equity ratio of the seven DFCs rose from 4.3:1 to 5.6:1. This trend is likely to continue because of the difficulties experienced by the DFCs in securing additional share capital. Nevertheless, with the exception of CF de Occi- dente, the DFCs still have the capacity to assume additional debt while  - 19 - maintaining adequate debt service ratios and have stayed within their debt/ equity limits set under the sixth loan, which also provided for a second limit for short-term operations authorized in 1975. The two debt/equity limits would be consolidated into a single limit under the proposed loan and supplemented by a current assets/equity ratio which focuses on operations rather than resources. This would facilitate the efforts of the DFCs to mobilize short-term resources that might be used for medium-term lending, provided an appropriate terms transformation mechanism is devised (paras 67-69). The consolidated debt/equity ratios would be set at 9:1 for the original five DFCs, at 7:1 for CF de Santander and del Occidente, and at up to 6:1 (depending on the recommendation of Banco de la Republica) for CF Aliadas and any new participants. The current assets/equity ratio would be a uniform 4.5:1 for all DFCs; it would ensure that the DFCs remain principally term lending institutions. 64. On the whole, the loan and equity portfolios of the eight DFCs are sound. Overall arrears have remained at acceptable levels and only small write-offs are foreseen. 65. In addition to the eight previous participants, there are ten privately controlled DFCs in Colombia. Some of them have the potential to become effective development banks and may qualify for participation on a limited basis, i.e. with access to US$2 million each of the proceeds of the proposed loan, if they are financially sound and are prepared to engage in an institution-building process designed to develop their capabilities as project financing institutions. Some might later join as full participants, if they are willing and able to comply with the Bank's normal institutional standards as regards project appraisal and supervision. The Bank is interested in encouraging participation of additional DFCs to maximize the diversifica- tion of beneficiaries among regions and enterprises. While eight of the ten recently established DFCs operate in Bogota, Cali and the Medellin area, two were set up in parts of the country where there are no other DFCs and where economic activities could be diversified through their intervention. 66. The fact that only three additional DFCs became participants in the past five years can be ascribed to several reasons. Not all DFCs have achieved the financial strength necessary to qualify even on a limited basis. The 4:1 debt/equity limit was considered to be low by potential participants. The relatively small allocation of US$750,000 for each DFC joining on a limited basis was not very attractive. Moreover, Banco de la Republica needed time to itrain and assign adequate staff to provide assistance and supervision to the new DFCs. It would seem, however, that the most important deterrient to participation was the authority given to the DFCs in 1975 to engage in short-term borrowing and lending to help industry meet its working capital requirements. The new DFCs found that they could expand rapidly on the basis of these short-term transactions, which were also quite profitable. Consequently, they had little incentive to develop the staff and expertise needed to satisfy the criteria of Banco de la Republica and the Bank for participation in longer term credit lines. Nevertheless, the proposed substantial increase in the allocation of the loan proceeds and the much higher debt/equity limit allowed, may provide a meaningful inducement to participate in the proposed loan.  - 20 - Mobilization of Local Funds 67. As was the case in the context of the sixth DFC loan, each DFC participating in the proposed loan would commit itself in a Subsidiary Loan Agreement with Banco de la Republica to make all reasonable efforts to secure locally, through debt instruments, share capital and retained earnings, on an annual basis, resources equivalent to the part of the net loan proceeds disbursed by it (Section 3.04(b)(ix)A of the draft Loan Agreement). An interim target for the mobilization of local funds by all participating DFCs between June 30, 1978 and December 31, 1979 has been set at Col$1.5 billion (Section 3.04(b)(ix)B of the draft Loan Agreement). These provisions of the Subsidiary Loan Agreements would be supported by a commitment of the Government to make all reasonable efforts to enable the DFCs to raise in the domestic capital markets, and in foreign capital markets, funds appropriate for medium- and long-term industrial financing. 68. While the DFCs were successful in meeting resource mobilization targets under the sixth loan, it will not be easy in the near future to raise significant amounts of local funds with maturities long enough to finance fixed assets. The proportion of total resources of the seven participating DFCs (excluding CF Aliadas) mobilized locally through debt instruments increased from 10% in December 1974 to 21% in September 1977, but this was mainly due to the rapid expansion of short-term borrowing since 1975. The supply of medium- and long-term funds to the DFCs did not expand in real terms. The main obstacles were the uncertainty created by a flare-up of inflation in 1976/77 and a structure of interest rates insufficient to cover the risk of holding medium- and long-term debt obligations. During the same period, total equity of the seven DFCs increased in nominal terms, principally through retained earnings and reinvestment of dividends by shareholders, but declined as a percentage of total resources. While the DFCs had to maintain high dividend pay-out ratios in order to qualify for tax exemption on their own dividend earnings, they were unable to attract significant amounts of fresh share capital due to low real profits. The measures being undertaken under the proposed loan to increase their profitability and the projected decline in the rate of inflation over the next few years should improve the DFCs prospects for mobilizing more substantial share capital resources in the future. 69. In view of the limited prospects for raising adequate medium- and long-term funds in the domestic capital market, the Bank has assisted the DFCs in carrying out a study exploring various possibilities of securing medium- and long-term resources. The study centered on liquidity mechanisms to enable the DFCs to use a proportion of their short-term funds in medium- term lending to industry, on methods of raising long-term funds from the public, and on related reforms encouraging the development of a more effec- tive capital market. Its findings and recommendations will shortly be presented to Banco de la Republica for consideration. The progress made by the DFCs in raising domestic resources, and the mechanism for use of these resources in medium- and long-term lending to industrial enterprises, would be reviewed and analyzed by the Guarantor, the Bank and the Borrower at the time (specified in para. 52) of the review of the interest rates on subloans denominated in pesos (Section 3.04(b)(ix) of the draft Loan Agreement).  - 21 - Simultaneously, the parties would analyze the progress made in resolving any remaining problems asscociated with the 1972/73 issue by the five original DFCs of medium-term bonds, of which a part is presently held by a support fund administered by Banco de la Republica. Co-financing 70. The proposed loan could serve as a catalyst to help the DFCs borrow additional external long-term resources required for industrial investment (see para 35) from foreign commercial banks on better terms than might be possible otherwise. It would also provide a good opportunity for introducing the DFCs, particularly the more mature ones, to the international capital market; the five original D)FCS are currently exploring possible co-financing arrangements for a private loan of about US$20 million. Should a co-financing materialize, we would return to the Executive Directors with full details regarding the proposed private loan and appropriate recommendations for amendments to the Bank's Loan Agreement. Benefits and Risks of the Project 71. The proposed loan is expected to help finance some 200 industrial projects, thereby increasing employment and output, particularly of exports. Based on the experience with past DFC operations in Colombia, these projects should result in about 13,000 additional direct jobs, 1/ with an indirect employment impact in the order of 50% of the direct one; and they are ex- pected to generate exports in the order of US$150 million annually. It is probable that about 40% of the loan proceeds would be applied to decentrali- zation projects and about 30% would benefit medium-size and smaller enterprises. The economic rate of return on most projects is expected to be in the range of 15-40%. The proposed loan would also help up-grade the competitiveness of Colombian exports through technological improvements and help reduce pollution caused by existing industrial plant and equipment. In addition, the loan should bring about institutional improvements in the work of the Department of Development Credit of Banco de la Republica and should help the DFCs to increase their resources and profitability. 72. The proposed project, as designed, does not involve unusual risks in achieving its major objectives. If - contrary to expectations - the rate of inflation were to accelerate again, the arrangements for a review of interest rates on peso subloans should act as a safeguard for maintaining the real interest rate and in this way reduce the possibility of resource misallocation. The experience of the participating DFCs in meeting resource mobilization targets under the sixth loan, and the efforts now being made in this respect, make a short-fall in local funds less probable and, therefore, the proceeds of the loan should be committed/disbursed as expected. 1/ At an estimated cost per job of about US$27,000. The cost per job created under the first four DFC loans had been estimated at the time of project appraisal by the DFCs to average US$25,000. Figures computed after project completion and start of operations indicated a higher direct employment impact, with the cost per job averaging about US$14,000 under these loans.  - 22 - PART V - LEGAL INSTRUMENTS AND AUTHORITY 73. The draft Loan Agreement between the Bank and Banco de la Republica, the draft Guarantee Agreement between the Republic of Colombia and the Bank, and the Report of the Committee provided for in Article III, Section 4(iii) of the Articles of Agreement are being distributed to the Executive Directors separately. 74. The draft agreements conform to the normal pattern for loans for DFC projects. Special conditions of the loan are listed in Section III of Annex III. After the normal conditions of effectiveness regarding the Borrower and the Guarantor are fulfilled, the Loan Agreement would become effective with respect to each DFC upon fulfillment of the conditions affecting such DFC, independently of the status of the conditions affecting the participation of the remaining DFCs. The Loan Agreement would, however, become effective in respect of CF de Occidente only after it has demonstrated that it has made sufficient progress in the execution of its "plan of action" (see para 60). 75. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECOMMENDATION 76. I recommend that the Executive Directors approve the proposed loan. Robert S. McNamara President Attachments Washington, D.C. June 2, 1978  - 23 - AE Page 1 of 4 COLOMBIA - SOCIAL INDICATORS DATA SHEET LAND AREA (THOU KM2) ----------------------------------------------- TOTAL 1138.9--- COLOMBIA REFERENCE COUNTRIES (1970) TOTAL 1238.9 MOST RECENT AGRIC. 224.8 1960 1970 ESTIMATE TURKEY BRAZIL MEXICOt* _- -- -_- -- -- -- -_- -- - --- -_- -- - --_ -- - -- _- ---- -- - ___-_- ----- -_-_- _-- -- -- --- GNP PER CAPITA (USS) 210.0 350.0 640.0 500.0 5S0.0 690.0 POPULATION AND VITAL STATISTICS POPULATION (MID-YR. MILLION) 15.4 20.6 24.2 35.6 92.8 50.4 POPULATION DENSITY PER SQUARE KM. 14.0 18a0 21.0 46.0 11.0 26.0 PER So. KM. AGRICULTURAL LAND 71.o. 93.0 108.0 65.0 49.0 52.0 VITAL STATISTICS CRUDE BIRTH RATE (/THOU, AV) 46.1 44.3 40.6 40.6 38.4 43.8 CRUDE nEATH RATE (/THOU,AV) 14.7 11.0 8.S 14.4 9.9 10.2 INFANT MORTALITY RATE (/THOU) 100.0 /a 70.0/a . 15320/a 110.0 66.5 LIFE EXPECTANCY AT BIRTH (YRS) 54.' - 58.5 - 60.9 54.4 59.4 62.4 GROSS REPRODUCTION RATE 3.2 3.2 3.1 2.6/b,C 2.6 3.1 POPULATION GROWTH RATE (%) TOTAL 2.9 2.9 2,8 2.5 2.9 3.5 URBAN 6.0/b 5.5/b 4.9 4.9/d 5.0 4.8 URBAN POPULATION (% OF TOTAL) 53.0/c 60.3 70.0/a 38.7 56.0 56.7 AGE STRUCTURE (PERCENT) 0 TO 14 YEARS 46.15/c 46.6 44.1 41.7 42.0 46.2 15 TO 64 YEARS so.4/ 50.4 52.7 54.0 55.0 50.1 65 YEARS AND OVER 3.0/t 3.0 3.2 4.3 3.0 3.7 AGE DEPENDENCY RATIO 1 ./c 1.0 0.9 0.9 0.8 1.0 ECONOMIC DEPENDENCY RATIO l .13 /E 1.S/c 1.6//b 1,1/e 1.5 2.0 FAMILY PLANNING ACCEPTORS (CUMULATIVE, THOU) 0.5 306.9 955.1 250.0 55.5 USERS (% OF MARRIED WOMEN) .V .. 31,0 S.2 1.6 EMPLOYMENT TOTAL LABOR FORCE (THOUSAND) 5100.0/c 6200.0 6800.0 14000.0/f 29400.0 13000.0 LABOR FORCE IN AGRIC:LTURE (%) 47.0/-7 39.0 ,, 63.4 40.4 45.0 UNEMPLOYED (% OF LABOR FORCE) B.O/d e 7.0 10.2/c 11.5 / 7.5 INCOME DISTRIBUTION _ _ ----- - --_ -- _ _ X OF PRIVATE INCOME RECOD BY- HIGHEST 5% OF HOUSEHOLDS 41.2/c f 31.9/d 27.2 32.8 /h 35.0/a 27.2 HIGHEST 20% OF HOUSEHOLDS 67.7 c 60.1/i 54.4 So.6 /h 62.0/a 58.3 LOWEST 20% OF HOUSEHOLDS 2.1 3.5/i 5.2 2.9 /jh 3 3 LOWEST 40% OF HOUSEHOLDS 6.8/ 10S /. 14.3 9 4 100,